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F ederal R eserve Bank
of

Dallas

ROB E RT D. McTEER, JR.
DALLAS, TEXAS

PR ES ID EN T
A N D C H IE F E X E C U T I V E O F F I C E R

75265-5906

October 6, 1997
Notice 97-89

TO: The Chief Executive Officer of each
member bank and bank holding company
in the Eleventh Federal Reserve District
SUBJECT
Modification of the Amendment to the
Capital Accord
DETAILS
The Basle Committee on Banking Supervision has modified the Amendment to the
Capital Accord to incorporate market risk. The amendment, issued in January 1996, was subse­
quently adopted by the Federal Reserve Board for state member banks and bank holding compa­
nies.
The modification removes the so-called floor that would have applied to banks using
internal models to assess specific risk as part of their overall modeling of market risk. Banks
will benefit from the removal of the floor since its retention would have burdened them with dual
calculations. The modified amendment becomes effective January 1, 1998.
ATTACHMENT
The Basle Committee’s document is attached. It is also available on the Bank for
International Settlement’s (BIS) Web site at http://www.bis.org.
MORE INFORMATION
For more information, please contact Dorsey Davis at (214) 922-6051. For addi­
tional copies of this Bank’s notice, please contact the Public Affairs Department at (214)
922-5254.
Sincerely yours,

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal
Reserve Bank of Dallas: Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012;
Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

Basle Committee
on
Banking Supervision

Explanatory Note
Modification of the Basle Capital Accord of July 1988,
as amended in January 1996
The Committee has decided to remove the provision of the 1996 Market
Risk A m endm ent which requires that the specific risk capital charge of the internal
models approach be subject to an overall floor equal to 50% of the specific risk amount
calculated under the standardized approach.
Since the release of the M arket Risk A m endm ent in early 1996, the
Com m ittee and national supervisors have had a dialogue w ith banks on their
m ethodologies for assessing specific risk. As reg ard s m eth od s for m odelling
idiosyncratic variation, the Committee notes that it has seen sufficient im provem ent
and in novation in these m odelling techniques and enough sim ilarity am ong
m ethodologies used by banks to set general criteria for m odelling idiosyncratic
variation (i.e., the day-to-day variation not explained by the general m arket).
H ow ever, the Com m ittee as a w hole has not yet agreed that currently existing
m ethodologies u sed by banks adequately capture event and default risk. The
Committee notes that approaches for m easuring and validating this risk differ widely
at present and that modelling in this area is in the process of rapid evolution, making
it impractical at this juncture to set forth general guidance for capturing this risk.
In the light of these findings, the Com m ittee has established certain
qualitative and quantitative requirem ents for idiosyncratic risk w hich will allow
banks that meet them to base their specific risk capital charge on modelled estimates of
specific risk w ithout reference to the floor. Banks that do not meet these requirements

2

(as set out in the attached text for am ending the M arket Risk package) m ust use the
standardized approach to calculate the specific risk capital amount. The requirements
are aim ed at ensuring that banks accurately estim ate and validate idiosyncratic
variation as part of a portfolio's overall price variation. Until a bank can demonstrate
that the methodologies it uses capture event and default risk adequately, its modelling
of specific risk will be treated on the same basis as if a m odel of general m arket risk
proved deficient during backtesting. As a result, it will be subject to a capital surcharge;
that is, a m ultiplication factor of four on the treatm ent of specific risk. The m inim um
multiplication factor of three could only be applied to specific risk models for which it
can be dem onstrated that all relevant aspects of market risk are captured.
The Com m ittee expects that the banks' continuing efforts to im prove their
m odels will soon lead to established m arket standards that adequately capture event
and default risk for traded-debt and equity instrum ents and is prepared to w ork with
the ind ustry to this end. The Com m ittee and national supervisors are ready to
exam ine at any tim e the ability of in d iv id u a l m ethodologies to m odel both
com ponents of specific risk set forth in the regulatory definition. If such an overall
ability can be show n to both bodies, any model that is based on the same methodology
m ay im m ediately obtain the m inim um m ultiplication factor of three; how ever, a
higher multiplication factor of four w ould be possible if future backtesting results were
to indicate a serious deficiency w ith the model. The Basle Committee and national
supervisors will continue to cooperate to ensure that the im plem entation of such
m ethodologies and practices are done in an appropriate and consistent m anner. As
soon as m arket standards have been established w ithin the industry, the Committee
will replace this interim approach by defining general guidance for capturing event
and default risk for trading book instruments.
The Com m ittee's desire to have banks refine their m odelling techniques for
capturing event and default risk in the trading book should not be interpreted as a
precursor to a decision concerning credit risk m odelling for the banking book. The
Committee believes that the modelling of event and default risk in the trading book is
very different from the modelling of the credit risk in the banking book. In this regard,
the Committee emphasizes that the modelling of event and default risk as an element
of specific risk within the trading book focuses on the potential for occurrences such as

3

default to lead to precipitous changes in m arket values over a short period. The easy
availability of m arket prices, the daily m arking-to-m arket process, and the ability to
trade instrum ents and to hedge using liquid instrum ents readily distinguishes specific
risk modelling of trading book positions from modelling of banking book positions.

