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The Supervisory Treatment of Market Risks


1. The Basle Committee on Banking Supervision ("the Committee") is issuing the attached proposals for the supervisory treatment of market risks incurred by banks. Market risk is the risk of losses in on and off­balance­skeet positions arising from movements in market prices, including interest rates, exchange rates and equity values. The basic thrust of the proposals is to require capital requirements for open positions in debt securities, equities and foreign exchange. It is intended that, following a comment period, the proposed new capital requirements would be integrated with the Basle Capital Accord (the Accord).

2. The primary objective of the Accord, adopted in July 1988, was to establish minimum capital standards designed to protect against credit risk. Credit risk was and remains the major risk facing banking institutions. At the time, however, it was recognised that in due course the capital adequacy framework would have to be broadened to take direct ant explicit account of market risk. In the intervening period, changes in technology, in market practices and in the nature of many banking activities have made it even more important that the 1988 Accord be broadened to take into account market risk.

3. In these circumstances the Committee has set out to develop a framework for integrating into the 1988 Accord an approach to assessing explicit capital charges for market risk that would satisfy two principal objectives, first, the framework for estimating the amount of such capital charges and the manner n which such capital charges could be satisfied should constitute a minimum prudential standard relative to the potential for losses that might be incurred for a given portfolio of open positions in debt and equity securities in the trading portfolio and in foreign exchange; second, the framework should be one in which the capital charges for each class of instruments (i.e. debt, equities and foreign exchange) would be roughly, equivalent in economic terms so as not to create artificial incentives favouring one class of instrument over others.

4. The Committee recognises fully that achieving these dual objectives represents something of a challenge, especially in a setting in which innovation and change in banking and financial markets continue at a very rapid pace. However, the very fact of this extraordinarily rapid pace of change underscores the Committee's belief that the time has come to solicit the views of market participants on the approaches to this task which the Committee has in mind.

5. Accordingly, with the consent of the Governors of the Group of Ten central banks, the Committee is inviting comments on the proposals described in this paper to apply capital requirements to banks for the market risks arising from position­taking in debt and equity securities in the trading portfolio and in foreign exchange. The framework would also encompass positions in many of the derivative instruments used in each of these three principal lines of activity. Section l describes the rationale for the framework ant considers what changes might be needed to the 1988 Capital Accord. Sections 2, 3 and 4 propose methodologies for computing capital charges for open positions in debt securities, equities and foreign exchange respectively.

6. The Committee is well aware of the discussions in the European Community which have resulted in the adoption of a Capital Adequacy Directive which covers much of the same ground. The proposals contained herein are in many cases identical to the Capital Adequacy Directive. Article 14 of that Directive provides for the possibility of revision, in the light of market innovation and developments in international regulatory fora, within a period of three years. The Committee believes it is essential that the proposals developed in different fora be as consistent as possible and is therefore keen to develop an international agreement which would apply to all the major market players, both inside and outside the EC. However. because the consultative process will, of necessity, be long and the phased implementation even longer, it is the Committee judgement that its internal deliberations cannot proceed further without the benefit of market participants' reactions to the overall approach.

7. The primary purpose of the consultative process is to seek market reactions to the specific methodologies proposed in Sections 2­4. The proposals in Sections 2 and 3 for debt and equity securities in the trading portfolio have been designed in such a way that eventually they may be applied to both banks and securities firms. These proposals contain certain features which bank supervisors acting on their own would not necessarily favour but are prepared to adopt in the hope that further convergence with securities regulators will be achieved at some future date. Thus, while the focus of the consultative process is the banking industry. the overall approach has been designed with a view toward its ultimate application to a wider spectrum of institutions.

8. Members of the Basle Committee are issuing these proposals in their respective countries. The consultative process will be handled at national level in the first instance and the Committee will coordinate the comments and responses made to its members individually. Eight months will be the maximum period envisaged for consultation (i.e. to end December 1993).

9. After careful consideration of all the comments received, the Committee will review the proposals with the intention of issuing a formal amendment to the Capital Accord. It is envisaged that an extended transitional period to implementation (i.e. to end­1996 at the earliest) would be needed to enable market participants to develop the necessary reporting and control systems.

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