W H I T E PA P E R

Fundamental Review of the Trading Book

Impacts on financial institutions in Australia
By Soon Kit Tham

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Fundamental Review of the Trading Book Impacts on financial institutions in Australia
The Fundamental Review of the Trading Book (FRTB) is a Basel
Committee for Banking Supervision (BCBS) revision of trading
book capital rules. FRTB aims to strengthen capital standards
for market risk by incorporating lessons learned from the G20-
endorsed Basel Committee’s investigation into the variability of
market risk weighted assets, and hones the current Basel measures
which were implemented in the aftermath of the financial crisis
as a stop gap measure for trading book capital requirement.
FRTB advances market risk management and capital charge
measurements, and delivers a globally consistent and coherent
regulatory framework that can be implemented consistently by
supervisors, and which achieves comparable capital assessment
across jurisdictions.
The BCBS has outlined a series of proposed measures under
FRTB that, if implemented, could force changes in the way firms
approach their trading book operations. The changes are so
fundamental that they may even cause some financial institutions
to reconsider their business strategy. The proposed changes
potentially affect a broad swathe of institution types and will likely
require significant infrastructure investment in order to comply.
While industry consultation on the proposed rules is still pending,
much of what’s being discussed is expected to make it to the final
rule-making, and that may come into effect during 2017.
Budget processes being as they are, much of the planning and
building out will need to be completed during 2016, with the bulk
of the heavy-lifting in terms of design and implementation taking
place during the first half of the year in order to ensure adequate
testing time.
As a result, firms need to pay attention to developments around
the FRTB and should start planning now for how they will organize
themselves and their internal processes to achieve compliance
within the tight deadline.
This paper aims to outline the FRTB’s key requirements, and how
they translate into processes in and around the trading book. It
offers suggestions with respect to best practices for the design and
development of a platform to meet concerns raised by Australia’s
banking industry.
Trading/Banking Boundary
Central to market risk capital management is the 80% difference
in capital cover charge between the trading and banking books.
This difference reflects the difference in regulatory frameworks
and introduces arbitrage possibilities to reduce capital charge
in conditions of market stress. Consequently FRTB specifies
governance in position and risk transfers between the banking
and trading book, reducing regulatory arbitrage between the two
books.
The Australian banking industry supports strengthening the
boundary between the trading book and banking book. This
boundary governance is likely to be aligned with banks’ internal
risk management practices to be effective. Therefore having a
workflow approval process with trails for internal and regulatory
audits helps banks to monitor position transfers between the
2
books. The workflow includes a process for banks to assess
if positions are eligible for transfer between the two books.
In addition, the workflow institutionalizes a trading evidence
approach to ensure banks are able to trade and manage risk for
a new instrument designated for the trading book. Moreover,
banks may need to support base reporting of positions according
to supervisory presumption of trading and banking book
instruments. This base report follows FRTB’s aim for regulatory
consistency across jurisdictions, and contains a structure for
flexible assignment of instruments to different books according to
regulatory rules.
Market Liquidity
The BCBS proposes to apply different liquidity horizons to different
risk factors which are not equally liquid, and therefore they must
be included in the bank’s risk management framework. FRTB
recommends a ‘one size fits all’ bucketing of liquidity factors. It
is likely that a layer of national discretionary rules will be added
to make liquidity factors more granular for different type of
instruments. Banks are also likely to be given autonomy to justify
for shorter liquidity factor with sufficient trading data disclosure.
Having said this, banks in Australia will likely need to review their
risk management capabilities to support the segmentation of
instruments and flexibility to calculate the risks of each instrument
to different liquidity horizons. It is likely that national discretionary
rules will allow banks to:
■■ apply scaling factors to one day market
perturbation for ease of implementation;
■■ or to apply similar liquidity factors for all
risk factors within an asset class;
■■ or to apply regulatory specified liquidity factors
per risk factor based on historical calibration;
■■ and finally the base option to use a supervisory
adjusted FRTB liquidity factors.
Market Risk Metric
Similar to its regional banking counterparts, the Australian
banking industry recognizes that expected shortfall addresses
tail risk by considering the losses and their likelihood above a
given confidence level. This merges existing metrics by combining
the losses from VaR and stressed VaR valuations. Reactions are
mixed for replacing VaR with expected losses. Key concerns are
supervisory justification for the banking industry to accept a
confidence level to be used for expected shortfall, and the move
to expected shortfall emphasizes the extreme data values which
are less certain. Moreover, expected shortfall is not able to be
effectively back-tested.
It is likely that both VaR and expected shortfall measures will
need to be supported until further agreement within the banking
industry in Australia and the global banking community at
large. Banks may also consider the added value of supporting a
comparative analysis of the existing VaR and the new expected
shortfall measure. Expected shortfall scales risk metrics on to an

