An Overview of FRTB

Sanjay Basu, NIBM,

October 2019.
 Lecture Outline
• IMA weaknesses.
• Summary of proposals for SA and IMA.
• Revised accounting boundary.
• Revised SA and IMA.
 IMA limitations – Global Crisis
• Inability to capture traded credit risk and market
liquidity risk.
• Use of benign correlations between positions –
overestimation of diversification benefits.
• Incentives to take tail risk, e.g. investing in highly
rated bonds or deep out-of-the-money options.
• Procyclicality of VaR-based capital charges.
• VaR violations were more frequent, much larger and
more clustered than what was expected.
 Recent Initiatives - SMM
• Better risk sensitivity: Regulatory correlations to reflect
genuine hedging and diversification benefits.
• Calibration: To capture differences in volatility and
correlations across assets and regions.
• Simple, transparent and consistent: Ease of
implementation for banks and regulators.
• Limited model reliance: Not based on bank pricing or
risk management models.
• Credible fallback: No capital relief, in case of problems
with IMA.
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 Recent Initiatives - IMA
• Focus on tail risk, i.e. losses beyond VaR.
• Estimation of capital buffer for stressed market
conditions.
• Liquidity horizons between 10 and 120 days for
different risk factors, based on square root rule.
• Capital add-ons for non-modellable risk factors.
• Spread risk and migration risk to be estimated
separately from Increnmental Default Risk.
• Possibility of mixed IMA and SMM portfolios.
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 Revised Accounting Boundary
• Banking and trading books very sharply defined.
• Items in one book cannot be moved to another, except
for its closure or change in accounting practice.
• If capital is saved as a result of transfer, it should be
added as a disclosed Pillar I capital surcharge.
• The restrictions on re-designation of items, and the
exceptions made, should be part of policy.
• Re-designation should be publicly disclosed.

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 Standardized Approach
• Much more granular than Basel I SA.
• Extends the sensitivity approach to all risk classes.
 Sharp rise in capital requirements with 1% shock.
• There are seven risk classes: General Interest Rate
Risk, Credit Spread Risk ( CSR, non-securitization),
CSR (securitization), CSR (correlation trading), FX
Risk, Equity risk, Commodity risk,
• It uses three measures – delta, vega and curvature risk
factor sensitivities for all risk classes.
 Vega and curvature risks are estimated for option positions.
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 Standardized Approach
• Risk weights, sensitivity and correlations given for
maturity vertices, ratings, sectors and currency types.
• Default Risk Charge aligned to the Banking Book
Treatment, to avoid discrepancy.
• Residual risk add-on – risk weights on notional for
nonlinear instruments – to capture other risks.
• Total capital charge = Sensitivity-based Charge +
Default Risk Charge + Residual Risk Charge.
• Simplified SA – scaled SA (1996) – also proposed.

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 Revised IMA
• Model approval at the desk level – regulatory
permission for migration to IMA more difficult.
• Stressed Expected Shortfall (ES) at 97.5% c.l. as the
relevant loss measure, instead of 99% VaR.
• Stressed ES (based on reduced set of risk factors) must
be scaled (using ES under normal conditions) to
include all risk factors.
• Stressed ES based on a 12-month stressed period.
• Default risk Charge and Non-modellable Risk Charges
to be added.
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 Revised IMA
• Liquidity horizons higher for most classes.
 Hedging could reduce capital burden if liquidity horizons for
underlying and hedge instruments are different.
• Capital charge: Higher of previous day loss estimates
and scaled average of last 60-business day estimates.
• The capital multiplier increases from 1.5 to 2, as the
number of 99% VaR violations rises from four to ten.
 Banks compare VaR with both clean and dirty P&L.
• P&L attribution captures the sources of daily variations
in P&L.
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