By Portia Richardson

There are few aspects of international banking more vexing-or more complicated-than standards of capital adequacy. The Basle Committee on Banking Supervision's proposals on market risk capital, issued in April 1995 and finalized in January 1996, are no exception.

One of the foremost features of the proposals, which amend the Basle Capital Accord of July 1988, is the agreement to allow banks to use in-house proprietary models for measuring market risks rather than what the banks saw as crude standardized supervisory frameworks. Despite this concession, which most banks see as a step in the right direction, the proposals have met with some dissension.

The Basle committee suggests, for example, that the capital charge for banks that use in-house models should be three times the average of the daily value-at-risk (VAR) of the preceding 60 days. This has been attacked as arbitrary and unnecessary. The calculation of VAR is based upon a 99 percent confidence level and a 10-day holding period for any transaction, standards which have been called unrealistic.

At the moment European countries are trying out the efficacy of the proposals before individual legislatures decide to implement them or not. The United States is enjoying a second comment period to consider the virtues and vices of backtesting, which Basle has suggested using to determine the accuracy of an institution's VAR model. Many banks in the U.S. believe that the proposed backtest of VAR is greatly different from that upon which the capital requirements are based. Indeed, ISDA stated in its comment letter on backtesting to the OCC, the FDIC and the Fed, "Many ISDA members believe that, contrary to its objective, the backtesting exercise simply does not test the model used for capital purposes."

Most U.S. banks much prefer the precommitment approach to capital adequacy, which was suggested by the Fed last year. But that is another story. For the meantime they will be watching with interest as European banks wrestle with the Basle proposals and the use of in-house VAR models. The committee hopes that the amended accord will be adopted by G10 authorities by the end of 1997 at the latest.

Robert Armstrong
Partner, KPMG Peat Marwick, London

It's a good solution. Fundamentally it's a convergence of banking supervisory regulations with industry best practices. The two began to converge with Basle's first proposal on capital adequacy and market risk in April 1993. The convergence is a high-water mark. Essentially it's now up to the banks to manage their activities and the job of the supervisors to see how well they're doing it. Rather than have supervisors request loads of data from the banks, the banks perform their own analysis. It's better when you run your own risk, have your own models, and the supervisor can see if you're doing well by examining your risk management process-it encourages all financial institutions to manage themselves better.

In the current Basle Capital Accord, which we call Basle '97, there are quantitative and qualitative standards on managing market risk and its difficult for anyone to argue against them. Basle '97 is less proscriptive than the 1993 Basle Capital Accord, which became the capital adequacy directive (CAD) and took effect in Europe in January 1996. This was set up to calculate market risk, but the models were unrefined and very crude.

Banks and other financial institutions are required to use value-at-risk (VAR) models. But the proposal doesn't tell you which ones to use: variance/co-variance, historical simulations or Monte Carlo methods. Banks have to combine these methods in robust and pragmatic ways. Some big banks are unhappy about complying with the proposal because of the complexity of the models, which increases geometrically with the size and scope of the dealing activity. In small banks there is a limited number of activities and currencies used. So we're encouraging even small banks to switch to the internal models approach.

KPMG has done a survey of European banks, who were asked about complying with Basle '97. Some big banks want to stick with the CAD which became effective in January 1996. They've already worked on implementing CAD standards and don't want to rework them, but they will if the supervisors push the banks to use the new models. The smaller banks can get away with using very inexpensive models and can implement VAR at a low cost.

Far Eastern and Middle Eastern countries, outside the G10 and European Monetary Union, actually are talking to supervisors about the Basle Committee initiative, so they can write it into their own banking codes. It used to take two or three years for a regulatory initiative to percolate around the world, but the time before adoption is shortening. We're urging the non-G10 countries to look at an internal models approach.

Problems with Basle '97 lie in the parameters. Supervisors opted for 99 percent confidence intervals, meaning that 99 percent of the time you won't lose more money than the value-at-risk. But senior management might rely on this number and believe that the bank will never lose more than the amount of money in the VAR model, when the model isn't that accurate. A 90 or 95 percent confidence level is realistic, and gives a better signal to management about how much they can rely on it. Similarly Basle '97 recommends a 10-day holding period. But 10 days has no real meaning for most trading environments, where one day is a long time to hold a position.

