Fundamental Review of the Trading Book: Understanding the Framework and Approaches

The trading book is a crucial component of a bank's risk management framework, and understanding its fundamental framework and approaches is essential for effective risk management. The trading book is responsible for managing market risk, credit risk, and liquidity risk.

The trading book is typically divided into two main categories: trading and banking book. The trading book includes positions taken by banks for their own account, such as proprietary trading, while the banking book includes positions taken for clients, such as customer deposits and loans.

To manage risk effectively, banks use a variety of approaches, including value-at-risk (VaR) models and stress testing. VaR models estimate the potential loss of a portfolio over a specific time horizon, while stress testing involves simulating extreme market scenarios to assess potential losses.

Understanding the fundamental framework and approaches of the trading book is critical for banks to manage risk, meet regulatory requirements, and maintain investor confidence.

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The regulatory framework of the trading book has undergone significant changes with the introduction of FRTB. FRTB has attempted to make the distinction between the banking book and the trading book clearer and less subjective.

To be allocated to the trading book, a bank must demonstrate more than just the intent to trade. A bank must be able to trade the asset, and physically manage the associated risks of the underlying asset on the trading desk.

The day-to-day price fluctuations must affect a bank's equity position and pose a risk to its solvency. This ensures that banks are not taking advantage of loopholes in the system.

Here are the two criteria that must be met to allocate an asset to the trading book:

Once an asset has been acquired and initially assigned to either the trading book or the banking book, it cannot be reclassified except under extraordinary circumstances. Examples of such circumstances include a firm-wide shift in accounting practices or total closure of the trading desk.

Risk charges are a crucial part of the Fundamental Review of the Trading Book (FRTB). There are three main components to risk charges: Risk Charges under the Sensitivities-based Method, Default Risk Charge, and Residual Risk Add-on.

Each risk class, such as General interest rate risk, Foreign exchange risk, and Credit spread risk, has a delta risk charge, vega risk charge, and curvature risk charge calculated. These charges take into account the weight and weighted sensitivities of each risk class, as well as the correlation between risk classes.

The delta risk charge formula is: Δ risk charge = ∑∑ ρij σi σj wi wj, where ρij is the correlation between risk classes, σi and σj are the standard deviations of the risk classes, wi and wj are the weights, and Δ is the delta.

For example, a 1% increase in the price of gold increases the value of a portfolio by $5,000, resulting in a delta of 500,000.

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The default risk charge is designed to capture jump-to-default-risk, and is calculated for every existing instrument separately. It's a function of the face amount, market value, and Loss Given Default (LGD).

The residual risk add-on is calculated for instruments that cannot be perfectly replicated as a finite linear combination of vanilla options. The risk weight for exotic options is 1%.

The default risk charge is a crucial component in calculating the risk associated with a company's financial instruments. It's designed to capture the loss that would occur if the issuer of a bond or equity were to default.

The default risk charge is calculated separately for each instrument, taking into account the face amount, market value, and Loss Given Default (LGD). This means that each instrument is treated individually, not as part of a larger portfolio.

To determine the default risk charge, three steps are involved. First, the jump-to-default loss amounts for each instrument are determined. This is the amount of loss that would occur if the issuer were to default.

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Next, all long and short positions featuring the same obligor are offset to produce net short or net long amounts. This means that if you have a long position in a bond and a short position in equity with the same obligor, they can be offset against each other.

However, there's an important condition for offsetting to occur: the short exposure must have the same or lower seniority relative to the long exposure. For example, a long exposure in a bond can offset a short exposure in equity, but not the other way around.

The net short exposures are then discounted by a hedge benefit ratio, which reduces the risk associated with those exposures. Finally, default risk weights are applied to arrive at the capital charge, which is the amount of capital required to cover potential losses.

The Basel Committee specifies both the LGD and the default risk weights. For example, the LGD for senior debt is specified as 75%, and the default risk for a counterparty rated A is 3%.

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The sensitivities-based method is the first component of risk charges, and it's used to calculate the risk charges under this method. This method involves seven risk classes, which are defined by the Basel Committee.

These risk classes are: General interest rate risk, Foreign exchange risk, Commodity risk, Equity risk, Credit spread risk – non-securitization, Credit spread risk – securitization, and Credit spread risk – securitization correlation trading portfolio.

Each of these risk classes has a delta risk charge, vega risk charge, and curvature risk charge calculated for it. The delta risk charge takes into account the weight and weighted sensitivities of each risk class, as well as the correlation between risk classes.

The formula for the delta risk charge is: $$ \text{Delta risk charge} =\sum_{\text i} \sum_{\text j} \rho_{\text {ij}} \sigma_{\text i} \sigma_{\text j} {\text w}_{\text i} {\text w}_{\text j} $$ where the risk weights and correlations are determined by the Basel Committee, and the weighted sensitivities are determined by individual banks.

