Media Release Capital Adequacy of Banks:
Incorporation of an Allowance for Market Risk

The Reserve Bank today released new prudential supervision guidelines in relation to capital adequacy for banks' market risks. These guidelines are Australia's response to the international guidelines issued by the Basle Committee on Banking Supervision in January 1996. Their development has been a lengthy process, involving considerable research and consultation with banks and other financial organisations. The requirements will become fully effective at the end of 1997, in line with the timetable recommended by the Basle Committee.

The new guidelines – contained in Prudential Statement C3, ‘Capital Adequacy of Banks: Market Risk’ – address the risks of losses for banks arising from fluctuations in interest rates, exchange rates, equity prices and commodity prices. They supplement the existing capital adequacy requirements which cover credit risk, ie the risk that a borrower or other counterparty will not meet its obligations to a bank.

The guidelines allow banks a choice between two broad approaches in calculating their market risk exposures – a calculation based on a standard supervisory model or one based on a bank's own internal models. Banks may use their own models as long as the underlying parameters meet various minimum standards, and the broader risk management practices surrounding the use of such models are satisfactory. During 1997, the Reserve Bank will be working with those banks wishing to use internal models to satisfy itself that their models meet these conditions.

The decision to take banks' internal risk measurement models into account in the supervision of market risk recognises the progress which banks have made in measuring and managing their risk exposures over the past decade, and reflects the aim of encouraging banks to improve further their risk management systems.

As previously announced, the Bank has not, at this stage, adopted the option in the Basle Committee's recommendations to allow a new form of capital (called Tier 3) to be used to cover market risks. The Bank is not convinced that Tier 3 securities – essentially term subordinated debt, with maturities as short as two years – have the permanence necessary for recognition as capital.

The impact of the new requirements will vary from bank to bank depending on the extent of their trading activities, their market risk exposures arising from these activities and their present capital position. It is not expected, however, that the Australian banking system as a whole will need to raise significant additional capital to meet the new requirements.