The financial crisis of 2007–2008 exposed significant vulnerabilities in the global banking system, particularly in how banks assessed and managed market risks. The reliance on risk measures that assumed normal behaviour when financial products were becoming more and more sophisticated didn’t work too well when markets went into distress.

In response, the Basel Committee on Banking Supervision (BCBS) introduced the Fundamental Review of the Trading Book (FRTB) as part of the Basel III regulatory reforms. This comprehensive overhaul aims to enhance the capital framework for market risks, ensuring banks are better equipped to withstand financial shocks.

Implementing the FRTB has proven challenging. The methodology requires a fundamental shift in how banks approach market risk. In many jurisdictions, it has not yet gone live, as regulators have been mindful of the operational hurdles involved.

What is the FRTB?

The FRTB is a set of international standards developed to reform the capital requirements for market risk in the trading books of banks. Its primary objectives include:

• Redefining the Boundary Between Trading and Banking Books: Establishing a clearer distinction to prevent regulatory arbitrage.
  
• Expected Shortfall (ES) Measure: Replacing the Value-at-Risk (VaR) metric with ES to better capture tail risks and provide a more relevant reflection of potential losses during market stress.
  
• Incorporating Varying Liquidity Horizons: Recognizing that different assets have different liquidity profiles, the FRTB assigns varying liquidity horizons to better account for the time required to liquidate positions without significantly impacting market prices.
  
• Enhancing the Internal Models Approach (IMA): Setting stricter criteria for banks that use internal models to calculate capital requirements, including rigorous back-testing and profit-and-loss attribution tests.
  
• Revising the Standardized Approach (SA): Making it more risk-sensitive and reflective of actual trading activities, ensuring it serves as a credible fallback to internal models.

Let’s go into each one of these objectives:

Banking and Trading Books

The difference between banking and trading books has to do with how you value financial products. On a banking book, you tend to have loans you give to individuals or companies. As time passes, you accrue the interest on these instruments and expect to receive the face value at maturity. The value does not change day to day apart from the interest accruing or when the loan defaults. The instruments on these books use accrual accounting and are usually called hold-to-maturity.

On the other hand, if a bank has stocks in its portfolio, their values do change. They change not only from day to day but intraday. And banks tend not to hold stocks all the way to their maturity. The same is true for government bonds when banks buy them to invest their excess cash and want something liquid in case they need the money to give to their depositors.

For these products, banks use available-for-sale books, where the price of the assets changes day to day, in a process that is called mark-to-market—meaning that the valuation of the portfolio represents its actual current value if it were to be liquidated at market price.

In the years before the GFC, banks would have trading and banking books under the same legal entity. When losses started to mount on leveraged positions, banks started to have issues with liquidity. With their assets losing value, the liabilities from real depositors were at risk, so the government had to bail out the banks.

The separation of banking and trading books under FRTB is very strict, so leveraged bets from banks, when gone wrong, will not affect the banking book positions and the deposits from regular folk.

Value at Risk (VaR) vs. Expected Shortfall (ES)

Value-at-Risk (VaR) is a risk measure that has been used for years. One of the most used versions is Historical VaR, where you build an empirical distribution of scenarios simply out of gains and losses of your portfolio if you had held it at different moments in the past. You can compute VaR as the, say, 1% largest historical scenario so that VaR is larger than what you may lose 99% of the time.

The problem with this measure is that it allows traders to take asymmetric bets that pay some if the market does not move much but lose a lot of money if it goes to extremes. In these scenarios, VaR would not work too well, as two portfolios could lose more than $1MM 1% of the time, but in one of them the most you could lose is $2MM, and in the other one you could lose $100MM.

Expected Shortfall is a very interesting measure, as it represents the average of losses at the 1%, so the latter portfolio would show a much larger Expected Shortfall. ES will be moderately larger than VaR in the first example but can go arbitrarily large if disproportionate losses are hidden in the tail.

Liquidity Horizons

This is a very interesting addition to the regulatory framework: Liquid instruments can be unloaded in days, while some other instruments might take weeks or months to be sold. The ES calculations assume these scenarios so you can have a more realistic view of how much money a bank can lose.

If for illiquid instruments the ES is $1MM daily, but it takes two weeks to unload the risk, then you need to assume that the ES should take into account windows of two weeks. FRTB has different windows for different products to calculate ES, which has a direct impact on how much capital a bank has to hold to be able to withstand these market moves.

Internal Models

Under the previous Basel framework, banks could calculate their capital requirements using some standard measures that could be extremely punitive in terms of capital allocation. So many would prefer to use internal models, meaning home-made frameworks to assess risk that were, in theory, more adapted to their specific situation.

