Fundamental Review of Trading Book (FRTB)
FRTB was introduced by Basel in May 2012 to set out a revised framework and more stringent trading book capital requirements in the wake
of the credit crisis. It aims to distinguish, as clearly as possible, between a Trading Book and Banking book, so as to have different
levels of capital requirements.
The following are the prominent areas of focus under this regulation.
- To reduce scope for regulatory arbitrage between trading and banking books
- Incentivising a standard model approach to risk modelling rather than internal model approach to risk modelling
- Creating new risk categories
- Regulatory examination of proprietary models
- Shift from value at risk to an expected shortfall measure of risk
- Establish realistic and manageable liquidity horizons
Under FRTB, a trading book is a portfolio of securities that the firm intends to actively trade (i.e. with a relatively short liquidity horizon),
whereas a banking book contains products that lenders intend to hold till maturity. Financial institutions will be required to disclose to
regulators a list of assets intended for migration from the trading book into the banking book. Trading will need to designate their holdings
under the category of trading book holdings and banking book holdings before they approach regulators for approvals to move their positions.
Further, the regulations will also introduce a more rigorous approval process for his firms seeking to use internal models compared to a standard models.
Currently, financial institutions have two options for measuring risk levels and applying them to capital adequacy calculations.
They can create their own risk measurement rules and submit them for regulator’s approval or use a standard, pre-approved model.
Because the former usually yields lower capital requirement, banks were more likely to choose it. However, the diversity in proprietary
models results in inconsistencies across market players, making comparison and regulation different.
Under FRTB, the standard model will be based on risk sensitivities across asset classes, providing consisting measure across geographies
that allow regulators to compare risk and aggregate systemic risk.
Once the regulation comes into force, the affected banks will require significant day to day operational changes. For example, towards the
end of the trading day, trading desk and middle office functions will need to calculate and report their P&Ls on a risk adjusted basis.
The tentative compliance year of this regulation is 2019.