Blog: JONES DAY TALKS®: Preparing For FRTB – What Banks Should … – Mondaq

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,
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TALKS® is produced by Tom Kondilas. As always, we thank you for
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