Risk-basedbankcapitalissuesandsolutions.docVIP

Risk-Based Bank Capital: Issues and Solutions Robert R. Bliss The author is an economist in the financial section of the Atlanta Fed’s research department. He thanks Peter Abken, Larry Wall, and Gerry Dwyer for helpful comments. Banks are subject to many forms of risk, of which credit and market risk are perhaps the most important. Credit risk involves the risk that a counterparty to a contractual obligation, be it a mortgage, loan, or swap agreement, will default on the promised payments. Market risk is the risk that the values of assets or the cash flows from assets will change in response to movements in broad market factors, such as interest or exchange rates. Traditionally, bank regulation has focused on credit risk, the quality of assets, and internal control systems. But financial markets have changed so that market risk has become increasingly important. Risk is an integral part of bank business. In assessing the creditworthiness of a loan applicant the bank makes a judgment about the riskiness of the loan. In taking a position in the foreign exchange market the bank takes on a risk that it factors into the price quoted to its customer. Regulatory interest is not in controlling the risk a bank can take on per se, but in limiting the chances that adverse outcomes will exceed the bank’s capacity to bear losses—hence the regulatory focus on bank capital, which provides a buffer against the potential for losses inherent in the bank’s conduct of its normal business. For exposures to market risks from trading desk operations, however, existing regulations for the determination of bank capital, based on the quality of assets held, are not appropriate. Derivatives—financial assets whose value and payoffs are determined by the value of an underlying asset or index—are used to transfer risks from one party to another (at a cost, of course) and thus are a means of risk management, much like insurance. Derivatives such as forward foreign exchange contracts, interest ra