Wednesday, May 23, 2012

The difference between the trading and banking book

What is the difference between the trading book and the banking book of a bank?

The trading book is an accounting term that refers to assets held by a bank that are regularly traded. The trading book is required under Basel II and III to be marked to market daily. The value-at-risk for assets in the trading book is measured on a ten-day time horizont under Basel II.

The banking book is also an accounting term that refers to assets on a bank's balance sheet that are expected to be held to maturity. Banks are not required to mark these to market. Unless there is reason to believe that the conter-party will default on its obligation, they are held at historical cost.

If a client wishes to sell debt securities to a bank instead of taking a loan, the asset will now be assigned to the trading book instead. The bank will then keep specific risk capital for the securities as well as market risk capital.

The main differences are:
1. Assets that are held for trading are put in the trading book, assets that are held to maturity are held in the banking book
2. Assets in the trading book are marked-to-market daily, assets in the banking book are held at historic cost
3. The value-at-risk for assets in the trading book is calculated at a 99% confidence level based on a 10-day time horizon. The value-at-risk for assets in the banking book are calculated at a 99.9% confidence level on a one-year horizon.

Number three was amended in 2009 by the Basel committee when it was recognized that banks would incur a lower risk charge by holding assets in the trading book rather than in the banking book. It was also recognized that the losses incurred in 2008 was the results of widening spreads due to credit downgrades, loss of liquidity and widening credit spreads, and not the result of defaults. 

An incremental risk charge (IRC) was agreed upon in 2009 to account for this. The IRC requires banks to calculate a one-year 99.9% value-at-risk measure for credit-sensitive products in the trading book, and also to account for the risk of credit downgrades.

Sources: 
"Risk Management and Financial Institutions" (John Hull)
Summary of the book

"Guidelines for Computing Capital for Incremental Risk in the Trading Book" (Base Committee on Banking SupervisionJuly 2009)

73 comments:

Anonymous said...

Thanks a lot for the clear writing.

FS said...

this is actually very clear and easy to understand. thx

Anonymous said...

Very precise and informative.. thks

Anonymous said...

Thank you! Beautifully done!

Anonymous said...

This was exactly what I needed

Anonymous said...

Thank you for the blog. Concise yet useful information

Anonymous said...

excellent descriptions, thank you for the clarity

Unknown said...

Thank you. Clear and useful .

Unknown said...

Crystal clear explanation

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Anonymous said...

Thank you so much.

composer07 said...

Thanks a lot for clear explanation !

Anonymous said...

Thanks for the clear explanation

Anonymous said...

very clear, thanks

Anonymous said...

1)trading book = MTM = Reg VaR @99% 10d = use for capital charge/ RWA.
2)banking book = cost or MTM = Reg VaR @99% 1Y ? = use for capital charge/ RWA?

2. Is my confusion..what measure are use for banking book capital charges? also VaR?

Anonymous said...

I would like to know wether intraday spot deals done to hedge the NOP, but also generates profit, should be reported under the banking book or the trading book

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