On September 26, 2022, ISDA and the Association for Financial Markets in Europe published a whitepaper on the prudential boundary between the banking and trading books in Europe and how that relates to instruments with embedded derivatives.
New requirements under the EU’s third Capital Requirements Regulation (CRR 3) that are related to the prudential allocation of risks between the banking book and trading book, and internal risk transfers between them, could cause unintended consequences for the capital treatment of instruments with embedded derivatives. This could lead to a disproportionately high risk-weighted assets calculation, which could render certain activities uneconomic.
This paper provides an overview of the different types of instruments with embedded derivatives, as well as the accounting and current prudential treatment of these products. The paper also provides an analysis of the various business and booking models for structured issuances to ensure a correct prudential book allocation. The industry believes that policymakers should consider the recommendations in the paper and amend the European Commission’s proposed CRR 3 accordingly.