The attribution of capital to foreign banking permanent establishments in the UK: The approach in determining an adjustment to funding costs - STEP 2: Risk weighting the assets: risk in the trading book
Where a bank has a trading book over a specified size it needs to meet the trading book capital requirements of the Capital Adequacy Directive (CAD) and its subsequent amendment - see INTM267701.
The framework, which applies to the trading book, takes into account market risk and counter party risk (additional capital can also be required for large exposures, as in the banking book). The definition of a bank’s trading book and the threshold for applying the CAD trading book requirements are covered in chapter CB in the Interim Prudential Source Book for Banks (IPRU (BANK)). Where the CAD trading book requirements do apply a bank should split its business between trading and banking books.
Counter party risk
In general, counter party risk is only present in the trading book on deals that are not finally settled. By their nature, derivative contracts involve a delay between the transaction date and some future maturity date. The time delay creates two types of risk for a bank:
- market risk - the risk that the market price will move against the bank so that when the position matures it will make a loss, and
- counterparty risk - the risk that the price will move in the bank’s favour, so that it makes a book profit, but that at maturity it cannot realise that profit because the other party defaults
Details of when capital should be assigned to counter party risk are set out in IPRU (BANK).
Whilst credit risk or counter party risk can feature in the CAD trading book requirements these requirements focus primarily on market risk. The standard treatment of trading book capital requirements for market risk can include calculations under five separate headings:
- foreign exchange position risk
- commodity position risk
- equity position risk
- interest rate position risk
- large exposure risk
Further details of these calculations can be found in the relevant chapters of IPRU (BANK).
A bank can calculate the amount of capital that it needs to cover market risk using different models. These may be based on the standard approach set out in the Financial Services Authority (FSA) source book or can be based on internal models, which produce a measure of the value at risk. A value at risk measure provides an estimate of the worst expected loss on a portfolio resulting from market movements over a period of time. UK regulated banks can use internal models in the calculation of market risk where they have been approved/recognised by the FSA. Further guidance on the use of such models in the calculation of the capital attribution tax adjustment is at INTM267721.