Basel Committee on Banking Supervision

Market risk is defined as the risk of losses in on and off-balance-sheet positions arising from movements in market prices. The risks subject to this requirement are:

1. The risks pertaining to interest rate related instruments and equities in the trading book;
2. Foreign exchange risk and commodities risk throughout the bank.

The capital requirements for interest rate related instruments and equities will apply to the current trading book items prudently valued by banks, alongside CAP50. The definition of trading book is set out in RBC25.

All transactions, including forward sales and purchases, shall be included in the calculation of capital requirements as from the date on which they were entered into. Although regular reporting will in principle take place only at intervals (in most countries quarterly), banks are expected to manage the market risk in their trading book in such a way that the capital requirements are being met on a continuous basis, ie at the close of each business day. Supervisory authorities have at their disposal a number of effective measures to ensure that banks do not “window-dress” by showing significantly lower market risk positions on reporting dates. Banks will also, of course, be expected to maintain strict risk management systems to ensure that intra-day exposures are not excessive. If a bank fails to meet the capital requirements, the national authority shall ensure that the bank takes immediate measures to rectify the situation.

The capital requirements for foreign exchange risk and for commodities risk will apply to banks’ total currency and commodity positions, subject to some discretion to exclude structural foreign exchange positions. It is understood that some of these positions will be reported and hence evaluated at market value, but some may be reported and evaluated at book value.

A matched currency position will protect a bank against loss from movements in exchange rates, but will not necessarily protect its capital adequacy ratio. If a bank has its capital denominated in its domestic currency and has a portfolio of foreign currency assets and liabilities that is completely matched, its capital/asset ratio will fall if the domestic currency depreciates. By running a short position in the domestic currency the bank can protect its capital adequacy ratio, although the position would lead to a loss if the domestic currency were to appreciate.

Supervisory authorities are free to allow banks to protect their capital adequacy ratio in this way. Thus, any positions which a bank has deliberately taken in order to hedge partially or totally against the adverse effect of the exchange rate on its capital ratio may be excluded from the calculation of net open currency positions, subject to each of the following conditions being met:

1. such positions need to be of a “structural”, ie of a non-dealing, nature (the precise definition to be set by national authorities according to national accounting standards and practices);
2. the national authority needs to be satisfied that the “structural” position excluded does no more than protect the bank’s capital adequacy ratio;
3. any exclusion of the position needs to be applied consistently, with the treatment of the hedge remaining the same for the life of the assets or other items.

No capital requirements need apply to positions related to items that are deducted from a bank’s capital when calculating its capital base, such as investments in non-consolidated subsidiaries, nor to other long-term participations denominated in foreign currencies which are reported in the published accounts at historic cost. These may also be treated as structural positions.

Positions in the bank’s own eligible regulatory capital instruments are deducted from capital. Positions in other banks’, securities firms’, and other financial entities’ eligible regulatory capital instruments, as well as intangible assets, will receive the same treatment as that set down by the national supervisor for such assets held in the banking book, which in many cases is deduction from capital. Where a bank demonstrates that it is an active market maker then a national supervisor may establish a dealer exception for holdings of other banks’, securities firms’, and other financial entities’ capital instruments in the trading book. In order to qualify for the dealer exception, the bank must have adequate systems and controls surrounding the trading of financial institutions’ eligible regulatory capital instruments.

In the same way as for credit risk, the capital requirements for market risk are to apply on a worldwide consolidated basis. Where appropriate, national authorities may permit banking and financial entities in a group which is running a global consolidated book and whose capital is being assessed on a global basis to report short and long positions in exactly the same instrument (eg currencies, commodities, equities or bonds), on a net basis, no matter where they are booked.¹ Moreover, the offsetting rules as set out in this section may also be applied on a consolidated basis. Nonetheless, there will be circumstances in which supervisory authorities demand that the individual positions be taken into the measurement system without any offsetting or netting against positions in the remainder of the group. This may be needed, for example, where there are obstacles to the quick repatriation of profits from a foreign subsidiary or where there are legal and procedural difficulties in carrying out the timely management of risks on a consolidated basis. Moreover, all national authorities will retain the right to continue to monitor the market risks of individual entities on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision. Supervisory authorities will be especially vigilant in ensuring that banks do not pass positions on reporting dates in such a way as to escape measurement.

For the purposes of this framework, the correlation trading portfolio incorporates securitisation exposures and n-th-to-default credit derivatives that meet the following criteria:

1. The positions are neither resecuritisation positions, nor derivatives of securitisation exposures that do not provide a pro-rata share in the proceeds of a securitisation tranche (this therefore excludes options on a securitisation tranche, or a synthetically leveraged super-senior tranche); and
2. All reference obligations are single-name products, including single-name credit derivatives, for which a liquid two-way market exists. This will include commonly traded indices based on these reference obligations. A two-way market is deemed to exist where there are independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined within one day and settled at such price within a relatively short time conforming to trade custom.
3. Positions which reference an underlying that would be treated as a retail exposure, a residential mortgage exposure or a commercial mortgage exposure under the standardised approach to credit risk are not included in the correlation trading portfolio.
4. Positions which reference a claim on a special purpose entity are not included either.
5. A bank may also include in the correlation trading portfolio positions that hedge the positions described above and which are neither securitisation exposures nor n-th-to-default credit derivatives and where a liquid two-way market as described above exists for the instrument or its underlyings.

