BC-A.1.1

The purpose of this module is to lay down rules and guidelines that lay down the regulations and provide guidance on best practices that banks should adhere to in relation to business and market conduct.

BC-A.1.2

This module provides support for certain other parts of the Rulebook, mainly:

BC-A.1.3

This module also provides support for certain aspects relating to business and market conduct in the Bahrain Commercial Companies Law of 2001 (as amended).

Promotion of financial products and services

Code of conduct for bank dealers and foreign exchange and money brokers in the foreign currency and deposit markets

Disclosure of information about individual accounts

Minimum balance and charges on savings accounts

Dinar Certificates of Deposits — Rules

Disclosure of charges

Accounts held for clubs and societies in Bahrain

Current accounts

Notification to the Agency on introduction of new or expanded customer products and facilities

Penalty system for dishonoured cheques

General guidance on administration of dishonoured cheques

Penalty charges on dishonoured cheques

Installation of an off-site ATM in Bahrain

GCC ATM network charges

Margin Trading System

BC-A.3.1

This module was first issued in July 2004 as part of the conventional principles volume. All regulations in this volume have been effective since this date. All subsequent changes are dated with the month and year at the base of the relevant page and in the Table of Contents. Chapter UG-3 of Module UG provides further details on Rulebook maintenance and control.

BC-A.3.2

The most recent changes to this module are detailed in the table below:

Summary of changes

Effective date and evolution of the Module

Introduction

General requirements

BC-2.1.1

The Code of Conduct, which is prepared in cooperation with the Bankers' Society of Bahrain and foreign exchange brokers, provides rules in respect of certain kinds of practice which experience has shown may cause difficulty and may jeopardise the good standing of the Bahrain market. Management of banks and money brokers are responsible for ensuring that their institutions are in full compliance with the Code.

BC-2.1.2

Every broker and dealer shall at all times comply with the criteria in respect to market practice, integrity and conduct. Failure to comply with such criteria will be regarded as a serious offence by the BMA, which reserves the right to investigate any complaints brought to its attention. All participants should adhere to the spirit as well as to the letter of the Code.

BC-2.2.1

The use of generally accepted precise terminology should reduce misunderstandings and frustration, and to this end Appendix BC 5 sets out, without claiming to be exhaustive, accepted market terminology and definitions.

BC-2.2.2

For the purpose of this chapter, the following definitions apply:

BC-2.3.1

Confidentiality is vital for the preservation of a reputable and efficient market. Accordingly, the exchange of confidential information in respect of third parties is forbidden.

BC-2.3.2

The rules which follow are not intended to define exhaustively the obligations of dealers and brokers but set down specific ways in which confidentiality should be safeguarded and operations should be conducted.

A broker asking for a specific support price should be prepared to qualify the principal in terms of geographical location, by country or by region when the broker genuinely believes it will enable business to be concluded satisfactorily to the benefit of both broker and principal.

A broker who quotes a firm rate without qualification shall be prepared to deal at the rate, in a marketable amount. A broker, if quoting only the basis of one or two names, shall qualify his quotation, e.g., 'one small offeror — only two names paying'. The broker should indicate whether prices are firm or simply for guidance and, if requested by the principal, should be willing to indicate the amount involved. Further he should confirm with banks at reasonable intervals that their interest is still firm.

It is the responsibility of the principal to ensure the broker is made aware of any circumstances which materially affect the validity of the order placed with the broker.

Whenever possible and subject to market conditions, a bank in the deposit market should, before he 'takes a broker off' either a single order or several orders, check whether the broker is already committed to deal on his behalf.

BC-2.4.1

The passing and recording of details forms an essential part of the transaction and the possibility of errors and misunderstanding is increased by delay and by the passing of details in batches. Brokers should pass details verbally, and principals should be prepared to receive them, normally within a few minutes after deals have been concluded.

BC-2.4.2

When arranging and passing details on forward contracts in foreign exchange, banks and brokers must ensure that the rate applied to the spot end of the transaction bears a close relationship to the spot rate at the time the deal was concluded.

BC-2.5.1

Written confirmation by a broker is the final check on the details of the transaction. The handling of confirmations must take account of the desire of brokers to have a realistic time-limit placed on their liability for differences. There is an obligation on recipients to check such confirmations. Initial confirmations should be sent out by telex without delay, and at the latest by close of business on the same working day. They should be followed up by written confirmation, normally hand-delivered and receipted before close of business on the following working day.

BC-2.5.2

Banks must check all confirmations carefully upon receipt so that discrepancies shall be quickly revealed and differences minimised. Principals shall also make enquiries of brokers about particular confirmations which have not been received within an appropriate time (as above) or about any changes in contract terms.

BC-2.5.3

In the case of deals where a bank pays against telex confirmation, the broker remains liable for differences until receipt of written confirmation is provided by the bank.

BC-2.6.1

The majority of differences payable by brokers arise from errors occurring in payment or repayment instructions. They also arise from a broker, having in good faith indicated a firm rate, being unable to substantiate his quotation.

BC-2.6.2

Any differences deemed payable by a broker to a bank (or by a bank to a broker) should be settled as soon as possible. The parties should provide each other with documents, setting out the exact details of and circumstances surrounding the deal.

BC-2.6.3

It is acknowledged that differences are sometimes paid by 'points'. The management of broking firms should always ensure that this practice is strictly controlled and monitored.

BC-2.6.4

All differences settled by direct payment should be advised in writing by the broker to the Director of Reserve Management, the BMA, (copied to the Bank) indicating the amount paid and the other party's name. The BMA reserves the right to ask for further information at its discretion.

BC-2.7.1

The BMA will regard any breaches of the rules stated below regarding gifts, favours, betting and entertainment unacceptable.

Gifts and favours

Bets

Entertaining

BC-2.8.1

Brokers shall be responsible for ensuring that:

BC-2.8.2

Bankers shall be responsible for ensuring that:

Currencies

Brokerage

Brokerage

BC-2.11.1

As part of its responsibility for supervising the conduct of brokers and dealers in the foreign exchange and currency markets, the Agency may, at its discretion:

BC-2.12.1

Spot transactions and outrights:

For pure outrights it would be advisable to adopt the same system as for swaps; however, implied swap difference is not visible or identical for both parties.

It is possible that payment instructions for counter-currency are already sent out and cannot be cancelled; in that case the paying party should be entitled to the proceeds of the unexpected use of funds by the receiving party.

BC-2.12.2

Deposits:

BC-2.12.3

Swaps:

If starting or maturing date of original swap under paragraph BC-2.12.1 or paragraph BC-2.12.2 are substantially different, per currency swap difference has to be recalculated in mutual agreement between the dealers;

BC-3.1.1

Banks should not publish or release information to third parties concerning the accounts or activities of their individual customers, unless:

BC-4.1.1

Banks may impose no more than a monthly charge of BD 1/– when the monthly weighted average balance for savings accounts for individuals falls below BD 20/– (or equivalent in other currencies).

BC-4.1.2

Orphans, widows, pensioners, individuals receiving social subsidies from the Ministry of Labour & Social Affairs, students and Bahraini nationals with a monthly salary below BD 250/– should be exempted from maintaining the above minimum balance requirement for savings accounts. Banks should establish criteria for determining the eligibility of a person for exemption from the above charges and should notify their concerned customers accordingly.

