Risk Library
   Documents by Author
     Committees at the Bank for International...
       Amendment of the Capital Accord to Incor...
         Part A - The standardised measurement me...
         Part B - Use of internal models to measu...
         Part C - Worked examples


Amendment of the Capital Accord to Incorporate Market Risk


I. The risk measurement framework

1. As from the end of 1997, or earlier if their supervisory authority so prescribes, banks will be required to measure and apply capital charges in respect of their market risks in addition to their credit risks. Market risk is defined as the risk of losses in on and off-balance-sheet positions arising from movements in market prices. The risks subject to this requirement are:

the risks pertaining to interest rate related instruments and equities in the trading book;

foreign exchange risk and commodities risk throughout the bank.

(a) Scope and coverage of the capital charges

2. The capital charges for interest rate related instruments and equities will apply to the current market value of items in banks' trading books. The trading book means the bank's proprietary positions in financial instruments which are intentionally held for short-term resale and/or which are taken on by the bank with the intention of benefiting in the short-term from actual and/or expected differences between their buying and selling prices, or from other price or interest-rate variations, and positions in financial instruments arising from matched principal brokering and market making, or positions taken in order to hedge other elements of the trading book.

3. In many banks the trading activities are carried out in quite separate units from the normal banking activities and so it is possible to identify the business which falls within the trading book. Even where this is not the case, the trading activities tend to be readily identifiable because of their intent. In order, however, to obtain an accurate and fair measure of market risk, it will be necessary to allow banks some freedom (subject to close supervisory monitoring as defined in the paragraph below) to include within the market risk measure certain non-trading instruments on- or off-balance sheet, which are deliberately used to hedge the trading activities. These instruments as any other financial instruments which are not integral to the trading book will, however, not be subject to the specific risk capital charges as set out in section A.1 but will remain subject to the credit risk capital requirements set out in the Capital Accord. On the other hand, there are often circumstances in which banks use, for example, derivative products such as swaps to hedge positions in their banking book. Such instruments qualifying in their own right normally to be a component of the trading book are, however, not part of the trading book and should, therefore, be excluded from the market risk measure but become subject to the credit risk capital requirements.

4. The member countries of the Committee intend to monitor carefully the way in which banks allocate financial instruments between the trading book and other accounts and will seek to ensure consistent implementation through the examination process or other means. In particular, they will seek to ensure that no abusive switching designed to minimise capital charges occurs and will be vigilant in seeking to prevent "gains trading" in respect of securities which are not marked to market. This will also apply to the allocation of hedging instruments referred to in the previous paragraph, which may be either with external counterparties or as the result of internal transactions between the banking and trading books. In both cases, there must be a clear audit trail created at the time such transactions were entered into to enable supervisory authorities to monitor the bank's compliance with its established criteria by which items are allocated to the trading or banking book.

5. To establish a relevant base for measuring the market risk in the trading book, all items should first be marked to market. In many countries, marking to market will be synonymous with the trading book; in these countries, therefore, the trading book may be defined as comprising all securities and associated derivatives that are marked to market. In some countries, however, accepted accounting procedures oblige banks to value at market prices some instruments that do not fall within the trading book. In others, even trading activities may be accounted for at book value or lower of cost and market, although for the purposes of measuring market risk they would be evaluated at market value.

6. The capital charges for foreign exchange risk and for commodities risk will apply to banks' total currency and commodity positions, subject to some discretion to exclude structural foreign exchange positions. It is understood that some of these positions will be reported and hence evaluated at market value, but some may be reported and evaluated at book value.

7. For the time being, the Committee does not believe that it is necessary to allow any de minimis exemptions from the capital requirements for market risk, except for those for foreign exchange risk set out in paragraph 13 of A.3, because the Capital Accord applies only to internationally active banks, and then essentially on a consolidated basis; all of these are likely to be involved in trading to some extent.

8. In the same way as for credit risk, the capital requirements for market risk are to apply on a worldwide consolidated basis. Where appropriate, national authorities may permit banking and financial entities in a group which is running a global consolidated book and whose capital is being assessed on a global basis to report short and long positions in exactly the same instrument (e.g., currencies, commodities, equities or bonds), on a net basis, no matter where they are booked. Moreover, the offsetting rules as set out in the remainder of this Amendment may also be applied on a consolidated basis. Nonetheless, there will be circumstances in which supervisory authorities demand that the individual positions be taken into the measurement system without any offsetting or netting against positions in the remainder of the group. This may be needed, for example, where there are obstacles to the quick repatriation of profits from a foreign subsidiary or where there are legal and procedural difficulties in carrying out the timely management of risks on a consolidated basis. Moreover, all national authorities will retain the right to continue to monitor the market risks of individual entities on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision. Supervisory authorities will be especially vigilant in ensuring that banks do not pass positions on reporting dates in such a way as to escape measurement.

