2. The proposals for applying capital charges to market risks issued in April 1993 envisaged the use of a standardised methodology to measure market risks as a basis for applying capital charges to open positions. The industry's comments on these proposals raised a number of issues which the Committee felt to be worthy of a considered response. These were, in brief, that:

• the proposals did not provide sufficient incentive to improve risk management systems because they did not recognise the most accurate risk measurement techniques;

• the proposed methodology did not take sufficient account of correlations and portfolio effects across instruments and markets, and generally did not sufficiently reward risk diversification;

• the proposals were not sufficiently compatible with banks' own measurement systems.

3. In considering the industry's comments, the Committee took account of the fact that the risk management practices of banks have developed significantly since the initial proposals were formulated in the early 1990s. In particular, the Committee is conscious of the need to ensure that regulatory requirements do not impede the development of sound risk management by creating perverse incentives. Many banks argued that their own risk management models produced far more accurate measures of market risk, adding that there would be costly overlaps if they were required to calculate their market risk in two different manners.

4. During 1994, therefore, the Committee investigated the possible use of banks' proprietary in-house models for the calculation of market risk capital as an alternative to a standardised measurement framework. The results of this study were sufficiently reassuring for it to envisage the use of internal models to measure market risks, subject to a number of carefully defined criteria. The precise requirements which the Committee is planning to apply to banks which use their models as a basis for calculating market risk capital are set out in Part B of the Supplement. The purpose of this paper is to explain some of the thinking behind those criteria.

5. The Committee has devoted a considerable amount of time and effort in studying the models used by banks and the measures of risk that they produce. In preliminary testing conducted in the second half of 1994, a number of banks in the major centres were asked to run an identical portfolio through their models and the results were examined for consistency. This process was extremely helpful in identifying methodological differences and in providing empirical support for certain common statistical parameters. This testing exercise is described further in Section II of the paper.

6. The proposed approach for a models-based supervisory capital requirement is based on the definition of a series of quantitative and qualitative standards that banks would have to meet in order to use their own systems for measuring market risk, while leaving a necessary amount of flexibility to account for different levels of detail in the systems.

• The quantitative standards are expressed as a number of broad risk measurement parameters for banks' internal models, together with a simple rule for converting the models-based measure of exposure into a supervisory capital requirement.

• The qualitative standards are designed to ensure that banks' measurement systems are conceptually sound and that the process of managing market risks is carried out with integrity. In addition, it is necessary to define the risks that need to be covered, the appropriate guidelines for conducting stress tests, as well as to give guidance on validation procedures for examiners and auditors charged with independently reviewing and validating banks' internal models.

8. The first section of this paper describes the general approach to managing market risks that is common to many large banks using proprietary models. Section II summarises the lessons learned from the testing exercise conducted in 1994. Section III presents certain generalised elements of a proposed supervisory framework for basing market risk capital requirements on banks' internal measurement systems. Section IV discusses quantitative standards for models and Section V looks at stress testing procedures. Section VI describes how examiners and auditors should validate internal models used to calculate supervisory capital charges.

Footnote:

2. The risks covered by the proposed framework were: (a) the risks in the securities trading book of debt and equity securities and related off-balance-sheet contracts and (b) foreign exchange risk. The Committee has now decided to incorporate commodities risk too.