Better capturing risks in the trading book

The 1996 Amendment to the Basel Capital Accord, which allows, under certain conditions, the use of internal models to calculate regulatory capital requirements for market risk, has resulted in an apparently sound supervisory trading book regime for internationally active banks. Since this amendment was passed, the composition of the trading book has nevertheless changed substantially to include a more and more credit-related products such as credit derivatives and tranches of collateralised debt obligations (CDOs), as well as complex products such as hedge fund or fund of funds structured products. Furthermore, the contents of the trading book are expected to broaden due to the implementation of new international accounting and prudential standards. This development has led to an increase in credit risk in the trading book and a concomitant rise in other risks such as default risk, event risk, liquidity risk, concentration risk and correlation risk, which were not adequately captured when market risk regulations were devised. This has prompted: • banks to improve their risk assessment and control systems for trading book activities. These systems still often use Value at Risk (VaR) calculations based on a uniform 10-day holding period, which does not always appear relevant; • banking supervisors to enhance the supervision of these systems, in particular by ensuring that the measures proposed in July 2005 by the Basel Committee and the International Organisation of Securities Commissions (IOSCO), known as “Basel 2.5”, are correctly implemented. These measures aim to capture risks in the trading book in a more rigorous and comprehensive manner.