Fundamental Review of the Trading Book (FRTB): EBA on Regulatory Challenges

The Fundamental Review of the Trading Book (FRTB) represents a significant overhaul of the global framework for assessing market risk, led by the Basel Committee on Banking Supervision (BCBS). The FRTB framework aims to address structural weaknesses and ensure that capital requirements for trading activities accurately reflect the risk exposures of financial institutions.

As a key component of global banking reform, the FRTB introduces stringent capital standards, enhanced risk sensitivity, and a clearer definition of the boundaries between the trading book and the banking book. This analysis delves into the technical and regulatory landscape of the FRTB, with a focus on its European implementation, recent regulatory updates, and the challenges faced by financial institutions.

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The EBA responds to the European Commission’s Delegated Act postponing the application of the market risk framework in the EU | European Banking Authority

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Banking package - Questions and answers

The European Commission adopted today a delegated act that postpones by one year the date of application of the Basel III fundamental review of the trading book (FRTB) standards in the EU for the banks’ calculation of their own funds requirements for market risk.

Finance

Regulatory Background: Recent Developments in FRTB

On 12 August 2024, the European Banking Authority (EBA) issued a no-action letter regarding the boundary between the banking book and the trading book, a crucial aspect of the FRTB. This letter addresses technical questions and provides guidance on issues related to the postponement of key FRTB provisions.

Earlier, on 24 July 2024, the European Commission adopted a Delegated Act under Article 461a of the Capital Requirements Regulation 3 (CRR3), delaying the implementation of alternative approaches for calculating own funds requirements for market risk by one year, now set to take effect on 1 January 2026. This postponement is accompanied by a series of Q&As that clarify the impact of the delay, including how the revised boundary between banking and trading books will be applied and how the alternative standardized approaches will interact with output floor calculations under the FRTB.

The EBA’s opinion elaborates on the implications of this postponement, particularly the transitional application of the boundary framework between the trading book and the banking book. Article 325 of Regulation (EU) No 575/2013 mandates that institutions calculate own funds requirements for market risk using both existing and new FRTB approaches, emphasizing a phased implementation to smooth the transition. This staged approach is designed to align EU regulatory practices with global FRTB standards, offering a preparatory period that minimizes operational disruptions for financial institutions.

Regulation (EU) No 2024/1623, effective from 1 January 2025, introduces FRTB-inspired approaches to calculating own funds requirements for market risk. However, the broader implementation of the FRTB framework is deferred until 1 January 2026 to ensure consistency and mitigate operational complexities, allowing banks to adapt gradually to the new regulatory requirements.

Technical Implications of the FRTB Boundary Framework

The EBA’s opinion on the FRTB highlights significant technical challenges arising from the transitional arrangements between the trading book and the banking book:

1. Fragmentation of Implementation: The early adoption of certain FRTB-inspired provisions results in a fragmented regulatory environment, imposing a dual-track system where institutions must simultaneously comply with both legacy and new market risk calculation methods. This dual approach increases operational complexity, requiring financial institutions to develop robust internal systems capable of managing multiple regulatory regimes in parallel.
2. Operational Burden and Internal Risk Transfers: The interim application of new boundary rules under the FRTB necessitates substantial changes in the classification of positions and the management of internal risk transfers between trading and banking books. Misclassification risks are heightened during this transition, which can lead to inaccurate capital requirements and increased regulatory scrutiny. The EBA’s no-action stance offers temporary relief, but financial institutions must proactively refine their internal risk management frameworks to fully meet FRTB standards.
3. Global Consistency and Level Playing Field: The staggered implementation of FRTB standards in the EU contrasts with the unified rollouts typically seen in other jurisdictions. This discrepancy can lead to inconsistent regulatory treatment for multinational banks, complicating cross-border risk management and capital allocation. The EBA’s guidance under the FRTB framework emphasizes the need for harmonization in the final implementation phase to ensure a level playing field for financial institutions globally.
4. Impact on Market Confidence and Financial Reporting: The misalignment between phased FRTB requirements and existing capital calculation methods poses significant challenges for financial reporting. Inconsistent disclosures during the transitional period can undermine market confidence by creating uncertainty around institutions’ risk profiles and capital adequacy. Clear and accurate communication of FRTB transitional adjustments is essential to maintaining investor confidence and ensuring compliance with the evolving regulatory landscape.

The EBA’s approach underscores the importance of synchronizing the application dates of all FRTB components to avoid operational and market disruptions. Financial institutions are encouraged to engage proactively with regulators, clarifying expectations and ensuring compliance with the full scope of the FRTB requirements.

This analysis integrates recent regulatory developments and technical insights related to the boundary between trading and banking books under the Fundamental Review of the Trading Book, as outlined by the EBA's opinions and the European Commission's Delegated Acts. The FRTB continues to reshape the market risk landscape, driving banks towards more rigorous and standardized approaches to capital requirement calculations, ultimately enhancing financial stability.