BC-4.2.1

The purpose of the contents of this section is to set out rules governing the issue of Dinar Certificates of Deposit by commercial banks.

BC-4.2.2

For the purpose of this section, 'Dinar Certificates of Deposit' are financial instruments payable in Bahraini Dinars. They must be negotiable — in accordance with the Law of Commerce (No. 7) of 1987 — and must satisfy the conditions set out in this section.

Issue

Denominations

Maturities

Interest rates

Negotiability

Safe custody

Reserve ratio

Other conditions

BC-4.3.1

In order to improve customer awareness and enhance transparency of bank charging structures, full commercial banks should display, by notice in their banking halls (both head offices and branches), a list of current charges.

BC-4.3.2

Banks should also ensure that each customer is in receipt of its current list of charges. The list should specify standard charges and commissions that will be applied by the bank to individual services and transactions and to specific areas of business.

BC-4.3.3

The requirement in this section is in addition to the requirements set out under section CM-8.2 that require all full commercial banks to display, by a conspicuous notice, their current effective rate of interest.

BC-4.4.1

All clubs and societies registered with the General Organisation for Youth and Sports (GOYS), are permitted under GOYS rules to only have one account with FCBs in Bahrain.

BC-4.4.2

The FCB is requested to notify GOYS when any club or society registered with GOYS requests the opening of an account with the bank. The purpose of the notification is to obtain clarification whether or not the account in question can be opened in accordance with the rules of GOYS.

BC-4.4.3

For accounts already held with the FCBs for clubs and societies registered with GOYS (i.e. before the application of the regulation in this section), the bank is requested to provide details of such accounts to GOYS (by reference to account name, relevant society, date opened and type of account) as soon as possible. If appropriate, GOYS will contact the relevant club or society in writing (with a copy to the bank) with instructions (e.g. to close the account) regarding such account.

BC-4.5.1

FCBs levying fees on their low-balance customer current accounts are required by the Agency to apply such fees to average balances when these fall below a prescribed level during a specified period.

BC-4.5.2

In order to prevent incidences of returned cheques due to maintenance of low-balance current accounts, the banks may convert some low-balance and/or inactive current accounts to savings accounts.

BC-4.6.1

The purpose of the contents of this section is to set out the new scale of brokerage fees effective for all banks in Bahrain.

BC-4.6.2

The new scale of fees is the result of discussion and consultation between The Bankers' Society and the Bahrain Money Brokers.

BC-4.6.3

For the list of brokerage fees, see Appendix BC 6.

BC-4.7.1

The content of this section is applicable only to full commercial banks licensed by the Agency.

BC-4.7.2

All institutions referred to under paragraph BC-4.7.1 are required to notify the Agency before the introduction of any new or expanded customer products and facilities. The Agency will respond to the concerned bank within one week of receipt of the notification if it has any observations on the new product.

BC-4.7.3

Further, institutions should also advise the Agency, on a six-monthly basis, on the status of new or expanded products and facilities. The advice should cover the following aspects:

the introduction of new or expanded products and facilities. The institution should also advise the Agency on any variances which are introduced to the terms and conditions applying to these products and facilities.

BC-4.8.1

The content of this section is applicable to all full commercial banks licensed by the Agency in the Kingdom of Bahrain.

BC-4.8.2

The Agency requires all commercial banks to follow the undermentioned procedures regarding the distribution of the financial assets of a deceased customer.

BC-5.1.1

The purpose of the contents of this section is to set out regulations relating to the system of penalising any person, whether natural or corporate in form, (referred to as a 'customer' in this chapter) whose cheque is

Cheques falling within this system are referred to as 'dishonoured cheques'. Due regard must be given by FCBs to the general provisions of Bahrain Law regarding joint accounts, partnership accounts and accounts in the name of corporate entities, as well as to the customer mandate in each case, to determine how such accounts may be dealt with for purposes of the Regulation in this chapter.

Procedures to be followed

BC-5.2.1

FCBs that wish to issue cheque guarantee cards for an amount not exceeding BD 200 may do so — subject to informing the Director of Banking Services at the Agency of their intention and the arrangements governing the issue of such cards.

BC-5.2.2

FCBs, generally, should take steps to extend their administrative supervision and control over current account customers (in particular those who are in repeated breach of normally-accepted behaviour), and to stress to account holders the need for an appropriate level of discipline in the usage of cheques.

BC-5.2.3

FCBs should exercise greater vigilance over borrowers, especially in the area of consumer finance, where such borrowers maintain their current accounts at a bank or banks other than at the lending bank.

BC-5.2.4

The Agency will monitor the incidence of returned cheques on a monthly basis (as stipulated in section BC-5.1) in order to determine the extent to which such incidence is being reduced or otherwise.

BC-5.3.1

The Agency will impose penalty charges of BD 5/= (five Bahraini Dinars) on each returned cheque for the reasons of 'Refer to Drawer', 'Not Arranged For', 'Re-present', and 'Account Closed'. Individual banks will continue to be informed daily of any charges accruing to their accounts. The respective accounts will be debited on the same day.

BC-5.3.2

FCBs will be entitled to charge customers no more than BD 10/= (ten Bahraini Dinars) in respect of each dishonoured cheque.

BC-6.1.1

The purpose of the content of this section is to set out the criteria to be followed by banks for the installation and usage of off-site ATMs in the Kingdom of Bahrain.

BC-6.1.2

Applications for the installation of off-site ATMs should be sent in writing, and in accordance with the requirements set out in paragraphs BC-6.1.3 to paragraphs BC-6.1.10, to the Executive Director of Banking Supervision at the Agency.

General criteria

BC-6.2.1

The purpose of this section is to set a limit on ATM charges imposed by full commercial banks in the Kingdom of Bahrain for customer withdrawals and other ATM services transactions relating to other banks in the GCC (i.e. linking to GCC ATM networks).

BC-6.2.2

The limits in this section do not apply to ATM service charges on local ATM networks.

BC-6.2.3

The Agency requires that the charges on such customer withdrawals and other ATM services should not exceed BD 1/= (one Bahraini Dinar) per transaction.

BC-7.1.1

This Chapter applies to all full commercial banks in Bahrain.

BC-7.1.2

Investors purchasing securities (as defined from time to time by the Bahrain Stock Exchange ("BSE")) listed on the BSE may pay for them under the Margin Trading System ("The System") by borrowing a portion of the purchase price from a participating bank. The System is subject to relevant provisions of the BMA Law, the BSE Law, any rules and regulations issued pursuant to such Laws and this Module. The System applies to equities in companies listed on the BSE. Unless restrictions apply under Bahrain law in this regard, the System shall be available to Bahraini or non-Bahraini investors, whether resident or non-resident in Bahrain.

BC-7.1.3

The main objective of introducing the System is to enhance the overall activity on the BSE, allowing investors to leverage their investments, in a controlled manner.

