This document presents an amendment to the Basel I Accord, introducing capital requirements for market risks that banks must face. Starting from the end of 1997, banks will be required to measure and apply capital charges for market risks in addition to credit risks. The main risks involved include those related to interest rate instruments, equities, foreign exchange, and commodities.
This document is an amendment to the Basel Accord (Basel I, 1988) published in January 1996 by the Basel Committee on Banking Supervision. It aims to integrate market risks into the regulatory framework for capital requirements of internationally active banks. The scope covers risks related to interest rate instruments, equities, foreign exchange, and commodities, as well as standardized measurement methods and internal models. The document is addressed to supervised banks, supervisory authorities, and risk management professionals, and concerns the period starting from the end of 1997 for mandatory implementation (p. 1-8).
This document introduces a major amendment to the 1988 Basel Accord by requiring international banks to consider market risks in the calculation of their capital requirements starting from the end of 1997, or earlier according to national authorities (p. 3). Market risk is defined as the risk of losses on on- and off-balance sheet positions resulting from market price fluctuations, including risks on instruments related to interest rates, equities, foreign exchange, and commodities (p. 3). The objective is to ensure better coverage of risks incurred by banks in their trading and portfolio management activities, complementing the existing consideration of credit risks (p. 3-4). Two methods are proposed to measure these risks: a detailed standardized method (Part A) and a method based on internal models subject to strict approval and control conditions (Part B) (p. 5-6). The standardized method distinguishes specific risk (related to a particular issuer or asset) and general market risk (related to overall market fluctuations) and proposes precise rules for each asset category and derivative instruments (p. 9-38). The internal models method requires rigorous qualitative and quantitative criteria, including stress tests and external validation, to be approved by authorities (p. 39-40). The required capital to cover market risk is added to capital requirements for credit risk, with a combined calculation using a multiplier of 12.5 (corresponding to a minimum ratio of 8%) (p. 8-9). A new capital category, tier 3, composed of short-term subordinated debt, is introduced to cover a limited part of market risks, under strict conditions (p. 7-8). The document also details specific treatments of risks related to options, with several levels of approach according to the complexity of the bank's activities (p. 32-38). Finally, a transitional period until the end of 1997 is granted for implementation, with the possibility of combined use of both methods and close supervision to prevent regulatory arbitrage (p. 7-8). This framework aims to strengthen banks' resilience to market risks, improve transparency, and harmonize supervisory practices internationally.
The amendment was developed to respond to the need to integrate market risks into the calculation of capital requirements for banks, complementing credit risks already considered in the 1988 Basel Accord (p. 3). Financial market developments and the increasing complexity of financial instruments made it essential to better measure and cover risks related to market price fluctuations, notably in trading activities. The objective is to ensure that banks hold sufficient capital to absorb potential losses related to these risks, thus strengthening the stability of the international banking system. The scope covers risks on interest rate and equity instruments in the trading book, as well as foreign exchange and commodity risks across the entire bank (p. 3-4). The document aims to define standardized methods and regulate the use of internal models to measure these risks, while providing a rigorous supervisory framework. The stated limitations notably concern the fact that market risks outside the trading book are not explicitly covered, and that certain specific categories such as mortgage-backed securities are left to national discretion (p. 11).
Definition and scope of market risks:
- Market risk covers potential losses on on- and off-balance sheet positions due to market price variations, including interest rates, equities, foreign exchange, and commodities (p. 3).
- The trading book groups positions held for short-term resale or trading purposes, including related derivatives, with strict rules for classification and monitoring to prevent abuse (p. 3-5).
Measurement methods for risks:
- Two methods are proposed: the standardized method (Part A) and the internal models method (Part B), the latter subject to approval and strict conditions (p. 5-6).
- The standardized method distinguishes specific risk (related to an issuer or asset) and general market risk (related to overall fluctuations), with detailed rules for each instrument type (p. 9-38).
Required capital and ratio calculation:
- Minimum capital combines credit risk (excluding trading book securities) and market risk, the latter calculated either by the standardized method, internal models, or a combination of both (p. 6-7).
