www.pwc.co.

uk/basel

The fundamental
review of the
trading book

What are the proposed

changes to the trading book
regime and what will the
impact be for banking?

August 2012
Contents

An overview of the fundamental review of the trading book 2

How will this affect your business? 7

The impact on regulatory capital levels and capital drivers 7

The operational impact 8

The impact on individual business segments 8

A critical view of the fundamental review of the trading book 9

Proposed changes to the trading book regime 9

A shifting supervisory focus for thetrading book 10

Trading book/banking book boundary condition 11

Reducing the gap between the internal model-based

approach and the Standardised Approach 11

Diversification 12

From legal entity to trading desk 12

A new risk metric 13

Adoption of stressed inputs for Expected Shortfall models 13

Capturing all risk in the trading book 14

Out of scope 14

Speak to our experts 15

Appendix 1 16
An overview of the fundamental
review of the trading book
Introduction
In May 2012, the Basel Committee on Banking Supervision
(BCBS) issued a consultative document referred to as the
Fundamental Review of the Trading Book (FRTB).
The changes suggested in the consultative document are
significant and cover numerous aspects of the trading book,
including the definition of the trading book, the market risk
and liquidity risk measurement and capitalisation and the
supervision of internal risk models.
The FRTB will have a profound impact to the way that
firms define future trading and risk management strategies.
Given the scope and level of impact that the FRTB will have,
analysing the proposed changes to the trading book regime
and communicating feedback to the BCBS is crucial.
2 The fundamental review of the trading book PwC
Overall, we believe that the trading book regime depicted
in the FRTB is a positive step towards a more robust trading
book framework.
In this document, we outline the key proposals put forward
by the BCBS and we give our initial thoughts on what these
rules, if fully implemented, might mean for the industry.
We aim to help firms better understand the implications to
their business and risk management, and to help plan their
analysis and response to the proposed regulatory
requirements.
Separately, we intend to respond formally to the BCBS as
part of the consultation process.
Why is the review happening now?
The 2009 Revisions to the Basel II market risk framework
(Basel 2.5) was the first attempt by the BCBS to address the
trading book issues revealed by the global financial crisis.
The implementation of Basel 2.5 resulted in a significant
increase in the regulatory capital requirement for market
risk in the trading book. However, this change introduced
some inconsistencies in trading book risk measurement,
and a substantial increase in regulatory capital charges
both in absolute terms and relative to economic capital
calculations. Also, Basel 2.5 did not fundamentally address
other significant issues, such as the definition of the trading
book, the use of VaR as a risk metric and capturing market
liquidity risk on the trading book.
The BCBS has now responded by launching the FRTB. This
signals the beginning of a consultation process with the
industry that aims to develop a new trading book framework.
The proposals reflect BCBSs key objectives, as follows:
to develop an effective trading book/banking book
boundary condition
to achieve a regulatory framework that captures and
capitalise all risks in the trading book
to improve risk measurement techniques, and
to achieve comparable levels of capital across internal
risk models and the Standardised Approach (SA).
To achieve these objectives, the BCBS is proposing some
far-reaching changes that will shape the future of the
trading book framework, including:
the new trading book/banking book boundary
the use of Expected Shortfall (ES) as an alternative
to VaR
the integration of market liquidity risk with market risk,
the application of capital floors and supervisory-based
model parameter calibrations, and
making the SA more risk sensitive.

The history of the trading book regime

1996 2004 2009 2012
Basel I Basel II Basel 2.5 FRTB

Initially, the 1988 Basel Capital
Accord addressed credit risk on
the banking book. In 1993, the
BCBS published the first
consultative document on the
Supervisory Treatment of
Market Risks and following
negotiations with the industry
on the use of VaR the
Amendment to the Basel
Capital Accord was originally
released in 1996 and modified
again in 1997.
The amendment to the Basel
Capital Accord provides a
detailed account of the
methodology laid down by the
BCBS to set capital
requirements for market risks
and describes both alternative
approaches to the measurement
of market risk, a standardised
method and an internal models
approach based on VaR.
The internal models-based
approach can be applied to
either general market risk (with
issuer-specific risk treated as
banking book credit exposure),
or both general and specific
risk.
The Amendment was further
revised on 2005 to incorporate
BCBS and IOSCO join paper on
The application of Basel II to
trading activities and the
treatment of double default
effects. The paper, among
others, changed the trading
book regime, especially with
respect to the treatment of
specific risk. The amendment
was finaly incorporate in the
comprehensive version of
International Convergence of
Capital Measurement and
Capital Standards: A Revised
Framework.
Following the 2008 global In May 2012, BCBS issued the
financial crisis, BCBS decided Fundamental Review of the
to review the trading book Trading Book (FRTB)
regime and published a final (BCBS219) consultation paper.
version of the Revisions to the The aim of the review is to
Basel II market risk framework readdress the prudential
in 2009 (BCBS158). The new regulation of the trading book
framework supplemented the and as such, it provides the
internal models-based opportunity to reshape the
approach with an incremental entire trading book regime.
risk capital (IRC) charge, BCBS is expected to consult
inclusive of default risk and with the banking industry
migration risk for unsecuritised through to 2013 and then
credit products. For securitised finalise the prudential
products, the capital charges of framework.
the banking book would apply
with a limited exception for
certain correlation trading
activities, where banks would
be allowed by their supervisors
to calculate a comprehensive
risk capital charge subject to
strict qualitative minimum
requirements as well as stress
testing requirements. In
addition, banks would have to
calculate stressed VaR taking
into account a one-year
observation period relating to a
period of relevant market
stress, further adding on to
their capital requirements.

