Basel may soften trading book rules on emissions

Latest FRTB tweaks also include increasing granularity of commodity risk weights

Basel Committee is thought likely to change treatment of emissions

The Basel Committee on Banking Supervision might opt to give a more favourable treatment to carbon emissions in bank trading books, as part of a bid to make the capital regime more environmentally friendly.

It is one of the latest proposed tweaks to the committee’s Fundamental review of the trading book (FRTB), which was expected to be finalised in December but has now been held back until January.

The FRTB, in the works since 2012, is a post-crisis effort to strengthen trading book rules by addressing the treatment of areas such as securitisations, diversification and liquidity risk. Among other things, the proposals replace the use of value-at-risk with expected shortfall, redraw the boundary between banking and trading books, and strengthen the relationship between the standardised and internal models approach used by more sophisticated global banks.

In the most recent proposals, emissions allowances are treated as exotics and receive a punitive capital charge, but the committee is thought likely to alter their treatment in an effort to ‘green’ Basel rules.

Emissions allowances are tradable instruments that must be surrendered annually by firms emitting greenhouse gases under various national and regional compliance schemes, the largest of which is the European Union Emissions Trading System. Such allowances are typically traded by banks in spot and futures markets on behalf of their clients.

Many banks have withdrawn from all or part of the commodities market in recent years, which could limit the potential benefits of the move. In the past two years, firms such as Barclays, Deutsche Bank and JP Morgan have exited or scaled back their commodity businesses due to declining revenues, regulation and capital constraints.

“I would struggle to find a bank with a huge carbon trading position. Some banks still have some minor activity in this space – though compared to their interest rate derivatives or forex businesses, this is not a significant position in their trading book,” says Thomas Ehmer, a London-based senior manager at financial and energy consultancy Baringa Partners.

More generally, it is understood that the Basel Committee intends to improve the treatment of commodity exposures under the FRTB. The most recent proposals assign risk weights of 20–80% to commodity trades, depending on which of 11 different buckets they fall into: coal, crude oil, electricity, freight, metals, natural gas, precious metals, grains and oilseed, livestock and dairy, softs and other agricultural commodities, and ‘others’.

It is expected that the number of commodity buckets will now increase, although it is unclear exactly what the new categories will look like.

In what is viewed as a more significant move for global banks, the FRTB is also likely to retain a controversial add-on for residual risk, set at 1% of notional for exotic derivatives with embedded optionality. However, the add-on is expected to be applied to a narrower band of trades.

Banks are increasingly concerned about the capital impact of the FRTB. Based on the results of an impact study conducted in mid-2015, three industry groups said the rules would result in a four-fold increase in market risk capital compared with current levels. The residual risk add-on – hastily inserted into the text by regulators as a way to curb exotics trading – was alone responsible for nearly half the total hike.

Dealers say part of the problem is that the add-on captures any trade that has embedded optionality, or gives clients the right to walk away. Consequently, the Basel Committee is rethinking the idea, says one regulatory source, and the final rules are likely to define two levels of residual risk charge. While exotics would continue to be subject to a punitive 1% charge, simpler instruments containing optionality would receive a lower charge.

It is not yet known exactly where this boundary will be set – and it may well emerge after the rules have been finalised. “The Basel Committee gives a loose definition at this point. My suspicion is we are going to be managing this for a while with FAQs,” says the regulatory source.

While regulatory sources suggest the upcoming document will be final, several critical issues are only expected to be ironed out during a subsequent monitoring period. They include the final calibration of the framework, along with the capital treatment of securitisations and sovereign risk exposures.

The Basel Committee did not respond to a request for comment.