On January 14, 2016, the Basel Committee on Banking Supervision (BCBS) published a final rule for minimum capital requirements for market risk as a conclusion to the BCBS’ fundamental review of the trading book or, as it is commonly known, the FRTB.

As explained by the BCBS in a related note, the revisions in the final rule focus on three key areas:

(a) Revised boundary: The boundary between the banking book and trading book has been revised to reduce incentives for a bank to arbitrage its regulatory capital requirements between the two regulatory books, while continuing to respect banks’ risk management practices. Notably, stricter limits along with capital disincentives are applied to the transfer of instruments between the banking book and trading book.

(b) Revised internal models approach: The enhancements to the internal models approach for market risk have three main aims: (i) more coherent and comprehensive risk capture that takes better account of “tail risks” and market illiquidity risk; (ii) a more granular model approval process whereby internal models are approved for use at the trading desk level; and (iii) constraints on the capital-reducing effects of hedging and portfolio diversification.

(c) Revised standardized approach: The standardized approach for market risk has been revised. While it remains suitable for banks with limited trading activity, it is also sufficiently risk sensitive to serve as a credible fallback for, as well as a floor to, the internal models approach. This is particularly relevant for banks whose internal models are found to be inadequate in certain areas by their supervisors and, as a consequence, are not permitted to be used to determine regulatory capital requirements. A key change to the standardized approach is the greater reliance on risk sensitivities as inputs into capital charge calculations. This means that a common risk data infrastructure would be able to support both the revised internal model and the standardized approaches, facilitating the use of the standardized approach as a fallback and floor to internal models.

The note includes a discussion of the previous quantitative impact studies undertaken by the BCBS and a relatively detailed analysis of the anticipated impact of the final rule. However, this analysis clearly points to significantly higher capital requirements even over the post-reform current framework (although the analysis concludes that minimum required capital under the final rule will be less than required under the prior proposal—at least, using the analyzed June 2015 data).

Industry response to the most recent consultative document (December 2014) was generally supportive of the improvements that had been made to the proposed rule. However, it was still relatively critical of the large and seemingly disproportionate increases in required capital for securitized products and suggested further time be taken for targeted impact studies before a final rule was published.

Initial research assessments of the final rule have concluded that, at least for certain securitized products, the rule likely will sharply increase related capital charges—2x to 5x for senior bonds, while subordinate bonds will attract dollar-for-dollar capital. It also will significantly pressure available liquidity for affected products with consequent risk of increased volatility therein and the possible withdrawal by affected banks from related markets, all of which likely will negatively affect primary as well as secondary markets for such products.