Bank Capital Requirements for Market Risk: The Internal Models Approach

he increased prominence of trading activities at many large banking companies has highlighted bank exposure to market risk—the risk of loss from adverse movements in financial market rates and prices. Recognizing the importance of trading operations, banks have sought ways to measure and to manage the associated risks. At the same time, bank supervisors in the United States and abroad have taken steps to ensure that banks have adequate internal controls and capital resources to address these risks. Prominent among the steps taken by supervisors is the development of formal capital requirements for the market risk exposures arising from banks' trading activities. These market risk capital requirements, which will take full effect in January 1998, depart from earlier capital rules in two notable ways. First, the capital charge is based on the output of a bank's internal risk measurement model rather than on an externally imposed supervisory measure. Second, the capital requirements incorporate qualitative standards for a bank's risk measurement system. This paper presents an overview of the new capital requirements. In the first section, we describe the structure of the requirements and the considerations that went into their design. In addition, we address some of the concerns that have been raised about the methods of calculating capital charges under the new rules. The paper's second section considers the probable impact of the market risk capital requirements. After performing a set of rough calculations to show that the effect of the internal models approach on required capital levels and capital ratios will probably be modest, we identify some significant benefits of the new approach. Most notably, the approach will lead to regulatory capital charges that conform more closely to banks' true risk exposures. Moreover, the information generated by the models will allow supervisors and financial market participants to compare risk exposures over time and across institutions. *Darryll Hendricks and Beverly Hirtle are vice presidents at the Federal Reserve Bank of New York.