The 1996 Basel Amendment

In 1996, an amendment to the Basel accord from 1988 was created to account for the shortcoming of the initial accord. It involves keeping capital for assets and liabilities held for trading

The 1996 amendment introduced marking to market for the trading book. Assets in the trading book now had to be reevaluated daily to their market price. The trading book include assets such as equities, most derivatives, foreign currencies, and commodities. The banking book consists of assets that are expected to be held to maturity and are not market to market. These include loans and som debt securities.

Under the 1996 amendment, the credit risk capital charge from the 1988 accord continued to apply to on- and off-balance sheet items in the trading and banking book. Some items in the trading book were excluded, such as equities and debt traded securities, as well as positions in commodities and foreign exchange. A market risk charge for the trading book was also introduced to account for the risk inherent in trading.

The standardized approach for measuring the market risk charge is to assign it to each set of securities separately. No account is taken for the correlation between for instance debt and equity instruments. More sophisticated banks were allowed to use an internal model-based approach. The banks calculate a VaR measure and convert it into a capital requirement using a pre-specified formula. The internal model-based approach was often preferred as it allowed banks to take the benefits of diversification into account.

The formula used to convert the internal model-based approach to a capital requirement is: k x VaR + "Specific Risk Charge".


k is minimum 3 and is set by regulators. The specific risk charge accounts for the idiosyncratic risk related to individual companies. A corporate bond for instance has two risk components, interest rate risk (captured by VaR) and credit risk that is captured by the specific risk charge.

The total capital a bank had to keep under the amendment was 0.08 x (Credit risk RWA + Market risk RWA)

Where
Market Risk, Risk Weighted Assets = 12.5 * (k x VaR + SRC)
Credit Risk, Risk Weighted Assets = sum(w*on balance sheet items) + sum(w*off balance sheet items)