Trading Book Review

 

Background

The fundamental review of the trading book (FRTB) refers to Basel Committee's latest work on capital standards for market risks. It aims to removing incentives for regulatory arbitrage from the banking book to the trading book, and developing a more risk-sensitive approach for market risks' exposures calculations. However, no legislative work to translate those recommendations is currently or in the near future part of the Commission's agenda.

Undercapitalised trading book exposures and weaknesses in the overall design of the trading book regime are well known. Following a number of temporary measures (known as Basel 2.5) to improve market risk, the FRTB is a fundamental review of what didn’t work. The areas for improvements that are suggested by the Basel Committee on Banking Supervision (BCBS) and that the improvements have been introduced regarding:

•review the definitions of trading and banking books

•change the calibration methods for risk models

•replace Value at Risk (VaR) with new measures of risk

•incorporate liquidity considerations into market risk

•make considerations around hedging

•carry out a review of the standardised methods and their relation to internal models.

To meet this requirement, banks will have to redesign their internal regulatory capital models, build a new standardised approach and develop new capabilities and policies that determine what can be included in the trading book, model back-testing techniques, new risk measurement methodologies, and new public disclosure frameworks, among others.

This represents a major change in the way banks will be asked to measure risk and calculate their regulatory capital requirements for the trading book in future. It also comes at a time when the implementation of the Basel III capital rules is still a challenge.

FRTB is expected to be finalized this year and implemented in 2017/2018, though we may see some delays.  In this context, below is a high level summary of what we believe market participants should start thinking about in the coming months.

By tightening the rules around what qualifies as a trading book holding – as opposed to a banking book holding – a distinction that has significant bearing on a bank’s capital adequacy requirement, the BCBS hopes to make it more difficult for firms to move assets between these two books in order to optimize their capital availability. At the same time, it seeks greater diversification of risk within the trading book, a more stringent approach to liquidity horizons and the promotion of standardized risk models across the board.

The FRTB is aimed at addressing these issues with the intention of establishing a more realistic view of risk, resulting in appropriate capital adequacy provisioning, in the hopes of avoiding a repeat of 2008’s credit crunch. It does this through a number of new requirements, four of which stand out as potential triggers for changes in firms’ trading book processes and underlying systems.

Actions of Finance Watch

Finance Watch is for the moment monitoring the Basel process and will publish a position once the work moves to the EU level.

Key risks

Finance Watch is of the view that a robust, simple metric would be much better and easier to explain and assess. This debate also evidences that a separation of banking activities (see the dossier on Bank Structure Reform) and macro-prudential measures (e.g. leverage cap) aimed at tackling systemic risks are needed. Therefore, within the Trading Book Review dossier, we are concerned (among other things) that risk-sensitiveness could be confused with a replication of the financial industry's current practices and that "sophisticated" calculations would lead to a false sense of security.

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