General criteria

BC-7.2.1

An investor may, through his relationship with any one individual participating bank under the System, invest a maximum of BD 200,000 in securities (i.e. BD 200,000 per investor/per individual participating bank, made up of BD 100,000 by way of the investor's own initial margin and BD 100,000 by way of financing from the relevant participating bank to that investor).

BC-7.2.2

An investor may, through approaching more than one bank under the System, invest a maximum of BD 500,000 in securities (i.e. BD 500,000 per investor/from all participating banks, made up of BD 250,000 by way of the investor's own initial margin with all participating banks and BD 250,000 by way of total financing from all participating banks to that investor.

BC-7.2.3

The amount of the margin facility made to an investor under the System shall be included as an exposure to that customer, and contribute towards the large exposures limit and the consumer finance limit for that person.

BC-7.2.4

The total amount of financing granted by an individual participating bank to all investors under the System shall not, at any time exceed 15% of that participating bank's capital base, such percentage to be reviewed by the BMA at its discretion from time to time.

BC-7.2.5

In relation to the aggregate limit under paragraph BC-7.2.2 above, the Agency will require participating banks to inform the Credit Risk Bureau of all facility limits approved to investors under the System from time to time. Participating banks must check with the CRB on the amount of facility limits outstanding under the System at any time to a particular investor.

Brokers

Documentation

Owner of the Securities bought using the System

Margin Percentage

Margin Call Top-up

Margin Interest

CA-A.1.1

Regulations in this module are applicable to locally incorporated banks on both a stand-alone, including foreign branches, and consolidated group basis.

CA-A.1.2

In addition to licensees mentioned in paragraph CA-A.1.1, certain of these regulations (in particular market risk requirements) are also applicable to full commercial branches of foreign banks.

CA-A.2.1

The purpose of this module is to set out the Agency's capital adequacy regulations and provide guidance on the risk measurement for the calculation of capital requirements by locally incorporated banks.

CA-A.2.2

The module also sets out the minimum gearing requirements which relevant banks (referred to in section CA-A.1) must meet as a condition of their licensing.

CA-A.2.3

The Agency requires in particular that the relevant banks maintain adequate capital, in accordance with the Regulation in this module, against their risks as capital provides banks with a cushion to absorb losses without endangering customer deposits. Due to this, the Agency also requires the relevant banks to maintain adequate liquidity and identify and control their large credit exposures that might otherwise be a source of loss to a licensee on a scale that might threaten its solvency.

CA-A.2.4

This module provides support for certain other parts of the Rulebook, mainly:

CA-A.3.1

All locally incorporated banks are required to measure and apply capital charges in respect of their credit and market risk capital requirements.

The capital requirement

Measuring credit risks

Measuring market risks

Minimum capital ratio requirement

Maintaining minimum RAR

Gearing requirements

CA-A.4.1

This module was first issued in July 2004 as part of the conventional principles volume. All regulations in this volume have been effective since this date. All subsequent changes are dated with the month and year at the base of the relevant page and in the Table of Contents. Chapter UG-3 of Module UG provides further details on Rulebook maintenance and control. The most recent changes made to this module are detailed in the table below:

Summary of changes

Evolution of the Module

Effective date

CA-B.1.1

This chapter provides general guidance on Capital adequacy requirements, unless otherwise stated.

CA-B.1.2

It sets best practice standards and should generally be applied by all licensees to their activities.

Basel Committee: Use of 'Backtesting' in Conjunction with the Internal Models Approach to Market Risk Capital Requirements

Basel Committee: The management of banks' off-balance-sheet exposures — a supervisory perspective

CA-B.3.1

This guidance should not be taken as legally binding requirements, unless otherwise embodied in Bahrain law or by regulation.

CA-B.3.2

It should be noted that the provisions in this chapter are to be taken as guidance, unless otherwise stated, supplementing the Regulations set out in this module.

CA-1.1.1

All locally incorporated banks are required to measure and apply capital charges in respect of their credit and market risk capital requirements.

CA-1.1.2

Credit risk is defined as the potential that a bank's borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk exists throughout the activities of a bank in the banking book and in the trading book including both on- and off-balance-sheet exposures.

CA-1.1.3

Market risk is defined as the risk of losses in on- or off-balance-sheet positions arising from movements in market prices. The risks subject to the capital requirement of this module are:

CA-1.2.1

In measuring credit risk for the purpose of capital adequacy, banks are required to apply a simple risk-weighted approach through which claims of different categories of counterparties are assigned risk weights according to broad categories of relative riskiness.

CA-1.2.2

The framework of weights consists of four weights — 0%, 20%, 50% and 100% for on- and off-balance-sheet items, which based on a broad-brush judgment, are applied to the different types of assets and off-balance-sheet exposures (with the exception of derivative transactions) within the banking book.

CA-1.2.3

The resultant different weighted assets and off-balance-sheet exposures are then added together to calculate the total credit-risk-weighted assets of the bank.

Trading book

Interest rate and equity risk

Foreign exchange and commodities risk

Exemptions

Hedging instruments

Allocation of financial and hedging instruments

Review of compliance by internal and external auditors

Valuation requirements

Consolidation

Approach to measurement

Monitoring

CA-1.4.1

Formal reporting, to the Agency, of capital adequacy shall be made in accordance with the requirements set out under section BR-3.1.

Review of Prudential Information Returns by External Auditors

CA-1.5.1

Each bank is expected to monitor and report the level of risk against which a capital requirement is to be applied, in accordance with section CA-1.3 above. The bank's overall minimum capital requirement will be:

The credit risk requirements laid down by the Agency, excluding debt and equity securities in the trading book and all positions in commodities, but including the credit counterparty risk on all over-the-counter derivatives whether in the trading or the banking books: PLUS one of the following:

CA-1.6.1

Banks which start to use internal models for one or more risk categories should, over a reasonable period of time, extend the models to all of their operations, subject to the exceptions mentioned in paragraph CA-1.6.4 below, and to move towards a comprehensive model (i.e., one which captures all market risk categories).

CA-1.6.2

On a transitional basis, banks will be allowed to use a combination of the standardised approach and the internal models approach to measure their market risks provided they should cover a complete risk category (e.g., interest rate risk or foreign exchange risk), i.e., a combination of the two methods will not be allowed within the same risk category¹. However, for banks that are, at present, still implementing or further improving their internal models, they will be allowed some flexibility, even within risk categories, in including all their operations on a worldwide basis. This flexibility shall be subject to the specific prior written approval of the Agency, and such approval will be given on a case-by-case basis and reviewed by the Agency from time to time.

¹ This does not, however, apply to pre-processing techniques which are used to simplify the calculation and whose results become subject to the standardised methodology.

CA-1.6.3

The Agency will closely monitor banks to ensure that there will be no "cherry-picking" between the standardised approach and the models approach within a risk category. Banks which adopt a model will not be permitted, save in exceptional circumstances, to revert to the standardised approach.

CA-1.6.4

The Agency recognises that even a bank which uses a comprehensive model may still incur risks in positions which are not captured by their internal models², for example, in remote locations, in minor currencies or in negligible business areas³. Any such risks that are not included in a model should be separately measured and reported using the standardised approach described in chapters CA-4 to CA-8.

