The Fundamental Review of the Trading Book: Implications for Portfolio and Risk Management in the Banking Sector

Abstract

The Fundamental Review of the Trading Book (FRTB) is the promised overhaul of bankmarket risk regulation. FRTB retains the authorized use of proprietary risk models, however, it introduces two additional criteria: (i) P&L attribution (PLA) tests and (ii) desk-level backtests. We examine empirically whether these additional criteria influence risk management and portfolio management practice, specifically portfolio construction and choice of risk model. We find that the PLA tests demand significant alignment with risk factors, however, the backtests do not incentivize use of superior risk models. This has important implications for the efficacy of the capital-based regulatory system.