RDP 9408: The Supervisory Treatment of Banks' Market Risk 2. Background

Deregulation of international financial systems over the 1980s was accompanied by a period of high price volatility in financial markets. Increased volatility in the prices of financial instruments and other financial assets opened new opportunities for profit for financial institutions from the trading of those instruments. With those new opportunities, however, came the potential for losses. While banks' market-related exposures remained relatively small and actual losses minimal, the case for the formal recognition of market risk within the supervisory structure did not seem strong. The growth in market-related exposures began to accelerate, however, especially over the latter half of the 1980s. The nature of banks' exposures to the market also changed; the traditional risks associated with large holdings of fixed-interest securities remained but were supplemented by additional risk associated with the rapid growth in off-balance sheet and derivative markets. While banks were becoming increasingly large players in those markets, the risks were still small when measured against credit risk arising from their traditional lending activities. Concerns, however, were focused more on future developments, and the possibility that banks' exposures in these areas would continue to expand.

It was against that background that work on the prudential treatment of market risk began. As it progressed in the final years of the 1980s and into the 1990s, three separate, though related, themes emerged as the main factors driving the market-risk exercise internationally.

1. A desire to see the existing capital adequacy framework generally expanded and strengthened;
2. A desire to remove distortions within the banking sector that may have arisen from the focus of capital standards on credit as opposed to other forms of risk; and
3. A desire to achieve greater consistency in supervisory treatment between international banking and securities regulators.

The first of these themes was a direct consequence of the market developments noted above. The case for expanding the capital framework grew stronger with growth in market exposures faced by banks. Increasing complexity of market-related instruments added to problems in identifying and assessing exposures.

The second reflected a growing recognition of the possible consequences of focusing supervisory effort on one aspect of risk; namely, the encouragement of alternative forms of risk taking by banks. It can be argued that the existing capital standards, by focusing largely on credit risk, provided a strong incentive for banks to turn their attention towards activities where credit risk was deemed low from a regulatory perspective, but where non-credit-related risks may be greater. Many have pointed to the growth in banks' off-balance-sheet/derivative business as evidence of that process. A strong case can be made that inconsistencies in supervisory arrangements should not bias banks' activities in particular directions.

The third motivation was broader in concept and concerned the desirability of applying consistent supervisory standards to institutions doing similar forms of business. While few would argue the case for equal supervisory treatment across all financial institutions, it is the case that competitive inequalities can arise when one set of institutions doing similar, or in some cases identical business, is supervised more rigorously than others. Internationally, that debate on competitive inequality focused on the regulatory treatment of the international security houses vis-a-vis the banks; in particular, the concern that differing supervisory treatment carried the potential for a significant shifting of business towards the unregulated or less regulated group. These concerns, while always present to some degree, increased as the distinctions between banking and non-banking activities blurred and as banks' market activities came to mirror, more and more, the activities of the international securities houses. An important catalyst to the work on market risk was the desire to develop consistent supervisory guidelines for these two groups of institutions.

One consequence was that in developing the market-risk proposals, the Basle Committee sought assistance from IOSCO (International Organization of Securities Commissions). IOSCO was represented on the various technical working parties whose task it was to develop the details of the market-risk proposals. The intention was that the regulatory guidelines that emerged would represent a joint product of the banking and securities regulators and would be applied equally to banks and securities houses. For a variety of reasons, those joint arrangements broke down in early 1993. However, the structure of the proposals as they were released still reflects the input of the securities regulators.

Having determined that some form of regulatory arrangement was necessary to supervise banks' market-related activities, debate turned to the issue of how that objective could be achieved. Two difficulties emerged; one philosophical, one practical in nature.

At the broadest level was the issue of how to reconcile the introduction of new regulatory arrangements with the objective of improving market efficiency, one of the main goals of financial deregulation. It was broadly accepted that with financial deregulation came a greater emphasis on, and need for, prudential supervision. The question at hand, however, was the form that any expansion in the supervisory net to capture market risk should take. Over the latter part of the 1980s, for example, many financial institutions invested heavily in the development of tailored risk-management systems to handle their growing levels of market risk. An important issue that arose in the development of the proposals was the extent to which banks' own risk-management structures should be taken into account or recognised in extending the supervisory structure. To what extent, for example, would any separate supervisory guidelines on market risk represent a duplication of what financial institutions had already put into effect on a voluntary basis? That issue remains current and is one of the key issues examined by the Basle Committee.

The more practical and immediate problem was how to translate the objectives of the market-risk exercise into a workable set of guidelines with applicability across a range of countries. The credit standards introduced in 1988 were able to achieve that by adopting a very simple approach involving a regime of risk weights applied to different credit exposures. While the assumptions on which that model was devised have been heavily criticised, the willingness of countries to implement the credit based standard over recent years has been assisted by their relative simplicity. It is doubtful that highly complicated credit standards would have enjoyed the same degree of international support that the current standards have had since their inception. The market-risk guidelines had the potential for much greater complexity than those covering credit risk.

The Committee tried to address the conflict between the inherent complexity of capturing market risk and the practical need for simplicity by taking a two-step approach. It involved:

• development of a ‘standard’ approach towards the treatment of market risk which was relatively simple in scope. The standard model formed the basis of the proposals; and
• introduction of some alternatives, within the standard approach, which would allow sophisticated banks to use more elaborate techniques in calculating the risks associated with their market activities, for example breaking down swap positions into cash flows from each interest payment.

Irrespective of which approach was adopted, it was emphasised that none of the techniques proposed to identify or measure market risk (either in the standard model or the more sophisticated options) was intended as a substitute for banks' own internal risk management systems. The objective was solely the creation of a structure to permit the calculation of a capital charge that provided a reasonably accurate assessment of banks' actual market-related exposures.

The main focus of this paper is on the standard methodologies proposed for calculating the capital charges and whether those simple methodologies are sufficient to provide an estimate of the risks associated with market-related instruments. For the foreign exchange proposal, an alternative simulation method proposed by the Basle Committee is assessed and compared to the standard method.