Skip to content

FRM Exam Part II · Fundamental Review of the Trading Book

Basel 2.5 Weaknesses and Why FRTB Was Introduced

Updated 11 October 2026 · Fact-checked

The Fundamental Review of the Trading Book (FRTB) replaced Basel II and Basel 2.5 market risk rules because the 2007-09 crisis showed they gave too little capital, allowed arbitrage between the trading and banking books, relied on VaR, and ignored illiquidity. To answer questions, match each weakness to its FRTB fix.

Understand Basel 2.5 and Why FRTB Was Introduced

Banks hold some positions to trade and others to hold to maturity. The trading book is marked to market daily and carries market risk capital. The banking book is held to maturity and carries credit risk capital. Before the crisis, the trading book usually needed much less capital for the same exposure.

The 1996 Market Risk Amendment let banks use internal VaR models, at 99% confidence over 10 days. In the crisis, trading book losses far exceeded the capital held. Losses came mainly from securitisations, credit-sensitive positions and illiquid assets, not from simple price moves in liquid markets.

In 2009 the Basel Committee issued Basel 2.5 as a quick patch. It added stressed VaR, the incremental risk charge (IRC) for default and migration risk on unsecuritised credit products, the comprehensive risk measure (CRM) for the correlation trading portfolio, and higher charges for securitisations in the standardised approach. It fixed the worst gaps but kept the VaR-based structure.

The Committee then launched the Fundamental Review of the Trading Book (FRTB) for a full redesign. Its main weaknesses to remember in Basel II and 2.5 were: VaR does not capture tail loss size; one 10-day horizon ignores that illiquid positions take longer to exit; the line between trading and banking books was vague and open to regulatory arbitrage; internal models and standardised approaches were not comparable; and risks were handled in separate, inconsistent pieces (VaR, stressed VaR, IRC, CRM).

FRTB's goals: a clearer trading book/banking book boundary; a more risk-sensitive standardised approach that works as a credible fallback and floor; an internal models approach using expected shortfall (ES) at 97.5% with liquidity horizons; model approval at trading desk level; and consistent treatment of risks. FRTB is also the label for the final market risk standard in the Basel III framework.

Key formulas to remember

Basel II/2.5 internal model measure
VaR at 99% confidence, 10-day horizon (plus stressed VaR, IRC, CRM under Basel 2.5)
The old approach. Several separate charges added together.
FRTB internal model measure
Expected shortfall at 97.5% confidence, calibrated to a period of stress
ES averages losses beyond the cutoff, so it captures tail severity. It replaces VaR.
Liquidity horizons in FRTB
Risk-factor horizons of 10, 20, 40, 60 or 120 days
Less liquid risk factors get longer horizons. Replaces one flat 10-day horizon.
Normal-distribution check
ES at 97.5% ≈ VaR at 99% for a normal distribution
Used to explain why the confidence level moved. Not true for fat-tailed losses.

How to solve Basel 2.5 and Why FRTB Was Introduced questions

Most questions give a scenario or a statement and ask which weakness it shows, or what FRTB changed. Use this method.

  1. 1Identify the regime in the question: Basel II, Basel 2.5 or FRTB.
  2. 2Name the risk or flaw described: tail risk, illiquidity, boundary arbitrage, credit or default risk, or inconsistent models.
  3. 3Recall the Basel 2.5 patch for it (stressed VaR, IRC, CRM) and why it fell short.
  4. 4Recall the FRTB fix: ES, liquidity horizons, boundary rules, revised standardised approach, desk-level approval.
  5. 5Check the details: 97.5% for ES, 99% for VaR, horizons 10 to 120 days.
  6. 6Eliminate options that swap the old and new features, or that call FRTB a minor tweak.
  7. 7Pick the option that links the weakness to the correct fix.

Quickest way: Weakness-to-fix pairing

When to use it: Use it for any 'why was FRTB introduced' or 'what changed' multiple-choice question.

  1. Think of five pairs: VaR to ES; flat 10 days to liquidity horizons; vague boundary to strict boundary; weak standardised approach to sensitivities-based approach; bank-wide model to desk-level approval.
  2. Find which pair the question tests.
  3. Reject options that mix up the pairs or reverse the direction.

