Fundamental Review of the Trading Book Business model and IT architecture evolution

London, February 2017

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Fundamental Review of the Trading Book (FRTB)

FRTB impacts expand far beyond new risk metrics and Internal Model Approach approval requirements. Efficient controls, analytical tools and capital-driven decision-making will be

essential for success in the post-FRTB business environment.

FRTB compliance

•New Standardised Approach (SA) framework

•New Internal Model Approach (IMA) framework

•IMA approval constraints

•Open issues still under discussion

Constraints, controls and analytical tools

•P&L attribution process

•Unexplained P&L, ES, DRC decomposition

•Modelling SA/IMA transitions

•High-performance computational capabilities

Capital-driven decision-making

•Modelling trading desk allocations

•Alignment with wider capital framework

•Risk-adjusted ROC optimisation

•Back-testing, What-If simulation and portfolio reallocation

FRTB prescribes an increased alignment between Front Office and Risk Management in terms of risk

metrics, models and conventions leading entities to rethink entirely their existing IT architectures.

New metrics such as Unexplained P&L and Expected Shortfall demand increased transparency from the

risk aggregation processes to enable analysis. In-memory analytics explored as the only way to achieve

performance required for intraday capital-driven decision-making.

Effective cross-functional governance is critical for the successful delivery of an FRTB programme’s

objectives, and to ensure that the architecture choices made are appropriate.

Key challenges

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Front Office and Risk Alignment

“Internal models used to calculate market risk charges are

likely to differ from those used by banks in their day-to-day

internal management functions. Nevertheless, the starting

point for the design of both the regulatory and the internal

risk models should be the same. In particular, the valuation

models that are embedded in both should be similar.”

[BIS d352, paragraph 180, IMA Qualitative Standards].

FRTB requires stronger alignment between Front Office and Risk in terms of risk metrics, revaluation models and conventions.

The regulatory risk associated with a failure to meet IMA P&L test can be mitigated by the architecture of the selected solution:

“The P&L attribution assessment is designed to identify whether a

bank’s trading desk risk management model includes a sufficient

number of the risk factors that drive the trading desk’s daily P&L.

[..] This “risk-theoretical” P&L is the P&L that would be produced

by the bank’s pricing models for the desk if they only included

the risk factors used in the risk management model.”

[BIS d352, Appendix B, P&L Attribution and Backtesting frameworks].

everis recommends re-use of Front Office engines for Risk where practicable to reduce risks associated with IMA P&L test failure and consequent capital impact.

FO 1

FO 2

FO n

Risk

FO 1

FO 2

FO n

Risk

…

…

Positions and

transactions

P&L vectors,

sensitivities

Different

engines

for Front

Office and

Risk

Single

engine for

Front

Office and

Risk

Positions and

transactions are

delivered to the risk

system for

calculation of risk

metrics.

P&L vectors and

sensitivities are

delivered to the risk

system for

aggregation.

↗ Application of more

efficient models adapted

to the particular needs of

each product

↘ Higher engine

synchonization effort and

risk of IMA failure

↗ Mitigates risk of IMA failure

↘ Front Office engines may

need to be adapted to

meet new requirements

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FRTB Reference Architecture

The re-use of Front Office engines for Market Risk and the segregation of the aggregation layer for Risk offers a simple solution, segregated from a business and geographical point of view

and with low regulatory risk.

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Big Data Reference Architecture

The Big Data logical

architecture is based on a

modular structure with well-

defined and uncoupled

components to provide the

technical capabilities to build

any functional use case.

It can be easily extended to

provide new capabilities (e.g.

new data sources, real time

processing, etc.) and can be

implemented with different

technical solutions.

An interactive aggregation

tool with rich visualisation

capabilities permits the

flexible and detailed analysis

of variations in results.

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The Goal: Dynamic Capital Management

Capital Framework

Counterparty Credit Risk

Securitisation Framework

Market Risk Operational Risk

Pre-trade Post-trade Risk management Capital charge

Capital estimate

Da

ta M

an

ag

em

en

t Data tools manage the ingestion and cleaning of data from multiple sources and make them available for analysis, flexibly integrating new data sources to support incremental use cases

Ag

gre

ga

tio

n

Aggregation solution compliant with BCBS 239 principles should deliver accuracy, integrity, completeness and timeliness whilst retaining flexibility to meet additional requirements

Mo

nito

rin

g a

nd

A

na

lysi

s Advanced analytics and visualisations implemented using high-performance technologies support the monitoring and decomposition of risk outputs to reduce the risk of P&L test breaches.

Dy

na

mic

Ca

pita

l M

an

ag

em

en

t What-if and back-testing tools assess the capital cost of new trading strategies and support portfolio reclassification across trading desks to maximise the efficient deployment of capital.

Stress-testing

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FRTB Cross-functional Governance

The cross-functional nature of FRTB demands robust governance with adequate stakeholder representation. Revaluation models, calibration procedures, market data Sets, cut-off times and many more conventions must be aligned to meet qualitative and quantitative requirements.

