FRTB (Part 1): FRTB Explained

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 Risk of All Investments is Not Equal

In assessing the capital requirement the riskiness of an asset is also essential. The higher the risk, the higher the capital the bank should have as a buffer. So, one should capture the risk along with the value of the assets in determining the amount of capital. This new risk-adjusted asset is called a “Risk Weighted Asset” or RWA. In RWA calculation, a risk weight is assigned to each type of asset to indicate how risky it is for the bank to hold the asset.

To clarify the point further, let’s go over an example. The below two banks look the same purely based on the value of their assets. But the Risk Weighted Asset (RWA) number will reveal the difference.

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%

RWA = (1*$50+1*$50) = $100MM
Required Capital = (1*50+1*50) * 8% = $8MM
Capital ($10MM) > Required Capital ($8MM)
Bank is compliant

RWA = (2*$50+2*$50) = $200MM
Required Capital = (2*50+2*50) * 8% = $16MM
Capital ($10MM) < Required Capital ($16MM)
Bank is not compliant


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:

FRTB regulations, as with all Basel agreements, are non-binding international agreements, with individual jurisdictions left to transpose the agreement into domestic law. As such, the FRTB or Basel 3 implementation date varies between jurisdictions.

FRTB or Basel 3 Implementation Dates
Jan 2023 Basel Guideline
Q2 2023 Switzerland
Q1 2024 Canada, Japan, Hong Kong
Jan 2025 US(*), UK, EU, Australia
(*) Fed did not publish the initial draft that was expected in Q1 of 2023.

Next, we will review FRTB and its two main Approaches.

FRTB Methodologies

FRTB proposes 2 Approaches for the Market Risk Calculation

  • SA: Standardized Approach
  • IMA: Internal Model Approach

IMA is more challenging to implement and more costly to run. Yet, based on BCBS estimates, it can lower the risk capital requirement between 9% and 55%. Banks need to weigh the two approaches considering the makeup of their assets and the capabilities of their risk system. The below table summarizes the differences.

Why is IMA More Costly to Calculate?

Under SA, the loss or gain is calculated for one scenario. The scenario is defined by the regulators.

Under IMA, the calculation of loss or gain is calculated under thousands of scenarios. Once we complete the calculation, we take the average of the worst 2.5%. We call this number Expected Shortfall (ES). Furthermore, we repeat the calculation of ES several times (for different liquidity buckets, periods, and rollup levels) to generate a final ES number.
As a result, IMA (w.r.t. SA) is more costly to run, and the IMA calculator is more challenging to implement.

Conclusion

FRTB will significantly impact banks’ operational capability, infrastructure, risk measurement, and reporting. Banks employing internal models (IMA) will face additional challenges regarding computational capacity, data availability, and regulatory scrutiny. Yet, IMA can reduce the risk capital requirement and increase profitability.

FRTB will lead to a comprehensive re-orchestration of many banks’ IT systems and data management. The good news is, with the help of new technologies (data streaming, distributed computing, etc.) the implementation is easier than ever. Furthermore, the transition is more trivial as the old and new systems can run in parallel.

Banks with the right design can easily overcome technological challenges and minimize their capital requirement. Ness’s deep domain expertise in technology and risk and experience in implementing risk management systems can help. Please refer to our blog “FRTB Part 2: Why We Need Next-Generation Risk Platforms” for more information about why firms need to modernize their risk platforms to meet the demands of FRTB.

Sources

Finalizing Basel III In brief
Basel Committee on Banking Supervision, Bank for International Settlements
https://www.bis.org/bcbs/publ/d424_inbrief.pdf

The market risk framework in brief – January 2019
Basel Committee on Banking Supervision, Bank for International Settlements
https://www.bis.org/bcbs/publ/d457_inbrief.pdf

Explanatory note on the minimum capital requirements for market risk – January 2019
Basel Committee on Banking Supervision, Bank for International Settlements
https://www.bis.org/bcbs/publ/d457_note.pdf

Basel Framework
Basel Committee on Banking Supervision, Bank for International Settlements
https://www.bis.org/basel_framework/index.htm?export=pdf

Why do banks need to hold capital? – 23 May 2019
European Central Bank, Banking Supervision
https://www.bankingsupervision.europa.eu/about/ssmexplained/html/hold_capital.en.html

Overcoming Hesitation About Capital Markets Application Modernization: Why a Critical Mindset Shift is Needed – February 2023
https://www.ness.com/overcoming-hesitation-about-capital-markets-application-modernization-why-a-critical-mindset-shift-is-needed/

Risk Architectures: From Batch To Streaming
https://www.ness.com/risk-architectures-from-batch-to-streaming/

Fundamental Review of the Trading Book (FRTB): Where do we stand?
https://www.bloomberg.com/professional/blog/fundamental-review-of-the-trading-book-frtb-where-do-we-stand/#:~:text=Although%20the%20agreed%20international%20implementation,January%202025%20go%2Dlive%20date.