² Banks may also incur interest rate and equity risks outside of their trading activities. However, there are no explicit capital charges for the price risk in such positions.

³ For example, if a bank is hardly engaged in commodities it will not necessarily be expected to model its commodities risk.

CA-1.6.5

Transitioning banks are required to move towards a comprehensive internal model approach.

CA-1.6.6

The Agency will closely monitor the risk management practices of banks moving towards the models approach, to ensure that they will be in a position to meet all the standards once they are applying a fully-fledged model for any risk category.

CA-2.1.1

Banks are allowed three types of capital instruments to meet their capital requirements for credit risk and market risk, as set out below:

CA-2.1.2

For a branch of a foreign bank operating as a full commercial branch, a designated capital is required, as agreed between the BMA and the licensee, taking into consideration the gearing requirement stated in section CA-10.1.

Tier 1: Core capital

Tier 2: Supplementary capital

Deduction from tiers 1 and 2 capital

Tier 3: Trading book ancillary capital

Tier 1: Core capital

Tier 2: Supplementary capital

Tier 3: Ancillary capital

CA-2.4.1

A bank should start the calculation of the capital ratio with the measure of market risk (i.e., specific risk plus general market risk) in accordance with the regulations in this module, including interest rate risk, equity risk, foreign exchange and commodities risks.

CA-2.4.2

The bank should next calculate its credit risk-weighted assets in accordance with the regulations in this module.

CA-2.4.3

The next step is to create an explicit numerical link between the capital requirements for credit and market risks. This is accomplished by multiplying the measure of market risk (calculated as stated in paragraphs CA-2.4.1 and CA-2.4.2 above) by 12.5 and adding the resulting figure to the sum of the credit risk-weighted assets. The capital ratio will then be calculated in relation to the sum of the two, using as the numerator only the eligible capital.

CA-2.4.4

In calculating the eligible capital, it will be necessary first to calculate the bank's minimum capital requirement for credit risk, and only afterwards its market risk requirement, to establish how much tier 1 and tier 2 capital is available to support market risk. Eligible capital will be the sum of the whole of the bank's tier 1 capital, plus tier 2 capital under the limits set out in section CA-2.3 above. Tier 3 capital will be regarded as eligible only if it can be used to support market risks under the conditions set out in section CA-2.2 and CA-2.3 above. The quoted capital ratio will thus represent capital that is available to meet both credit risk and market risk. Where a bank has tier 3 capital, which meets the conditions set out in section CA-2.2 above and which is not at present supporting market risks, it may report that excess as unused but eligible tier 3 capital alongside its capital ratio. A worked example of the calculation of the capital ratio is set out in Appendix CA 1.

Banking group

Individual bank

Maintaining minimum RAR

CA-3.1.1

This chapter describes the standardised approach for the measurement of the credit risk exposure in the bank's banking book.

CA-3.1.2

As illustrated in sections CA-3.2, CA-3.3 and CA-3.4, banks are required to apply a simple risk-weighted approach through which claims of different categories of counterparties are assigned risk weights according to broad categories of relative risk.

CA-3.2.1

Risk weights by category of on-balance-sheet asset are illustrated in the table below:

CA-3.3.1

The framework takes account of the credit risk on off-balance-sheet exposures by applying credit conversion factors to the different types of off-balance-sheet instruments or transactions (with the exception of derivatives).

CA-3.3.2

The conversion factors are derived from the estimated size and likely occurrence of the credit exposure, as well as the relative degree of credit risk as identified in the Basel Committee's paper on "The management of banks' off-balance-sheet exposures: a supervisory perspective" (see www.bis.org/publ/bcbsc134.pdf) issued in March 1986.

CA-3.3.3

The credit conversion factors applicable to the off-balance-sheet items are set out in the table below:

CA-3.3.4

The applicable credit conversion factors should be multiplied by the weights applicable to the category of the counterparty as set out below:

CA-3.4.1

The treatment of forwards, swaps, purchased options and similar derivative contracts needs special attention because banks are not exposed to credit risk for the full face value of their contracts, but only to the potential cost of replacing the cash flow (on contracts showing positive value) if the counterparty defaults. The credit equivalent amounts (as referred to under paragraph CA-3.4.13) will depend inter alia on the maturity of the contract and on the volatility of the rates and prices underlying that type of instrument.

CA-3.4.2

Instruments traded on exchanges may be excluded where they are subject to daily receipt and payment of cash variation margins.

CA-3.4.3

Options purchased over-the-counter are included with the same conversion factors as other instruments.

Interest rate contracts

Exchange rate contracts

Equity contracts

Gold contracts

Other commodities

General guidance on treatment of derivatives contracts

Calculation of weighted derivative exposures

CA-4.1.1

This chapter describes the standardised approach for the measurement of the interest rate risk in the bank's trading book, in order to determine the capital requirement for this risk. The interest rate exposure captured includes exposure arising from interest-bearing and discounted financial instruments, derivatives which are based on the movement of interest rates, foreign exchange forwards, and interest rate exposure embedded in derivatives which are based on non-interest rate related instruments.

CA-4.1.2

For the guidance of the banks, and without being exhaustive, the following list includes financial instruments in the trading book to which interest rate risk capital requirements will apply, irrespective of whether or not the instruments carry coupons:

⁴ See section CA-5.1 for an explanation of the circumstances in which convertible securities should be treated as equity instruments. In other circumstances, they should be treated as debt instruments.

⁵ Traded mortgage securities and mortgage derivative products possess unique characteristics because of the risk of pre-payment. It is possible that including such products within the standardised methodology as if they were similar to other securitised assets may not capture all the risks of holding positions in them. Banks which have traded mortgage securities and mortgage derivative products should discuss their proposed treatment with the Agency and obtain the Agency's prior written approval for it.

CA-4.1.3

For instruments that deviate from the above structures, or could be considered complex, each bank should agree a written policy statement with the Agency about the intended treatment, on a case-by-case basis. In some circumstances, the treatment of an instrument may be uncertain, for example bonds whose coupon payments are linked to equity indices. The position risk of such instruments should be broken down into its components and allocated appropriately between the equity, interest rate and foreign exchange risk categories. Advice must be sought from the Agency in cases of doubt, particularly when a bank is trading an instrument for the first time.

CA-4.1.4

A security which is the subject of a repurchase or securities lending agreement will be treated as if it were still owned by the lender of the security, i.e., it will be treated in the same manner as other securities positions.

CA-4.1.5

The minimum capital requirement is expressed in terms of two separately calculated charges, one applying to the 'specific risk" of each position, and the other to the interest rate risk in the portfolio, termed "general market risk". The aggregate capital requirement for interest rate risk is the sum of the general market interest rate risk capital requirements across currencies, and the specific risk capital requirements.

CA-4.1.6

The specific risk capital requirement recognises that individual instruments may change in value for reasons other than shifts in the yield curve of a given currency. The general risk capital requirement reflects the price change of these products caused by parallel and non-parallel shifts in the yield curve, as well as the difficulty of constructing perfect hedges.

CA-4.1.7

There is general market risk inherent in all interest rate risk positions. This may be accompanied by one or more out of specific interest rate risk, counterparty risk, equity risk and foreign exchange risk, depending on the nature of the position. Banks should consider carefully which risks are generated by each individual position. It should be recognised that the identification of the risks will require the application of the appropriate level of technical skills and professional judgment.

