Policy essay - risk-based bank capital: issues and solutions

Market risk has become an integral consideration in bank business. Derivatives are increasingly used as a means of risk management, and bank involvement in derivatives trading represents a new, different, and very important line of business. Existing regulations for the determination of bank capital, based on the quality of assets held, are not appropriate for trading portfolio assets where exposure to market risk factors is of primary importance. ; This essay discusses three major proposals for dealing with market risk in determining banks' risk-based capital. The standard and internal model approaches are concerned with regulating the models used internally by banks for risk assessment and management. The third alternative, called the precommitment approach, emphasizes incentives and goals while leaving modeling issues entirely to banks. The author argues that, properly implemented, the precommitment approach is best suited to attaining regulatory goals.