FRTB (Part 1): FRTB Explained

Executive Summary

A safe and sound banking system is the crucial ingredient of a healthy economy. There are several domestic and international regulations in place to achieve this goal. One of the most ubiquitous regulations in the international arena is the Basel framework issued by Basel Committee on Banking Supervision (BCBS).

The Basel framework prescribes several rules around banks’ capital and financial risks, such as market, credit, and operational risks. During the 2008 global financial crisis, many financial institutions suffered significant losses from materializing market risks in their trading book (portfolio). After that, BCBS refined its market risk methodology following several consultations called the Fundamental Review of Trading Book or FRTB.

FRTB became synonymous with market risk calculation. The calculation’s primary purpose is to ensure that banks have enough capital to sustain the market risk-related unexpected losses.

In this blog, we will examine FRTB calculation at a high level and explain the challenges ahead for the banking sector and, in particular, internationally active banks, which are the main focus of FRTB.
But first, let’s lay down some background on the bank’s operation, risk, and capital.

How Do Banks Operate?

In simple terms, banks raise money (deposits, debt, and capital) and invest that money (loans to customers – banking book, investment in capital markets – trading book). Let’s take a closer look at these definitions.

Overall, every bank has two sources of funds: capital and debt.

In simple terms, capital is the money that a bank has obtained from its shareholders and other investors and any profit that it has made and not paid out. Consequently, if a bank wants to expand its capital base, it can do so, for example, by issuing more shares or retaining profits rather than paying them out as dividends to shareholders. There is no obligation for a bank to pay the capital back.

Debt (or liability) is the money a bank borrows from its lenders and will have to repay. Debt includes, among other things, deposits from customers, debt securities issued, and loans taken out by the bank.

Funds from these two sources are employed by the bank in several ways, for example, to give loans to customers (banking book) or to make investments in marketable securities (trading book). These loans and investments are the bank’s assets.

Capital Is a “Cushion”

As there is no obligation for a bank to pay the capital back (as opposed to liabilities), the bank can stay solvent as long as there is enough capital to sustain an unexpected loss. In other words, the capital plays a “Cushion” role against bankruptcy and protects lenders.

When, for example, many borrowers are suddenly unable to pay back their loans or some of the bank’s investments fall in value, the bank will make a loss and, without a capital cushion, might even go bankrupt. However, if it has a solid capital base, it will use it to absorb the loss and continue to operate and serve its customers.

In the below example, we analyze how losing money results in capital depletion and causes bankruptcy under extreme circumstances. A healthy, well-capitalized bank with a capital equivalent to 15% of its assets starts losing money. The loss puts the bank in a distressed situation, reducing its capital to 5% of its assets. Then, further losses diminish its capital to 1% of its assets, forcing it into bankruptcy.

The High-Risk Bank’s RWA will be higher than the Low-Risk Bank’s RWA. As a result, if we base our Capital assessment on RWA, we will also ensure that Higher-Risk bank has more capital. Next, we will investigate how the regulator defines the capital needed for a bank to be “safe,” namely “Required Capital.” Then, we will calculate the capital required for our Low-Risk and High-Risk banks to comply.

Capital Calculation

The capital should be proportional to risk (i.e., the higher the risk, the higher the capital). To formularize this, regulators defined a ratio called “Capital Ratio” and made the capital requirement the product of the RWA and the Capital Ratio.

Capital Required = RWA * Capital Ratio
Next, we will use this formula to calculate our two banks’ “Required Capital” and check for compliance.

Let’s assume that the weight used in the “Risk Weighted Asset” (RWA) calculation and the “Capital Ratio” are given to us by the regulators:

• Weight for US Treasury = Weight for AAA Corporation = 1
• Weight for Crypto = Weight for CCC Corporation = 2
• Capital Ratio = 8%

Although the assets of the two banks are equal in value, the RWA of the High-Risk Bank is twice as much as the RWA of the Low-Risk Bank. Therefore, the capital required for the High-Risk Bank is also twice as much.

Now that we know how much capital we should have to check for compliance, we can compare it against the capital we do have.

The Required Capital of the Low-Risk Bank being lower than its capital, the bank is compliant. The opposite is true for the High-Risk Bank. High-Risk Banks should raise capital or reduce their risk to become compliant. To reduce the risk, the bank can sell assets or hedge them. In either case, its RWA will diminish.

FRTB & Basel Framework

Basel framework is a global set of rules specifying banks’ minimum regulatory capital requirements. The Basel Committee on Banking Supervision (BCBS), following the global financial crises in 2008, introduced a set of revisions to the market risk framework, which led to a more fundamental review of the trading book regime, and hence the name FRTB regulations.
The main purpose of Basel is to make banks more resilient to unexpected losses. After its initiation in 1996, it went through several revisions: