I attended an FRTB conference on last Thursday/Friday.
There a speaker gave a very nice and interesting overview about why FRTB on the first place. Listening to him was a treat to ears!
I was able to capture some notes from his presentation.
During pre-crisis era
- Rules between trading book and banking boundary were imprecise and regulators could not stop the regulatory arbitrage that was happening in the banking sector by transferring the assets between banking and trading book and vice versa.
- There was no desk wise visibility for the regulators. Regulators had right to look into the details within the enterprise level but because there were no set procedures around it, so regulators seldom looked into details.
- Because of this reason regulators were not able to question the desks which were carrying out complex trades under seniority tranches.
- There was no regulatory tool which they could use to stop the model usage. Regulators could question the model usage but had to deal each model individually. In the due process many risks remained uncovered.
- There was not linkage between standardized approach and model based approach. There was no logical or intuitive relationship between the capitals calculated between these two approaches.
- Degree of complexity was not punished in a way regulators deemed fit, rating migrations/default risk were not captured.
- With VaR approach regulators and risk managers were looking at a point where the tail began rather than what was within the tail.
- 2008 crisis proved that the way liquidity was measured was inadequate.
After the crisis
Regulators came up with Basel 2.5/3 which was a quick patch up activity to address some of the above challenges
- Rating migration risk was captured by including CVA in capital calculations.
- Liquidity was captured by introducing the multiplication factor 3.
- Tail risk was captured by calculating the VaR in stressed market conditions.
- A complex calculation was introduced to capture incremental risk charges.
- Comprehensive risk measures were applied to correlation trading books.
FRTB rules were decided in a course of almost 5 years. They address all the above issues and also include
- The need to address data quality issues by including non modelable risk factors.
- Comparability of Standardized Approach and Internal Model Approach by making Standardized Approach risk sensitive.
- Mandatory PnL attribution hence triangulation between front office data and risk management data.
I will update this page as I learn and understand FRTB more.