Equity investments in funds under FRTB SA a persistent challenge

While Canada and Japan are leading the way & gone live with FRTB with none of the participants applying for IMA. With the deadline to comply with FRTB is just around the corner in other major jurisdictions, we observe similar trends where banks typically prefer to adopt SA first, become compliant with the regulatory requirement and simultaneously explore IMA viability.

Though the SA infrastructure has been in place for quite some time, banks need to now optimise and build governance and controls around SA numbers as industry is moving from mere reporting to putting aside capital.

To be sure, FRTB SA implementation faces several challenges due to operational complexity and conservative capital requirements.

This paper focuses only on the challenge of treatment of equity investment in funds (EIIFs).

The use of funds either directly or via derivative contracts allows investors, asset managers and bank trading desks to obtain (or hedge) diverse exposures in ways that are operationally efficient and cost effective.

FRTB has proposed methodologies for handling EIIFs under SA as well as IMA. Under SA, four different methodologies can be used: the look-through approach (LTA), index-based approach, mandate-based approach and fallback approach. Each approach faces its own set of challenges such as data sourcing, operational and computational infrastructure, which will result in different capital requirements.

But under IMA, only LTA can be used.

Also, all methods, except the fallback approach, for EIIFs under SA are complex and require large amount of data frequently, based on the funds mandate and constituents with weightage. It also demands substantial improvement in infrastructure to consume and generate risk.

In contrast, the fallback method is punitive. The disproportionate capital requirements for funds under this method will force banks to trim down positions, sucking out liquidity from the market.

Let us look at the alternate viable options the banking industry is proposing to counter this.