BCBS Fundamental Review of the Trading Book (FRTB): Bad for CLOs and Other ABS? | Practical Law

BCBS Fundamental Review of the Trading Book (FRTB): Bad for CLOs and Other ABS? | Practical Law

ISDA published an analysis of the Basel Committee on Banking Supervision (BCBS) Fundamental Review of the Trading Book (FRTB), describing the FRTB’s increased capital burdens on banks, especially with regard to certain securitization holdings. A recent report by the LSTA also discussed the FRTB effect on holdings of collateralized loan obligations (CLOs).

BCBS Fundamental Review of the Trading Book (FRTB): Bad for CLOs and Other ABS?

Practical Law Legal Update w-000-7536 (Approx. 4 pages)

BCBS Fundamental Review of the Trading Book (FRTB): Bad for CLOs and Other ABS?

by Practical Law Finance
Published on 12 Nov 2015 • USA (National/Federal)
ISDA published an analysis of the Basel Committee on Banking Supervision (BCBS) Fundamental Review of the Trading Book (FRTB), describing the FRTB’s increased capital burdens on banks, especially with regard to certain securitization holdings. A recent report by the LSTA also discussed the FRTB effect on holdings of collateralized loan obligations (CLOs).
On October 24, 2015, ISDA published an Industry Fundamental Review of the Trading Book Analysis (FRTB analysis), followed by a November 4, 2015 letter to the European Central Bank, the Basel Committee on Banking Supervisions (BCBS,) and the Bank for International Settlements (BIS). In these documents, ISDA describes the increased capital burden on banks, especially with regard to certain securitization holdings, that could result from the recent BCBS proposal on its fundamental review of the trading book (FRTB).
A recent report by the LSTA also discussed the FRTB effect on holdings of collateralized loan obligations (CLOs).
The FRTB is a consultative document issued by the Basel Committee on Banking Supervision (BCBS) and is meant to align the regulatory capital requirements of banks with their trading books and to minimize differences across regulatory jurisdictions (for more on the Basel Committee, see Practice Note, BCBS Standards and Guidelines). The FRTB is scheduled to be finalized by year-end, so that individual jurisdictions can work on implementing the rules, which are currently scheduled to take effect in 2019.
According to ISDA's FRTB analysis, as proposed, the FRTB could significantly increase the amount of capital required for banks to carry certain securitization assets on their trading books.
Additionally, as recently reported by the LSTA, JPMorgan has expressed concern that under the FRTB as currently proposed, capital requirements for CLOs could increase by a factor of between 3 and 42, depending on the tranche. The LSTA report states that these high increases stem from a combination of factors, including:
  • An increase of certain variables from the current standardized approach methodology.
  • The addition of a "credit spread shock multiplier," which replaces market risk capital. The credit spread multiplier is multiplied by the spread duration of a tranche, then divided by 8% to arrive at the Risk Weighted Asset (RWA) Value. The multiplier ranges from:
    • 6% on senior investment grade tranches;
    • 12% on non-senior investment grade tranches; and
    • 24% on high-yield and not rated tranches.
  • A residual add-on charge equal to 1% of the face value of the bond.
ISDA's analysis is the result of information submitted to ISDA by 28 different banks on the FRTB (both quantitative and qualitative), which was combined to create a theoretical "aggregate bank." This differs from the approached used by the BCBS, which used a "median bank" based on the average anticipated effect of the FRTB on 40 different banks. However, ISDA asserts that this is not representative of the industry.
ISDA's FRTB analysis states that, for securitizations, there will be an increase in capital of 2.2 times over Basel 2.5, which already incorporates increased capital charges (for more information on Basel, see Practice Notes, Overview: Basel III and Overview: Basel 2.5) . As an alternative to the FRTB as proposed, ISDA suggests removing the credit spread risk charge, among other things in its letter to the European Central Bank, BCBS, and BIS.
The proposed FRTB rules include a Standardized Approach and an Internal Models Approach, but ISDA says that both still require a significant amount of work.
Under ISDA's analysis of the Standardized Approach (SA):
  • The capital charge under the SA method would be 4.2 times the total market risk capital that firms hold currently, and is non-risk sensitive (doesn't change depending on the risk of the tranche).
  • The residual risk add-on, introduced in June 2015, accounts for 47% of total market risk capital.
  • There may be a cliff effect when using the SA approach compared to the Internal Models approach, discussed below.
  • Differences in required capital across asset classes do not reflect economic risk.
  • Major concerns exist for securitizations and CLOs under the SA, as discussed below.
Under ISDA's analysis of the Internal Models Approach (IMA):
  • “Non-modellable” risk factors account for 29% of the total proposed market risk capital charge.
  • Profit and loss attribution test data is not easily obtainable, meaning the calibration of thresholds would not be based on representative data.