Dealers warn of FRTB impact on funding programmes

EMTNs issued by treasury functions may need to be moved to trading desk because of new market risk rules

Euro medium-term notes issued to raise funding for banks are usually managed as part of the banking book

Certain notes issued by banks’ treasury functions to raise funding could be caught under new market risk rules, potentially forcing dealers to move them into the trading desk.

Euro medium-term notes (EMTNs), issued to raise funding for banks and generally managed as part of the banking book, are usually hedged using swaps where the structured leg of the swap matches the coupon that is paid out, creating a derivatives leg.

But dealers say it is unclear whether this could mean the notes now have to be considered as part of the trading book instead of the banking book under the Basel Committee on Banking Supervision’s revamp of market risk capital rules, known as the Fundamental Review of the Trading Book (FRTB).

“In general different practices apply, but if it is held as a perfect hedge or expected to be held as a perfect hedge, we are not quite sure going forward how that [applies] to a new framework that has now been laid down,” said Suman Datta, a director in the portfolio quantitative research team at Lloyds Banking Group, speaking on a panel at the 2018 Banking Book Risk Summit in London on November 28.

Dealers usually shift exposures between the banking book and the trading book – known as risk transfers – for hedging purposes, allowing them to claim capital relief. The FRTB, however, imposes strict restrictions on the transfer of risks between the trading book and the banking book, under its so-called internal risk transfer framework (IRT). The restrictions are aimed at preventing regulatory capital arbitrage. Under the rules, transfers are allowed for equity, credit and interest rate exposures. The latter also involves the setting up of a regulator-approved IRT desk.

Lloyds’ Datta argued that the derivatives leg of the EMTNs could mean they would now need to be moved to and capitalised as part of the IRT desk – but this is unclear in the regulation.

“Do these move into an IRT-like structure, or do they stay? I think these are still unanswered questions, which need to be answered,” said Datta.

Etienne Varloot, the head of global markets regulatory strategy and quant research at Natixis, speaking on the same panel, said his firm is already considering making the move. “EMTN is definitely a trading instrument already… that cannot be in the banking book. So we have to move it out of the treasury. We are going to move it into the trading desk,” said Varloot.

This raises the question of which desk will manage the funding leg of the notes, something treasury functions would typically be experienced at handling.

“What is complex is how you shift back the funding to the treasury. It is complex – it truly changes the way we do business… You need to keep all market risk on the trading book because of the FRTB,” added Varloot. “What we’re doing as of today is let treasury issue notes and do a total return swap with equity derivatives. That is simple, but that does not fly.”

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