Source: PwC

PwC The fundamental review of the trading book 3



4 The fundamental review of the trading book PwC

Key areas you need to consider
Overall, the new proposals appear on the face of it to serve
the objectives of the new trading book regime:
the proposed changes improve the capture of market
risk in the trading book and gives the supervisors the
ability to control the use of internal risk models at
trading desk level, and
the proposed trading book/banking book boundary
conditions should help to remove regulatory arbitrage
and introduce consistency across jurisdictions.
However, given the extent of the changes, there is a high
risk of unforeseen difficulties and unintended consequences.
For example given the difficulties from both an operational
and an accounting point of view, we expect the trading
book/banking book boundary conditions to be a critical
subject of debate with the industry.
Likewise, the closer alignment between internal model and
SA regimes, while laudable, could undermine an important
incentive for banks to invest in their risk models and
processes.
The ES metric, while valid from a capital standpoint, may
not be the right way to think about and manage risk at the
margin.
Finally, we welcome BCBS attempt to incorporate market
liquidity, the introduction of a coherent market risk metric
and the review of the SA. However, setting capital floors for
internal risk model capital and using supervisor-implied
correlation are two elements of the proposals that require
careful consideration.
How will this affect firms?
We dont anticipate a dramatic increase in a banks overall
regulatory capital requirement, however, the regulatory
capital requirement for trading book activities will
increase slightly for firms that rely on internal market
risk models. However, the operational impact will be
substantial as, going forward, these firms will need to
maintain both SA and internal risk model infrastructures
for regulatory capital production and benchmarking
purposes. Meanwhile, smaller firms will need to adapt
to the new SA. Though the new SA will be more risk
sensitive, model parameters set by the supervisor will
limit excess opportunities for capital reduction.
The proposed trading book regime will also affect the
composition of the firms position risk requirement,
market risk management methodologies and standards.
With the introduction of ES, the overall position capital
requirement will consist of components that will include
stressed ES for modellable risks, ES for non-modellable
risks, discrete credit risk (integrated with ES or
standalone) and market liquidity add-ons. We also expect
firms to use a capital multiplier to compensate for poor
model performance. The level of the capital multiplier
will be a key subject of the anticipated Qualitative Impact
Study (QIS). Overall, the FRTB signals a potentially
dramatic shift in regulatory capital determination and
great care will be needed to ensure that it can align with
internal decision making frameworks for both capital and
risk management.
The FRTB implies that regulators will increase their
involvement in calibrating models, setting capital floors
and validating internal risk model performance at the
trading desk level. The broadened supervisory scope will
not only increase the regulators responsibilities but also
increase firms obligations to generate risk model information
and to communicate this information in a more timely
and effective way to the regulator.
PwC The fundamental review of the trading book 5
 What do firms need to
do now?
Given the importance of the FRTB for
the industry, we expect the consultation
process to evolve over two stages.
The first consultation period ends on
7 September 2012. We expect an
additional consultation document to
follow, outlining the options selected
and providing more detail on the
internal model calibration, capital
floors and the SA.
We also expect a QIS to start following
the first consultation period. The
industry will benefit from doing a QIS
review as early as possible, to enable
both banks and BCBS to assess the
impact of the suggested changes.
Firms will then have the opportunity
to assess in detail the behaviour and
stability of the ES method at trading
desk level, and (given the operational
lead time for such a substantial change)
to start implementing the new market
liquidity regime and building an
appropriate infrastructure to support
the ES metric and enhanced SA.
The QIS will also provide cost/benefit
information to the regulators, help
them observe convergence between
internal models and the SA, and test
the processes and overheads involved
in implementing and managing
supervisory implied parameters.
Even before embarking on operational
and policy changes, we expect that
firms will need to instigate a complex
programme of initiatives to respond to
the FRTB consultation process. These
initiatives will include the analysis of
the consultative documents, drafting
responses, participating in the QIS and
liaising with industry bodies to form a
collective opinion. These activities will
need to be organised under a coherent
programme that engages with all
stakeholders, including the BCBS,
industry bodies and internal teams
from the front office, finance and risk
management departments.

