The trading assets and liabilities of a firm are maintained in a book that is defined
as a trading book or as a banking book. The distinction between the two is quite
important for regulatory reporting requirements and accounting treatment. The
trading books should be marked to market allowing regulatory capital calculations
to be based more on market risks. The banking book is based on accrual accounting
and capital calculations are based more on counterparty credit risk.
Ω Trading books contain short-term assets, customer and bank trades and the
securities portfolio for trading, hedging and resale. The trading book typically
contains marketable assets that are required to be marked to market or marked
to model. The key risks in the trading book are market events and are addressed
by the Market Risk Amendment. Profits from the assets maintained in the trading
book are expected to be generated from the difference between the buying and
selling prices. Regulatory capital is based mostly on market factors.
Ω Banking books generally include the deposits, loans and the investment portfolio.
These assets are usually considered to be held to term and the main component
of risk is due to default or credit risk for the counterparty. They typically contain
mortgages, personal loans and a portfolio of proprietary securities in stocks and
bonds. As these assets are not expected to be sold in the short term, it is thought
that the PnL derived from the marked to market or marked to model of these
assets does not present a clear picture of the actual PnL and risks reflected by
the strategies. These assets are typically maintained using accrual accounting
practices and are not marked to market or marked to model. Regulatory capital
is based on default risk, that is, counterparty credit risk.
Price testing the banking books may be viewed as a ‘nice to have’ compared to the
absolute requirements of the trading books. As the banking book is not marked to
market, and positions may not be actively managed for changes in market conditions,
then one may question the purpose of price testing these books, which is for control
and management reporting. Price testing the banking book makes sure that there
are no large landmine losses hidden in the accrual-based banking book. Management
should be aware of the value of positions that are maintained on these books that
have significantly changed since they were booked. This can be due to market
movements or to changes in counterparty credit profiles. Additional challenges in
the banking book arise as it is the place where illiquid positions are booked and it
may be extremely difficult to obtain valid prices for these. However, quantifying and
reporting the number of these positions does have added value in an organization
and lends itself to best practices.
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