A wipeout of the trading book has so far been avoided, but banks fear certain niche parts of the business could fall victim to the still-at-large suspect: the Fundamental Review of the Trading Book.
Before the Basel Committee on Banking Supervision’s revisions to the FRTB were finalised in January, fears were rife that the rules would greatly damage investment banking divisions due to the expected capital hike. An industry study in 2016 found market risk capital would rise by 1.5 times using the internal models approach (IMA) and 2.4 times under the regulator-set sensitivities-based approach (SBA).
Those fears have been (somewhat) allayed, but there are still some pockets of the trading book that banks fear will be killed off by the most recent set of rules.
Structured products – either swaps or options – pegged to the performance of funds are one such potential victim. As supervisory approval of the IMA for exposure to funds seems almost impossible, banks would be forced on to the SBA, which translates into sky-high capital charges for this category of risk.
To use the IMA, banks must demonstrate two things: their front- and back-office pricing systems are closely aligned; and, specifically for fund products, that they have a regular breakdown of individual components within each fund to which they are exposed.
Most banks agree the second condition will be almost impossible for them to meet, as fund managers do not disclose the make-up of their funds – and nor do they want to, for fear the information might leak to their competitors.
The Basel Committee’s intentions are good… But Basel is using a hammer to crack the nut of transparency
The Basel Committee’s intentions are good. Regulators want to ensure banks truly understand the exposures in the fund and avoid any nasty surprises if the fund manager takes more risk than the bank bargained for.
But Basel is using a hammer to crack the nut of transparency. In the worst case scenario under the SBA, banks must use a risk weight of 70%, which is the same weighting assigned to exposures that banks run against small corporates in an emerging market. It is highly unlikely that most funds have been heavily concentrating their investments in those types of risky assets, and neither is a properly diversified fund likely to be as volatile as a single small cap stock.
The second method in the SBA, based on the fund’s investment mandate, is supposed to produce lighter capital charges, but it does not curb the rise in risk-weighted assets that much, because mandates deliberately allow funds plenty of leeway in choosing their assets. One source likened the choice to being offered cholera or the plague.
While banks’ trading businesses can still continue if these structured products are eliminated, it will mean they will have to do so without this relatively stable source of income. For one bank, these products deliver up to 10% of its total markets revenue.
The second set of victims that banks worry about are correlation trading portfolios. The latest FRTB rules prevent banks from offsetting credit-default swap indexes against their single-name constituents, which the trades depend on to arbitrage the two components.
For both of these products, banks are looking for changes to the rules, or else they will have to scale back – and perhaps kill off – those business lines. Sources say policymakers are reluctant to make changes at the Basel Committee level, so local regulators are the only realistic saviours of the trading book now.