Potential consultation process roadmap

May 2012 Oct 2012 Jan 2013 May 2013 Oct 2013
Sep 2012 Dec 2012 Apr 2013 Sep 2013 Dec 2013

1st consultation 2nd consultation Policy document

2nd May. FRTB consultative document 2nd FRTB consultative document

7th June. Industry- BCBS meeting FRTB QIS 1

Consultation
process

7th Sep. Consultative 2nd FRTB consultative

document response document response
deadline deadline
FRTB QIS 2

FRTB policy document

Initial assessment and lobbying

Review consultation document
Detailed impact analysis and planning
industry response

and qualitatively assess impact

Formulate initial views on Perform quantitative impact analysis
Anticipated

Mobilisation and implementation

trading book regime options
(trading book boundary, SA
method, etc.) and lobby through
industry bodies and local
regulators
Respond to the 1st consultative
document
and cost/benefit analysis (FRTB QIS 1)
Continue lobbying to influence
final draft
Start formulating plans for
implementation
Embed new requirements to
business planning
Respond to the 2nd consultative
document
Perform impact analysis on
final rules and assess in detail
RWA behaviour (FRTB QIS 2)
Retool business/trading desks
under new regulatory
requirements
Mobilise resources for
implementation

Estimated timeline

6 The fundamental review of the trading book PwC

How will this affect your business?
The impact on regulatory capital
levels and capital drivers
The main objectives of the new
proposals are to better capture all
risks in the trading book, strengthen
risk measurement and more closely
align the Standardised Approach and
the internal risk models-based
approach. These proposals were not
set out with a regulatory intent to
increase capital requirements.
Consequently, we do not expect that
these proposals will result in a
material increase in overall regulatory
capital levels for trading book
positions across the industry, after
allowing for the impact of the July
2009 amendments, or Basel 2.5, which
have already come into force. That
said, individual firms could find their
capital levels impacted in the
following ways:
We expect that regulatory capital
levels will increase for firms that
rely heavily on the internal risk
models for market risk
measurement. Firms that rely on
the SA may see some advantages in
capital but any significant decrease
will be restricted by supervisory
model parameterisation.
PwC The fundamental review of the trading book
W hile the overall position in
regulatory capital levels is not
expected to dramatically change
for firms because of the FRTB
proposals, the components or
drivers of market risk regulatory
capital most probably will. These
components are:
stressed ES (modellable risks)
ES (non-modellable risks)
discrete credit risk (integrated
or standalone), and
market liquidity add-ons.
Regulators and the industry are
currently discussing a number of issues
that underpin the level of market risk
regulatory capital. There is some
uncertainty around the impact of these
issues on capital levels. We expect that
the QIS review will shed some light on
this. These issues include:
the implementation and calibration
of ES
the integration of liquidity risk
(liquidity horizons and liquidity
add-ons)
supervisory risk class correlations
integration of credit risk, and
capital floors.
7
The impact on individual business segments
The implementation of the new
proposals will have a varying level of
impact across business segments.
We expect that the Fixed Income
business will be the most impacted.
This is because of the new trading
book definition, the new models-based
approach, the incorporation of
liquidity risk (extended liquidity
horizons and add-ons) and the
supervisory risk class correlations
for hedging and diversification.
The operational impact
We expect these proposals to have
significant impact on firms operating
models, processes, policy frameworks
and systems. While the level of impact
will vary for each bank, in broad
terms, the FRTB will affect the
following areas:
Risk methodology framework:
The use of ES as the new market
risk metric will mean that firms
will need to develop their models
further. The integration of liquidity
and credit risks to the market risk
metric will be another change in
the methodology framework. The
framework must include ES model
validation procedures and
disclosure of model performance,
both internally and externally.
Identifying risks and mapping
these to trading desks will also
require some significant changes to
banks overall risk management
frameworks.
8 The fundamental review of the trading book
The Equities business will also be
impacted by the same factors, but
relatively less compared with Fixed
Income.
We anticipate the Foreign Exchange
and Currencies business (FX) to be
affected the least by these proposals.
The use of the new models-based
approach and the use of regulatory
defined correlations will drive the
impact for FX business.
Risk policies and procedures:
We anticipate that the proposals
will result in a review and revision
of policies and procedures,
particularly the Trading Book
policy, the Market Risk policy, the
Model Management policy, and
the Model Validation and
backtesting policy.
Business processes and controls
The implementation of these
proposals will present some
challenges to business processes
and controls. There may be a
further divergence between the
representation of risk in business
