Basel III Market Risk: FRTB Implementation for Banks

The Fundamental Review of the Trading Book (FRTB) fundamentally reforms the market risk framework: Value at Risk is replaced by Expected Shortfall as the primary risk measure, the standardised approach is redesigned as a sensitivities-based method (SbM), and the trading book/banking book boundary is tightened. Banks must pass the P&L attribution test to use internal models (IMA). The Residual Risk Add-On (RRAO) and Default Risk Charge (DRC) are added as additional capital requirements. CRR3 transposes these changes into EU law.

FRTB implementation in the EU has been postponed multiple times. After the original deadline of 1 January 2025 and a first postponement to January 2026, the European Commission decided on a further postponement to 1 January 2027 to synchronise implementation with other jurisdictions (US, UK). Banks should use the remaining time for data quality projects, model validation and system adjustments, as requirements for data granularity and process automation are substantial.

The FRTB Standardised Approach (Sensitivities-based Method, SbM) calculates capital requirements using standardised risk sensitivities for delta, vega and curvature, applicable without supervisory approval. The Internal Models Approach (IMA) permits bank-specific Expected Shortfall models but requires regulatory approval, passing P&L attribution tests and back-testing at desk level. The IMA can result in lower capital requirements but places significantly higher demands on data infrastructure, model validation and governance.

Expected Shortfall (ES) replaces Value at Risk as the primary risk measure under FRTB. While VaR only indicates the loss threshold at a given confidence level, ES measures the average loss beyond that threshold, capturing tail risks more effectively. Under FRTB, ES is calculated at the 97.5% confidence level across varying liquidity horizons from 10 to 120 days depending on the risk factor. Non-modellable risk factors (NMRF) receive separate stress scenarios.

The FRTB significantly tightens the trading book boundary: instruments must follow clear assignment criteria, and reclassifications between trading book and banking book are only permitted under strict conditions with supervisory approval. Internal risk transfers (IRT), hedging risks internally between trading and banking books, are subject to detailed documentation and valuation requirements to prevent regulatory arbitrage.

Data quality is the critical success factor for FRTB implementation. The sensitivities-based standardised approach requires granular risk factor data for each instrument, the look-through requirement for fund units demands transparency down to individual position level, and the P&L attribution test requires exact daily P&L data. Banks that invest early in data infrastructure can achieve significant RWA savings, for example through correct bucket assignment and avoiding the conservative residual bucket surcharge.

ADVISORI guides banks through the entire FRTB implementation process: gap analysis of the existing market risk framework, selection between standardised approach and IMA, building the required data infrastructure, implementing Expected Shortfall calculations and P&L attribution, preparing regulatory application documents for IMA approval and training specialist departments. The approach is pragmatic and audit-ready, aiming to combine regulatory compliance with optimal capital efficiency.