Basle '97's technical models and small-print definitions of trading are a bit arbitrary and narrow; they exclude money market deposits, for example. Banks have more inclusive definitions of trading than regulators use. There is more consistency between what banks define as a trading book than what supervisors define it as. Most banks are unhappy with the changes in the proposal made between the comment period in April 1995 and its effective date of January 1996. Supervisors say, "use internal VAR models and multiply by three," but banks suggest they'd need considerable extra capital this way. Banks lobbied for a smaller multiplier, but didn't get it.

What they did get, though, was a concession to correlate risk across products or asset classes. Basically banks now can correlate across all books, including currencies, interest rates, equities and others. This produces a 20­30 percent reduction in capital because of the risk values. Yet the banks don't value the 20­30 percent concession as much as they might, and this is because it is technically difficulty for banks to cross-correlate-the complexity of the models increases geometrically. Even sophisticated banks don't allow for offsetting risk this way. The supervisor is one step more sophisticated than banks, and has applied the narrowly defined concept of VAR widely to financial institutions. A lot of systems will have to be boosted or developed.

Michel Nadeau
Senior Vice President, Core Portfolios, and Deputy General Manager, Caisse de Dépôts et Placements du Quebec, Montreal

Yes, I agree with the Basle Market Risk Proposal. I think derivatives are useful tools, and they are here to stay. Our position, in a nutshell, is we use derivatives to increase, reduce or neutralize risk. So it's simple for a reader of a financial statement to know exactly what the level of risk that Caisse is taking. It isn't just a matter of describing the types of derivatives and their amounts, but rather to see the increase, reduction or neutralization of risk.

We have $7.5 billion of foreign equity stock and want to hedge the equity exposure by using currency swaps, futures and various other currency instruments. We must explain what the exposure is and what strategy has been used to increase, reduce or neutralize the risk. For us this is a major factor.

With regards to market risk, we have used value-at-risk (VAR) strategies for two years. Our manager bonus is related to VAR. If managers get 20 percent VAR returns, then their salaries and mine are increased by 20 percent. The first market risk is liquidity risk. If there is a problem, it comes down to how much could you liquidate in a specific market with a specific tool. If the tool is $500 million worth of Dutch bond futures, and my view of the market changes, will it be possible to liquidate the position in a single day? This should be made clear to the reader of a financial statement.

Basle should increase the concept of credit risk. It's important to know counterparty risk. We never know. The major brokers are very stable and well-managed organizations, but for total consolidated products, for example, there should be a list of brokers who are involved in the counterparty risk, either by paying for counterparty risk or charging for counterparty risk in a swap. If 60 percent of the derivative risk is done with one brokerage firm, it's different than having 10 specific amounts done with 10 different brokers. It should be made clear to the reader of the financial statements, and to us, senior management, that all the concepts are for the best protection for the organization. We want transparency. You should publicize what you're doing. Internal controls are useful also, as well as public disclosure. It should be clear what risk is taken in the portfolio. We believe Basle's Market Risk Proposal is a step in the right direction.

Joel Finard
Partner, Deloitte & Touche, New York

I think the Basle Market Risk Proposal is a positive step in establishing guidelines for risk-based capital. The VAR framework, which the proposal suggests using for risk evaluation, draws upon portfolio theory and is, I believe, a sound approach to measuring and analyzing financial risk. The readiness of regulators to accept the use of VAR by financial institutions is a significant development in the evolution of risk management. For the first time regulators are trying to understand the benefits and disadvantages of using a sophisticated methodology for measuring risks. The proposal has "raised the bar" for many of the less sophisticated financial institutions and posed questions about how they will approach financial risk quantification and management in the future.

However, even though the Basle Market Risk Proposal provides a sophisticated framework for analyzing capital at risk, many components of the proposed guidelines need further development. For example, the multiplication factor of three, which was designed to account for potential weaknesses in the modeling process, requires further review. In theory, the multiplication factor compensates for many of the nonquantifiable factors that can influence the estimation of risk-such as flawed distribution assumptions, the inadequacy of past events as a guide to future ones, extreme market movements, and other factors that may limit the accuracy of a VAR approach-but its ability to accomplish this seems doubtful.

It is important to say that as institutions adapt their internal models to better address potential weaknesses in the modeling process, I think they should be given latitude to adjust the multiplication factor to an appropriate number that will fit the risks of their particular institution. Regulatory guidelines, similar to the risk management process, must be dynamic and continue to evolve as our understanding of quantifying and measuring risk also evolves.

