In April 1993, the Basle Committee on Banking and Supervisory practices issued three papers: the Supervisory Recognition of Netting for Capital Adequacy Purposes; 1 the Supervisory Treatment of Market Risks; 2 and, the Measurement of Banks' Exposure to Interest Rate Risk. 3
Following up on the 1990 report on interbank netting schemes, 4 it was agreed that credit and liquidity risks could be reduced by some form of bilateral and multilateral netting. The bilateral netting would employ the current exposure method, meaning the mark-to-market value of interest rate or currency instrument, plus add-on. Since the replacement cost can often amount from 50% to 80% of the total capital charge--replacement cost plus add-on--bilateral netting (of replacement cost) can reduce replacement cost by up to 50%, which would represent a 25% to 40% alleviation in capital charge (depending upon the counterparty). 5 Naturally, netting must be by novation--the fictional creation of a new contract.
Multilateral netting inevitably involves the use of a clearing house that would have to replace the losses that defaulting members' portfolios of forex or interest-rate swap contracts would have produced. Consequently, losses would have to be calculated by requiring each member to post collateral equal to its own net debit with the clearing house.
Pursuant to the EEC Capital Adequacy Directive (CAD), 6 which became final in 1993 subject to future international agreements, the Basle Committee issued a statement or a proposal on the supervisory treatment of market risks. The proposal applied to position taking in debt and equity securities in the trading portfolio (as opposed to the investment portfolio in the 1988 G-10 Agreement). 7 The 1988 G-10 Agreement was mainly directed toward the assessment of capital in relation to credit risk (the risk of counterparty failure). However, deregulation of interest rate risk, capital controls and financial innovation permitted a range of activities that have