Fundamental Review of the Trading Book (FRTB) – Market Risk Framework

Author: Geetanjali Adhikari
Publish Date: June 10, 2019

The Fundamental Review of the Trading Book (FRTB) is a complete suite of capital rules developed by the Basel Committee on Banking Supervision (BCBS). It acts as part of Basel III, consider to applied on banks’ wholesale trading activities. It introduced in January 2016 as the Minimum Capital Requirements for Market Risk. It was being initiated to tackle many structural flaws in the framework that were not labeled by those revisions in the existing Basel II.5 framework. It was planned to put in place as final rules under domestic legislation on January 1st of 2019. But, on 7 December 2017, the Basel’s Committee oversight body, Group of Central Bank Governors (G20) and Heads of Supervision (GHOS), announced a delay in the implementation until 2022. In the EU, FRTB will put in place as part of the Revised Capital Requirements Regulation (CRR II), published in November 2016.

Focused Areas of FRTB:

  • Trading Book Guidelines: The BIS Committee has suggested strict guidelines for banks to switch from a regular banking book with trading book. They have also strived to close the loop slots in the capital dissimilarity in the event only where reverse is being permitted. The BIS Committee called this as the “revised boundary”, where in trading book guidelines will focus on minimizing the arbitrage, rather than questioning the justification of including a book in the trading book.
  • Stressed Value at Risk: The Basel committee introduced Stressed Value at Risk (sVaR). Approach to risk management will being calibrate to a stressed market condition time frame. Current VaR does not express the tail risk. The new trading book rules proposes to express the average of the expected risk in the tail, with a maximum per-centile confidence interval.
  • Treatment of Credit: The BIS Committee has convinced to bring the trading book requirements parallel to the ordinary banking book. Besides to this the committee also view differential treatment of the Securitized and non-securitized products. They also change the concept of CVA for including the counterparty credit risk valuation. The Committee has proposed that the CVA will kept unconnected from the Market Risk calculations for time being, and calculation of both will be separate.
  • Market Illiquidity horizon: A liquidity horizon is being defined as the time required to execute transactions that end an exposure to a risk factor, without disturbing the price of the hedging instruments, in stressed market conditions. Liquidity Horizon was introduced under Basel 2.5, as part of the Incremental Risk Charge and the Comprehensive Risk Measure. Under FRTB, the assigned risk factor will be under Banks’ liquidity horizon categories, ranging from 10 days to one year, to ensuring consistency in capital outcomes and balancing of the trade-off between simplicity and risk sensitivity.
  • Relationship between internal models-based and standardized approaches: The existence of large difference in calculation of capital by banks when they use the internal models as compared with the standardized approaches. The BIS committee is trying to bridge this gap between the models-based charges to determine their least capital requirements required to disclose the minimum capital requirements calculated according to the standardized charges that will help in bring the models-based calculation closer to the standardized approach calculations.

Impact of FRTB

FRTB expected to have larger impact on how it will affect banks’ business model and their capital structure. A lot of changes will come at the Trading Desk level, where they will have to certify their models. Also need to define how well these models capture the daily operations. FRTB will also impact their operating costs, solvency risks, and their ability of managing liquidity and profitability across their organization. Also, the trading desks will have to reconcile between their deferred losses versus the actual losses incurred. We can expect to see a lot of models changes and also technology and support services changes at all the trading desks. The current Basel 2.5 internal models’ approach have made more rigorous. Regulators can now provide approval for internal models at the trading desk level instead of at the entity level. Modeling risk for regulatory reporting has changed.