extreme stressed measurement. On the other hand, VaR enables
a view of current conditions utilizing the bank’s capital. A risk
management solution that enables parallel support for both
metrics could help a bank to leverage the comparative advantages
provided by each of them, ensuring market risk management
confidence and greater transparency in analyzing the risk position,
and therefore risk capital required by the bank.
Stress Calibration
Expected shortfall for capital purposes requires a calibration to
stressed observation periods using a reduced set of risk factors
which explains at least 75% of current period expected shortfall.
This regulatory capital requirement may necessitate banks to
consider a layer of analytical process and supporting tools to break
down valuations into risk factors and corresponding contributions.
Subsequently, banks enable a reduced set of risk factors to be
revalued with a stressed historical period. Banks will need to
further invest in data collection and data management to ensure
quality requirements on the historical market data to be used.
Hedging and Diversification
The current Basel framework gives rise to differences between
the treatment of hedging under standard and model-based
approaches. The model-based approach recognizes hedging
benefits if market implied correlations are demonstrated in the
historical market data used for valuations. On the other hand, the
standard approach is more conservative in recognizing benefits
for only near or perfect hedges. Estimated correlation parameters
used for model based approaches have been empirically shown to
be unstable for measuring stressed period risk. Therefore hedges
among correlated instruments may further reduce the fit during
stressed periods, resulting in higher risk exposures for the same set
of instruments held in stressed periods versus in normal periods.
These could result in potential inconsistencies between the two
approaches and should be improved within the FRTB.
Banks in Australia may consider the benefits of using multiple
types of stress tests to assess the stability of hedges during
stressed periods. These stress tests could be a composition of
sensitivity, historical or economical scenarios. In addition, it would
be beneficial to incorporate flexibilities in the stress testing tools
to update rules that recognize hedges using the standard approach
as it is expected that supervisors will play a larger role in managing
the incentives for banks to hold well-diversified portfolios in the
local context.
Parallel Disclosure
FRTB recommends parallel disclosure of both the standard and
the model-based approach for trading desks qualified for model-
based capital charges. Having a standardized capital measurement
offers supervisors a way to determine a capital floor or surcharge
for model-based capital, which is exposed to model risk during
stressed market conditions. Banks may consider the benefits
of designing a workflow that periodically validates and tracks
each trading desk’s qualification status to use a model-based
approach, and an automated credible fallback to the potentially
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higher standardized capital charge when the desk is disqualified
from using a model-based approach. Disclosure of standardized
capital also enables banks in Australia to have an additional option
to assess their international trading desk’s performance across
different jurisdictions on the same risk measurement.
Aggregation & Granularity
The Australian banking industry may likely take a staged
implementation to FRTB, beginning with measures that enable
a bank to align internal practices with recent changes in the
global market. This translates into a bank’s capability to generate
accurate and reliable risk data for each stage on a largely
automated basis to minimize the probability of errors.
The ability to aggregate information at the group level and
segregate back to the desk level will be crucial for banks to meet
a broader range of regulatory base reporting and corresponding
analysis. Extensive business intelligence capabilities enable
on-demand risk analysis for internal needs and requests to meet
supervisory queries, as well as to support the progressive QIS
exercises prior to each review of FRTB measures.
Conclusion
As FRTB edges towards finalization, banks in Australia need to
evaluate how they will be impacted based on feedback provided
by the Australian banking industry and its supervisor. Infrastructure
will play an important role in ensuring compliance with the final
regulation, whether or not the bank decides it needs to establish
an independent risk control unit to meet the new requirements.
There is also the additional consideration of the ongoing BCBS
239 enterprise risk aggregation initiative, which, like FRTB, requires
banks to respond rapidly and accurately to regulators’ enquiries,
whether they are scheduled or on an ad-hoc basis. This will require
a high degree of flexibility from the bank’s chosen infrastructure
for meeting its risk and regulatory capital calculation obligations.
To ensure they are optimizing their use of capital under the new
rules, banks will need to identify all asset classes and trading
desks that contribute to the capital charge. All affected portfolios
will need to be analyzed and optimized according to capital
parameters.
All of these changes point to the need for a consistent underlying
data and IT infrastructure to support ongoing requirements. And
all of this needs to be achieved at a reasonable cost.
The cost consideration may by the key factor in determining
whether some market participants decide to completely overhaul
their business strategy, concluding that the new rules are too
onerous and compliance is to difficult and costly.
All too often, literature on the fundamental review of the trading
book focuses merely on expected shortfall calculation as the
banks’ main challenge resulting from the FRTB. We attempt
to offer a more comprehensive view on the impact to banks
from multiple angles. This approach identifies the following key
capabilities that many institutions may need to improve further;
any platform supporting FRTB should include an auditable
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workflow approval process, a flexible assignment of liquidity horizons to granular risk factors, integrate expected shortfalls into VaR
processes for the integrity of both measures, possess comprehensive stress and back testing capabilities, support both standard and model-
based approaches, and contain structured data management platform backed by business intelligence tools for data transparency. This helps
banks to realize business improvement while simultaneously improving risk management.

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