and controls versus the regulatory
environment. In addition, the new
methodology may result in a
change in business strategy
towards improving internal models
at the expense of advances in risk
measurement. The introduction of
ES will provide some practical
challenges, particularly around
backtesting and the use test.
PwC
Ultimately, firms will only know what
the impacts of the FRTB will be on
their business and portfolios as
implementation details emerge of
the ES method, market liquidity
and correlation parameters, and
the QIS process gets underway.
Risk systems and data management:
The impact to systems will be from
the introduction of the ES
methodology and the compulsory
maintenance of the Standardised
Approach for benchmarking
purposes. These proposals will result
in increased pressure to improve
data quality, particularly around
market risk, as well as improve the
flexibility and agility of risk systems
to be able to switch on/off trading
desk models.
Resources: We expect that the
above changes will provide a
temporary demand for further
skilled risk resources within
the bank.
A critical view of the fundamental
review of the trading book
Proposed changes to the trading book regime
Trading book/banking book boundaries
The FTRB intends to redefine the boundary between
the trading and the banking books in order to remove
subjectivity. The regulators are proposing two alternative
boundary definitions: the trading evidence-based
boundary and the valuation-based boundary.
Stressed calibration
To ensure sufficient levels of regulatory capital in periods
of significant market stress and reduce the cyclicality of
market risk capital charges, it is proposed that the
trading book framework will be calibrated to a period of
significant financial stress in both the internal models-
based and Standardised Approaches.
New risk metric
The BCBS is proposing the use of ES for the internal
models-based approach. It also plans to extend the
Expected Shortfall methodology to determine risk
weights for the Standardised Approach.
Market liquidity
The revised market risk regime intends to capture
market liquidity risk more comprehensively by assigning
exposures into five liquidity horizon categories (from 10
days to one year), incorporating capital add-ons for
jumps in liquidity premia and incorporating the
endogenous aspect of market liquidity.
Treatment of hedging and diversification
The BCBS is proposing to align the treatment of
hedging and diversification benefits between the
Standardised Approach and the internal models-based
approach. In part, the BCBS will achieve this by
constraining diversification benefits in the internal
models-based approach.
Revised internal risk models based approach
The BCBS intends to (i) strengthen requirements for
defining the scope of portfolios that will be eligible for
internal models treatment, and (ii) strengthen the
internal model standards to ensure that the output of
such models reflects the full extent of trading book risk
that is relevant from a regulatory capital perspective.
Revised standardised approach
To improve the risk sensitivity of the SA, the BCBS is
proposing a partial risk factor approach to market risk
measurement. It is also inviting feedback on a fuller risk
factor approach as an alternative.
Out of scope of the FRTB
Credit Value Adjustment (CVA) and Interest Rate Risk
in the Banking Book (IRRBB) are not included in the
current proposals. CVA has been addressed in the
revised Basel III framework, under the enhanced risk
coverage regime. We believe that incorporating CVA
in the market risk framework may be something to be
considered in the future, particularly for CVA that is
mark to market and actively hedged. IRBBB is
currently addressed in the Basel framework under
Pillar II, but given the significant dependencies in
capitalising market risks across trading and banking
books, the integration of IRRBB may also be considered
in future consultation papers.
PwC The fundamental review of the trading book 9
 A shifting supervisory focus for
thetrading book
Initially, the internal risk models and maintaining adequate levels of
based approach was favoured by BCBS risk capital under periods of severe
for its ability to better align the risk market stress.
profile of firms with regulatory capital
The new trading book regime aims
requirements. National supervisors
to better measure and control the
maintained the right to review and
amount of market risk from trading
withdraw approvals for firms to use
activities. To achieve this goal, the
internal models, or to approve capital
consultative document has revealed
buffers to compensate for inadequate
changes to the scope of prudential
model performance. However,
supervision, broadening rules and
increasingly complex financial
regulatory scrutiny in internal model
products and markets have resulted in
development and validation. The FRTB
complex risk models. This increased
makes a clear turn towards a prescriptive
model risk and complicated the
rule-based trading book framework,
supervisory review process.
with the introduction of capital floors,
The poor performance of internal risk the use of supervisory-supplied model
models during the global banking parameters, and the use of the SA to
crisis challenged the view that internal benchmark internal risk models.
models were effective in estimating
market and counterparty credit risk

