Barclays' private credit swap dispute asks whether an illiquid loan belongs in the trading book
The Bank of England is examining Barclays swaps on illiquid private credit loans. The classification determines the capital charge, and a hedge alone does not make the loan tradable.
A regulator is reportedly asking a major British bank whether a swap on illiquid private loans sits in the right book. The answer decides how much capital the bank holds against the position. Barclays shares were down 2.6% to 421.4 pence at 0750 GMT on Monday. The FTSE 100 index of large London stocks was down 0.9%.
The Bank of England is examining whether Barclays traders misrepresented illiquid private credit loans to understate their risk. An insider at the bank raised concerns, the Financial Times reported. Private credit means loans made by funds and other lenders rather than by banks.
A hedge transfers credit risk, but it does not prove that an illiquid loan is genuinely traded. The swap therefore belongs in the banking book unless the bank can provide that evidence. The exit problem remains.
The classification determines the capital charge. A total return swap is a contract in which one side pays the other the return on an asset. A swap that pays the return on an illiquid loan is still exposure to that loan. The book it sits in determines which charge applies.
A matching swap with another bank moves part of the risk to a counterparty. It does not turn the loan into something that trades.
The two books follow different logic. A banking book position is held to collect what the borrower owes. Its capital charge therefore reflects credit risk over a long horizon.
A trading book position is held to be bought and sold. Its capital reflects market risk over a short horizon, and the bank marks its value frequently. Marking means restating the value at current prices.
Moving an exposure from the first book to the second can lower the capital required. The saving is largest where the exposure is large and hard to sell. That is why the boundary draws scrutiny.
A trading book position must be valued at prices the market supplies. An illiquid loan has no such prices. So its value rests on a model and on the judgement of the desk that holds it.
The complaint reached the Prudential Regulation Authority (PRA), the Bank's supervisory arm, earlier this year. As reported, it centred on how Barclays was recording derivatives used to finance private credit loans. In particular, it concerned putting total return swaps on illiquid private credit loans in the trading book.
Traders argued the exposure should count as a traded position. They said it was hedged through a back to back total return swap, meaning a mirror contract with another counterparty. They made the case even though the loan behind it is illiquid. The FT says Barclays has built billions of dollars of exposure to private credit loans through these derivatives.
The hedge argument has force and a limit. A matching swap removes the loan's default risk from the bank's own account. It replaces that risk with exposure to whoever sits on the other side. If the two swaps differ in their terms, a gap remains between them.
What the hedge cannot change is the property the boundary rule asks about. That property is whether the bank can sell the underlying asset at an observable price when it needs to. A hedged position can carry little market risk and still be an illiquid one.
The rule puts the weight on evidence. PRA rules restrict banks from putting derivatives backed by illiquid collateral in the trading book unless they can supply enough evidence to justify it. The PRA's letter to finance directors last year was blunt. It said repackaging illiquid assets into a tradeable format is not, without appropriate supporting evidence, sufficient to justify trading book capital.
The rule therefore asks for evidence of trading intent. The PRA Rulebook's trading book part reads the same way. Article 102 requires that trading intent be evidenced through the bank's strategies, policies and procedures. Article 104 requires documented policies for deciding which positions go in, subject to periodic internal audit.
Barclays rejects the concern. It told the FT its treatment of the swaps was "consistent with accounting and regulatory capital requirements". It said the conditions for trading book classification "were met and supported by appropriate governance internally and by external advisers". The Bank of England declined to comment, and no finding has been reported.
The timing is awkward for the regulator. Its chief executive, Katharine Braddick, joined this year from Barclays. She must recuse herself, meaning step aside, from matters concerning the bank until the end of the year.
Analysts cannot yet size the damage. Gary Greenwood of Shore Capital told clients the financial impact "cannot yet be determined". The shares were about 3% lower at 420 pence by midday in London.
A trading book label that depends on a hedge alone is a claim that a regulator can test. It also buys tighter pricing for a fund client. That pricing is only as good as the evidence behind the label.
Private credit loans are normally treated as illiquid because they cannot be traded and have no daily mark to market price. That is the opposite of what trading book capital assumes. The Bank's private markets work now reaches the banks' own books.
Its system wide exploratory scenario exercise is a stress test of the sector. It covers private equity funds, private credit funds, leveraged loans and banks that lend to funds. The Bank's page puts private market funds at about $16 trillion.
The same page says private equity and private credit grew from about $3 trillion to about $11 trillion over the past decade. It also says alternative lines of credit make up more than 80% of the debt of private equity sponsored companies. For UK corporates overall the figure is about 30%.
A bank that finances a private credit fund through a swap sits in the middle of that chain. Its booking choice is the point where fund risk becomes bank capital.
Barclays publishes third quarter results at 0700 UK time on Thursday 22 October. That is the first scheduled date on which it can say whether these swaps stay in the trading book. A change in how it books them or a provision linked to the matter would show the examination has moved from complaint to consequence. Both would hit the bank and its shareholders.
The Bank's exercise is due to publish its final report in early 2027. Until then the classification question stays open for every bank that finances private credit funds through swaps. The evidence file is the only thing that settles it.