What does FRTB or Fundamental Review of trading book really mean?

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Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk of the banking sector. The Basel Committee is the primary global standard-setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters.

Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.

The problem was that this reduction did not represent a genuine reduction in risk in the banking system. One of the main reasons the economic and financial crisis became so severe was that the banking sectors of many countries had built up excessive on and off-balance sheet leverage. This was accompanied by a gradual erosion of the level and quality of the capital base. At the same time, many banks were holding insufficient liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses nor could it cope with the reintermediation of large off-balance sheet exposures that had built up in the shadow banking system.

The crisis was further amplified by a procyclical deleveraging process and by the interconnectedness of systemic institutions through an array of complex transactions. During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions. The weaknesses in the banking sector were rapidly transmitted to the rest of the financial system and the real economy, resulting in a massive contraction of liquidity and credit availability.

Ultimately the public sector had to step in with unprecedented injections of liquidity, capital support and guarantees, exposing taxpayers to large losses. The effect on banks, financial systems and economies at the epicentre of the crisis was immediate. However, the crisis also spread to a wider circle of countries around the globe. For these countries the transmission channels were less direct, resulting from a severe contraction in global liquidity, cross-border credit availability and demand for exports.

Given the scope and speed with which the recent and previous crises have been transmitted around the globe as well as the unpredictable nature of future crises, it is critical that all countries raise the resilience of their banking sectors to both internal and external shocks.

SIFIs are financial institutions whose disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity. We read in the final G20 Communique: The framework includes an internationally harmonized leverage ratio to serve as a backstop to the risk-based capital measures.

With this, we have achieved far-reaching reform of the global banking system. The new standards will markedly reduce banks' incentive to take excessive risks, lower the likelihood and severity of future crises, and enable banks to withstand - without extraordinary government support - stresses of a magnitude associated with the recent financial crisis.

This will result in a banking system that can better support stable economic growth. We are committed to adopt and implement fully these standards within the agreed timeframe that is consistent with economic recovery and financial stability. The new framework will be market risk framework basel iii liquidity into our national laws and regulations, and will be implemented starting on January 1, and fully phased in by January 1, Market risk framework basel iii liquidity is especially important that jurisdictions that are home to global systemically important banks G-SIBs make every effort to issue final regulations at the earliest possible opportunity.

But simply issuing domestic rules is not enough to achieve what the G20 Leaders asked for: The RCAP process will be fundamental to ensuring confidence in regulatory ratios and promoting a level playing field for internationally-operating banks.

The financial crisis identified that, like the standards themselves, implementation of global standards was not as robust as it should have been. This could be classed as a failure by global standard setters. To some extent, the criticism can be justified — not enough has been done in the past to ensure global agreements have been truly implemented by national authorities.

RWAs are an estimate of risk that determines the minimum level of regulatory capital a bank must maintain to deal with unexpected losses. A prudent and credible calculation of RWAs is an integral element of the risk-based capital framework. The standardised approach is used by the majority of banks around the world, including in non-Basel Committee jurisdictions.

For example, the Basel II standardised approach assigns a flat risk weight to market risk framework basel iii liquidity residential mortgages. In the revised standardised approach mortgage risk weights depend on the loan-to-value LTV ratio of the mortgage. In addition, the risk-weighted treatment for unrated exposures is more granular than market risk framework basel iii liquidity existing flat risk weight. A standalone treatment for covered bonds has also been introduced. A specific risk weight applies to exposures to small and medium-sized enterprises Market risk framework basel iii liquidity.

In addition, the revised standardised approach includes a standalone treatment for exposures to project finance, object finance and commodities finance. For example, the regulatory retail portfolio distinguishes between revolving facilities where credit is typically drawn market risk framework basel iii liquidity and transactors where the facility is used to facilitate transactions rather than a source of credit.

The initial phase of Basel III reforms introduced a capital charge for potential mark-to-market losses of derivative instruments as a result of the deterioration in the creditworthiness of a counterparty. This risk — known as CVA risk — was a major source of losses for banks during the global financial crisis, exceeding losses arising from outright defaults in some instances.

The Committee has agreed to revise the Market risk framework basel iii liquidity framework to:. This component is directly related to the price of the transactions that are within the scope of application of the CVA risk capital charge. As these prices are sensitive to variability in underlying market risk factors, the CVA also materially depends on those factors. Accordingly, the Committee is of the view that such a risk cannot be modelled by banks in a robust and prudent manner. The revised framework removes the use of an internally modelled approach, and market risk framework basel iii liquidity of:.

As such, the standardised and basic approaches of the revised CVA framework have been designed and calibrated to be consistent with the approaches used in the revised market risk framework. In particular, the standardised CVA approach, like the market risk approaches, is based on fair value sensitivities to market risk factors and the basic approach is benchmarked to the standardised approach.

