In the never-ending world of regulatory reform, even the rollbacks of unpopular rules can have unintended consequences, particularly as they bump up against other rules in the process of being formulated. Such is the case between the proposed revisions to the Volcker Rule (VR) and the often-delayed Fundamental Review of the Trading Book (FRTB). The implications of these two developments are buried in the voluminous texts, but they are real nonetheless.
Some Basic Concepts
The two rules take a very different approach to the same perceived issue, the regulation and management of trading risk by banks. The VR, a US-based rule, prohibits trading by banks, except under certain specific and verifiable exemptions. The FRTB, a global rule, focuses on the capital requirements for carrying trading positions (the trading book), but not for carrying other positions (the banking book). As a result, the boundary line between trading books and other books becomes a big deal for both rules, and is our first point of reference.
The FRTB Approach
In the 2016 version, FRTB approaches this boundary on an instrument basis – saying, A trading book consists of all instruments that meet the specifications in the list it provides. It defines a financial instrument as any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity.
But then it complicates things by saying, Any instrument a bank holds for one or more of the following purposes must be designated as a trading book instrument:
(a) short-term resale;
(b) profiting from short-term price movements;
(c) locking in arbitrage profits;
(d) hedging risks that arise from instruments meeting criteria (a), (b) or (c) above.
In other words, any instrument not on the original list can be considered part of the trading book, based on the banks motivation in taking the position. So, after starting out admirably by providing a black-and-white definition, FRTB introduces a varying-shades-of-gray approach which has been shown in the past to lead to confusion.
Then the 2018 FRTB update says, The Committee has identified that in some cases financial instruments can be both in the list of instruments that must be in a particular book, and in the list that are expected to be in the other book. In these cases, it may not be clear which requirement takes precedence. As a clarification, it says, banks may assign to the trading book funds: (i) for which daily price quotes are available; (ii) which track a non-leveraged benchmark; and (iii) which demonstrate a tracking difference, ignoring fees and commissions, for which the absolute value is less than 1%. Given that a bank would always rather assign a position to the banking book, Im not sure what the term may means or accomplishes.
The VR Approach
The original VR (Section 13 of the Bank Holding Company Act) expressly prohibits banks from engaging in any proprietary trading – with these exemptions (among others):
- Trading in certain government obligations;
- Underwriting and market making-related activities;
- Risk-mitigating hedging activity; and
- Trading on behalf of customers.
Thus the VR doesnt have the concept of a trading or banking book, and focuses instead on exemptions to an overall prohibition against proprietary trading by banks.
In the current proposed revision, the Agencies are proposing to tailor the application of the rule based on the size and scope of a banking entitys trading activities… [T]he Agencies also seek to streamline and clarify … certain definitions and requirements related to the proprietary trading prohibition, [and] to reduce metrics reporting, recordkeeping, and compliance program requirements for all banking entities and expand tailoring to make the scale of compliance activity required by the rule commensurate with a banking entitys size and level of trading activity.
Getting Into the Details
The part of the VR revision that has garnered the most attention says:
Under the proposal, each trading desk that operates under the presumption of compliance with the prohibition on proprietary trading would be required to determine on a daily basis the absolute value of its net realized and unrealized gains or losses on its portfolio …The sum of the absolute values of gains or losses for each trading date in any 90-calendar-day period is the trading desks 90-calendar-day absolute P&L. If this value exceeds $25 million at any point, then the banking entity would be required to notify the appropriate Agency that it has exceeded the threshold in accordance with the Agencys notification policies and procedures.
So marking non-trading portfolios to market becomes a very significant VR requirement. However, since the trigger point of $25 million P&L is measured at the trading desk level, encompassing all positions that the desk carries, there may be an incentive to fragment the trading desks such that the trigger point would be very hard to reach. What is not known is whether breaching the new VR trigger would also cause those positions to be deemed part of the trading book for FRTB purposes.
However, the detailed relationship between these two regulations really comes into focus when banks try to grow their business. Growing the business today almost always means innovation in the financial markets. Whether it is acting as an authorized participant (AP) in the ETF space, creating new structured notes for high net worth clients, or building risk hedging programs for corporate customers, the future of banking, for the big ones at least, is all about venturing into uncharted territory.
And uncharted territory is the place where both VR and FRTB fall down. For example, it is impossible to generate the 24 required trade/quote observations needed to qualify for the internal model approach (IMA) under FRTB if instrument hasnt existed before today. I asked the Basel Committee on Banking Supervision (BCBS), the administrator of FRTB, if this meant that every bank would have to use the standardized approach (SA) on any new product until they had 24 pricing observations, but I havent heard back yet.
For the VR, the new product dilemma revolves around the $25 million P&L trigger for these new products. Since this is an aggregate measurement for the trading desk, it means that any business growth strategy must be calibrated so that the individual trading desk doesnt show a profit larger than the trigger amount. Lets imagine a bank developing a new product which is both popular and profitable. As the desks volume of business grows, it continually faces a dilemma. Do we curtail the growth of a popular product so as to avoid the trigger, or split the desks so as to keep the P&L volume down, or offload enough positions as we create them to keep the 90-day P&L below the trigger? What would any of these actions mean for the FRTB trading/banking book determination?
Negotiating the Shoals
For banks that are subject to both the VR and FRTB, staying safe means negotiating the shoals in some uncharted waters. That requires keeping a sharp lookout in the following areas:
- For FRTB, how do you demonstrate the motivations for taking positions? Since the FRTB allows positions in the banking book to be reclassified if the motivation was for such things as short-term resale, banks will need to make sure that they dont have too much turnover in those books. If, at the same time, banks are trying to stay under the VR P&L trigger by offloading profitable positions, they could very much be between a rock and a hard place.
- Does using the FRTB SA or IMA automatically trigger the VR? If a bank is required to subject a position to the capital requirements under FRTB, does that automatically mean it is a proprietary position under the VR? If so, which exemption will apply? Will they have to determine RENTD before the fact, if it is a market-making position? Will they have to have all their hedging homework done ahead of the trade, if it is a hedging position? If they move the position offshore, does the VR go away?
- For FRTB, can banks use the IMA for new instruments? Given that the SA is always more penal than the IMA, the profitability, and thus the attractiveness, of new products will be significantly impacted by the answer to this question. Already we are seeing banks starting to model their new product strategies around the SA/IMA question.
As we appear ready to enter a new era of higher interest rates, and, in all probability, more volatility in most markets, banks will have to incorporate both FRTB and the VR into their market strategies. Keeping the two regulations from banging into each other just adds another level of complexity to the management puzzle.
George Bollenbacher is Partner, Head of the Market Evolution Practice at Capital Markets Advisors
