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Framework for applying capital requirements to market risks

II. The application of the framework

7. Two issues need to be addressed in determining a capital standard. The first is to calculate how much capital would be required to support varying portfolios of open positions in debt securities, equities and foreign exchange. The second is to define how these capital charges should be met.

(a) Capital requirements

8. The capital charges proposed for debt securities and equities would apply to the current market value of items in banks' trading books. 2 Trading positions are understood to mean the bank's proprietary positions in financial instruments 3 which are taken on with the intention of benefiting in the short term from actual or expected differences between their buying and selling prices or of hedging other elements of the trading book, or which are held for short­term resale, or in order to execute a trade with a customer. Inclusion in or exclusion of items from the trading book would be in accordance with objective procedures including, where appropriate, accounting standards in the institution concerned, such procedures and their consistent implementation being subject to review by the relevant supervisory authority.

9. Items not covered by these criteria, for example those reverse sale and repurchase agreements which are not integral to the trading book, would continue to be subject to the present capital requirements for credit risk as set out in the 1988 Accord, along with other banking assets. 4 It would also seem reasonable to allow banks to exclude from their trading books derivative products which are taken on explicitly to hedge positions in the banking book. The members of the Committee intend to monitor carefully the way in which banks allocate financial instruments between the trading book and other accounts ant will seek to ensure through the examination process or other means that no abusive switching designed to minimise capital requirements occurs. In particular, they will be vigilant in seeking to prevent gains trading. in respect of securities which are not marked to market, through which banks improve their short­term profitability by realising accrued profits and deferring the realisation of losses. The Committee will seek to clarify over time the appropriate distinction between the trading book and the other business of banks.

10 The proposals for debt securities and equities are based upon the so­called building block' approach which differentiates specific risk requirements from those for general market risk. 5 Specific risk is the risk of loss caused by an adverse price movement of a security (or a derivative product linked to it) due principally to factors related to the issuer of the security. Specific risk has some parallels with, but is broader than, credit risk in the sense that it exists whether the position is long or short. General market risk is the risk of loss caused by an adverse market movement unrelated to any specific security. This dual approach has been chosen because it provides a sound conceptual and practical basis for permitting offsetting of marched (i.e. long and short) positions.

11. The proposals for foreign exchange risk are intended to apply specifically to banks, but they could equally well be used by other institutions. There is a two­step approach to the measurement of the risk. The first task is to measure the exposure in each currency, where the main challenge is to decide how to treat derivatives involving foreign currency risk, especially options. The second task is to measure the risks inherent in a mix of long and short positions in different currencies. It is proposed that banks should have a choice between this in a relatively rough broadbrush manner or using computer simulations based on past exchange rate relationships.

12. While the present proposals cover the position risk in foreign exchange, debt securities and equities, they do not address counterparty or settlement risk. However, the 1988 Accord already covers the counterparty risk in some over­the­counter 6 derivatives by calculating the replacement cost of the contract, measured as the current mark­to-market value (if positive) plus an ìadd­on'ì to reflect the potential increase in the exposure over the remaining life of the contract.

13. Each bank affected by these proposals would be expected to monitor and report the position outstanding for each category of risk against which a capital requirement would be applied. The bank's overall minimum capital requirement would be:

  • the existing credit risk requirements for the banking business, e.g. loans, investments and the counterparty risk on over-the-counter derivatives;

  • the capital charges for debt and equity securities in the trading portfolio, as described in Sections 2 and 3;

  • the charges for foreign exchange risk described in Section 4.

14. The market risk proposals could result in a higher or lower aggregate capital requirement than those to which banks are already subject under the present credit risk framework, depending on the risk profile of the individual institution. In the case of debt securities and equities held in the trading book, the proposed market .risk charges would substitute for the credit risk weights presently applied to the balance­sheet assets. Whether this would lead to higher capital charges on balance would depend on the pattern of each bank's book and on the category of issuer. A bank with well­hedged positions or with significant holdings of high grade corporate debt securities could well have a lower capital requirement than at present.

15. The measure in respect of foreign exchange risk would in principle be additive in the sense that no compensating reduction in credit risk is being proposed. However, in the simplified approach described in Section 4 on foreign exchange risk, it is proposed to apply a de minimis exemption which would enable those banks with negligible business in foreign currency to escape any capital charge.

16. Although regular reporting would in principle take place only at intervals (in most countries quarterly), banks would be espected to manage the market risk in their trading portfolio in such a way that the capital requirements would be met on a continuous basis, i.e. at the close of each business day. Supervisors have at their disposal a number of effective measures to ensure that banks do not ìwindow­dressî. by showing significantly, lower market risk positions on reporting dates. Banks would also, of course, be expected to maintain strict risk management systems to ensure that intra­day exposures are not excessive.

17. In the belief that all risks should be captured when they arise, it is proposed that all transactions, including forward sales and purchases, should be reported on a trade date basis. If, however. its use would not produce a material difference, it is suggested that national authorities could choose to allow settlement date reporting, so long as this was on a continuous basis.

