Time for COOs and their Desk Heads to think strategically
The feature that puts the “fundamental” into FRTB is that the capital charge for market risk will not be applied evenly across the trading desks. All desks will follow the new standard approach (SBA) but some will seek capital relief from internal model approval (IMA).
The new capital regime forces each desk head to decide whether they can adapt their style to survive under the more onerous SBA regime or invest in analytics, process, and technology to shoot for IMA. At this junction, they need to have a frank conversation with their COO on what their competitive advantage really is – client penetration, market/flow share, structuring capability – and which products they intend to provide and what risk they will warehouse. The quality of revenue and inventory turnover needs to be measured and balanced against the cost of ownership under SBA and IMA capital regimes.
Each desk needs to dig deep to analyse the drivers of revenue from portfolio management and if it does not reach a minimum threshold, then running near-zero deltas might be the most cost-effective strategy compared to shooting for IMA. If the desk is unable to close out their deltas at the end of each day, then a narrowing of product/underlying/tenor should be a priority.
A desk on IMA will have a lower capital charge and higher costs running to cope with more complex processes and higher computational efforts. The benefits are not guaranteed given the continuous P&L eligibility and VaR back-tests as well as add-ons when risk factors becoming unobservable.
The Risk department has traditionally delivered the new regulatory methodology based on data sent from the back-end of the FO and then provide results to the desk head. The deep analysis described above pushes the FO quants to build their own tools that operate at the pricing model, risk factor level as well as aggregating for impact analysis. The regulators are expecting that for IMA, desk head must evidence full control of how their risk positions are priced, hedged as well as risked and disclosed, all within the context of a well-defined product and trading strategy.
The logical conclusion is for firms to move to the “Strat Model” where the FO Quants take ownership of risk methodologies such as VaR, ES, and DRC. Originated by Goldman’s and adopted by a number of Tier 1 banks, this is a reflection that the devil in risk calculations is not the methodology, but the micro-decisions made around risk factors and risk normalisation. All these should be done by those closest to the positions and the Risk department can adopt their challenger role.
FO quants need to develop tools that support the analysis under a framework that adheres to Technology’s mandated controls otherwise chaos will ensue. Most tools will be specific to individual desks, but some should be picked up by Technology and industrialised for users across Risk and Finance. This Darwinian approach to picking useful functional tools that support IMA will be a much more agile and less costly approach to delivering FRTB compared to previous regulatory change programs and more importantly enables the COO to ask the searching questions around how and where desks make money.
The new capital regime forces each desk head to decide whether they can adapt their style to survive under the more onerous SBA regime or invest in analytics, process and technology to shoot for IMA. At this junction they need to have a frank conversation with their COO on what their competitive advantage really is – client penetration, market/flow share, structuring capability – and which products they intend to provide and what risk they will warehouse. The quality of revenue and inventory turnover needs to be measured and balanced against the cost of ownership under SBA and IMA capital regimes.
Each desk needs to dig deep to analyse the drivers of revenue from portfolio management and if it does not reach a minimum threshold, then running near-zero deltas might be the most cost-effective strategy compared to shooting for IMA. If the desk is unable to close out their deltas at the end of each day, then a narrowing of product/underlying/tenor should be a priority.
A desk on IMA will have a lower capital charge and higher costs running to cope with more complex processes and higher computational efforts. The benefits are not guaranteed given the continuous P&L eligibility and VaR back-tests as well as add-ons when risk factors becoming unobservable.
The Risk department has traditionally delivered the new regulatory methodology based on data sent from the back-end of the FO and then provide results to the desk head. The deep analysis described above pushes the FO quants to build their own tools that operate at the pricing model, risk factor level as well as aggregating for impact analysis. The regulators are expecting that for IMA, desk head must evidence full control of how their risk positions are priced, hedged as well as risked and disclosed, all within the context of a well-defined product and trading strategy.
The logical conclusion is for firms to move to the “Strat Model” where the FO Quants take ownership of risk methodology such as VaR, ES and DRC. Originated by Goldman’s and adopted by a number of Tier 1 banks, this is a reflection that the devil in risk calculations is not the methodology, but the micro-decisions made around risk factors and risk normalisation. All these should be done by those closest to the positions and the Risk department can adopt their challenger role.
FO quants need to develop tools that support the analysis under a framework that adheres to Technology’s mandated controls otherwise chaos will ensue. Most tools will be specific to individual desks, but some should be picked up by Technology and industrialised for users across Risk and Finance. This Darwinian approach to picking useful functional tools that support IMA will be a much more agile and lest costly approach to delivering FRTB compared to previous regulatory change programs and more importantly enables the COO to ask the searching questions around how and where desks make money.