FRTB — Overview Of Fundamental Review Of Trading Book
By: Farhad Malik
Tags: Fintech, Risk Management, Finance, Frtb, Banking

FRTB — Overview Of Fundamental Review Of Trading Book

Understand How Basel I, II, II.5 and Basel III Capture The Market Risk

This article provides an overview of the new banking capital requirements known as Fundamental Review Of The Trading Book (FRTB). There are two prescribed approaches to calculate the market risk under FRTB. These two approaches are known as internal models approach (IMA) and standardised approach (SA).

Please ensure you read this regulatory FRTB document to understand the requirements in depth.

Nearly every large bank has a team dedicated to calculate FRTB. Hence it’s important to understand FRTB.

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I will be concentrating more on the internal models based approach (IMA) in this article. Having said that, I will provide a quick overview on the standarised approach (SA) to ensure that the readers are familiar with the concept. However I will avoid taking a deep dive into the SA approach due to its simplicity.

Please read FinTechExplained disclaimer. Also please let me know if any of the information is incorrect or if you spot a mistake so that I can ammend it accordingly as it will help the wider community too.

Understand The Reasoning Of FRTB

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Let’s quickly go over the history first:

A number of regulatory requirements have been introduced in the past such as Basel I, Basel II, Basel II.5, Solvency II and Basel III regulatory requirements.

Basel I required calculating the VaR market risk capital for 10-day holding period with 99% confidence level. This approach did not take the historic data into account and was very much focused on the recent risks. Basel II.5 then improved on the Basel I calculation and required banks to compute a stressed VaR measure. This measure was then added to the 10-day VaR. The stressed VaR was intended to capture the 250 day period of stressed market conditions. Additionally, incremental risk charge (IRC) was introduced in Basel II.5. IRC highlighted the credit spread risk and jump to default risk. Both of the risks are present in the credit-dependent risk assets. Jump to default risk is the risk that the issuer company might default. Incremental default risk (IRD) charge was introduced to capture the aforementioned risks. Additionally, comprehensive risk measure (CRM) charge was introduced to address risks from the securitised positions. The price of an asset is dependent on the credit spread of the asset. IRC assumed that the risk level is constant. The risks were calculated using the internal models of the bank which lead to significant variations in the risk figures amongst different banks. Each position on an asset belongs to a book, being trading or a banking book. Trading book assets are traditionally marked-to-market on timely basis whereas the banking book assets are held until maturity. As a consequence, credit risk rules were applied more to the banking book assets and the market risk capital rules were applicable more to the trading book assets. The issue with this approach was that it introduced regulatory arbitrage as the capital requirements were relaxed by the institutions by moving the credit dependent assets into the trading book.

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Addressing Problems With VaR

The risk researchers were still unsure whether VaR is an appropriate measure due to its apparent weaknesses and inabilities to capture the losses when crises do occur. VaR did not capture the tail risk. FRTB then proposed a new measure. This measure is known as Expected Shortfall (ES). The key point to take is that the measure is coherent. It captures when things DO get bad.

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Expected Shortfall Was Introduced

Expected shortfall (ES) can capture the tail risk. As a result, 97.5% confidence interval expected shortfall was proposed by FRTB. Subsequently, banks are now required to compute capital based on ES using a 250-day stressed period. Note, the 250 day window can be self-selected by the bank. 250 day is equivalent to one financial year.

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Solving Trading & Banking Book Issue

A clear distinction between the trading and banking book assets was proposed by FRTB which is very much rule based. FRTB requires banks to prove their intent to move an asset to the trading book as the assets in the trading book are there with an intent to trade and the banks are required to physically manage the risk that are associated with the underlying asset. To block the institutions from moving assets from trading to banking books, new strict rules are proposed. Unless an extraordinary circumstance has occurred, once an asset is assigned to a book, it has to remain in the book. This rule now prevents switching books of the assets to relax the capital requirement. Listed equities, options, repos and instruments that can be marked to market are placed in the trading book where as unlisted equities and those instruments that are not MtMd are placed in the banking book. FRTB ensures that the securitizations should use the standardised approach to compute the CRM which I will be highlighting later.

