The risks subject to this requirement are:1. The risks pertaining to interest rate related instruments and equities in the trading book.2. FX risk and commodities risk throughout the bank.These lines above are copy from Basel II Accord. However, I don't see the logic behind them. Shouldn't interest rate risk be calculated for the whole bank since the entire balance sheet largely depends on it? And shouldn't commodities risk be only in the trading book since commodities are bought and sold largely for trading?Am I missing something here? Thanks for any input!

The logic behind the current guidelines is as below :1.The trading book is an MTM Book and P&L shows up in capital directly yearly .2.The banking book is accrual accounted and hence no P&L mans capital impact will beover a long period which is sufficiently long not to impose an additional capital requirement as typically banking books run on NII and banks do not expect to los money on these .However , note that the Basel committee has been thinking of requiring capital to be held for banking books as well .This may kick in in the near future especially after the recent market volatilities .Note that market risk in banking books typically will impact capital in only a small way as for commerical banks at least the trading risks are a small fraction o credit risks though profitability of trading is much higher due to intraday activities .Your question is very valid and BTW regulators ask for stress testing and justification for why banks should not be asked to hold capital against IR risk in the banking book .especially for banks which have large mortgage portfolios now .

Thanks PCG. Sorry for delayed response. OK, interest rate risk for banking book is dealt through Asset/Liabilites Mgt. and its various techniques, and, as you say, additional regulatory capital in the future. But, I still don't understand why commodity risk is calculated throughout the bank.

why would a bank have HFI assets in commodities?

To my knowledge, the formulation has always been so and there seems to be no clear explanation to why it was formulated like that.. edit 16.04.2009 20:50CET: Actually in this Lehman case below you would clearly have an example of what can happen and why this (BII) was done so...a IB with a "hold" in commodities"Bloomberg reports that Lehman Brothers Holdings is 'sitting on enough uranium cake to make a nuclear bomb'. The firm apparently acquired the uranium cake under a 'matured commodities contract', and is waiting for a rebound in commodity prices before offloading it and sticking the proceeds in the fund to repay creditors. The radioactive material, which is thought to be stored somewhere in Canada, is likely to be sold piecemeal over the next two years."

Basel has divided bank capital into pools1. Banking book - consists instruments held for long term 2. Trading book - consists instruments held for short termfx and commodities may have been considered as part of both the books owing to their speculative and volatile nature. They may become expensive/cheap in months,days, hours, or sometimes, in minutes