RDP 9408: The Supervisory Treatment of Banks' Market Risk 1. Introduction

The 1988 International Accord on Banking Supervision – the Basle Accord – introduced a new regime for defining, measuring and determining minimum levels of capital within the international banking system. The Accord was founded on the principle that banks should hold a minimum level of capital which should be linked directly to the risks faced by banks in their operations. The Accord was the product of the Committee on Banking Regulations and Supervisory Practices, a group formed in the early 1970s by the supervisory authorities of the G10 countries. Its risk-based capital adequacy standards subsequently became the model for supervisory structures, not only for member countries of the G10, but in a range of other countries, including Australia.

The scope of the Accord was limited in the sense that it addressed only one aspect of risk facing banks; credit risk or the risk of loss associated with counterparty failure. The focus on credit did not deny the presence of other types of risks and it was acknowledged explicitly that market-related risks arising from the effects of changing prices (interest rates, exchange rates and equity prices) should also be taken into account by supervisors in framing prudential policy for banks.

Over recent years, the Basle Committee has conducted work on formally including market risk in the capital adequacy framework. The first stage of that work was completed in early 1993 and a series of ‘consultative’ papers were released for discussion and comment. The market-risk proposals^[1] consisted of three separate proposals to measure risks arising from banks' trading activities in debt securities and equities markets, and in relation to their foreign exchange exposures. The proposals set out procedures for applying capital charges commensurate with those risks.^[2] The Reserve Bank prepared a detailed submission to the Committee, drawing on analysis and empirical work and on comments from Australian banks. The Basle Committee is reviewing the proposals in the light of all comments received.

This paper summarises the three proposals and describes some simple empirical work to test their efficacy in covering potential losses from banks' market-related portfolios.

Section 2 provides some background to the development of the market-risk proposals while Section 3 considers some of the main structural features of the proposals. Sections 4, 5 and 6 deal with the traded-debt proposals, the traded equity proposals and the foreign exchange proposal respectively. A brief conclusion, in Section 7, touches on some of the main policy issues raised by the proposals.

Footnotes

Basle Committee on Banking Supervision (1993), The Supervisory Treatment of Market Risk, Basle, April. [1]

At the same time as the release of the market risk proposals, the Basle Committee released a proposal covering the treatment of bilateral netting for capital adequacy purposes and a discussion paper on the measurement of interest rate risk across the whole of a bank's operations. [2]