The Fundamental Review of the Trading Book (FRTB) is a set of regulations introduced by the Basel Committee on Banking Supervision (BCBS) to overhaul banks’ trading book capital requirements. FRTB aims to improve the resilience of the global banking system, enhance the risk sensitivity of capital requirements, and reduce the possibility of arbitrage between the trading book and the banking book.
The FRTB was introduced as a response to the shortcomings of the existing market risk framework, which was exposed during the global financial crisis of 2007-2008. The revised framework was first published in January 2016 and has since undergone various updates and clarifications. The FRTB has two main components:
The Standardized Approach (SA):
The Standardized Approach is a set of rules and methodologies provided by the BCBS to calculate banks’ market risk capital requirements. It serves as a floor for the capital requirements and acts as a fallback for banks that do not have an approved Internal Models Approach. Under the SA, banks must calculate risk sensitivities and bucket them into risk classes (e.g., interest rate, credit, equity, foreign exchange, and commodities). The SA also introduces a new Default Risk Charge (DRC) to address the default risk of traded instruments.
The Internal Models Approach (IMA):
The Internal Models Approach allows banks with sophisticated risk management capabilities to use their internal models to compute their capital requirements for market risk, subject to regulatory approval. The IMA requires banks to calculate Expected Shortfall (ES), a measure of tail risk that captures potential losses in extreme market conditions. Banks using IMA must also comply with qualitative and quantitative criteria known as the “IMA eligibility test,” which includes the P&L Attribution (PLA) test and backtesting requirements.
To implement the FRTB, banks must change their risk management infrastructure, data management, and reporting systems significantly. This may involve updating their risk models, enhancing data quality, and investing in new technology solutions to comply with the stringent requirements. The FRTB has been implemented in several jurisdictions, with the deadline for compliance varying depending on the region.
The FRTB is a comprehensive regulatory framework designed to strengthen the global banking system by enhancing the risk sensitivity of capital requirements and improving the overall resilience of banks. It introduces significant changes to the market risk capital framework, which requires banks to adapt their risk management practices, data management, and reporting systems.