RDP 9408: The Supervisory Treatment of Banks' Market Risk 3. Structure of the Proposals

While the three proposals vary in terms of structure and complexity, they share some common features. In particular:

• they all focus on the need for capital to cover market risk.

  Other methods of risk control, such as use of internal limit systems (without explicit capital coverage) were considered as alternatives to an arrangement requiring dedicated capital for market risk. Supervisors in some countries already have such arrangements in place. These alternative approaches were dismissed on the grounds that:

  – only physical holdings of capital can, in the final resort, provide an institution with a buffer against losses. Limit-based systems, although generally linked to capital, only set an upper bound on the losses that might be experienced by an institution; and

  – only a structure based on holdings of capital could be viewed as consistent with the current capital adequacy standards.

• the focus of the proposals is on the market risks found in a bank's ‘trading book’.

  As structured, the proposals were not intended to cover all market-related risks faced by banks. While the proposals cover all foreign exchange risk incurred by a bank, only positions in debt instruments or equities held for short-term trading purposes are captured. The proposal does not define the trading book precisely; the implicit assumption however, is that it covers those instruments which are held for trading, as opposed to longer-term investment and which are marked to market at regular intervals. The focus on the trading book as the basis for measuring and applying a capital charge to market risk reflected two factors. The first was the technical difficulty in estimating the market risk associated with traditional banking activities i.e. borrowing and lending. The treatment of market risk across the whole bank was considered as an issue to be addressed in the longer term. The second factor was that by concentrating on risk in the trading book, it captured the sorts of activities carried out within dedicated securities firms, and was therefore consistent with the objective of creating a regulatory structure applicable to both banks and securities firms.

• the proposals assume, implicitly, that risks are additive.

  It is assumed that the individual market risks associated with changes in exchange rates and interest rates, and arising from variations in equity prices, can be summed and added to the associated credit risks to form an overall risk position. This methodology is referred to in Basle literature as the ‘building block’ approach. The proposals do not approach risk from a portfolio perspective; that is, they do not seek to identify and take into account the presence of inter-relationships between various types of risk (for example, relationships between exchange rate movements and changes in security yields) and build those empirical linkages into the risk measurement system.

The following sections look at each of the three proposals, covering traded-debt instruments, foreign exchange and equities.