FRTB: An Overview
What is the Fundamental Review of the Trading Book regulation?
There have been many in-depth articles written about the Fundamental Review of the Trading Book (FRTB) and its implications on capital requirements using the different calculation methods. This is not one of those articles. This article aims to give you a high-level overview of what FRTB is, which in turn will help enable you in your quest to learn in more about it.
Where does FRTB originate from?
On the back of the 1974 Herstatt bank collapse, the G10 countries came together to create a committee under the Banking of International Settlement (BIS) known as the Basel Committee on Banking Supervision (BCBS).
In 1988, BCBS published a set of standards, known as Basel I, which became banking regulations focusing mainly on credit risk. These regulations defined the minimum capital requirements for banks.
These regulations were then revised and extended in 2004 and were creatively named Basel II. They were introduced as the 3 Pillars. These 3 Pillars were referring to:
- Minimum Capital
- Supervisory review
- Market Discipline
On the back of the 2008 financial crisis, the standards were extended and refined further, resulting in Basel III regulation, which includes FRTB.
Note: Capital requirements refer to how much cash or cash-like products a bank needs to hold at any point in time, to be in a position to cover their risk. In other words, the higher the risk a bank takes, the more capital it will need to hold.
What does FRTB bring to the table?
There are two main components to FRTB that you need to be aware of; Expected Shortfall and a refined definition of the banking and trading book.
Expected Shortfall
When it came to calculating Market Risk under Basel II (what is known as Pillar 1), the required standard was Value at Risk (VaR). This was in turn, fed into Pillar 2, which was used for the internal capital adequacy.
As we have previously seen when we learnt to calculate VaR, Value at Risk does not cater for tail risk. Black Swan events are not catered for, which was something heavily criticised in the 2008 financial crisis. Expected Shortfall caters for that, as it calculates the exposure on the tail end of the distribution.
Going forward with FRTB, banks will be required to report Expected Shortfall and therefore report a better representation of their risk.
Definition of Banking and Trading Book
Banking and Trading books are essentially accounting definitions which a bank’s assets are categorised under. Assets under each category are treated differently and hence influence risk differently.
The trading book definition refers to assets which are frequently traded. Under the Basel regulation, these assets are to be marked to market daily. Consequently, as the value of these assets changes daily, so does the VaR and hence the capital requirements.
The banking book definition, on the other hand, refers to assets are will be held by the bank to maturity and will not be traded. As such, these assets are allowed to be held using their historical cost.
FRTB introduces a stricter definition of the instruments categorisation to the banking or trading book. This ensures that the correct traded instruments make it to the capital calculations.
NB: FRTB also changes the definition of the interest rate and credit spread risk (with IR being calculated for the banking book). This blog post goes into the details about it.
What are the different FRTB calculations?
There are two different types of calculation approaches when it comes to FRTB. You can think of it as the simple calculation and the more complex, potentially less punitive calculation. Depending on the size and complexity of each bank’s portfolio, choosing one over the other could make sense.
Firstly, the “simple calculation”, is known as the Standardised Approach, which is a sensitivity based approach. This calculation method involves calculating sensitivities for each position and then aggregating them per risk factor to find the correct weights for the capital calculation.
The “more complex” calculation, is known as the Internal Method Model (IMM) approach which involves each bank coming up with their own model and providing sufficient backtesting evidence to the regulator to get it approved.
When is FRTB going live?
There have been several iterations on the regulations, with the standards being published in 2016, revised in 2018 and again in 2019. The final go-live date, for the Pillar 1 calculation, is 1st Jan 2022.
Why do you care?
If you are a financial services professional, this is a hot topic right now, and it’s good to know what are some of the projects or initiatives your institution is undertaking. Having a high-level understanding helps you piece things together and understand how the industry is changing — especially how the industry is evolving on the back of each financial crisis.
If you are an investor, on the other hand, you would want to know that there will be a change in the risk-weighted assets of the bank from the banking/trading book definition update and hence impacting how much capital the banks would need to hold.
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