FRTB: banks fearful of risk transfer missteps

Short credit and equity positions held in banking book will be caught by market risk capital requirements

Tightrope walk
Balancing act: banks will have to weigh up the costs and capital benefits of hedges under FRTB

The redrawing of the boundary between dealers' trading and banking books under the Basel Committee's forthcoming market risk capital rules could deter dealers from hedging equity and credit exposures on a portfolio basis, market participants say.

Due to be implemented by January 1, 2019, the Fundamental review of the trading book (FRTB) states that instruments giving rise to a net short credit or equity position in the banking book will be subject to market risk capital requirements, as they would if they were held in the trading book.

FRTB clarifies that a bank will have a net short risk position for equity or credit in the banking book "if the present value of the banking book increases when an equity price decreases or when a credit spread on an issuer or group of issuers of debt increases". For instance, this could occur when dealers use imperfect hedges such as credit or equity index trades to protect tailored long positions on individual stocks or credit default swaps (CDS).

"That may change the way certain banks hedge. Banks engaging in portfolio hedging – for example by buying a CDS index contract over a credit portfolio – will have to determine if there are net short exposures in the banking book as a result of the hedge, and subject the net short positions to market risk capital charges," says Michael Sheptin, principal in financial services risk management at EY in New York. "Banks engaging in such activities will have to assess the market risk capital costs of any such credit hedges with the economic and credit capital benefits of such hedging."

Dealers say the provisions could upend the manner in which they conduct internal risk transfers, whereby exposures in the banking book are hedged with instruments sourced by the trading book.

The head of market risk at one global bank says dealers typically follow one of two models when it comes to managing banking book risk. In the first, the dealer establishes a desk within the banking book that faces the external market and executes hedges directly. In the second, the dealer funnels all trades for the banking book through the trading book.

In the second example, says the market risk head, "many positions are accumulated into one position and handed over to the banking book desk. This accumulated position has some flaws and is not an absolute direct match – as indicated by the new regulations."

FRTB requires all credit and equity exposures transferred from the banking book to the trading book to be hedged with an instrument sourced from a third party that exactly matches the internal risk transfer. The price of a mismatch is high: not only is the banking book exposure deemed to be unhedged, but the third party instrument held in the trading book must be included in the market risk capital calculation on a standalone basis.

It boils down to showing intent: the hedge needs to – and be seen to – take the firm genuinely out of [a] risk position
David Kelly, Parker Fitzgerald

An interim impact analysis published by the Basel Committee in November 2015 revealed that half of respondents used internal risk transfers to shift interest rate risk from their banking book to trading book, while 13.3% used them for credit risk, and 29.3% for equity risk. The remainder largely transferred banking book risk directly to the Street.

"Banks that use internal risk transfers typically do so due to a combination of their legal entity structure, limitations of systems and processes – meaning it might be operationally difficult for them to control certain traded products in the banking book – and dependency on key resources. There are a finite number of traders who deal in these products for a bank, and getting dedicated people might not be cost effective given a low number of trades," says Thomas Ehmer, a London-based senior manager at financial and energy consultancy Baringa Partners.

The International Swaps and Derivatives Association has previously called for banks to "retain the ability to transfer banking book risk to the trading book in a way that allows the risks to be managed on a portfolio basis, subject to trading book regulatory capital requirements, trading book limits and governance standards that meet supervisory approval."

An Isda spokesperson says the trade body continues to engage with regulators on FRTB.

EY's Sheptin adds that banking book hedging under FRTB could also fall foul of the Volcker rule in the US, which places strict limits on proprietary trading. Banks will have to make sure any changes to their banking book hedge processes resulting from FRTB are appropriately incorporated within their internal compliance programme, he says, and classified as permitted risk-mitigating hedging activities under Volcker.

David Kelly, London-based partner in the UK financial services practice at consultancy Parker Fitzgerald, agrees: "The lesson learnt with loan hedging through CDS is that the risk has to genuinely leave the bank for the regulators to get comfort that they are indeed hedges. It boils down to showing intent: the hedge needs to – and be seen to – take the firm genuinely out of the risk position, and not simply push it between trading books. If this approach is properly executed then the bank can avoid clashes with the Volcker rule," he says.

  • LinkedIn  
  • Save this article
  • Print this page  

Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.

To access these options, along with all other subscription benefits, please contact [email protected] or view our subscription options here: http://subscriptions.risk.net/subscribe

You are currently unable to copy this content. Please contact [email protected] to find out more.

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here: