Updated: Aug 15, 2018
The FRTB rules are the latest version of a recipe for how banks should go about calculating their minimum capital needs for a subset of their business, the so-called ‘trading books’. The rules define in detail situations under which a book/position qualifies for trading book treatment. The idea in general is that marketable securities (stocks, bonds, currencies, commodities etc.) would be trading book instruments and will require a certain treatment for capital calculations. Other types of assets such as mortgage loans the bank holds or shares in hedge funds would most likely qualify for ‘banking book’ treatment. Minimum capital requirements for banking books are addressed separately from FRTB.
Standard or Advanced?
In order to calculate capital charges for a trading book, you need to look at the risk you have in that book. The higher the risk, the higher the capital charge. That said, there are many ways of looking at and measuring risk, FRTB provides a highly prescriptive but quite intuitive way of doing that. It offers two different possible approaches, the standard approach and the advanced approach.
As its name suggests, the advanced approach is (well) more advanced. That means it requires more effort on the part of the bank and usually it’s expected to result in a lower capital charge (otherwise there would be little incentive for banks to even try it). From the systems perspective, the standard approach is mandatory, so everyone needs to implement it. The advanced approach is optional, and banks require specific approval from their national regulators to be able to use it. There are also a series of tests that banks have to pass on an ongoing basis in order to maintain the advanced approach calculation.
General Standard FRTB Considerations
To calculate minimum capital requirements using the standard FRTB approach, regulations require that various risks that influence the market value of a financial instrument be classified in seven risk classes: general interest rate risk, equity risk, commodity risk, FX risk, credit risk non-securitization, credit risk securitization non- correlation and credit risk securitization correlation.
On a separate dimension, each risk class can have three separate risk types: delta, vega and curvature. In general, instruments with optionality (such as equity options, mortgage-based securities or convertible bonds) will have all three risk types. Simpler instruments such as stocks and bonds with no optionality will only have the delta risk type. Our simple example only shows the treatment of the delta risk type. “Vega’ and ‘curvature’ are treated in a similar way and the next installment of this document will illustrate it with an example.
Another key concept in FRTB is the risk factor. This is the lowest level in the risk hierarchy and it represents a ‘sensitivity’, i.e. the change in the market value of an instrument when a market input changes by a pre-defined amount divided by the size of that amount.
The way to think about the risk hierarchy is that one or more risk factors are associated with a ‘curve’, one or more curves form a ‘bucket’ and one or more ‘buckets’ form a risk class. The FRTB rules provide a recipe for how risk factors get aggregated into buckets and then how buckets get aggregated at the risk class level. It’s rather complicated, but our example will make it a bit clearer.
An important concept to note is that of ‘diversification’. FRTB prescribes ‘correlations’ such as when we aggregate two risk factors their aggregate value may be the simple sum (this would correspond to a correlation of 100%) or it may be less than the simple sum (when the correlation is less than 100%) depending on how closely related the quantities that we aggregate are. The main point of
diversification is that the regulator recognizes that the risk of a diversified portfolio is generally less than the simple sum of the risks of individual components.