Despite its limitations VAR is a potent approach that has allowed financial institutions and regulators to establish an open dialogue on how much capital is appropriate to hold. It has attempted to add discipline and rigor to the very difficult process of establishing capital guidelines.

Gay Evans
Chairman of ISDA, Managing Director, Bankers Trust International, London

The amendment to the Capital Accord issued in January 1996 by the Basle Committee on Banking Supervision has allowed banks to use internal models to calculate how much capital they are required to hold against market risk. This allowance should minimize any misperception of banks' activities caused by the original, rigid capital rules. This amendment permits market participants to measure and convey market risk of the entire portfolio and encourages banks to improve their risk management systems.

ISDA has expressed concerns to the Basle Committee regarding some of the specifications required, including the multiplier and other parameters imposed on the internal models approach. Nevertheless, we have every expectation that each institution's internal model will continue to evolve to reflect its particular risk profile.

ISDA continues to devote resources to minimize uncertainty in the derivatives world, including continued analysis in fine-tuning the measurement of risk-internally and for capital purposes-of a portfolio of financial assets; continued education in risk management for our members; and an awareness of the importance of institutions having internal policies and procedures, controls and adequate systems surrounding their risk management activities. These developments will permit banks to manage their risk prudently and lead to the acceptance by regulators of internal models for capital purposes without stated parameters.

David Palmer
Associate Director, Trading Risk, NatWest Markets, London

I think most people in the industry welcome the Basle Market Risk Proposals because they introduce the concept of banks using their own VAR models to calculate capital charges. This has to be a good thing, but the difficulties lie in the details. The choice of a 10-day holding period and a 99 percent confidence level seem quite severe, particularly when they're coupled with the minimum multiplication factor of 3. On top of this, there is also an add-on factor of between 0 and 1, which is there to penalize the banks whose models turn out to be poor predictors of the real risks, so these banks could have a minimum multiplication factor of 4. Some people have asked whether it would be possible to reduce the multiplication factor to 2, but increase the add-on to between 0 and 2. The net effect is the same and it strikes me that this suggestion is worth further consideration.

Throughout the process of preparing the new rules, the Basle Committee have shown their willingness to listen to the industry's comments and take action based upon them. For example, the rules were amended to allow correlation across all risk classes, which is a great improvement. In the latest proposals the committee have indicated that they are still seeking industry views on specific risk. The current 50 percent floor is certainly difficult to justify, but it's up to the banks to come up with something better. Quite a lot of work is currently being done on this and we will just have to wait and see if the committee likes what is finally proposed.

I think people tend to underestimate the difficulties involved in implementing proposals like this. Banks in Europe, and particularly in London, have already had the experience of implementing very similar rules for the EU's Capital Adequacy Directive. I think Basle should take note of the lessons learned from this and make sure that their proposals allow local regulators enough room to interpret the rules to suit individual cases. The scenario matrix rules for options and the "traffic light" approach to backtesting are both examples where I think Basle is currently over-prescriptive.

In Europe we also have the added complication of CAD II. The Basle proposals won't just automatically be enforced here; they first have to be made law by the European Parliament. This process may take two years or more, so it is quite possible that some parts of the world will be under the new Basle regime long before Europe. I suppose this could be a good or bad thing depending upon how the final rules turn out!

Pierre Yves Thoraval
Commission Bancaire, Secrétariat Gènérale des Affaires Internationales, Paris

The Basle Market Risk package definitely represents a major improvement in setting risk-based capital requirements by broadening the scope of the 1988 Capital Accord beyond the coverage of credit risk alone. If the standard approach provides sensible and prudent methods to determine capital requirements for most of the financial institutions, the most significant innovation concerns the possibility for internationally active market players to rely on their in-house models to measure markets risks. This internal-models alternative is subject both to quantitative standards ensuring comparability of models' outputs and qualitative requirements to secure the integrity and reliability of the risk management frameworks. The Basle package aims at encouraging the major banks to use this alternative in order to take advantage of a more accurate market risk measurement and prodding them to develop efficient internal systems.

Thus, beyond the measurement and coverage of market risks, the Basle package stresses the quality of internal measurement and control systems, and implies closer involvement by the bank's top management in setting the risk strategy and ensuring sound monitoring and control systems. In this respect, the implementation of Basle guidelines and the continuing open dialogue with financial institutions, particularly in the course of recognition and validation of their internal management systems, will mark an important further step towards strengthening the soundness and stability of the international banking system and of financial markets as well.