[Federal Register Volume 60, Number 142 (Tuesday, July 25, 1995)]
[Proposed Rules]
[Pages 38142-38144]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-17541]



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FEDERAL RESERVE SYSTEM

12 CFR Chapter II

[Docket No. R-0886]


Capital Requirements for Market Risk

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Request for comments.

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SUMMARY: The Board is requesting comment on a possible approach to 
setting capital requirements for market risk, which, if feasible, might 
form the basis for future enhancements to supervisory procedures. The 
approach would require a bank to specify the amount of capital it chose 
to allocate to support market risks. If cumulative losses over some 
subsequent trading interval exceeded the commitment, the bank would be 
subject to regulatory penalties, such as fines, higher capital 
requirements, or restrictions on trading activities. In theory, the 
penalties could be calibrated to ensure that capital allocations were 
consistent with supervisory objectives.

DATES: Comments must be submitted on or before November 1, 1995.

ADDRESSES: Comments should refer to Docket No. R-0886, and may be 
mailed to William W. Wiles, Secretary, Board of Governors of the 
Federal Reserve System, 20th Street and Constitution Avenue, NW., 
Washington, D.C. 20551. Comments also may be delivered to Room B-2222 
of the Eccles Building between 8:45 a.m. and 5:15 p.m. weekdays, or to 
the guard station in the Eccles Building courtyard on 20th Street NW. 
(between Constitution Avenue and C Street) at any time. Comments 
received will be available for inspection in Room MP-500 of the Martin 
Building between 9 a.m. and 5 p.m. weekdays, except as provided in 12 
CFR 261.8 of the Board's rules regarding availability of information.

FOR FURTHER INFORMATION CONTACT: Patrick Parkinson, Associate Director 
(202-452-3526), or Paul Kupiec, Senior Economist (202-452-3723), or 
James O'Brien, Senior Economist (202-452-2384), Division of Research 
and Statistics; for users of the Telecommunications Device for the Deaf 
(TDD) only, Dorothea Thompson (202-452-3544); Board of Governors of the 
Federal Reserve System, Washington, D.C. 20551.

SUPPLEMENTARY INFORMATION: The Board is requesting comment on a 
proposed rulemaking that would amend its risk-based capital 
requirements to incorporate measures of market risk that have been 
developed by the Basle Committee on Banking Supervision. This proposed 
rule is published elsewhere in today's Federal Register, under Docket 
No. R-0884. The Board's publication of this proposed rulemaking 
reflects its judgment that the Basle proposal, especially the internal 
models option, constitutes a very significant improvement in 
supervisory methods for assessing capital adequacy.
    Nonetheless, the Board believes that further evolution of 
supervisory approaches to assessing capital adequacy will be necessary 
over time. Techniques for measuring and managing market risk have been 
progressing rapidly in recent years, and further advances can be 
expected in the future. It is important that capital requirements 
provide incentives for such advances and that these requirements remain 
compatible with best practices as they evolve.
    Recognizing the need for further evolution in supervisory 
approaches to capital adequacy, the Board is requesting comment on a 
novel approach, which has been termed the ``pre-commitment'' approach. 
While in theory this approach might offer significant advantages over 
existing alternatives, many of the practical details have not yet been 
worked out. The Board believes that public comments would be of great 
assistance in evaluating the overall feasibility of the approach and in 
identifying the most practical and effective means of implementing it. 
Public comments would also be of value in assessing whether future 
implementation of the proposal might have unintended consequences on 
banks or on financial markets.

I. Description of the Pre-Commitment Approach

    The pre-commitment approach draws its inspiration from the economic 
literature on ``incentive-compatible'' regulatory schemes.1 As in 
the internal models approach to market risk capital requirements that 
the Board has proposed, the regulatory objective is to require a bank 
to maintain sufficient capital to cover potential losses in its trading 
activities from all but the most extreme price movements.2 The 
internal models approach seeks to ensure compliance with this objective 
by standardizing the parameters under which a bank would calculate the 
value at risk (VaR) of its trading portfolio and then applying a 
multiplication factor to each bank's calculated VaR, in part to cover 
potential losses over longer horizons. By contrast, the pre-commitment 
approach would seek to induce banks to meet the regulatory objective by 
providing them with a common set of economic incentives.

