Trading Book vs Banking Book

Banks and financial institutions makes a distinction of their assets into the “trading book” and the “banking book” for capital management. The trading book records assets intended for active trading, such as market making and proprietary trading in bonds and derivatives. The banking book records assets intended to be held to maturity — this would cover lending to individuals as well as corporates and other banks.

Below is sample balance sheet of the bank highlighting this distinction

Financial institute’s trading book contains assets intended for active trading (e.g.: Fixed income, standardized derivatives) while banking book contains assets intended to be held to maturity (e.g.: loans). Derivatives that are used to hedge exposures arising from the banking book activity, are considered part of banking book.

Trading books are usually managed by desks in bank with trading and risk mandate, allowing it to be exposed to financial risks while buying, selling, owning and quoting prices on securities. Banking books are usually managed by the treasury department and supervised by the Asset and liability Management (ALM) committee.

Trading book assets are required under regulations (e.g.: Basel) to marked to market on a daily basis. Banking book assets are not required to be marked to market and assets are usually held at historical cost.

Trading books are often affected with market risk and hence in purview of regulatory rules governing the capital requirements that banks must hold against market risk exposures => higher regulatory risk reserve/capital requirements. Banking books are largely affected with credit and refinancing risk. For regulatory and accounting purposes, the banking book has minimal interest rate risk => relatively lower regulatory risk reserve/capital requirements.

Since the capital reserve requirements for trading book is greater than those of banking book, there is an inherent regulatory arbitrage in this structure. Basel rules allow banks to use internal models to measure market risks in the trading book. Before global financial crisis in 2007–09, many securitized credit instruments (e.g.: CDO tranches) in trading book were subject to lower capital requirements — hence FRTB (Fundamental Review of the Trading Book) regulations sets a more rigorous approval process for banks to use their own models for calculating capital (Internal Model Approach) or else use a rather more broad-based standardized model approach (SMA) to calculate capital under FRTB. Banks are strictly prohibited from re-allocating an instrument in the trading book into the banking book for regulatory arbitrage benefits. If such a switch happens after supervisor approval, the difference in capital will be recorded as additional capital surcharge.