Ch6. FRM Financial Risk Manager — Basel IV & FRTB Deep Dive

What Is Basel IV?

Basel IV refers to the 2017 finalization package (fully effective 2025), officially called “Basel III Finalisation.” Its core goal is to reduce excessive variability in risk-weighted assets (RWA) caused by banks’ internal models.

Basel IV Key Changes

Area	Pre-Basel IV	Basel IV
Credit risk	High IRB model flexibility	IRB output floor (72.5% of SA)
Operational risk	AMA (internal model) allowed	SMA only
Market risk	VaR-based (99%)	FRTB — ES-based (97.5%)
RWA output floor	None	Total RWA ≥ 72.5% of standardized RWA

Output Floor: Even banks using internal models must keep RWA at or above 72.5% of the standardized approach. This prevents capital underestimation through model optimism.

FRTB: Fundamental Review of the Trading Book

Why FRTB Was Needed

During the 2008 financial crisis, market risk capital in the trading book proved drastically insufficient. The Basel Committee redesigned the entire trading book capital framework from the ground up.

FRTB Core Changes

1. VaR → Expected Shortfall (ES)

Standard	Old IMA	FRTB IMA
Risk measure	VaR 99%, 10-day	ES 97.5%, variable liquidity
Tail risk	Not captured	Captured (ES > VaR)
Liquidity adjustment	None	Asset class LH (10–120 days)

2. IMA Eligibility per Trading Desk

IMA approval is granted at the desk level, not firm-wide
P&L Attribution (PLA) test: model-based P&L must align with actual P&L
Failed backtesting at a desk → forced migration to Standardized Approach (SA)

3. Clearer Trading Book / Banking Book Boundary

Trading intent must be documented and demonstrated
Mid-stream reclassification heavily restricted (anti-regulatory-arbitrage)

FRTB Standardized Approach (SA-FRTB)

Sensitivities-Based Method (SBM):

Capital charges for Delta (Δ), Gamma (Γ), Vega (ν) across risk factors
Use the maximum across three correlation scenarios (low / medium / high)

Jump-to-Default (JTD):

Captures immediate default loss on bonds, equities, credit positions

Residual Risk Add-On (RRAO):

Additional charge for exotic options, gap risk, and risks not captured by SBM

SA-CVA (Standardized CVA Capital)

Under Basel IV, CVA capital uses either Basic Approach (BA-CVA) or Standardized Approach (SA-CVA).

BA-CVA

Uses regulatory parameters; no sensitivity calculations required
CVA capital = RW × EAD × DF (simplified formula)

SA-CVA

Sensitivity-based, similar to FRTB SA
Hedging credit recognized: CDS bought as CVA hedges reduce capital
IMA-CVA abolished under Basel IV

P&L Attribution (PLA) Testing

PLA testing is the gatekeeper for maintaining FRTB IMA eligibility.

Testing Methodology

Risk-theoretical P&L (RTPL): Model sensitivities × market movements = predicted P&L
Actual P&L (APL): Actual change in portfolio value
Compare: Difference between RTPL and APL must stay within tolerance

Traffic Light Zones

Zone	Condition	Consequence
Green	Good alignment	IMA maintained
Amber	Minor divergence	Capital surcharge
Red	Significant divergence	IMA revoked → SA required

FRTB Exam Summary

Item	Key Takeaway
ES confidence level	97.5% (captures more tail than 99% VaR)
Liquidity horizon (LH)	10 days (FX, large-cap) to 120 days (small-cap, credit)
IMA approval unit	Trading desk (not firm-wide)
PLA traffic light	Green/Amber/Red — surcharges or revocation on failure
Output floor	Internal model RWA ≥ 72.5% of standardized RWA

Chapter 7 covers Investment Management Risk — hedge fund analysis, ALM, and economic capital allocation.