In our first article, we saw that a porous boundary between the trading book and the banking book was one of the structural weaknesses regulators pointed to after the 2008 crisis. Banks could hold the same instrument in either book depending on their stated intent, and shifting positions toward whichever book carried a lighter capital charge became a known form of arbitrage. It is fitting, then, that RBC25 — the boundary chapter — is the very first chapter of the FRTB standard, before a single formula appears.
This classification decision is not a technicality. An instrument in the trading book is capitalised under the market risk framework we are building through this series — the Sensitivities-Based Method, Default Risk Charge, and Residual Risk Add-On. The same instrument in the banking book is capitalised under an entirely different regime: credit risk capital rules. Get the classification wrong, and the capital number attached to a position can be wrong by a wide margin. This article works through exactly how the standard decides where an instrument belongs, and how tightly it restricts a bank’s ability to change its mind later.
What Counts as an “Instrument” in the First Place
The standard defines the trading book as consisting of all instruments that meet its specified trading book criteria — everything else defaults to the banking book. “Instruments” here is a deliberately broad term: it covers financial instruments (both cash instruments and derivatives), foreign exchange, and commodities. Commodities are defined broadly enough to include intangible goods such as electric power, not just physical stockpiles.
Two conditions apply before anything can even be considered for the trading book. First, a bank may only include a financial instrument, FX position, or commodity in the trading book when there is no legal impediment against selling or fully hedging it. Second, every trading book instrument must be fair-valued daily, with valuation changes flowing through the profit and loss account — the mark-to-market discipline that distinguishes trading book treatment from the accrual-based world of the banking book.
The Core Test: Why Was the Position Taken?
At the heart of the boundary is a test of intent, applied at initial recognition. Any instrument held for one or more of four purposes must be designated as a trading book instrument when it is first recognised on the bank’s books.
| # | Qualifying Purpose (RBC25.5) |
| 1 | Short-term resale |
| 2 | Profiting from short-term price movements |
| 3 | Locking in arbitrage profits |
| 4 | Hedging risks arising from instruments meeting purposes 1, 2 or 3 |
Any instrument that does not meet one of these four purposes at inception, and is not otherwise deemed to be held for these purposes under the mandatory list below, must be assigned to the banking book. There is no middle ground — every instrument lands in one book or the other.
Sourced from RBC25.1–RBC25.7. https://www.bis.org/bcbs/publ/d457.htm
The Mandatory Trading Book List
Three categories of instrument are automatically deemed to be held for a qualifying trading purpose, and must be included in the trading book regardless of the bank’s stated intent:
- Instruments in the correlation trading portfolio (CTP).
- Instruments that would give rise to a net short credit or equity position in the banking book — meaning the present value of the banking book would increase if an equity price fell, or if a credit spread on an issuer widened.
- Instruments resulting from underwriting commitments, limited specifically to securities underwriting where the securities are expected to actually be purchased by the bank on the settlement date.
Sourced from RBC25.6, including its footnote defining a net short position.
The Mandatory Banking Book List
In the opposite direction, eight categories of instrument must be assigned to the banking book, no matter what purpose the bank claims to be holding them for. This list exists precisely to close off the kind of intent-based gaming that caused problems before the crisis.
| Category | Detail |
| Unlisted equities | No public market, harder to fair-value reliably on a daily basis. |
| Securitisation warehousing | Instruments designated for warehousing ahead of a securitisation. |
| Real estate holdings | Direct holdings of real estate and derivatives on direct holdings. |
| Retail and SME credit | Retail and small/medium-sized enterprise credit exposures. |
| Fund equity investments | Banking book by default, unless the bank can look through to the fund’s components with verified, frequent information, or obtains daily price quotes plus access to the fund’s mandate. |
| Hedge funds | Investments in hedge funds. |
| Derivatives/funds on the above | Derivative instruments and funds whose underlying assets are any of the categories above. |
| Hedges of the above | Instruments held to hedge a particular risk of a position in any of the categories above. |
Sourced from RBC25.8, condensed for readability — see the source document for the full conditions on fund look-through treatment.
The Presumptive List: Guilty Until Proven Innocent
Between the two mandatory lists sits a presumptive list — instruments that are assumed to be held for a qualifying trading purpose, and therefore presumed to belong in the trading book, unless the bank successfully argues otherwise to its supervisor.
- Instruments held as accounting trading assets or liabilities.
- Instruments resulting from market-making activities.
- Equity investments in a fund, excluding those already assigned to the banking book under the mandatory list above.
- Listed equities (though certain listed equities, such as those tied to deferred compensation plans, may be excluded from the market risk framework subject to supervisory review).
- Trading-related repo-style transactions.
- Options, including embedded derivatives, from instruments the bank itself issued out of its own banking book that relate to credit or equity risk.
A bank that believes an instrument on this presumptive list genuinely does not belong in the trading book cannot simply reclassify it. It must submit a request to its supervisor, with evidence that the instrument is not held for any of the four qualifying purposes, and receive explicit approval. If approval is not given, the instrument stays in the trading book by default, and every deviation from the presumptive list must be documented on an ongoing basis.
The supervisor’s power runs in both directions. Even for an instrument the bank has already classified, a supervisor can demand evidence that a trading book instrument is genuinely held for a qualifying purpose (and reassign it to the banking book if unconvinced), and equally can demand evidence that a banking book instrument is not being used for trading purposes (and reassign it to the trading book if unconvinced) — except, in each case, where the instrument appears on one of the two mandatory lists above.
