5.4.2 The Basel approach to market risk

209. The previous section discussed the credit risk that institutions face on their exposures. In essence all exposures are subject to credit risk. “The person who has lent [€ 100] to company X is, in credit terms, in the same position as a person who owns a [€ 100] security issued by company X”.1 The difference between credit risk and market risk, according to Gleeson,2 is that “[…] whereas the owner of a loan is obliged to wait until [that loan] is repaid, the owner of a security is able to sell [that security]”. This means that the owner of a security is not exposed to the full credit risk of the issuer of that security in the same way as the holder of a loan. The owner of a security is able to sell that security and is thus only subject to the risk of finding a buyer of that security in a certain time frame. The risk is thus not based on the probability of default of the issuer and the exposure at default, but primarily on the risk that the securities value may change (i.e. the specific risk)3 or that the market as a whole may change (i.e. general market risk).4 Market risk is an estimation of the amount lost on a single security due to movements in the price of that security resulting either from a change in that security itself or from changes in the market as a whole.5

210. To be able to calculate the market risk of an institution, one first has to identify which exposures should fall within the market risk framework or the credit risk framework. The Basel Accords divide all exposures into exposures in the banking book (subject to credit risk) and exposures in the trading book (subject to market risk). Where the line between trading book and banking book should be drawn has been a subject of debate since the introduction of the market risk requirements in the Basel Accord in 19966 and has seen amendments up until the Basel III accord. Basel II7 states that “the trading book consists of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book. To be eligible for trading book capital treatment, financial instruments must either be free of any restrictive covenants on their tradability or able to be hedged completely. In addition, positions should be frequently and accurately valued, and the portfolio should be actively managed”. The core criteria in this definition of trading book is the ‘trading intent’. If the intention of the institution is to actively trade that exposure, then that exposure should be subject to the market risk requirements. Trading intent is defined in the Basel II Accord as positions “held intentionally for short-term resale and/or with the intent of benefiting from actual or expected sort-term price movements or to lock in arbitrage profits, and may include, for example, proprietary positions, positions arising from client servicing (e.g. matched principal broker) and market making”.8