CA-4.1.8

Banks which have the intention and capability to use internal models for the measurement of general and specific interest rate risks and, hence, for the calculation of the capital requirement, should seek the prior written approval of the Agency for those models. The Agency's detailed rules for the recognition and use of internal models are included in chapter CA-9. Banks which do not use internal models should adopt the standardised approach to calculate the interest rate risk capital requirement, as set out in detail in this chapter.

CA-4.2.1

The capital charge for specific risk is designed to protect against a movement in the price of an individual instrument, owing to factors related to the individual issuer.

CA-4.2.2

In measuring the specific risk for interest rate related instruments, a bank may net, by value, long and short positions (including positions in derivatives) in the same debt instrument to generate the individual net position in that instrument. Instruments will be considered to be the same where the issuer is the same, they have an equivalent ranking in a liquidation, and the currency, the coupon and the maturity are the same.

CA-4.2.3

The specific risk capital requirement is determined by weighting the current market value of each individual net position, whether long or short, according to its allocation among the following five broad categories:

CA-4.2.4

Eligible central "government" debt instruments will include all forms of government paper, including bonds, treasury bills and other short-term instruments, but the Agency reserves the right to apply a specific risk weight to securities issued by certain foreign governments, especially to securities denominated in a currency other than that of the issuing government.

CA-4.2.5

Governments eligible are those which are members of either the Gulf Co-operation Council (GCC) or the Organisation for Economic Co-operation and Development (OECD).

CA-4.2.6

The "qualifying" category includes securities issued by or fully guaranteed by public sector entities and multilateral development banks (refer to Appendix CA 2), plus other securities that are:

CA-4.3.1

The capital requirements for general market risk are designed to capture the risk of loss arising from changes in market interest rates, i.e. the risk of parallel and non-parallel shifts in the yield curve. A choice between two principal methods of measuring the general market risk is permitted, a "maturity" method and a "duration" method. In each method, the capital charge is the sum of the following four components:

CA-4.3.2

Separate maturity ladders should be used for each currency and capital charges should be calculated for each currency separately and then summed, by applying the prevailing foreign exchange spot rates, with no off-setting between positions of opposite sign.

CA-4.3.3

In the case of those currencies in which the value and volume of business is insignificant, separate maturity ladders for each currency are not required. Instead, the bank may construct a single maturity ladder and slot, within each appropriate time-band, the net long or short position for each currency. However, these individual net positions are to be summed within each time-band, irrespective of whether they are long or short positions, to arrive at the gross position figure for the time-band.

CA-4.3.4

A combination of the two methods (referred to under paragraph CA-4.3.1) is not permitted. Any exceptions to this rule will require the prior written approval of the Agency. It is expected that such approval will only be given in cases where a bank clearly demonstrates to the Agency, the difficulty in applying, to a definite category of trading instruments, the method otherwise chosen by the bank as the normal method. It is further expected that the Agency may, in future years, consider recognising the duration method as the approved method, and the use of the maturity method may be discontinued.

CA-4.4.1

A worked example of the maturity method is included in Appendix CA 3. The various time-bands and their risk weights, relevant to the maturity method, are illustrated in paragraph CA-4.4.2(a) below.

CA-4.4.2

The steps in the calculation of the general market risk for interest rate positions, under this method, are set out below:

Maturity method: time-bands and risk weights

CA-4.5.1

The duration method is an alternative approach to measuring the exposure to parallel and non-parallel shifts in the yield curve, and recognises the use of duration as an indicator of the sensitivity of individual positions to changes in market yields. Under this method, banks may use a duration-based system for determining their general interest rate risk capital requirements for traded debt instruments and other sources of interest rate exposures including derivatives. A worked example of the duration method is included in Appendix CA 4. The various time-bands and assumed changes in yield, relevant to the duration method, are illustrated below.

Duration method: time-bands and assumed changes in yield

CA-4.5.2

Banks should notify the Agency of the circumstances in which they elect to use this method. Once chosen, the duration method must be consistently applied, in accordance with the requirements of section CA-4.3.

CA-4.5.3

Where a bank has chosen to use the duration method, it is possible that it will not be suitable for certain instruments. In such cases, the bank should seek the advice of the Agency or obtain approval for application of the maturity method to the specific category(ies) of instruments, in accordance with the provisions of section CA-4.3.

CA-4.5.4

The steps in the calculation of the general market risk for interest rate positions, under this method, are set out below:

CA-4.6.1

Banks which propose to use internal models to measure the interest rate risk inherent in derivatives will seek the prior written approval of the Agency for using those models. The use of internal models to measure market risk, and the Agency's rules applicable to them, are discussed in detail in chapter CA-9.

CA-4.6.2

Where a bank, with the prior written approval of the Agency, uses an interest rate sensitivity model, the output of that model is used, by the duration method, to calculate the general market risk as described in section CA-4.5.

CA-4.6.3

Where a bank does not propose to use models, it must use the techniques described in the following paragraphs, for measuring the market risk on interest rate derivatives. The measurement system should include all interest rate derivatives and off-balance-sheet instruments in the trading book which react to changes in interest rates (e.g. forward rate agreements, other forward contracts, bond futures, interest rate and cross-currency swaps, options and forward foreign exchange contracts). Where a bank has obtained the approval of the Agency for the use of non-interest rate derivatives models, the embedded interest rate exposures should be incorporated in the standardised measurement framework described in sections CA-4.7 to CA-4.9.

CA-4.6.4

Derivative positions will attract specific risk only when they are based on an underlying instrument or security. For instance, where the underlying exposure is an interest rate exposure, as in a swap based upon interbank rates, there will be no specific risk, but only counterparty risk. A similar treatment applies to FRAs, forward foreign exchange contracts and interest rate futures. However, for a swap based on a bond yield, or a futures contract based on a debt security or an index representing a basket of debt securities, the credit risk of the issuer of the underlying bond will generate a specific risk capital requirement. Future cash flows derived from positions in derivatives will generate counterparty risk requirements related to the counterparty in the trade, in addition to position risk requirements (specific and general market risk) related to the underlying security.

CA-4.6.5

A summary of the rules for dealing with interest rate derivatives (other than options) is set out in section CA-4.9. The treatment of options, being a complex issue, is dealt with in detail in chapter CA-8.

CA-4.7.1

The derivatives should be converted to positions in the relevant underlying and become subject to specific and general market risk charges as described in sections CA-4.2 and CA-4.3, respectively. For the purpose of calculation by the standard formulae, the amounts reported are the market values of the principal amounts of the underlying or of the notional underlying. For instruments where the apparent notional amount differs from the effective notional amount, banks should use the latter.

CA-4.7.2

The remaining paragraphs in this section include the guidelines for the calculation of positions in different categories of interest rate derivatives. Banks which need further assistance in the calculation, particularly in relation to complex instruments, should contact the Agency in writing.

