Allen & Overy Briefing Paper No.

8
The Trading Book

The framework for risk weighting of assets divides the assets of banks into two categories. This Briefing is for general guidance only and does not constitute definitive advice. and therefore the rules in other EEA States. BACKGROUND AND SCOPE The bank regulatory framework requires the risk weighting of assets in order to establish the amount of capital required to be held by a bank. Note: The UK FSA Handbook provisions referred to in this Briefing are based on "intelligent copy-out" of the CRD. Annexes I. This briefing sets out trading book eligibility requirements and key principles which underlie the risk weighting of assets in the trading book. or books – the banking book and the trading book. The trading book regime is provided for by the recast CAD. Building Societies and Investment Firms (BIPRU).January 2009 | The Trading Book THE TRADING BOOK This briefing paper is part of a series of briefings on the Capital Requirements Directive (CRD) and its implementation in the UK via the General Prudential sourcebook (GENPRU) and the Prudential sourcebook for Banks.allenovery. the regulatory capital requirements associated with the trading book assets of an institution attract a lower regulatory capital burden than assets held in the banking book. It is applied to banks by virtue of Article 75 of the recast BCD. See Regulatory Capital Briefing 1 (Introduction to Basel II) for further details. on a net basis. the trading book eligibility criteria and the appropriate means of risk-weighting trading book assets are all under question. As a result trading book positions are measured. © Allen & Overy 2008 1 www. This is the result of an assumption that underpins the regulatory framework that banking book assets are non-tradable – and therefore presumed to be held for life – whereas trading book assets are tradable and therefore can be disposed of in the market for their market value. Recast Banking Consolidation Directive (recast BCD) Article 75. The banking book is discussed in Regulatory Capital Briefings 3 and 4. The rules for risk weighting of assets in the trading book are complex and asset-specific. They should therefore be consistent in very broad terms with the CRD. Do not rely on this briefing as an accurate guide to regulatory capital in EEA member states outside the UK. It is expected that if these proposals are implemented the trading book capital requirements may increase significantly. The regime in other member states may therefore differ in a number of respects. and regulatory capital is held. TRADING BOOK ELIGIBILITY The trading book is defined as consisting only of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book and which are either free of any restrictive covenants on their tradability or able to be hedged. It is to be expected that significant changes to the risk-weighting of trading book assets will be made by the European Commission and/or the FSA in the near future. BIPRU chapters 7 and 13. in which generally (with the exception of certain derivative instruments) positions are measured on a gross basis.com/regulatorycapital . and are outside the scope of these briefings. This assumption has of course been challenged in recent months – most particularly in respect of structured securities and the ability of Value at Risk (VaR) models to capture all relevant losses in the trading book. Health Warning: the CRD contains a large number of discretions for member states in implementing the CRD. This may be distinguished from the banking book. both the Basel Committee and the European Commission have been working on proposals in relation to incremental risk in the trading book. II and IV. WHY TREAT THE TRADING BOOK DIFFERENTLY FROM THE BANKING BOOK? As a policy matter. Under the proposals the internal models will capture the credit and event risk dimension better. In particular. As a result the definition of the trading book. SOURCES Recast Capital Adequacy Directive (recast CAD) Articles 18-19. which sets out the capital requirements for investment firms.

