Banks Ready FRTB Carve-out Request for LIBOR

Under the incoming capital rules – the Fundamental Review of the Trading Book (FRTB) – banks that use the internal model approach will face an additional capital charge for all risk factors not backed by a minimum level of trading. This has led to speculation that as banks begin to move roughly $370 trillion in swaps (notional) away from LIBOR, they will ask regulators for capital relief according to an article from Risk.net.

The concern is that the less-liquid portions of the portfolio, which one study estimates could account for as much as 30 percent of the total capital charge, could rise even higher, as an alternative benchmark brings in more trades, as liquidity tails off in LIBOR swaps, and slowly builds in replacement benchmarks.

Under the FRTB, a bank is permitted to include a risk factor in its internal model for capital calculation if it can point to at least 24 so-called real price observations of the value of the risk factor over the previous 12 months, with no more than a one-month gap between any two observations. Failing this, the risk factor would be deemed non-modellable and attract an additional capital charge.

Given that the first SOFR-pegged swaps were only just traded and cleared on Tuesday, July 17, some market participants worry it will take some time for sufficient liquidity to materialize to avoid the capital penalties. Risk.net reports these worries have led the industry to begin building the case for a carve-out request from the capital requirements while the market transition to the new benchmark.

A market risk head at a European bank, who wished to remain anonymous said, “This FRTB issue is an interesting aside, but it will not be allowed to stop the project. If necessary an exception will be made. It is perhaps a good example of one of the main flaws in the current FRTB rules – and this will surely be improved before the FRTB go-live.”

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