For example, if a 1% increase in the price of a commodity, say, gold increases the value of a portfolio by $5,000, the delta will be 5,000/0.01 = 500,000.

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There are several approaches to calculating capital requirements under the Fundamental Review of the Trading Book (FRTB). The standardized approach is used for large systematically important banks, which involves calculating three components: risk charges under the sensitivities-based method, a default risk charge, and a residual risk add-on.

The sensitivities-based method requires banks to calculate risk charges for various risk factors, including vega and curvature risks. However, for small banks, a simplified version of the standardized approach is available, which removes capital requirements for vega and curvature risks and simplifies the calculation of basis risk.

Banks can also use the internal models approach, which involves using their own models to calculate capital requirements. This approach requires banks to provide regulatory compliant data, such as Real Price Observations (RPOs), which can be obtained from data providers like LSEG.

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The Standardized Approach to Regulatory Capital is a method used by banks to calculate their capital requirements. This approach is used by large, systemically important banks.

The standardized approach involves calculating three components: risk charges under the sensitivities-based method, a default risk charge, and a residual risk add-on. These components are added together to determine the total capital requirement.

The sensitivities-based method requires specific data fields, including risk class, risk bucket, and risk weight, which can be obtained from LSEG. This data is essential for calculating the risk charges.

Banks can also use LSEG data to access individual constituents and weights for listed equity or credit indices, known as the Index Look-Through Approach Data. This helps to simplify the calculation of basis risk.

Here are the three components of the standardized approach:

For small banks, a simplified version of the standardized approach is available. This version removes capital requirements for vega and curvature risks, simplifies the calculation of basis risk, and reduces the correlation scenarios to be applied in associated calculations.

The Internal Models Approach is a method used by banks to estimate stressed Expected Shortfall (ES) with a 97.5% confidence. This approach requires banks to allocate risk factors to liquidity horizons, which are categorized into five groups: 10-day, 20-day, 40-day, 60-day, and 120-day.

Under the IMA, the expected shortfall is measured over a base horizon of 10 days. To calculate the liquidity-adjusted ES, banks use a formula that involves five successive shocks to the categories in a nested pairing scheme.

Here's a breakdown of the five categories and their corresponding liquidity horizons:

The IMA also involves calculating ES for each category, denoted as ES_j, where j represents the category number. The liquidity-adjusted ES is then determined using a formula that involves the ES values for each category.

In the meantime, banks are required to continue applying the Revised Standardized Approach (RSA), which involves grouping risks into "buckets" based on liquidity horizons. The standardized risk measure for each bucket is calculated using a formula that involves the value and risk weight of each risk factor.

LSEG provides regulatory compliant Real Price Observations (RPOs) data for cross-asset class financial instruments traded in both regulated and over-the-counter (OTC) markets, which can be used to comply with the Risk Factor Eligibility Test.

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The FRTB liquidity horizons are a crucial aspect of the new proposals, and they vary significantly depending on the asset class. For example, the liquidity horizon for interest rate risk factors ranges from 10 to 60 days.

A 10-day liquidity horizon is proposed for equity price risk factors with large caps. This is a relatively short horizon, which is not surprising given the high liquidity of large-cap stocks.

Credit spread risk factors, on the other hand, have longer liquidity horizons, ranging from 20 to 120 days. For instance, credit spread risk factors for corporate, non-investment grade entities have a 60-day liquidity horizon.

The liquidity horizon for foreign exchange rate risk factors also varies, ranging from 10 to 40 days. This is likely due to the fact that foreign exchange markets can be highly liquid, but also subject to sudden and significant price movements.

The Basel committee has determined the correlation between risk factors, denoted by ρij. This correlation is used to determine the liquidity horizon for each risk factor.

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Implementation of the Fundamental Review of the Trading Book (FRTB) requirements is a complex and challenging process for banks worldwide. The international deadline for implementation is January 2023, but many banks are struggling to meet this deadline due to various challenges.

One of the biggest challenges is the Standardized Approach, which requires banks to calculate capital using three different metrics, including the Sensitivities Based Method, which is particularly complex. This method demands the application of relevant risk class, risk weight, and risk bucket metrics to calculate capital.

Banks need to address their data gaps, particularly in over-the-counter (OTC) products, to achieve FRTB compliance. Legacy technology infrastructure, data governance issues, and other challenges can be mitigated by working with a trusted data partner.

Here's a brief overview of the implementation status in different regions:

The EU's proposal is expected to be faithful to the original Basel III accord, but with some divergences to account for the specifics of the EU banking sector. The UK and US are expected to align their FRTB policies with the original Basel standards, but the exact timing and details are still uncertain.