    \1\ The theory underlying the pre-commitment approach is 
presented in Paul H. Kupiec and James M. O'Brien, ``A Pre-Commitment 
Approach to Capital Requirements for Market Risk.'' Board of 
Governors of the Federal Reserve System, Division of Research and 
Statistics, staff memorandum, June 1995. This paper can be obtained 
from the Board's Freedom of Information Office.
    \2\ The scope of activities and banks that would be covered 
under a pre-commitment approach presumably would be the same as the 
scope of the proposed rulemaking on market risk that was referenced 
above.
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    Specifically, in the pre-commitment approach a bank would specify 
its desired amount of capital for supporting market risks and would 
commit to manage its trading portfolio so as to limit any cumulative 
trading losses over some subsequent interval to an amount less than 
that capital allocation. The length of the interval would be 
established by the bank's regulator, based on the regulator's ability 
to 

[[Page 38143]]
monitor losses from the bank's trading activities and, if necessary, to 
force reductions in the size of the bank's open positions. The interval 
might be three or six months, but a shorter interval would be possible 
if the regulator can effectively monitor trading activity at that 
frequency and if the relevant markets are sufficiently liquid that the 
trading positions could, if necessary, be closed out promptly without 
substantial market impact. At the end of the interval, the bank could 
either increase or decrease its capital commitment.
    To ensure that the bank committed an amount of capital commensurate 
with the risks in its trading portfolio and its capacity to manage 
those risks, the regulator would need to provide appropriate incentives 
in the form of economic costs or ``penalties'' for failing to limit 
losses to less than the capital commitment. The magnitude of the 
penalties would depend on the regulatory objective. A bank that is 
managed as a going concern would be expected to choose a capital 
commitment that entailed a marginal cost of regulatory capital equal to 
the expected cost of the penalty for a violation. The more conservative 
the capitalization that the regulator desired, the larger would be the 
specified penalty.
    Given these costs, the bank's choice of a capital commitment would 
be based on a self-assessment of its capabilities to measure and 
control the risks of its trading activities. The adequacy and 
reliability of its internal models for measuring risk would play an 
important role in the bank's determination. But, as recognized in the 
qualitative standards for risk management that are part of the internal 
models approach, there is more to risk management than risk 
measurement. In addition to internal models for risk measurement, sound 
risk management requires a detailed structure of limits on risk and a 
strong management information system for controlling, monitoring, and 
reporting risks.
    The measurement of market risk is fraught with uncertainty.
    The magnitude of the low probability events about which regulators 
are concerned (for example, the lower limit of a 99 percent confidence 
interval for trading gains and losses) simply cannot be estimated with 
much precision.3 A corollary of this result is that ``back-tests'' 
of a null hypothesis that a bank's internal model is accurately 
estimating a 99 percent confidence limit have little statistical power 
against alternatives that would involve substantial underestimation of 
potential losses.