The financial crisis market risk framework basel iii liquidity two main shortcomings with the existing operational risk framework. First, capital requirements for operational risk proved insufficient to cover operational risk losses incurred by some banks.

Second, the nature of these losses — covering events such as misconduct, and inadequate systems and controls — highlighted the difficulty associated with using internal models to estimate capital requirements for operational risk. The Committee has streamlined the operational risk framework. The leverage ratio complements the risk-weighted capital requirements by providing a safeguard against unsustainable levels of leverage and by mitigating gaming and model risk across both internal models and standardised risk measurement approaches.

To maintain the relative incentives provided by both capital constraints, the finalised Basel III reforms introduce a leverage ratio buffer for G-SIBs. The leverage ratio buffer takes the form of a capital buffer akin to the capital buffers in the riskweighted framework. As such, market risk framework basel iii liquidity leverage ratio buffer will be divided into five ranges.

As is the case with the risk-weighted framework, capital distribution constraints will be imposed on a G-SIB that does not meet its leverage ratio buffer requirement. A G-SIB that does not meet one of these requirements will be subject to the associated minimum capital conservation requirement expressed as a percentage of earnings.

A G-SIB that does not meet both requirements will be subject to the higher of the two associated conservation requirements. The full set of Basel III reforms will help enhance the resilience of the banking system.

The Basel Committee will continue to exercise its mandate to strengthen the regulation, supervision and practices market risk framework basel iii liquidity banks worldwide. The agenda changes, but the purpose is constant — to safeguard and enhance financial stability. The Market risk framework basel iii liquidity Committee has agreed that jurisdictions may exercise national discretion in periods market risk framework basel iii liquidity exceptional macroeconomic circumstances to exempt central bank reserves from the leverage ratio exposure measure on a temporary basis.

Jurisdictions that exercise this discretion would be required to recalibrate the minimum leverage ratio requirement commensurately to offset the impact of excluding central bank reserves, and require their banks to disclose the impact of this exemption on their leverage ratios.

The Basel iii Accord Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk of the banking sector.

In summary, the key revisions are as follows: The CVA framework The initial phase of Basel III reforms introduced a capital charge for potential mark-to-market losses of derivative instruments as a result of the deterioration in the creditworthiness of a counterparty.

The Committee has agreed to revise the CVA framework to: The revised framework removes the use of an internally modelled approach, and consists of: Operational risk The financial crisis highlighted two main shortcomings with the existing operational risk framework. The leverage ratio To maintain the relative incentives provided by both capital constraints, the finalised Basel III reforms introduce a leverage ratio buffer for G-SIBs.

A G-SIB that meets: The agenda changes, but the purpose is constant — to safeguard and enhance financial stability The Basel Committee has agreed that jurisdictions may exercise national discretion in periods of exceptional macroeconomic circumstances to exempt central bank reserves from the leverage ratio exposure measure on a temporary basis.

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For the first time, the microeconomic dimension of prudential rules came to be surrounded by a macro-prudential layer intended to target systemic risks, [4] while concerns over liquidity shortages in bad times led regulators to establish standards for liquidity coverage [5] and stable funding. Certainly, the implementation of the Basel III framework came at a significant price.

Compliance with the new prudential provisions required banks to sustain tremendous costs for recapitalization and risk management improvements. Some banks preferred to re-size their balance sheets, cutting billions of dollars of assets and rebalancing their portfolios.

One may wonder whether the overall benefits provided by Basel III in terms of stability of the financial system and resilience of its components outweigh these costs. Several studies sought to make this analysis by forecasting the overall impact of Basel III on the banking industry and the real economy. What is certain, however, is that today the Basel III framework is under international pressure.

Only a few years after the enactment of Basel III, critics have highlighted concerns about the fundamental underpinnings of its prudential rules. And, more importantly, international policymakers are already at work to reframe some of its most significant components in response to these criticisms.

Despite general support from the global community, Basel III has not been free of criticism. Immediately after its introduction, a number of scholars and officers started questioning its effectiveness in addressing idiosyncratic and systemic risks. For a large, complex bank, this has meant a rise in the number of calculations required from single figures a generation ago to several million today Haldane It also raises questions about regulatory robustness since it places reliance on a large number of estimated parameters.

Across the banking book, a large bank might need to estimate several thousand default probability and loss-given-default parameters.

To turn these into regulatory capital requirements, the number of parameters increases by another order of magnitude. Their granularity makes it close to impossible to account for differences across banks. It also provides near-limitless scope for arbitrage. This degree of complexity also raises serious questions about the robustness of the regulatory framework given its degree of over-parameterisation.

This million-dimension parameter set is based on the in-sample statistical fit of models drawn from short historical samples.

