FRTB: Are you ready for a new era in market risk management?

Time is ticking. Changes introduced by the Fundamental Review of the Trading Book (FRTB) are upon us, ushering in a new era in market risk management. While there have been delays, the new FRTB rules are expected to take effect in the next one to two years, with some staggering in timing across geographical regions and markets. Thus, much of the banking industry is already investing in technology, data and analytics to meet upcoming requirements. In fact, a 2023 EY Global Basel III Reforms Survey reported that 25% of banks are spending over $100m to deliver FRTB.

What changes will FRTB introduce – and when?

FRTB specifies how to determine the minimum amount of capital a bank is required to hold. The latest FRTB guidelines will replace existing rules for market risk capital in certain global financial jurisdictions and are intended to better capture the risk of a bank’s trading book positions. It’s worth highlighting that these new rules will apply only to banks with at least $250 billion in assets in U.S. dollars and deals only with the trading book, as opposed to the banking book.

Because various geographical markets may set their own timelines for FRTB, it is causing some fragmentation across regions. What’s more, certain regions have not yet published definitive go-live dates for adopting the new FRTB rules, which is creating additional uncertainties.   

Below is a table of expected FRTB deadlines as they stand today.

Modelling Considerations

When determining an appropriate capital level for risk exposure, banks can choose between two approaches— the standardized model approach (SA) and the internal model approach (IMA). This decision revolves around securing sufficient capital to absorb potential losses, thus banks are likely to select the less complex approach that allows for less capital consumption. Additionally, banks can opt for a mix of SA and IMA since the decision is made at the desk level.

The SA method leans on risk sensitivities and is computationally intensive yet simpler to implement due to its exemption from stringent quantitative P&L attribution and back-testing criteria that are required for the IMA. Nonetheless, the SA often results in notably higher charges compared to the IMA, although it must be calculated for all trading desks.

In contrast, the IMA necessitates trading desks to pass challenging backtesting and profit-and-loss attribution tests for approval, leading to the likelihood that many banks may default to SA anyway. However, a clear advantage of IMA is that it should lead to less capital consumption.

In the U.S., the Notice of Proposed Rulemaking (NPR) was published in July 2023. One requirement of NPR is that banks that want to use the IMA must be ready by July 2024 to start testing and produce one year’s worth of evidence that the IMA works and risk factors can be adequately modelled. It would be difficult to accomplish this within such a short time frame, so many U.S. banks may simply select to use the SA.

Navigating FRTB complexity

It’s clear that the capital markets are investing a great deal of time and effort in preparing for the impending FRTB implementation, largely due to the technical complexity of regulations being introduced. Forthcoming FRTB guidelines are anticipated to substantially increase capital requirements for large banks, particularly for products with illiquidity or complex risk profiles. Risks that lack sufficient pricing data to be modelled will incur additional costs for firms.

In terms of modelling, the choice is really left up to individual firms, as Basel guidelines remain neutral between the use of IMA and SA approaches.

Want additional FRTB guidance?

For a more detailed look at FRTB’s impacts on the capital markets and how you can prepare, download our insightful white paper: As Action Time Nears, Be Aware of These 3 Big FRTB Issues

You can also watch our recent webinar: FRTB-SA Analytics: Transforming a Regulatory Obligation into an Opportunity