Menu
Home
Log in / Register
 
Home arrow Management arrow Risk management in banking

THE ACCORD FOR MARKET RISK

A significant amendment was enacted in 1995-6, when the Committee introduced a measure whereby trading positions in bonds, equities, foreign exchange and commodities became subject to capital charges for market risk related to the bank's open positions in each instrument [7]. The amendment made explicit the notions of banking book and trading book, defined capital charges for market risk, and allowed banks to use a tier 3 capital in addition to the previous two tiers, 1 and 2.

The 1995 proposal introduced capital charges to be applied to the current market value of open positions (including derivative positions) in interest rate related instruments and equities in banks' trading books, and to banks' total currency and commodities positions. The extension to market risk provides two alternate options for assessing capital charges. The "Standardized Approach" allows measuring the four risks, interest rate, equity, foreign exchange and commodity risk, using sets of standard capital charges. The alternate method allows banks to use risk measures derived from their own internal risk models, or VaR models, subject to a number of conditions, related to qualitative standards of models and processes.

The Standardized Approach

The standardized approach relies exclusively on sets of standard percentages of value for assessing potential losses as percentage of current exposures. Those are summarized in grids for capturing the differences in sensitivities of various market instruments, and on offsetting rules allowing netting the risks within a portfolio whenever there is no residual "basis" risk[1]. For example, for stocks, capital charge is 8% of the net balances, after allowed offsetting long and short comparable exposures. For bonds, the 8% is used with various weights depending upon maturity buckets, because sensitivity differs across maturities.

Within a given class of instruments, such as bonds, equity, and foreign exchange, regulators allow offsetting risks to a certain extent. For instance, being long and short on the same stock results is zero risk, because the gain on the long leg offsets the loss in the short leg when the stocks goes up, and vice versa. Offsetting is limited to exact matches of instrument characteristics. The regulators rely on the "specific" versus "general" risk distinction, following the principle of adding up specific risk while allowing the offsetting of effects for general risk. The rationale is that the general risk represents co-movements of prices driven by the equity index, while specific risk is unrelated to underlying market parameters.

The capital charges calculated under the standardized approach remain conservative because they do not allow capturing the full extent of diversification effects. This is the main incentive for moving on to VaR models.

The standardized approach uses a complex grid of weights for interest rate instruments, equity, derivatives, foreign exchange and commodities. The 8% ratio remains the reference when there are no offsetting positions. For interest rate instruments, the grid of coefficients depends on the duration of the bonds, unless they are credit risk-free. Offsetting is permitted within bands of durations and partially across bands. For derivatives which can be replaced by a static portfolio (swaps for example), the capital charge applies to each component of such portfolio (each leg of an IRS for example). Dealing with options implies using scenarios for defining worst-case loss. For equity, the capital charge is 8% for specific risk unless there is a wide diversification, allowing using a 4% capital charge. The general risk capital charge is also 8% but offsets across positions are allowed. Foreign exchange positions in the same currency are offset and the 8% weight applies to the net exposure. Commodity risk is more complex than market instrument risks because it combines a pure commodity price risk with other risks, such as basis risk (mismatch of prices of similar commodities), interest rate risk (for carrying cost of exposures), forward price risk, plus directional risk in commodities price (trends). The capital charges are defined by breaking down the portfolio according to maturities and offset is allowed if there is no basis risk (no mismatch).

  • [1] Basis risk refers to the mismatch between the risk factors of two offsetting positions, for example when one position depends on Libor 3-month and another on Libor 6-month.
 
Found a mistake? Please highlight the word and press Shift + Enter  
< Prev   CONTENTS   Next >
 
Subjects
Accounting
Business & Finance
Communication
Computer Science
Economics
Education
Engineering
Environment
Geography
Health
History
Language & Literature
Law
Management
Marketing
Mathematics
Political science
Philosophy
Psychology
Religion
Sociology
Travel