Explain how the FRTB amends Basel rules for deciding between trading and banking book, for backtesting, for P&L attribution, for credit risk, and for securitizations.
The idea
FRTB tightens several Basel rules. The trading book boundary moves from stated intent to a presumptive list of instruments that belong in the trading book. Switching books is allowed only in extraordinary circumstances with supervisory approval and no capital relief. Backtesting and P&L attribution are run desk by desk. A desk fails backtesting if over the latest 250 days it has more than 12 exceptions at the 99 percent VaR level or more than 30 at 97.5 percent. The P&L attribution test compares hypothetical P&L with risk-theoretical P&L from the risk model. A failing desk must use the standardized approach. For credit risk, the incremental risk charge becomes a default risk charge, a 99.9 percent one-year VaR, while spread risk sits in ES. Securitizations cannot use internal models and go to the standardized approach. Exam point: approval, backtesting and attribution are tested at desk level, not bank level.
A practice question
How does the FRTB define which instruments belong in the trading book, compared with the earlier Basel approach?
- It places in the trading book every instrument carried at fair value in the accountsWhy not: Accounting measurement is not the test; the boundary rests on instrument types and trading purpose.
- It lets each bank choose freely, as before, but requires the choice to be disclosedWhy not: The earlier approach relied on intent and was open to arbitrage; FRTB adds presumptions and supervisory oversight.
- It places all instruments in the banking book unless they are traded on an exchangeWhy not: No such exchange-based rule exists; positions held for short-term resale or hedging trading positions are presumed trading book.
- It adds a presumptive list of trading book instruments, rather than relying only on stated trading intent - correct
The earlier boundary rested on intent, which allowed capital arbitrage. FRTB adds a presumptive list and supervisory powers so that short-term trading-type positions land in the trading book.
A harder one
What does the FRTB P&L attribution test compare, and what is its purpose?
- Hypothetical P&L against risk-theoretical P&L, to check the risk model captures P&L drivers - correct
- Actual P&L against the 99 percent VaR, to count how many days losses exceed VaRWhy not: That describes backtesting, which counts exceptions; P&L attribution compares two P&L measures.
- The 99 percent VaR against the 97.5 percent ES, to confirm ES exceeds VaRWhy not: The test compares P&L series, not risk measures; ES and VaR are not compared.
- Front-office P&L against accounting P&L, to detect misstatement of earningsWhy not: Attribution is about whether the risk model explains P&L, not an audit of reported earnings.
Hypothetical P&L revalues the previous day's portfolio with front-office models; risk-theoretical P&L is computed from the risk model's factors. If they diverge, the risk model misses real drivers, and the desk may lose internal-model eligibility.
The hardest tier
A desk on the internal models approach holds a long position in a single-name corporate bond. Under FRTB, which pair of charges captures its spread risk and its jump-to-default risk respectively?
- The default risk charge for spread changes, and expected shortfall for jump-to-defaultWhy not: Reverses the roles: spread moves feed ES, and jump-to-default is the job of the DRC.
- Expected shortfall for both, since a 97.5 percent ES over a long liquidity horizon already includes defaultsWhy not: Defaults are rare and sit far beyond the 97.5 percent tail, which is why a separate 99.9 percent DRC exists.
- Expected shortfall with liquidity horizons, and the default risk charge measured as a 99.9 percent one-year VaR - correct
- The stress scenario charge for spread and the residual risk add-on for defaultWhy not: The stress scenario charge covers non-modellable factors and the residual risk add-on covers exotic payoffs, neither of which is the default risk charge.
Daily spread movement is a market risk factor in ES. Default is an extreme event captured by the default risk charge, a 99.9 percent one-year VaR that replaces the Basel 2.5 incremental risk charge and also covers equities.
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