Sourced from RBC25.9–RBC25.12.
| The Documentation Discipline Behind Every Classification Getting the classification right on day one is not enough. The standard requires banks to maintain clearly defined policies, procedures, and documented practices for deciding which instruments sit in which book — taking into account the bank’s own risk management capabilities. The bank’s internal control functions must continuously evaluate instruments in both books to check they remain properly designated, this compliance must be fully documented, and it is subject to periodic internal audit at least once a year, with results available for supervisory review. |
Sourced from RBC25.13.
Why You Can’t Just Move Positions Between Books
Outside of the moves required by the classification rules above, the standard places a strict limit on a bank’s discretion to reassign instruments between books after initial designation. Switching instruments for regulatory arbitrage is explicitly and strictly prohibited. In practice, switching is meant to be rare, permitted only in extraordinary circumstances — the standard gives examples such as a publicly announced bank restructuring that permanently closes trading desks, or a change in accounting standards that newly allows an item to be fair-valued through P&L.
Crucially, the standard is explicit about what does not qualify as a valid reason to switch: market events, changes in a financial instrument’s liquidity, or a change of trading intent alone are not acceptable grounds for reassignment, however genuine they may feel to the desk holding the position.
| “…a capital benefit as a result of switching will not be allowed in any case…” — Basel Committee on Banking Supervision, Minimum Capital Requirements for Market Risk, RBC25.15 |
This is enforced mechanically, not just as a principle. A bank must calculate its total capital requirement — across both the banking book and trading book — immediately before and immediately after any switch. If the switch reduces that combined capital requirement, the difference is imposed on the bank as a disclosed Pillar 1 capital surcharge, calculated at the time of the switch. The surcharge is allowed to run off only as the underlying positions mature or expire, in a manner agreed with the supervisor — it is not recalculated on an ongoing basis, but the positions remain subject to whichever book’s normal capital requirements they were switched into.
Any reassignment also requires senior management approval, thorough documentation, an internal review confirming compliance with the bank’s own policies, prior supervisor approval based on supporting documentation, and public disclosure. Outright sales of securities at arm’s length between the two books count as a reassignment for these purposes too. Once approved, a reassignment is generally irrevocable unless the underlying characteristics of the position change. One narrow exception exists: if an instrument is reclassified as an accounting trading asset or liability, it is presumed to belong in the trading book under the presumptive list, and an automatic switch without separate supervisor approval is acceptable in that specific case.
Sourced from RBC25.14–RBC25.16.
The Annual Policy Requirement
Banks must adopt formal policies covering the entire boundary framework, and these policies must be reviewed and updated at least yearly, based on an analysis of any extraordinary events identified during the previous year. Updated policies, with changes clearly highlighted, must be sent to the relevant supervisor. At a minimum, these policies must cover:
- The reassignment restrictions above, including the extraordinary-circumstances requirement and a description of the specific circumstances or criteria under which a switch might be considered.
- The process for obtaining senior management and supervisory approval for a transfer.
- How the bank identifies what counts as an extraordinary event.
- A requirement that any reassignment into or out of the trading book be publicly disclosed at the earliest reporting date.
Sourced from RBC25.17.
Putting the Rules Together: Two Quick Scenarios
| Illustrative Scenario (Not From the Source Document) Scenario A: A bank buys a corporate bond intending to resell it within days to capture a short-term price move. This falls squarely under purpose 2 of RBC25.5 (profiting from short-term price movements), so it must be designated to the trading book at inception. Scenario B: The same bank takes an unlisted equity stake in a private company as a long-term strategic holding. Regardless of the bank’s intent, RBC25.8 mandates unlisted equities to the banking book — there is no presumptive test to argue around here; it is an absolute rule. These two scenarios illustrate the difference between the intent-based test (RBC25.5, open to interpretation and supervisory challenge) and the mandatory lists (RBC25.6 and RBC25.8, which override intent entirely). |
This illustrative pairing is composed by us to clarify the rule interaction — the specific bond/equity example is not contained in the source document.
Looking Ahead
RBC25 does not stop at classification. Once an instrument sits in a particular book, banks sometimes want to transfer the economic risk of a banking book position into the trading book for hedging purposes, using what the standard calls an internal risk transfer — without physically moving the instrument itself. That mechanism comes with its own strict conditions, and it is dense enough to deserve its own article next.
Frequently Asked Questions
What is the difference between the trading book and the banking book?
The trading book holds instruments a bank intends to trade short-term, profit from price movements on, arbitrage, or hedge such positions with — capitalised under market risk rules. The banking book holds everything else, including mandatory items like unlisted equities and retail credit, capitalised under credit risk rules.
Can a bank freely move an instrument into the trading book to reduce capital?
No. Switching for regulatory arbitrage is strictly prohibited, is permitted only in extraordinary circumstances such as a restructuring or accounting standard change, and any capital reduction from a switch triggers a Pillar 1 surcharge equal to the difference.
What is the presumptive list?
A list of instrument types — such as market-making positions and listed equities — that are presumed to belong in the trading book unless the bank obtains explicit supervisor approval to classify them otherwise.
Are there instruments that must always be in the banking book?
Yes. Eight categories, including unlisted equities, retail and SME credit, real estate holdings, and hedge fund investments, must be assigned to the banking book regardless of the bank’s stated trading intent.
https://decode-finance.com/category/market-risk-credit-risk-and-operational-risks