JONES DAY TALKS®: Preparing for FRTB – What Banks Should Know
First introduced following the 2008 global financial crisis, the Fundamental Review of the Trading Book (FRTB) was designed to establish worldwide rules pertaining to banks’ regulatory capital requirements as they apply to trading activities. Jonathan Gould and Josh Sterling talk about the changes proposed by FRTB, how those changes address specific problems, and what banks should do now.
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A full transcript follows below:
Dave Dalton:
Changes to the fundamental review of the trading book or FRTB could have serious implications for financial institutions in terms of their risk related capital requirements. Jones Day's Jonathan Gould and Josh Sterling are here to talk about what's being proposed, how those potential changes address specific problems and what banks need to do now. I'm Dave Dalton. You're listening to JONES DAY TALKS®.
Washington based Jones Day partner, Jonathan Gould, brings regulatory and strategic advice to financial service providers. Prior to Jones Day, he served as the senior deputy comptroller and chief counsel of the office of the comptroller of the currency. In that role, he oversaw the agency's legal and licensing activities including legal advisory services to banks and bank examiners.
Also in Washington, partner Josh Sterling is a recognized leading practitioner in commodities and derivatives law. He helps banks, FinTech companies, corporations, and several of the world's largest trading platforms successfully address enforcement, regulatory and transactional matters. Josh's client work is informed by his tenure and leadership roles at the Commodity Futures Trading Commission or CFTC, the primary US regulator of the derivatives markets. And of course, Josh is a frequent and popular contributor to JONES DAY TALKS® when subjects steer toward financial markets matters. Jonathan, Josh, thanks for being here.
Josh Sterling:
Thank you.
Jonathan Gould:
Thanks, Dave.
Dave Dalton:
Now Jonathan, Josh is a Jones Day talk veteran. He's been on several of our podcasts as for certain, but I think this is your first voyage with us. Give us a little bit about your background. I know you joined the firm late last year, correct?
Jonathan Gould:
That's right. My career has been split among about a third of my time in the private sector as a lawyer, both in-house and at a law firm. Another third spent in the regulatory and risk consulting business at Promontory and BlackRock. And then I spent a third as a government lawyer, including most recently at the office of the comptroller of the currency, which is the regulator of National Bank. So I have a background as a lawyer, consultant, and a regulator, but all focused on the financial services world and banking regulation in particular.
Dave Dalton:
Interesting balance between private sector work and working for the federal government and so forth. That's perhaps not unique, but unusual and I think a real asset I think to certain clients. Tell us how your experience might help clients address some of their needs and concerns.
Jonathan Gould:
So my practice at Jones Day basically involves a range of clients, anything from traditional banks to FinTechs and cryptos, but also non-bank like private equity firms and even retailers offering financial services and products. And to me there's the competitive transformation going on within financial services world and regulation is one of the key playing fields in which banks and non-bank alike are competing. So I try to use my knowledge of regulation to help traditional players and their would be disruptors alike understand and comply with that framework. And that's got three facets. I think one, kind of in the pure play regulatory compliance and strategy area. Two, with transactions where there's some regulatory considerations that are a factor driving the transaction or a constraint on it. And three, in more adversarial actions like enforcement actions or litigation or investigations, which again, often have a regulatory component to them. Sometimes it's the reason for them.
Good lawyers, the ones who can really translate complicated regulatory frameworks into terms that make sense that businesses that have to deal with them and having been a consultant and a regulator helps me understand the different perspectives and find solutions. I also appreciate the fact that legal factors are just one input into business decisions and they're often not this positive. So if you want to be a trusted advisor to your clients, you really need to understand the other factors that enter into your client's business decisions and it's helpful to have spent some time too, kind of on the quantitative side at BlackRock where I actually worked on financial models and trying to find newer uses for them. One of the things I realized is that it's not enough to be able to make qualitative arguments in support of your client's goals. As a lawyer, you also need to marshal quantitative evidence in support of your arguments and that's certainly true of the topic we're going to discuss today, the fundamental review of the trading book.
Dave Dalton:
Sure. Josh, sounds like he's going to fit in just fine here.
Josh Sterling:
Well thanks Dave and I had a very well written paragraph put together about the virtues of Jonathan Gould joining Jones Day, but I think you basically just heard it from the guy himself. Jones Day, we have a tremendous 300 person strong financial markets practice that's in all the major money centers in the world, effectively traditional finance and of course FinTech as well. Having the former top lawyer at the OCC, which oversees the largest banks out there, many of whom we do represent, is just an incredible tool for strengthening our financial markets capability in Washington to be able to provide the kind of advice our clients need from this town to the towns where they work and do their business. So it's just a plus for us.
