FRTB threatens dynamic FX hedging of capital ratios

Industry says recent Basel proposals are unclear and retain burden of pre-approval for hedges

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  • On March 22, the Basel Committee published a consultation paper revising elements of the market risk framework known as the Fundamental Review of the Trading Book.
  • The rules require banks to capitalise all foreign exchange positions – whether in the trading book or the banking book – under FRTB. An exemption is provided to hedges that are placed to mitigate the FX risk to banks’ capital ratios.
  • The consultation alters the qualifying criteria for the exemption by removing limitations on the amount of hedging banks can put in place.
  • However, banks complain the rules still require them to seek regulatory approval for any hedging changes, precluding the effective deployment of dynamic hedging strategies.
  • Uncertainty exists over whether the hedging activity of bank subsidiaries qualifies for the exclusion.

Comic book heroes Batman and Robin are dubbed the ‘Dynamic Duo’ due to their effectiveness in fighting crime on the streets of Gotham City. But if the pair had to ask the mayor for permission before apprehending each criminal mastermind, fans of the duo would have to find a different nickname to describe the partnership.

Treasurers may feel the same way about the Basel Committee’s Fundamental Review of the Trading Book. The market risk rules make allowances for banks to use dynamic hedging strategies for their capital ratios – but only with pre-approval from the regulator, among other restrictions. Changes proposed recently by Basel have done little to assuage fears that the new rules could hinder these hedging efforts.

Under FRTB, banks have to capitalise all foreign exchange positions as market risk, whether or not the position is held in the trading book or banking book. But the rules provide an exemption to hedges undertaken to mitigate the impact on banks’ capital ratios from expected or actual adverse movements in exchange rates – known as structural FX hedges.

Banks are vulnerable to changes in the exchange rate between the currencies in which overseas subsidiaries operate and the currency in which their parent company’s capital ratio is denominated.

On March 22, the Basel Committee launched a consultation revising aspects of the FRTB, including the exemption provided to structural FX hedges. Banks and lobbyists had previously complained about the limiting nature of the exemption, and so the latest changes aim to align the exemption more closely with current market practices.

But the revisions do not go far enough, warn bankers and lobbyists, and the proposed exemption still does not reflect the reality of hedging techniques. In particular, the need for local supervisors to pre-approve changes to hedges, together with lingering ambiguities in the text, could tie the hands of treasurers when hedging their banks’ capital ratios.

“If each time you need to change your position you have to approve it with the regulator, it would be hard to be dynamic,” says a capital manager at a large European investment bank. “It doesn’t work as efficiently as you would like, given the time it would take for you to go to your supervisor, [and] for the supervisor to then review it and then come back to you.”

This isn’t something that stays static. As your assets and liabilities change you may want to change the size of the FX hedge you have in place
Bank capital manager 

While banks have to capitalise the counterparty credit risk of the trade for uncollateralised swaps, they are exempt from capitalising the market risk due to the position being a risk management tool for capital. This helps to lower the overall capital burden of the new FRTB regime.

The exemption is even more significant for banks aiming to pass the profit-and-loss attribution test, which allows them to use their own internal models to capitalise market risk exposures. The internal models approach is desirable because it is likely to produce significantly lower capital numbers than the alternative regulator-set standardised approach.

The P&L attribution test compares the profit and loss outputs of the bank’s internal risk model with the numbers produced by the front-office pricing model. Ideally, these numbers should match closely, affirming the validity of the bank’s modelling efforts. Only then can the desk in question use the internal models approach for calculating its risk capital. Divergences between the two figures could result in the failure of the test and loss of internal model approval.

Banks face a challenge to incorporate the structural FX hedge into the front-office pricing model because it is held in the banking book rather being a trading book exposure, which the front office undertakes and accounts for. As a result, including banking book hedges under market risk could cause FX desks to fail the P&L attribution test. Banks are keen, therefore, to make use of the exemption to avoid the prospect of the more punitive standardised approach.

Not so dynamic

Under the current drafting of the consultation paper for structural FX, banks would be prevented from changing their hedging position as frequently or as quickly as they would need to.

