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

The trading book refers to assets held by a bank that are available for sale and hence regularly traded. ... The banking book refers to assets on a bank's balance sheet that are expected to be held to maturity. Banks are not required to mark these to market. They are usually held at historical cost.

Trading book(TB) contains trades that are done with Trading Intent (this is the Regulatory terminology which is translated into trading with the intention to make a profit). Everything else is banking book (BB), which includes:

• AFS (Available for Sale) and trades that are booked under Accrual method. All AFS and Accruals must be BB.
• Trades the bank uses to manage its own risk such as liquidity risk, capital risk - usually these are under Treasury however trading desks sometimes manage their own risks as well and book these hedging trades under banking book. These trades are also marked to market even though they are in BB.

To summarise, all TB must be marked to market (MTM). BB contains trades that are MTM and also AFS and Accruals.

The difference between MTM trades in TB and BB is whether they are traded with the intention to make a profit. TB is if the intention is profit. BB is if the intention is risk management.

Same formulae apply for interest calculation for both TB and BB.