How does the FRTB define the boundary between the trading book and banking book, and why does it matter for capital?

The Fundamental Review of the Trading Book (FRTB) was introduced in Basel III.1 (also called Basel IV by some) to address a critical weakness: under the old rules, banks could exploit the boundary between the trading book and banking book to minimize capital.

The Problem with the Old Boundary:

Under Basel II/II.5, banks had significant discretion to classify instruments as either trading book (subject to market risk capital) or banking book (subject to credit risk capital). Some banks placed assets in whichever book required less capital, a practice known as 'boundary arbitrage.'

For example, a corporate bond might receive lower capital treatment in the trading book during calm markets but be moved to the banking book when market volatility spiked.

FRTB's Solution — Strict Boundary Rules:

1. Presumptive Assignment — Instruments are assigned to books based on their nature, not the bank's intent:

• Trading book: Instruments held for short-term resale, market-making, or hedging of trading positions
• Banking book: Instruments held to maturity, loans, deposits, and illiquid positions

1. Specific Presumptions:

• All listed equity and short positions → Trading book
• All derivatives and options → Trading book (unless banking book hedges)
• Hold-to-maturity bonds → Banking book
• Loans originated by the bank → Banking book

1. Strict Transfer Restrictions — Moving an instrument between books requires senior management approval, regulatory notification, and may trigger a capital surcharge. The transfer cannot reduce overall capital requirements.

1. Internal Risk Transfer (IRT) — If the banking book hedges a risk by entering an internal trade with the trading desk, the trading desk must hedge externally for the capital benefit to be recognized. Circular internal hedging is eliminated.

Why the Boundary Matters for Capital:

Exam Tip: FRTB boundary questions test whether you can identify the correct book assignment for specific instruments and explain why boundary arbitrage was problematic under the old rules.

Master FRTB concepts in our FRM Part II study materials.