Common mistakes in Basel 2.5 and Why FRTB Was Introduced

  • Saying Basel 2.5 was the full redesign of market risk rules.

    The name sounds like a new framework.

    Fix: Basel 2.5 was a quick 2009 patch that added charges. FRTB was the fundamental redesign.

  • Stating that FRTB uses 99% VaR.

    Old Basel VaR parameters are well memorised.

    Fix: FRTB uses ES at 97.5%. VaR at 99% belongs to Basel II and 2.5.

  • Treating stressed VaR as an FRTB feature.

    Both deal with stress periods.

    Fix: Stressed VaR was a Basel 2.5 add-on. FRTB calibrates ES to a stress period instead.

  • Thinking the flat 10-day horizon was fine for all positions.

    It is a simple and familiar number.

    Fix: The crisis showed illiquid positions cannot be sold in 10 days. FRTB assigns longer liquidity horizons.

  • Ignoring the boundary problem.

    Students focus on the measures and skip the structural issue.

    Fix: Banks could move positions between books to cut capital. FRTB tightens the boundary and limits switching.

  • Saying ES is better only because it is higher.

    Capital rose in practice.

    Fix: ES is better because it measures tail loss size and is coherent. VaR ignores losses beyond its threshold.

Worked examples

Example 1

A bank held structured credit products in its trading book in 2007. VaR at 99% over 10 days showed small risk, yet losses were huge. Which two FRTB design choices most directly address this weakness? (A) Moving to ES and adding liquidity horizons (B) Raising VaR to 99.9% and keeping 10 days (C) Removing the standardised approach (D) Allowing banks to reclassify positions freely

Show the solution
  1. The flaw: VaR ignores loss size beyond the cutoff, and 10 days assumes positions can be exited quickly.
  2. Option A fixes both: ES measures tail severity, and liquidity horizons lengthen the holding period for illiquid positions.
  3. Option B keeps both flaws.
  4. Option C removes the fallback FRTB wants to strengthen.
  5. Option D would worsen regulatory arbitrage.

Answer: (A)

Example 2

Which of the following was a Basel 2.5 measure rather than an FRTB measure? (A) Expected shortfall at 97.5% (B) Stressed VaR (C) Desk-level model approval (D) Liquidity horizons from 10 to 120 days

Show the solution
  1. ES at 97.5% is the core FRTB internal model measure.
  2. Stressed VaR was added in 2009 under Basel 2.5 to capture losses from a period of stress.
  3. Desk-level approval and liquidity horizons are FRTB features.

Answer: (B) Stressed VaR

Exam tips

  • Memorise the Basel 2.5 additions: stressed VaR, IRC and CRM, with what each covers.
  • Know the numbers: 99% VaR old, 97.5% ES new, horizons 10 to 120 days.
  • Questions often ask why, not what. Link each flaw to its FRTB response.
  • Watch for options that attribute old features to FRTB, or the reverse.
  • Remember the boundary and regulatory arbitrage issue. It is easy to skip but often tested.

Practice questions from Fundamental Review of the Trading Book

Basel 2.5 and Why FRTB Was Introduced: frequently asked questions

Why was FRTB introduced after Basel 2.5?

Basel 2.5 was a quick patch that kept the VaR framework. The Committee found deeper flaws in measures, liquidity treatment, the book boundary and comparability. FRTB redesigned the framework to fix them.

What is the main difference between Basel 2.5 and FRTB?

Basel 2.5 added extra capital charges on top of VaR. FRTB replaces VaR with expected shortfall, uses liquidity horizons, tightens the book boundary and revises the standardised approach.

What were the main goals of FRTB?

A clear trading book and banking book boundary, a more risk-sensitive standardised approach, a better internal models approach using ES and liquidity horizons, and more consistent capital across banks.

Why does FRTB use expected shortfall instead of VaR?

VaR says nothing about losses beyond its threshold. ES averages those tail losses, so it captures severity and is a coherent risk measure.