Our view
The new regulatory approach represents a shift to a more conservative risk
management regime, particularly in relation to the use and management
of internal risk models. This change is a necessary step to control model
risk and the internal model view on regulatory capital requirements that
proved unreliable over the most recent period of market stress.
However, we encourage both the BCBS and the industry to be careful
in how they strive to achieve this goal. The proposed capital floors and
supervisory-supplied model parameters are crude means to that end that
may prove counterproductive to the overall purpose of developing and
using internal risk models.

10 The fundamental review of the trading book PwC

Trading book/banking book boundary condition
The definition of the trading book has long been the subject
of regulatory arbitrage and is therefore one of the most
important areas of the FRTB. Ideally, identifying and
capitalising financial risks in any portfolio should not
require such a classification system. However, the absence
of a treatment of interest rate risk in the banking book
(IRRBB) under Basels Pillar 1 framework means that
Our view
Given advances in derivatives trading and banking
activities, this binary classification between the trading
and banking book may be too superficial. Logically, a
review of the boundary condition should start from the
analysis of portfolio categories (including portfolio
characteristics), applicable risk types and appropriate
risk management standards. This analysis may lead to
additional classes of books, thus removing the effect of
strict transfer restrictions and unintended consequences,
for example to the treatment of banking book hedges.
Nevertheless, the industry will have to make a decision
between these two alternative boundary conditions after
assessing their respective advantages and disadvantages.
The valuation-based approach appears more objective
and relatively arbitrage-free, but has some undesirable
shortcomings. The approach encourages divergence
Reducing the gap between the internal model-based
approach and the Standardised Approach
Traditionally, adopting the internal models-based approach
was a decision based on cost-benefit analysis. Firms could
seek regulatory capital relief from using internal models
but at the expense of associated development and
ownership costs. Internal models are more risk sensitive
and incorporate capital benefits from hedging and
diversification, so most large, internationally active firms
opted for internal risk models to benefit from these and
generate significant regulatory capital savings, as well as
reputational kudos.
Our view
Understandably, there is a supervisory need to compare
internal models against a credible benchmark. It may be
preferable however, to construct a benchmark not
necessarily based on the SA but rather on regular
thematic reviews by the regulators that will facilitate a
fallback plan at the trading desk level. If a floor (or
equivalent) is imposed this may force a high trading
book capital base. This may require a transition period
from one trading book regime to another to mitigate any
steep increase in own funds given the elimination of Tier
3 capital under Basel III.
We welcome the revision of the SA despite the additional
overheads that it will create for firms. Both options (the
partial risk factor and full risk factor) gradually increase
the degree of risk sensitivity and cover hedging and
classifying exposure between trading and banking books
through a boundary condition is necessary. The
consultative document gives the industry the option to
comment on the boundary condition based on either
trading evidence or valuation and therefore makes the
assumption that exposures can be efficiently classified
under one or other criteria.
between the economic and regulatory definitions of
trading exposures and could lead to inconsistencies
across jurisdictions because of different accounting
standards. It will also require adjustments to exempt
banking book hedges.
It would be more desirable to strengthen the existing
trading evidence-based approach with additional
controls to make it more objective, robust to arbitrage
and consistent across different jurisdictions.
Nevertheless, some issues will need to be resolved in the
way that trading activity is measured and reposted, in
order to support the evidence-based approach.
Particularly for exposure to emerging derivatives
markets/products in which market liquidity is low in the
early stages and therefore any exposure to these new
markets will be hard to justify as trading book.
The quick fixes to the trading book framework announced
in July 2009 had the effect of significantly increasing
capital requirements under the internal risk models
approach. In contrast, the SA remained largely unchanged.
The FRTB intends to rationalise the levels of capital
between the two approaches by setting capital floors to the
internal models based-approach, increasing the risk
sensitivity and better recognition of hedging in the SA and
linking the way that parameters are calibrated between the