Each bank subject to capital requirements for market risk will be expected to monitor and report the level of risk against which a capital requirement is to be applied. In measuring their market risks, a choice between two broad methodologies (described in MAR20 and MAR30, respectively) will be permitted, subject to the approval of the national authorities.

1. One alternative will be to measure the risks in a standardised manner, using the measurement frameworks described in MAR20.
2. The alternative methodology, which is subject to the fulfilment of certain conditions and the use of which is therefore conditional upon the explicit approval of the bank’s supervisory authority, is set out in MAR30. This method allows banks to use risk measures derived from their own internal risk management models, subject to seven sets of general conditions, namely:
   1. certain general criteria concerning the adequacy of the risk management system;
   2. qualitative standards for internal oversight of the use of models, notably by management;
   3. guidelines for specifying an appropriate set of market risk factors (ie the market rates and prices that affect the value of banks’ positions);
   4. quantitative standards setting out the use of common minimum statistical parameters for measuring risk;
   5. guidelines for stress testing;
   6. validation procedures for external oversight of the use of models;
   7. rules for banks which use a mixture of models and the standardised approach.

Unless a bank’s exposure to a particular risk factor, such as commodity prices, is insignificant, the internal models approach will in principle require banks to have an integrated risk measurement system that captures the broad risk factor categories (ie interest rates, exchange rates (which may include gold), equity prices and commodity prices, with related options volatilities being included in each risk factor category). Thus, banks which start to use models for one or more risk factor categories will, over time, be expected to extend the models to all their market risks. A bank which has developed one or more models will no longer be able to revert to measuring the risk measured by those models according to the standardised methodology (unless the supervisory authority withdraws approval for that model). However, pending further experience regarding the process of changing to an internal models approach, no specific time limit will be set for banks which use a combination of internal models and the standardised approach to move to a comprehensive model. The following conditions will apply to banks using such combinations:

1. Each broad risk factor category must be assessed using a single approach (either internal models or the standardised approach), ie no combination of the two methods will in principle be permitted within a risk category or across banks’ different entities for the same type of risk (but see MAR10.12 above);²
2. All the criteria laid down in MAR30 will apply to the models being used;
3. Banks may not modify the combination of the two approaches they use without justifying to their supervisory authority that they have a good reason for doing so;
4. No element of market risk may escape measurement, ie the exposure for all the various risk factors, whether calculated according to the standardised approach or internal models, would have to be captured;
5. The capital requirements assessed under the standardised approach and under the models approach are to be aggregated according to the simple sum method.

The minimum capital requirement for market risk is expressed in terms of:

1. general market risk; and
2. specific risk (ie risk associated with exposures to specific issuers of debt securities or equities).³

The standardised approach uses a “building-block” approach in which specific risk and the general market risk arising from debt and equity positions are calculated separately. The focus of most internal models is a bank’s general market risk exposure, typically leaving specific risk to be measured largely through separate credit risk measurement systems. Banks using models should be subject to capital requirements for the specific risk not captured by their models. Accordingly, a separate capital requirement for specific risk will apply to each bank using a model to the extent that the model does not capture specific risk. The capital requirement for banks which are modelling specific risk is set out in MAR10.15 to MAR10.18 and MAR30.28 to MAR30.43.

For equity positions, where a bank has a value-at-risk (VaR) measure that incorporates specific risk from equity risk positions and where a supervisor has determined that the bank meets all the qualitative and quantitative requirements for general market risk models, as well as the additional criteria and requirements set out in paragraphs MAR30.28 to MAR30.32, the bank is not required to subject its equity positions to the capital requirement according to the standardised measurement method as specified in MAR20.

For interest rate risk positions other than securitisation exposures and n-th-to-default credit derivatives, the bank will not be required to subject these positions to the standardised capital requirement for specific risk, as specified in MAR20.4 to MAR20.21, when all of the following conditions hold:

1. The bank has a VaR measure that incorporates specific risk and the supervisor has determined that the bank meets all the qualitative and quantitative requirements for general market risk models, as well as the additional criteria and requirements set out in MAR30.28 to MAR30.32; and
2. The supervisor is satisfied that the bank’s internally developed approach adequately captures incremental default and migration risks for positions subject to specific interest rate risk according to the standards laid out in MAR30.33 and MAR30.34.

For securitisation exposures and n-th-defualt credit derivatives, the bank is allowed to include its securitisation exposures and n-th-to-default credit derivatives in its VaR measure. Notwithstanding, it is still required to hold additional capital for these products according to the standardised approach, with the exceptions noted in MAR30.35 to MAR30.43.

For the correlation trading portfolio, the bank is allowed to include comprehensive risk of correlation trading portfolio in its internally developed approach as set out in MAR30.35 only when the bank is active in buying and selling correlation trading portfolio products.