Journal of Risk

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A review of the fundamentals of the Fundamental Review of the Trading Book II: asymmetries, anomalies, and simple remedies

Hany M. Farag

  • The FRTB framework has some anomalies in its measurement of risk and capital requirements which can lead to unexpected results.
  • We highlight a few methodological issues; some explicit, and some that lie deeper and need more awareness.
  • We offer simple and pragmatic solutions to the issues we present.
  • We give an updated status in light of the recently published consultative paper, which contains potential modifications of the framework.

In this paper, we highlight some anomalies in both the standardized approach (SA) and the internal models approach (IMA) of the Fundamental Review of the Trading Book (FRTB) that may not be well known. These anomalies may be unintentional and simply require clarification or rewording of the FRTB text. Alternatively, they may be aspects that were not fully considered from certain angles. Here, we wish to highlight the unintended consequences of ignoring them. These anomalies vary in the degree to which they impact capital, and they can grossly misstate risk in either direction. Indeed, we demonstrate in many cases that the framework can record high risk when there is none, or record zero risk when the risk is high. We offer simple adjustments to eliminate these problems. None of our suggestions require new calibration or a material change to the framework; they are just minor modifications to the wording of the text that can restore logical consistency. It is our hope that this paper will assist both regulators and practitioners in a productive dialog.

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