Abstract:

Design Methodology: A substantial overhaul of the aggregation, measurement and assessment of trading book regulatory market risks was introduced by the Basel Committee on Banking Supervision (BCBS) in 2016. Full compliance with these rules was originally set at January 2022, but the COVID-19 pandemic has pushed this date outwards to somewhere between 2022 and 2024 depending on the jurisdiction. Using a simple portfolio of assets and tradeable securities, we simulate a worked example of the sequence of steps required to determine the market risk regulatory capital under the Basel IV FRTB's internal models approach.

Purpose: While regulatory market risk rules have allowed banks to choose a standardised approach or an internal models approach since the Basel addendum introduced in 1996, the new rules are considerably more complex and discriminating. Establishing and implementing the requisite calculations for the latter approach are complex and daunting. Using a set of stylised example trades, we elucidate common pitfalls and highlight important considerations of the estimation of regulatory market risk capital.

Findings: The new regulatory market risk rules are more conservative than the old, capturing risks previously unaccounted for. Most quantitative impact studies show that trading book capital will increase for most banks. This work demonstrates how to capture and calculate various risk metrics under the internal model's approach.

Research Limitations: The portfolio of trades used is necessarily a non-complex, small one. The trading possibilities using real bank portfolios are endless and would only lead to deeper confusion. Using a small, stylised portfolio, comprising sensible commonly used traded assets should provide more useful and usable information than a large, complex trading book portfolio.

Practical Implications: This work explores the rules governing the internal models approach market risk capital calculations using practical, worked examples. Although simple portfolios are used, these should be useful to many banks which qualify for the internal models approach yet struggle with its innate complexity. A subsequent article will provide practical examples for banks opting for the standardised approach.

Social Implications: None.

Originality: Studies providing simple implementation guidance are scarce to non-existent. This work introduces and demystifies the required calculations for the internal models approach of the FRTB for the first time.

Keywords:

Market risk, Value-at-Risk, expected shortfall, capital requirements, liquidity horizons, FRTB.

JEL Classification:

JEL Classification: G18, G21, G32.

How to Cite:

Christiaan Wessels and Gary van Vuuren. Basel's Fundamental Review of the Trading Book: Implementation Principles for the Internal Models Approach. [ref]: vol.21.2023. available at: https://refpress.org/ref-vol21-a203/