two approaches.
diversification. The specific behaviour of the two options
will heavily depend on regulator-implied calibrations
and bank-specific portfolios. Therefore, a quantitative
impact study is necessary to draw any meaningful
conclusions. Under both approaches, the regulator will
need to play an active role in maintaining the relevance
of the externally provided parameters of the SA as the
market conditions continuously change.
These changes to the SA, assuming that the new
approach results in a decrease in capital, would counter
the capital advantage from the use internal models.
Without such an advantage, firms would most likely be
inclined to change their strategy towards investing in
internal risk models for regulatory capital purposes.
PwC The fundamental review of the trading book 11
Diversification
The level of diversification implied by internal models
represents a challenge to both firms and regulators. Firms
calibrate correlation coefficients to imply a level of risk
diversification. The method of calibration is usually based
on time-series analysis of market data.
The regulators have a vested interest in supervising model
parameter calibration to make sure that calibration is
prudent. To enforce prudent levels of model parameters
Our view
The capital aggregation formula employs a set of
supervisor-implied correlation parameters. However, the
firms will still have to allocate risk factors to risk classes
and this can cause significant divergence in possible capital
levels. The ability to differentiate between risk positions
that hedge or diversify may become an area of concern
for both firms and regulators. Given the option, firms will
prefer to allocate risk factors with the largest hedging
impact on the same risk class rather than in different risk
classes that rely on the supervisor-implied correlation
parameters.
From legal entity to trading desk
According to the existing trading book regime, internal
models are validated and approved through backtesting at
a legal entity level. Additional backtesting is performed on
portfolios that exhibit specific risk concentration. However,
only legal entity backtesting exceptions arereported to the
regulator and influence the capital multiplier add-on.
This approach has proved problematic for both internal
model validation and for the supervision of internal
Our view
The new internal model management framework will
help the regulators to turn on and off internal model
permissions at a desk level. This will make the
management of internal model permissions more
flexible and add to the credibility of regulatory capital.
12 The fundamental review of the trading book PwC
they have the option to pre-specify values, set floors or
assign this responsibility to the actual risk management of
the firms.
The FRTB proposes a formula to produce regulatory
capital, net of diversification. The risk aggregation formula
operates at risk class level, assuming that each risk class
position can be characterised as short or long.
Given that correlation coefficients are dependent on
portfolio composition, the regulators may find providing
exact values challenging. Therefore, the use of a possible
range of values could prove more advantageous.
From the firms point of view, the use of supervisor-implied
correlation parameters would create operational challenges
in terms of hedge recognition. More importantly, it will also
create a risk diversification status that will influence capital
allocation to trading desks. It is more desirable to use an
overall diversification capital buffer or multiplier, based
on the banks model of diversification.
models. As a result, the FRTB is proposing a new internal
model and management framework that increases the
granularity of model validation and regulatory supervision.
The proposed framework validates internal models at
trading desk level as well as legal entity level; assuming
mapping of risk factors to trading desks. The validation
methods will extend to cover both backtesting and P&L
attribution tests.
Nevertheless, the possibility that trading desks can more
easily switch between internal model approaches and SA
may increase regulatory capital volatility, particularly if
the convergence envisioned between the two approaches
is not achieved in practice.
A new risk metric
Compared to VaR, the ES method offers some advantages.
ES addresses the issue of capturing fat tails in the
distribution of asset returns and, on a theoretical basis, ES
is a risk-coherent metric.
However, the effectiveness of ES as a metric of regulatory
capital will be dependent on the actual calibration and
implementation standards. The robustness of the risk
capital estimated through ES will be subject to challenges
in the availability of historical data, the definition of the
Our view
We welcome the use of a risk coherent risk metric to
measure market risk. However, the regulators will need
to work diligently with the industry to parameterise
ES-based capital requirements and prove ES reliability
under low frequency tail events as well as defining an
