The optimal desk coverage ratio and the Basel III FRTB internal models approach

Abstract

The implementation of the internal models approach under the Fundamental Review of the Trading Book (FRTB) is a contemporary topic among regulators and the global banking industry, considering the pending finalisation or implementation of localised standards in some major jurisdictions including the US, UK and European Union (EU). This paper proposes a simple intuitive approach to assess the joint impact and sensitivities of Basel III capital Output Floor and minimum desk coverage threshold on the internal models approach (IMA) application. In particular, the paper introduces the optimal desk coverage ratio as a metric to quantify the optimal proportion of the trading desks that a bank may cover under IMA to maximise capital savings given the constraints of Output Floor, minimum desk coverage threshold and other factors. The paper also presents Japan and Canada, where FRTB is in force, as live examples for analysis using actual bank-level regulatory disclosures from ten major banks. The paper illustrates the coverage cliff effect and concludes that the IMA application from a capital savings perspective is heavily driven not only by Output Floor and minimum desk coverage threshold but also by credit and market risk weightings and their respective capital saving ratios from internal models. This article is also included in The Business & Management Collection which can be accessed at https://hstalks.com/business/.