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The EU is one of the first jurisdictions to release draft legislative proposals to implement Basel III. It announced the Commission’s ‘banking package’ in October 2021 to amend the existing Capital Requirements Regulation (CRR) and the Capital Requirements Directive (CRD).

The EU's proposal is a two-year delay to the Basel go-live of January 2023, with a proposed implementation date of January 2025. This delay is likely due to the EU's desire to be seen as the global standard-setter and its complex legislative process.

The EU's proposal is "faithful" to the original Basel III accord, but it does propose some divergences to account for the specifics of the EU banking sector. These divergences include a lower risk weight for carbon trading and detailed governance and control requirements for the alternative standardized approach.

The EU has already implemented reporting requirements for the standardized approach (SA) under CRR II, and draft rules on the internal models approach (IMA) are awaiting adoption. This will trigger a three-year waiting period before application.

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The UK and US are both key players in the technical development of FRTB policy, thanks to their close working relationships with each other.

The US Federal Reserve and the UK's Bank of England are working together to implement FRTB policy, reflecting the original Basel standards.

In the US, proposals to implement the remaining elements of Basel III are expected to be released in the first half of 2022, with a coordinated effort required from the Fed and other US bank regulators.

The agencies expect to put out a proposal generally consistent with BCBS standards, but the timing is still somewhat uncertain.

Banks in the US should not delay their preparation, as there will be a period for industry feedback and the Fed will require hypothetical portfolio exercises prior to implementation.

In the UK, proposals to implement FRTB rules are expected to be released for consultation in the second half of 2022.

The current implementation date for Basel III in the UK is "post-March 2023", according to the latest version of the UK's Regulatory Initiative Grid.

The UK is likely to implement both the reporting and capital elements of FRTB simultaneously, in contrast to the EU's staggered approach.

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Implementing the Fundamental Review of the Trading (FRTB) requirements is a daunting task for banks worldwide. The international deadline of January 2023 is looming, and banks are facing significant challenges.

The Standardised Approach capital calculations demand three different metrics, making it a complex task for banks to apply the relevant risk class, risk weight, and risk bucket metrics to calculate their capital. This is particularly true for the Sensitivities Based Method.

The Funds Look-Through Approach and the Index Look-Through Approach within the Standardised Approach require detailed price and reference data about individual funds and index constituents. This can be a significant data gap for many banks.

To pass the Risk Factor Eligibility Test (RFET) under the Internal Models Approach, banks must obtain “real price observations” (RPOs) for 12 months, attribute RPOs to individual risk factors, and check if there is enough activity to pass liquidity thresholds. This requires large amounts of data, sometimes from opaque markets.

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Legacy technology infrastructure and data governance issues can exacerbate these challenges, making it difficult for banks to work with the required data. Working with a trusted data partner can help reduce the time and resources needed to achieve FRTB compliance.

Here are some of the key implementation challenges faced by banks:

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Banks can either use their own internal models or a standardised approach to calculate capital under FRTB.

The standardised approach is a credible fallback to internal models and is still appropriate for banks that don't require sophisticated measurement of market risk.

Banks using the internal models approach must employ the expected shortfall measure to calculate capital, as well as applying capital add-ons for risk factors that lack sufficient data for modelling.

These are known as non-modellable risk factors.

In January 2019, the Basel Committee unveiled a package of reforms to the regime designed to ease its complexity and soften its anticipated capital impact.

The reforms were a response to criticism that the body had pursued a unilateral approach during the framework's initial development.

The revised standardised approach involves a shift in the measure of risk from value-at-risk to expected shortfall so as to better capture "tail risk".

The Committee is also considering the merits of introducing the standardised approach as a floor or surcharge to the models-based approach.

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However, this decision will only be made after a comprehensive Quantitative Impact Study has been conducted.

Here are the key features of the proposed revised framework:

FRTB replaces Value at Risk (VaR) and Stressed VaR (sVaR) metrics with Expected Shortfall (ES), which captures potential extreme losses better.

FRTB uses varying liquidity horizons for different risk factors, ranging from 10 days to 250 days, reflecting the understanding that assets and positions have different liquidity profiles during market stress.

The Basel Committee's Fundamental Review of the Trading Book (FRTB) is a significant update to market risk capital requirements. FRTB's move to Expected Shortfall (ES) reflects a more conservative approach to capture tail events and extreme market shock.

FRTB introduces a more stringent internal models approach (IMA), but it doesn't exclusively promote its use over the standardized approach. Certain risk factors might not be eligible for IMA and would require the standardized approach.

Here are the five different liquidity horizons used by FRTB for risk factors:

FRTB's shift to Expected Shortfall (ES) is a significant change from Value at Risk (VaR) and Stressed VaR (sVaR) metrics.