• Industry: Financial Services
  • Type: Regulatory update
  • Date: 11/14/2013

Tougher trading book regime moves closer 

The Basel Committee issued at the end of October a second consultative paper on the Fundamental review of the trading book: a revised market risk framework (PDF 1.10 MB). The paper sets out a detailed set of proposals for a comprehensive revision of the market risk framework.

This follows an earlier consultative paper from the Basel Committee in May 2012. Since then, the Basel Committee has narrowed the range of options to a single set of proposals which will form the basis for a Quantitative Assessment Study (QIS). The final proposals will be finalised once the results of the QIS have been considered.

Comments on the proposals are due by 31 January 2014.

This is important for banks because:

Under the latest proposals, banks will:

  • Have less flexibility under a “revised boundary” to assign instruments between the trading book and the banking book;
  • Be required to use only the standardised approach to the calculation of capital charges for the credit risk in securitisations;
  • Have to hold more capital against market risks in the trading book, under both the standardised and internal model-based approaches;
  • Receive less benefit from using internal model-based approaches relative to using the standardised approach to calculating regulatory capital requirements; and
  • Be required to disclose more information about their market risk capital charges, including the disclosure of both standardised approach and internal model-based calculations of regulatory capital requirements, at both a trading desk level and in aggregate.


The overall effect of these proposals, if implemented, would be to reduce significantly the benefit available to users of internal models, as a result of both restrictions on capital benefits and increased operational costs.

The reduced capital benefits arise from a range of factors, including restrictions on the trading book boundary; the use of stressed calibrations of risk; the move from VaR to an Expected Shortfall approach; longer liquidity horizons; and possibly a floor on the extent to which internal models-based calculations can be below the calculations based on the standardised approach. Moreover, the proposals will also increase the capital required under the standardised approach.

The operational costs will include the time and resources required to move to an Expected Shortfall approach; the implementation of all the other changes to the trading book boundary and to capital calculations; the requirement to calculate the capital required under both the standardised and the internal models-based approaches; and the significant increase in public disclosure requirements.

In addition, these proposals will have broader implications.

  • First, they add to the uncertainty about the amounts of capital that banks will be required to maintain – the continuing discussions about the use of internal model-based approaches for both credit and market risks mean that banks’ regulatory requirements remain to be fully determined, even after the implementation of Basel 3;
  • Second, it is not entirely clear how these proposals are supposed to relate to liquidity requirements – high quality liquid assets would seem to fall on the “trading book” side of the revised boundary, which could make such assets more expensive for banks to hold;
  • Third, the increased capital costs will drive banks to reassess the pricing and continuation of product lines, with implications for banks’ customers; and
  • Fourth, these proposals – together with regulatory requirements for the central clearing of derivatives and market and regulatory driven increases in collateral – will fundamentally change the dynamics and economics of trading.

In the detail…

The trading book/banking book boundary

The Basel Committee proposals would introduce a tighter approach to the boundary between the trading and the banking book, limit the extent of switching between the two books, introduce greater consistency across banks, and reduce the extent to which banks can engage in regulatory arbitrage. Whereas the May 2012 consultation put forward a choice between an evidence-based approach and a valuation-based approach, the latest consultation opts for a “revised boundary” that combines some elements of both.

The revised boundary would be based on the application of:

  • A presumptive list of instruments that should be in the trading book;
  • A presumptive list of instruments that should generally not be in the trading book;
  • Limits on switching, together with a capital charge that would fully offset any reduction in capital requirements where switching is allowed;
  • All trading book instruments being fair valued on a daily basis through a bank’s profit and loss statements; and
  • More reporting to enable the boundary to be more easily supervised.

Credit risks

Credit risks on securitisations in the trading book would have to be calculated using the revised standardised approach.

Non-securitised exposures would be subject to separate capital charges for (a) credit spread risk (changes in the market value of credit instruments with respect to the volatility of credit spreads) and (b) incremental default risk (the loss arising from a jump to default).

The Credit Valuation Adjustment (CVA) introduced in Basel 3 would continue to be applied separately, in addition to the other credit risk capital charges.

Market risk

Two high-level changes proposed in the first consultative paper have been carried forward to the latest proposals.

First, both internal models-based approaches and the standardised approach will be calibrated against stressed market conditions. This will increase capital charges under both approaches.

Second, the basis of calculation (and the basis on which the standardised approach is calibrated) will change from value-at-risk (VaR) to Expected Shortfall (ES) measures. In essence, the ES measure will be based on the size and likelihood of loss beyond the 97.5 per cent confidence level. The use of an ES measure will increase capital requirements for assets that are more likely to ‘jump’ from lower risk to higher risk of prospective loss at the extreme ‘tail’ of probabilities.

As we observed in our May 2012 alert, banks have invested significantly in VaR models. Moving to ES measures would require supplementing or replacing these models – with major investment of time, resource and money.

There are also some drawbacks to the use of ES measures:

  • Actual daily losses under normal trading conditions will appear relatively small when compared with ES potential losses. ES based models may therefore be less useful in alerting management to developments in market conditions unless they have a clear understanding of the ES approach and how to monitor against it effectively;
  • ES calculations are also more complex – making it more difficult for senior management to understand ES based risk reports and to use them effectively for their own scrutiny of risks; and
  • ES measures require large amounts of data to predict potential losses, but cannot fully predict what has not yet happened. Over reliance on complicated models was an issue in the previous crisis which is not necessarily addressed by the move to ES.

Market illiquidity

The proposals address the risk of market illiquidity by moving from an assumed 10 day horizon (as the time taken to extinguish an exposure to a risk factor in stressed market conditions without moving the price of the hedging instruments) to five liquidity horizon categories ranging from 10 days to one year. Risk factors are then assigned to one of these categories – for example, the 10 day horizon for large capitalisation equity, but 20 days for small capitalization equity.

Furthermore, a model independent assessment tool will be applied at the level of individual trading desks, especially those that trade complex, illiquid products in large volumes. This tool will apply a threshold whereby if internal model-based capital charges are less than some percentage of overall exposure then that desk can be excluded from using internal models or be subject to a conservative capital add-on. The precise calibration of this tool will be developed using the results of the QIS.


A tougher approach will be taken to allowing benefits from hedging, based on whether a hedge is likely to be effective during periods of market stress.

Standardised approach

For the standardised approach the Basel Committee has opted for the "partial risk factor" approach – this groups instruments with similar risk characteristics into buckets and applies regulatory prescribed risk weights to their notional positions or market value. This can be applied more easily by both small and large banks than the alternative “fuller risk factor” approach that was also consulted upon in May 2012.

Relationship between standardised and internal model-based approaches

The Basel Committee is still considering whether to limit the benefits of internal models-based approaches by applying a floor or a surcharge to limit the extent to which these approaches can deliver lower regulatory requirements than under the standardised approach.


Banks using internal models will be required to disclose both their internal models-based capital charges (disaggregated by type of capital charge) and the capital charges that would have been required under the standardised approach. They will have to make these disclosures at both desk level and in aggregate.

In addition, banks will have to disclose details of what they have included in their trading book, and disclose their trading desk structures.

To discuss the implications further please contact Giles Williams or Clive Briault.

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