What Is FRTB in Banking? Key Concepts Explained

The Fundamental Review of the Trading Book (FRTB) represents a significant overhaul of how financial institutions manage and calculate capital requirements for market risk. Developed by the Basel Committee on Banking Supervision (BCBS), FRTB is a core component of the broader Basel III reforms, aimed at strengthening the global financial system. The framework’s primary objective is to enhance the accuracy and robustness of market risk capital measures for banks worldwide, drawing lessons from the 2008 financial crisis.

FRTB addresses deficiencies in the previous market risk framework, known as Basel 2.5. Regulators intend to ensure that banks hold sufficient capital to cover potential losses from trading activities. FRTB improves the consistency and comparability of market risk capital requirements across different banking institutions. Ultimately, FRTB aims to create a more resilient banking sector capable of withstanding periods of significant market volatility.

Foundational Concepts and Objectives

FRTB introduces fundamental shifts to improve market risk capital measurement. The framework aims to reduce variability in risk-weighted assets (RWAs) across banks, improving the consistency and comparability of market risk capital calculations.

A significant change under FRTB involves a stricter, more explicit definition for delineating between the “trading book” and the “banking book.” The trading book comprises financial instruments held with trading intent, while the banking book holds assets intended to be held to maturity, such as customer loans and deposits. This clearer boundary reduces incentives for banks to arbitrage regulatory capital requirements by misclassifying instruments between the two books. Internal transfers and reclassification criteria are now more tightly controlled to prevent capital optimization strategies.

FRTB also shifts from a bank-wide approval process for market risk capital methodologies to a more granular, desk-level approach. Internal models and capital calculations are assessed and approved for individual trading desks. This granular focus ensures risk measurement is more precise and tailored to each trading unit’s specific activities. This has implications for banks’ internal organization, data management, and operational processes, requiring more detailed data at the desk level.

Another key concept is risk factor modellability, which determines whether a particular risk factor can be included in an internal model for capital calculation. This concept ensures internal model reliability by requiring risk factors are adequately supported by observable prices and sufficient data. Only risk factors with robust and liquid data can be modeled internally, while others must be treated differently. This ensures capital charges accurately reflect underlying market risks, particularly for less liquid instruments.

The Internal Model Approach

The Internal Model Approach (IMA) under FRTB allows banks to use their own proprietary models to calculate market risk capital, provided they meet stringent regulatory requirements. Eligibility for IMA is determined at the trading desk level, requiring desks to pass rigorous qualitative and quantitative tests for regulatory approval. If a desk fails to qualify for IMA, or loses approval, it must revert to the Revised Standardized Approach for capital calculation.

Under IMA, Expected Shortfall (ES) replaces Value at Risk (VaR) as the primary risk measure for capital calculation. ES captures “tail risks” by estimating the expected loss in the worst-case scenarios beyond a certain confidence level. Unlike VaR, which only indicates the maximum loss within a given probability, ES considers the magnitude of losses that can occur in the extreme tail of the profit and loss distribution.

Desks using IMA must perform the Profit and Loss (P&L) Attribution Test. This test verifies that the risk factors used in the internal model adequately explain the actual daily profit and loss of a trading desk. The P&L Attribution Test compares hypothetical P&L, derived from the risk model, with actual P&L. A failure in this test can lead to loss of IMA approval.

Enhanced backtesting requirements also apply, serving as another validation tool for internal models. Backtesting compares the hypothetical P&L values generated by the model with the actual P&L realized by the trading desk over time. Results are assessed using a “traffic light” approach, where green, amber, or red zones indicate the model’s performance. Persistent failures in backtesting can lead to increased capital multipliers or even the revocation of IMA approval.

Risk factors that fail the modellability test, known as Non-Modellable Risk Factors (NMRF), receive a separate capital charge under IMA. These are risk factors with insufficient historical data or observable prices to model them reliably. The capital charge for NMRF is determined through stress scenarios, reflecting the higher uncertainty associated with these factors. This ensures that even illiquid or data-scarce risk exposures are adequately capitalized, preventing banks from underestimating their risk.

The Revised Standardized Approach

The Revised Standardized Approach (SA) under FRTB is a more robust, risk-sensitive method for calculating market risk capital. All banks must calculate their capital requirements using the SA, even if they have approval to use the Internal Model Approach for some trading desks. The SA serves as a credible fallback for desks that do not qualify for IMA and acts as a floor for overall market risk capital requirements. This ensures a minimum level of capital is held regardless of internal model sophistication.

The SA’s core component is the Sensitivities-Based Method (SBM), which calculates capital charges based on a desk’s sensitivities to various risk factors. These risk factors include interest rate risk, equity risk, commodity risk, and foreign exchange risk. SBM breaks down the capital charge into three components: Delta, Vega, and Curvature risks. Delta risk captures the sensitivity of an instrument’s value to small changes in underlying risk factors, while Vega risk measures sensitivity to changes in implied volatility. Curvature risk accounts for non-linear price movements beyond what Delta and Vega capture, addressing larger changes in risk factors.

The Default Risk Charge (DRC) is another component of the Revised Standardized Approach, capturing default risk for trading book positions. Unlike credit risk in the banking book, which relates to loan defaults, the DRC applies to instruments like bonds, equities, and derivatives held for trading purposes. This charge recognizes that even trading positions can be exposed to counterparty default risk. The DRC ensures that banks hold capital against potential losses stemming from the failure of an issuer or counterparty within their trading portfolio.

The Residual Risk Add-on (RRAO) captures risks not fully addressed by the Sensitivities-Based Method or the Default Risk Charge. This add-on applies to instruments with complex or exotic features where standard risk measures might not adequately capture all potential losses. Examples include instruments with gap risk, which refers to the risk of sudden, discrete price jumps, or correlation risk, where the relationship between different risk factors changes unexpectedly. The RRAO ensures that banks hold additional capital for these harder-to-model risks, particularly for instruments with embedded options or other non-linear characteristics.