What impacts will the Fundamental Review of the Trading Book have on banks’ capital requirements in a post-COVID-19 context?

Details

Supervisors

Knaepen, Denis ; Lejeune, Christophe

Faculty

Louvain School of Management

Degree label

Master [120] en ingénieur de gestion

Abstract

In January 1996, the Basel Committee on Banking Supervision (BCBS) issued the first version of its framework for the market risk minimum capital requirements. Under this framework, banks were required to maintain a minimum level of regulatory capital to allow them to absorb potential losses arising from fluctuations in the market price of instruments held in the trading book. Following the financial crisis of 2008, which highlighted serious shortcomings in the versions published until then, the BCBS began work on a Fundamental Review of the Trading Book (FRTB) in order to adapt the existing rules for market risk capitalization. In February 2019, the final version was released. This framework provides a comprehensive view by covering all aspects of minimum capital requirements for market risk. It clarifies the methods for assessing and quantifying the risks associated with banks' trading activities and portfolios. This master's thesis focuses on this new regulation's consequences on the capital requirements that banks will have to provide. It addresses the two main methods described under FRTB: the standardized and the internal model approaches. By simulating these two approaches on a portfolio, this master's thesis highlights the weaknesses of the SA while specifying the advances that the IMA brings in order to stabilize the banking and financial system of tomorrow. A comparison of periods of stress is also made, analysing the consequences of FRTB during the year 2008 and during the period of COVID-19. In this way, the characteristics of FRTB are plotted according to two very different stress periods. The findings of this master's thesis are as follows: 1. The risk weights described in the SA do not always allow banks to capitalise the amounts of capital required to meet market risk (CSR & Commodity classes). 2. The IMA appears to be a robust solution, by taking better account of tail risks thanks to the Expected Shortfall, and the liquidity risk by a liquidity-adjustment, and finally by penalizing banks that hold risky positions. 3. The COVID-19 period was a source of great stress on the markets, much more significantly than the Global Financial Crisis for the instruments analysed. This period will therefore undoubtedly be a relevant backtesting period for risk models.