Gives an introduction to the proposals and changes introduced due to the Fundamental Review of the Trading Book (FRTB)

Basel Committee on Banking Supervision (BCBS) released a consultative document titled, "The Fundamental Review of the Trading Book" (FRTB) in 2012 1. The intent of this document and the subsequent discussions and studies was to address the shortcomings of the existing market risk capital framework, and reduce the variability in the minimum capital standard for market risk across different jurisdictions.

The key changes proposed under the new market risk framework finalized on 14th January 2016:

  • A revised internal models-approach (IMA). The new approach introduces a more rigorous model approval process that enables supervisors to remove internal modelling permission for individual trading desks, more consistent identification and capitalisation of material risk factors across banks, and constraints on the capital-reducing effects of hedging and diversification.

  • A revised standardised approach (SA). The revisions fundamentally overhaul the standardised approach to make it sufficiently risk-sensitive to serve as a credible fallback for, as well as a floor to, the IMA, while still providing an appropriate standard for banks that do not require a sophisticated treatment for market risk.

  • A shift from Value-at-Risk (VaR) to an Expected Shortfall (ES) measure of risk under stress. Use of ES will help to ensure a more prudent capture of “tail risk” and capital adequacy during periods of significant financial market stress.

  • Incorporation of the risk of market illiquidity. Varying liquidity horizons are incorporated into the revised SA and IMA to mitigate the risk of a sudden and severe impairment of market liquidity across asset markets. These replace the static 10-day horizon assumed for all traded instruments under VaR in the current framework.

  • A revised boundary between the trading book and banking book. Establishment of a more objective boundary will serve to reduce incentives to arbitrage between the regulatory banking and trading books, while still being aligned with banks' risk management practices.

The BCBS estimates that FRTB will result in 40% increase in total market risk capital requirements as compared to the current Basel 2.5 framework. The changes proposed under FRTB not only have an impact on the capital requirements, but it will also pose significant challenges to a bank's technology infrastructure.

.. to be continued

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