FRTB Compliance – New Rules and Data Challenges for Global Banks

The Fundamental Review of the Trading Book (FRTB) was developed by the Basel Committee on Banking Supervision (BCBS) as part of the Basel III framework to address several key shortcomings identified in the market risk regulatory framework that existed under Basel II.5.

FRTB was finalized in January 2016 and initially scheduled for implementation by January 2019. However, following feedback from market participant and regulators, the implementation was delayed. The new target date for compliance was revised to January 2023, with full adoption expected by January 2025. The majority of regulatory jurisdictions are targeting this implementation date except for the United States which will start its phased roll-out in July 2025 with anticipated completion by 2028.

One of the primary objectives of FRTB is to enhance the risk sensitivity of the capital framework for market risk. The existing framework under Basel II.5 was criticized for its inability to adequately capture certain risk exposures, particularly during periods of market stress.

Another objective is limiting opportunities for regulatory arbitrage. This refers to the practice of exploiting differences between regulations to gain an advantage, often leading to risk being transferred in ways that are not transparent or adequately capitalized. FRTB aims to reduce opportunities for such arbitrage by providing clearer criteria for the boundary between the trading book and banking book, ensuring that similar risks are treated consistently regardless of where they are booked.

By improving risk sensitivity and reducing arbitrage, FRTB is expected to lead to an increase in capital requirements for market risk. This ensures that banks hold sufficient capital to cover potential losses, thus enhancing the overall resilience of the banking sector. This increase in capital is necessary to address the underestimation of risks observed under the previous framework and to restore confidence in the capital adequacy of banks.

The New Rules and Data Impacts

The FRTB imposes strict requirements to ensure a clear and clean separation between trading book and banking book transactions. This separation is crucial to mitigate regulatory arbitrage and accurately assess and manage risks associated with each book. The additional data requirements necessary to maintain this separation include:

• Each transaction must be clearly classified as either trading book or banking book based on its intent and characteristics. This involves detailed tagging of transactions with metadata that indicate their book classification.
• Maintain comprehensive transaction-level data including trade date, settlement date, instrument type, and purpose of the trade to support the classification.
• Establish and document policies and criteria for classifying transactions into trading or banking books. This documentation should include the rationale for classification decisions and be reviewed regularly.
• Maintain robust audit trails to track the decision-making process for classifying transactions. This includes records of approvals, changes, and reviews to ensure transparency and accountability.
• Use consistent data formats and standards across systems to ensure data integrity and facilitate aggregation and reporting.
• Implement regular data reconciliation processes to ensure that data across trading and banking books are accurate and up to date.
• Implement data quality controls such as validation checks, error detection mechanisms, and data cleansing procedures to maintain high-quality data.
• Establish a single, authoritative source of data (golden source) to ensure consistency across different systems and reports.
• Ensure that data related to trading book transactions are updated in real-time or near real-time to reflect intraday trading activities accurately.
• Implement continuous monitoring systems to detect any discrepancies or anomalies in the classification and reporting of transactions.
• Develop comprehensive reporting frameworks that meet regulatory requirements for both trading and banking books. Reports should include detailed breakdowns of positions, risk exposures, and capital requirements.
• Generate internal reports to support management and oversight functions, providing insights into the risk profile and performance of both books.
• Collect and maintain data on risk factors relevant to both trading and banking books, ensuring that these are properly attributed and segregated.
• Ensure availability and accuracy of market and reference data used for pricing, risk assessment, and capital calculation purposes.

The new rules under FRTB impose stricter requirements for the use of internal models, including rigorous validation processes and backtesting. This is designed to ensure that models used to calculate capital requirements are reliable and accurately reflect the risk exposures.

By standardizing the methodologies and criteria for calculating market risk capital requirements, FRTB helps ensure that the risk-based capital ratios are comparable across banks globally. This consistency is crucial for maintaining a level playing field and for stakeholders to accurately assess and compare the risk profiles of different institutions.

The New Modelling Approaches

The revised Standardized Approach (SA) and Internal Models Approach (IMA) under the FRTB offer distinct methodologies for calculating market risk capital requirements, each with unique data demands and implications.