Dave Dalton:
Awesome, awesome. Well, Jonathan, we're glad you're here. Glad you're on this program today and I hope we talk in the future, that's for sure. So let's get into this right now, fundamental review of the trading book. Let's start with Josh. Real high level, give us some background on the FTRB, Josh, I think some of this, if not all, this has its roots back in the financial crisis of 2007, 2008. Is that correct?
Josh Sterling:
Thanks, Dave. That is totally correct and it has been a long running project of regulators around the globe. It is Basel Committee for Banking Supervision that's been responsible for rolling this out. There has been a desire for a long time to tell you a hard look at effectively what is in the trading book of a bank versus what is in the banking book of the bank. And that's the difference between what you're moving in and out of and the trading book and what you expect to hold in maturity, which is in the banking book. Speaking at an incredibly high level that is probably a straining credulity with Mr. Gould as he's listening to me. And the desire there is to sort of have appropriate categorization of assets and liabilities and to apply appropriate capital standards to them, appropriate being in the eyes of the supervisors globally for these institutions.
There's no doubt about it this is going to continue to unfold, thinking about what even a book is and what's in the book is going to be a tremendous lift. And then arguing over or debating what the appropriate ways to measure capital for that, which is basically money that the bank has to hold back and otherwise effectively not put to work is significant as well. All of that has a huge impact on the markets where I represent our clients, which would be either financial markets, particularly the derivatives markets because the derivative is derivative of something else that a bank may or may not hold or deal in. So long time coming and long time still to go and two incredible depths, and I've reached the depth of what I know.
Dave Dalton:
What a segue, Josh. I told you he's done this before. Let's swing over to Jonathan. So sounds like, and some of the research I did and some of the notes that Josh was kind enough to send over, sounds like a lot of this has to do with bank capital standards relative to market risk. Were there very basic structural problems in the standards that needed to be addressed? Is that how we got here?
Jonathan Gould:
That's right Dave, or at least I should say, certainly the minds at Basel thought that there were some deficiencies with the current approach to market risk capital rules, and there are at least kind of four areas that I'd like to point out that FRTB is designed to address. Now, it's hugely complicated as Josh has mentioned, and it's part of a larger kind of regulatory capital package known as the Basel Three Endgame. I'm just going to confine myself to the FRTB, that's more than enough for today. So four things that I think they're really focused on, the regulators, both the Basel and of course our own US regulators are focused on. One is, as Josh alluded to, the lack of a clearly defined boundary between the trading book and the banking book. There was a real concern that banks were finding arbitrage opportunities and characterizing things in the banking book that really should have been in the trading book.
And they were doing so because you got kind of more favorable regulatory capital treatment by classifying them in the banking book. Another structural thing that the regulators were focused on were weaknesses associated with the existing value at risk or VAR approach to modeling risk. The 2008 crisis exposed a fallacy of a lot of assumptions, for example, that housing crisis couldn't go down for one, but also it showed certain shortcomings of how certain risk models performed in extreme conditions and high market volatility. It was the concept of tail risk really entered the kind of popular consciousness post 2008. So that was a factor in models as well. And one of the shortcomings of the value at risk approach was that it didn't do so well, or at least regulators thought it didn't do so well in terms of tail risks. So they come up with a new approach called expected shortfall that does a better job, we hope, of modeling what can happen in extreme volatility situations.
A third area they're focused on is the failure to consider the relative liquidity of trading book positions and the risks of market illiquidity. So one of the things we learned in the crisis that there can be a real trade-off between liquidation speed and price that you get. So how long does it take actually to liquidate positions and at what price and stress times depending upon the asset class? Is it 10 days? Does it take longer? What are the trade-offs, again, in terms of execution speed and the price you can get? So some of the assumptions that were built into the current market risk capital rules proved wrong or at least wrong in certain scenarios. And the fourth thing that I just wanted to mention is there was a perceived lack of transparency and comparability between the internal models that banks were using to predict risk and thus to determine what level of capital they'd have to hold against market risk and the standardized approaches.
There's really been kind of an increasing level of skepticism among regulators that banks' own internal models where just two black box to be comprehensible to either the market or the regulators and that neither markets nor regulators could compare and contrast one bank to another. So FTRB essentially, at least as proposed at the Basel level, makes it harder for banks to use these internal models. It requires supervisory approval at each trading desk rather than firm-wide. It imposes penalties in the form of capital add-ons for risk factors that fail model ability tests and it imposes requirements to meet profit and loss attribution and back testing standards to see if the models are actually performing to real world data, among other things.
Dave Dalton:
So those are the proposed changes, at least at a high level what you were getting to there, Jonathan, correct?
Jonathan Gould:
That's right.
Dave Dalton:
Josh, anything you'd add there in terms of where this is going, what the proposed changes will do and how this impacts clients?
