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Account for why the FRTB reform was undertaken, and outline how it modifies the way Basel requires banks to compute capital against market risk.

FRM® Part II · Market Risk Measurement and Management · Fundamental Review of the Trading Book · FRM2.MR.18.a

The idea

Before the 2007 to 2009 crisis, trading book capital rested on a 10-day 99 percent VaR. Banks decided by their own trading intent which positions sat in the trading book, where capital was lower than in the banking book. The crisis showed that VaR ignores losses beyond its quantile, that many positions could not be sold in 10 days, and that the boundary could be exploited. Basel 2.5 added stressed VaR and the incremental risk charge as patches. The Fundamental Review of the Trading Book (FRTB) replaces that patchwork. Under the internal models approach the core measure becomes expected shortfall at 97.5 percent calibrated to a stress period. It adds liquidity horizons, a default risk charge, and a stress scenario charge for non-modellable risk factors, all approved desk by desk. A revised standardized approach applies to every desk. Exam point: for a normal distribution ES at 97.5 percent is close to VaR at 99 percent, so the change lies in tail sensitivity, stress calibration and liquidity, not in a higher confidence level.

Formulas

Expected shortfall of a normal loss distribution

ES = σ × φ(z) ÷ (1 − c)

σ
the standard deviation of P&L
φ(z)
the standard normal density at the quantile z for confidence c
c
the confidence level, 97.5 percent under FRTB

Assumes zero mean and normality. At 97.5 percent the multiple is about 2.338, close to the 99 percent VaR multiple.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which statement best explains why the Basel Committee undertook the Fundamental Review of the Trading Book?

  1. Market risk capital did not exist before the review, so banks held no capital against trading positionsWhy not: Market risk capital has existed since the 1996 amendment to Basel I; the review reformed it rather than created it.
  2. Regulators wanted to remove internal models altogether and place every bank on one standardized formulaWhy not: FRTB keeps an internal models approach, with desk-level approval, alongside a revised standardized approach.
  3. Crisis trading losses far exceeded VaR-based capital, and booking choices let banks lower it - correct
  4. Trading book capital had to be aligned with expected credit loss accounting introduced by IFRS 9Why not: Confuses an accounting change with a regulatory capital reform; accounting alignment was not the driver of FRTB.

The 2007 to 2009 crisis showed that 10-day 99 percent VaR missed tail losses, ignored illiquidity, and left room for boundary arbitrage between the books. FRTB was designed to fix those weaknesses, not to create market risk capital or abolish models.

A harder one

A bank's market risk team knows its Basel 2.5 capital stack: VaR, stressed VaR, the incremental risk charge and the comprehensive risk measure. How is internal-model capital for an approved desk built under FRTB?

  1. A current 99 percent VaR plus a separate stressed VaR, each multiplied by a factor, exactly as under Basel 2.5Why not: Describes the Basel 2.5 structure that FRTB replaces; the VaR and stressed VaR pair is merged into one stress-calibrated ES.
  2. Only the sensitivities-based standardized charge, because internal models are no longer allowed for any deskWhy not: FRTB retains internal models for desks that pass backtesting and attribution tests; it does not abolish them.
  3. ES at 97.5 percent with a uniform 10-day horizon for every risk factor, ignoring factors with too few pricesWhy not: Ignores liquidity horizons and the stress scenario charge that FRTB applies to non-modellable factors.
  4. One stress-calibrated ES with liquidity horizons, plus a default risk charge and a stress scenario charge - correct

The FRTB internal models charge combines one stress-calibrated, liquidity-adjusted ES, the default risk charge (replacing the incremental risk charge) and the stress scenario charge for non-modellable factors. It is not a VaR plus stressed VaR stack.

The hardest tier

A risk factor in a desk's internal model cannot be shown to have enough observable prices to be modellable. How does the FRTB internal models approach capitalise it?

  1. It stays in the ES model and is assigned the longest liquidity horizon of 120 daysWhy not: Liquidity horizons do not substitute for modellability; a non-modellable factor is removed from ES, not given 120 days.
  2. It is excluded from internal-model capital until enough price data are availableWhy not: Excluding it would leave the risk uncapitalised, which FRTB prevents with a stress scenario charge.
  3. It is removed from ES and capitalised through a separate stress scenario charge - correct
  4. It is covered by the default risk charge, a 99.9 percent one-year VaRWhy not: Confuses non-modellable risk with jump-to-default risk; the DRC covers default of issuers, not data gaps.

Non-modellable risk factors cannot be reliably fed into ES, so FRTB takes them out and charges them separately with a stress scenario capital charge, added to the ES-based charge. Dropping them or giving them 120 days would understate risk.

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