FRTB readiness: Examining the potential pitfalls ahead

The Fundamental Review of the Trading Book (FRTB) is one of the central pillars of post-financial crisis reform.

The market risk FRTB covers is related to a bank’s trading book, and is defined by the Basel Committee as “the risk of losses arising from movements in market prices”. This covers default risk, interest rate risk, credit spread risk, equity risk, foreign exchange risk and commodities risk within the trading book, and forex risk and commodities risk in banking book instruments. 

National supervisors are not required to begin implementing FRTB until January 2019, with banks not being forced to report their figures under the new standards until December 31, 2019. The rules are complex and require reworking of bank models to correctly capture the risk being taken. This work is timely and needs to be a major focus for institutions as the deadline approaches. 

Banks may use a standardised approach (SA) or an internal model approach (IMA) to calculate their capital. Both approaches are being overhauled to better understand trading-book risk that regulators deemed insufficient under the previous Basel II market risk capital framework. The SA is now being recalibrated to capture default risk and other residual risk, and will underpin the IMA as it is more punitive.

The IMA requires approval by national regulators and can be removed at any time. To be approved, it must meet the requirements of a profit-and-loss (P&L) attribution test, which requires a measure of hypothetical P&L and a risk-theoretical P&L. The other key component that must be signed off by regulators is ‘backtesting’, which consists of determining how well the risks in the IMA are captured, and is generally understood to be a more straightforward test to pass.

The new IMA will also replace the value-at-risk (VaR) measure, which was commonly based on a 10-day liquidity horizon, 99% confidence level and a stressed VaR component. The FRTB rules will now also be implementing expected shortfall, which should more accurately capture a bank’s tail risks. 

As the 2019 FRTB deadline looms over financial institutions, firms must prepare today to create a foundational system for the future that provides the visibility and flexibility required to comply with the new standards. By seeking an architecture that encompasses next-generation model validation and governance, advanced predictive analytics, unified data foundation, expanded data modelling and governance capabilities, and extensive automated reporting capabilities, financial institutions will be well positioned for the new world ahead.

Read/download the survey report & white paper, FRTB readiness: Examining the potential pitfalls ahead

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