Quarterly Bulletin
Regulatory Policy Articles

Bank capital standards: the new Basel Accord
(78k)
(by Patricia Jackson of the Bank's Financial Industry and Regulation Divison). The 1988 Basel Accord was a major milestone in the history of bank regulation, setting capital standards for most significant banks worldwide—it has now been adopted by more than 100 countries. After two years of deliberation, the Basel Committee on Banking Supervision has set out far-reaching proposals for revising the original Accord to align the minimum capital requirements more closely with the actual risks faced by banks.

On 16 January 2001 the Basel Committee released a consultation package setting out the details of the new Accord. The Bank of England and Financial Services Authority jointly represent the United Kingdom on the Basel Committee. Comments are requested by the end of May and the Committee is expecting to release the final version of the Accord by end-2001 for implementation in 2004. A parallel consultative process is also operating at the EU level. A directive to implement the Basel proposals in the EU, which will cover both banks and investment firms, is also due to take effect from 2004.

The 1988 Accord was based on broad credit risk requirements, although it was amended in 1996 to introduce trading-book requirements as well. The proposed new Accord has three pillars: Pillar 1 will set new capital requirements for credit risk and an operational risk charge; Pillar 2 will require supervisors to take action if a bank's risk profile is high relative to capital held; and Pillar 3 will require greater disclosure from banks than hitherto to enhance market discipline.

The new credit risk requirements will be much more closely tied to the riskiness of particular exposures. In order to set such risk-based requirements the Committee had to consider a wide range of issues regarding the determinants of credit risk. This article sets out the background to the proposed changes and some of the issues that arise.

Testing value-at-risk approaches to capital adequacy (643k)
(by Patricia Jackson and William Perraudin of the Bank’s Regulatory Policy Division and David Maude of the Bank’s Monetary Assessment and Strategy Division).
This article looks at the nature of whole-book value-at-risk models, and describes how the Bank of England set out in 1995 to assess their performance in accurately predicting risk and in providing a basis for reliable trading-book capital calculations.

The article sets out the results of the tests carried out by the Bank to assess the accuracy of the risk-measurement models used by firms to evaluate risk on their trading-book portfolios. The main conclusions from these tests were as follows:

• Different VaR models performed more or less well in supplying unbiased measures of the value at risk. (For some VaR models built with a 99% confidence level, significantly more than 1% of losses exceeded the value-at-risk estimate.)
• Simulation-based VaR models met this test better than parametric VaR models based on normal distributions, because of the severely fat-tailed nature of reasonably diversified fixed-income exposures. Most banks’ trading books are made up largely of such exposures.
• Use of short data samples (or a weighting scheme that places heavy weight on recent data) worsened the biases in the VaR estimates for parametric models.
• The extra safeguards around the use of the VaR models (the requirement that a firm must meet the higher of the estimated VaR, or three times the 60-day moving average of the current and past VaRs) would probably mean, for market-risk models of the kind tested, that only extremely risky portfolios would fail to be covered by sufficient capital.
• The back-testing requirements incorporated in the Basle approach are likely to lead to some banks holding higher capital. A bank holding the portfolios employed in the study could find its capital requirements adjusted upwards from time to time if it used the parametric approach.