Fundamental review of the trading book (FRTB) – A revised market risk framework

Initial situation

The Basel Committee on Banking Supervision (BCBS) published a second consultation paper (“Fundamental review of the trading book: A revised market risk framework”) for a basic overhaul of the capital requirements in trading books at the end of October 2013. Two simultaneous evaluations for capital charges of market risks in trading books at institutions with approved internal models (Regulatory Consistency Assessment Programme, February and December 2013) have shown significant differences in capital charges and thus confirmed that the market risk framework is in need of reform. With the fundamental review of the trading book (FRTB), the BCBS strives for a reform of following areas:

Differentiation between trading and banking book

A clear definition for the differentiation between trading and banking book positions shall help prevent regulatory arbitrage regarding capital charges. The BCBS basically takes the differentiation approach, that is aligned to the trading intent. Thus, following positions are to be assigned to the trading book: positions, which are held with the intention of a short-term resale, with a profit expectation from short-term price fluctuations, with the intention to generate arbitrage profits or for hedging risks of the aforementioned positions. All other positions are to be assigned to the banking book. In comparison to the previous differentiation, which is based on the subjective definition of trading intentions by the institutions, specific differentiation and allocation criteria are defined by the supervisory authority in the new regime. Deviations from these criteria require comprehensible reasoning from the institutions. Furthermore, subsequent changes to the initial assignment are only possible in special circumstances. with approval of the supervisory authority and without restrictions to the capital requirement. In the end, the national supervisory authorities have the possibility of revising the institutions’ assignment of positions to the trading or banking book

Revised standard approach

Stronger consideration of diversification and hedging effects makes the revised standard approach more risk-sensitive, but at the same time its calculation also more complex. The trading book positions are assigned to pre-defined risk classes (general interest rate risk, spread risk, default risk, share price risk, currency fund and commodity risk) within a “partial risk factor” approach. Then they are allocated to pre-defined risk factors, equipped with factor-specific risk weights and aggregated with correlations defined from supervision (to take hedging and diversification effects into consideration) beyond several steps for the whole capital requirement. The revised standard approach, that had been proposed in the second consultation paper, was overhauled once again within the consultation process with the banking business. The BCBS currently tends to a sensitive-based approach, in which first factor-specific sensitives are calculated for each risk position depending on the relevant risk class. Afterwards, they are integrated into the further process of risk weighting and aggregation. The “default risk” risk class is the only exception. For non-linear risks from options and tools with option components, additional capital requirements are intended for the “curvature risk” and “vega risk”.

Internal market price risk models

At the same time, the degrees of freedom for internal modelings of market price risks are limited. Internal models will be approved on the level of trading desks in future. Trading desks are defined as lines of business with a specified business strategy and a clearly defined risk management process. Internal market price risk models will be subject to a continuous quantitative evaluation in future, that plans a daily variance analysis of the actual and modeled P&L in addition to the previous backtesting as well as a model-independent risk monitoring (risk assessment tool), that is also to be carried out on the level of trading desks. The revised standard approach acts at the same time as a benchmark, which has to be published, a threshold value and a regulatory fallback. Thus, all institutions with internal market risk models have to simultaneously identify, report and publish the capital requirements according to the revised standard approach. The calibration of the internal market price risk model is carried out in an historical stress period in order to prevent procyclicality in the capital requirement. In addition, product-specific liquidity horizons between 10 and 250 trading days are introduced. A liquidity horizon is the period of time required to sell or hedge a risk position under adverse market conditions without a significant market influence. The expected shortfall will be used as a risk measure with a confidence interval of 97.5%, that takes extremely rare events (fat tails) better into consideration than the previous VaR and stress VaR risk measures. The capital charge of internal market price risk models will significantly increase because of the modeling on the level of trading desks, a calibration of risk parameters in stress periods, extended liquidity horizons and regulatory defined correlations for the aggregation of risk factors.

Migration and default risks

Institutions with approved internal market risk models will have to design migration and default risks with a two-factor model and have to deposit capital. The incremental default risk (IDR) capital charge measures the migration and default risks beyond credit spread fluctuations and substitutes the existing incremental risk charge (ICR) and comprehensive risk measure (CRM). The credit valuation adjustment (CVA) for the creditworthiness migration risk of OTC traded, derivative trading book positions will still be calculated separately with the corresponding banking book positions.

Securitization and correlation trading positions

The revised standard approach will generally apply for securitization and correlation trading positions in the trading book.

Currency and commodity positions in the banking book

The currency and commodity positions in the banking book will in all probability be subject to the new capital requirements for the market risks in the trading book. The BCBS is conducting a quantitative impact study for identifying the final parameters and threshold values within the half-yearly Basel III monitoring in August and September 2014. zeb expects the publication of the final version of the fundamental review of the trading book in the beginning of 2015, a European implementation by the end of 2015 and a binding application by institutions from the beginning of 2016 on. The new regulations require respective analysis and change activities at all institutions with trading books. The institutions, that don’t claim the exemption for “trading book activities of little scope” (CRR article 94), will have to act most. These institutions will face higher capital requirements and significant implementation efforts.