Fundamental review of the trading book: outstanding issues - consultative document

December 2014

The Basel Committee on Banking Supervision has today issued a consultative paper on outstanding issues for its fundamental review of the trading book capital standards. In undertaking its review, the Committee's goal is to improve trading book capital requirements and to promote consistent implementation of the rules so that they produce comparable levels of capital across jurisdictions.

Today's consultative paper sets out a limited set of revisions to the Basel Committee's proposed market risk framework, which was published in October 2013. That second consultative proposal put forward a revised market risk framework to address weaknesses in risk measurement under the current framework's internal models-based and standardised approaches.

The Committee has reviewed the comments received on the second consultative paper, including feedback provided in the course of a hypothetical portfolio exercise as well as the results of a comprehensive Quantitative Impact Study (QIS) that was conducted to assess the proposed trading book framework. In particular, the Committee notes the concerns expressed about the implementation challenges posed by certain elements of the new framework.

To address these challenges, the consultative paper published today outlines several refinements in three broad areas:

  • A specified treatment of internal risk transfers (IRTs) of equity risk and interest rate risk between the banking book and the trading book, to supplement the existing treatment of internal transfers of credit risk. IRTs allow banks to focus their derivative hedging activity in the trading book, which may be better suited to execute trades efficiently, as well as to monitor counterparty limits, thereby contributing to better risk management of the bank. At the same time, IRTs, if not appropriately constrained, could provide banks with a mechanism to shift risk between the banking book and trading book so as to take advantage of lower capital requirements in one or the other, creating incentives for capital arbitrage. The Committee's proposal seeks to balance the objectives of a less permeable boundary between the banking book and the trading book; efficiency in risk management practices; and the need for consistent and transparent implementation of the revised boundary across jurisdictions.
  • A revised standardised approach that uses as inputs changes in the value of an instrument based on sensitivity to underlying risk factors. This sensitivity-based approach will enable banks to overcome IT system constraints associated with using cash flows as inputs. The updated approach will also allow for a more granular treatment of market risk factors, thus strengthening the standardised approach as a functional fallback or floor for the internal models approach.
  • A simpler method for incorporating the concept of liquidity horizons in the internal models approach. Liquidity horizons are the time required to execute transactions that extinguish an exposure to a risk factor, without moving the price of the hedging instruments, in stressed market conditions. Refinements have been made to reduce modelling complexity and data revalidation costs associated with incorporating the risk of varying market liquidity into the expected shortfall model.

Comments on these proposals should be uploaded by Friday 20 February 2015. All comments may be published on the website of the Bank for International Settlements unless a respondent requests confidential treatment.