Proposed revisions to the Basel II market risk framework

July 2008

The Basel Committee/IOSCO Agreement reached in July 2005 contained several improvements to the capital regime for trading book positions. Among the revisions was a new requirement for banks that model specific risk to measure and hold capital against default risk that is incremental to any default risk captured in the bank's value-at-risk model. The incremental default risk charge was incorporated into the trading book capital regime in response to the increasing amount of exposure in banks' trading books to credit-risk related and often illiquid products whose risk is not reflected in value-at-risk. At its meeting in March 2008, the Basel Committee on Banking Supervision (the Committee) decided to expand the scope of the capital charge to capture not only defaults but a wider range of incremental risks, to improve the internal value-at-risk models for market risk and to update the prudent valuation guidance for positions subject to market risk of the Basel II Framework.

Given the interest of both banks and securities firms in the potential solutions to these particular issues, the Committee has worked jointly with the International Organization of Securities Commissions (IOSCO) to consult with industry representatives and other supervisors on these matters.

The decision to capture not only defaults but a wider range of incremental risks in the incremental risk capital charge is reflected in the proposed changes to the Basel II market risk framework. Additional guidance on the incremental risk capital charge is provided in a separate consultative document.

The improvements in the Basel II Framework concerning internal value-at-risk models will in particular require banks to justify any factors used in pricing which are left out in the calculation of value-at-risk. They will also be required to use hypothetical backtesting at least for validation, to update market data at least monthly and to be in a position to update it in a more timely fashion if deemed necessary. Furthermore, the Committee clarifies that it is permissible to use a weighting scheme for historical data that is not fully consistent with the requirement that the "effective" observation period must be at least one year, as long as that method results in a capital charge at least as conservative as that calculated with an "effective" observation period of at least one year.

To complement the incremental risk capital framework, the Committee has made the language with respect to prudent valuation for positions subject to market risk (paragraphs 690 to 701) more consistent with existing accounting guidance, and has clarified that regulators will retain the ability to require adjustments to current value beyond those required by financial reporting standards, in particular where there is uncertainty around the current realisable value of a position due to illiquidity. This guidance focuses on the current valuation of the position and is a separate concern from the risk that market conditions and/or variables will change before the position is liquidated (or closed out) causing a loss of value to positions held.

The Committee welcomes comments from the public on all aspects of this consultative paper by 15 October 2008. These should be addressed to the Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, Centralbahnplatz 2, 4002 Basel, Switzerland. Alternatively, comments may be sent by e-mail to baselcommittee@bis.org.