In January 2016, after five years of discussion and four quantitative impact studies (QIS), the Basel Committee published the final rule of the Fundamental Review of Trading Book (FRTB), which represented the revised standards for minimum capital requirements for market risk.
Final Major Piece in Basel 3 Puzzle
FRTB is intended to address the undercapitalisation of trading book exposures witnessed during the financial crisis. The 2008 crisis highlighted shortcomings of the Basel 1 and 2 market risk capital frameworks. In response, a revision of Basel 2 in the form of Basel 2.52 took effect in December 2011. Basel 2.5 took a broader view of capital risk with new elements in the framework designed to improve banking regulations. For example, in their trading operations, banks were mandated to include stressed period VaR in the capital calculations, incremental risk charge (including default and migration risk) and others.
At the same time, taking on board the hard lesson of the 2008 crisis, the BCBS started developing the third instalment of the Basel Accords -Basel 3. Intending to strengthen bank capital requirements, the BCBS publicly released the final version of FRTB on 14 January 2016.
While the basic goals and ideas of FRTB are simple, it differs materially from the existing Market Risk regulations. It is, therefore, likely that the new rules will substantially change both the operating and business models of a large number of industry players.
The final release of FRTB introduces various changes to Basel 2.5 Market Risk capital rules, both qualitative and quantitative. For example, the definition of banking and trading books are more prescriptive, with tighter restrictions on trading/banking book reclassifications designed to reduce regulatory arbitrage. The rules governing the separation of trading and banking books are now more robust. It is far more difficult, although not impossible, to move trades and positions between trading and banking books – and it is impossible for firms to gain any capital relief from doing so. Any gains are considered a capital surcharge, therefore, leaving the capital position unchanged.
Internal risk (IR) transfers are also restricted as internal trades are only recognised if they are hedged with an external party (with the exception of interest rates risk). FRTB also includes more stringent and granular trading desk level Internal Model Approach (IMA) approvals. Under current regulation (Basel 2.5), IMA approval was valid for all desks trading the approved products. With FRTB, individual desks can achieve or lose IMA accreditation, as outlined in later sections. Trading books shifting to and from IMA accreditation leads to more dynamic capital situations as the IMA and Standardised Approach capital requirements are substantially different.