The traditional three lines of defence approach to Risk Management is being reinforced on several fronts. The Senior Managers Regime focuses attention on the accountability of the Front Office as the first line to effectively manage all of their risk origination and warehousing activities. Risk and Finance, the second line, are expected to focus on daily monitoring of risk-taking activities and attribution of PL, evidencing an effective challenge process and governance structure. Audit has also had regulatory scrutiny to increase the authority, stature and technical capability of the function to provide assurance of this ownership-accountability-challenger model.
It’s called Fundamental for a reason
FRTB presents a number of methodology, data granularity and computation challenges for all banks regardless of whether they deliver the internal model approach or stick with the sensitivity based approach. As the 2019 deadline comes into view, there is a tendency for groups within Risk, Finance and Technology to rush into designing a solution based on their current infrastructure without engaging fully with the Front Office, who traditionally have taken a less active role.
Given the time it takes to execute on large IT programmes, this is understandable. The “Fundamental” part of FRTB centres on the linkage between model approval and its application at the desk level. This requires the Front Office to take a much more active role in the adoption of FRTB, to take ownership back from Risk and Finance and to evidence meaningful accountability to senior management and the regulators.
Back to the Front Office
Each desk head needs to take full ownership and control of the business that they are accountable for. The list of activities is not exhaustive; the key feature of the new governance model is that these are expected to be performed by the Front Office rather than syndicated across Risk/Finance: –
- Business Strategy – product mandates, revenue, cost of resources, turnover
- Operational Integrity – booking issues, confirmation backlog
- Resource Usage – balance sheet, capital costs, liquidity, reserves
- Portfolio Risk – market, model, credit, counterparty, concentrations
- Liquidity Management – Stale risk reports and inventory holding against turnover, collateral and repos
- EOD Valuation – Product/model configuration, market data calibration and snapping, flash PL and attribution
- Transfer Pricing – Pricing under master agreements and CCP, link to XVA
- Data Provenance – Ownership of all transaction data including tagging for capital and disclosure reporting
Given the complexities of FRTB and the capital cost of running market risk, the desk head will need to refine a suite of products that provides a value-added service for clients at an attractive cost of origination. For a portfolio of individual client transactions, the resultant mix of underlying, strike and maturities together with their hedges is likely to have a capital charge that accumulates with each new deal. This accumulation will need to be priced on a marginal basis based on additional cost of hedging or capital that in time will impact the overall value of the product offering.
Such repricing of the capital impact requires continuous and forensic analysis of how the portfolio consumes capital and what hedges are most efficient. Such prototyping requires multiple recalculation of the capital and fits well in a FO quant model of development. This should be a complement to the traditional large central batch processing run in Risk. Given the cost pressures however, this duplication of effort and lack of joined up engagement, in our view is not sustainable. Technology needs to industrialise the code created by the FO quant teams and deploy on a compliant production platform so that the output can be used downstream.
Much of the new operating model centres on the definition of how Product is valued and risked – its model configuration, what risk factors accurately attribute the PL and describe the risk, how to calibrate market data to observable marks, define liquidity profile etc. This is best done by the Front Office who are closest to the trade. Risk and Finance need to monitor and challenge the embedded assumptions and move away from creating their own version through normalisation and enrichment which at best is second-guessing the Front Office.
For the Audit function, the challenge is that the need to step into the role recently done by the regulators to be able to provide assurance. Like the regulators, Audit need to form review teams that includes those with deep subject expertise from the other lines of defence.
Changing the operating model between Front Office, Risk/Finance and Technology is always harder than changing code – in the end it boils down to people, process and systems. At PFG, we propose that the FRTB programmes should sponsor the setting up of a working group consisting of Traders, FO quants, Risk, Finance, Technology and Audit. Their objective is to provide a roadmap to move the bank towards the model. Their first task is to address the following challenges: –
- KPIs – Articulate an appropriate set of KPIs needed to provide evidence of an effective risk management process and where in the Front Office technology landscape then can be measured and made available for monitoring by Risk/Finance
- Product – For each product define the instruction set for; valuation, risk factors for PL attribution plus capital, and data tagging for disclosure reporting. Agree how to transfer responsibility to the Front Office and how Risk and Finance can agree on a common set of Risk Factors that drives PL attribution and capital
- Data – Highlight data that contributes to capital and disclosure reporting that is not stored in a unique golden source repository – reference/hierarchy, market and transactional data plus common hierarchies. Provide roadmap for data production to move upstream and integrated into a singular product instruction set
- Quant – Define very specific functions that FO quant team should be allowed to do, agree a transition of code that is used in any part of the PL and Risk process onto a secure production environment with the necessary mandated controls
- Flexibility – Highlight compensating activities in Risk/Finance based on too much flexibility provided by Front Office Risk systems (e.g. Murex, Sophis). Agree what choices by the Front Office need to be curtailed or locked-down
- Governance – With a clearer separation of responsibilities across the lines of defence and a focus on challenge, can the current risk governance framework be streamlined in terms of committees and reporting demands, can Audit be convinced of model assurance
Working Group Support
Setting up a functioning working group that crosses the three lines of defence plus technology groups is not easy. The key to a successful group is to have facilitators that have deep experience across the silos and have a strong grounding in technology delivery. Parker Fitzgerald is a practitioner-led consulting firm that is focused exclusively on the risk disciplines in the finance industry. Our practitioners have an average 15 years of industry experience with core knowledge across Front Office risk technology, providing IT support for FO quant teams, and working across many teams to deliver programs such as Basel 2.5/3.
Through their “Co-sourcing” offering, Parker Fitzgerald work with audit teams to provide subject expertise during each stage of a more technical audit. This expertise spans pricing model validation, capital model development, traders and risk managers.