Regulating Market Risk in Banks: A Comparison of Alternative Regulatory Regimes

Abstract

The author evaluates three approaches to regulating market risk in banks on the basis of efficiency, competitive neutrality, and effectiveness in regulation. Each approach is judged on how well it fulfills the aims of regulation without overburdening the financial system with the cost of regulation. The three approaches are the building bloc approach where separate capital requirements are determined for each of four major market risk categories and then aggregated; the internal models approach where loss to the bank's portfolio is calculated with a specified probability over a specified holding period of time; and the pre-commitment approach where each bank pre-commits a capital amount to cover what is believed to be its maximum trading loss exposure over a given regulatory period. The author concludes -given the current inability to develop measures that capture an institution's overall portfolio risks- that piecemeal regulatory capital requirements (such as the one for market risk) are necessary. Of the approaches he analyzes, the author considers the internal models approach to be, for the time being, the most reliable, market-friendly, and effective method for banks.