As banks in the UK prepare for the implementation of the Basel 3.1 standards for market risk, also known as Fundamental Review of the Trading Book (FRTB), one of the most crucial decisions they face is choosing which approach to take. The PRA has laid out three approaches: the Simplified Standardised Approach (SSA), the Advanced Standardised Approach (ASA), and the Internal Model Approach (IMA). Banks need approval for SSA, which is a slight update to Basel 2.5 rules, and it is only eligible for certain banks with small market-risk exposed liabilities and assets.
So, the main decision point for banks is likely to be between the ASA, the default approach, and the IMA. This choice will significantly impact a bank’s capital requirements and operational processes. Let’s explore the key factors to consider when making this decision.
Understanding ASA vs. IMA
The ASA is the default approach of all banks under PRA supervision that offers standardised, consistent treatment calculating market risk capital requirements, while the IMA allows banks to use their internal models for those calculations. Both approaches have their strengths and challenges.
Advanced Standardised Approach (ASA)
The ASA consists of three main components: the Sensitivities-based method (SBM), Default risk charge (DRC), and Residual risk add-on (RRAO). This approach offers several strengths for banks implementing Basel 3.1 Market Risk requirements. It is more risk-sensitive than the simplified standardised approach, providing a consistent framework across banks that improves comparability for regulators. Generally less complex to implement than IMA, ASA also doesn’t require regulatory approval of internal models, which can be advantageous for many institutions.
However, ASA comes with its own set of challenges. It may result in higher capital requirements compared to IMA, which is a significant consideration for banks. The approach requires substantial data inputs and calculations, especially for the SBM component. While it provides a standardised framework, ASA is less tailored to a bank’s specific risk profile compared to IMA. Additionally, there’s a potential issue with the RRAO, as it may capture risks already accounted for in other components, potentially leading to double-counting of certain risks.
Internal Model Approach (IMA)
The IMA allows banks to use their internal models, subject to regulatory approval and the trading-desk level. It includes Expected Shortfall (ES) calculations, Default Risk Charge (DRC), and Stressed Capital Add-on (SCA). One of the primary strengths of IMA is its potential to offer lower capital requirements, which can be a significant advantage for banks. It’s more tailored to a bank’s specific risk profile and trading strategies, allowing for more sophisticated risk measurement and management. This approach can also provide competitive advantages in pricing and risk management, making it attractive for banks with complex trading activities.
However, IMA also presents its own set of challenges. It requires substantial investment in risk management infrastructure and expertise, demanding ongoing model validation, and regulatory approval. Banks opting for IMA are subject to more intense regulatory scrutiny and must meet rigorous backtesting requirements. The approach may be restricted or disallowed for certain risk types or trading desks, and banks need to meet minimum coverage requirements for stress period risk factors. The complexity involved in implementing and maintaining these models can lead to operational risks. Moreover, banks using IMA are subject to capital add-ons if their models underperform or fail regulatory tests, adding another layer of risk to this approach.
Key Factors to Consider When Choosing
- Resource Requirements: IMA demands more resources for model development, validation, and ongoing maintenance. ASA, while still complex, generally requires fewer resources.
- Capital Implications: IMA may result in lower capital requirements, but this advantage must be weighed against implementation costs.
- Regulatory Scrutiny: IMA is subject to more intense regulatory scrutiny and ongoing justification.
- Implementation Complexity: ASA is generally less complex to implement, but still requires significant effort.
- Flexibility and Adaptability: IMA offers more flexibility in risk measurement but requires continuous model updates and validation[1].
- Trading Desk Structure: The PRA has clarified that trading desks managing IMA-ineligible positions can be included in a firm’s IMA application, provided ineligible positions are addressed through ASA[1].
- Sovereign Exposures: For trading desks using IMA with sovereign exposures, the ASA must be used, aligning with the standardised approach to credit risk[1].
- Data Availability: IMA requires extensive historical data and the ability to demonstrate risk factor modellability[2].
- Risk Profile: Banks with more complex trading activities may benefit more from IMA, while those with simpler portfolios might find ASA sufficient[3].
- Regulatory Consistency: The PRA has improved consistency across the overall regime by only allowing banks to use ASA for sovereign exposures, even under IMA[2].
Recent Regulatory Developments
The PRA has made several clarifications and changes to the FRTB proposals, particularly for the IMA[2]:
- The 75% minimum coverage requirement for stress period risk factors is now imposed at a portfolio level, not for individual trading desks.
- Consequences for breaching this requirement are imposed after one month rather than two weeks.
- The Non-Modellable Risk Factor (NMRF) framework now allows firms to use either regulatory or firm-defined “buckets” for different dimensions of a single risk factor.
These changes provide additional flexibility and potentially reduce the operational burden for banks considering IMA[2].
Making the Decision
When deciding between ASA and IMA, banks should:
- Conduct a thorough cost-benefit analysis, considering both immediate implementation costs and long-term capital impacts.
- Assess their current risk management capabilities and the investment required to meet IMA standards.
- Consider their trading portfolio complexity and whether the potential capital savings from IMA justify the additional operational overhead.
- Evaluate their ability to meet ongoing regulatory requirements for model validation and justification.
- Consider the impact on business strategy and potential constraints on trading activities.
In the End…
Choosing between ASA and IMA is a complex decision that requires careful consideration of multiple factors. While IMA may offer potential capital savings, it comes with significant operational and regulatory challenges. ASA, on the other hand, may be more straightforward to implement but could result in higher capital requirements.
As you navigate this critical decision, FRG and SAS are here to help simplify your FRTB compliance journey. Our comprehensive Regulatory Capital Management solution, powered by SAS technology and FRG’s expertise, offers:
- Support for both ASA and IMA calculations
- Flexible deployment options to fit your specific needs
- Advanced analytics and AI capabilities to enhance risk management
- Streamlined regulatory reporting and audit trails
Don’t let the complexities of FRTB implementation slow you down. Contact FRG today to schedule a demo and discover how our tailored solutions can help you confidently navigate Basel 3.1 Standards for Market Risk compliance and optimise your capital management strategy.
Ian Oglesby is a seasoned expert in financial risk management, specializing in regulatory capital solutions for credit and market risk. With a focus on where business needs meet risk technology, he drives initiatives in stress testing, climate risk, and risk analytics across the Northern Europe and the UKI region.
[1] Basel 3.1 Implementation in the UK; Skadden (Jan, 2024)
[2] Basel 3.1 near-final rules; the fog starts to clear; Deloitte (Dec, 2023)
[3] Basel III endgame: Complete regulatory capital overhaul; PWC