(b) satisfying the capital charges

18. Once the capital charges have been calculated as described in the preceding paragraphs, the second step is to define how those requirements can be satisfied. The definition of capital for banks set out in the 1988 Accord differs from the definition of capital commonly used for securities firms and from the definition of capital in the EC's Capital Adequacy Directive. This can be justified b, the nature of the risks stemming from traditional banking activities and the nature of those arising from trading activities. In particular, bank assets are often illiquid and not easily marked to market, and therefore are typical, reported at book value. This treatment is consistent with the inherent going­concern nature of banking, in which recognising short­term fluctuations in the value of assets held for the long run is generally inappropriate. In contrast, trading positions are marked to market frequently, reflecting the shorter­term nature of these positions and the market risk to which they are exposed. Capital requirements for market risk thus tend to be far more volatile than those for credit risk and a more flexible source of capital may be considered appropriate. For example, securities firms are customarily permitted to include in eligible capital a high proportion of short­term subordinated debt, often subject to lock­in provisions. a facility not currently available to banks.

19. Were the proposals to be designed for banks alone, the Basle Committee would favour the retention of the present definition of capital in the Basle Accord to cover all banks' capital requirements. However, it is still hopeful that over time it may be possible to move towards meaningful convergence in the capital requirements of banks and securities houses. It is also aware that many banks affected by these proposals will be operating under the provisions of the Capital Adequacy Directive. 7 It therefore proposes 8 that banks be permitted, at the discretion of their national supervisors, to employ an additional form of subordinated debt for the sole purpose of meeting a part of the capital requirements for market risks up to certain limits described in paragraph 21. For such instruments to be eligible, they need, if circumstances demand, to be capable of becoming part of an institutions permanent capital and thus be available to absorb losses. They should, 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 supervisor agrees;

  • be subject to a lock­in clause which stipulates that neither interest nor principal may be paid (even at maturity) if such payment would mean that the capital allotted to the trading book for debt securities and equities would fall below a threshold 20% above the required capital laid down in these proposals.

20. For banks, any such debt would form a third tier of capital, supplementary to the existing tiers 1 and 2. There are three principal differences between this and the subordinated debt currently permitted as a subset of tier 2 in the 1988 Accord. First, the minimum original maturity is significantly shorter (two years as opposed to five years). Second, the debt is valued at par while in the 1988 Accord it is amortised over the last five years of life. Third, and most important, tier 3 has the lock­in feature which means that, because of the restriction on payment, the debt is effectively, available to absorb losses if allotted capital falls below an early­warning level 20% above the minimum. The distinction drawn between tier 2 and tier 3 subordinated debt is not due to judgements about relative quality, but to the fact that short­term debt with a lock­in is more appropriate for trading activities whereas longer term debt is more appropriate to normal banking business.

21. The Committee proposes that the following limitations should be applied to the use of tier 3 by banks:

  • banks would be entitled to use such debt solely to support the market risks in the trading book for equities and debt securities (including the specific risk in the trading book). this means that any capital requirement arising in respect of banksí foreign exchange risk, or in respect of credit and counterparty risk, would need to be met by .he existing definition of capital in the 1988 Accord;

  • tier 3 capital would be limited to 250% of tier 1 capital allocated to support securities trading
  • book risks, which is consistent: with the EC's Capital Adequacy, Directive applicable to both banks and securities firms. This means that a minimum of about 28 1/2% : of trading
  • book risks would need to be supported by tier 1 capital not required to support risks in the remainder of the book;

  • tier 2 elements could be substituted for tier 3 insofar as the overall limits in the 1988 Accord were not breached, that is to say total tier 2 capital could not exceed total tier 1 capital, and long
  • term subordinated debt could not exceed 50: of tier 1 capital;

  • since several members of the Committee do not favour the use of tier 3 capital for banks at all. the Committee is also contemplating, pending further developments in the convergence process more generally, retaining the principle in the present accord that tier 1 capital should represent at least half of total capital, i.e. that the sum total of tier 2 plus tier 3 capital should not exceed total tier 1.

National supervisors would have discretion to refuse the use of short-term subordinated debt for individual banks or for their banking systems generally.

Footnotes:

2. The proposals in respect of foreign exchange risk are designed to apply to banks' total currency positions, some of which would be reported at book value.

3. Including positions in derivative products and interest rate instruments.

4. All interest rate related on and off­balance­sheet positions would fall within the measure of interest rate risk described in the third paper in the present package.

5. In discussions with the securities regulators, several have indicated a wish to retain their existing comprehensive measures for equities. This could be acceptable subject to the conditions laid down in paragraph 5 of Section 3.

6. Instruments traded on approved exchanges which require daily receipt and payment of cash variation margin, where the counterparty risk is in essence an intra­day one, are exempt from counterparty risk weightings in the Accord.

7. However, Article 14 of this Directive requires an examination and, if necessary, a revision of the Directive within three years of its implementation in the light of the experience acquired in applying it "taking into account market innovation ant. in particular, developments in international fora of regulatory authorities".

8. One member country objects to the inclusion of tier 3 capital. That country would have been prepared to accept tier 3 if harmonisation had been achieved with securities regulators. It believes, however, that the divergences that currently exist, at both national and international levels, are of such magnitude that it would be inappropriate to widen the definition of capital at this time.

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