Forward foreign exchange contracts

Deposit futures and FRAs

Bonds futures and forwards bond transactions

Swaps

Permissible offsetting of fully matched positions for both specific and general market risk

Permissible offsetting of closely matched positions for general market risk only

CA-4.9.1

After calculating the derivatives positions, taking account of the permissible offsetting of matched positions, as explained in section CA-4.8, the capital charges for specific and general market risk for interest rate derivatives are calculated in the same manner as for cash positions, as described earlier in this chapter.

Summary of treatment of interest rate derivatives

CA-5.1.1

This chapter sets out the minimum capital requirements to cover the risk of holding or taking positions in equities in the bank's trading book.

CA-5.1.2

For the guidance of the banks, and without being exhaustive, the following list includes financial instruments in the trading book, including forward positions, to which equity position risk capital requirements will apply:

CA-5.1.3

Convertible debt securities must be treated as equities where:

In other instances, convertibles should be treated as either equity or debt securities, based reasonably on their market behaviour.

CA-5.1.4

For instruments that deviate from the structures described in paragraphs CA-5.1.2 and CA-5.1.3 above, or which could be considered complex, each bank should agree a written policy statement with the Agency about the intended treatment, on a case-by-case basis. In some circumstances, the treatment of an instrument may be uncertain, for example bonds whose coupon payments are linked to equity indices. The position risk of such instruments should be broken down into its components and allocated appropriately between the equity, interest rate and foreign exchange risk categories. Advice must be sought from the Agency in cases of doubt, particularly when a bank is trading an instrument for the first time.

CA-5.1.5

Where equities are part of a forward contract, a future or an option (i.e. a quantity of equities to be received or delivered), any interest rate or foreign currency exposure from the other leg of the contract should be included in the measurement framework as described in chapters CA-4 and CA-6, respectively.

CA-5.1.6

As with interest rate related instruments, the minimum capital requirement for equities is expressed in terms of two separately calculated charges, one applying to the "specific risk" of holding a long or short position in an individual equity, and the other to the "general market risk" of holding a long or short position in the market as a whole.

CA-5.1.7

Banks which have the intention and capability to use internal models for the measurement of general and specific equity risk and, hence, for the calculation of the capital requirement, should seek the prior written approval of the Agency for those models. The Agency's detailed rules for the recognition and use of internal models are included in chapter CA-9. Banks which do not use internal models should adopt the standardised approach to calculate the equity position risk capital requirement, as set out in detail in this chapter.

CA-5.2.1

A bank may net long and short positions in the same equity instrument, arising either directly or through derivatives, to generate the individual net position in that instrument. For example, a future in a given equity may be offset against an opposite cash position in the same equity, albeit the interest rate risk arising out of the future should be calculated separately in accordance with the rules set out in chapter CA-4.

CA-5.2.2

A bank may net long and short positions in one tranche of an equity instrument against another tranche only where the relevant tranches:

CA-5.2.3

Positions in depository receipts may only be netted against positions in the underlying stock if the stock is freely deliverable against the depository receipt. If a bank takes a position in depository receipts against an opposite position in the underlying equity in different markets (i.e. arbitrage), it may offset the position provided that any costs on conversion are fully taken into account. Furthermore, the foreign exchange risk arising out of these positions should be included in the measurement framework as set out in chapter CA-6.

CA-5.2.4

More detailed guidance on the treatment of equity derivatives is set out in section CA-5.5.

CA-5.2.5

Equity positions, arising either directly or through derivatives, should be allocated to the country in which each equity is listed. Where an equity is listed in more than one country, the bank should discuss the appropriate country allocation with the Agency.

CA-5.3.1

Specific risk is defined as the bank's gross equity positions (i.e. the sum of all long equity positions and of all short equity positions), and is calculated for each country or equity market. For each national market in which the bank holds equities, it should sum the market values of its individual net positions as determined in accordance with section CA-5.2, irrespective of whether they are long or short positions, to produce the overall gross equity position for that market.

CA-5.3.2

The capital charge for specific risk is 8%, unless the portfolio is both liquid and well-diversified, in which case the capital charge will be 4%. To qualify for the reduced 4% capital charge, the following requirements need to be met:

CA-5.4.1

The general market risk is the difference between the sum of the long positions and the sum of the short positions (i.e. the overall net position) in each national equity market. In other words, to calculate the general market risk, the bank should sum the market value of its individual net positions for each national market, as determined in accordance with section CA-5.2, taking into account whether the positions are long or short.

CA-5.4.2

The general market equity risk measure is 8% of the overall net position in each national market.

CA-5.5.1

For the purpose of calculating the specific and general market risk by the standardised approach, equity derivative positions should be converted into notional underlying equity positions, whether long or short. All equity derivatives and off-balance-sheet positions which are affected by changes in equity prices should be included in the measurement framework. This includes futures and swaps on both individual equities and on stock indices.

CA-5.5.2

The following guidelines will apply to the calculation of positions in different categories of equity derivatives. Banks which need further assistance in the calculation, particularly in relation to complex instruments, should contact the Agency.

CA-5.5.3

A summary of the treatment of equity derivatives is set out in paragraph CA-5.5.8.

Specific risk on positions in equity indices

Counterparty risk

CA-6.1.1

A bank which holds net open positions (whether long or short) in foreign currencies is exposed to the risk that exchange rates may move against it. The open positions may be either trading positions or, simply, exposures caused by the bank's overall assets and liabilities.

CA-6.1.2

This chapter describes the standardised method for calculation of the bank's foreign exchange risk, and the capital required against that risk. The measurement of the foreign exchange risk involves, as a first step, the calculation of the net open position in each individual currency including gold⁶ and, as a second step, the measurement of the risks inherent in the bank's mix of long and short positions in different currencies.

⁶ Positions in gold should be treated as if they were foreign currency positions, rather than as commodity positions, because the volatility of gold is more in line with that of foreign currencies and most banks manage it in a similar manner to foreign currencies.

CA-6.1.3

The open positions and the capital requirements are calculated with reference to the entire business, i.e. the banking and trading books combined.

CA-6.1.4

The open positions are calculated with reference to the bank's base currency, which will be either Bahraini Dinars or United States dollars.

CA-6.1.5

Banks which have the intention and capability to use internal models for the measurement of their foreign exchange risk and, hence, for the calculation of the capital requirement, should seek the prior written approval of the Agency for those models. The Agency's detailed rules for the recognition and use of internal models are included in chapter CA-9. Banks which do not use internal models should adopt the standardised approach, as set out in detail in this chapter.

CA-6.1.6

In addition to foreign exchange risk, positions in foreign currencies may be subject to interest rate risk and credit risk which should be treated separately.

CA-6.2.1

A bank doing negligible business in foreign currencies and which does not take foreign exchange positions for its own account may, at the discretion of the Agency evidenced by the Agency's prior written approval, be exempted from calculating the capital requirements on these positions. The Agency is likely to be guided by the following criteria in deciding to grant exemption to any bank:

CA-6.2.2

The criteria listed in paragraph CA-6.2.1 above are only intended to be guidelines, and a bank will not automatically qualify for exemptions upon meeting them. The Agency may also, in its discretion, fix a minimum capital requirement for a bank which is exempted from calculating its foreign exchange risk capital requirement, to cover the risks inherent in its foreign currency business.

