Why Banks’ Trading Books Are New Target of Rules: QuickTake Q&A


The 2008 financial crisis showed that the world’s biggest banks had far too little capital to weather losses, especially on bonds, derivatives and other securities that they kept on their books. That’s why regulators have imposed, and may add to, a lengthy list of curbs that have resulted in higher capital levels. One of the last restrictions completed by the standard-setting global regulatory committee is intended to take effect in 2019, and it’s emerged as a major challenge to banks’ trading desks across the world. Officials in Washington and Brussels might walk the rule back.

1. Why the focus on trading books?

Banks keep assets in their banking books and their trading books. Real estate holdings and retail and small business lending must go in the banking book. Securities and financial contracts that a bank intends to trade, re-sell or profit from on short-term price movements are assigned to the trading book. The fair value of assets in the trading book must be calculated each day. Regulators found that banks moved assets back and forth between the two types of books with the goal of minimizing capital requirements, a strategy known as regulatory arbitrage. In the run-up to the 2008 crisis, banks held large exposures to credit-related contracts in their trading books without adequate capital.

2. What are the new rules?

The Basel Committee on Banking Supervision, the global panel of regulators that includes the U.S. Federal Reserve and European Central Bank, adopted a set of reforms in 2009 but later said those didn’t go far enough. In January 2016, it completed its so-called Fundamental Review of the Trading Book -- FRTB, as it’s known -- which produced the looming regulations that seek to ensure banks have enough capital to offset the risk of a plunge in market prices.

3. How exactly will the new rules work?

They will curb the use by banks of internal models to estimate the risk of securities on their books. If a regulator flunks a bank’s model, the firm must then fall back on a formula laid out by regulators that determines how much capital is necessary to cover potential losses.

4. What will that accomplish?

Regulators say the new standardized approach will help prevent banks from gaming the rules. Banks say it will force them to have more capital than their internal assessments do.

5. How big an impact will this have on banks?

The Basel Committee said in September that globally systemic banks could see a weighted-average increase of 2 percent in overall minimum required capital levels because the trading book standards apply to a relatively small share of banks’ total business. Still, the rule could be felt hard on trading desks for bonds, swaps and other derivatives at many of the world’s biggest banks. The committee, using data from the end of 2016, found that the same banks could see a weighted-average increase in market risk capital requirements of 51 percent. One of the big questions about the effect of the rule is whether banks’ models will win approval from authorities. The International Swaps and Derivatives Association, one of the industry’s main lobbying group, estimated in June that capital charges could be 2.5 times current levels if all trading desks are forced to use standardized formulas.

6. What will banks do?

They’ve pushed back on the regulations ever since they were completed, and some bank executives have been optimistic that officials will heed their calls for changes. Atop their list of priorities is a shift in the system regulators will use to assess whether lenders can use models for specific trading desks.

7. Is this a fight the banks could win?

Maybe. The new standards won’t take effect until and unless they are implemented by individual countries and jurisdictions. In the U.S., under President Donald Trump, the Treasury Department has said that the implementation of FRTB should be postponed until its effect can be considered further. The European Commission, which proposed its version of the rule in November 2016, is coming under pressure from the European bank lobby to hold off until it’s clear the U.S. and other jurisdictions will also adopt the rule. The industry argues that without a delay, European lenders will be at a competitive disadvantage. The commission, the European Union’s executive arm, had already proposed to add additional time before the rule fully took effect.

The Reference Shelf

    Before it's here, it's on the Bloomberg Terminal.