Under FRTB, how does a bank decide between the Standardized Approach and Internal Models Approach for market risk capital?

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The Fundamental Review of the Trading Book (FRTB) is the Basel Committee's overhaul of market risk capital requirements. Under FRTB, the choice between Standardized Approach (SA) and Internal Models Approach (IMA) is made at the **trading desk level**, not the bank level. This is a major change from Basel II.5. ```mermaid graph TD A[Trading Desk Seeks IMA Approval] --> B{Desk-Level Model Approval by Regulator?} B -->|No| SA[Use Standardized Approach] B -->|Yes| C{P&L Attribution Test - PLAT} C -->|Fail: Spearman < 0.7 or KL > 0.12| SA C -->|Pass| D{Backtesting at Desk Level} D -->|Red Zone: 10+ exceptions in 250 days| SA D -->|Amber Zone: 5-9 exceptions| E[IMA with Capital Surcharge] D -->|Green Zone: 0-4 exceptions| F[IMA Approved - Full Benefits] F --> G[Capital = max of ES, Stressed ES + DRC + RRAO] SA --> H[Capital = Sensitivities + DRC + RRAO] style A fill:#c9a84c,color:#0a0a0f style SA fill:#8b2020,color:#fff style E fill:#c9a84c,color:#0a0a0f style F fill:#1a3c2a,color:#fff ``` **The IMA Qualification Gauntlet:** **Gate 1 — Regulatory Model Approval:** The bank must obtain regulatory approval for its internal models at the desk level. This includes documentation of model methodology, validation, governance, and IT infrastructure. Langford Global Bank's rates trading desk submits a 400-page model package to its regulator. **Gate 2 — P&L Attribution Test (PLAT):** This test compares the risk model's hypothetical P&L to the front-office's actual P&L. Two metrics must pass: - **Spearman correlation >= 0.7** between hypothetical and actual daily P&L - **Kolmogorov-Smirnov (KL divergence) <= 0.12** measuring the distribution similarity If Langford's rates desk shows a Spearman correlation of 0.82 and KL of 0.08, it passes PLAT. If the exotic derivatives desk shows correlation of 0.61, it fails and must use SA. **Gate 3 — Backtesting:** The desk's VaR model is backtested over the most recent 250 trading days at 99% confidence: - **Green zone (0-4 exceptions):** Full IMA approval - **Amber zone (5-9 exceptions):** IMA allowed but with a capital multiplier surcharge (3.0 to 4.0x) - **Red zone (10+ exceptions):** Desk reverts to SA **Capital Calculation Under Each Approach:** | Component | Standardized Approach | Internal Models Approach | |---|---|---| | Core charge | Sensitivity-based (delta, vega, curvature) | Expected Shortfall (ES) at 97.5% | | Stress component | Included in SA calibration | Stressed ES (using stress period) | | Default risk | Default Risk Charge (DRC) | Default Risk Charge (DRC) | | Non-modelable risk | Residual Risk Add-On (RRAO) | RRAO for non-modelable risk factors | **Worked Example — Capital Comparison:** Langford's rates desk has the following: - SA capital requirement: $285 million - IMA capital (ES + stressed ES + DRC + RRAO): $210 million IMA saves $75 million in capital — a 26% reduction. This is the incentive for banks to invest heavily in model infrastructure. **Key Exam Points:** 1. FRTB is desk-level, not bank-level — some desks may use IMA while others use SA within the same bank 2. PLAT is new under FRTB — it did not exist under Basel II.5 3. The shift from VaR to Expected Shortfall (ES) captures tail risk better 4. Non-modelable risk factors (NMRFs) receive punitive capital charges even under IMA Deepen your FRTB knowledge with our FRM Part II Market Risk module on AcadiFi.

Under FRTB, how does a bank decide between the Standardized Approach and Internal Models Approach for market risk capital?

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