What is a market risk?

The ‘Market risk’ is an umbrella term used for multiple types of risk associated with adverse changes in market variables that include Liquidity Risk, Interest rate risk, Foreign exchange rate risk and equity price risk. Market risk causes substantial changes in income and economic value of banks. The Bank of International Settlements (BIS) defines market risk as “the risk that the value of ‘on’ or ‘off’ balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices”. Basel II Framework offers a choice between two broad methodologies in measuring market risks for the purpose of capital adequacy viz. (1)The Standardised Measurement Method (2) The Internal Models Approach (IMA)

Standardised Measurement Method:  In January 2016, the Basel Committee on Banking Supervision (BCBS) published revised standards for minimum capital requirements for market risk (Standards). The Standards replace the existing requirements for market risk. The Standarised Approach(SA) comprises three main blocks viz. the sensitivities-based method (SBM), the default risk charge (DRC) and the residual risk add-on (RRAO). Each block covers specific types of risk that are relevant in the context of market risk. A risk charge is computed for each of the three blocks, the sum of which is the overall risk charge for market risk under the SA. No diversification benefits are allowed across the three blocks.

Internal models approach (IMA):

The Internal Models Approach (IMA): IMA is the alternative methodology which allows banks to use risk measures derived from their own internal market risk management models. The permissible models under IMA are the ones which calculate a value-at-risk (VaR) – based measure of exposure to market risk. VaR-based models could be used to calculate measures of both general market risk and specific risk. As compared to the SMM, IMA is considered to be more risk sensitive and aligns the capital charge for market risk more closely to the actual losses likely to be faced by banks due to movements in the market risk factors. This method is subject to the explicit approval of the supervisory authority.