Market risk capital is the amount of regulatory capital that a bank is required to hold against the possibility of losses caused by movements in market prices. It covers interest rate and equity positions held in the trading book, together with foreign exchange and commodity positions wherever they are booked. Along with the charges for credit risk and operational risk, it is one of the three components of the minimum requirement set by the Pillar 1 capital requirement of the Basel framework.
The requirement is calculated as a capital figure and then converted into risk-weighted assets by multiplying by 12.5, so that it can be added to the other risk types and compared with the bank's capital. The rules are written by the Basel Committee on Banking Supervision and put into law by each jurisdiction. They matter most to banks with large dealing operations; for a typical retail or commercial bank, market risk is a small share of total requirements.
Development of the rules
The original 1988 Basel Accord dealt only with credit risk. Market risk was added by an amendment in 1996, which for the first time allowed banks to use their own models, based on value at risk, to calculate a regulatory requirement, subject to supervisory approval. A standardised method was provided for banks without approved models.
The financial crisis of 2007 to 2009 exposed weaknesses in this approach. Trading losses at large banks far exceeded the capital held against them, in part because models calibrated on calm periods understated risk, and in part because illiquid credit products had been placed in the trading book where charges were lower. An interim package in 2009, often called Basel 2.5, added a stressed value-at-risk measure and extra charges for default and migration risk. The Basel Committee then undertook a full redesign, the Fundamental Review of the Trading Book (FRTB), published in 2016 and revised in 2019 as part of the final Basel III reforms.
Scope and the trading book boundary
Which rules apply to a position depends on whether it sits in the banking book or the trading book. Trading book instruments are those held for short-term resale, to profit from price movements or to hedge other trading positions; they are marked to market daily and attract market risk capital. Banking book positions are generally held to maturity and attract credit risk capital instead, with their interest rate exposure handled separately as interest rate risk in the banking book.
Because the two books can produce different charges for the same instrument, the boundary creates an incentive for regulatory arbitrage. The revised framework gives lists of instruments presumed to belong in each book, restricts movements between them and requires any capital benefit from a switch to be disallowed.
How the requirement is calculated
Under the revised framework a bank uses one of two main methods, with a simplified version available to banks with small trading activity:
- Standardised approach. The bank computes the sensitivity of its positions to prescribed risk factors, such as interest rates at set maturities, credit spreads, equity prices, commodity prices and exchange rates, applies supervisory risk weights and aggregates the results using prescribed correlations. A separate default risk charge and an add-on for exotic risks are then included.
- Internal models approach. With supervisory approval granted desk by desk, the bank uses its own model. The measure is expected shortfall at a 97.5 per cent confidence level, calibrated to a period of stress, which replaces value at risk and captures the size of losses in the tail rather than only their frequency. Risk factors with too little price data are capitalised separately, and default risk is modelled on its own.
A trading desk keeps model approval only while it passes backtesting, which compares daily model estimates with actual results, and a profit and loss attribution test, which checks that the risk model explains the desk's real gains and losses. Desks that fail fall back to the standardised approach, which every bank must calculate in any case.
Implementation and criticism
The Basel Committee set January 2023 as the date for the revised market risk standard, but adoption has been uneven. Several major jurisdictions have postponed the trading book rules more than once, partly out of concern about competitive disadvantage if others move later, and the timetable continues to differ between regions. Supervisors therefore still apply a mixture of older and newer rules depending on location.
Critics of the reform point to its complexity and data demands, and to the possibility that higher charges reduce the willingness of dealers to hold inventory and act as a market maker, especially in less liquid bonds. Supporters respond that the previous regime left trading activities seriously undercapitalised. Market risk capital also interacts with other parts of the framework: derivatives positions attract separate charges for counterparty risk, and the aggregate benefit of internal models is limited by an output floor tied to the standardised calculations. Results are published under Pillar 3 disclosure rules, and supervisors may add requirements through Pillar 2 where they judge model results too low. A bank's own measure of market risk for internal limits may differ from the regulatory figure.