2. There are two main difficulties with the current approach. First, in some cases the current add-on, which is a function of a factor that depends on both the type of the underlying instrument and the remaining maturity as well as the notional amount, does not accurately reflect the cash flows and thus the true level of potential future credit exposure. Second, the add-on factors in the Capital Accord were designed for interest rate and exchange rate instruments, not for commodity and equity derivatives, which are rapidly growing segments of the market.

3. To address these difficulties the Committee concluded that an acceptable approach would be to adapt the matrix of add-on factors in the Capital Accord to take account of problem cases. Specifically, the Committee is proposing an expanded matrix which incorporates an additional maturity row and three additional columns to cover instrument types not explicitly dealt with in the Capital Accord.

4. The proposed expanded matrix is attached as Annex 3. The add-on factors in the original Capital Accord have been left unchanged. The proposed factors were developed using Monte Carlo simulations of matched pairs of representative transactions and are intended to provide reasonable prudential coverage for a high proportion of potential exposures. The proposed add-on factors thus may seem overly conservative in some specific cases and understated in others. In a portfolio context, however, the Committee would expect this to result overall in a reasonable level of prudential coverage.

5. For transactions such as commodity swaps, in which full exchanges of the contract principal are made periodically throughout maturity, the higher potential future exposure would be captured by multiplying the add-on factors by the number of remaining payments. In the equity column a footnote has been added indicating that for contracts automatically resetting to zero value following a payment the remaining maturity is set equal to the time until the next payment. This is to reflect the nature of equity index swaps which typically trade a return on an equity index against a floating interest rate and thus reprice to zero value following a payment. The Committee invites comment on this treatment and whether there are other transactions of a similar nature which might deserve such treatment. In addition, the Committee invites comment on the possible distinction between the automatic reset feature of equity index swaps and transactions involving interim cash settlements to extinguish (or diminish) outstanding credit exposure, which could involve changes to the original terms of the transactions.

6. More generally, the Committee invites comment on the structure of the proposed expanded matrix as well as on the scale of add-ons for the different instrument classes. The Committee is aware that it could achieve a greater degree of accuracy by making further breakdowns in maturities and instruments. However, it has tried to strike a balance between the relative simplicity of the Capital Accord's approach and achieving a reasonable level of capital for a wide variety of transactions.

7. Finally, all banks engaging in transactions covered by the proposed new columns in the matrix (i.e. equity, precious metals and other commodities) must use the current exposure method. The Committee strongly believes that banks involved in such transactions must have the capacity to implement the marking-to-market process associated with the current exposure method as part of a sound risk management program