Part A of this mini-series established the basics: an internal risk transfer is just an internal record of moving risk, and moving risk from the trading book to the banking book never earns capital recognition. This part covers the reverse and more interesting direction — a bank hedging a banking book credit or equity exposure using its trading book — and the precise test that decides whether that hedge actually reduces the bank’s capital requirement.
The Setup: Hedging a Banking Book Exposure Through the Trading Book
Picture a bank holding a loan or bond in its banking book that carries credit risk, or an equity stake in its banking book. The bank wants to hedge that risk, and it does so by having its trading book purchase a hedging instrument. Internally, this is recorded as an internal risk transfer from the banking book to the trading book. The question the standard answers is: under what conditions does this internal arrangement actually reduce the bank’s capital requirement, rather than just being an internal bookkeeping entry?
Sourced from RBC25.21 (introductory text).
The Exact-Matching Test
The banking book exposure is only deemed hedged for capital purposes if both of the following conditions are true, and the standard treats credit risk and equity risk slightly differently on the second condition.
| Condition | Credit Risk Exposure | Equity Risk Exposure |
| 1. External hedge exists | The trading book must enter into an external hedge with an eligible third-party protection provider that exactly matches the internal risk transfer. | The trading book must enter into an external hedge from an eligible third-party protection provider that exactly matches the internal risk transfer. |
| 2. Hedge qualifies | The external hedge must meet the requirements of paragraphs 191 to 194 of the Basel II standard, as they apply to the banking book exposure. | The external hedge must be recognised as a hedge of a banking book equity exposure. |
In plain terms: an internal record alone is never enough. The trading book must genuinely go out and transact with a real, eligible external counterparty, and that external hedge must line up exactly with what the internal risk transfer claims to be hedging. The external hedge is allowed to be built from multiple transactions with multiple counterparties, as long as the combined, aggregate external hedge exactly matches the internal risk transfer, and the internal risk transfer in turn exactly matches that aggregate external hedge — the matching has to work in both directions, transaction for transaction.
Sourced from RBC25.21(1)–(3).
| A Technical Footnote Worth Knowing Basel II paragraph 192 caps recognition of a credit derivative without a restructuring obligation at 60% of the position it is hedging. The source document clarifies that this 60% cap only limits how much credit risk mitigation the banking book instrument can claim for regulatory capital purposes — it does not cap the size of the internal risk transfer itself. The internal risk transfer and the external hedge can still be sized to exactly match each other; the 60% ceiling is a separate, banking-book-side constraint on recognition. |
Sourced from RBC25.21, footnote 7.
Two Outcomes: Matched or Not Matched
Everything downstream depends on whether the exact-matching test above is satisfied. The standard sets out two clean, opposite outcomes.
Outcome 1: The Conditions Are Fulfilled
If the exact-matching test is met, the banking book exposure is deemed to be hedged by the banking book leg of the internal risk transfer, for capital purposes within the banking book. At the same time, both legs on the trading book side — the trading book leg of the internal risk transfer and the external hedge itself — must be included in the market risk capital requirement calculation.
| Why Both Legs Get Counted on the Trading Book Side This can look like double-counting at first glance, but it isn’t. The trading book desk is genuinely holding two separate risk positions: the internal leg (representing the risk taken on from the banking book) and the external hedge (the real market transaction it entered into to offset that risk). Because these two legs are required to exactly match, they largely offset each other within the trading book’s own market risk capital calculation. Counting both simply ensures the trading book’s own sensitivities-based capital calculation reflects its true, complete position. |
Sourced from RBC25.22.
Outcome 2: The Conditions Are Not Fulfilled
If the exact-matching test is not met, the outcome flips entirely. The banking book exposure is not deemed hedged for banking book capital purposes — meaning the banking book continues to hold capital against that exposure as if no hedge existed. On the trading book side, the external hedge must be fully included in the market risk capital requirement, while the trading book leg of the internal risk transfer must be fully excluded from the market risk capital requirement.
In other words, an internal risk transfer that fails the matching test is simply disregarded for capital purposes. Only the real, external hedge is capitalised — as a standalone trading book position with no offset, since the internal leg it was supposed to offset against does not count.
Sourced from RBC25.23.
| If Matched (RBC25.22) | If Not Matched (RBC25.23) | |
| Banking book exposure | Deemed hedged | Not deemed hedged — capitalised as if unhedged |
| Trading book: internal risk transfer leg | Included in market risk capital | Fully excluded from market risk capital |
| Trading book: external hedge | Included in market risk capital | Fully included in market risk capital |
What Happens When a Bank Over-Hedges
There is one more scenario the standard addresses directly: what if an internal risk transfer ends up over-hedging the banking book position? This creates what the standard calls a banking book short credit position or a banking book short equity position — because the banking book instruments are over-hedged relative to their documented internal risk transfer, the excess hedge effectively creates a short risk position sitting in the banking book.
Where such a short position is not otherwise capitalised under the banking book’s own rules, it must be capitalised under the market risk rules, alongside the related trading book exposure. This closes a potential gap: a bank cannot use over-hedging through an internal risk transfer to create a short risk position that ends up falling through the cracks between the banking book and market risk frameworks.
Sourced from RBC25.24, including footnote 8. https://www.bis.org/bcbs/publ/d457.htm
Looking Ahead
This exact-matching framework covers credit and equity risk. Interest rate risk — general interest rate risk, or GIRR — is treated differently again, built around the idea of a dedicated, supervisor-approved internal risk transfer desk rather than a transaction-by-transaction matching test. That is the subject of Part C.
Frequently Asked Questions
Can a bank hedge a banking book credit exposure using only an internal record?
No. An internal risk transfer alone is never sufficient. The trading book must also enter into a real external hedge with an eligible third-party protection provider that exactly matches the internal risk transfer.
What happens if the external hedge does not exactly match the internal risk transfer?
The banking book exposure is treated as unhedged for capital purposes, the external hedge is fully capitalised in the trading book, and the internal risk transfer leg is excluded entirely from market risk capital.
Does the 60% cap on credit derivatives limit the size of an internal risk transfer?
No. That cap, from Basel II paragraph 192, only limits how much credit risk mitigation the banking book can claim for capital purposes. It does not cap the size of the internal risk transfer itself.
What happens if a bank over-hedges a banking book position through an internal risk transfer?
The excess creates a short credit or equity position in the banking book. If that short position is not capitalised under the banking book’s own rules, it must be capitalised under market risk rules together with the related trading book exposure.
https://decode-finance.com/category/market-risk-credit-risk-and-operational-risks