There is therefore an exemption for banks which are "active market makers" in the securities concerned. Where MTM valuation is not possible. equities and collective investment undertakings (CIUs) in the trading book. equities. National supervisors are given discretion as to implementation of this exemption. Long and short positions which are otherwise very similar or identical are netted together. The resulting net position is then adjusted by a "haircut". Trading book positions must be frequently and accurately valued. Banks and investment firms are required to have a trading book policy which sets out the firm's policy for booking of positions in the trading book.and off-balance sheet positions arising from movements in market prices. Firms have a choice of different methodologies for calculation of general risk. Capital requirements are primarily calculated for: ƒ risks arising from interest rate related instruments. The size and method of applying PRA depends on the risk type of the position. or from other price or interest variations. and reporting to senior management): Qualifying deductions The CRD requires banks to deduct from their own funds holdings of capital instruments issued by other banks to avoid double-counting of capital.allenovery. Regulatory capital requirements are designed to ensure that firms hold capital for any potential changes in underlying prices or rates. which focuses on potential fluctuations in market prices or rates. and ƒ foreign exchange risk and commodities risk in both the trading book and the banking book (application of these risks to positions in the banking book is necessary because the banking book requirements are focused on credit events and are not designed to capture risks arising from movements in market prices. Under the standard MTM approach risks arising from each risk factor are calculated separately (eg interest rates.January 2009 | The Trading Book The definition of the trading book makes clear that positions held with trading intent are those held intentionally for shortterm resale and/or with the intention of benefiting from actual or expected short-term price differences between buying and selling prices. so the market risk requirement. commodities. Firms are also required to maintain systems and controls in relation to the operation of their trading book operations. by marking the position to market (MTM) and the relevant holding should be actively managed. etc). applies). FX. a position risk adjustment (PRA). CALCULATION OF CAPITAL REQUIREMENTS Calculation of market risk Market risk is the risk of losses in on. options. and clearly defined policies and procedures for the active management of positions (including establishing and monitoring position limits. Interest rate pre-processing models allow firms to net positions within certain maturity buckets before applying the standard rules for calculation of interest rate position risk requirements (PRR) that © Allen & Overy 2008 2 www. Firms may only use CAD1 and VaR models with permission from the FSA and provided they meet certain quantitative and qualitative minimum criteria. firms may use more advanced models-based approaches based on a CAD1 model (which is split in two different methodologies for options risk aggregation and/or interest rate pre-processing) or a VaR model.com/regulatorycapital . and ƒ specific risk (idiosyncratic risk) is the risk of potential price or rate changes due to factors related to the issuer of the relevant investment. This requirement creates problems for banks who wish to trade in bank shares and subordinated notes. which are available only to more sophisticated firms who hold a CAD1 waiver. Interest rate and equity risks are split between general risk and specific risk. Credit derivatives are subject to special calculations which reflect the additional risks that such products may contain. This must be done daily using readily available close-out prices. CAD1 models. where possible. including the creation of a clearly documented trading strategy for the position/instrument or portfolios (including expected holding horizons) approved by senior management. as represented by main market indices or government yield curves. where: ƒ general risk is the risk of potential market-wide fluctuations in prices or rates. PRA represents a potential change in the price of the position. provide for a more risksensitive treatment than other models.

Under this method an exposure is determined as the MTM plus the PFE where the PFE is a percentage of the notional value of the contract.January 2009 | The Trading Book relates to general interest rate risk. Where a bank uses the Standardised Approach in its banking book. The rules on calculation of exposures arising from underwriting commitments are based on the assumption that the final exposure an underwriter takes up is normally significantly less than the underwriting commitment. it will use that approach to calculate credit risk in the trading book. via an OTC derivative) where the firm is exposed to both the credit risk of the derivative counterparty and fluctuations in the price of the underlying exposure. the firm will suffer a credit loss. an interest rate swap may have a positive or negative value over the life of the trade depending on the movement of swap rates. and is based on a risk management model which uses a statistical measure to predict profit and loss movement ranges with a confidence interval. Options aggregation models allow greater recognition of netting within an options portfolio while ensuring all other risks inherent in such a portfolio are covered. Once the exposure value is assessed. accordingly. at the time of default. Financial derivatives Exposures to any particular counterparty are calculated on a net basis provided that a legally enforceable netting agreement is in place. Standardised method © Allen & Overy 2008 3 www. counterparty credit risk exposure arising from a derivative fluctuates over the life of the transaction as underlying markets move and. Calculation of counterparty credit risk In general trading book positions attract a regulatory charge based on market risk rather than credit risk on the issuer. and where it uses the IRB approach in the banking book. measuring the value of the current exposure (the MTM of the transaction) alone is not sufficient. The PFE depends on the product type and its maturity.allenovery. ƒ the standardised method. If the transaction has a close-out value greater than zero at the time of default of the counterparty. VaR covers general risk and may also cover specific risk. an assessment of the potential future exposure (PFE) of the transaction must be carried out. may recognise capital benefits of risk diversification of a trading portfolio. MTM method This is the most basic method which pre-dates the CRD. These methods are available to a firm irrespective of the firm's overall approach to credit risk. This is also the case where a position is taken synthetically (for example. Given the nature of the transaction. or the amount of posted collateral exceeds the firm's obligation to its counterparty. VaR models are different from the standard methodology in that VaR models may take into account correlation between different risk types and. Therefore. and ƒ the internal model method. trading book positions will be successfully liquidated. it must be measured in a way which takes into account potential future fluctuations in the price of derivative. For example. However in some circumstances (eg unsettled trades and repo transactions) credit risk must be reflected in the trading book as well. Calculation of counterparty credit risk is based on measuring the exposure value for a position arising from a financial derivative or a securities financing transaction (SFT). This is because the trading book regime is based on an assumption that most. The approach to credit risk in the trading book will follow on the approach used in the banking book. For example. credit losses under a repo transaction may arise if. If specific risk is not covered then the standard methodology should be used. it will use the IRB approach in the trading book. it is then included in the firm's credit risk requirement calculations in accordance with the applicable approach used by the firm (either under the Standardised or IRB approach to credit risk). therefore. There are three alternative methods available for calculating an exposure arising from over-thecounter (OTC) derivatives: ƒ the MTM method.com/regulatorycapital . This risk is referred to as counterparty credit risk – the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows. a firm on the standardised approach to credit risk may choose to use an internal model method. if not all. the close-out value of collateral held is not sufficient to replace the exposure in the market. A VaR model is an alternative to a CAD1 model. For example.

