atively turbulent year that featured considerable currency and financial market
volatility in Eastern Europe and Asia. This volatility was magnified further through-
out 1998 with additional losses on Russian bonds as the ruble fell in value and the
prices of Russian bonds collapsed. The problems in Russia forced big U.S. banks like
Bank of America and Chase Manhattan (now J.P. Morgan Chase) to write off hun-
dreds of millions of dollars in losses on their holdings of Russian government secu-
rities. As traditional commercial and investment banking franchises shrink and mar-
kets become more complex (e.g., emerging country equity and bond markets and new
sophisticated derivative contracts), concerns are only likely to increase regarding the
threats to FI solvency from trading.
Conceptually, an FI’s trading portfolio can be differentiated from its investment
portfolio on the basis of time horizon and liquidity. The trading portfolio contains as-
sets, liabilities, and derivative contracts that can be quickly bought or sold on organ-
ized financial markets. The investment portfolio (or in the case of banks, the so-called
“banking book”) contains assets and liabilities that are relatively illiquid and held for
longer holding periods. Exhibit 8.1 shows a hypothetical breakdown between bank-
ing book and trading book assets and liabilities. Note that capital produces a cushion
against losses on either the banking or trading books. As can be seen the banking
book contains the majority of loans and deposits plus other illiquid assets. The trad-
ing book contains long and short positions in instruments such as bonds, commodi-
ties, foreign exchange (FX), equities, and derivatives.
With the increasing securitization of bank loans (e.g., mortgages), more and more
assets have become liquid and tradable (e.g., mortgage-backed securities). Of course,
with time, every asset and liability can be sold. While bank regulators have normally
viewed tradable assets as those being held for horizons of less than one year, private
FIs take an even shorter-term view. In particular, FIs are concerned about the fluctu-
ation in value—or value at risk (VAR)—of their trading account assets and liabilities
for periods as short as one day [so-called daily earnings at risk (DEAR)]—especially
if such fluctuations pose a threat to their solvency.
Market risk (or value at risk) can be defined as the risk related to the uncertainty
of an FI’s earnings on its trading portfolio caused by changes in market conditions
such as the price of an asset, interest rates, market volatility, and market liquidity.^2
8 • 2 MARKET RISKAssets LiabilitiesBanking Book Loans Capital
Other illiquid assets DepositsTrading Book Bonds (long) Bonds (short)
Commodities (long) Commodities (short)
FX (long) FX (short)
Equities (long) Equities (short)
Derivatives (long) Derivatives (short)
Exhibit 8.1. The Investment (Banking) Book and Trading Book of a Commercial Bank.
(^2) J.P. Morgan, Introduction to RiskMetrics(New York: October 1994), p. 2.