What Is the Fundamental Review of the Trading Book (FRTB)?

The Fundamental Review of the Trading Book (FRTB) is a global regulatory framework developed by the Basel Committee on Banking Supervision (BCBS) to revise market risk capital requirements for banks. Its primary purpose is to enhance the banking system’s resilience by ensuring banks hold sufficient capital to cover potential losses from trading activities. This framework emerged from lessons learned during the 2008 global financial crisis, addressing shortcomings in previous capital standards and establishing a more robust and consistent approach to market risk measurement and capital adequacy.

Understanding the Need for FRTB

The 2008 global financial crisis exposed significant weaknesses in the existing market risk capital framework, Basel 2.5. Regulators observed that banks often held insufficient capital to absorb large losses from trading positions during severe market stress. This inadequacy stemmed from inconsistent treatment of market risk exposures across institutions.

A notable problem was the lack of clear boundaries between a bank’s trading book and its banking book, leading to regulatory arbitrage. Banks could classify positions to minimize capital charges, rather than accurately reflecting underlying risks. This allowed for shifting assets between books to exploit differences in capital requirements, potentially understating overall risk. The framework also permitted discretion in how banks modeled market risks, leading to varying capital outcomes for similar risk profiles.

Furthermore, Basel 2.5 did not adequately capture certain market risks, particularly those associated with less liquid assets or complex derivatives. Models often underestimated tail risks—extreme, infrequent events that can lead to significant losses. During market turmoil, capital reserves proved insufficient to cover unexpected downturns in asset values. These shortcomings underscored the need for a more comprehensive, stringent, and consistent approach to market risk capital.

These deficiencies prompted a review by international regulators, leading to FRTB. This new framework addresses inconsistent risk capture, insufficient capital, and arbitrage opportunities apparent during the crisis. It aims to mandate higher quality and quantity of capital, ensuring banks are better prepared for future market volatility and stress, and fostering greater transparency and comparability across financial institutions regarding their market risk exposures.

Core Components of FRTB

FRTB introduces a revised, more stringent definition for the boundary between the trading book and the banking book. Positions are assigned to either the trading book (market risk capital rules) or the banking book (credit risk capital rules). This framework significantly reduces reclassification flexibility, requiring objective criteria like trading intent and liquidity. Instruments for short-term profit or hedging trading positions generally fall into the trading book.

The framework mandates a new Standardized Approach (SA) for calculating market risk capital, which is more risk-sensitive and granular than its predecessor. This approach includes a sensitivity-based method for various risk factors (interest rates, equity prices, foreign exchange, commodity prices), capturing delta, vega, and curvature risks. It also features a default risk charge for counterparty credit events and a residual risk add-on for risks not covered by the other two, such as exotic options or complex instruments with non-linear characteristics.

For banks using sophisticated internal models, FRTB introduces a revamped Internal Model Approach (IMA). The IMA is subject to stricter approval and ongoing validation requirements. A key requirement is the Profit & Loss (P&L) Attribution Test, which assesses if risk factors in a bank’s internal model accurately explain the observed daily P&L of its trading desks. This test ensures consistency between front-office risk calculations and back-office accounting outcomes.

Enhanced backtesting requirements are a central feature of the IMA, demanding rigorous validation of models against historical data. Banks must demonstrate their internal models consistently produce accurate risk measures by comparing model-generated estimates with actual trading losses. FRTB also addresses Non-Modellable Risk Factors (NMRF)—risk factors with insufficient observable market data to reliably model their behavior. These factors, common in illiquid markets, are subject to a separate, often higher, capital charge, reflecting their inherent uncertainty.

Key Changes Introduced by FRTB

FRTB shifts from Value-at-Risk (VaR) to Expected Shortfall (ES) as the primary measure for market risk capital requirements. VaR estimates maximum potential loss over a specific time at a given confidence level but doesn’t provide information on losses beyond that level. ES, however, measures the average of all losses exceeding a certain confidence level, making it a more robust measure of tail risk. ES captures the potential severity of losses in extreme market conditions, providing a more conservative and comprehensive risk assessment.

Under FRTB, internal model approval is required for individual trading desks, not bank-wide. Each desk must independently demonstrate its internal models meet stringent regulatory requirements, including passing the P&L Attribution Test and backtesting. This granular approach aligns capital calculations with specific risk profiles and trading strategies, preventing a single model failure from impacting the entire institution’s capital relief. It also places greater accountability on individual trading units for their risk management practices.

The framework places increased emphasis on stringent validation and governance for market risk models and data. Banks must implement robust processes for model validation, ensuring internal models are sound, accurately implemented, and perform as intended. This includes rigorous independent reviews, ongoing monitoring, and comprehensive documentation. Data quality is also a major focus, as accurate and granular data is essential for reliable risk measurement and capital calculation under both the Standardized Approach and the Internal Model Approach.

FRTB introduces capital floors, specifically an output floor, ensuring a minimum capital level regardless of internal model results. This floor dictates that a bank’s capital requirements, even with internal models, cannot fall below a percentage of the capital required under the Standardized Approach. Capital floors limit excessive capital relief from internal models and ensure a level playing field among banks, regardless of their modeling sophistication. This provision acts as a backstop, maintaining a minimum level of prudential capital.

The framework demands a deeper focus on liquidity and data granularity for accurate risk measurement. Banks must assess the liquidity of their trading positions and underlying risk factors, as liquidity significantly impacts potential losses during market stress. This requires granular data collection and sophisticated analytical capabilities to understand how market illiquidity can amplify losses. Increased emphasis on data granularity ensures risk calculations are based on precise, up-to-date market information, allowing for a more accurate reflection of a bank’s true market risk exposure.