Fundamental Review of the Trading Book (FRTB)

In 2016, the Basel Committee on Banking Supervision (BCBS) performed a hypothetical portfolio exercise on risk-weighted assets calculated on the same portfolio by multiple banks.  The exercise exposed substantial variations in the calculations between these banks,  signifying the need for a more uniformly applied treatment of market risk. As a result, the Fundamental Review of the Trading Book (FRTB) was introduced by the BCBS in January 2016 with a goal to remediate the shortcomings of market risk capital framework developed in Basel 2.5, and create a more harmonized treatment of market risk in an effort to reduce excessive variation in capital ratios resulting from significant internal modelling differences.

In achieving the desired objectives, the FRTB has introduced revisions to five key areas:

  • Trading Book vs. Banking Book aims to establish a more objective, concrete boundary with explicit requirements for inclusions/exclusions to reduce the scope of arbitrage between the regulatory banking and trading books.
  • Overhaul of Internal Models-Approach (IMA) introduces more rigorous model-approval processes at the trading desk level and new risk capturing methods that will replace the previously used VaR / SVaR methodology.
  • Overhaul of Standardized Approach (SA) to make this approach more risk-sensitive by requiring it to capture residual and basis risks not captured in the existing framework.
  • Shift from VaR to Expected Shortfall (ES) to remediate a shortcoming of the current VaR by introducing a new industry standard, “Expected Shortfall,” for capturing tail risk and capital adequacy during periods of high financial stress.
  • Incorporation of Risk of Market Illiquidity incorporates varying liquidity horizons into revised SA and IMA approaches to mitigate the risk of sudden impairment of liquidity across asset markets.

The impacts of FRTB include high costs for rule implementation, as investments in technology and infrastructure and additional operational and process complexity will result in increased BAU costs.National supervisory rule-making is required by January 2019banks are required to be fully compliant and reporting under the new standards by December 31, 2019.

Gartland and Mellina is engaging clients to assess FRTB impacts and needs. GMG develops approaches that are customized to the specific needs of each individual client and formalizes subsequent support in preparing for the implementation of FRTB.

Gartland & Mellina Group — A Management Consulting Company