Financial Risk Management

CHAPTER 3Amendment to the Basel I Framework to Incorporate Market Risks

THE ADVENT OF MARKET RISK

In January 1996, the Basel Committee issued a document to amend the Capital Accord of July 1988 to take account of market risks. This new risk measurement framework set capital requirements for market risks. As from the end of 1997, banks were required to measure and apply capital charges in respect of their market risks in addition to their credit risks.

According to BCBS (1996), market risk is defined as “the risk of losses in on and off‐balance sheet positions arising from movements in market prices”. This definition encompasses:

• The risks pertaining to interest rate‐related instruments and equities in the trading book.
• Foreign exchange risk and commodities risk throughout the bank.

A bank's trading book includes financial instruments intended for active trading, such as equities, debt, commodities, foreign exchange and other financial contracts intentionally held for short‐term resale to benefit from short‐term price fluctuations. It contrasts with the banking book, whose financial assets should be held until maturity.

The boundary between the financial instruments to be included in the trading book and the banking book is clearly defined in BCBS (2019a, p. 3). In short, the trading book includes financial instruments subject to market risk capital requirements, whereas those subject to credit risk capital requirements are registered in the banking book. This distinction ...