“This isn’t something that stays static. As your assets and liabilities change, you may want to change the size of the FX hedge you have in place. If then you have to go through supervisory approval each time you have to modify it, it just seems burdensome,” says the bank capital manager.

Dynamic hedging is where a firm reviews and changes its hedges frequently in response to anticipated market movements. This contrasts with static hedging where the firm does not rebalance the exposure and the position is maintained until maturity. As currency rates can change frequently and sometimes unpredictably, firms often deploy a dynamic hedging strategy to neutralise structural FX risk.

Missing media item.
Jouni Aaltonen

“Where banks have multiple branches and subsidiaries around the world, they often adjust those hedges and roll the hedges over,” says Jouni Aaltonen, a director at the Association of Financial Markets in Europe (Afme), a banking industry body. “It is not like you have an open FX position and try to establish maturity, and put on a trade for that maturity and that’s it. That’s not how it works in reality and the Basel Committee need to recognise that in the FRTB.”

Changes to hedges largely depend on the parameters set by the overall policy assigned by the treasury. Treasurers would define how much the underlying exposure would need to move before altering any hedge stemming from the exposure. If a small move occurs, the bank may opt to wait before changing the position, while more significant moves could require immediate action.

A capital-management expert at a consultancy says the restrictions would be particularly problematic during a period of volatility in the FX market, such as in the months following the UK’s decision to leave the European Union. A UK firm with foreign subsidiaries, for example, would have a capital ratio denominated in sterling. With the value of sterling constantly decreasing and increasing with each development relating to Brexit, its capital ratio would correspondingly shrink and inflate.

“If you have a very large fluctuation of one currency to another on a daily basis, then there are circumstances [where] what you expected to be an effective hedge for a week, month or year becomes completely ineffective just overnight,” says the consultant. “If they want to design the regulation in a way that is useful, it should at least take into account situations like that and provide the banks with the opportunities to readjust their hedge for very large market movements.”

Wasting everyone’s time

Pre-approval could also prove unnecessary and burdensome for the supervisor, says the bank capital manager, as the rules require all banks to submit documentation to their regulator regarding the positions and amounts of structural FX hedges.

If the local regulator had cause to suspect the bank was no longer using the exemption for legitimate structural FX hedges, this could give grounds for the regulator to challenge the bank.

“There is a burden on the supervisor,” says the bank capital manager. “They have got to look at this again and again each time a bank wants to change something. It is also unnecessary because there is already a requirement to report the positions to the regulator in the text, so they have documents and they could review that, and then ask questions. It doesn’t make sense to have the additional approval for each change.”

Right now, dynamic hedging is not being recognised and it is very complicated to do if you want recognition from the regulator of that strategy

Capital management expert

The intention of the structural hedging requirements is to ensure banks do not use the exemption for FX positions that are ultimately traded to gain profit from a move in currency rates, rather than for hedging the structural FX risk.

Being able to scrutinise banks’ every move before they even make them would help local regulators to keep banks in check. But this objective might not fit perfectly with the loose hedging strategies banks deploy to tackle the risk.

“Right now, dynamic hedging is not being recognised and it is very complicated to do if you want some sort of recognition from the regulator of that strategy. The regulators want to see a consistent approach and that is not always the case for dynamic hedging strategies,” says the capital management expert at the consultancy.

Instead, Aaltonen of Afme says regulatory pre-approval should be reserved only for changes to the bank’s overall policy.

“The wording is that you get a supervisory pre-approval for the hedge. Is it for individual transactions or the hedging strategy? It makes sense to pre-approve the hedging strategy but not each individual transaction if there are changes in your balance sheet structure and current valuations. It is not hedged once at that top-of-the-house level – it is a much more granular and much more gradual change,” says Aaltonen.

Provisional problems

Regulatory pre-approval is not the only requirement in the exemption that would threaten hedging strategies. Ambiguities in other provisions could result in restrictive interpretations hindering treasury departments.

One area of ambiguity in the consultation paper is what is meant by the exclusion of the hedge “remaining in place for the life of the assets or other items”. Bankers are unclear about the meaning of “assets” – whether it refers to the capital instrument or the hedge that is put in place.

