Fundamental Review of the Trading Book (FRTB)

The severe market stress during the financial crisis exposed significant weaknesses in the current framework for capitalizing market risks. To address the most pressing shortcoming the Basel Committee for Banking Supervision (BCBS) started an initiative to review the fragmentary Basel 2 rules. After several consultative documents and quantitative impact studies the BCBS published on 14th of January 2016 its final standard on minimum capital requirements for market risk. The new standard fundamentally modifies the way banks are required to measure market risk and contains the following key issues:

  • A revised boundary between the trading book and banking book: The final standard introduces a revised boundary between the trading book and banking book to reduce incentives for arbitrage regulatory capital between the books. In the future there will be explicit specifications whether a certain positions must be recognized in the banking or in the trading book. The reallocation of positions is strictly limited and subject to prior approval by the supervisory authority.
  • Revision of the internal model approach (IMA): The final standard implies a stricter and more granular approval process for internal models at a trading desks level. This makes it easier for supervisors to take decisions on disallowing the use of internal models. The statistical quality of internal models must be verified and documented also on the trading desk level. Additionally it will be required to calculate the standard approach, which serves as a fallback and benchmark measure.
  • Revision of the standard approach (SA): The final standard introduces a new sensitivity-based standard approach which is intended to be more risk sensitive compared to the existing requirements. The total capital charge results from the sum of delta-, vega-, damma- and default risks as well as a residual add-on for risks, which cannot be modeled by sensitivities.
  • Revision of risk methodology: The capital calculation based on the value-at-risk method will be replaced by the expected shortfall (97,5 %), which must be calibrated to a period of significant market stress. From the BCBS’s point of view the expected shortfall as a risk measure captures extreme losses (so-called tail risks) more adequately and meets the property of subaddivity.
  • Incorporating market illiquidity: The concept of varying liquidity horizons (10 to 120 days) is established under the internal model approach to capture the required time to liquidate a specific instrument under adverse market conditions. The liquidity horizons substitute the former 10-day scaling of the value-at-risk.

Based on the regulatory requirements, institutions need to take action in the following areas:

  • Revising the process of allocating risk positions to the trading and banking book as well as the process of subsequent changes.
  • Introducing the new standard approach
  • this is especially important for institutions which exclusively apply an internal model for market risks.
  • Upgrading internal models from value-at-risk based design to an expected-shortfall based calculation. Introducing new statistical methods and processes for back testing and validation of the expected-shortfall.
  • Analyzing the effects on capital requirements for different products, portfolios, trading strategies and business models.
  • Adjusting internal risk management and controlling practices to the new regulations.
  • Implementing new requirements concerning regulatory and internal risk reporting.
  • Enhancement of existing market risk engines or the implementation of new systems, as well as their integration into the existing front office architecture.

The new standard will enter into force on the 31th of December 2019. The transfer into European law and the adaptation of the corresponding legal texts (CRR/CRD IV) are still due. As these changes have a strong impact, it is highly recommended to initiate impact studies and projects at an early stage.

We offer the following services in the field of “Fundamental Review of the Trading Book”:

  • Performing impact studies to analyze the effects on the organizational structures, processes, data supply and systems of the institution
  • Analysis of the legal requirements to deduct business requirements with regard to the client’s status quo
  • Development of target solutions for the calculation and optimization of the capital charge
  • Functional requirements, test planning and management, rollout of IT architecture
  • General management of entire projects