The primary motivation behind the modifications to the trading book and banking book under FRTB is to eliminate regulatory arbitrage. Regulatory arbitrage is a practice where firms exploit the differences in regulatory treatment between the trading book and banking book to minimize their capital requirements. For instance, some banks have been known to hold credit-dependent instruments in the trading book because it requires less regulatory capital compared to the banking book. By making these modifications, regulators aim to ensure that capital requirements are more accurately reflective of the actual risks associated with different financial instruments, thereby discouraging regulatory arbitrage.

Choice A is incorrect. While internal fraud can be a concern for financial institutions, it is not the primary motivation behind the regulatory modifications brought about by FRTB. The FRTB primarily aims to address issues related to market risk and counterparty credit risk in the trading book, rather than focusing on internal fraud.

Choice B is incorrect. Default risk, although an important aspect of financial regulation, is not the main driver behind the changes introduced by FRTB. The focus of these changes is more on reducing possibilities of regulatory arbitrage and improving risk sensitivity.

Choice C is incorrect. Interest rate risk does play a role in shaping regulations for financial institutions' trading books; however, it's not the primary motivation for FRTB's modifications. These changes are mainly aimed at addressing issues related to market and counterparty credit risks as well as minimizing opportunities for regulatory arbitrage.

Things to Remember

• Regulatory arbitrage is the practice of taking advantage of the differences in regulations to reduce regulatory capital requirements.
• FRTB (Fundamental Review of the Trading Book) aims to address market risk and counterparty credit risk in the trading book.
• Capital requirements are designed to ensure that financial institutions have enough capital to cover potential losses and risks.
• Market risk refers to the risk of losses in on and off-balance sheet positions arising from movements in market prices.
• Counterparty credit risk is the risk of loss due to the default of a counterparty in a transaction.