But as we experienced during the GFC, a lot of these models were not good enough, and risk managers found out that there was a lot more risk in the banks’ balance sheets than what they believed.

Under FRTB, banks must calculate their risk measures using the standard method—which turns out to be much less punitive than the previous method—and they are only allowed to “save” capital to a percentage of what the standard methods would show.

Moreover, the calculations for the internal method assume historical calculations over different time periods and assume stressed situations that cover a wide range of scenarios, meaning that there is a lot of processing needed.

Standard Approach

The standard approach was revamped to better align with reality. The previous methods were notional-based and rudimentary, which resulted in unreasonable capital requirements. The new standard approach is risk-based and rather reasonable for plain vanilla products, while requiring more capital for complex ones.

Relevance of FRTB

FRTB is highly relevant in today’s financial landscape for several reasons:

• Addressing Post-Crisis Regulatory Gaps: The 2007–2008 financial crisis revealed significant shortcomings in the existing market risk frameworks. FRTB addresses these gaps by introducing more robust risk assessment methodologies, thereby restoring confidence in the financial system.
  
• Adapting to Market Evolution: Financial markets have become increasingly complex, with the emergence of new instruments and trading strategies. The FRTB’s enhanced risk sensitivity ensures that capital requirements keep pace with these developments, effectively capturing the risks associated with modern trading activities.
  
• Promoting Global Regulatory Consistency: As financial markets are globally interconnected, the FRTB provides a harmonized regulatory framework. This consistency reduces the potential for regulatory arbitrage and ensures that banks worldwide adhere to similar risk management standards.

Forecasted Impact on the Financial Industry

Several studies have forecasted the impact of FRTB on the financial industry:

• Increased Capital Requirements: The Basel Committee’s quantitative impact studies indicate that the FRTB could lead to a weighted average increase of about 22% in total market risk capital requirements relative to the previous Basel 2.5 framework. This increase aims to ensure that banks are better capitalized to withstand market shocks.¹
  
• Operational and Infrastructure Overhaul: Implementing the FRTB necessitates significant changes in banks’ internal systems. A study by McKinsey & Company highlights that banks will need to revamp their trading-risk infrastructure, including data management and IT systems, to comply with the new standards. This overhaul is expected to enhance risk assessment capabilities but may also lead to increased operational costs in the short term.²
  
• Impact on Trading Strategies and Market Liquidity: The FRTB’s stringent capital requirements for less liquid assets might prompt banks to reassess their trading portfolios. This reassessment could lead to reduced market-making activities in certain asset classes, potentially impacting market liquidity. The International Capital Market Association (ICMA) notes that while the FRTB aims to make markets more resilient, there is a concern that it could also lead to decreased liquidity in specific segments.¹

FRTB Implementation Timeline: When Will It Finally Be Deployed?

Since its initial proposal in 2016, the FRTB’s implementation has experienced several delays, with timelines varying across jurisdictions:

• Early Adopters: Countries like Korea, China, Canada, and India have already implemented the FRTB standards.
  
• Upcoming Implementations:
  
  United Kingdom: Implementation is scheduled for January 2027.
  
  United States: Implementation is expected by January 2026.
  
  Eurozone: The European Commission has postponed the application of FRTB standards to January 2027 to align with international peers and maintain a level playing field.

These staggered timelines reflect the complexities involved in overhauling market risk frameworks and the need for coordination among global financial systems.

Challenges and Considerations

The fragmented implementation schedule poses challenges for multinational banks operating across different jurisdictions. Banks must navigate varying regulatory requirements, which can lead to increased operational complexities and compliance costs.

Moreover, the need for robust data management systems to meet the FRTB’s stringent reporting and risk assessment standards cannot be overstated.

Fazit

The Fundamental Review of the Trading Book represents a pivotal step toward reinforcing the global banking sector’s resilience to market risks. While its implementation has been protracted and varies by region, the overarching goal remains consistent: to cultivate a more robust, transparent, and stable financial system.

As the FRTB continues to take effect worldwide, banks and regulators alike must remain vigilant, ensuring that the lessons from past financial crises translate into effective risk management and regulatory practices.

Works Cited

1. International Capital Market Association (ICMA). Fundamental Review of the Trading Book (FRTB). Available at: https://www.icmagroup.org/market-practice-and-regulatory-policy/secondary-markets/secondary-markets-regulation/fundamental-review-of-the-trading-book-frtb
   
2. McKinsey & Company. FRTB Reloaded: The Need for a Fundamental Revamp of Trading-Risk Infrastructure. Available at: https://www.mckinsey.com/capabilities/risk-and-resilience/our-insights/frtb-reloaded-the-need-for-a-fundamental-revamp-of-trading-risk-infrastructure