Josh Sterling:
Yes, thank you Dave. I think that's an excellent summation by Jonathan. I mean, I should say that when I was at the CFTC, we finalized a capital rule for swap dealers. A lot of that was highly deferential to what the bank regulators would require for dealers that were regulated prudentially by the bank regulators like the OCC where Jonathan was the top lawyer. And I feel like a lot of work went into setting that standard into sort of prescribing the models that would be used for those standards. That work is just going to continue and this is all I believe pursuant to Basel Three, that being through third Basel, there may be more Basels. And so one would hope that fundamental principles remain in the minds of regulators as well as the industry and trying to think about how this could be implemented. The core concepts are banks need not only access to liquidity, they need to be able to continue to provide liquidity.
Sometimes enhanced capital standards can make that difficult. We saw that in 2020 when the market for treasury securities, one of the largest markets in the world for financial products, effectively dried up. There were letters from different parts of the government to other parts of the government saying, please can you let up on capital requirements so that treasury auctions can continue and things like that. So liquidity is important in making sure that capital charges and capital requirements are not what people now call pro-cyclical like in making it worse, and making sure fundamentally that we continue to have healthy banks.
2020 was a taste of what it must have been like to have been in government in '08, '09. I will just tell you that in those circumstances it really helps an economy and a country to have incredibly strong banks. We have the strongest banks in the world by far in the United States. And so hopefully as these things get unfolded and baked in, some of these bigger picture concepts are not lost. We need to be able to make sure banks can be liquid, can provide liquidity, that no capital charges are procyclical and that no capital requirement or change in modeling the results from this fundamental review weakens banks in the broadest possible sense. They need to stay strong to make the economy go.
Dave Dalton:
Sure. Jonathan, pick up on any points there you'd like from Josh and if you will reflect on your perspective as a former OCC official, how do you see all this working?
Jonathan Gould:
Yeah, thank you, Dave. So as Josh mentioned, we've got a long way to go still. So we still don't know how US banking agencies are actually going to propose to implement FRTB that's now just sitting at the Basel level and we're not sure how it's going to interact with the rest of the regulatory capital rules, many of which will also be modified in the so-called Basel Three Endgame package I mentioned earlier. That's due out this year as well. So it's really important to think holistically about impact of capital and that really goes to some of the points that Josh is making about what this means, liquidity and key markets and so forth. So we've got the broad outlines from Basel and other countries have begun implementing, but US markets are different from other countries markets and US regulators in my opinion, really have an obligation to modify as needed to reflect idiosyncrasies of the US market.
For example, the US has been consistently gold plating Basel standards for some time now, holding US banks to higher capital standards than many non-US jurisdictions. The US, for example, has a global market shock scenario under the Fed's stress testing program, which already captures market risk based on a tail risk event. So on some level, you can think of FRTB at least as conceptualized at the Basel level, and again, we'll see how it's actually implemented or proposed to be implemented at the US level, but potentially it could be double counting market risk for the biggest banks in the US. Obviously, that has pretty significant implications for US banks. The US also has certain legal requirements around regulatory capital, notably the Collins Amendment, which has the potential to complicate the implementation of Basel rate capital standards in the US again, exposing US banks to additional complexity in managing regulatory capital and also higher capital than other jurisdictions. Again, at least potentially.
So we clearly need to see what the US banking agencies are going to propose and to what extent they're willing to deviate from Basel. So again, we've got a long process still to go. Second, I guess I would say as both a former regulator and a consultant, I imagine banks will need to rethink or may need to rethink their trading desk structure to optimize for FRTB, you have to get supervisory approval at the trading desk level for the use of internal models under the FRTB at least as proposed by Basel. And if you can't get that approval, you have to use the standardized approach, which is generally viewed by banks as being more costly from a capital perspective. That kind of trading desk building block approach is really similar to what we saw with the Vockler rule and Vockler rule compliance, which again, also thinks about compliance in terms of specific trading desks at banks in terms of not just compliance, but also reporting and metrics and so forth.
And banks went through a process about a decade ago of reorganizing their trading desk structure to comply with the Volcker rule. My guess is they may need to take another look based on FRTB, but obviously again, we need to wait to see what the US regulators actually propose. And finally, in consistent with what Josh was saying, high level, one of the things I saw at the OCC was the very real cost of regulatory capital complexity, particularly in a crisis. The complexity and lack of transparency around regulatory capital can obscure regulatory accountability. And frankly, when regulatory capital becomes unintuitive, it also becomes hard for policy makers to know what button to push or lever to pull in a crisis. And I saw that firsthand back in March, 2020 when financial markets almost went off the cliff, again. And at least some of the post 2008 reformers were not necessarily that helpful or certainly weren't necessarily doing exactly what people intended them to do.
