Fundamental Review of the Trading Book explained

The Fundamental Review of the Trading Book (FRTB), is a set of proposals by the Basel Committee on Banking Supervision for a new market risk-related capital requirement for banks.

Background

See also: Basel III: Finalising post-crisis reforms. The reform, which is part of Basel III, is one of the initiatives taken to strengthen the financial system, noting that the previous proposals (Basel II) did not prevent the financial crisis of 2007–2008.^{[1] [2]} It was first published as a Consultative Document in October 2013.^[3] Following feedback received on the consultative document, an initial proposal was published in January 2016,^[4] which was revised in January 2019.^[5]

Key features

The FRTB revisions address deficiencies relating to the existing ^[6] Standardised approach and Internal models approach^[7] and particularly revisit the following:

• The boundary between the "trading book" and the "banking book": ^[8] i.e. assets intended for active trading; as opposed to assets expected to be held to maturity, usually customer loans, and deposits from retail and corporate customers; ^[9] important since the "vast majority of losses were from trading books during the 2008 crisis"^[10]
• The use of expected shortfall instead of value at risk as a measure of risk under stress; thus ensuring that banks capture tail risk events
• The risk of market illiquidity

FRTB additionally sets a "higher bar" for banks to use their own, internal models for calculating capital, as opposed to the standardised approach.^[11] Here, for a desk to qualify for the internal models approach, its model must pass two tests: a profit and loss attribution test and a backtest.

Calculation of capital requirements

The calculations incorporate the above outlined enhancements, as follows. As for other Basel frameworks, the Standardised approach is directly implementable, but, at the same time, carries more capital; whereas the Internal models approach, by contrast, carries less capital, but the modelling is more complex.

• Under the standardised approach, ^[12] the mimimum capital requirement ^[13] is the sum of three components: (i) Sensitivities-based capital, for seven risk classes, which reflects linear risks via their delta and vega (for options) risk factors, and non-linear risks via curvature. A capital charge is calculated here for three correlation scenarios, multiplying the sensitivities by supervisory risk-weights, and then applying rules for trade-by-trade and then overall aggregation, with the largest finally used. (ii) A default risk charge, capturing any jump-to-default risk. (iii) A residual risk add-on, appended for other market risks not captured, such as gap risk and behavioural risk.
• Under the internal models approach, ^[14] the mimimum capital requirement ^[15] uses expected shortfall (i.e. as opposed to VaR) at a 97.5% quantile, with differentiated “liquidity horizons” for five categories of instruments (standard 10 days previously); the expected loss is calibrated to the one-year period of the most severe stress since 2005. For non-modellable risk factors, those where appropriate data does not exist, stress scenarios are used as a proxy. Capital requirements are calculated on the level of trading desks and are aggregated for the whole trading book. To this is appended a default risk charge.

Bibliography

• Ioannis Akkizidis, Lampros Kalyvas (2018). Basel III Modelling: Implementation, Impact and Implications. Palgrave Macmillan.
• Sanjay Sharma, John Beckwith (2018). The FRTB: Concepts, Implications and Implementation. Risk Books.

Notes and References

1. Web site: The Basel Committee - overview . 28 June 2011 . The Basel Committee on Banking Supervision . 5 April 2019.
2. Book: Basel Committee on Banking Supervision . 2019. Explanatory note on the minimum capital requirements for market risk . 978-92-9259-236-3 .
3. Web site: Fundamental review of the trading book: A revised market risk framework - consultative document . www.bis.org . BIS . 17 April 2022.
4. Book: Basel Committee on Banking Supervision . 2016. Minimum capital requirements for market risk . 978-92-9197-416-0 .
5. Book: Basel Committee on Banking Supervision . 2019. Minimum capital requirements for market risk . 978-92-9259-237-0 .
6. https://www.bis.org/publ/bcbs128.pdf International Convergence of Capital Measurement and Capital Standards
7. https://www.bis.org/publ/bcbs17.pdf An internal model-based approach to market risk capital requirements
8. https://www.bis.org/basel_framework/chapter/RBC/25.htm "Boundary between the trading book and the banking book"
9. http://www.bankpedia.org/index.php/en/87-english/b/23139-banking-book Banking book
10. http://pubdocs.worldbank.org/en/253431477065134529/4-Minimum-Capital-Requirements-for-Market-Risk.pdf Minimum Capital Requirements for Market-Risk
11. https://www.risk.net/definition/fundamental-review-of-the-trading-book-frtb Fundamental Review of the Trading Book (FRTB)
12. https://www.bis.org/basel_framework/chapter/MAR/20.htm?inforce=20230101&published=20200327 MAR 20: Standardised approach
13. For an overview of the calculations, see, e.g., PwC (2016). Basel IV: Revised Standardised Approach for Market Risk, pwc.com
14. https://www.bis.org/basel_framework/chapter/MAR/30.htm?inforce=20230101&published=20221208 MAR 30: Internal models approach
15. For an overview of the calculations, see, e.g., PwC (2016). Basel IV: Revised Internal Models Approach for Market Risk, pwc.com