Modification of the Basle Capital Accord of July 1988, as amended in January 1996

BASLE COMMITTEE ON BANKING SUPERVISION
BANK FOR INTERNATIONAL SETTLEMENTS, CH-4002 BASLE

Explanatory Note
Modification of the Basle Capital Accord of July 1988,
as amended in January 1996

The Committee has decided to remove the provision of the 1996 Market Risk Amendment which requires that the specific risk capital charge of the internal models approach be subject to an overall floor equal to 50% of the specific risk amount calculated under the standardised approach.

Since the release of the Market Risk Amendment in early 1996, the Committee and national supervisors have had a dialogue with banks on their methodologies for assessing specific risk. As regards methods for modelling idiosyncratic variation, the Committee notes that it has seen sufficient improvement and innovation in these modelling techniques and enough similarity among methodologies used by banks to set general criteria for modelling idiosyncratic variation (i.e., the day-to-day variation not explained by the general market). However, the Committee as a whole has not yet agreed that currently existing methodologies used by banks adequately capture event and default risk. The Committee notes that approaches for measuring and validating this risk differ widely at present and that modelling in this area is in the process of rapid evolution, making it impractical at this juncture to set forth general guidance for capturing this risk.

In the light of these findings, the Committee has established certain qualitative and quantitative requirements for idiosyncratic risk which will allow banks that meet them to base their specific risk capital charge on modelled estimates of specific risk without reference to the floor. Banks that do not meet these requirements (as set out in the attached text for amending the Market Risk package) must use the standardised approach to calculate the specific risk capital amount. The requirements are aimed at ensuring that banks accurately estimate and validate idiosyncratic variation as part of a portfolio's overall price variation. Until a bank can demonstrate that the methodologies it uses capture event and default risk adequately, its modelling of specific risk will be treated on the same basis as if a model of general market risk proved deficient during backtesting. As a result, it will be subject to a capital surcharge; that is, a multiplication factor of four on the treatment of specific risk. The minimum multiplication factor of three could only be applied to specific risk models for which it can be demonstrated that all relevant aspects of market risk are captured.

The Committee expects that the banks' continuing efforts to improve their models will soon lead to established market standards that adequately capture event and default risk for traded-debt and equity instruments and is prepared to work with the industry to this end. The Committee and national supervisors are ready to examine at any time the ability of individual methodologies to model both components of specific risk set forth in the regulatory definition. If such an overall ability can be shown to both bodies, any model that is based on the same methodology may immediately obtain the minimum multiplication factor of three; however, a higher multiplication factor of four would be possible if future backtesting results were to indicate a serious deficiency with the model. The Basle Committee and national supervisors will continue to cooperate to ensure that the implementation of such methodologies and practices are done in an appropriate and consistent manner. As soon as market standards have been established within the industry, the Committee will replace this interim approach by defining general guidance for capturing event and default risk for trading book instruments.

The Committee's desire to have banks refine their modelling techniques for capturing event and default risk in the trading book should not be interpreted as a precursor to a decision concerning credit risk modelling for the banking book. The Committee believes that the modelling of event and default risk in the trading book is very different from the modelling of the credit risk in the banking book. In this regard, the Committee emphasises that the modelling of event and default risk as an element of specific risk within the trading book focuses on the potential for occurences such as default to lead to precipitous changes in market values over a short period. The easy availability of market prices, the daily marking-to-market process, and the ability to trade instruments and to hedge using liquid instruments readily distinguishes specific risk modelling of trading book positions from modelling of banking book positions.