    \3\ This point is developed further in Paul H. Kupiec, 
``Techniques for Verifying the Accuracy of Risk Measurement 
Models.'' Board of Governors of the Federal Reserve System, Division 
of Research and Statistics, staff memorandum, April 1995. This paper 
can be obtained from the Board's Freedom of Information Office.
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    A further implication is that declines in the market values of 
portfolios beyond those anticipated by the models are inevitable. In 
such circumstances, what is critical--and what cannot be captured in 
standard risk measures--is the potential for losses to be contained 
through active portfolio management, and, conversely, the potential for 
catastrophic losses if such active management is not forthcoming. In 
choosing its capital commitment, a bank's management would incorporate 
its judgments about the combined effectiveness of all critical elements 
of the bank's risk management system--not only its internal models, but 
also its structure of risk limits and the management information 
systems and audit programs it has in place to ensure compliance with 
those limits. Furthermore, management would have a strong incentive to 
strengthen over time all elements of its risk management system to 
economize on capital while avoiding the penalties.
    The bank's choice of a capital commitment for market risk could be 
subject to review by supervisory authorities. Bank management could be 
expected to explain how cumulative losses would be contained within the 
amount of the commitment. This necessarily would require documentation 
of how internal models are used to measure risks, how limits are 
applied to the measured risks, how compliance with limits is ensured, 
and how management would respond to unanticipated losses. Furthermore, 
supervisors could condition use of the pre-commitment alternative on 
the bank's meeting the same qualitative standards for market risk 
management systems that would be required for use of the internal 
models approach, or perhaps on even more stringent standards.
    It would be important to emphasize, however, that any supervisory 
review of the commitment would in no way diminish the bank management's 
responsibility for setting aside adequate capital to cover its market 
risks. An attractive feature of the pre-commitment approach is that it 
would underscore the responsibility of bank management for maintaining 
adequate capital, even if the amount needed exceeds what otherwise 
might be regulatory minimum requirements.
    The key to the feasibility and effectiveness of the pre-commitment 
approach is the specification of the penalties that would result from a 
failure to limit trading losses to an amount less than the commitment. 
Analysis suggests that the cost of the penalties should increase with 
the size of the gap between the losses incurred and the pre-commitment. 
These penalties could take various forms. Fines (monetary penalties) 
would be especially effective in creating appropriate incentives 
because of their transparency. (U.S. insured banks might be required to 
pay any fines into the Bank Insurance Fund.) As an alternative to 
fines, supervisors could impose punitive capital charges. The severity 
of fines or capital penalties could be reduced if they were accompanied 
by supervisory sanctions, such as restrictions on future trading 
activity. The costs of these restrictions would be measured by the loss 
of profitable trading activities in future periods. Such costs could be 
considerable; a bank that is unable to pursue profitable trading 
opportunities for an extended period would have difficulty covering 
overhead costs in its trading businesses and, over time, likely would 
suffer defections by its best traders to other firms.
    For the pre-commitment approach to be credible, banks would need to 
be reasonably certain that supervisory authorities would impose the 
specified penalties when losses exceed the commitment. The certainty of 
the penalty would strengthen the incentive for the bank to make the 
initial capital commitment commensurate with the supervisor's desired 
coverage of potential losses. Nonetheless, supervisors would need to 
reserve the right to suspend the penalties in the event of extreme 
price movements that reflect macroeconomic instability. This would help 
ensure that banks could continue to provide liquidity to markets 
following such stressful episodes. But suspensions should not include 
situations in which a penalty would simply be very costly to an 
individual bank but without systemic consequences.
    Market forces might also be utilized to provide banks with 
incentives to allocate adequate capital. If the capital commitment were 
publicly disclosed, the reporting of losses in excess of the commitment 
not only would imply that supervisory sanctions had been imposed on the 
bank, but could also cast doubts on the effectiveness of the bank's 
risk management capabilities. Together, these factors could adversely 
affect its share price and its funding costs. For this reason, some 
banks might actually be tempted to commit more capital than is 
necessary to meet regulatory 

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objectives. However, this tendency toward conservatism would be 
tempered by fears that an excessive capital commitment would cause the 
public (including stock analysts and rating agencies) to overestimate 
the riskiness of the bank's trading activities. Thus, market forces 
could be harnessed to induce banks to make appropriate capital 
commitments.

