In 1996, Basel Committee on Banking Supervision (BCBS) published an amendment to the 1988 Basel Accord to provide an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. This amendment was brought into effect in 1998.
Salient features of the amendment are given below:
- Allows banks to use proprietary in-house models for measuring market risks
- Banks using proprietary models must compute VaR daily, using 99th percentile, one-tailed confidence interval with a time horizon of ten trading days using a historical observation period of at least one year.
- The capital charge for a bank that uses a proprietary model will be the higher of the previous day’s VaR and three times the average of the daily VaR of the preceding sixty business days.
- Use of ‘back testing’ (ex-post comparisons between model results and actual performance) to arrive at the ‘plus factor’ that is added to the multiplication factor of three.
- Allows banks to issue short-term subordinated debt subject to a lock-in clause (Tier 3 capital) to meet a part of their market risks.
- Alternate standardized approach using the ‘building block’ approach where general market risk and specific security risk are calculated separately and added up.
- Banks to segregate trading book and mark to market all portfolio/position in the trading book.
- Applicable to both trading activities of banks and non-banking securities firms.
Originally released in January 1996 and modified in September 1997, the Amendment was further revised on 14 November 2005 to incorporate the Basel Committee’s 18 July 2005 paper, The application of Basel II to trading activities and the treatment of double default effects, solely as a matter of convenience to readers.
Amendment to the capital accord to incorporate market risks – This document, commonly referred to as the Market Risk Amendment, represents the main section of a three-part package of documents issued by the Basel Committee to amend the Capital Accord of July 1988 to take account of and set capital requirements for market risks. It describes two alternative approaches to the measurement of market risk, a standardised method and an internal models approach, closing with a number of worked examples. The other papers in the three-part package are an overview of the market risk amendment and a technical paper on the backtesting of models.Originally released in January 1996 and modified in September 1997, the Amendment was further revised on 14 November 2005 to incorporate the Basel Committee’s 18 July 2005 paper, The application of Basel II to trading activities and the treatment of double default effects, solely as a matter of convenience to readers.