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3 Key Points

There are three key points to note:

Instead of 99% confidence level VaR, 97.5% confidence level Expected Shortfall measure is favoured. A rule based criteria for assets has been outlined. This criteria can help us determine whether the asset is for a banking or a trading book. Asset level liquidity horizons have been prescribed by the regulators. These horizons reflect the volatility of the assets.

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Let’s Go Over The Third Point On Liquidity In Depth

The ten day horizon was not considered good enough as the liquidity of the transactions are dependent on the risk factors. There are many risk factors that can impact the portfolio.

Examples of the risk factors include interest rate, credit spreads, equity price, FX rate, energy price and so on. FRTB proposed that each risk factor should be assigned a liquidity horizon for the capital calculation.

A liquidity horizon (time) is mapped to the risk factors. As an instance, Fx Volatlility risk factor has been assigned the liquidity horizon of 60 days. The liquidity horizon indicates the time it is required for a transaction to execute in a stressed market condition without impacting the price of the hedging instrument. It is the time taken to extinguish an exposure to a risk factor.

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FRTB team proposed 5 categories for the risk factors as each risk factor shock might not be correlated across liquidity horizons. Each category has its liquidity day horizons.

In the internal models based approach, following steps are taken in to calculate the expected shortfall.

The expected shortfall is measured for 5 successive shocks. The main goal is to measure how the P&L will alter for the five expected shortfalls shocks. The final expected short-fall is then calculated by scaling to the square root of the difference in the horizon lengths of the risk factors.

This can be represented as a formula:

Lastly, the standardised risk measure for each bucket is calculated. The buckets are computed by grouping the risk assets with similar characteristics into the buckets.

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To find the standarised risk measure for each bucket, following data is used:

Value of the risk factor Weighting factor given by the Basel committee Correlation given by the Basel committee

The regulatory capital is then calculated by combining the standardised risk measures for each bucket.

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Profit And Loss (P&L) Attribution & Backtesting

It is fairly difficult to back test stressed ES measures because it is very unlikely for stressed scenarios to occur in the future with the same frequency. Instead, backing VaR is recommended. Additionally, the P&L attribution is computed for the difference between the actual and model’s P&L on a given day and the actual P&L. If the number of exceptions fall outside the range that is prescribed by the FRTB then the standardised approach has to be taken.

Standardised Approach (SA) For FRTB

Finally, I want to mention the standardised approach which is much simpler in nature. It is not as computationally intensive as the IMA approach. Furthermore, there is no requirement to back test and pass P&L attribution in the SA approach.

The standardised approach for market risk has three components:

Sensitivities based approach whereby the first order delta, vega and curvature risk factor sensitivities is calculated for the risk classes.

Only non linear products such as options have vegas and curvatures. Delta is present in all of the trading products. The calculation is straight forward:

Default risk is computed for the risk classes. It takes the jump to default loss for each position and offsetting into account. Finally, the discounted exposure by a hedge benefit ratio is computed by taking the default risk weights into account. Finally residual risk add on (RRAO) is computed by applying the risk weights to the notional of the instruments with non-linear payoffs. RRAO is computed for the products with correlation and gap risk. The calculation is fairly simple: Take the notional of the position and multiply it to the risk add on weight. Finally sum all of the RRAO charges together.

FRTB prescribed the risk weights and the required correlations between them. Please ensure you read this regulatory FRTB document thoroughly.

Summary

This article explained what FRTB is and how it is computed:

Instead of 99% confidence level VaR, 97.5% confidence level Expected Shortfall measure is favoured. A rule based criteria for assets has been outlined. This criteria can help us determine whether the asset is for a banking or a trading book. Asset level liquidity horizons have been prescribed by the regulators. These horizons reflect the volatility of the assets.

Finally it provided an overview of the standarised approach.

Please ensure you read this regulatory FRTB document thoroughly to understand the requirements in depth. And please do let me know if you spot any mistakes/changes that I need to take into account.