CA-6.2.3

The Agency may, at a future date, revoke an exemption previously granted to a bank, if the Agency is convinced that the conditions on which the exemption was granted no longer exist.

CA-6.3.1

A bank's exposure to foreign exchange risk in any currency is its net open position in that currency, which is calculated by summing the following items:

All assets and liabilities, as described above, should be included at closing mid-market spot exchange rates. Marked-to-market items should be included on the basis of the current market value of the positions. However, banks which base their normal management accounting on net present values are expected to use the net present values of each position, discounted using current interest rates and valued at current spot rates, for measuring their forward currency and gold positions.

CA-6.3.2

Net positions in composite currencies, such as the SDR, may either be broken down into the component currencies according to the quotas in force and included in the net open position calculations for the individual currencies, or treated as a separate currency. In any case, the mechanism for treating composite currencies should be consistently applied.

CA-6.3.3

For calculating the net open position in gold, the bank will first express the net position (spot plus forward) in terms of the standard unit of measurement (i.e. ounces or grams) and then convert it at the current spot rate into the base currency.

CA-6.3.4

Forward currency and gold positions should be valued at current spot market exchange rates. Using forward exchange rates is inappropriate as it will result in the measured positions reflecting current interest rate differentials, to some extent.

CA-6.3.5

Where gold is part of a forward contract (i.e. quantity of gold to be received or to be delivered), any interest rate or foreign currency exposure from the other leg of the contract should be reported as set out in chapter CA-4 or section CA-6.1 above, respectively.

Structural positions

Derivatives

CA-6.4.1

The net long or short position in each currency is converted, at the spot rate, into the reporting currency. The overall net open position is measured by aggregating the following:

CA-6.4.2

Where the bank is assessing its foreign exchange risk on a consolidated basis, it may be technically impractical in the case of some marginal operations to include the currency positions of a foreign branch or subsidiary of the bank. In such cases, the internal limit for that branch/subsidiary, in each currency, may be used as a proxy for the positions. The branch/subsidiary limits should be added, without regard to sign, to the net open position in each currency involved. When this simplified approach to the treatment of currencies with marginal operations is adopted, the bank should adequately monitor the actual positions of the branch/subsidiary against the limits, and revise the limits, if necessary, based on the results of the ex-post monitoring.

CA-6.5.1

The capital charge is 8% of the overall net open position.

CA-6.5.2

The table below illustrates the calculation of the overall net open position and the capital charge:

CA-7.1.1

This chapter sets out the minimum capital requirements to cover the risk of holding or taking positions in commodities, including precious metals, but excluding gold (which is treated as a foreign currency according to the methodology explained in chapter CA-6).

CA-7.1.2

The commodities position risk and the capital charges are calculated with reference to the entire business of a bank, i.e., the banking and trading books combined.

CA-7.1.3

The price risk in commodities is often more complex and volatile than that associated with currencies and interest rates. Commodity markets may also be less liquid than those for interest rates and currencies and, as a result, changes in supply and demand can have a more dramatic effect on price and volatility. Banks need also to guard against the risk that arises when a short position falls due before the long position. Owing to a shortage of liquidity in some markets, it might be difficult to close the short position and the bank might be "squeezed by the market". All these market characteristics of commodities can make price transparency and the effective hedging of risks more difficult.

CA-7.1.4

For spot or physical trading, the directional risk arising from a change in the spot price is the most important risk. However, banks using portfolio strategies involving forward and derivative contracts are exposed to a variety of additional risks, which may well be larger than the risk of a change in spot prices (directional risk). These include:

CA-7.1.5

The capital charges for commodities risk envisaged by the rules within this chapter are intended to cover the risks identified in paragraph CA-7.1.4. In addition, however, banks face credit counterparty risk on over-the-counter derivatives, which must be incorporated into their credit risk capital requirements. Furthermore, the funding of commodities positions may well open a bank to interest rate or foreign exchange risk which should be captured within the measurement framework set out in chapters CA-4 and CA-6, respectively.⁷

⁷ Where a commodity is part of a forward contract (i.e.. a quantity of commodity to be received or to be delivered), any interest rate or foreign exchange risk from the other leg of the contract should be captured, within the measurement framework set out in chapters 4 and 6, respectively. However, positions which are purely of a stock financing nature (i.e., a physical stock has been sold forward and the cost of funding has been locked in until the date of the forward sale) may be omitted from the commodities risk-calculation although they will be subject to the interest rate and counterparty risk capital requirements.

CA-7.1.6

Banks which have the intention and capability to use internal models for the measurement of their commodities risks and, hence, for the calculation of the capital requirement, should seek the prior written approval of the Agency for those models. The Agency's detailed rules for the recognition and use of internal models are included in chapter CA-9. It is essential that the internal models methodology captures the directional risk, forward gap and interest rate risks, and the basis risk which are defined in paragraph CA-7.1.4. It is also particularly important that models take proper account of market characteristics, notably the delivery dates and the scope provided to traders to close out positions.

CA-7.1.7

Banks which do not propose to use internal models should adopt either the maturity ladder approach or the simplified approach to calculate their commodities risk and the resultant capital charges. Both these approaches are described in sections CA-7.3 and CA-7.4, respectively.

Netting

Derivatives

CA-7.3 CA-7.3 Maturity ladder approach

CA-7.4 CA-7.4 Simplified approach

CA-8.1.1

It is recognised that the measurement of the price risk of options is inherently a difficult task, which is further complicated by the wide diversity of banks' activities in options. The Agency has decided that the following approaches should be adopted to the measurement of options risks:

CA-8.1.2

The scenario approach and the internal models approach are generally regarded as more satisfactory for managing and measuring options risk, as they assess risk over a range of outcomes rather than focusing on the point estimate of the 'Greek' risk parameters as in the delta-plus approach. The more significant the level and/or complexity of the bank's options trading activities, the more the bank will be expected to use a sophisticated approach to the measurement of options risks. The Agency will monitor the banks' options trading activities, and the adequacy of the risk measurement framework adopted.

CA-8.1.3

Where written option positions are hedged by perfectly matched long positions in exactly the same options, no capital charge for market risk is required in respect of those matched positions.

CA-8.2.1

In the simplified approach, positions for the options and the associated underlying (hedges), cash or forward, are entirely omitted from the calculation of capital charges by the standardised methodology and are, instead, "carved out" and subject to separately calculated capital charges that incorporate both general market risk and specific risk. The capital charges thus generated are then added to the capital charges for the relevant risk category, i.e., interest rate related instruments, equities, foreign exchange and commodities as described in chapters CA-4, CA-5, CA-6 and CA-7 respectively.

CA-8.2.2

The capital charges for the carved out positions are as set out in the table below. As an example of how the calculation would work, if a bank holds 100 shares currently valued at $ 10 each, and also holds an equivalent put option with a strike price of $ 11, the capital charge would be as follows:

[$ 1,000 x 16%¹¹ ] minus [($ 11–$ 10)¹² x 100] = $ 60

A similar methodology applies to options whose underlying is a foreign currency, an interest rate related instrument or a commodity.

¹¹ 8% specific risk plus 8% general market risk.