The SA is more prescriptive and designed to be universally applicable across all banks. It introduces a Sensitivities-Based Method (SBA), which calculates risk based on specific sensitivities (Delta, Vega, and Curvature) across seven defined risk classes. This approach relies heavily on standardized risk weights and correlations provided by regulators, necessitating accurate and granular data from banks’ pricing models to derive capital requirements. The SA capital charge is composed of three main components: the SBA, the Default Risk Charge (DRC), and the Residual Risk Add-on (RRA), each of which has its own data requirements for precise calculation of risk exposures.

In contrast, the IMA allows banks to use their internal risk models, subject to regulatory approval and ongoing performance testing. This approach shifts from the traditional Value at Risk (VaR) method to an Expected Shortfall (ES) methodology, which better captures the risk of extreme market movements and tail events. The IMA requires banks to perform daily profit and loss attribution tests and backtesting at the trading desk level, demanding a higher granularity of data on individual trades and risk factors.

Additionally, the IMA requires comprehensive historical data to model the expected shortfall accurately and to manage non-modellable risk factors (NMRFs), which necessitates frequent data observations to ensure robustness and compliance. NMRFs are subject to standardized charges if they do not meet data availability criteria.

The key difference in data requirements between the SA and IMA lies in the level of granularity and the frequency of data needed. The SA relies on standardized regulatory inputs and is thus less data-intensive in terms of internal calculations. However, it still requires precise input data to apply the prescribed risk weights and correlations effectively. The IMA, on the other hand, demands a much more detailed and continuous flow of data, including high-frequency observations and extensive historical datasets, to validate internal models and meet stringent regulatory standards

These differences underscore the need for robust data management systems and advanced analytics capabilities, particularly for banks opting for the IMA, which faces more stringent data demands to ensure model accuracy and regulatory compliance.

Expected Shortfall (ES) vs Value at Risk (VaR)

Expected Shortfall (ES), also known as Conditional Value-at-Risk (CVaR), is a risk measure used to assess the risk of extreme losses in a portfolio. Unlike Value-at-Risk (VaR), which only provides the potential loss at a certain confidence level, ES gives an average of the losses that occur beyond the VaR threshold.

ES is determined by selecting a confidence level (97.5% or 99%), calculate VaR which represents the threshold loss value, identify all the losses that exceed the VaR threshold and calculate the average of the tail losses. This average represents the Expected Shortfall.

The data requirements for calculating Expected Shortfall (ES) differ from those for Value-at-Risk (VaR) in several key ways:

VaR requires historical data to calculate the loss distribution up to a specified quantile (e.g., the worst 1% of losses for a 99% confidence level).

ES on the other hand requires additional data to assess the distribution of losses beyond the VaR threshold. This means not only identifying the worst losses but also calculating the average of these extreme losses, which demands a more detailed loss distribution analysis.

VaR focuses on the quantile threshold and does not consider the magnitude of losses beyond this point whilst ES needs granular data on all losses in the tail beyond the VaR threshold. Accurate ES calculation depends on having sufficient data points in the tail to reliably estimate the average loss.

VaR can be estimated using simpler models such as historical simulation, variance-covariance, or Monte Carlo simulation. ES requires more sophisticated modelling techniques to accurately capture the tail behaviour of loss distributions. This includes advanced statistical methods and more complex simulation techniques to ensure the tail losses are well understood and averaged correctly.

VaR backtesting involves comparing the VaR estimates to actual losses to see how often actual losses exceed VaR. ES validation is more challenging because it requires that the average of the tail losses is accurate. This involves deeper statistical analysis and validation against observed tail losses.

FRTB Progress – a Tale of Two Continents

In Europe, the FRTB framework is being integrated into the Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD) packages. The European Banking Authority (EBA) has provided detailed guidelines and timelines, with initial reporting requirements using the Standardized Approach (SA) starting back in 2021 and a clear path towards full compliance by 2025

This timeline aligns with the UK’s implementation plan, where the Prudential Regulation Authority (PRA) is working towards the same 2025 deadline.

European banks have been active in their preparations, with major institutions like BNP Paribas, Deutsche Bank, and Intesa Sanpaolo already applying for internal model approach (IMA) approvals from the European Central Bank (ECB).

Japan, Canada, and Switzerland have finalized their domestic rules, with Canada and Japan bringing these rules into force by mid-2024. Australia’s implementation is set for January 2025. In the United States, while detailed rulemaking is still pending, regulators have indicated a phased approach, with significant movement expected following the Advanced Notice of Proposed Rulemaking (ANPR) later this year.

