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2.6 AMENDMENT TO THE CAPITAL ACCORD TO INCORPORATE MARKET RISKS
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Starting at the end of 1997, or earlier, if their supervisory authority so prescribed, banks were required to measure and apply capital charges to their market risks in addition to their credit risks.78 Market risk is defined as the risk of losses in on- and off-balance-sheet positions arising from movements in market prices. The following risks are subject to this requirement:
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Risks pertaining to interest-rate-related instruments and equities in the trading book Foreign exchange risk and commodities risk throughout the bank
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2.6.1 Scope and Coverage of Capital Charges The final version of the amendment to the capital accord to incorporate market risks regulates capital charges for interest-rate-related instruments and equities and applies to the current market value of items in the bank s trading books. By trading book is meant the bank s proprietary positions in financial instruments (including positions in derivative products and offbalance-sheet instruments) which are intentionally held for short-term resale. The financial instruments may also be acquired by the bank with the intention of benefiting in the short term from actual or expected differences between their buying and selling prices, or from other price or interest-rate variations; positions in financial instruments arising from matched principal brokering and market making; or positions taken in order to hedge other elements of the trading book.79 Capital charges for foreign exchange risk and for commodities risk apply to the bank s total currency and commodity positions, subject to some discretion to exclude structural foreign exchange positions:
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For the time being, the Committee does not believe that it is necessary to allow any de minimis exemptions from the capital requirements for market risk, except for those for foreign exchange risk set out in paragraph 13 of A.3, because the Capital Accord applies only to internationally active banks, and then essentially on a consolidated basis; all of these are likely to be involved in trading to some extent.80
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The definition of capital is based on that of the BIS, from the Amendment to the Capital Accord to Incorporate Market Risks:
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The principal form of eligible capital to cover market risks consists of shareholders equity and retained earnings (tier 1 capital) and supplementary capital (tier 2 capital) as defined in the 1988 Accord. But banks may also, at the discretion of their national authority, employ a third tier of capital ( tier 3 ), consisting of short-term subordinated debt as defined in paragraph 2 below for the sole purpose of meeting a proportion of the capital requirements for market risks, subject to the following conditions. . . .81
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The definition of eligible regulatory capital remains the same as outlined in the 1988 accord and clarified in the October 27, 1998, press release on instruments eligible for inclusion in Tier 1 capital. The ratio must be no lower than 8 percent for total capital. Tier 2 capital continues to be limited to 100 percent of Tier 1 capital.82 To clarify the impact of the amendment for market risk on the risk steering of the banks, the capital definitions are summarized as follows:
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Banks are entitled to use Tier 3 capital solely to support market risks as defined in Parts A and B of the amendment. This means that any capital requirement arising in respect of credit and counterparty risk in the terms of the 1988 accord, including the credit counterparty risk in respect of derivatives in both trading and banking books, needs to be met by the existing definition of capital in the 1988 accord (i.e., Tiers 1 and 2). Tier 3 capital is limited to 250 percent of a bank s Tier 1 capital that is required to support market risks. This means that a minimum of about 28.5 percent of market risks needs to be supported by Tier 1 capital that is not required to support risks in the remainder of the book. Tier 2 elements may be substituted for Tier 3 up to the same limit of 250 percent if the overall limits in the 1988 accord are not breached. That is, eligible Tier 2 capital may not exceed total Tier 1 capital, and long-term subordinated debt may not exceed 50 percent of Tier 1 capital. In addition, because the committee believes that Tier 3 capital is appropriate only to meet market risk, a significant number of member countries are in favor of retaining the principle in the present accord that Tier 1 capital should represent at least half of total eligible capital that is, that the sum total of Tier 2 plus Tier 3 capital should not exceed total Tier 1. However, the committee has decided that any decision whether to apply such a rule should be a matter for national discretion. Some member countries may keep the constraint, except in cases in which banking activities are proportionately very small. In addition, national authorities will have discretion to refuse the use of shortterm subordinated debt for individual banks or for their banking systems generally.
For short-term subordinated debt to be eligible as Tier 3 capital, it must, if circumstances demand, be capable of becoming part of a bank s permanent capital and thus be available to absorb losses in the event of insolvency. It must, therefore, at a minimum:
Be unsecured, subordinated, and fully paid up Have an original maturity of at least two years Not be repayable before the agreed repayment date unless the supervisory authority agrees Be subject to a lock-in clause which stipulates that neither interest nor principal may be paid (even at maturity) if such payment means that the bank will fall below or remain below its minimum capital requirement
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