February 2015

Fundamental Review of the Trading Book

During the last crisis it turned out that the regulatory capital Key impact of the new regulation:
for market risk was not adequate enough to cover the risk.
 It is mandatory for all relevant financial institutions to
Therefore the Basel Committee for Banking Supervision and
implement the standard approach
Regulation has created with the Fundamental Review of the
 The new regulation focuses on the reduction of regulatory
Trading Book (FRTB) a new framework to replace the old
arbitrage – clear differentiation between trading and banking book
market risk regulation defined under Basel II.5. The intention
 Complexity of the methodology increases significantly by
is “to improve trading book capital requirements and to
considering sensitivities in the standard approach and stressed
promote consistent implementation of the rules so that they
expected shortfall in the model approach
produce comparable levels of capital across jurisdictions”.
 Introduction of liquidity horizons in the model approach
Based on the new regulation financial institutions will face
 Strong increase of data requirements for the calculation
various challenges.

Differentiation between banking and trading book Portfolio Positions

The regulatory boundary separating the banking from the trading
book is in the current regulation loosely defined based on the EQ FX FI CMDTY …
subjective definition of the bank’s trading intention. This results in
regulatory arbitrage by shifting assets between the two books to 1
minimize capital charges. Accordingly, the Basel Committee Split Banking book
considers this “a source of weakness in the current regime”.
By introducing a set of unbiased criteria and suggestions for
Trading book
mapping the portfolio positions to the two books, the Basel
Committee aims to increase objectivity in the definition of
the boundary, reduce regulatory arbitrage, stabilize the Subject to approval
boundary and simplify its application to the portfolio.
Liquidity Horizon Based Stressed Expected Shortfall
2
Risk Type

GIRR CSR EQ FX …
1 1 1 1 1

∑
Asset Class

2 2 Sensitivities
2 2 2

3 3 3 3 3

… … … … …

Capital Requirements

Revised standard approach Revised internal approach

The Basel Committee suggests a new standard approach to the
calculation of regulatory capital based on market and credit risk
sensitivities. In contrast to the first and second consultative paper where
a cash-flow based approach is suggested, the advantage of the sensitivity
approach is that the required data are easier accessible than cash flow
data. Risks beyond first order (curvature risks) are covered by capital
add-ons, which may require an institution to have sophisticated
valuation processes in place.
The internal model approach will shift the underlying risk
measure from VaR to expected shortfall (ES). For the calibration
a time period with portfolio stress will be used. Additionally,
various liquidation horizons are determined for different risk
factors. In last consultative paper, this is achieved by scaling ES
from one base horizon.
Our subject matter experts are available to further clarify
details of the approach.

Upcoming Challenges
Data Availability
 The data processes must be checked to
provide the necessary data for correctly
mapping instruments to the trading or
the banking book and capital calculation.
 Insufficient data on instruments may
result in instruments being mapped to
residual buckets, thus increasing
regulatory capital.
Discuss more?
For more information
please contact:
Regulatory Reporting Capital Optimization
 Business specifications must be in place  Asset classes and trading desks
defining the aggregation & final reporting contributing mainly to the capital
process. charge should be identified and their
 Capital requirements must be calculated portfolio analyzed.
on trading desk level.  This may lead to the identification of
 Optionality features in the portfolio data issues increasing regulatory
require an appropriate instrument capital.
valuation methodology for the curvature  Adapting the asset allocation can
risk charge. minimize the capital charge.
Manuel Plattner Sebastian Gerigk Thomas Busch
+ 41 (0)79 382 6712 + 41 (0)79 574 3275 + 41 (0)79 878 0168
manuel.plattner@ch.pwc.com sebastian.gerigk@ch.pwc.com thomas.busch@ch.pwc.com
1 Revised Definition
of the Trading Book Instrument
Instrument Type Path

As the name suggests, FRTB Guidance Principle

Instrument

Directly to the trading book

A instrument belongs in the trading • Accounting trading • Unlisted equity
introduces hard criteria and guidance is managed book if the bank holds it

Illiquidity Criterion
asset/liability • Designated for
at a trading
which products must be included in • Resulting from market- securitization

Presumptions
desk a. with the intention of short-term making warehousing
the trading book – and which not. resale • Resulting from • Real estate holding
b. with the expectation of profiting
This might lead to a unexpected from short-term price-
underwriting activities • Equity investment in a
• Equity investment in a fund that cannot be
increase in size of the trading book Any movements fund valued on a daily basis
c. with the intention of making
and in turn to a necessary revision of position
arbitrage profits or
• Listed equity • Derivatives on
leading to a • Naked short positions instruments of the
the regulatory capital. net short d.for hedging an instrument • option above type
position meeting criteria a, b & c.
Further, a transfer from one book to
the other is only allowed in extreme
cases and subject to approval by the
senior management, reducing
regulatory arbitrage opportunities. Trading Banking
Book FX & commodity positions in notional Book
However, internal risk transfers for terms
hedging purposes are acknowledged.

2 New Sensitivity-Based Calculation in the Standard Approach

BIS suggests a sensitivity based approach (SBA), the main advantage being that the sensitivity data should already be
accessible through the current data infrastructure or data providers. The sensitivities are risk-weighted and diversification
effects are accounted for in the aggregation method by specified correlation matrices. The risk weights and matrices were
determined by an expected shortfall analysis to align the standard with the internal model approach. Additionally, if the
portfolio contains optionality, an additional charge (curvature risk charge) contributes to the overall capital. This risk add-on
requires the bank’s possibility to re-value financial products with shifted risk factors. Further, vega risk will be captured.

Curvature Risk Factors Risk Bucket Aggregation Capital Charge

Sensitivities
(grouping of risk factors) Factors of Sensitivities Aggregation
General Interest Rate Risk &
Credit Spread Risk

Capital Charge
Linear Risk

Regulatory Capital
(without Vega Risk Charge)
EQ, FX,
Cmdty

+
V L CVR

V L CVR
Risk Charge
Curvature

V - L CVR
Curvature
Risk
V L CVR
Exposure

V L CVR

Exact Valuation of Asset Linear Approximation of Curvature

Class with shifted Curvature Valuation with shifted Risk
Exposure
Risk Factor Curvature Risk Factors