II. Issues and Questions for Public Comment

    The basic issue is whether the pre-commitment approach is feasible 
and, if so, whether it might form the basis for future enhancements to 
supervisory approaches to assessing capital adequacy.
    Q1. Should the Board explore use of the pre-commitment approach 
during the time that will elapse before the scheduled implementation of 
the proposed market risk capital requirements?
    Q2. What are the advantages of the pre-commitment approach compared 
to other approaches under consideration by supervisors? Would it, in 
fact, produce capital allocations that more accurately reflect banks' 
assessments of trading risks? Would it be more compatible with banks' 
risk measurement systems? Would it provide stronger incentives for the 
improvement of risk management systems?
    Q3. What are the potential drawbacks to the pre-commitment 
approach? Could penalties be destabilizing to banks? To the financial 
system? What other unintended consequences might result from 
implementation of the approach?
    Before the pre-commitment approach could be implemented,the 
penalties associated with failure to limit trading losses to an amount 
less than the capital commitment would need to be specified more 
precisely.
    Q4. What form should the penalties take? Fines? Higher future 
capital requirements? Other restrictions on future trading 
opportunities?
    Q5. Should regulators reserve the right to waive the penalties 
under certain circumstances? If so, under what circumstances? To avoid 
adverse effects on market liquidity? To avoid impairing a bank's 
capital so significantly that its viability is threatened? Is there a 
danger that the prospect of a waiver could undermine the incentive 
effects of the penalties? How could such adverse incentive effects of 
waivers be minimized?
    Q6. Should capital commitments, trading results, and penalties be 
publicly disclosed? What effects would public disclosure have on 
capital allocations? On trading behavior? How would stockholders and 
creditors react to news that a capital commitment had been violated? 
Could the reactions be destabilizing? On the other hand, if commitments 
and results are not publicly disclosed, would the approach lack 
credibility?
    Another set of issues that would need to be addressed is the 
restrictions and limitations that would be placed on use of a pre-
commitment approach.
    Q7. Are qualitative standards for market risk management necessary 
to implement the pre-commitment approach? What qualitative standards 
for market risk management should be met by banks seeking to use the 
pre-commitment approach? Are the qualitative standards set out by the 
Basle Supervisors for use of the internal models approach sufficient? 
Or should more stringent standards be imposed? If so, in what ways 
should the standards be more stringent?
    Q8. Should a bank's choice of a capital commitment be subject to 
review by supervisory authorities? Or would such a review be 
unnecessary or undesirable?
    Q9. The incentive effects of the pre-commitment approach can be 
relied upon to induce banks to make realistic capital commitments only 
if the bank is being managed as a going concern. (A bank would not 
necessarily be concerned about penalties that would be imposed only in 
the event of its insolvency.) Could this potential problem be addressed 
adequately by limiting use of the pre-commitment approach to adequately 
capitalized banks (or even to well-capitalized banks)?
    Q10. Even for well-capitalized banks, is the approach viable if 
market risk is the predominant element in the institution's overall 
risk profile? Or must its use be restricted to banks for which market 
risk associated with the trading account is a relatively small element 
in their overall risk profile? As practical matter, do banks typically 
allocate more than a small fraction of their total capital to cover 
market risk?
    A final issue that would benefit from public comment relates to how 
trading gains and losses should be measured for purposes of determining 
whether the capital commitment has been violated.
    Q11. Should spreads on customer or market-making businesses be 
included in trading gains and losses or should they be excluded? Why or 
why not? Can revenues from customer accommodation and market making be 
separated reliably from revenues from position taking?
    Q12. Should gains or losses from changes in the credit quality of 
assets held in trading accounts be included or excluded? If included, 
would there be any need for separate capital requirements for specific 
risk (as opposed to general market risk)?
    Q13. In general, are profits and losses on trading accounts 
sufficiently transparent that supervisors could reliably determine 
whether a capital commitment has been violated? Could concerns on this 
score be addressed through qualitative standards for valuation (e.g., 
standards for documentation of policies regarding valuation adjustments 
and adherence to those policies)?

    By order of the Board of Governors of the Federal Reserve 
System, July 12, 1995.
William W. Wiles,
Secretary of the Board.
[FR Doc. 95-17541 Filed 7-24-95; 8:45 am]
BILLING CODE 6210-01-P