MODIFICATIONS TO THE MARKET RISK AMENDMENT
Textual changes to the Amendment to the Basle Capital Accord of January 1996

Table of Contents page of the Tanuarv 1996 Market Risk Amendment: Add a section under
part B (Use of internal models to measure market risk) entitled B.8 Treatment of Specific
Risk.
Section b. paragraph 11 of Introduction: Substitute the following for the final sentence: The
capital charge for banks which are modelling specific risk is set out in section B.8.
Delete wording under Section k of B.4 Quantitative standards (p. 45) and add the following
language:
(k)
Banks using models will also be subject to a capital charge to cover specific risk (as
defined under the standardised approach) of interest rate related instruments and equity
securities. The manner in which the specific risk capital charge is to be calculated is set out in
Section B.8 below.
Add a new Section to the Market Risk Package:
B.8 Treatment of Specific Risk
1.
Banks using models will be permitted to base their specific risk capital charge on
modelled estimates if they meet all of the qualitative and quantitative requirements for
general risk models as well as additional criteria set out below. Banks which are unable to
meet these additional criteria will be required to base their specific risk capital charge on the
full amount of the standardised-based specific risk charge.
2.
The criteria for applying modelled estimates of specific risk require that a bank's
model:
explain the historical price variation in the portfolio;1

1

The key ex ante measures of model quality are "goodness-of-fit" measures which address the question
of how much of the historical variation in price value is explained by the model. One measure of this
type which can often be used is an R-squared measure from regression methodology. If this measure is
to be used, the bank's model would be expected to be able to explain a high percentage, such as 90%, of
the historical price variation or to explicitly include estimates of the residual variability not captured in
the factors included in this regression. For some types of models, it may not be feasible to calculate a
goodness-of-fit measure. In such an instance, a bank is expected to work with its national supervisor to
define an acceptable alternative measure which would meet this regulatory objective.

2

demonstrably capture concentration (magnitude and changes in composition) ;2
be robust to an adverse environment;3 and
be validated through backtesting aimed at assessing whether specific risk is
being accurately captured.
In addition, the bank must be able to demonstrate that it has methodologies in place which
allow it to adequately capture event and default risk for its traded-debt and equity positions.
3.
Banks which meet the criteria set out above for models but do not have methodologies
in place to adequately capture event and default risk will be required to calculate their specific
risk capital charge based on the internal-model measurements plus an additional prudential
surcharge as defined in the following paragraph. The surcharge is designed to treat the
modelling of specific risk on the same basis as a general market risk model that has proven
deficient during backtesting. That is, the equivalent of a scaling factor of four would apply to
the estimate of specific risk until such time as a bank can demonstrate that the methodologies
it uses adequately capture event and default risk. Once a bank is able to demonstrate this, the
minimum multiplication factor of three can be applied. However, a higher multiplication
factor of four on the modelling of specific risk would remain possible if future backtesting
results were to indicate a serious deficiency with the model.
4.
For banks applying the surcharge, the total market risk capital requirement will equal
a minimum of three times the internal model's general and specific risk measure plus a
surcharge in the amount of either:
a) the specific risk portion of the value-at-risk measure which should be isolated
according to supervisory guidelines;4 or, at the bank's option,

2

The bank would be expected to demonstrate that the model is sensitive to changes in portfolio
construction and that higher capital charges are attracted for portfolios that have increasing
concentrations.

3

The bank should be able to demonstrate that the model will signal rising risk in an adverse
environment. This could be achieved by incorporating in the historical estimation period of the model at
least one full credit cycle and ensuring that the model would not have been inaccurate in the downward
portion of the cycle. Another approach for demonstrating this is through simulation of historical or
plausible worst-case environments.

4

Techniques for separating general market risk and specific risk would include the following:
Equities
•
The market should be identified with a single factor that is representative of the market as a
whole, for example, a widely accepted broadly based stock index for the country concerned.
•
Banks that use factor models may assign one factor of their model, or a single linear combination
of factors, as their general market risk factor.

3

b) the value-at-risk measures of sub-portfolios of debt and equity positions that
contain specific risk.5
Banks using option b are required to identify their sub-portfolio structure ahead of time and
should not change it without supervisory consent.
5.
Banks which apply modelled estimates of specificrisk arerequired to conduct
backtesting aimed at assessing whether specific risk is being accurately captured. The
methodology a bank should use for validating its specific risk estimates is to perform separate
backtests on sub-portfolios using daily data on sub-portfolios subject to specific risk. The key
sub-portfolios for this purpose are traded-debt and equity positions. However, if a bank itself
decomposes its trading portfolio into finer categories (e.g., emerging markets, traded
corporate debt, etc.), it is appropriate to keep these distinctions for sub-portfolio backtesting
purposes. Banks are required to commit to a sub-portfolio structure and stick to it unless it
can be demonstrated to the supervisor that it would make sense to change the structure.
6.
Banks are required to have in place a process to analyse exceptions identified through
the backtesting of specific risk. This process is intended to serve as the fundamental way in
which banks correct their models of specific risk in the event they become inaccurate. There
will be a presumption that models that incorporate specificrisk are "unacceptable" if the
results at the sub-portfolio level produce a number of exceptions commensurate with the Red
Zone as defined in this Amendment. Banks with "unacceptable" specific risk models are
expected to take immediate action to correct the problem in the model and to ensure that there
is a sufficient capital buffer to absorb the risk that the backtest showed had not been
adequately captured.

Bonds
•
The market should be identified with a reference curve for the currency concerned. For example,
the curve might be a government bond yield curve or a swap curve; in any case, the curve should
be based on a well-established and liquid underlying market and should be accepted by the
market as a reference curve for the currency concerned.

Banks may select their own technique for identifying the specific risk component of the value-at-risk
measure for purposes of applying the multiplier of 4. Techniques would include:
•
•
•

5

using the incremental increase in value at risk arising from the modelling o f specific risk factors;
using the difference between the value-at-risk measure and a measure calculated by substituting
each individual equity position by a representative index; or
using an analytic separation between general market risk and specific risk implied by a particular
model.

This would apply to sub-portfolios containing positions that would be subject to specific risk under the
standardised-based approach.


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102