James Okarimia - Fundamental Review Of The Trading Book (FRTB)

1. James Okarimia - The Fundamental
Review of the Trading Book (FRTB)
The first Basel Committee publication of 2016 was the highly anticipated BCBS 352,
minimum capital requirements for market risk. Due for implementation in 2019, the
regulation aims to tighten the loopholes of the current Basel 2.5 regime and ensure that
banks are able to withstand any potential market crash.
The new revised framework
In the wake of the 2008 financial crisis, the Basel Committee decided to implement
Basel 2.5 as a short-term response in order to strengthen Market Risk capital base. The
Fundamental Review of the Trading Book (FRTB) aims to be the long term solution to
Market Risk by addressing the persisting issues and allow supervisory authorities to
better compare institutions: predominantly the boundary between the banking and
trading book being too lenient and the internal model approach being inconsistent.
Furthermore, the standardised approach is not risk sensitive enough to constitute a
credible alternative to the internal models introduced by the banks themselves.

2. The Fundamental Review of the Trading Book (FRTB) imposes the most stringent
capital requirements of any regulation to date, and will involve significant required
challenges for the Risk department, and the trading activity of banks. The FRTB
amends the existing Basel market risk rules in the following areas:
 Increasing controls on the boundary between the banking book and trading book
 Removing Value-at-Risk in favour of Expected Shortfall
 Strengthening the relationship between the standardised and internal models approach
The key theme of the review is to safeguard against banks “window-dressing” their
regulatory reporting and ensure that firms have in place sufficient risk management
practices to verify their intraday exposures are never excessive. If banks fail to meet the
capital requirements at any point, the national regulator can force banks to take
remedial action.
Although the impact on overall capital levels across the economy is not yet clear, and is
subject to final calibration, it is likely to lead to punitive capital increases in certain
business lines, and will potentially cause some key markets, such as the trading of
securitised products, to become uneconomic. Certain credit products could see capital
requirements increase by up to six times, while a sovereign downgrade could increase
capital charges by 73%. This could lead to lower liquidity and increased financing costs
for borrowers, please see the full version of this article.
Challenges faced in the implementation
Prior to implementing a target framework, the main task will be to calculate existing
capital at desk level, as the removal of compensation between trading desks will require
a major culture and computational change for banks. Banks will now have to revise their
risk measures and tools to ensure they are able to collate the correct data at the
appropriate granularity. At present, most Risk departments are organised at group level,
utilising data which has been collated centrally; however, due to the new rules there will
be at least six sub-trading books, which will all require their own risk reporting. Banks
will have to consider how they restructure their data architecture to enable reporting at
source level.

3. Due to the removal of compensation between desks, it may no longer be profitable
under the revised capital requirements to continue with all existing trading activities.
Banks will have to conduct a review of their current undertakings and may find they
have to merge certain desks or cease some of their trading activities as they are no
longer profitable.
Distributing new business between trading and banking books requires a
comprehensive audit trail capability – all new trading book business will impact the risk
profile of the overall book. The audit trail will need to take into account the volume of
trades and more widely the number of books involved. Furthermore, it is essential to
understand the component risk elements on a historical basis – this also applies to the
diversification requirement.
Banks will have to demonstrate adequate internal controls for each of their trading
books. This will require firms to put in place a management structure to overseas
activities around each trading book. Moreover, this will include actively managing the
risk on portfolios with multiple liquidity horizons – this will be particularly challenging due
to the complexity of the calculation and the lack of data to input, making consistency
difficult to maintain across multiple liquidity horizons.
Conclusion

4. The complexity of the new rules is such that there is likely to be a complete review of
the Risk organisation within many banks, in order to ensure compliance to the increased
multitude of reporting calculations. In conjunction with this, banks will review their
trading strategies to verify that each trading desk will remain independently profitable in
the medium-to-long term.
James Okarimia