Many banks in the Asia Pacific region are favouring the IMA approach, reflecting their commitment to adopting more sophisticated and risk-sensitive models

In contrast, the U.S. approach has been more cautious, with regulators taking additional time to assess the potential impacts on the domestic banking sector. While European banks are moving towards more standardized and prescriptive regulatory frameworks, U.S. regulators are considering a more flexible approach that takes into account the unique characteristics of the U.S. financial markets and the need for a balanced regulatory burden.

There has also been strong resistance to any additional capital requirements from some of the strongest voices in the industry. Jamie Dimon, Chairman and CEO of JPMorgan Chase, has been vocal in his criticism of the Basel III Endgame, including its implications for the Fundamental Review of the Trading Book (FRTB). In his remarks to the Senate Banking Committee in December 2023, Dimon highlighted several concerns regarding the new regulatory framework.

Dimon emphasized that the Basel III Endgame, which includes FRTB, could lead to a significant increase in capital requirements for banks. He argued that this could have harmful effects on the banking sector by reducing lending capacity and increasing costs for consumers. Specifically, Dimon pointed out that the proposal would raise capital requirements for large banks by 20-25%, which he believes could stifle economic growth and innovation within the financial industry.

He also highlighted the complexity and operational challenges associated with implementing the FRTB framework. Dimon noted that the increased data and technological demands required to comply with FRTB would place a substantial burden on banks, particularly in terms of upgrading their risk management systems and ensuring data quality.

In summary, Jamie Dimon has expressed significant concerns about the potential negative impacts of the Basel III Endgame and FRTB on the banking industry, emphasizing the increased capital requirements and operational complexities that could arise from these regulations.

The U.S. implementation of FRTB will begin on July 1, 2025, with a phased approach culminating in full compliance by July 1, 2028. This timeline is part of the broader Basel III “endgame” reforms aimed at enhancing the robustness of the financial system by addressing shortcomings in the current market risk framework. The U.S. regulatory agencies, including the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC), have proposed these changes to align with international standards while considering the unique aspects of the U.S. banking system. More details can be found here – Interagency Overview of the Notice of Proposed Rulemaking for Amendments to the Regulatory Capital Rule.

Staggard Timelines Raise New Concerns

The staggered implementation dates of the FRTB between the United States and other regions, particularly Europe, present several challenges for financial institutions operating across multiple jurisdictions. These challenges include regulatory arbitrage, operational complexities, competitive disparities, and difficulties in achieving consistent risk management practices.

Different implementation timelines can create opportunities for regulatory arbitrage, where firms exploit the differences in regulations to gain a competitive advantage. For instance, banks might shift trading activities to jurisdictions with less stringent or delayed regulations to benefit from lower capital requirements temporarily. This could undermine the global financial stability that FRTB aims to enhance by ensuring consistent risk management standards worldwide.

Financial institutions with global operations will need to manage and comply with different regulatory timelines, which can be operationally challenging. This involves maintaining multiple sets of risk management systems, reporting frameworks, and compliance protocols to meet the varying requirements. The need for dual reporting and parallel systems increases the operational burden and can lead to inefficiencies and higher costs.

Banks in regions where FRTB is implemented earlier, such as Europe, may face higher capital requirements and stricter risk management standards before their U.S. counterparts. This could place European banks at a competitive disadvantage, as they would need to allocate more capital to cover market risks sooner than U.S. banks. The disparity in implementation could affect the pricing of financial products and the competitive landscape of global financial markets.

Achieving consistent risk management practices across different jurisdictions becomes more challenging with staggered implementation dates. Global banks need to ensure that their risk management frameworks are robust enough to comply with the most stringent standards while managing the transition in regions with delayed implementation. This inconsistency can lead to fragmented risk management practices and potential gaps in risk coverage, impacting the overall effectiveness of FRTB.

Coordinating with multiple regulatory bodies across different timelines requires effective communication and strategic planning. Financial institutions must stay abreast of regulatory updates, interpret diverse regulatory expectations, and engage in proactive dialogue with regulators to ensure compliance. The lack of synchronized implementation can lead to confusion and increased regulatory scrutiny, complicating the compliance landscape for global banks.

Despite these challenges, the implementation of FRTB is designed to address critical deficiencies in the previous market risk framework by enhancing risk sensitivity, reducing regulatory arbitrage, improving model governance, increasing capital requirements, and promoting consistency across jurisdictions, and strengthening the stability and resilience of the global banking system.