FUNDAMENTAL REVIEW of THE TRADING BOOK (FRTB)

Measuring and managing the risk capital in a bank is critically important in maintaining global financial stability. Especially when large losses are common in the market common or in times of highly volatile markets.

Thus, It makes sense to ensure that banks are correctly regularized and sufficiently capitalized. The goal of FRTB regulations is to lead a transformation in calculations of market risk capital. FRTB aims at the contribution towards more resilient and vibrant banking governance and functionating system that fairly remains afloat amid any deepening crisis by bringing more granular guidelines focusing towards Market Risk.

The level of capital against trading books has proven to be insufficient to absorb losses in the past.

Moving Away from VaR to Expected Shortfall

• FRTB regulations proposed that instead of VAR99% C.I, Expected shortfall i.e. ES97% C.I to be used.
• ?Capital charge should be calculated solely on Expected shortfall using a 12-month stressed period. Which is different from BASEL 2.5 in which CAPITAL = VAR+SVAR, similar to that regulation banks need to search down through time and look for a period that would suit its current portfolio position.

Trading Book vs Banking Book Items

• The FRTB attempts to make the distinction between the trading book and the banking book clearer and less subjective.
• ?Prior to FRTB, the designation of any instrument was left on banks discretion. Banks were allowed to put any instrument in any book on intent basis and further misuse it gets added advantages.
• ?Instruments in the trading book are marked to market (i.e., revalued) daily while instruments in the banking book are not. Instruments in the banking book are subject to credit risk capital while those in the trading book are subject to market risk capital. The two sorts of capital are calculated in quite different ways. This has in the past given rise to regulatory arbitrage.
• ?Banks hold credit-dependent instruments in the trading book because they are then subject to less regulatory capital than they would be if they had been placed in the banking book. The incremental risk charge (IRC) introduced in Basel II.5 was designed to stop this kind of regulatory arbitrage.

?Under FRTB regulations, BASEL further tightens these norms by adding certain clauses:

Once an instrument is put into either of book, they can’t be moved except in extraordinary circumstances.

If such a situation arises then banks must inform the regulator about the same and seek their approval to do so & it should be disclosed to the public about it.

In case, regulator disapproves the change then the bank will have to follow the regulator.

Banks will not be allowed to take advantage of lower capital requirements that arise in the event of switching.

“The BIS WAS HIGHLY CAUTIOUS ABOUT THE REGULATORY ARBITRAGE & CAPITAL ARBITRAGE MITIGATION”

Liquidity Horizons

• ?Time is required to sell a financial instrument or hedge all of its material risk associated with it. In stressed market condition, without moving its price.
• ?In the latest set of guidelines, it was decided that liquidity horizons will be assigned to Risk factors rather than instruments.
• In BASEL I and BASEL II.5, the measure of 10-day time horizon was used, which is to be changed because the market variable underlying transaction varies according to their liquidity.
• FRTB proposes that changes in the market variable should take place over different time horizons that should reflect differing liquidities of market variables.
• The periods of time are referred to as liquidity horizons. Five different liquidity horizons are used: 10 days, 20 days, 60 days, 120 days, and 250 days.

SBM: Sensitivity Based Methods

• ?This approach is compulsory for all the banking institutions irrespective of their internal model mechanism to compute the same. It should be used for the calculation of the market risk capital charge and reported to the supervisors at least monthly.
• In addition, Banks must be in the position to explain and produce all the calculations for the supervisory review, if necessary.
• If the bank has not set out any explicit mechanism for a particular instrument, then it should apply the general rules prescribed in this approach.?

Internal Models Methods

• VaR & SVaR is replaced with Expected Shortfall.
• Expected Shortfall (ES)?

?for capturing of Liquidity (defined at factor level not position levels)?

• Incremental Risk Charge (IRC) is replaced with Direct Capital Charge (DRC).
• ?The Comprehensive Risk Measure (CRM) is abandoned.
• RNIV is replaced with SCS (NMRF)