What does the Fundamental Review of the Trading Book (FRTB) have to do with the Paris Agreement?

At first glance, there is no real connection between the two:

• The FRTB is a regulatory framework designed to enhance the resilience of banks’ trading activities. Its primary objective is to address the weaknesses of the previous market risk framework, which was exposed by the 2008 financial crisis.
• The Paris Agreement represents a global commitment to combat climate change and limit global warming to well below two degrees Celsius, above pre-industrial levels.

However, if you take a closer look, you can see some interesting similarities.

Globally relevant problems tackled globally

Both the FRTB and the Paris Agreement aim to mitigate complex, globally relevant problems (excessive risk taking in trading activities, issues arising with global warming). Generally, there is a common understanding that global problems must be handled in a joint effort, as regional differences in regulations would lead to ineffective incentives. These regulations can be sustainable only if all major players are reliably on board.

Mechanics

Both the FRTB and the Paris Agreement work the same way. A group of experts has, after lengthy discussions, issued a framework of rules which represents a minimum agreement on how each problem should be tackled. Namely, these experts are the Basel Committee on Banking Supervision (BCBS) and the United Nations Framework Convention on Climate Change (UNFCCC). There is a general agreement that these frameworks are legally binding and that these rules need to be transposed into national law. We have so-called nationally determined contributions (NDCs) for the Paris Agreement, as well as national regulations that follow the minimum capital requirements for market risk of BCBS.

Content differences in local implementations

The Paris Agreement allows NDCs to vary, depending on each country’s specific circumstances, capabilities, and priorities. One might think that this should not be the case for FRTB regulations, and expect that identical rules should apply across the world. However, looking at local rules, it is evident that there are differences. For example, each local regulator seems to be convinced that local government bonds are less risky, compared to those of other countries.

Timing

For NDCs, there are a variety of implementation periods, target years, short-term, and long-term goals. The submission date for NDCs varies between April 2016 and March 2025! What’s more, FRTB rules do not enter into force worldwide on the same day. For countries like Japan and Canada it is already fully implemented; for others (like the European Union), there are respective reporting requirements. So, it is unclear what is going to happen.

Incentives to not follow the rules

If countries set their NDC ambition levels comparatively low, they might be able to produce goods at a cheaper price, and gain competitive advantages. The same holds for financial markets. If banks in Country A must follow higher capital requirements for the same market risk profile than banks in Country B, then Country B’s banks have a clear competitive advantage. In financial terms for both FRTB and the Paris Agreement, there are incentives to delay implementation, weaken national implementations, or even not implement the rules at all. This is especially true in economically and politically difficult times.

The role of the USA The United States of America (USA) is obviously a major player in both FRTB and the Paris Agreement. The global financial crisis, which created the need for a review of the rules, was primarily triggered by the collapse of the USA housing market. The country has also been one of the major contributors to global warming.

The USA is far from being a pioneer when it comes to regulations. The country stepped out of the Paris Agreement for a second time, and is more restrained regarding FRTB implementation. This has prompted the United Kingdom to again delay FRTB, with the European Union likely to follow.

Thus, the USA, as a major global player, significantly influences the success of both the FRTB and the Paris Agreement. Its decisions and actions can have a profound impact on global efforts to manage financial risks and combat climate change.

The future evolution of these frameworks will reflect the complex interplay between national interests, global challenges, and the need for coordinated action. As both financial markets and climate change continue to evolve, the adaptability and responsiveness of these regulatory frameworks will be crucial in addressing new and emerging challenges.