2. While the Accord was mainly directed towards the assessment of capital in relation to credit risk (the risk of counterparty failure ¹, it also stated that the Committee was examining other risks which need to be taken into account by supervisors in assessing overall capital adequacy. Deregulation of interest rates and capital controls, the liberalisation of banks' permitted range of activities and the rapid development of financial markets have all increased the opportunities for banks to incur market risks. In particular, banks. trading in derivative products has continued to grow at a rap d rate. Although the recent survey of foreign exchange market activity issued by the BIS reported a slowing­down in the growth of activity between April 1989 and April 1992, foreign exchange trading resins at a high level. Recent experience in the financial markets, particularly in relation to the ERM, has heightened sensitivity to trading risks and reinforced the Committee's belief that supervisors of international banks need to update their supervisory methods to ensure that adequate capital is available to cover banks' exposure to market­related risks.

3. The current proposals are necessarily more complex than existing capital requirements and focus on a somewhat shorter time horizon, commensurate with the difference in perspective between banking and trading activities. They are not, however, intended to substitute for banks' own internal control ant risk management procedures. The management of risk remains the task of banks and not the task of supervisors.

4. Although the prudential objective is similar for each of the three risks, the particular methodologies used to measure risks, the reporting frameworks, and some of the assumptions used in tabulating open positions vary. This reflects the differing characteristics of the foreign exchange, traded debt, and equity markets. The Committee has undertaken substantial statistical research to ensure that the capital charges calculated according to the varying methodologies broadly satisfy a common economic criterion. The test applied was that the capital required should cover adequately a high proportion of the losses that would have been experienced in any two­week holding period in a range of representative portfolios over the last five years.

5. There is no methodology that can full' anticipate price movements of assets or classes of asset based on historical experience. These are therefore minimum standards. As with existing capital requirements, national supervisors would be free to apply higher minimum standards than those indicated to individual banks in their jurisdictions or to their banking systems generally.

6. The Committee favours capital requirements in preference to limits as the appropriate instrument for international convergence in the treatment of market risk. unlike limits, capital requirements give banks added incentives to use hedging techniques, while ensuring that a prudent capital cushion remains available to cover possible losses. They also enable bank managements to retain flexibility in managing their risks by assessing the risk/reward profile and allocating capital accordingly. Nonetheless, the Committee believes limits have an appropriate place in national supervisory arrangements. Individual national supervisors are encouraged to maintain limits where they judge it appropriate to do so, both as a means of imposing absolute ceilings on banks' exposures ant of reinforcing internal controls. For example, supervisors who use limits to restrain position­taking in foreign exchange markets would be free to continue to use limits in conjunction with the proposed capital requirements on open positions.

Footnote:

1. For a definition of counterparty risk and some other technical terms used in this paper, a glossary is supplied in Annex 1.