Guidelines for Computing Capital for Incremental Default Risk in the Trading Book

The Basel/IOSCO Agreement reached in July 2005 (The Application of Basel II to Trading Activities and the Treatment of Double Default Effects), contained several improvements to the capital regime for trading book positions. Among the revisions to the Market Risk Amendment was a new requirement for banks that model specific risk to measure and hold capital against default risk that is incremental to any default risk captured in the bank's value at risk (VaR) model. The incremental default risk charge (IDRC) was incorporated into the trading book capital regime in response to the increasing amount of exposure in banks' trading books to credit-risk related and often illiquid products whose risk is not reflected in VaR. The requirement for the IDRC was set forth in the form of very high-level standards in paragraphs 718(xcii) and 718(xciii) of the Basel II Framework.

The Basel Committee set up the Accord Implementation Group on the Trading Book (AIGTB) primarily to conduct the work on further clarification, as well as to provide a forum for supervisors to share their experience in overseeing banks' implementation of the trading book capital regime. As there is no clear industry standard for measuring incremental default risk for the trading book, the AIGTB has worked closely with industry groups in developing principles for implementing the new charge that build off the principles in banks' internal approaches.

To evaluate the quantitative impact of the guidelines on banks' portfolios, the Basel Committee currently is conducting a data collection exercise.

The Committee expects banks to develop their own internal models for calculating a capital charge for incremental default risk in the trading book. This paper provides additional guidance on how the general principles in paragraphs 718(xcii) and 718(xciii) may be met and contains both guidance on how supervisors will evaluate internal models and fallback options deemed acceptable by the Committee.

Banks are expected to fulfil the principles for the IDRC laid out in this document to receive specific risk model recognition. Banks that have already received the specific risk model recognition under the 1996 Market Risk Amendment would not be required to implement the IDRC until 1 January 2010.

The Basel Committee welcomes comments from the public not only on specific issues in Section VIII but also on all aspects of this consultative paper by 15 February 2008. These should be addressed to the Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, Postfach, CH-4002 Basel, Switzerland. Comments may also be submitted by email: baselcommittee@bis.org or by fax: +41 61 280 9100.