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Bank capital standards for foreign exchange and other market risks

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  • Mark E. Levonian

Abstract

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.

Suggested Citation

  • Mark E. Levonian, 1994. "Bank capital standards for foreign exchange and other market risks," Economic Review, Federal Reserve Bank of San Francisco, pages 3-18.
  • Handle: RePEc:fip:fedfer:y:1994:p:3-18:n:1
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    File URL: http://www.frbsf.org/publications/economics/review/1994/94-1_3-18.pdf
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    Cited by:

    1. Chamberlain, Sandra & Howe, John S. & Popper, Helen, 1997. "The exchange rate exposure of U.S. and Japanese banking institutions," Journal of Banking & Finance, Elsevier, vol. 21(6), pages 871-892, June.

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    Keywords

    Bank capital ; Risk ; Foreign exchange;

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