The Fundamental Review of the Trading Book is an international standard that sets out rules governing capital banks must hold against market risk exposures.
The Basel Committee on Banking Supervision designed the framework to remove supposed deficiencies in the previous market risk framework which came to light during the global financial crisis. It sets a higher bar for banks to use their own models for calculating capital; ensures banks are capturing tail risk events; and cements the boundary between trading and banking books.
Banks can either use their own internal models or a standardised approach to calculate capital under FRTB. For a desk to qualify for the internal models approach, they must pass two tests: a profit and loss attribution test and a backtest. The P&L attribution test compares the profit and loss generated by a bank’s front-office pricing system with the figures generated in the back office for risk measures. Backtesting compares the P&L values with the value-at-risk figures. In both tests, if a bank’s own estimates are found to deviate excessively from realised P&L on a given desk over a 12-month period, the desk risks losing IMA approval, and being forced to use the standardised approach.
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, following criticism that the body had pursued a unilateral approach during the framework’s initial development.
