FRTB: An Executive Summary

The Fundamental Review of the Trading Book (FRTB) represents a significant overhaul of the regulatory framework governing capital requirements for banks' market risk exposures. Developed by the Basel Committee on Banking Supervision (BCBS), this initiative emerged in response to shortcomings identified during the 2007-2008 financial crisis. The FRTB aims to enhance the resilience of the banking sector by introducing more stringent requirements and methodologies for calculating capital adequacy.

Key Objectives of FRTB

Strengthening Capital Requirements: The FRTB is designed to ensure that banks hold sufficient capital against potential market risks, thereby enhancing financial stability.
Addressing Tail Risk: A primary focus of the FRTB is to better capture tail risks—extreme market events that can lead to significant losses—which were inadequately addressed in previous frameworks like Basel II.5.
Eliminating Regulatory Arbitrage: By establishing a clear boundary between trading and banking books, the FRTB seeks to prevent banks from exploiting regulatory loopholes to minimize capital requirements.

Core Components of FRTB

The FRTB framework introduces several critical components that reshape how banks assess and manage market risk:

Revised Trading Book Boundary: The FRTB enforces a stricter distinction between trading and banking books, requiring explicit justification for any reallocation of instruments between these categories. This aims to prevent regulatory capital arbitrage and ensure accurate risk categorization¹².
Market Risk Approaches:
Standardized Approach (SA): This approach involves predefined parameters for calculating capital requirements, serving as a baseline for all banks.
Internal Models Approach (IMA): Banks can use their internal models to calculate capital, provided they pass rigorous tests, including profit and loss attribution and backtesting. IMA emphasizes the use of Expected Shortfall (ES) over traditional metrics like Value at Risk (VaR), reflecting a more holistic view of potential losses, especially during periods of market stress²³⁶.
Simplified Standardized Approach (SSA): Designed for smaller institutions with limited trading activities, this approach offers a less complex method for managing market risks².

Implementation Challenges

The implementation of FRTB poses several challenges for financial institutions:

Data Requirements: The framework demands high levels of data granularity and quality, necessitating substantial investments in data management systems²⁴.
Cost-Benefit Analysis: Banks must evaluate whether to adopt the IMA or remain with the SA based on their specific business models and trading activities²⁶.
Regulatory Compliance: Institutions will need to establish robust governance frameworks to comply with new regulations, which may involve significant operational changes¹⁷.

Impact on Financial Institutions

The FRTB is expected to have varying impacts across different banks, largely dependent on their size and complexity:

Larger institutions may face substantial increases in their risk-weighted assets (RWA), with estimates suggesting an average increase of around 65% for top banks adopting internal models¹⁰.
Smaller banks may benefit from the SSA but will still need to adapt to new reporting requirements and risk management practices.

Conclusion

The Fundamental Review of the Trading Book represents a pivotal shift in how banks manage market risk and calculate capital requirements. By addressing previous deficiencies in regulatory frameworks and emphasizing a more rigorous approach to risk management, the FRTB aims to foster greater stability within the financial system. As banks navigate these changes, proactive adaptation will be crucial not only for compliance but also for enhancing their overall risk management capabilities in a dynamic market environment.