FRM Handbook Ch 28: The Basel Accord (Market Risk Charge and Conclusions)

Book: Financial Risk Manager Handbook Plus Test Bank
Author: Philippe Jorion
ISBN: 978-0-470-90401-5

The second half of Chapter 28 zooms in on the market risk charge (MRC). This is where Basel meets the VaR models banks actually run every day. Two paths exist: a rigid standardized approach and a flexible internal models approach with strings attached.

The standardized approach

The standardized method applies fixed add-ons by risk category:

• Interest rate risk: Charges computed per currency zone, then summed. Maturity buckets assign weights. No recognition of offsetting positions across zones.
• Equity risk: 8% of gross position (4% if liquid and diversified).
• Currency risk: 8% of the larger of net long or net short positions.
• Commodity risk: 15% of net position per commodity in the simplified approach.
• Option risk: Lesser of underlying market risk charge or option premium for purchased options.

The standardized approach is easy to implement and hard to game with model assumptions. But it has serious flaws:

1. Arbitrary weights. Equities and currencies both get 8% regardless of actual volatility.
2. No diversification. Charges add across risk types as if worst losses happen simultaneously.
3. No incentive to hedge prudently. A bank with offsetting positions in two currencies still pays capital on both gross exposures.

For a conservative regulator, these features are features. For a bank trying to allocate capital efficiently, they are expensive.

The internal models approach

The IMA lets banks use their own VaR systems for the MRC, but only after regulatory approval. The bar is high.

Qualitative requirements

Before the math matters, the bank must prove its risk culture is real:

• Independent risk control unit reporting to senior management
• Regular backtesting of VaR models
• Senior management and board actively involved
• VaR integrated into daily limits and decisions, not just regulatory filings
• Regular stress testing reviewed by leadership
• Documented policies and annual independent review

If VaR is a spreadsheet for the quarterly regulatory report and nothing else, you do not qualify.

Quantitative parameters

Once approved, the MRC uses standardized inputs for comparability:

• Horizon: 10 trading days (banks can scale daily VaR by square root of time)
• Confidence level: 99%
• Historical observation period: At least one year, with recent data weighted more heavily
• Updates: At least quarterly

The charge is based on the higher of the previous day’s VaR and an average of daily VaRs over the prior 60 business days. A multiplication factor (minimum 3.0) is applied. Backtesting results can push this factor up to 4.0 if the model underestimates risk consistently.

Specific risk and stress testing

General market risk covers factor movements (rates, FX, equity indices). Specific risk covers idiosyncratic exposures (individual bond issuers, single stocks). Banks must model both or pay standardized specific risk charges alongside their IMA general charge.

Stress testing is not optional. Regulators expect scenarios beyond what VaR captures.

Building block vs integrated approaches

Within the standardized framework, the building block approach computes charges for each risk type separately and adds them. The integrated approach allows some offsetting within risk categories but is harder to qualify for.

The IMA is the real integrated approach. It captures correlations within and (if the model is sound) across broad risk categories. That is why large trading banks invest heavily in qualifying for it.

Conclusions on Basel’s evolution

Jorion closes with the bigger picture. Basel I created a global minimum standard. Basel II added risk sensitivity and operational risk capital. The 2007 crisis exposed gaps in both, especially for structured credit and liquidity.

The MRC specifically showed that internal models work when backtesting is honest and governance is real. They fail when banks treat regulatory VaR as a compliance checkbox. The multiplication factor and backtesting overlay exist precisely because regulators learned that lesson.

What stuck with me

The standardized approach is a worst-case sum. The IMA is a negotiated trust relationship between bank and supervisor. You earn the right to use your own models by proving you use them seriously.

For anyone studying the FRM exam, the qualitative requirements list is worth memorizing. Examiners love asking which conditions must be met before a bank can use internal models. The answer is never just “have a VaR system.”

Previous: FRM Handbook Ch 28: The Basel Accord (Basel I and Basel II)
Next: FRM Handbook Ch 29: Portfolio Risk Management