Portfolio Diversification in FRTB

FRTB impacts financial institutions across all functions as it poses operational, methodology and technology challenges. To meet the requirements financial institutions will need to rethink their business and technology strategies with a view to streamlining their processes and architecture.

FRTB program design structure will be influenced by how firms are set up internally. If executed correctly, financial institutions can benefit from operational and capital efficiency gains, and enhance the way it manages risk. Financial institutions that adopt a more disciplined and cohesive approach in executing it strategy for front office and IT operations will help shape its prospects in the post FRTB world.

Diversification is ‘The process of constructing a portfolio of long or short positions in different instruments that are relatively uncorrelated with one another, in order to minimise exposure to individual risks, such as issuers or risk classes.’ (BCBS, Minimum Capital Requirements for market risk, January 2016). This paper explores the effect of portfolio diversification on Standard Approach (SA) and Internal Model Approach (IMA).

FRTB is a major change to the banking industry’s current market risk management practices, including a stricter boundary between the trading and banking book to a more stringent approval process for the use of an internal model. The option to use the internal model approach (IMA) as opposed to a standardised approach (SA) is not new. The criteria however for gaining regulatory approval for the more capital-efficient IMA as part of the revised FRTB standard are more rigorous and require firms to demonstrate robustness in the models themselves. IMA can only be obtained (and lost) at the desk level. The requirements to receive approval have been intensified and make it a more challenging task.

By specifying that IMA is given at desk level opens up a debate about which approach, IMA or SA, to use for each desk. The decision cannot be based on looking at all the combinations, since these grow exponentially with the number of desks.

The analysis highlights some tendencies in the behaviour of the charge which can help financial institutions select the right approach or mix. Additionally, diversification effects between products can have a strong influence on decreasing and or increasing the charge if poorly managed (i.e. the cliff-effect). Our analysis confirmed that the SA-charge can be as up to 50% higher than IMA. However, for a well-diversified portfolio, both approaches benefit in principle from diversification, making the choice between the two approaches less relevant.

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