To SA or not to SA

To SA or not to SA

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One of the important questions with the upcoming FRTB regulation is “Should we still try to stay on IMA or just use SA?”

Historically, just about every institution wanted to have IMA. Not only was the standardized approach costly, but it marked a lack of sophistication. No-one wanted to look simple, both in eyes of their peers and in the eyes of their clients or investors.

FRTB SA wants to change this and be a credible choice for a number of institutions.

To get there, FTBS SA for all terms and purposes looks like a parametric VaR that doesn’t allow intra-asset diversification, includes default migration risk, and tries to capture even more esoteric risks – it can be a credible, if a rough, tool.

SA or not SA

That’s not really the question. Everybody has to do SA – in fact, on some asset classes (principally securitization) only SA is allowed.

The real question is IMA or not IMA. Or put differently, is IMA worth it?

On one hand, IMA can decrease the capital requirements significantly – especially for more complex portfolios and products, and also for portfolios geared towards emerging markets, which are penalised in about all asset classes with higher risk weights.

On the other hand, the complexity of running IMA is an order of magnitude, if not orders of magnitude, higher than SA – which is a baseline that has to be implemented regardless.

IMA implementation requires significant investment in IT systems and processes – both initial, and ongoing.

Simpler banks may argue that they have no NMRFs, but we do not doubt their regulators will require them to prove it – repeatedly.

Even if a bank has no NMRFs, it still needs to meet the PnL attribution tests or suffer the consequences. That is again likely to require substantial investment into systems and processes – and potentially not limited to Market Risk ones only.

We believe that especially regional institutions should consider whether the capital savings are really worth the operational complexity.

Choose your costs

For an average EU bank, the capital requirements for Market Risk are in tens of millions EUR (for example, for Raiffeisen Bank it was about 77m EUR at the end of 2015 based on their financial statement).

If we assume, very conservatively, that:

  • the MR capital requirements are EUR100m
  • the SA will double them
  • the cost of capital to be around 10%

then the capital cost of SA compared to IMA would be EUR10m/year.

This does not seem an excessive all-in cost (covering staff, premises, hardware and software costs etc.) for a Market Risk IT department of a medium sized bank. We do not imply that moving to SA would make the whole department redundant, but at the same time we believe that implementing IMA will add significant additional costs – not just in MR IT, but in MR department itself, possibly even in front office and finance.

Move to SA may represent an opportunity to simplify one’s portfolio. We believe that even with IMA, a number of businesses may become marginal, especially for advanced economy banks operating across multiple emerging markets. Almost all of emerging markets companies will fall under the “small cap” (required capitalization of USD2bln or more). An equity position in such a company will then go across two liquidity horizons (10 and 20), an option position across four (10,20,40 and 60), generating significant ES across liquidity horizons compared to “large caps” equity exposure.

Add to that the fact that the positions also generate FX exposure in non-domestic or specified currency, and the position may be quite costly.

We thus believe that a careful analysis of SA vs IMA is required. It should take into account:

  • operational costs of IMA (as noted before, SA is baseline and has to be implemented regardless)
  • consideration of existing businesses from return-on-capital (on both IMA and SA) perspective
  • considering the above not from moment-in-time, but across business cycle (including switching between SA and IMA)

The above would allow an institution to make an informed decision on whether SA or IMA is more appropriate for them.