Risk Management in Banking and Insurance · Market Risk Management

Market Risk Capital: Standardised and Internal Models Approach

Updated 11 October 2026 · Fact-checked

Market risk capital is the minimum capital a bank holds against losses from price moves in its trading book. Basel allows a standardised approach (regulator-set risk weights and formulas) or an internal models approach (bank's own models, with approval). Under FRTB, the internal models approach uses Expected Shortfall instead of VaR. Solve questions by identifying the approach, then summing the charges.

Understand Market Risk Capital: Standardised and Internal Models

Banks hold securities, foreign exchange and derivatives that change in value every day. A fall in prices can wipe out capital. Market risk capital is the buffer the regulator requires against those losses. It applies to positions in the trading book and to foreign exchange and commodity positions across the whole bank.

Basel gives banks two routes. In the standardised approach, the regulator fixes the method. You apply prescribed risk weights or sensitivities to positions and add up the charges. It is simple and comparable across banks. In the internal models approach (IMA), the bank uses its own risk models, but only after supervisory approval and with continuing tests of the models.

The older Basel 2.5 framework used 10-day 99% Value at Risk (VaR), plus stressed VaR and extra charges for incremental risk. The crisis showed that VaR missed tail losses and that the line between trading and banking books could be gamed. The Fundamental Review of the Trading Book (FRTB) was the response.

FRTB made four main changes. First, a stricter boundary between the trading book and the banking book. Second, a revised standardised approach based on sensitivities, which also serves as a floor and fallback for IMA. Third, Expected Shortfall (ES) at 97.5% replaces VaR in IMA, with liquidity horizons that differ by risk factor. Fourth, IMA approval is given desk by desk, and desks must pass back-testing and a P&L attribution test. A desk that fails the P&L attribution test, or breaches the back-testing thresholds, is ineligible for IMA and is charged under the standardised approach. Minor back-testing exceptions first lead to a higher capital multiplier.

In India, RBI sets market risk capital under its Basel III capital framework. The older RBI standardised method uses a maturity or duration method for interest rate positions and fixed percentage charges for specific risk and general market risk on equity positions. For exams, know the structure and logic of FRTB. Do not quote RBI implementation dates unless the question gives them.

Key rules to remember

Total market risk capital (standardised, older method): Capital charge = Specific risk charge + General market risk charge; The older method uses a maturity or duration method for interest rate positions and fixed percentage charges for specific and general market risk on equity positions. Add foreign exchange and commodity charges separately.
Risk-weighted assets equivalent: RWA for market risk = Capital charge × 12.5; Under Basel, the market risk capital charge is converted into RWA by multiplying by 12.5, the reciprocal of the 8% minimum. RBI uses the same 12.5 conversion for market risk. Separately, RBI's minimum total capital ratio is 9% of total RWA, excluding buffers such as the capital conservation buffer. This ratio is applied to total RWA. It does not change the 12.5 factor.
Revised standardised approach (FRTB): Capital = Sensitivities-based method charge + Default risk charge + Residual risk add-on; The sensitivities-based method covers delta, vega and curvature risk across risk classes.
Expected Shortfall: ES = average loss in the worst 2.5% of outcomes (97.5% confidence); ES captures the size of tail losses. VaR only gives the threshold.
Liquidity horizon scaling: ES = √[ ES_T(P)² + Σ (j ≥ 2) (ES_T(P, j) × √((LH_j − LH_(j−1)) ÷ T))² ], with base horizon T = 10 days; FRTB uses horizons (LH) of 10, 20, 40, 60 and 120 days by risk factor category. ES_T(P) is computed for the 10-day base horizon using all risk factors. This first term covers LH_1 = 10 days. The sum runs over j ≥ 2, where LH_(j−1) is the previous horizon. Each ES_T(P, j) is scaled by √((LH_j − LH_(j−1)) ÷ 10), and the terms are aggregated. ES_T(P, j) is computed using only risk factors whose horizon is at least LH_j. Less liquid factors get longer horizons, so they attract more capital.
FRTB IMA test: Desk approval = back-testing pass + P&L attribution pass; A desk that fails the P&L attribution test, or breaches back-testing thresholds, is ineligible for IMA and is charged under the standardised approach. Minor back-testing exceptions lead to a higher capital multiplier first.

How to solve Market Risk Capital: Standardised and Internal Models questions

Use this order for descriptive questions, numerical questions and case-based MCQs on market risk capital.

1Identify the book. Check whether positions are in the trading book or banking book. Foreign exchange and commodity risk apply bank-wide.
2Identify the approach asked: standardised, internal models or FRTB. State it in your first line.
3List the risk classes involved: interest rate, equity, foreign exchange, commodity, credit spread.
4For standardised numerical questions, compute each charge separately: specific risk, then general market risk, then the other classes.
5Add the charges to get the total capital charge. Convert to RWA by multiplying by 12.5 only if the question asks for RWA.
6For IMA or FRTB theory questions, mention ES at 97.5%, liquidity horizons, desk-level approval, back-testing and P&L attribution.
7Close with a one-line conclusion: the capital charge, or the approach that suits the bank and why.

Quickest way: Charge-then-convert shortcut

When to use it: Use this for numerical MCQs where positions and percentage charges are given.