If previous studies tell us it may take years of data for a complex asset pricing model to beat a simple one, it is difficult to imagine how long a sample would be needed to justify a million-digit parameter set. Against this backdrop, the massive structure of Basel III can hardly be seen as an efficient and rational framework. The continuing reliance on internal model-based regulation to calculate capital requirements. Since Basel II became effective in , banks have been allowed to use their own internal models for the calculation of their funds and capital requirements, subject to approval by the competent authorities.

The use of internal models by global banks, permitted under and incentivized by the Basel II framework, has resulted in a number of negative spillover effects.

A number of analytical studies show how banks using these models can easily play with their own estimates in order to reduce the amount of capital required to be put aside. The Basel III framework does not significantly question the reliability of the internal risk model approach to capital regulation.

Internationally active banks are therefore incentivized, even under Basel III, to use their own risk models for the purpose of calculating their prudential requirements, in view of the inherent capital savings and competitive advantages. The calculation of capital requirements is basically constructed around three typologies of idiosyncratic risks, namely credit risk, market risk, and operational risk.

The Basel III standards—under either the standardized or the internal risk model approach—seek to provide sensitive methodologies for the determination of each of these risks. In order to enhance risk coverage of off-balance sheet activities, the Basel III framework introduced specific metrics for measuring counterparty credit risk related to trading book and complex securitization exposures, along with derivatives, repurchase agreements, and securities financing transactions.

However, although Basel III represents a praiseworthy effort to better detect the potential build-up of these risks, its provisions have fallen short of fully capturing residual risks, [20] such as interest rate risk arising from non-trading activities. To provide a common set of data on the capital and liquidity adequacy of banks to market participants and thus enhance market discipline, Basel III included the Pillar 3 disclosure requirements.

For a banking entity of any risk profile, the Basel Committee set out common principles and templates that allow stakeholders to conduct cross-jurisdictional comparisons among banks on business models, prudential metrics, risk management, and governance performance. However, critics have raised concerns about the lack of disclosure requirements for certain pivotal information. In one of his keynote speeches, William Coen, Secretary General of the Basel Committee, compared the Basel III framework to a bridge, which requires not only solid construction, but also regular maintenance.

They must be sympathetic to their surroundings and their design and construction rely on the expertise of many parties. A weak bridge jeopardises the safety of those crossing it, and may create wider problems for society at large. A loss of confidence in a structure or its builders shakes confidence in every similar structure. These knock-on effects can be severe and persistent.

So it is essential that a bridge, like the Basel framework, is built to last. We must also not forget the importance of regular maintenance. The Harbour Bridge opened with four traffic lanes but now has eight, together with a complementary tunnel. Some parts are repainted every five years, while others last as long as 30 years. We face the same imperatives with the Basel framework. Maintenance does not imply re-opening every previous decision; we understand the importance of stability and certainty.

But it does mean staying vigilant to market developments and keeping in mind the increasingly widespread use of the Basel framework. The significance of this statement is twofold. On one hand, a complex regulatory architecture, such as the one of Basel III, requires continuing adjustments over time due to market innovations and industry developments.

On the other hand, the BCBS recognizes its policy limitations and seems to suggest that Basel III should not appear as a complete regulatory framework. Rather, it represents, in essence, an ever-evolving system [26] that should balance the stability of its normative content with evolving understanding of its policy foundations. When gaps and weaknesses are found in the application of the prudential framework, international policymakers should re-discuss the premises of their previous work and, accordingly, lay down new regulatory proposals that might better capture the externalities of market behaviors.

Over the last two years, in acknowledging its past policy-making limitations, the BCBS has followed this path. As of , several regulatory adjustments to the Basel III framework have been made, and public consultations by BCBS on these new proposals have been carried out to gauge market reactions.

Some examples are worth noting. For the same purpose, in March , the BCBS launched an effort to revise the standardized approach for calculating operational risk [29] and proposed changes to the Basel III internal ratings-based approaches [30] in order to reduce variations in credit risk-weighted assets. In the same month, the BCBS published its consultative document on consolidated and enhanced Pillar 3 disclosure requirements [31] aimed at addressing disclosure shortcomings found in the Basel III framework.

In April , the BCBS also issued a revised version of the leverage ratio requirement [32] and new standards regarding the management and supervision of interest rate risk in the banking book. If these indications about a future Basel IV package are accurate, it is of outmost importance to figure out what are likely to be its main components.

In view of the criticisms of the Basel III framework, and considering some of the reform proposals issued over the last few years by the BCBS, the following elements are likely to be considered in the future prudential package: A the total loss-absorbing capacity requirements; B standardized and internal model-based approaches; C operational, interest rate, and step-in risks; D sovereign risk; E large exposures and concentration; F securitization; G additional macroprudential instruments; and H enhanced disclosure requirements.

Although TLAC cannot be considered a revised version of the Basel III capital requirements—as it is supposed to constitute an add-on requirement for G-SIIs already subject to the Basel III prudential standards—the actual implementation of these provisions will require consistency in the calibration of both frameworks.

