Regulatory capital has to date taken as its starting point the more easily quantifiable risks and exposures, notably credit and market risk. Capital charges currently applied by securities supervisors and banking supervisors (the latter under the Basle 'standard' approach) in some respects overcompensate for these particular categories of risk. For instance, on the market risk side, both securities and bank supervisors allow limited or no recognition of correlations across currencies or across markets. Similarly, there is only limited recognition of offsets in the area of credit risk; even within the trading book, exposures may only be fully offsettable for opposite positions in exactly the same issue.
Implicitly, this conservatism creates a "buffer" (i.e. additional capital) that serves a dual purpose. 5 First, it gives protection against the eventuality that in some extreme circumstances - such as very sharp market moves or credit quality deterioration in a whole geographical region - capital weightings or haircuts calculated on the basis of more normal market conditions will be inadequate. Secondly, it gives some protection against those risks which are not included in the calculation at all, notably operational risk. Overall, therefore, current capital charges are not excessive for the totality of risks.
Capital requirements based solely on the outputs of VaR models are not in themselves sufficient. In moving towards a capital regime that gives wider recognition of hedges and correlations - such as VaR modelling - part of the implicit buffer will be lost. Supervisors will, however, need to ensure that overall capital remains adequate, implying that two types of explicit buffers should be introduced into the capital calculation: first, a cushion against model risks (including inadequate capture of extreme market moves), and second, a cushion for operational and other non-modelled risks (other than credit risk which for the time being would be covered by existing approaches).
The following sections discuss various approaches. In considering these, supervisors should bear in mind the balance of cost and benefit which arises from the greater degree of supervisory involvement and complexity of judgement entailed by many of these approaches.
Footnotes:
5. This implicit buffer is supplemented in many regimes by explicit buffers. For example, most regulators require a minimum level of capital to be in business, and securities firms operating in the European Union under the Capital Adequacy Directive (CAD) must maintain capital equal to one quarter of their previous year's fixed overheads (to help ensure an orderly wind-down of the firm). Of course, these only act as additional buffers to the extent that they add to capital required against market and credit risk (for most firms they would not bite). In addition, some regulators (eg the UK banking supervisors) require higher capital ratios for higher risk firms.
