trading book vs banking book

[shanlane]

Hello,

What are the advantages or disadvantages, from a capital requirement perpsective, of being treated as part of the trading book or part of the banking book?

In other words, why would we want a position to be treated as one as opposed to the other? Can we hold less capital against trading book positions?

Thanks!

Shannon

 

[David Harper CFA FRM]

Hi Shannon,

It's a whole thing with a history (for me, starting with this post from Aug 2007: http://www.bionicturtle.com/how-to/article/market_risk/ )

BIS just last week (!) released a fabulous summary, an unrivaled synthesis, a must-read on the subject: http://www.bis.org/publ/bcbs219.htm

The really brief version (IMO) is that, basically, banks could (regulatory) arbitrage by shifting from the banking book to the trading book. In particular, loans that would have been charged for credit risk, at one-year 99.9% horizon, could get the much more favorable interest rate (market risk) VaR charge at 10-day 99.0%. But, the credit crisis demolished this assumption, and the IRC was introduced to restore some credit risk (default) charge to the trading book, among other fixes. Much of the efforts, ongoing too, since has been to "fix" the weakness of the advantageous trading book. Thanks,

 

[shanlane]

That makes perfect sense.

Thanks!

Shannon

 

[shanlane]

Sorry, I think I am missing something really basic here, but I think I see the light at the end of the tunnel.

If we have an interest rate sensitive item that should be considered banking book, this treated as a credit risk (99.9% 1 yr VaR), whereas if we securitize it and hold onto it, it would then be treated as a trading book asset (99% 10 day VaR). Is this correct?

And now, under the new rules, if we do this, the securitizations come with hefty capital charges and this is considered the specific risk charge and basically be treated as though it were a banking book item?

And this is the reason that the IRC would not include the securitization, because it would be accounted for under the specific risk charge?

If this is correct, then exactly what DOES the IRC cover?

I REALLY hope this is right. It has been one of my most confused subjects.

THANKS!!!

Shannon

 

[celclevil89]

Hi Shannon,

It's a whole thing with a history (for me, starting with this post from Aug 2007: http://www.bionicturtle.com/how-to/article/market_risk/ )

BIS just last week (!) released a fabulous summary, an unrivaled synthesis, a must-read on the subject: http://www.bis.org/publ/bcbs219.htm

The really brief version (IMO) is that, basically, banks could (regulatory) arbitrage by shifting from the banking book to the trading book. In particular, loans that would have been charged for credit risk, at one-year 99.9% horizon, could get the much more favorable interest rate (market risk) VaR charge at 10-day 99.0%. But, the credit crisis demolished this assumption, and the IRC was introduced to restore some credit risk (default) charge to the trading book, among other fixes. Much of the efforts, ongoing too, since has been to "fix" the weakness of the advantageous trading book. Thanks,

Hi David,

I really don't know where to ask this question so I would like to use this forum for that. Probably it is a basic question but I am confused about how the forwards should be treated.

The trading book refers to assets and liabilities related to a bank's trading activites (such derivatives) and unlike other assets and liabilities, trading book items are marked to market daily.

However, a forward contract is a private agreement that settles at the end of the agreement (despite the futures that is settled on a daily basis until the end of the contract).

So I guess my question is how we are diferenciating in the trading book between those two types of contracts and if the forward contracts are market to market daily. I would appreciate some color here.

Thanks