In view of this, Basel IV will need to align a number of Basel III provisions with the TLAC regulatory package, particularly with regard to the eligibility of capital instruments, deduction approaches, and holdings restrictions. As noted above, one of the main criticisms of Basel III framework has been the level of complexity underlying the capital requirements calculation. Against this backdrop, Basel IV is expected to revisit the scope of internal model-based rules in the calculation of risk-weights.

To further this purpose, future proposals will introduce floors for credit risk parameters to reduce distortions on the determination of the EAD, LGD, and PD. Credit counterparty risk and market risk frameworks will probably be revisited along the same lines. For a number of derivatives classes and long settlement transactions, the credit counterparty risk will be measured primarily by relying on the standardized approach developed by the BCBS in March For market risk, minimum capital requirements will be calculated by either a revised internal model approach or a revised standardized approach, which would permit a more sensitive capitalization of material risk factors across banks while limiting the capital-reducing effects of hedging and diversification.

Finally, in order to clarify the regulatory boundaries between the trading book and banking book of credit institutions and to reduce the related risk of arbitrage, the BCBS will implement new definitions for the instruments deemed to be held either on the banking book or the trading book. To address this concern, the BCBS revealed a revised operational risk framework in March , and its principles are likely to constitute a prominent component of the Basel IV package.

By the same token, Basel IV is expected to revisit the framework for capturing interest rate risk. As a foundation for this, in April the BCBS updated its principles on interest rate risk in the banking book, setting out methods that banks should use for measuring, managing, monitoring, and controlling this risk typology.

The BCBS proposal focuses on identifying unconsolidated entities that could generate significant step-in risk for banks. Although the development of such framework is at an early stage and its basic contours are only preliminary, [57] it is easy to assume that the Basel IV package will incorporate this risk category as one of its innovative prudential profiles.

The Basel IV framework is also likely to reflect the outcome of the ongoing policy discussions on special prudential treatment of sovereign bonds. The magnitude of sovereign risk and its spillover effects have been at the center of policy attention following the severe deterioration of Greek, Irish, Portuguese, Spanish, and Italian government bonds during the Euro zone debt crisis. At this stage it is not possible to determine what might be the likely outcome of this policy debate due to the variety of options available.

However, a BCBS consultation paper on this subject is expected in the upcoming months. In April the BCBS published its final supervisory framework on measuring and controlling large exposures as a backstop to risk-weighted capital requirements. This large exposure framework is expected to be applied as of and will overrule the previous standards on large exposures set out in Another notable element of the likely Basel IV package relates to securitization.

In order to refine the Basel III provisions on securitization, which date back to the Basel II era, in July the BCBS published a final paper setting out the regulatory treatment for capitalizing securitization exposures.

Based on this paper, a number of innovations are expected to be introduced for the purpose of calculating capital requirements. The framework aims at reducing complexity by limiting the number of approaches accepted for determining securitization capital. To this end, it favors the internal ratings-based approach in order to reduce the mechanistic reliance on external ratings.

Although this new framework is considered to be part of Basel III, given the number of substantial changes proposed and the timeframe for implementation January , [69] it is more appropriate to conceptualize it as a complementary element of the Basel IV credit risk revisions described above. Beyond the microprudential proposals outlined thus far, the Basel IV package could incorporate a number of new macroprudential instruments, which would complete the countercyclical regulatory dimension introduced with Basel III.

As part of such an effort, not only can exposure-based capital surcharges for G-SIIs and other credit institutions be implemented, but real estate tools, such as loan-to-value and debt-to-income caps, could also be developed in the near future by the BCBS. In addition, the Basel IV framework could incorporate a macroprudential stress testing framework for liquidity and solvency risks. Finally, in order to reflect the number of regulatory changes proposed under the Basel IV package, it is likely that the Basel III disclosure framework will be amended accordingly.

The foundations of this enhanced disclosure regime can be found in the consultative document on Pillar 3 disclosure requirements published by the Basel Committee in March If all these proposals were implemented, what would remain of the Basel III framework?

The adoption of these proposals as supplementary prudential standards would override the core components of Basel III, setting the stage for a radical reformulation of banking law throughout the world. If this holds true, market participants need to ponder the implications of these regulatory reforms on the banking industry as a whole.

Compliance with Basel III imposed substantial costs on credit institutions. The array of regulatory changes introduced by the BCBS in required banks to adjust not only their capital and liquidity structure, but also their business models, governance structure, and investment strategies. In this evolving scenario, the implications of a future Basel IV package might be overwhelming.

One the one hand, the likely simplification of risk-weighting and parameter calculations could provide some compliance cost savings to banks. On the other hand, limitations on the use of internal risk models for the purpose of capital requirements, along with the general increase of prudential buffers, could further undercut the viability of banking activities.