The Fundamental Review of the Trading Book

In the aftermath of the Global Financial Crisis of 2007 – 2009, the Basel Committee on Banking Supervision (BCBS) initiated the Fundamental Review of the Trading Book (FRTB) with the goal to revise the risk-based capital requirements related to trading activity. FRTB was initially scheduled to become effective on January 1, 2022 but the date has been pushed back to January 1, 2023 and may be further delayed as many regulators are unlikely to be ready for implementation and supervision of the new requirements. However, as this initiative will have wide-ranging implications for trading risk and banks’ ability to provide capital, firms should be monitoring developments and actively engaging with regulators and industry groups.?

The BCBS identified several structural deficiencies in the methodologies used to calculate risk-based capital during the crisis, including the lack of a clearly defined boundary between banking book and trading book, which created an arbitrage opportunity, where capital could be reduced via the transfer of positions from trading book to banking book. In addition, traditional VaR measures, that were appropriate during normal market conditions, failed as an accurate measure of risk during periods of elevated market volatility. The existing framework also didn’t handle liquidity adequately, as it was based on a liquidity horizon assumption of 10 days whereas many positions would take longer to unwind.?

The goals of the FRTB are:

·??????To create clear regulatory boundaries between trading book and banking book

·??????To replace the VaR risk measurement with a more comprehensive Expected Shortfall (ES) approach

·??????To revise the Standardized Approach (SA) to make it more risk sensitive and an appropriate fallback to the Internal Model Approach (IMA)

·??????To replace the 10 day liquidity horizon with variable horizons in the IMA

·??????To introduce a capital add-on for factors that fail modelability tests, a Non-Modellable Risk Factor (NMRF)

·??????To create a new approvals process for the IMA and to require those approvals to be made at a desk level as opposed to firm level

The banking industry in the US has raised concerns that the FRTB will add market risk RWA unevenly to trading firms, depending on the composition of their portfolios, so it’s likely that the BCBS will revisit certain aspects of the approach after reviewing industry impact analysis.

Firms can adopt two approaches to calculate their market-risk capital requirements, the SA and the IMA. All banks must implement the SA while some may opt for the IMA, subject to stringent model performance standards. The SA is the default market-risk capital requirement for all banks. The IMA is subject to initial and continuous performance testing, so the SA is the fallback if a firm fails to meet its model performance goals.?

The SA is significantly more risk sensitive than the current VaR-based approach as it introduces a new Sensitivities-Based Approach (SBA) which is reliant on data produced by the bank’s pricing models. It’s expected that many banks will need to create new modelling capability to meet this requirement. The SA capital risk charge consists of the SBA, the Default Risk Charge (DRC) and the Residual Risk Add-on (RRA). The SBA is an aggregate of delta, vega and curvature-based sensitivities. The DRC seeks to capture a “jump to default” or credit risk spread. The RRA is designed to capitalize exposures that are not captured by the SBA. Generally, the RRA is applied to more complex instruments where the exposure is difficult to quantify.?

The IMA replaces the VaR-based approach for quantifying market risk with the ES approach. The ES approach is a better measure of tail risk in stressed market conditions. The IMA applies a DRC to capture losses from an obliger defaulting. For a desk to qualify for IMA, they must demonstrate that a model is supported by adequate P&L attribution tests and back testing results. ES measures the expected changes of all positions in the portfolio in the tail of the P&L distribution that exceeded the VaR. For a firm to use the IMA, it must be able to model risk factors. If a firm can no longer model risk factors it must include the NMRF charge.?

The implementation of FRTB will have a significant impact on market risk RWA and banks’ ability to make markets in certain instruments. Each approach and metric could be the subject of a separate post but, this overview is intended to provide a view of the scope and impact of this initiative for banks in the next few years. All firms should be constantly monitoring developments in this area and actively engaging with regulators and industry groups to prevent significantly adverse treatment of market-risk capital measurement, specific to the composition of their trading books.?