Fundamental Review of the Trading Book: An Overview of Key Components

By Sergiy Ladokhin & Aijaz Siddique / March 2021

Executive Summary

Fundamental Review of the Trading Book (FRTB) is a regulatory framework to calculate capital requirements for banks’ market risk. The FRTB is a long-awaited response of the regulators to the financial crisis of 2008, and it overhauls multiple elements of the current capital calculations. The FRTB consists of various elements; the banks will need to report to the national regulators based on some of these elements starting as early as September 2021.

Let us summarise the key elements of the FRTB regulation. First of all, the framework defines a strict boundary between the trading and banking books. All the securities that fall under the trading book will be subject to FRTB calculations. The regulation defines requirements on banks’ internal rules for assigning products to either the banking or the trading book. The FRTB allows several approaches for the calculation of market risk capital requirements:

  • Standardised Approach (SA) is a set of rules to calculate capital requirements based on regulatory prescribed parameters. The SA calculations are detailed in nature and are based on the Sensitivity-Based approach, namely sensitivities of the positions to a pre-defined risk factor.
  • Internal Models Approach (IMA) contains a number of changes compared to the current requirements. A switch to a new risk measure (Expected Shortfall) with multiple liquidity horizons and a P&L attribution test are the main new elements.
  • Simplified Standardised Approach (SSA) is a light version of SA and can be used by smaller local banks without a significant trading book.

FRTB SA will be used as the floor to calculate the capital requirements according to FRTB IMA. It means that even if a trading desk decides to use IMA for capital reporting purposes, the SA approach should always be calculated.

Successful FRTB implementation poses a number of challenges for financial institutions. The FRTB puts a significant emphasis on the data requirements and data granularity. Additionally, banks may consider a cost-benefit and impact analysis to determine whether to implement the IMA approach or stay with the SA.

The FRTB regulation will affect all Dutch banks. However, the level of the impact will differ significantly per financial institution, depending on the business model and the chosen type of the FRTB approach. Some banks will need to build governance around the split between the banking and trading book only, while others will implement the new models on top of the new data vendors’ feeds and other significant IT changes. Nevertheless, all banks will be involved with some level of reviews of the market risk activities and associated risk calculations.

This paper is the first in a series of white papers that Probability & Partners will publish about the FRTB regulation. This article provides a general overview of the FRTB, while the Standardised and Internal Models Approaches’ details will be covered in the consequent white papers.