FRTB May Disadvantage Emerging Markets – ISDA

There is a need for supervisors to consider local specificities when implementing the framework in less developed markets, ISDA says. 

ISDA (the International Swaps and Derivatives Association) has released a new report outlining some of the challenges jurisdictions will face in implementing the new market risk capital standards, also known as FRTB (the Fundamental Review of the Trading Book).

The report follows recent release of the final revisions to the Basel III market risk framework, set to take effect on 1 January 2022. The final revisions make a number of changes from previous versions, including the introduction of a more risk-sensitive SA (standardised approach), desk-level approval for internal models, and a capital add-on for NMRFs (non-modellable risk factors).

ISDA’s report considers how FRTB will be transposed in national implementation, whether all jurisdictions will meet the 2022 implementation target, and its impact on emerging market banks and economies.

“As attention now turns to implementation, it is important that the framework is applied as consistently as possible – both in terms of substance and timing – to avoid fragmentation and the emergence of an unlevel playing field,” the paper says.

ISDA notes that most jurisdictions have not yet set out their plans for implementing FRTB, with the exception of Hong Kong, which appears to be aiming for compliance with the 2022 timeline. Singapore and Australia are also expected to follow the global timeline. The EU has proposed a two-step approach, starting with reporting requirements first before moving to capital.

The report acknowledges that the framework was primarily calibrated for large, globally active banks in advanced economies. “There are questions about which approach might be best for smaller banks, and to what extent the framework will impact those institutions in emerging markets,” it says, noting that the impact on emerging market banks and economies has not been assessed.

While most emerging market banks are likely to use the revised SA, some are considering the more advanced IMA (internal models approach), which provides more comprehensive risk-sensitivity. But, emerging market banks that wish to apply the IMA are likely to face challenges as a result of a lack of liquidity.

The revised FRTB provides a framework to capture risks that do not meet certain liquidity criteria – NMRFs, which involve a higher capital charge. This may act as a barrier to entry for some emerging market banks that wish to use the IMA, the report says, adding that it may also disincentivise G-SIBs from operating in these jurisdictions, further compounding the liquidity problem.

ISDA also highlights concerns about the treatment of sovereign debt held in trading books. FRTB uses a rating-based approach to identify the relevant risk weight, which penalises holders of some emerging market sovereign debt if national discretion is not applied to domestic currency sovereign risk. The inclusion of national discretion for the treatment of sovereign risk recognises that debt issued in domestic currency is generally considered safer than in foreign currency.

“However, this principle is not carried through to the sensitivity based method in the SA, where there is no national discretion to distinguish between bonds issued in foreign currency and domestic currency,” ISDA says. “A sovereign bond issued in domestic and foreign currency will therefore attract the same credit spread risk charge irrespective of the issuance currency.”

ISDA says the concept of domestic currency sovereign bonds being considered ‘risk-free’ should be consistently reflected across the FRTB framework, and that there is a need for supervisors to consider local specificities when implementing the framework in less developed markets.

The full report is available here.

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