Financial Services Advisory

Wind-Down of Trading Books – An ECB Occasional Paper Series

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This ECB paper is relevant to banks with derivatives and trading books; it explores the operational aspects and hidden costs associated with the wind-down of a bank’s trading book.

An orderly wind-down of a trading book may be a recovery option or an element of a bank’s preferred resolution strategy. This paper details principles of ECB’s supervisory expectations with respect to both recovery and resolution planning.

Since the global financial crisis, regulatory authorities have implemented guidelines to ensure an orderly wind-down process during periods of financial stress. The motivation behind the wind-down of trading books stems from regulatory objective to bolster banks' resolvability and reduce systemic risk.

The paper begins by distinguishing between an orderly and disorderly wind-down:

  • An orderly wind-down would occur as part of a recovery option for a bank under stress or part of a resolution strategy.
  • A disorderly wind-down often occurs as a result of a fire sale. Such a wind-down would characteristically be very expensive for a bank, resulting in substantial losses on the sale of the trading book positions and potentially impacting the bank’s soundness and ability to be resolved.

Key components necessary for a successful wind-down strategy are early planning, stress testing, and the appropriate governance structures. Banks should have a phased approach with clear triggers and milestones to facilitate an organised and controlled wind-down process during times of stress or resolution.

The paper details the challenges associated with winding down complex trading book positions. Crucial factors to consider are accurate valuation of assets, the utilisation of appropriate risk models and metrics, and liquidity management. The ECB stresses the importance of considering potential market impacts on the bank's ability to sell assets at fair prices.

Stress testing plays a crucial role in the wind-down process. By identifying and quantifying potential risks and losses, stress testing helps assess the effectiveness of wind-down strategies under adverse market conditions.

Finally, global regulatory coordination is crucial in the wind-down process. Synchronisation of wind-down practices across multiple jurisdictions is necessary to prevent regulatory arbitrage and ensure a level playing field. Effective information sharing and coordination between banks and regulators are needed to facilitate a smooth wind-down process.

In conclusion, the paper provides valuable insights into the wind-down of bank’s trading books, highlighting the importance of proactive planning, risk management, and stress testing in developing effective strategies. It underscores the need for careful consideration of market impact, liquidity management, and regulatory coordination to minimise systemic risks and maintain financial stability.

How can Grant Thornton help?

Wind-down planning remains a key focus for prudential supervisors, therefore banks should consider conducting a comprehensive assessment of current wind-down preparedness. This includes evaluating existing wind-down strategies, stress testing methodologies, risk models, and governance structures.

Grant Thornton is well positioned to assist your institution with assessing wind-down preparedness and benchmarking against best practices and regulatory requirements. Our team of regulatory specialists can provide support with wind-down planning and wider recovery and resolution expectations.