28th June 2023: Do not get caught on the wrong side of the FRTB trading book/ banking book boundary

FRTB Trading Book/ Banking Book transfer and IRT rules are scheduled to go live in Europe in Summer 2023 as part of CRR 2. Banks have to move quickly to insure against lock-in of positions on the wrong side of the TB/BB boundary.

As of now, the CRR 2 rules adopted in the EU contain the full FRTB rules for internal risk transfers and reassignments between trading and banking book, scheduled to go live on 28th June 2023. These rules will have material impact on the ability of banks to recognize hedges between banking and trading book, the transfer of instruments between both, and the hedging models of banks. These issue applies both to IMA and SA banks.

Introducing this part of FRTB actually makes limited sense without the new rules on the mapping of instruments between trading and banking book; these will only be part of CRR 3. Hence, articles 104a and 106 are widely considered a “regulatory accident”. However, despite some apparent acknowledgement of the issue by legislators and regulators, it is unclear whether (and how) these rules could be stopped with only 7 months left.

This paper reviews the regulation and potential courses of actions for banks.

The trading book/ banking book boundary and internal risk transfers

FRTB introduces new rules which positions should be assigned to the trading vs the banking book which make the mapping hugely more prescriptive (“trading/ banking book boundary”, RBC25.3 - 13). This delineation is accompanied by rules restricting transfers between trading and banking book to only the rarest of circumstances (RBC25.14 – 17), and by rules restricting the way how hedges are to be constructed between the banking and trading book (internal risk transfers/ IRTs, RBC25.18 - 29).

The key objective of these rules is to avoid regulatory arbitrage, i.e. to make sure instruments are not denominated as trading or non-trading book based on capital considerations, or to hide losses. ?

The boundary definition may force some activities to move from banking to trading book or vice versa. Many banks have not moved any positions between trading and banking book since the end of the financial crisis, so the rules on moves will have limited operational impact - except for the moves forced by the TBBB rules themselves, The IRT rules require the setup of a separate risk transfer desk for interest rate risk and the externalization of credit and equity risk hedges. Hence they directly interfere with the hedging and funding models of many banks.

CRR 2 implements the Basel rules to block moves between trading and banking book (Art. 104a) and the rules on internal risk transfers (Art. 106), but not the rules specifying precisely which instrument has to be assigned where. So in case a bank has positions assigned to the “wrong side” of the boundary, they will be locked there by the new rules, and when the actual assignment rule come into force and require redesignation, banks may be penalized for that. (The new rules have been copied almost verbatim into the TRIM guidelines, so IMA banks might at least have started moving towards compliance.)

The situation might be a result of a “legislative accident” - when in 2019 the FRTB update was published at an advanced stage of the legislative process for CRR 2, the EU decided to introduce the “reporting-only” obligation and to postpone the capital rules to CRR 3. Leaving part of the TBBB and IRT rules in CRR 2 may simply have been an oversight. Regulators seem to agree that the situation is far from ideal, but getting any change of primary EU legislation into place within 7 months to go-live seems unlikely. A no-action letter of ECB and national regulators may do the trick, but there is no sign of that. As of now, banks urgently need to prepare.

The “weaponization” of the Trading Book/ Banking Book Boundary

To discourage regulatory arbitrage across the trading book/ banking book boundary, FRTB has introduced a number of hurdles:

• Redesignations require senior management and in most cases supervisory approval
• Any capital benefit from redesignation has to be recognized as a penalty until the position matures
• Redesignations have to be published in Pillar 3 reporting

All this should be sufficient reason not to run into the go-live date of the rules in June 2023 with positions on the wrong side of the TB/BB boundary, and to do any reassignments before the rules change. Having been responsible for an FRTB operating model before, my experience is that it takes a couple of weeks to brainstorm where these positions may sit (Treasury, corporate pension funds, trading in illiquid and unlisted instruments – hence (U)HNW wealth management – are amongst the usual suspects). The differences between the TB/BB regime and the “covered position” rules in the US may add an additional level of complexity. Product control has to be on the table, as well as accounting – it is not easy to change the accounting treatment ?after initial recognition. In the next step, controls have to be defined, policies to be updated, individual positions identified, rebooking mechanisms decided, and positions reclassified. If all goes well, this takes another six to twelve weeks – as long as no system changes are required.

In most cases, the new rules are a more prescriptive overlay to the Basel II concept of “trading intent” (for details see https://www.dhirubhai.net/pulse/frtb-detail-trading-banking-book-boundary-thomas-obitz-frm/). Hence translating them into policy right now – rather than waiting for CRR 3 – is a no-regret move in most cases.

Generally, it is easier to change policy well before the deadline, allow old positions to expire and to book new positions in the new framework – but time is running out, so some reassignments are likely to be required.

Dealing with the IRT rules

The FRTB rules for internal risk transfers heavily restrict the recognition of internal hedges between the banking and the trading book: Risk transfers are recognized only from the banking book to the trading book, credit and equity risk must be hedged externally 1:1 in the market, and for interest rate risk a separate stand-alone desk must be set up which hedges externally the risk it cannot diversify away.

These rules clearly aim at avoiding any co-mingling of trading book and banking book risk – but they also increase the cost of hedging dramatically: If the banking book is hedged through the trading book, the inability to offset risk internally against own and client position forgoes diversification benefit and triggers transaction cost, liquidity impact and counterparty risk charges. If the banking book decides to go to market directly (the alternative setup), counterparties may price trades differently, and the bank needs to ?be conscious of “one price” rules and self-arbitrage. Either way, trading desks will lose profitable order flow – interesting politics guaranteed.

Operationally, this requires the set-up of a separate IRT desk capitalized “stand-alone”; there are different options for anchoring of this desk in the organizational structure which have implications for the business model of this desk. It also requires changes in booking model, which typically have IT implications (unless hedges are managed manually, which is error-prone). Existing funding models, in particular using structured notes, may become problematic.

Interestingly, the FRTB rule preventing risk transfers from the trading to the banking book (RBC25.18) apparently has not made its way explicitly into CRR 2 (or even CRR 3). This provision not only interferes with funding models (a 5 year fixed-rate funding of the bank through the trading desks does carry considerable interest rate risk); as most positions may move in both directions, the rule may be seen as dangerously ambiguous.

So what should banks do? A blanket adoption of the new rules is expensive in case the rules are pushed back to 2025, and it will be resisted by trading. On the other hand, if the rules go ahead, losing capital recognition of hedges by mid of next year would even more costly - and reporting as if the hedges were still recognized would be non-compliant with regulation.

The best option for most banks will be to create the option to switch, but to defer execution until it is clear when the rules will enter into force. This includes setting up the IRT desk and assigning responsibility, defining the new operating and booking model, and plan re-booking of hedges. Depending on volumes, initial operationalization may involve manual activities. While opportunity cost of scarce experts may be a constraint, “hard” incremental cost for creating this option are limited. Risk and effort can be reduced using experts with experience setting up an FRTB-compliant operating model.?

#Marketrisk #FRTB #Basel #CRR #CRR2 #CRR3

Thomas Obitz is founder and director of RiskTransform, a London-based consultancy that works with banks to succeed in implementing regulatory change. Any opinions, findings and conclusions are those of the author and do not necessarily reflect the views of RiskTransform or any of its clients. They should not be considered actionable advice.