Question

"Banks are typically exposed to interest rate risk in both their trading book and banking book."

Define banks' trading book and banking book, and explain the above statement in approximately 200 words.

Answer 1

Answer: Banks are exposed to many risks, interest rate risk is one of them. Interest rate risk occurs due to fluctuations in interest rates. Change in interest rates has impact on net interest income of banks. Nature of interest rate risk is different in trading book and banking book.

Banks' trading book- This book has the assets, held by bank that are ready to be sold and traded daily. Assets in trading book are bought and sold frequently. These are important for marked to market basis. In trading book, Value at risk (VaR) is measured on a 10 day time under Basel 2. Basel Committee on banking supervision (BCBS) addresses IRR under the Fundamental review of the trading book (FRTB).

Bank's banking book- This book has the assets that are kept till maturity. These assets are held at the historical cost and are not important for marked to market basis. These consist deposits and loans of customers. It also includes derivatives to hedge the interest rate risk. BCBS addresses the loss from interest rate risk (IRR) and Credit spread risk (CSR) in the banking book.