Trading Book Survey: A Summary of Responses

In January 2004, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) decided to set up a joint working group (hereafter the Joint Group) to consider the issues that could potentially arise from implementation of the International Convergence of Capital Measurement and Capital Standards: A Revised Framework (hereafter the Revised Framework), especially with respect to certain aspects of the trading book. Indeed, in the process of revising the 1988 international solvency standards, the BCBS focused mainly on the assessment of credit and operational risk, with less emphasis on the market risks, previously tackled in the 1996 Market Risk Amendment. In comments received on the third consultative paper on the Revised Framework (CP3), released in April 2003, many firms and industry associations expressed concerns about potential distortions that could arise, between banking book and trading book regimes, as a result of interpretation and/or implementation of the Revised Framework. These concerns are magnified by the fact that, in some jurisdictions, the Revised Framework is going to apply to both banks and investment firms, whose activities are more focused on trading. In that respect, the Joint Group identified three sets of issues that needed to be addressed before implementation of the Revised Framework, in order to avoid such distortions and create a level playing field between banks and investment firms.

These three sets of issues are:

1. Updating the treatment of counterparty credit risk arising from certain derivative and securities financing transactions to increase consistency with the internal rating based (IRB) approach of the Revised Framework.

2. Reviewing some aspects of the Revised Framework to align them with firms' current practices in their trading and/or banking book. Specifically, the focus is on the treatment of double-default effects on hedged exposures and the maturity adjustment for short-term transactions in the IRB approach.

3. Revising some aspects of the current trading book treatment to adapt it to the Revised Framework or to the recent developments observed in trading activities. This third set of issues also includes some clarifications on the Revised Framework like the treatment of unsettled and failed trades.

As a first step, the Joint Group launched, in July 2004, a survey of banks' and investment firms' trading books. Indeed, considering the growth and development of financial markets, the extent of innovations in those markets, and improvements in risk management techniques since the implementation of the Market Risk Amendment, in 1996, as well as the growing complexity of trading book activities, the Joint Group deemed it appropriate to review the risk-sensitivity and level of capital required under the current trading book regime. In this survey, special emphasis was placed on:

• Further clarifying the intent-based definition of the trading book, as set forth in the Revised Framework;
• Understanding the range of practices across firms for translating applicable accounting and regulatory capital standards into internal policies and procedures relating to the inclusion and treatment of positions in the trading book;
• Considering the risk-sensitivity of the current VaR-based and standardised trading book regime;
• Better understanding valuation methodologies and adjustments across firms, including interactions with applicable accounting standards, their interpretation, and their implementation in practice; and
• Evaluating the adequacy of capital treatment for less liquid positions currently held in trading book.

To achieve this objective, the trading book survey was divided into three sections. The first section aimed to identify criteria for determining suitability for market risk treatment. The second section was intended to take stock of firms' practices for the valuation and risk measurement of trading book positions. The third section was more specifically directed to the treatment, for risk management purposes, of counterparty credit risk issues related to repo-style transactions, securities financings, unsettled trades, and credit derivatives.

A total of 47 banks, investment banks and investment firms across the G10 countries provided detailed responses to the survey.