If the word indicates the capital instrument, and the underlying is debt, then banks would have to match the duration of the hedge with the underlying. This would be a drawback for any attempts at dynamic hedging.

If the underlying is equity, further doubts exist. “With instruments that don’t have a maturity, such as equity, does that mean you can’t hedge at all? I think the wording needs clarity to ensure dynamic hedging can still be done,” says the bank capital manager.

Holding companies may hedge subsidiary ratios themselves and the capital ratio can change because of both the capital and the risk-weighted assets

Bank capital manager

Another point of uncertainty is the requirement that “the exclusion…is made for at least six months”. Sources are interpreting this in different ways. The capital manager reads it as requiring the firm to review every six months whether the position is a legitimate hedge.

But understands from other sources that the Basel Committee’s intention is for six months to be an indicator for supervisors to assess whether a position is genuinely structural – with a discretionary degree of leeway the supervisor could apply.

The rationale is these positions are held over the long term and are not intended to make a profit, which suggests the exemption is provided to positions lasting for a minimum of six months. This could prove problematic if the bank needs to place or replace short-dated hedges due to expected changes in the underlying price movement for a currency.

Aaltonen of Afme says: “I would think it should be that the ‘open FX strategy in place’ or ‘hedging strategy in place’ should be reviewed every six months. The problem with the current wording is the delta and ratio may change over that six-month period, so you may need to adjust your hedges over time. That needs to be more aligned with industry practices.”

The bank capital manager agrees this interpretation would make it hard for banks to use suitable hedges: “Sometimes the liquidity in these markets means you may want to keep rolling a short-dated position, particularly if the risk is short.”

A further complaint is the FRTB defines structural FX in the limited context of exposure from overseas entities, without directly mentioning the denominated currency of the firm’s capital ratio. For example, a German bank with global business might want to hedge the fall of the euro against a basket of currencies, rather than hedging the rise of each individual currency against the euro. Currently, the wording of the consultation paper does not allow for structural FX activity explicitly undertaken for this purpose.

The proposals also do not state whether the exemption covers subsidiaries that might need to hedge the FX risk to their own capital ratios. A UK bank with a subsidiary in Hong Kong, for example, might hedge the GBP/HKD rate. But if the Hong Kong subsidiary also runs operations in Malaysia, the parent may wish to hedge the HKD/MYR rate to protect the subsidiary’s capital ratio. Any reduction in the subsidiary’s capital ratio would eat into the amount of dividend payments passed from the subsidiary to the holding company.

“The bit the Basel Committee don’t put across in the structural FX requirements is that the holding companies may hedge subsidiary ratios themselves, and the capital ratio can change because of both the capital and the risk-weighted assets, which would mean there could be a hedge stemming from a move of both parts of the ratio,” says the bank capital manager.

The manager adds: “They need to make sure the structural hedge can hedge a subsidiary ratio and either side of the capital ratio, and each one of those gets picked up for the exemption.”

So although bankers might not be relying on a fictional ‘Dynamic Duo’ to help fix shortcomings in the FRTB’s latest text, a concerted push from the industry could take them some of the way there.

Silver linings

The March 22 consultation paper updating the Basel Committee’s original Fundamental Review of the Trading Book text does offer some solutions to the ambiguities and bureaucratic process in the requirements for structural FX hedges, sources say.

The previous version of the exemption limited the hedge to the size of the parent’s holdings in the affiliate or subsidiary. But banks complained this metric was misguided; hedging is intended to protect against adverse FX movements for the capital ratio. As such, the original rules imposed the wrong benchmark for the amount of structural FX hedging the banks would be able to undertake.

The previous exemption also suggested banks would not be able to hedge the FX exposure arising from branches, since that entity type was not specified in the wording.

The Basel Committee has now altered the language. Instead of limiting the amount of the hedge to investments in foreign entities, the consultation paper limits the hedge to the amount that would mitigate the sensitivity of a bank’s capital ratios to movements in exchange rates.

Also, branches are included in the definition of the activity falling under a structural FX hedge. “Branches are included in scope, which is helpful because banks need to be able to hedge the exposure from those entities,” says Jouni Aaltonen of Afme.

Additional reporting by Philip Alexander. Editing by Alex Krohn

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