Guidelines for computing capital for incremental risk in the trading book - consultative document
The Basel Committee/IOSCO Agreement reached in July 2005, contained several improvements to the capital regime for trading book positions. Among these 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 (VaR) 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 VaR. In October 2007, the Basel Committee on Banking Supervision (the Committee) released guidelines for computing capital for incremental default risk for public comments. At its meeting in March 2008, it reviewed comments received and decided to expand the scope of the capital charge to capture not only price changes due to defaults but also other sources of price risk, such as those reflecting credit migrations and significant moves of credit spreads and equity prices. The decision was taken in light of the recent credit market turmoil where a number of major banking organisations have experienced large losses, most of which were sustained in banks' trading books. Most of those losses were not captured in the 99%/10-day VaR. Since the losses have not arisen from actual defaults but rather from credit migrations combined with widening of credit spreads and the loss of liquidity, applying an incremental risk charge covering default risk only would not appear adequate. For example, the incremental default risk charge would not have captured recent losses in CDOs of ABS and other re-securitisations held in the trading book. Moreover, a number of global financial institutions commented that singling out just default risk was inconsistent with their internal practices and could be potentially burdensome.
Broadly, the incremental risk charge (IRC) set forth in this document is intended to address a number of perceived shortcomings in the current 99%/10-day VaR framework. Foremost, the current VaR framework ignores differences in the underlying liquidity of trading book positions. In addition, these VaR calculations are typically based on a 99%/one-day VaR which is scaled up to 10 days. Consequently, the VaR capital charge may not fully reflect large daily losses that occur less frequently than two to three times per year as well as the potential for large cumulative price movements over periods of several weeks or months. Moreover, the current framework's emphasis on modelling short-run P&L volatility (eg backtesting requirements) allows the use of relatively short data windows for estimating VaR parameters (as short as one year), which can produce insufficient required capital against trading positions following periods of relative calm in financial markets.
The Committee expects banks to develop their own models for calculating the IRC for trading book positions. This paper provides guidelines on how an IRC model should be developed. It also contains both guidance on how supervisors should evaluate banks' IRC models and fallback options deemed acceptable by the Committee.
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 email@example.com.