trading book

The Fundamental Review of the Trading Book (FRTB), is a set of proposals by the Basel Committee on Banking Supervision for a new market risk-related capital requirement for banks.

Background

The reform, which is part of Basel III, is one of the initiatives taken to strengthen the financial system, noting that the previous proposals (Basel II) did not prevent the 2008 financial crisis. It was first published as a ''Consultative Document'' in October 2013. Following feedback received on the consultative document, an initial proposal was published in January 2016, which was revised in January 2019.

Key features

The FRTB revisions address deficiencies relating to the existing ''International Convergence of Capital Measurement and Capital Standards''
Basel Committee on Banking Supervision, 2006 '' Standardised approach'' and '' Internal models approach'' and particularly revisit the following:
*The boundary between the " trading book" and the " banking book": i.e. assets intended for active trading; as opposed to assets expected to be held to maturity, usually customer loans, and deposits from retail and corporate customers; important since the "vast majority of losses were from trading books during the 2008 crisis"''Minimum Capital Requirements for Market-Risk''
International Monetary Fund, 2016
*The use of expected shortfall instead of value at risk as a measure of risk under stress; thus ensuring that banks capture tail risk events
*The risk of market illiquidity

FRTB additionally sets a "higher bar" for banks to use their own, internal models for calculating capital, as opposed to the standardised approach.''Fundamental Review of the Trading Book (FRTB)''
risk.net
Here, for a desk to qualify for the internal models approach, its model must pass two tests: a profit and loss attribution test and a backtest.

Calculation of capital requirements

As for other Basel frameworks, the Standardised Approach is directly implementable, but, at the same time, carries more capital; whereas the Internal Models approach, by contrast, carries less capital, but the modelling is more complex. More specifically, the calculations incorporate the above outlined enhancements, as follows.

*Under the Standardised Approach, the minimum capital requirement is the sum of three components: (i) Sensitivities-based capital, for seven risk classes, which reflects linear risks via their delta and vega (for options) risk factors, and non-linear risks via curvature. A capital charge is calculated here for three correlation scenarios, multiplying the sensitivities by supervisory risk-weights, and then applying rules for trade-by-trade and then overall aggregation, with the largest finally used. (ii) A default risk charge, capturing any jump-to-default risk. (iii) A residual risk add-on, appended for other market risks not captured, such as gap risk and behavioural risk.

*Under the Internal Models approach, the minimum capital requirement For an overview of the calculations, see, e.g., PwC (2016)
Basel IV: Revised Internal Models Approach for Market Risk
pwc.com uses expected shortfall (i.e. as opposed to VaR) at a 97.5% quantile, with differentiated “liquidity horizons” for five categories of instruments (standard 10 days previously); the expected loss is calibrated to the one-year period of the most severe stress since 2005. For non-modellable risk factors, those where appropriate data does not exist, stress scenarios are used as a proxy. Capital requirements are calculated at the level of trading desks and are aggregated for the whole trading book. To this is appended a default risk charge.

References

Bibliography

*Ioannis Akkizidis, Lampros Kalyvas (2018). ''Basel III Modelling: Implementation, Impact and Implications''. Palgrave Macmillan.
*Sanjay Sharma, John Beckwith (2018). ''The FRTB: Concepts, Implications and Implementation''. Risk Books. {{ISBN, 9781782723240

Bank regulation
Market risk
Capital requirement