appropriate capital multiplier.
Adoption of stressed inputs for Expected Shortfall models
The consultation paper envisages keeping of the stressed
VaR approach as introduced in the July 2009 amendment
of the trading book regime, to address the issue of ES
pro-cyclicality.
Our view
While this approach seems sensible in principle, fixing
the observation period to a static period (e.g. the last
financial crisis) may not be useful in a future crisis
situation. For example, in October 2008 the DJIA (Dow
Jones Industrial Average) index fell by 22% over the
period between 1 and 10 October, whereas in the Black
Monday crisis in 1987 the fall over a similar period of
time was 31%. These time periods are broadly consistent
with the 10-day VaR measure and take the biggest
confidence interval and developing backtesting standards.
The implementation and performance challenges of ES
based internal risk models will most likely require the use
of a capital multiplier. Given the nature of ES, a multiplier
will need to provide an adequate capital buffer to potential
P&L losses. Therefore, the level of the ES multiplier will
evolve in relation to other features of the trading book
framework (i.e. capital floor, correlation parameters) and
consequently will be tested and justified through the
anticipated QIS.
Appropriate calibration of ES is also important for
internal risk management and control. ES is frequently
used to express appetite for market risk at portfolio level.
However, it is less popular than VaR in managing trading
limits. To facilitate consistency between regulatory
capital measures and internal market risk management
measures (the Use Test principle) ES should be calibrated
to comparable levels of risk capital to VaR. We expect the
QIS to accomplish this objective by electing an
appropriate confidence interval for ES.
peak-to-trough fall in the respective periods. Emerging
markets, commodities prices and government bonds did
not generally exhibit anything like the same degree of
volatility, which is in contrast with the Asian financial
crisis of 1997/98. By selecting the recent stress period,
we may run the risk of understating the volatility in a
part of the market less affected in the last crisis but
which is at the heart of the next one.
PwC The fundamental review of the trading book 13
Capturing all risk in the trading book
One of the key objectives of the new trading book
framework is to capture and capitalise all risks in the
trading book. The introduction of an Incremental Risk
Charge (IRC) to capture defaults and migration risk over a
one-year liquidity horizon was a step in the right direction.
The FRTB takes this further by investigating the potential
benefits of integrating market and credit risk through a
single measurement approach.
Our view
The implementation of liquidity risk factors and the
incorporation of varying liquidity horizons for modelling
purposes will be the subject of future QIS. The QIS will
confirm some of the options suggested by the regulators
Out of scope
The FRTB consultative document excludes Credit Valuation
Adjustment (CVA) and interest rate risk in the banking
book (IRRBB). Integrating CVA and IRRBB into the
framework is important for achieving a comprehensive
capture of market risk under Pillar I.
Our view
The Basel III framework addressed counterparty credit
risk and introduced a capital requirement for CVA. These
rules will apply to European Union firms through the
amended Capital Requirements Directive (CRD IV)
which we expect to come into force on 1 January 20132.
As a result, any initiative through the FRTB process on
how CVA interacts with the trading book is on hold.
However, it may be beneficial to consider sooner rather
than later how the integration of CVA and market risk
will occur.
2. This may be delayed given discussions in Brussels are due to resume in September 2012.
14 The fundamental review of the trading book
In addition, the FRTB suggests a liquidity bucket-based
approach to capture market liquidity risk, which until now
has remained broadly unaddressed. Liquidity premia in
market-observed prices and concentration of illiquid
positions in the trading book will also be captured and
capitalised.
however, it may highlight some issues arising from the
introduction of broad liquid portfolios. As firms will
argue, this overlaps with bid-offer valuation
adjustments.
Currently, IRRBB is captured under Pillar 2 in the Basel
framework. Treating IRRBB under Pillar 1 will require
substantial work both in defining the scope of interest-rate
risk and in determining the maturity of assets and
liabilities that have perpetual profiles.
Going forward, the FRTB may attempt to address some
of the shortcomings of the Basel III CVA approach,
including the inability to offset CVA with trading book
risks and inconsistencies with the use of stressed CVA
VaR given the migration to ES. We anticipate that all
stakeholders will work towards resolving the existing
issues of the regulatory CVA framework through the
integration of CVA in the market risk and IRC
measurements.
PwC
Speak to our experts
Miles Kennedy
Partner