    (b) Methods of measuring market risks

9. In measuring their market risks, a choice between two broad methodologies (described in Parts A and B) will be permitted, subject to the approval of the national authorities. One alternative will be to measure the risks in a standardised manner, using the measurement frameworks described in Part A. The first four sections of Part A (A.1-4) deal with the four risks addressed by this Amendment, i.e., interest rate, equity position, foreign exchange and commodities risk. A fifth section (A.5) sets out a number of possible methods for measuring the price risk in options of all kinds. The capital charge under the standardised measurement method will be the measures of risk obtained from A.1­5, summed arithmetically.

10. The alternative methodology, which is subject to the fulfilment of certain conditions and the use of which is therefore conditional upon the explicit approval of the bank's supervisory authority, is set out in Part B. This method allows banks to use risk measures derived from their own internal risk management models, subject to seven sets of conditions, namely:

  • certain general criteria concerning the adequacy of the risk management system;
  • qualitative standards for internal oversight of the use of models, notably by management;
  • guidelines for specifying an appropriate set of market risk factors (i.e., the market rates and prices that affect the value of banks' positions);
  • quantitative standards setting out the use of common minimum statistical parameters for measuring risk;
  • guidelines for stress testing;
  • validation procedures for external oversight of the use of models;
  • rules for banks which use a mixture of models and the standardised approach.

11. The standardised methodology uses a "building-block" approach in which specific risk and the general market risk arising from debt and equity positions are calculated separately. The focus of most internal models is a bank's general market risk exposure, typically leaving specific risk (i.e., exposures to specific issuers of debt securities or equities) to be measured largely through separate credit risk measurement systems. Banks using models should be subject to capital charges for the specific risk not captured by their models. Accordingly, a separate capital charge for specific risk will apply to each bank using a model to the extent that the model does not capture specific risk. The capital charge for banks which are modelling specific risk is set out in section B.8.

12. In measuring the price risk in options under the standardised approach, where a number of alternatives with varying degrees of sophistication are provided (see A.5), supervisory authorities will apply the rule that the more a bank is engaged in writing options, the more sophisticated its measurement method needs to be. In the longer term, banks which are significant traders in options will be expected to move to comprehensive value-at-risk models and become subject to the full range of quantitative and qualitative standards set out in Part B.

13. Each bank subject to this Amendment will be expected to monitor and report the level of risk against which a capital requirement is to be applied. The bank's overall minimum capital requirement will be:

  1. credit risk requirements laid down in the present Accord, excluding debt and equity securities in the trading book and all positions in commodities, but including the credit counterparty risk on all over-the-counter derivatives whether in the trading or the banking books; plus
  2. neither the capital charges for market risks described in A.1­5, summed arithmetically; or
  3. measure of market risk derived from the models approach set out in Part B; or
  4. mixture of (b) and (c) summed arithmetically.

14. All transactions, including forward sales and purchases, shall be included in the calculation of capital requirements as from the date on which they were entered into. Although regular reporting will in principle take place only at intervals (in most countries quarterly), banks are expected to manage the market risk in their trading book in such a way that the capital requirements are being met on a continuous basis, i.e., at the close of each business day. Supervisory authorities have at their disposal a number of effective measures to ensure that banks do not "window-dress" by showing significantly lower market risk positions on reporting dates. Banks will also, of course, be expected to maintain strict risk management systems to ensure that intra-day exposures are not excessive. If a bank fails to meet the capital requirements, the national authority shall ensure that the bank takes immediate measures to rectify the situation.

    (c) Transitional arrangements

15. The Committee permits a transition period until the end of 1997, starting from the final release of this Amendment, before the standardised approach and the internal models approach will become effective for calculating market risk capital. However, national authorities will have the right to implement the Amendment earlier. Banks that wish to use their internal models will be required, during the transition period, to adapt their models to incorporate the general criteria and to use the parameters specified in this Amendment when calculating their regulatory capital requirements. They should also be able to participate in a testing exercise which would provide supervisory authorities with additional information and comfort with the results produced. Until such time as the national authority chooses to implement the capital charges for market risk, the risks from positions covered by the market risk package will continue to be subject to the present capital charges laid down in the 1988 Accord.

16. Banks will on a transitional basis be free to use a combination of the standardised measurement method and the internal models approach to measure their market risks. As a general rule, any such "partial" models should cover a complete risk category (e.g., interest rate risk or foreign exchange risk), i.e., a combination of the two methods will not be permitted within the same risk category. However, as most banks are at present still implementing or further improving their risk management models, the Committee believes that banks should be given - even within risk categories - some flexibility in including all their operations on a worldwide basis; this flexibility will be subject to approval by the national authority and reviewed by the Committee in the future (supervisory authorities will take precautions against "cherry-picking" between the standardised approach and the models approach within a risk factor category). Banks which adopt the modelling alternative for any single risk category will be expected over time to include all their operations subject to the exceptions mentioned below and to move towards a comprehensive model (i.e., one which captures all market risk categories). Banks which adopt a model will not be permitted, save in exceptional circumstances, to revert to the standardised approach. Notwithstanding these general principles, even banks using comprehensive models to measure their market risk may still incur risks in positions which are not captured by their internal trading risk management models, for example, in remote locations, in minor currencies or in negligible business areas. Any such risks that are not included in a model should be separately measured and reported using the methodologies described in A.1­5.

