Hedge Funds, Financial Stability and Market Integrity Appendix 3: The Capital Treatment of Financial Market Activities

The Basle capital arrangements require banks to hold capital against both credit and market risk.

Credit Risk

The credit risk capital charge on traded instruments is calculated by first translating the exposure into a balance-sheet equivalent; and then applying the relevant risk weight.

The Balance-Sheet Equivalent

The balance-sheet equivalent (the ‘credit equivalent’ in supervisory parlance) is defined as the sum of the current exposure and the potential future exposure. There are two methods of calculation.

The first method calculates the current and future exposures separately. The current exposure is measured by the current market value of the contract; that is, the cost to the bank that would result if the counterparty collapsed, and a replacement contract had to be obtained in the market. If the current value of the contract is negative, the bank owes money to its counterparty and has no current credit exposure.

The future potential exposure is calculated as a percentage of the contract's notional principal (this exposure exists regardless of the size of the current exposure). The relevant percentage depends upon the maturity of the contract and the asset underlying the contract (see Table 1). For example, a forward contract to sell foreign exchange in six month's time would have a potential future exposure of 1 per cent of the amount to be sold.

The second method does not use the current market value of the contract to assess the current exposure, but simply calculates the sum of the current and future exposures as a percentage of the notional principal. The relevant percentages are shown in Table 2.

All foreign-exchange contracts with a maturity of 14 days or less are excluded from all the above calculations. Thus, a short-dated foreign exchange swap does not incur a capital charge.

The Risk Weight

The risk weight depends on the counterparty. In general, the standard risk weights that apply to on-balance sheet exposures – 0 per cent for government obligations and 20 per cent for OECD banks – also applies to the credit – equivalent exposures. The exception is the risk weight that applies to banks' exposures to the non-bank private sector (including hedge funds). If these exposures are on the balance sheet, a risk weight of 100 per cent applies. In contrast, if the same exposure is generated through a derivatives contract, the risk weight is only 50 per cent risk.

If a bank holds collateral against the credit equivalent exposure, the risk weight becomes the weight that would normally apply to the asset used as collateral. Thus, no capital is required to be held against a repurchase agreement involving government securities issued by OECD countries.

Market Risk

The market-risk capital requirements distinguish between a bank's trading activities and its non-traded or ‘banking book’ activities. The market risk capital requirements apply only to the former. Banks may choose between two broad calculation methods in assessing market risk – the standard and the internal-model methods.

The standard model sets out fixed formulae for the aggregation of exposures across asset classes (interest rates, foreign exchange, equities and commodities). Within each asset class a charge against the net open position (adjusted for the extent to which differing instruments may be regarded as offsetting) is levied. These asset-class charges are then summed. The internal model approach allows banks to make their own assessment of the extent to which differing instruments offset one another based on empirically observed correlations. Thus, the capital charge attributable to any individual contract depends not only on the individual contract, but on the composition of the bank's overall portfolio and the extent to which that individual contract has been hedged.

Both the standard model and internal model methods are calibrated against a ten-day holding period and 99 per cent confidence interval. That is, the market risk charge addresses the trading losses that may be incurred in the event that a portfolio were held constant for ten trading days. It is expected that, 99 times out of 100, the capital charge would cover the losses accumulated over any ten-day period. An amount equal to the market risk change must be held in capital.