Call: +44 (0)207 212 4440

Email: miles.kennedy@uk.pwc.com

Stefano Mortali
Director

Call: +44 (0) 207 213 2033

Email: Stefano.m.mortali@uk.pwc.com

Richard Barfield
Director

Call: +44 (0) 207 804 6658

Email: richard.barfield@uk.pwc.com

Athanasios Karanassos
Senior Manager

Call: +44 (0) 207 212 6796

Email: athanasios.karanasos@uk.pwc.com

Christos Leventakis

Call: +44 (0) 207 212 2537

Email: christos.leventakis@uk.pwc.com

Anastasios Zavitsanakis

Call: +44 (0) 207 804 3578

Email: anastasios.zavitsanakis@uk.pwc.com

PwC The fundamental review of the trading book 15

Appendix
Comparing Basel 2.5 with the FRTB
Trading book Current approach FRTB proposed Main considerations for
regimeobjective (Basel 2.5) approach proposed changes
Subjective trading Revised trading book Proposing two alternative Firm will need to review the
book/banking book definition but boundary definitions: the proposed boundary requirements as
boundary condition boundary condition trading evidence-based it will highly impact the recognition
to remove was left unchanged. boundary and the of trading book positions, including
regulatory valuation-based the flexibility to change designation
arbitrage. boundary. as market liquidity changes.
Achieve comparable Currently the internal Link the way that T he linkage of parameter
levels of capital risk models approach parameters are calibration between the two
across internal risk and SA share no calibrated between the approaches will produce more
models and the common characteristics. two approaches realistic/comparable capital
Standardised Basel 2.5 increased Mandatory calculate results for firms. This will
Approach (SA). levels of capital for capital through the SA facilitate the ability of regulators
internal risk models to be used as to move easier firms from one
by using stressed VaR, benchmark to internal approach to another.
incremental risk risk model based Firms that relay on internal risk
charge (IRC) and capital models may see capital increases
comprehensive risk because of the introduction of
Use SA based capital
measure (CRM). capital floors.
as a regulatory
It also treated non
capital floor. Firms will need to maintain a SA
correlation trading
infrastructure, adding to
book securitasation
operational overheads.
exposure under the
credit risk SA. Capital convergence between the
two approaches may remove
motivation for investing in
internal risk models.

Prudently recognise Basel 2.5 allows firms Constrain diversification T he use of supervisory specific
the benefit of using internal risk benefits in the internal correlation parameters will
hedging and models firmsto freely risk models by using remove some of the internal risk
diversification recognise the risk- supervisory-specific model flexibility and, in some
reducing benefits of calibration parameters. cases, increase regulatory capital.
hedging and T he allocation of risk factors to
diversification. risk classes may prove subjective
among firms.
Regulators will require to
maintain the supervisory-specified
parameters in changing market
conditions.

Use a coherent risk VaR is currently used Substitute VaR with ES Though details of ES on calibration,
metric that can by the Basel for the internal risk capital multiplier and backtesting
capture tail risk. framework, calibrated models based approach are not clear, the migration to a
to a 99% confidence and to determine risk new risk metric will represent a
interval and over a weights for the SA. significant methodology challenge
10-business day for those firms that do not use this
holding/liquidity approach for economic capital
period. purposes.
Firms need to consider
dependencies and future
integration of Credit Value
Adjustment (CVA) to the market
risk framework.

16 The fundamental review of the trading book PwC

Comparing Basel 2.5 with the FRTB
Trading book Current approach FRTB proposed Main considerations for
regimeobjective (Basel 2.5) approach proposed changes
Use a stressed Basel 2.5 introduced The FRTB is proposing to Calibrating models to stressed
calibration to Stressed VaR. Stressed maintain the calibration periods alone may not solve the
ensure adequate VaR is added to of internal risk models pro-cyclicality issue, as it is hard
levels of capital normal VaR and is and SA using data from to select a universally bad period
under periods of estimated over the periods of extreme across all markets represented in a
market stress. worst one-year PL market stress. typical portfolio.
performance of the
portfolio.
Revise the internal Basel 2.5 introduced Internal risk models will T he production of ES at the
risk models based stressed VaR, IRC and need to estimate trading desk level and the
approach CRM but did not regulatory capital at the extended model validation
framework to fundamentally change trading desk level. Model requirements may represent a
increase their the overall internal validation will be methodology challenge for firms.
ability to capture risk model framework. performed using T he use of trading desk level for
and capitalise risks. backtesting and PL model approval will increase the
attribution at both the level of detail in model
legal entity and trading performance reporting and
desk levels. supervision. This will increase
overheads for both firms and
regulators.

Revise the SA to The current SA lacks Provide a more risk T he new SA will benefit less
make the approach risk, provides very sensitive approach to complex firms that are based on
more risk sensitive limited recognition of estimating regulatory this approach.
and provide a hedging and capital. Advanced firms will need to play
credible fallback in diversification benefits Facilitate the smooth an active role in selecting the
the case that an and ignores risks transition between the appropriate methodology for the
internal risk model associated with more internal risk model SA and the use of supervisory
is inadequate. complex instruments. approach and the SA. specific calibrations that
A llow for a harmonised indirectly, through capital floors,
reporting of risk affect regulatory capital levels.
positions in a format
that is consistent across
firms and jurisdictions.

Capture market The current The FRTB suggests that The use of multiple liquidity
liquidity risk in the framework assumes a market risk liquidity can horizons will increase the
trading book. 10-day liquidity be better captured by: regulatory requirement for less
horizon for measuring liquid positions, particularly if
Using multiple liquidity
market risk. This allocated to the six month and
horizon, ranging from
assumption would not one year liquidity buckets.
10 days to one year, in
hold for all trading
estimating market risk
book products,
particularly in periods Incorporating capital
of market stress. add-ons for jumps in
liquidity premia

PwC The fundamental review of the trading book 17

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