Tackling trading book risk in resolution

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. 

Banks in scope have made tangible progress in meeting the SRB’s expectations

Two years after the publication of the SWD guidance, the SRB has taken stock of the progress realised so far.

In the two first years of application, global systemically important banks (G-SIBs) and some other banks were requested to submit the first iterations of their SWD plans and playbooks. The working group analysis shows that, on the whole, banks in scope are mostly compliant with the SWD policy and demonstrate a sound understanding of the SRB’s day-one expectations.

The largest lenders in the SRB remit, European G-SIBs, showed advanced capabilities in mapping relevant desks for trading, identifying internal and external interdependencies and associating exit strategies for the winding down of trading positions. Most G-SIBs consider that they could wind down at least 75 percent of their trading activities’ RWAs over the two-year period foreseen by the guidance post-resolution, which could offer a significant line of additional liquidity. This also improves the prospect of a swift recovery of the resolved bank, as it is capable of presenting a credible snapshot of its expected cleaned balance sheet post resolution. 

For other banks in scope, with total assets ranging from ca. EUR 100bn to 800bn, results are promising but also more heterogeneous. In a few cases, the banks’ operational capabilities are still insufficiently developed to meet the SRB’s expectations in terms of reporting and identifying the relevant scope of derivatives and trading positions to wind down. This translates into higher target rumps, which correspond to the “sticky” trades that the bank cannot dispose of due to their complexity, illiquidity, lack of attractiveness, costs or dependencies.

The case for continued vigilance and emerging risks 

While our analysis highlights the tangible progress made by banks in scope, there is still room for improvement, especially in light of their exposure to non-banking financial institutions (NBFIs), such as money market funds, insurance companies, hedge funds and private equity funds. In addition, as highlighted in the ECB’s latest financial stability reports[1], the exposure of Euro area banks to NBFIs remains elevated and highly relevant. Banks are therefore expected to also focus on the analysis of external dependencies and counterparties in order to assess the risk of contagion from non-bank financial institutions. Recent experiences have shown that these shocks can quickly materialise across institutions[2], calling for continued vigilance to better anticipate and avoid any underestimation of risk.

The SRB will follow up with banks to address some of the shortcomings identified in their SWD plans and playbooks with a view to meeting steady state expectations. This will include pursuing the efforts to enrich their plans and playbooks with complete and sufficiently granular information, especially for complex or legacy portfolios. In a similar vein, banks are expected to complement their analysis of operational and risk-related costs and estimates of liquidity impact as market factors can affect the fair value and profitability of the books and lead to substantially higher and more frequent margin calls. In the future, banks should also test the SWD steps to ensure their operational capabilities are effective and can be timely implemented, in line with SRB’s broader shift in focus to the testing and operationalisation of resolvability capabilities[3].