Banks’ trading activities can carry a substantial part of their total risk and be a channel of contagion in bank crises. A keen understanding of what’s in trading books and of how to wind them down post resolution while staying solvent is key for a healthy and resilient banking sector.
Drawing the lessons from past financial crises
The global financial crisis stressed vulnerabilities in banks’ practices of trading books risk management. Complex and interlinked positions held in large derivative and trading portfolios hid substantial underlying market and liquidity risks. Trading books also acted as a significant contagion channel, as global footprint of these activities exacerbated the diffusion of the financial crisis across continents.
Why a keen understanding of trading books makes resolution stronger
In times of market stress, contagion can materialise quickly with a very substantial impact from a liquidity perspective. Against this risk, the planning of a solvent wind down (SWD) strategy can provide a timely release of liquidity and capital (via risk weighted assets reduction) to restore banks’ viability and trust. It is equally important to avoid a winding down of trading books through an overly extended period. Past cases have shown that the lack of SWD planning can lead to a long and costly wind down of trading books post-resolution.
To address these risks, and following up on work initiated at the level of the Financial Stability Board through a public consultation in 2019, the SRB introduced its operational guidance on the “solvent wind-down of trading books” in December 2021. Our guidance provides a framework for banks with material trading books in developing operational capabilities to wind down trading portfolios in an orderly manner should they be facing troubles under a recovery option or should they fail, without posing risks to financial stability.
The SRB decided to extend its guidance to all banks holding either relatively sizeable or complex trading books that could impede the implementation of their resolution strategy. While not all banks under the SRB’s remit engage in significant trading activities, for a sub-set of banks trading assets represent about one-fifth of their total assets and in a few cases, more than one quarter. On average, the share of derivatives among trading assets nears 50 percent. More often than not, the complexity, interdependencies and the stickiness of certain trades require a keen understanding and monitoring of how they could evolve in time of crisis, in good cooperation with supervisory authorities.
In its operational guidance, the SRB requests banks to plan their strategy via the elaboration of a playbook to execute a solvent wind-down to prevent any disorderly close-out, and to update it regularly. A carefully planned wind down makes a bank’s business reorganisation after resolution more credible as the entailed deleveraging not only converts less liquid trading assets into cash but also reduces regulatory capital needs going forward. In a similar vein, a well-planned wind down is also key for the successful sale of a bank in crisis (one of the resolution tools at our disposal), as no one would want to buy a troubled bank with a large and opaque trading portfolio. ...
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