Front Office conventions

Risk Management conventions

Revaluation models

Calibration Market data set Cut-off time P&L definition

Support teams

Revaluation models

Calibration Market data set Cut-off time P&L definition

Support teams

Close collaboration between front office, risk, finance and IT stakeholders is essential to ensure

that the to-be architecture strikes an appropriate balance where trade-offs are necessary and meets the full range of requirements as comprehensively as possible.

The complexity of change management related to FRTB implementation should not be underestimated.

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Flexible Approach to FRTB Implementation

The approach to the definition of business model, operating model and technology architecture must reflect the need to maintain flexibility to respond to regulatory obligations and market developments in an agile way.

Global governance needed Local governance permitted

Bu

sin

ess

Mo

de

l Risk appetite

Capital allocation

Diversification strategy

Internal Model Approach Authorisation

Trading desk structure

Revaluation models

P&L and Risk representation

Op

era

tin

g M

od

el Market data sourcing

Model calibration

Trading conventions

Limits and controls

Trading workflows

Scenario generation

Risk calculation and aggregation

P&L testing

Reporting

Tec

hn

olo

gy

Market data feeds

Data quality checks

Real-time vs batch integration

Computational performance

Vendor vs in-house solutions

Global vs Local Project delivery

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Summary

The specific challenges of FRTB may be addressed by the establishment of a cross-functional governance framework and by evolving or replacing functional components within a bank’s front office and risk architecture.

We can consider consolidation on a ‘front-to-risk’ solution, but bear in mind the trade-off

between the benefits of consolidation and flexibility.

Where Front-to-Risk consolidation is not practicable, we can define an aggregation solution that enables the re-use of components and delivers the required analytical capabilities to calculate and monitor FRTB outputs at a sufficient level of performance.

A Big Data approach can address the computational intensity and complexity associated with FRTB and can be readily extended to accommodate new data sources and analytical tasks.

Such an architecture can be defined to meet specific FRTB requirements and then extended

to be the foundation of a true dynamic capital management process.

Effective cross-functional governance is critical for the successful delivery of an FRTB programme’s objectives, and to ensure that the architecture choices made are appropriate.

everis.com

Thanks, we are

delighted to

have the

opportunity to

share our vision

with you JONATHAN PHILP Director, Treasury & Capital Markets

jonathan.philp@everis.com

Gilmoora House. 57-61 Mortimer Street London W1W 8HS

Tel: +44 74 6293 1415

ENRIC OLLE Director, Head of Murex Services

enric.olle.soteras@everis.com

Avenida Diagonal 561, Planta 5 08028 Barcelona

Tel: +34 936 007 744

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Annex: Risk appetite and limits monitoring

Beyond the regulatory limits established to preserve FRTB/IMA authorization, pre-trade and post-trade market risk limits and controls should be reviewed at the level of each trading desk

in order adapt the whole risk appetite framework to the new risk metrics introduced by FRTB.

New risk limits, controls and analysis tools

The new Target Operating Model will leverage on new risk limits and controls to ensure a closer monitoring of trading desk activities by the risk management unit.

In addition, proper analysis tools will be required to explain any sudden shift in a complex risk metric and to capture the root cause and expected development in the future.

New risk metrics introduced by FRTB

Curvature risk which expands existing delta and vega risks capturing the worst loss of two stress scenarios.

Jump to Default (JTD) risk based on notional amounts and market values intended to capture stress events in the tail of the default distribution.

Residual Risk Add-on applied to notional amounts of instruments with non-linear payoffs.

Expected Shortfall (ES) adjusted to include stressed period and liquidity horizon effects which should be confronted to the VaR risk metric currently in use.

Default Risk Charge (DRC) which should be measured using a VaR model and must recognize the impact of correlations between defaults among obligors including the effect of periods of stress.

Stressed Capital Add-on (SES) which will capture non-modellable risk factors in model-eligible desks and will be based on a stress scenario calibrated to be at least as prudent as the ES calibration.

SA

IMA

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Annex: Initial assessment and critical path management

An early assessment of capital impact at the level of every desk and strategy both under FRTB-SA and FRTB-IMA is recommended to establish business priorities and identify the critical path of the whole transformation project. The resulting management framework should be ready to dynamically accommodate new business requirements and/or regulatory amendments.

