FRTB Trading Desk Approval: Basel III Trading Desk Approval Processes and Model Validation Optimization

Under the Fundamental Review of the Trading Book (FRTB), market risk capital is calculated at the level of individual trading desks. Each desk that wishes to use the Internal Models Approach (IMA) requires separate regulatory approval. The desk must demonstrate that its internal risk model reliably reflects actual profits and losses. Approval is based on the P&L Attribution Test and backtesting. If a desk fails these tests, it falls back to the Standardised Approach (SA).

Desk-level IMA approval requires three criteria to be met: First, the P&L Attribution Test (PLAT) must be passed, which checks the consistency between daily front-office P&L and risk-model P&L — measured via Spearman correlation and Kolmogorov-Smirnov test. Second, backtesting over a 12-month period must be passed at desk level. Third, the risk factors used must pass the eligibility test (RFET), meaning they must have sufficient price observations to qualify as modellable.

The P&L Attribution Test compares the hypothetical P&L of the risk model with the actual front-office valuation on a daily basis. Its purpose is to ensure the risk model correctly captures all material risk drivers of the desk. The test uses two statistical metrics: the Spearman rank correlation (at least 0.7 for the green zone) and the Kolmogorov-Smirnov test (p-value above 0.09). If a desk falls into the red zone, it loses IMA approval. In the amber zone, a capital surcharge applies.

If a desk loses IMA approval — for example by failing the PLAT or backtesting — it falls back to the FRTB Standardised Approach. This typically means significantly higher capital requirements, as the Standardised Approach is more conservatively calibrated. The fallback applies for at least 12 months before a new IMA application is possible. Robust monitoring of test results is therefore essential for banks to detect an impending fallback early and take corrective action.

A trading desk in the FRTB context is a clearly delineated organisational unit with its own risk manager, defined trading positions and a documented business strategy. The desk definition must be reported to the supervisor and forms the basis for capital calculation. Importantly, the desk structure must not be chosen solely for capital optimisation reasons — it must reflect the actual trading organisation. Changes to the desk structure require supervisory approval.

The RFET assesses whether the risk factors used in a desk’s risk model are modellable. A risk factor is deemed modellable if at least 24 real price observations are available within 12 months, with a maximum gap of one month. Non-modellable risk factors (NMRF) receive a separate capital add-on via the Stressed Expected Shortfall (SES). For desks with many NMRFs, the IMA approach can become more expensive than the Standardised Approach.

ADVISORI guides banks through the entire approval process: from initial desk definition and delineation through preparation of IMA application documents to implementation of the PLAT framework and ongoing monitoring. Our consultants have experience with supervisory reviews (SREP, on-site inspections) and support communication with BaFin and the ECB. We also help optimise the desk structure to find the right balance between capital efficiency and regulatory compliance.