Summary of FRTB for Risk Professionals

The article is intended for professionals already in investment banking and risk domain who have basic understanding of market risk. This shall introduce them to the FRTB (Fundamental Review of Trading Book) requirements and guidelines as specified within BASEL umbrella.

It's been more than a decade since the great financial crisis of 2008. Regulators have revised and redirected several guidelines since then to alleviate gaps existing current practices. One such regulation is called FRTB i.e. Fundamental Review of Trading Books (which comes under BCBS 352.

The FRTB addresses material weaknesses of the current market risk framework exposed by the financial crisis and aims to replace the existing regulation by harmonising the treatment of market risk across national jurisdictions. During the last crisis it turned out that the regulatory capital for market risk was not adequate enough to cover these risks. Therefore the Basel Committee on Banking Supervision has created with the fundamental review of the trading book (FRTB) a new framework to replace the old market risk regulation defined under “Basel II.5”. The intention is “to improve trading book capital requirements and to promote consistent implementation of the rules so that they produce comparable levels of capital across jurisdictions”.

The failure to prudently measure risks associated with traded instruments caused major losses for some banks during the global financial crisis. The Basel Committee’s revised framework marks a significant improvement to the pre-crisis regulatory framework by addressing major fault lines.

A brief history of regulations around capital requirement is illustrated in below timeline:

Given the challenges that the banks will face in implementing revised guidelines of the FRTB, the deadline of its adoption has been revised and extended to 2022 which is when most banks and financial institutions are expected to operate under FRTB.

What's a trading book though?

Many banks have portfolios of traded instruments for short-term profits. These portfolios – referred to as trading books – are exposed to market risk, or the risk of losses resulting from changes in the prices of instruments such as bonds, shares and currencies. Banks are required to maintain a minimum amount of capital to account for this risk.

Key objectives of FRTB happen to be:

• To develop an effective trading book vs banking (investment) book boundary condition
• To achieve a regulatory framework that captures and capitalises all market risks in the trading book,
• To improve risk measurement techniques and
• To achieve comparable levels of capital across internal risk models and the standardised approach.

The FRTB introduces several enhancements to the existing framework. Overview of the enhancements proposed are illustrated below:

FRTB sets a "higher bar" for banks to use their own, internal models for calculating capital, as opposed to the standardised approach. The Logic: the standardised approach is directly implementable, but, at the same time, carries more capital; the internal models approach, by contrast, carries less capital, but the modelling is more complex, requiring that expected shortfall is applied, together with add-ons for the "non-modellable risk factors" that lack sufficient data. Given this complexity, for a desk to qualify for the internal models approach, its model must pass two tests: a PnL attribution test and a backtest.

While this article is just to introduce the subject there is a lot more to it for inquisitive mind. You may like to read the full guidelines as proposed by BCBS here.