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Currently, there is no regulatory capital requirement that accounts for market risks in banks' trading accounts. Bank regulators are considering a capital charge for such risks based directly on risk estimates from banks' internal models typically used to measure one-day exposures. While an improvement over an earlier proposal that would rely on a regulatory risk measurement system, the internal models approach has significant drawbacks. The models are not appropriate for estimating trading account market risk exposure over a relatively lengthy period of interest to regulators and it is extremely difficult to validate the risk estimate a bank reports. These difficulties are eliminated in an alternative approach developed in this paper, referred to as a pre-commitment approach. Under this alternative approach, the bank pre-commits to a maximum loss exposure over a fixed subsequent period that takes intoaccount risk management and trading objectives and allocates capital to cover that exposure. The regulator determines the likelihood of the bank's market trading losses exceeding its capital allocation through the incentive effects of capital penalties or fines imposed in the event of a violation of the commitment.
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