Fundamental Review of the Trading Book (FRTB): EBA's No-Action Letter

The EBA's no-action letter is a critical regulatory tool in the context of the FRTB, providing crucial guidance during the phased implementation of the new market risk standards across the European Union. The letter specifically advises Member State competent authorities not to prioritize enforcement actions related to the boundary between the trading book and the banking book until the full implementation of the FRTB framework is achieved. This guidance extends previously issued directives from 2023, reinforcing that those instructions remain relevant under the current regulatory landscape shaped by the FRTB.

The EBA's no-action stance acknowledges the significant technical challenges and operational complexities that banks and regulators face as they transition to the new FRTB standards. By granting a grace period, the no-action letter allows financial institutions to adjust their internal models, recalibrate risk assessments, and update reporting mechanisms to align with the evolving FRTB requirements without the immediate threat of supervisory enforcement. This regulatory approach reflects the need for a balanced and measured transition towards full FRTB compliance.

FRTB: Key Technical Questions and Issues

In response to technical questions raised by market participants, the EBA has identified several critical issues that have emerged following the Delegated Act postponing the implementation of FRTB. These issues are particularly relevant in the context of aligning current practices with the comprehensive market risk standards introduced by the FRTB.

1. Market Risk Contribution to Floored Risk-Weighted Exposure Amounts: The FRTB framework introduces enhanced methodologies for calculating risk-weighted exposure amounts, which are designed to ensure that capital requirements remain above certain thresholds, thus addressing potential model risks and measurement errors. However, the delayed implementation of these alternative approaches complicates the calculation process, requiring financial institutions to carefully manage revised calculation models and adjust sensitivity analyses to comply with the updated FRTB standards. This aspect is critical to maintaining accurate capital reserves under the new market risk rules set forth by the FRTB.
2. Structural Foreign Exchange (FX) Positions: Under the FRTB, the treatment of structural FX positions requires a meticulous reassessment, as these positions—often exempt from daily trading book requirements—must now be evaluated against the new boundary definitions. Institutions must determine whether structural FX exposures belong within the trading or banking book, impacting their overall risk management strategy and capital requirements. This reevaluation is crucial for compliance with the FRTB, as it influences how institutions calculate and manage their market risk capital charges.
3. ‘Main Risk Driver’ Approach for Market Risk Thresholds: A cornerstone of the FRTB is the main risk driver approach, which necessitates the accurate classification of financial exposures based on their predominant risk factors, such as interest rate risk, credit spread risk, or equity risk. This classification directly impacts the applicable market risk thresholds and the resulting capital charges under the standardized approach of the FRTB. The operational challenges associated with this classification require robust data management and advanced analytics to ensure consistency across diverse portfolios, aligning with the stringent demands of the FRTB.
4. Change in Scope of Positions Subject to Own Funds Requirements: The FRTB framework broadens the scope of positions subject to market risk capital charges, particularly with the inclusion of Credit Valuation Adjustment (CVA) hedges. This change represents a significant shift from previous practices, where such hedges were often excluded from market risk capital calculations. Under the FRTB, institutions must reassess these exposures, potentially increasing their capital requirements. This adjustment necessitates advanced risk assessment techniques and model recalibrations to comply with the expanded scope mandated by the FRTB.
5. Disclosures and Reporting: Enhanced disclosure and reporting requirements are a critical aspect of the FRTB, aiming to improve transparency in how banks measure and manage market risk. The FRTB mandates that financial institutions provide detailed disclosures on market risk capital requirements, internal model outputs, and the methodologies used in risk assessments. The postponed implementation period offers banks additional time to refine these processes; however, it also places a greater emphasis on aligning with the evolving expectations of the FRTB. Accurate, consistent, and timely reporting is essential to demonstrating compliance and maintaining market integrity under the FRTB standards.
6. ‘Prudential Boundary’ Approach of the Operational Risk Framework: The FRTB introduces the prudential boundary approach within the operational risk framework, which delineates the separation of risks linked to trading activities from those associated with banking operations. Financial institutions must clearly define these boundaries to ensure accurate risk categorization and appropriate capital allocation. The EBA's guidance emphasizes the need for consistency in applying boundary rules, particularly concerning market-driven operational risks, to fully align with the objectives of the FRTB.

Deferral of the full implementation of the FRTB framework

The deferral of the full implementation of the FRTB framework to 1 January 2026 provides financial institutions with additional time to refine their internal models, enhance operational frameworks, and improve reporting practices. This extended timeline is vital for institutions to ensure their compliance infrastructure meets the stringent requirements of the FRTB. It allows banks to focus on the development and validation of internal models (IMA) and refine the definitions of trading book and banking book boundaries to align with the updated FRTB standards.

However, this delay also introduces challenges during the interim period, where institutions must operate within a complex regulatory environment with partially established guidelines. The postponement provides a critical window for banks to address technical deficiencies, such as enhancing data quality, refining risk measurement techniques, and improving governance structures. These adjustments are essential to fortify the overall robustness of risk management practices and prepare for the full-scale implementation of the FRTB.

This extended preparatory phase under the FRTB framework is crucial to mitigating potential disruptions in market confidence and ensuring that financial institutions are well-positioned to meet the comprehensive requirements of the FRTB once fully implemented.