Under the standardised method risks may be bucketed at a more granular level and risk position are measured more accurately rather than simply using the notional value of the contract. Internal model method The internal model method is the most sophisticated approach to calculating the exposure value of financial derivatives.com/regulatorycapital . firms are also required to carry on price verification at least monthly by a unit independent of the dealing room. All such provisions must be reflected in the regulatory capital calculations. Securities financing transactions Generally. © Allen & Overy 2008 4 www. liquid two-way market.January 2009 | The Trading Book The standardised method is more advanced and provides more risk-sensitive calculations. it must treat such transactions in accordance with that approach. ƒ the extent to which legal restrictions or other operational requirements would impede the bank’s ability to effect an immediate liquidation of the exposure. if the firm has an internal model method permission it may treat securities financing transactions (eg repos or stock lending) in accordance with its FSA permission. the firm must treat securities financing transactions in accordance with certain prescribed rules within the credit risk mitigation framework. TRADING BOOK COMPLIANCE Valuation In addition to the valuation requirements mentioned above.allenovery. ƒ hedge the material risks of the exposure and the extent to which hedging instruments would have an active. highly concentrated or otherwise likely to be difficult to dispose of at the market valuation. ƒ for exposures that are marked-to-model. This method is based on an effective expected positive exposure (effective EPE) method. haircuts should be applied to valuations where the price obtained may not be robust. All applicable haircuts and provisions must be taken into account in establishing regulatory capital requirements. Trading book policies and procedures In addition to valuations. and ƒ derive reliable estimates for the key assumptions and parameters used in the model. In the absence of either of the above FSA permissions. Firms must apply for an FSA waiver before they are able to use this method and they must demonstrate that they meet certain quantitative and qualitative minimum criteria. which is an approach available within the credit risk mitigation framework. Alternatively. Netting requirements Rules and guidance on netting requirements are specific to each method but also contain common netting requirements which include the general requirements for appropriate contractual netting agreements and legal recognition of netting arrangements. ƒ the extent to which an exposure can be marked-to-market daily by reference to an active. liquid two-way market. if the firm has an FSA permission for a master netting agreement internal models approach. and should be performed to a higher standard than daily marking to market. Where considered necessary. This provides the most risksensitive approach to calculating exposure values and is aligned to the firm's internal risk management practices. Independent price valuation is separate from marking to market valuation. the extent to which the bank can: ƒ identify the material risks of the exposure. ƒ the extent to which the bank can and is required to generate valuations for the exposure that can be validated externally in a consistent manner. and should aim to value the whole of the trading positions held within the trading book. Banks are also required to consider making provisions where a position is illiquid. firms are required to have robust trading book policies and procedures which address: ƒ the activities the bank considers to be trading and as constituting part of the trading book for regulatory capital purposes.

RELATED AREAS See Regulatory Capital Briefing 3 (Standardised Approach to Credit Risk in the Banking Book) and Regulatory Capital Briefing 4 (Internal ratings based approach to credit risk in the banking book).January 2009 | The Trading Book ƒ the extent to which the bank is required to.com or your usual Allen & Overy contact.com Damian Carolan Partner 020 3088 2495 damian. and ƒ the extent to which the bank may transfer risk or exposures between the banking and the trading books and criteria for such transfers.allenovery.com/regulatorycapital .penn@allenovery.com Irina Molostova Associate 020 3088 4913 irina. and can.molostova@allenovery. © Allen & Overy 2008 5 www.phillips@allenovery.com Paul Phillips Partner 020 3088 2510 paul.com Charlotte Phipps Business Development Co-ordinator 020 3088 2136 charlotte.phipps@allenovery. CONTACT INFORMATION For further information please speak to: Bob Penn Partner 020 3088 2582 bob.carolan@allenovery. actively risk manage the exposure within its trading operations.

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