Nuts & Bolts of FRTB – Introduction

In January 2016, the BCBS published the final rules under FRTB for calculating market risk capital. These rules to be implemented by the end of 2019. As the name suggests, the rules have fundamentally changed the ways market risk capital will be calculated for the Trading Book. These rules are expected to change the Financial Markets in a significant way. In this Nuts & Bolts of FRTB series, I will provide information on the key aspects of the new FRTB rules which are now known as Minimum Capital Requirements for Market Risk.

Key Objectives

FRTB rules can be seen to achieve following main objectives:

1. Reduce the ability for banks to arbitrage capital requirements by transferring transactions between Banking Book and Trading Book. This is achieved by providing
   • prescriptive guidance on what qualifies for the trading book;
   • rules on capital treatment when transactions move between trading and banking books;
   • requirements for regulatory reporting on compliance with trading book boundary rules, inventory ageing and limits.
2. Risk sensitive standard model for calculating market risk capital. New standard approach is completely redesigned to take into account three risk sensitivities – Delta, Vega and Curvature risks. Capital charge is calculated for individual risk factors and is aggregated using pre-defined correlations.
3. Fix shortcomings in VaR based internal market risk model.
   • New measure based on Expected Shortfall to be used by banks to calculate market risk capital;
   • Risk factor based granular liquidity horizon;
   • Model approval at individual trading desk level;
   • Introduction of non-modellable risk factors;
   • New desk level P&L attribution and backtesting requirements.

Certainly there is more to this but most of the changes or new rules can be placed into one of these three main categories. These changes will have significant impact on the bank’s Business strategy (Organisational, Trading, Customer, Products, Capital Management), Data strategy and Market Risk IT infrastructure strategy due to increased complexity in performing calculations and the substantial increase in market risk capital requirements. According to the BCBS’ FRTB – interim impact analysis, compared to the current market risk framework, the proposed market risk framework would result in a weighted average increase of 74% in aggregate market risk capital charges.

In my next blog, I discuss requirements around Trading Book boundary.