Bank capital standards for foreign exchange and other market risks

The Basle Committee on Banking Supervision has proposed methods for incorporating consideration of market risks--exchange rate, interest rate, and equity price risks--into risk-based capital standards for banks. This paper shows that the separate and seemingly different proposed approaches to the three sources of risk are consistent with one another, reflecting a single unifying theme. That theme is the measurement of risk through a weighting of two different measures of portfolio size, the gross position and the net position. A simple theoretical model demonstrates that such an approach can be viewed as a simple (specifically, an affine) approximation to a portfolio variance calculation based on the full variance-covariance matrix of market returns, and thus provides a reasonable basis for a practical approach to capital standards. An empirical test of one part of the framework, the proposal for exchange rate risk, shows that the approximation may be very accurate: the proposed Basle approach captures over 95 percent of the variation in foreign exchange risk across a sample of banks from the Twelfth Federal Reserve District.