Module: | MODULE B: RISK MANAGEMENT
Q284: Scenario: A commercial bank holds a large portfolio of corporate bonds in its Trading Book (AFS category). Following a severe market shock, the bonds face an immediate downgrade and huge mark-to-market losses. To avoid the capital hit, the bank's management decides to quickly shift these bonds into the Held to Maturity (HTM) category of the Banking Book. Based on Basel FRTB and RBI regulations, consider the following statements regarding this action:
1. Banks are freely permitted to reclassify assets between the trading book and the banking book at any time to minimize their regulatory capital charges.
2. The reclassification of a bond to the banking book shifts its regulatory capital requirement from a market risk charge to a credit risk charge.
3. Regulatory frameworks strictly limit such boundary reclassifications to prevent capital arbitrage, requiring explicit supervisory approval in exceptional circumstances.
Which of the statements given above is/are correct?
2. The reclassification of a bond to the banking book shifts its regulatory capital requirement from a market risk charge to a credit risk charge.
3. Regulatory frameworks strictly limit such boundary reclassifications to prevent capital arbitrage, requiring explicit supervisory approval in exceptional circumstances.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is incorrect: Banks are absolutely not permitted to freely shift assets between the Trading Book and the Banking Book.
Doing so to avoid MTM losses or lower capital requirements is termed "capital arbitrage" and is strictly prohibited under the Fundamental Review of the Trading Book (FRTB) framework.
Statement 2 is correct: Operationally, the regulatory capital regime is tied to the book.
Trading Book items carry a Market Risk capital charge, while Banking Book items carry a Credit Risk capital charge.
Reclassifying an asset inherently changes the type of capital charge applied.
Statement 3 is correct: To enforce the boundary between the books, regulators require that any reclassification be driven by a genuine, documented change in intent, and it mandates explicit prior supervisory approval from the RBI.
Doing so to avoid MTM losses or lower capital requirements is termed "capital arbitrage" and is strictly prohibited under the Fundamental Review of the Trading Book (FRTB) framework.
Statement 2 is correct: Operationally, the regulatory capital regime is tied to the book.
Trading Book items carry a Market Risk capital charge, while Banking Book items carry a Credit Risk capital charge.
Reclassifying an asset inherently changes the type of capital charge applied.
Statement 3 is correct: To enforce the boundary between the books, regulators require that any reclassification be driven by a genuine, documented change in intent, and it mandates explicit prior supervisory approval from the RBI.