According to the Basel framework, market risk is defined as the risk of losses in on and off-balance-sheet positions arising from movements in market prices.
Since the financial crisis began in mid-2007, an important source of losses and of the build up of leverage occurred in the trading book.
A main contributing factor was that the capital framework for market risk, based on the 1996 Amendment to the Capital Accord to incorporate market risks, did not capture some key risks.
In response, the Basel Committee supplemented the value-at-risk based trading book framework with an incremental risk capital charge, which includes default risk as well as migration risk, for unsecuritised credit products.
For securitised products, the capital charges of the banking book will apply with a limited exception for certain so-called correlation trading activities, where banks may be allowed by their supervisor to calculate a comprehensive risk capital charge subject to strict qualitative minimum requirements as well as stress testing requirements.
These measures will reduce the incentive for regulatory arbitrage between the banking and trading books.
An additional response to the crisis is the introduction of a stressed value-at-risk requirement.
Losses in most banks' trading books during the financial crisis have been significantly higher than the minimum capital requirements under the former Pillar 1 market risk rules.
The Basel Committee therefore requires banks to calculate a stressed value-at-risk taking into account a one-year observation period relating to significant losses, which must be calculated in addition to the value-at-risk based on the most recent one-year observation period.
The additional stressed value-at-risk requirement will also help reduce the procyclicality of the minimum capital requirements for market risk.
In the same way as for credit risk, the capital requirements for market risk are to apply on a worldwide consolidated basis.
Where appropriate, national authorities may permit banking and financial entities in a group which is running a global consolidated book and whose capital is being assessed on a global basis to report short and long positions in exactly the same instrument (e.g. currencies, commodities, equities or bonds), on a net basis, no matter where they are booked.
Moreover, all national authorities will retain the right to continue to monitor the market risks of individual entities on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision.
Supervisory authorities will be especially vigilant in ensuring that banks do not pass positions on reporting dates in such a way as to escape measurement.
So, as a response to the undercapitalisation of market risk, the Basel Committee on Banking Supervision introduced a range of revisions to the market risk framework in July 2009 which focused capital requirements on stressed calibrations and introduced capital against credit risks which had not been considered in the pre-crisis framework.
The July 2009 package, often referred to as "Basel 2.5", was recognised as a necessary, but not sufficient, update to the capital framework and in parallel a fundamental review of the entire market risk framework was initiated.
In May 2012 the Basel Committee published its first consultative paper on its Fundamental Review of the trading book, which presented high level proposals for the structure of the new market risk framework.
Following consideration of the comments received the Committee published a second consultative paper in October 2013 with revised proposals for the new framework including draft standards.
An essential element of the Committee's work to revise the trading book standards is its quantitative impact assessments, in which banks play a key role.
These Quantitative Impact Studies help the Committee to better to understand the effects of the proposed new framework on capital requirements and further refine the standards.
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