Measuring Market Risk - Reserve Bank of India

2 RESERVE BANK OF INDIA OCCASIONAL PAPERS
management framework adopted at banks globally in recent years.
Regulators across the world today follow banking supervision
systems broadly similar to the framework articulated in these
documents. A key feature of this framework is the risk capital – the
minimum amount of capital a bank requires to keep for its exposure
to risk. It is argued that the risk capital acts as a cushion against
losses, protecting depositors’ interest and increasing the resilience of
the banking system in the event of crisis. Risk capital also makes the
banks take risk on their own fund, thereby induces them to invest in
prudent assets and curb their tendency to take excessive risk, which
reduces the chances of bank runs greatly. So, the risk-based capital
regulation has emerged as a tool to maintain stability of banking
sector. Eventually, not only the banks but an increasing number
of other financial institutions and firms are also aligning their risk
management framework in the similar line.
Two important changes are notable in the supervisory framework
in recent years. First, determination of minimum required capital is
now made more risk-sensitive (also more scientific) than earlier.
Second, there has been an expansion in coverage of risk events in
banks’ portfolio. In contrast to traditional focus solely on credit risk
(BIS, 1988), the regulatory framework has gradually covered two
more important risk categories, viz., market risk (BIS, 1996a, 1996b)
and operational risk (BIS, 2004).
The Basel Accords and associated amendments/revisions provide
broad guidelines to determine the level of minimum required capital a
bank should maintain for all three types of financial risks mentioned
above. Under each risk category there have been a number of alternative
approaches – starting from simple/basic to advanced in increasing level
of sophistication. Also a distinction between basic and more advanced
approach is that later emphasizes more on actual quantification of risk.
In the case of ‘market risk’ the advanced approach is known as
‘internal model approach’ (IMA), wherein risk capital is determined
based on the new risk measure, called value-at-risk (VaR). Higher the
value of VaR, higher the level of market risk, thereby; larger the level