Value at Risk and Precommitment: Approaches to Market Risk Regulation

• Published in: Policy File 1998
• Main Authors: Daripa, Arupratan, Varotto, Simone
• Format: Report
• Language: English
• Subjects: Banking/Finance; Economic policy; Federal Reserve Bank of New York; Government

Traditionally, regulation of banks has focused on the risk entailed in bank loans. Loans are typically nontraded assets. In recent years, another component of bank assets has become increasingly important: assets actively traded in the financial markets. These assets form the "trading book" of a bank, in contrast to the "banking book," which includes the nontraded assets such as loans. Though for most large banks the trading book is still relatively small compared with the banking book, its rising importance makes the market risk of banks an important regulatory concern. In January 1996, the European Union (EU) adopted rules to regulate the market risk exposure of banks, setting risk-based capital requirements for the trading books of banks and securities houses. At this point, one must ask what the purpose of such regulatory capital is. The authors proceed under the hypothesis that the purpose of regulatory capital is to provide a buffer for contingencies involving large losses, in order to protect both depositors and the system as a whole by reducing the likelihood that the system will fail. In this paper, the authors look at two different ways of calculating bank capital for market risk exposures and compare their performance in delivering an adequate cover for large losses.