Multiply each position by its stated charge percentage.
Add all charges. Do not net across classes unless the question allows it.
Multiply by 12.5 if RWA is asked.
For theory MCQs, match the keyword: ES means FRTB IMA; desk-level approval means FRTB; sensitivities means revised standardised approach.

Common mistakes in Market Risk Capital: Standardised and Internal Models

Saying FRTB IMA still uses 99% VaR.
Basel 2.5 and FRTB details get mixed up.
Fix: Remember: VaR 99% belongs to the older approach. FRTB IMA uses ES at 97.5%.
Forgetting that IMA needs supervisory approval.
Students treat the internal model as a free choice for banks.
Fix: Write that approval is needed, and under FRTB it is granted desk by desk.
Treating the standardised approach as obsolete under FRTB.
Students think the new IMA replaces it.
Fix: State that the revised standardised approach is compulsory to calculate, since it acts as a fallback and a floor for IMA banks.
Multiplying by 12.5 when the question asks only for the capital charge.
Students apply the RWA step by habit.
Fix: Read the last line of the question. Convert only when RWA is requested.
Adding the specific and general risk charges incorrectly by netting them.
Students assume offsetting is always allowed.
Fix: Compute each charge on its own and add, unless the question explicitly states a netting rule.
Mixing up trading book and banking book boundaries.
The boundary rules under FRTB are stricter and are not memorised.
Fix: Remember that FRTB sets a stricter boundary to curb capital arbitrage through reclassification.

Worked examples

Example 1

A bank has trading book positions with these charges: interest rate specific risk ₹2,00,000; interest rate general market risk ₹3,50,000; equity specific risk ₹1,20,000; equity general market risk ₹1,30,000; foreign exchange ₹80,000. Compute the total market risk capital charge and the market risk RWA using a multiplier of 12.5.

Show the solution

Interest rate charge = 2,00,000 + 3,50,000 = ₹5,50,000.
Equity charge = 1,20,000 + 1,30,000 = ₹2,50,000.
Foreign exchange charge = ₹80,000.
Total capital charge = 5,50,000 + 2,50,000 + 80,000 = ₹8,80,000.
RWA = 8,80,000 × 12.5 = ₹1,10,00,000.

Answer: Capital charge is ₹8,80,000 and market risk RWA is ₹1,10,00,000.

Example 2

Explain how the internal models approach under FRTB differs from the earlier VaR-based internal models approach. Should a bank whose trading desk fails the P&L attribution test keep using its own model for that desk?

Show the solution

Measure: the earlier approach used 10-day 99% VaR plus stressed VaR. FRTB uses Expected Shortfall at 97.5%, which averages tail losses.
Horizon: FRTB applies liquidity horizons of 10, 20, 40, 60 and 120 days by risk factor. ES is computed for a 10-day base horizon and scaled by √((LH_j − LH_(j−1)) ÷ 10) for each liquidity horizon bucket, then aggregated. So illiquid factors attract more capital.
Approval: FRTB grants approval desk by desk, not for the whole bank.
Tests: a desk must pass back-testing and the P&L attribution test, which checks that the risk model matches how the desk's profit and loss moves.
Consequence: a desk that fails the P&L attribution test, or breaches the back-testing thresholds, is ineligible for IMA and is charged under the standardised approach. Minor back-testing exceptions lead first to a higher capital multiplier.
Conclusion: a desk that fails the P&L attribution test should not keep using its own model. It moves to the standardised approach.

Answer: FRTB IMA uses ES at 97.5%, scaled liquidity horizons and desk-level approval with back-testing and P&L attribution. A desk failing the P&L attribution test loses IMA eligibility and is charged under the standardised approach.

Exam tips

Write a short comparison table in sentence form: approach, measure, who sets the method, and approval. Examiners reward contrast.
In numerical questions, show each risk class charge on a separate line before the total.
Use the exact terms: Expected Shortfall, liquidity horizon, desk-level approval, P&L attribution, back-testing.
For MCQs, check whether the question asks for the capital charge or the RWA before calculating.
Avoid quoting implementation dates or RBI circular numbers unless given in the question.

Practice questions from Market Risk Management

Market Risk Capital: Standardised and Internal Models in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

FRM Part IIRevised Standardised Approach for Credit Risk

Market Risk Capital: Standardised and Internal Models: frequently asked questions

What is the difference between the standardised approach and the internal models approach?

In the standardised approach, the regulator sets the formulas and risk weights, and every bank applies them. In the internal models approach, the bank uses its own models after supervisory approval. Under FRTB, the standardised approach also acts as a floor and fallback.

What is FRTB in simple words?

FRTB is the Fundamental Review of the Trading Book, a Basel reform of market risk capital. It tightens the trading and banking book boundary, revises the standardised approach and replaces VaR with Expected Shortfall in the internal models approach. It also introduces desk-level approval of models.

Why did Basel replace VaR with Expected Shortfall?

VaR gives only a loss threshold and ignores how bad losses can be beyond it. Expected Shortfall averages the losses in the tail, so it captures severity better. FRTB uses it at 97.5% confidence.

Do I need to remember RBI-specific details for market risk capital?

Know that RBI applies market risk capital within its Basel III framework and that banks compute charges for the trading book, foreign exchange and commodities. Focus on the Basel logic and the method. Use figures only as supplied in the question.