- Capital is calculated by multiplying the market risk measure by 12.5 (inverse of the minimum ratio of 8%) and adding it to risk-weighted assets for credit risk (p. 8-9).
- Introduction of tier 3 capital, consisting of short-term subordinated debt, limited to 250% of tier 1 capital allocated to market risks, to partially cover these risks (p. 7-8).
Specific risk treatment by instrument type:
- Interest: distinction between specific risk (0 to 8% depending on issuer category and maturity) and general risk measured by maturity or duration methods with offsetting rules and weighting by maturity bands (p. 9-18).
- Equities: required capital for specific risk (4% or 8% depending on liquidity and diversification) and general risk (8%), with treatment of derivatives and specific arbitrages (p. 19-23).
- Foreign exchange and gold: calculation of net positions by currency, with possible exclusion of structural positions, and required capital of 8% on the larger sum of net long or short positions plus gold (p. 24-27).
- Commodities: simplified or maturity-based methods, with 15% capital on net positions and additional charges for basis risk, interest rate risk, and spreads (p. 27-33).
- Options: several approaches according to complexity, from simplified for purchased options to delta-plus and scenario for written options, with specific calculations of sensitivities (delta, gamma, vega) and associated capital charges (p. 32-38).
Internal models:
- Strict approval conditions, including qualitative criteria (risk control independence, back-testing, management involvement) and quantitative criteria (statistical parameters, stress tests, external validation) (p. 39-40).
- Progressive approach with a transition period, close supervision to prevent arbitrage, and continuous improvement requirements (p. 7-8).
Supervision and implementation:
- Close monitoring of trading book/banking book classifications, control of offsetting practices and regulatory optimization (p. 4-5).
- Regular reporting (at least quarterly), daily risk management, and immediate corrective measures in case of non-compliance (p. 7).
- Transitional period until the end of 1997, with possibility of early application by national authorities (p. 7-8).
Established facts:
- Integration of market risks into capital requirements is mandatory for international banks from the end of 1997 (p. 3).
- Two measurement methods are defined: standardized and internal models, with detailed rules for each risk category and instrument (p. 5-38).
- Required capital combines credit risk and market risk, with a multiplier of 12.5 for market risk (p. 8-9).
- Introduction of tier 3 capital limited to 250% of tier 1 capital to partially cover market risk (p. 7-8).
Assumptions:
- Internal models must be validated and approved by authorities, with strict qualitative and quantitative criteria (p. 39-40).
- Specific risk is partially covered by internal models, but a minimum specific charge is maintained (p. 6).
Interpretations:
- The distinction between specific risk and general risk allows better granularity in risk measurement (p. 9).
- The framework promotes transparency and rigor in market risk management, limiting possibilities for regulatory arbitrage (p. 4-5, 7-8).
Uncertainties:
- The document does not cover certain risks outside the trading book nor certain specific instruments such as mortgage-backed securities (p. 11).
- Future evolution of measurement methods, notably for complex options, remains to be monitored (p. 38).
- The effectiveness of supervision and international consistency in rule application will depend on cooperation among national authorities (p. 39).
The Basel Committee recommends implementing this regulatory framework to integrate market risks into capital requirements for international banks starting from the end of 1997, with the possibility of early application by national authorities (p. 7). It advocates the use of the standardized method or, under strict approval conditions, validated internal models, emphasizing the need for rigorous control, stress testing, and external validation (p. 5-6, 39-40). The document highlights the importance of clear classification between trading book and banking book, daily risk management, and regular reporting to ensure ongoing compliance (p. 3-5, 7). It introduces a new capital category (tier 3) to partially cover market risks, with precise limits (p. 7-8). The Committee encourages banks to progress towards comprehensive internal models covering all market risks, while maintaining minimum capital requirements for specific risk (p. 6-8). Finally, it provides for close supervision to prevent regulatory optimization practices and ensure consistent international application (p. 4-5, 7-8).
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