How does the FRTB internal models approach work and what is desk-level approval?

The Fundamental Review of the Trading Book (FRTB) is the most significant reform of market risk capital since Basel I. It fundamentally changes how banks calculate capital for their trading books. Let's walk through the internal models approach.

FRTB Overview:

FRTB provides two approaches:

1. Standardized Approach (SA): Sensitivity-based, all banks must be able to calculate it
2. Internal Models Approach (IMA): Model-based, requires regulatory approval at the desk level

Key Change: Desk-Level Approval

Pre-FRTB: Banks got model approval at the entity level — if approved, they could use internal models for their entire trading book.

FRTB: Each individual trading desk must independently qualify for IMA. Desks that fail must use the standardized approach. This is revolutionary because a bank might have 20 desks on IMA and 5 on SA.

Qualification Tests:

Each desk must pass TWO tests:

Test 1: Backtesting (VaR Exceptions)

At the desk level and firm-wide level, count the number of days where actual P&L exceeds the model's 99% VaR over the prior 250 days.

Test 2: P&L Attribution Test (PLAT)

This is the major innovation. It compares the risk model's theoretical P&L to the desk's actual (hypothetical) P&L to ensure the model captures the same risk factors driving real profits and losses.

Two statistics are calculated:

• Spearman correlation between theoretical and actual P&L: must exceed a threshold
• KL divergence (Kullback-Leibler): measures how different the two P&L distributions are: must be below a threshold

Capital Calculation Under FRTB IMA:

FRTB replaces 99% VaR with three components:

1. Expected Shortfall (ES): 97.5% ES with liquidity-adjusted horizons (10-120 days depending on risk factor)
2. Default Risk Charge (DRC): Captures jump-to-default risk for credit positions
3. Stressed ES: ES calibrated to a 12-month stress period

Capital = max(ES_t, m_c x ES_avg) + DRC + SES

Where m_c is the multiplier (minimum 1.5, increased for backtesting failures).

Liquidity Horizons — A Major Change:

Pre-FRTB assumed a uniform 10-day liquidation period. FRTB assigns different horizons:

• Large-cap equities: 10 days
• Small-cap equities: 20 days
• Investment-grade credit: 40 days
• High-yield credit: 60 days
• Exotic positions: 120 days

This penalizes illiquid positions that can't be exited quickly during a crisis.

Key Exam Points:

• FRTB uses ES at 97.5% (not VaR at 99%)
• Desk-level approval means banks can have a mix of IMA and SA desks
• PLAT is the key new test: measures whether the risk model captures the right factors
• Non-modellable risk factors (NMRFs) get a stressed capital add-on

For comprehensive FRTB coverage, join our FRM Part II course.