Diameter linked to projected Business P&L Diameter linked to projected Business P&L

Capital charge vs Project delivery risk

S01 S02 S03 S04 S05 S06 S07 S08 S09 S10 S11 S12 S13 S14 S15 S16 S17 S18 S19 S20 S21 S22 S23 S24 S25 S26 S27 S28 S29 S30 S31 S32

Spain Trading Room

Trading Desk 1

Strategy 101 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1

Strategy 102 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1

Strategy 103 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1

Trading Desk 2

Strategy 201 0 0 1 1 0 0 1 1 0 0 1 1 0 0 1 1 0 0 1 1 0 0 1 1 0 0 1 1 0 0 1 1

Strategy 202 0 0 1 1 0 0 1 1 0 0 1 1 0 0 1 1 0 0 1 1 0 0 1 1 0 0 1 1 0 0 1 1

Trading Desk 3

Strategy 301 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1

Strategy 302 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1

Strategy 303 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1

Strategy 304 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1 0 0 0 0 1 1 1 1

Trading Desk 4

Strategy 401 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1

Strategy 402 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1

Strategy 403 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1

Trading Desk 5

Strategy 501 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

Strategy 502 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

S01 S02 S03 S04 S05 S06 S07 S08 S09 S10 S11 S12 S13 S14 S15 S16 S17 S18 S19 S20 S21 S22 S23 S24 S25 S26 S27 S28 S29 S30 S31 S32

Business Value 16.0 17.4 16.0 17.4 20.8 22.3 20.8 22.3 21.1 22.6 21.1 22.6 26.0 27.4 26.0 27.4 16.5 18.0 16.5 18.0 21.4 22.8 21.4 22.8 21.7 23.1 21.7 23.1 26.5 28.0 26.5 28.0

Capital Cost (mEUR) 886 864 720 695 633 607 461 433 807 783 638 611 550 523 375 345 699 673 529 500 439 411 264 233 616 589 443 413 353 323 174 142

Project Cost (mEUR) 8.2 10.6 17.7 17.7 14.9 14.9 20.0 20.0 13.4 14.0 19.3 19.3 16.5 16.5 21.6 21.6 21.0 23.4 24.8 24.8 25.9 25.9 27.1 27.1 24.4 25.0 26.4 26.4 27.5 27.5 28.7 28.7

% Project Risk 0.6 3.2 20.5 20.5 17.7 17.7 31.3 31.3 4.6 4.8 21.0 21.0 18.1 18.1 31.7 31.7 59.0 60.0 63.4 63.4 65.6 65.6 68.4 68.4 60.2 60.3 63.6 63.6 65.8 65.8 68.6 68.6

Migration Scenarios

S16 S16

Capital charge vs Project delivery costs

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Annex: P&L Attribution governance framework

FRTB establishes a stringent model validation framework at the trading desk level based on backtesting and P&L attribution to preserve IMA approval. A strong P&L attribution governance

framework should be put in place to closely monitor P&L attribution backtesting performance and to react promptly in case IMA approval is jeopardized.

P&L attribution requirements

Based on two metrics:

Mean unexplained daily P&L (i.e. risk-theoretical P&L minus hypothetical P&L) over the standard deviation of actual daily P&L.

Ratio of variances of unexplained daily P&L and hypothetical daily P&L.

If the first ratio is outside of the range of -10% to 10% or if the second ratio were in excess of 20% then the desk experiences a breach. If the desk experience four or more breaches within the prior 12 months then it must be capitalized under SA.

The desk must remain on SA until it can pass the monthly P&L attribution requirement and provided it has satisfied its backtesting exceptions requirements over the prior 12 months.

Backtesting requirements based on VaR

Based on comparing each desk’s 1-day static value-at-risk measure (calibrated at the most recent 12 month’s data, equally weighted) at both 97.5th percentile and 99th percentile, using at least one year of current observations of the desk one-day P&L.

If any given desk experiences either more than 12

exceptions at the 99th percentile or 30 exceptions at the 97.5th percentile in the most recent 12-month period, all of its positions must be capitalized using SA.

Positions must continue to be capitalized using SA until the desk no longer exceeds the above threshold over the prior 12 months.

A proper solution is required to drill down risk exposures from risk factors and to identify conflicting positions which should be hedged or removed from the portfolio. The solution should not only focus on exceptions but on how closely the desk if operating from the threshold.

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Annex: Cross-regulation impact assessment

FRTB impacts and actions should be aligned with those of other on going regulations in order to ensure full compliance while preserving data integrity and process automation which will in the root of a competitive operating model moving forward.

FRTB

EMIR

SA-CCR

CVA

Stress Test

Volcker

MIFID II

EMIR which prescribes the central clearing of specific categories of OTC transactions and reporting to a trade repository.

SA-CCR which imposes to new capital charges for the accounting of counterparty risk for margined/unmargined, bilateral/clearer derivative transactions.

CVA which is an adjustment to the fair value (or price) of derivative instruments to account for counterparty credit

risk (to be further amended under FRTB-CVA framework).

Stress Test exercises which estimate economic impact under unfavourable market scenarios with focus on regulatory capital.

Volcker which prohibits banks from conducting certain investment activities with their own accounts and establishes new rules on trading desk classification and

PL explain.

MIFID II which establish new investor protection and distribution rules in addition to new market infrastructure and transparency requirements may hinder the profitability of existing business lines.