(a) The standard method

13. Long or short positions in debt securities and debt related derivative instruments (see III below) would be slotted into a maturity ladder comprising thirteen maturity bands Fixed rate instruments would be allocated according to the residual term to maturity and floating-rate instruments according to the next repricing date. ¹⁴ Opposite positions of the same amount in the same issues (but not different issues by the same issuer), whether actual or notional, incur no interest rate risk and could therefore be omitted from the reporting framework, as could closely matched swaps, forwards, futures and FRAs which meet the conditions set out in paragraphs 32 and 33 below.

14. The first stage in the proposed calculation would be to weight the positions in each time-band by a factor designed to reflect the price sensitivity of those positions to changes in interest rates. The weights proposed have two components: the modified duration¹⁵ of a bond with a maturity equal to the mid-point of the respective time-band, assuming an 8% interest rate environment and an 8% coupon; and an assumed change in yield which is designed to cover about two standard deviations of one month's yield volatility in most major markets. ¹⁶ The two numbers are multiplied to give a weighting factor for each time-band. as set out in Annex 2.

15. The duration of a bond, although primarily influenced by its maturity, is also influenced by its coupon. Zero-coupon and deep-discount ^l7 bonds are much more volatile than coupon bonds; for example, in an 8% interest rate environment, the price of a 30-ear zero-coupon bond is more than twice as volatile as that of a 30- year 8% bond. Slotting such bonds according to residual maturity would underestimate risk and allow offsetting between positions where substantial risk is still present. Some adjustments therefore need to be made to slot zero-coupon bonds and deep- discount bonds (which it is proposed to define as bonds with a coupon of less than 3%) into the maturity ladder. This treatment, which in effect converts zero-coupons into the equivalent of 8% bonds, is set out in the second column of Annex 2. At the far end of the maturity ladder, there are two time-bands with higher weights for zero-coupon bonds whose maturities exceed twelve years.

16. The next step in the calculation is to offset the weighted longs and shorts in each time-band, resulting in a single short or long position for each band ("vertical offsetting"). However, each band would include positions whose maturities are not identical as well as different instruments with the same maturity, exposing the bank to basis risk. The Committee does not believe it would be consistent with its prudential objective to permit full offsetting of longs and shorts and favours a compensating adjustment. The nature of the adjustment would be to disallow some fraction of the offset by applying a "vertical disallowance" factor to the smaller of the offsetting positions, be it long or short. It is proposed that a 10% "vertical disallowance" be applied to one side of the weighted matched positions within each time-band.¹⁸ For example, if the sum of the weighted longs in a time-band is $100 million and the sum of the weighted shorts $90 million, the vertical disallowance for that time-band would be 10% of $90 million (i.e. $9 million).

17. The result of the above calculations is to produce two sets of weighted positions, the net long or short positions in each time-band ($10 million in the example above) and the vertical disallowanceís, which have no sign. The net short and long positions in different time-bands might also be regarded as offsettable to the extent that interest rate at different points in the maturity spectrum tend to move in step. Observed correlations suggest that the likelihood of divergent movements is lower for nearer segments of the yield curve and higher for more distant segments. It is therefore proposed that there should be two rounds of partial "horizontal" offsetting, first between the net positions in each of the three zones (zero to one year, one year to four years and over- four years), and subsequently between the net positions in the different zones. At each stage, the offsetting of opposite positions would be subject to a disallowance (expressed, in the same way as the vertical disallowance, as a fraction of the smaller of the offsetting positions), based on observed correlations of interest rate movements. The disallowances proposed, which are set out in Annex 3, would result in a greater recognition of hedging for offsets taking place within the same zone than for offsets between different zones. The resulting disallowances would be added to the disallowances for vertical offsetting referred to above, and to the absolute amount of the residual net short or long position within the whole book. The total would be the market risk charge for the portfolio which, together with the specific risk charges for each issue referred to in Section I above, would be the institutiont`s overall capital requirement under the standard measurement method. A simplified example of the calculations required is set out in Annex 4.

18. In accordance with the concerns about high-yield debt securities expressed in paragraph 10 above, it is intended that no vertical or horizontal offsetting between such securities and any other debt securities would be permitted unless high-yield debt securities were made subject to 8 higher specific risk weight than 8%.

19. It is proposed that separate reporting ladders be used for each currency, except for those in which business is insignificant, and that capital charges be calculated for each currency separately with no offsetting between positions of opposite sign. It is recognised that such treatment would be rather harsh since it assumes a worst-case scenario in the movements of interest rates in different currencies. On the other hand, the purpose of the proposals is to provide protection against movements in interest rates over relatively short periods and while some correlation across currencies is observable circumstances quite frequently occur in which interest rates in different countries move in opposite directions. It might be possible to devise a practical method of recognising such partial correlation between the interest rates in different countries ^l9 and comment is invited on this aspect.

(b) The alternative method

20. It is proposed that institutions with the necessary capability could, with their supervisors' consent, use a more accurate method of measuring duration by calculating the price sensitivity of each position separately. This would involve taking into account the exact coupon of each bond, rather than an assumed 8% rate, and calculating duration according to the precise residual maturity of the instrument rather than the mid-point of a time-band. Recognising that the alternative method is similar to and more accurate than the standard method, the Committee would be content for this method to be used so long as those who use it demonstrate that it produces results which are consistently equivalent with the standard method.²⁰ Institutions would be required to elect and use the method on a continuous basis (unless a change in method is approved by the national authority) and subject to supervisory monitoring of the systems used.

21. Certain members of the Committee believe that there is some justification for using a lower vertical disallowance than 10% for the alternative method, in recognition of the greater accuracy which makes it no longer necessary to account for maturity mismatches within each time-band. ²¹ Comment is invited on this matter, bearing in mind that the vertical disallowance is also designed to capture basis risk, which would still be present.

Footnotes:

14. In the case of callable bonds, if a bond is trading above par it would be slotted according to its first call date. If priced below par (making a call unlikely) it would be slotted according to its residual term to maturity.

15. Duration is a mathematical concept designed to measure the price sensitivity of debt securities to changes in interest rates. Modified duration is duration divided by a factor of one plus the interest rate. The term duration used throughout the text refers to modified duration.

16. Since in most countries long-term rates are less volatile than short-term rates, the protection sought diminishes progressively along the yield curve, from a 12 change in interest rates at the short end to a 0.6% change at the long end.

17. Where the coupon of a debt security appears to be "low coupon" but the coupon and principal are linked to movements in a consumer price index, the securities should be treated as normal coupon debt securities.

18. Several countries would prefer to have a 15Z vertical disallowance for the time-bands in zone 1 (see Annex 3), while accepting 101 for the other zones.

19. A possible approach favoured by one delegation would be to allow partial offsetting of the final residual unmatched position in all currencies by taking the larger of the sum of shorts and longs.

20. In order to be certain of producing equivalent results, i.e. those that do not result in any systematic bias, the following processes would need to be followed:

• the institution would first calculate the price sensitivity of each instrument in terms of a change in interest rates of between 0.6 and 1.0 percentage points depending on the maturity of the instrument (using the same scale as in column B of Annex 2);

• the resulting sensitivity measures would then be slotted into a duration-based ladder with fifteen time-bands as set out at the foot of the table in Annex 2;

• long and short positions in each time-band would be subject to the 10% vertical disallowance;

• the net positions in each time-band would be carried forward for horizontal offsetting subject to the disallowances set out in Annex 3.