So regulators really need to be aware of the unintended consequences of what they're doing and the impact of capital on banks' willingness and ability to absorb shocks in the system. To me, FRTB, if they don't get the balance right here, runs the very real risk of further disintermediating banks from key capital markets because it'll be too expensive for them to hold inventory and leaving central banks even more exposed and needing to intervene to stabilize markets.
Dave Dalton:
A lot of great information here, a lot for our listener to unpack, but I want to start winding up with two things, and I hate this question, but I always have to ask it, timetable, what are we looking at? Is this months or years? And by the way, people listening, Jonathan's shaking his head like, you wouldn't believe what you're about to hear. So that's number one. But number two, what can clients do to start preparing for this, whether we're looking at a six month or a six year horizon? So Jonathan, let's start with you and then wrap up with Josh.
Jonathan Gould:
So FRTB has already been delayed pretty dramatically. The Basel processes are always slow. You can think of it like a train coming down the station, a cargo train with 200 freight cars kind of running behind it, and it just keeps coming and keeps coming. So FRTB has been delayed even beyond normal just because of obviously what happened with COVID. So that's kind of slowed down national level implementation, but it is coming and it's coming again as part of this larger Basel Three package of regulatory capital changes. We don't know for sure, but we're anticipating it's going to come out sometime this year, maybe the first half of this year, and then you can imagine it taking still months and months. It's just a proposal, it's going to have to be finalized. People are going to have a lot of opinions that are going to need to be weighed in carefully by the regulators, and then there's going to be an implementation time period even after the rule's finalized. So we're still talking about many months, if not a year or two to actually get to finalization.
Dave Dalton:
So what does a conscientious, responsible client do to start to prepare?
Jonathan Gould:
Given the slow motion, delayed nature of the FRTB process as well as more generally the Basel Three Endgame, a lot of folks have done a lot of great work already, not just banks, but trade associates have been trying to anticipate the impact of FRTB on market liquidity, credit costs and availability and the like. Lots of work done already. Lots of quantitative impact studies, again, not just by the regulators themselves, but also by the industry and their trade associations. To me, what a responsible bank should be doing in their trade associations, which again, most of them already are, is really focusing on and articulating very clearly what the impact of the US proposal will be when it comes out.
So as soon as that thing comes out, everybody's going to need really dig in and understand and put in real world terms what the cost of capital means for kind of main Street USA and make sure that they are engaging vigorously, not just with the regulators through the kind of comment process, but also with their trade associations and with frankly, Capital Hill policymakers in understanding how important it's to get the balance right between protecting against market risk in the system, but also acknowledging we can't kind of double count or go over the top in terms of capital requirements or we'll have very real and very harmful real world impacts.
Dave Dalton:
Great summation. Josh, we'll give you the last word. Wrap us up.
Josh Sterling:
Sure. The very last word should be Jonathan really knows what the heck he's talking about.
Dave Dalton:
For sure.
Josh Sterling:
But on top of that, I'll simply say that this is an area that we're continuing to watch actively. Our job as lawyers is to sort of think around the curve as to what's coming to our clients. Clients think every day about capital. Clients think every day about liquidity, and I mean our bank clients of course. And so we look forward to engaging in discussions with our clients and with our friends at the trade associations, of course, about this. I think we can offer a great perspective here at the firm, having a few folks that were in government the last time we had experienced pro-cyclical problems with capital standards that were supposed to make things better in a crisis. So we have some views on that. We also have some views on what, to us, was effective advocacy in that context.
And so the advanced planning needs to move into goal setting and pursuing it. Those goals should be categorized for potential second term of a Democratic administration as well as for, if I may, perhaps the first term of a Republican administration. I mean, there might be different responses in each case. So I just think that there are multiple points to consider and we look forward to talking with our clients about them as we have been already.
Dave Dalton:
Josh, Jonathan, we'll leave it right there. Hey, thank you so much for your time today, and I've got a hunch we're going to be talking again about perhaps this issue or maybe going a little more broad very soon. So thanks for your time today.
Josh Sterling:
Thank you.
Jonathan Gould:
Thank you.
Dave Dalton:
You can find complete bios and contact information for Jonathan and josh at jonesday.com. And while you're there, visit the Jones Day insights page where you'll find more podcasts, publications, videos, blogs, and other interesting content. You can subscribe to JONES DAY TALKS® at Apple Podcast, Google Play, Stitcher, or wherever else you find your podcast. JONES DAY TALKS® is produced by Tom Kondilas. As always, we thank you for listening. I'm Dave Dalton. We'll talk with you next time.
Thank you for listening to JONES DAY TALKS®. Comments heard on JONES DAY TALKS® should not be construed as legal advice regarding any specific facts or circumstances. The opinions expressed on JONES DAY TALKS® are those of lawyers appearing on the program and do not necessarily reflect those of the firm. For more information, please visit jonesday.com.
