Curbing subjectivity: A technical brief on the Fundamental Review of the Trading Book proposal
This note provides Finance Watch’s assessment of the proposals of the Basel Committee on Banking Supervision figuring in the “Fundamental Review of the Trading Book”. This set of proposals aims at reinforcing banks’ robustness by strengthening the distinction between banking and trading book, where banks book their financial assets. The trading book includes all positions that banks intend to trade actively and is focused on market risk, while the banking book includes all positions that banks intend to hold until maturity and is focused on default risk. The differential prudential treatment was originally meant to reflect the presumed liquidity advantages of actively traded assets through lower capital requirements and use of internal models for risk assessment but in practice led to regulatory arbitrage, since the distinction between books was solely based on intention and easily circumvented.
After some short-term fixes, such as add-ons to regulatory capital charges, the Basel Committee decided to further fix its regulatory framework. The main changes include a new definition of the boundary between banking and trading books, the use of the Expected Shortfall instead of the Value-at-Risk as a risk metric, and changes in the Standardised approach.
Finance Watch welcomes the Basel Committee’s proposal to revise the market risk framework for the trading book, which has proven to be ineffective during the past crisis. We have however some reservations on some of the recommendations:
- In our view, a truly objective boundary between books should be made through the use of accounting standards in order to remove any intent in the definition.
- Moreover, although the Expected Shortfall is a superior risk metric compared to the Value-at-Risk, the overreliance on a single mathematical figure to assess risks is dangerous.
- Lastly, the use of a less risk-sensitive Standardised approach, along with aggregate risk-neutral metrics, should be sufficient to provide an effective, balanced and transparent micro-prudential framework.