Basel IV: Fundamental Review of the Trading Book (FRTB)

In January 2016, the Basel Committee on Banking Supervision (BCBS) published a new standard for determining the capital requirement for market price risks. Due to ongoing criticism of some key points of the standard, the Basel Committee published a consultation paper in March 2018 - even before the standard came into force - with selective suggestions for improvement, which were received favourably by the industry as a whole. In January 2019, the Basel Committee adopted a revised standard for determining the capital requirement for market price risks, essentially following the consultation paper.

At the European level, the above requirements were incorporated with various adjustments into CRR 2, which came into force on 28 June 2019. However, the amendments to the BCBS standard published shortly before have not yet been reflected. These are to be introduced downstream via delegated acts and regulatory technical standards.

The new regulations within the framework of the Fundamental Review of the Trading Book (FRTB) include a stricter separation of positions between the trading and banking book, the introduction of a new standardised approach for market price risks as well as revised regulations on the use of internal models. The stricter distinction between trading and banking book is intended to make reallocations between the two books more difficult and thus prevent regulatory capital arbitrage. For this purpose, explicitly designated financial instruments as well as certain listed equity instruments or options are explicitly assigned to the trading book. This allocation can only be deviated from with justification and supervisory approval. The rules proposed by the Basel Committee on the distinction between the trading book and the banking book were not included in CRR 2. However, the requirements for a more restrictive reclassification between the trading and banking book have been adopted and will apply from mid-2023.

The newly developed standardised approach comprises three components to be determined independently: a sensitivity-based variance-covariance approach for capital backing of "classic" market price risks, furthermore a default risk component for debt and equity positions as well as a surcharge for residual risks, for example for financial instruments with exotic or other underlyings. This approach is accompanied by corresponding disclosure requirements.

Banks with small trading books have the option of using a simplified standardised approach, which is defined as a scaled variant of the existing standardised approach under Basel II. Depending on the type of risk, the capital requirement is scaled to 120 % (for FX risk) to 350 % (for equity risk) of the current value.

When internal models are used, approval will no longer be granted at the bank level, but at the trading desk level. The capital requirements were tightened - among other things by taking into account risk factor-specific liquidity horizons, the introduction of so-called non-modellable risk factors and restrictions on diversification assumptions - and, similar to the standardised approach, result from the sum of three components: an expected shortfall for capital backing of "classic" market price risks, a conservatively designed measure for non-modellable risk factors and a default risk component for debt and equity positions. Furthermore, banks that use internal models to measure market risks must additionally calculate the capital adequacy on a comparative basis using the standardised approach.

CRR 2 provides for an FRTB reporting requirement under the standardised approach for banks with material market risk positions for the end of 2020 and a reporting requirement for the results of the internal models approach under FRTB for the beginning of 2023 at the earliest. The capital requirements according to FRTB are to apply four years after CRR 2 comes into force, i.e. in the middle of 2023. This results in considerable implications and need for action for all institutions.

Depending on the individual portfolio, increased capital requirements compared to the status quo are to be expected as a result of the expansion of the trading book allocation. Furthermore, for small and medium-sized banks, the changed trading and banking book allocation may lead to the thresholds for the simplified treatment of market price risks being exceeded. In addition, even the standard approach results in significantly higher requirements for the granularity of the data as well as increased methodological complexity. For internal models, the organisational effort for application or for ongoing operation increases significantly.

KPMG has extensive experience at the interface between risk measurement, supervisory law and trading and IT. Our advisory services include carrying out simulations of the future capital requirement as well as designing calculations according to the selected capital approaches and their implementation and integration into the regulatory reporting system.