Wolters Kluwer: Fundamental Review Of The Trading Book - Are You Covered?
Posted: 1 July 2015 | Source: Wolters Kluwer
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.
Changes to trading book boundary
The BCBS proposes in effect to change the definition of the trading book. Under current rules, firms that buy an asset for trading purposes would typically hold that asset and its associated risk in its trading book, where it would attract an 8% capital cover requirement. But should the market move against that asset – and reduce the possibility of liquidating that asset at a profit – firms are able to transfer it to their banking books, which are designed for longer-term holdings and attract the lower, 1.6% capital cover.
This situation encourages firms to push non-performing trading book holdings to the banking book, thereby reducing the amount of required capital cover by 80%. The BCBS has concluded that this inconsistency results in trading firms inadequately assessing the risk and capital cover for what are in effect their most risky holdings.