17. At the present juncture, at least, the Committee has not set a time limit for the transition to comprehensive models although individual member countries may decide to do so. In the meantime, banks whose models do not capture all their market risks will be subject to the standardised measurement method for the risks not captured and the Committee will monitor the situation to prevent possible regulatory arbitrage that may arise from using a combination of the standardised and internal models approaches. Moreover, the supervisory authorities of banks moving towards the models approach will wish to be reassured that those banks are progressively improving their risk management practices to the extent that they will be in a position to meet all the standards once they are applying a fully-fledged model for any risk category.

II. The capital requirement

    (a) Definition of capital

1. The principal form of eligible capital to cover market risks consists of shareholders' equity and retained earnings (tier 1 capital) and supplementary capital (tier 2 capital) as defined in the 1988 Accord. But banks may also, at the discretion of their national authority, employ a third tier of capital ("tier 3"), consisting of short-term subordinated debt as defined in paragraph 2 below for the sole purpose of meeting a proportion of the capital requirements for market risks, subject to the following conditions:

  • banks will be entitled to use tier 3 capital solely to support market risks as defined in Parts A and B. This means that any capital requirement arising in respect of credit and counterparty risk in the terms of the 1988 Accord, including the credit counterparty risk in respect of derivatives in both trading and banking books, needs to be met by the existing definition of capital in the 1988 Accord (i.e., tiers 1 and 2);
  • tier 3 capital will be limited to 250% of a bank's tier 1 capital that is required to support market risks. This means that a minimum of about 28½% of market risks needs to be supported by tier 1 capital that is not required to support risks in the remainder of the book;
  • tier 2 elements may be substituted for tier 3 up to the same limit of 250% in so far as the overall limits in the 1988 Accord are not breached, that is to say eligible tier 2 capital may not exceed total tier 1 capital, and long-term subordinated debt may not exceed 50% of tier 1 capital;
  • in addition, since the Committee believes that tier 3 capital is only appropriate to meet market risk, a significant number of member countries are in favour of retaining the principle in the present Accord that tier 1 capital should represent at least half of total eligible capital, i.e., that the sum total of tier 2 plus tier 3 capital should not exceed total tier 1. However, the Committee has decided that any decision whether or not to apply such a rule should be a matter for national discretion. Some member countries may keep the constraint, except in cases where banking activities are proportionately very small. Additionally, national authorities will have discretion to refuse the use of short-term subordinated debt for individual banks or for their banking systems generally.

2. For short-term subordinated debt to be eligible as tier 3 capital, it needs, if circumstances demand, to be capable of becoming part of a bank's permanent capital and thus be available to absorb losses in the event of insolvency. It must, therefore, at a minimum:

  • be unsecured, subordinated and fully paid up;
  • have an original maturity of at least two years;
  • not be repayable before the agreed repayment date unless the supervisory authority agrees;
  • be subject to a lock-in clause which stipulates that neither interest nor principal may be paid (even at maturity) if such payment means that the bank falls below or remains below its minimum capital requirement.

    (b) Calculation of the capital ratio

3. In order to ensure consistency in the calculation of the capital requirements for credit and market risks, an explicit numerical link will be created by multiplying the measure of market risk by 12.5 (i.e., the reciprocal of the minimum capital ratio of 8%) and adding the resulting figure to the sum of risk-weighted assets compiled for credit risk purposes. The ratio will then be calculated in relation to the sum of the two, using as the numerator only eligible capital.

4. In calculating eligible capital, it will be necessary first to calculate the bank's minimum capital requirement for credit risk, and only afterwards its market risk requirement, to establish how much tier 1 and tier 2 capital is available to support market risk. Eligible capital will be the sum of the whole of the bank's tier 1 capital, plus all of its tier 2 capital under the limits imposed in the 1988 Accord. Tier 3 capital will be regarded as eligible only if it can be used to support market risks under the conditions set out in paragraphs 1 and 2 above. The quoted capital ratio will thus represent capital that is available to meet both credit risk and market risk. Where a bank has tier 3 capital, within the limits set out in paragraph 1, which is not at present supporting market risks, it may report that excess as unused but eligible tier 3 alongside its standard ratio. An example of how this works is set out in Part C of the paper, together with other worked examples.


Contact us * Risk Library * Documents by Author * Committees at the Bank for International Settlement (BIS) * Amendment of the Capital Accord to Incorporate Market Risk