Distinguish a bank's banking book from its trading book.
The idea
The banking book holds loans, deposits and other positions the bank intends to hold to maturity. It is accounted for at amortised cost with loan-loss provisions, so price changes do not hit profit and loss at once. Its main exposures are credit risk and interest rate risk, managed through asset-liability management. The trading book holds positions taken for market making, short-term profit or hedging other trading positions. These are marked to market daily, gains and losses go straight to profit and loss, and capital is set against market risk, using VaR or expected shortfall. Intent and liquidity decide the allocation. Regulators restrict transfers between the books. A bank could otherwise hide a mark-to-market loss by moving a position to the book carried at cost, or pick the book with the lower capital charge, which is regulatory arbitrage. Exam point: the same bond can receive very different accounting and capital treatment depending on its book.
A practice question
Which position would normally be held in a bank's trading book?
- A portfolio of consumer loans originated to be held until repayment.Why not: Held-to-maturity loans belong to the banking book.
- Customer current accounts and term deposits.Why not: Deposit liabilities are banking book items.
- Fixed-rate loans to small businesses intended to be held to maturity.Why not: Hold-to-maturity loans are banking book items.
- Corporate bonds bought as inventory to make a market for clients. - correct
The trading book contains positions held for market making, short-term profit or hedging trading positions. Loans and deposits held in the ordinary course of banking are in the banking book.
A harder one
A bank holds a fixed-rate mortgage portfolio to maturity, funded by short-term deposits. Interest rates rise and the portfolio's market value falls. Which statement is correct?
- The fall is recognised immediately in profit and loss because all positions must be marked to market daily.Why not: Banking book assets are carried at amortised cost, not marked to market.
- The portfolio attracts a market-risk capital charge based on 10-day VaR, as for any interest-rate position.Why not: Held-to-maturity loans are not subject to the trading-book VaR charge.
- No immediate loss is recognised on the banking book, but net interest income falls as deposits reprice. - correct
- There is no effect on the bank, since loans held to maturity carry no interest rate risk at all.Why not: The repricing mismatch still compresses net interest income, so there is rate risk.
Interest rate risk in the banking book is an earnings and economic value risk: accounting shows no immediate loss, but funding costs rise while the loan yield is fixed.
The hardest tier
A bank has two identical USD 40 million bond positions with modified duration 4: one in the trading book and one in the banking book held to maturity. Yields rise by 100 basis points. Approximately, the profit and loss recognised immediately is:
- A loss of USD 1.6 million on each position, since economic value falls equally.Why not: The banking book position is not marked to market, so no immediate loss is reported.
- A loss of USD 1.6 million on the trading book and none immediately on the banking book. - correct
- A loss of USD 0.4 million on the trading book position and none on the banking book position.Why not: Applies 1% to the position and ignores the duration of 4.
- A gain of USD 1.6 million on the trading book position and none on the banking book position.Why not: Sign error: a rise in yields lowers bond prices.
Trading book loss = modified duration x yield change x value = 4 x 1% x 40 = 1.6 million, taken to profit and loss at once. The held-to-maturity position is at amortised cost; its economic loss is not reported immediately.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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