¹² The amount the option is "in the money".

¹³ In some cases such as foreign exchange, it may be unclear which side is the "underlying instrument"; this should be taken to be the asset which would be received if the option were exercised. In addition, the nominal value should be used for items where the market value of the underlying instrument could be zero, e.g., caps and floors, swaptions etc.

¹⁴ Some options (e.g., where the underlying is an interest rate, a currency or a commodity) bear no specific risk, but specific risk is present in the case of options on certain interest rate related instruments (e.g., options on a corporate debt security or a corporate bond index — see chapter CA-4 for the relevant capital charges), and in the case of options on equities and stock indices (see chapter CA-5 for the relevant capital charges). The capital charge for currency options is 8% and for options on commodities is 15%.

¹⁵ For options with a residual maturity of more than six months, the strike price should be compared with the forward, not the current, price. A bank unable to do this should take the "in the money" amount to be zero.

¹⁶ Where the position does not fall within the trading book options on certain foreign exchange and commodities positions (not belonging to the trading book), it is acceptable to use the book value instead of the market value.

CA-8.3.1

Banks which write options are allowed to include delta-weighted option positions within the standardised methodology set out in chapters CA-4 through CA-7. Each option should be reported as a position equal to the market value of the underlying multiplied by the delta. The delta should be calculated by an adequate model with appropriate documentation of the process and controls, to enable the Agency to review such models, if considered necessary. A worked example of the delta-plus method is set out in Appendix CA 6.

CA-8.3.2

Since delta does not sufficiently cover the risks associated with options positions, there will be additional capital buffers to cover gamma (which measures the rate of change of delta) and vega (which measures the sensitivity of the value of an option with respect to a change in volatility), in order to calculate the total capital charge. The gamma and vega buffers should be calculated by an adequate exchange model or the bank's proprietary options pricing model, with appropriate documentation of the process and controls, to enable the Agency to review such models, if considered necessary.

Treatment of delta

Where the underlying is a debt security or an interest rate

Where the underlying is an equity instrument

Options on foreign exchange and gold positions

Options on commodities

Calculation of the gamma and vega buffers

CA-8.4.1

As stated in section CA-8.1, banks which have a significant level of options trading activities, or have complex options trading strategies, are expected to use more sophisticated methods for measuring and monitoring the options risks. Banks with the appropriate capability will be permitted, with the prior approval of the Agency, to base the market risk capital charge for options portfolios and associated hedging positions on scenario matrix analysis. Before giving its approval, the Agency will closely review the accuracy of the analysis that is constructed. Furthermore, like in the case of internal models, the banks' use of scenario analysis as part of the standardised methodology will also be subject to external validation, and to those of the qualitative standards listed in chapter CA-9 which are appropriate given the nature of the business.

CA-8.4.2

The scenario matrix analysis involves specifying a fixed range of changes in the option portfolio's risk factors and calculating changes in the value of the option portfolio at various points along this "grid" or "matrix". For the purpose of calculating the capital charge, the bank will revalue the option portfolio using matrices for simultaneous changes in the option's underlying rate or price and in the volatility of that rate or price. A different matrix is set up for each individual underlying as defined in section CA-8.3 above. As an alternative, in respect of interest rate options, banks which are significant traders in such options are permitted to base the calculation on a minimum of six sets of time-bands. When using this alternative method, not more than three of the time-bands as defined in chapter CA-4 should be combined into any one set.

CA-8.4.3

The first dimension of the matrix involves a specified range of changes in the option's underlying rate or price. The Agency has set the range for each risk category as follows:

For all risk categories, at least seven observations (including the current observation) should be used to divide the range into equally spaced intervals.

CA-8.4.4

The second dimension of the matrix entails a change in the volatility of the underlying rate or price. A single change in the volatility of the underlying rate or price equal to a shift in volatility of ±25% is applied.

CA-8.4.5

The Agency will closely monitor the need to reset the parameters for the amounts by which the price of the underlying instrument and volatility must be shifted to form the rows and columns of the scenario matrix. For the time being, the parameters set, as above, only reflect general market risk (see paragraphs CA-8.4.10 to CA-8.4.12).

CA-8.4.6

After calculating the matrix, each cell contains the net profit or loss of the option and the underlying hedge instrument. The general market risk capital charge for each underlying is then calculated as the largest loss contained in the matrix.

CA-8.4.7

In addition to the capital charge calculated as above, the specific risk capital charge is determined separately by multiplying the delta-equivalent of each option position by the specific risk weights set out in chapters CA-4 through CA-7.

CA-8.4.8

To summarise, capital requirements for, say OTC options, using the scenario approach are as follows:

CA-8.4.9

Banks doing business in certain classes of complex exotic options (e.g. barrier options involving discontinuities in deltas etc.), or in options at the money that are close to expiry, are required to use either the scenario approach or the internal models approach, both of which can accommodate more detailed revaluation approaches. The Agency expects the concerned banks to work with it closely to produce an agreed method, within the framework of these rules. If a bank uses scenario matrix analysis, it must be able to demonstrate that no substantially larger loss could fall between the nodes.

CA-8.4.10

In drawing up the delta-plus and the scenario approaches, the Agency's present set of rules do not attempt to capture specific risk other than the delta-related elements (which are captured as explained in paragraphs CA-8.4.7 and CA-8.4.11). The Agency recognises that introduction of those other specific risk elements will make the measurement framework much more complex. On the other hand, the simplifying assumptions used in these rules will result in a relatively conservative treatment of certain options positions.

CA-8.4.11

In addition to the options risks described earlier in this chapter, the Agency is conscious of the other risks also associated with options, e.g., rho or interest rate risk (the rate of change of the value of the option with respect to the interest rate) and theta (the rate of change of the value of the option with respect to time). While not proposing a measurement system for those risks at present, the Agency expects banks undertaking significant options business, at the very least, to monitor such risks closely. Additionally, banks will be permitted to incorporate rho into their capital calculations for interest rate risk, if they wish to do so.

CA-8.4.12

The Agency will closely review the treatment of options for the calculation of market risk capital charges, particularly in the light of the aspects described in paragraphs CA-8.4.10 and CA-8.4.11.

CA-9.1.1

As stated in chapter CA-1, as an alternative to the standardised approach to the measurement of market risks (which is described in chapters CA-4 through CA-8), and subject to the explicit prior approval of the Agency, banks will be allowed to use risk measures derived from their own internal models.

CA-9.1.2

This chapter describes the seven sets of conditions that should be met before a bank is allowed to use the internal models approach, namely:

CA-9.1.3

The standardised methodology, described in chapters CA-4 through CA-8, uses a "building-block" approach in which the specific risk and the general market risk arising from debt and equity positions are calculated separately. The focus of most internal models is a bank's general market risk exposure, typically leaving specific risk (i.e., exposures to specific issuers of debt securities and equities) to be measured largely through separate credit risk measurement systems. Banks using models are subject to separate capital charges for the specific risk not captured by their models, which shall be calculated by the standardised methodology. The capital charge for banks which are modelling specific risk is set out in section CA-9.10.

CA-9.1.4

While the models recognition criteria described in this chapter are primarily intended for comprehensive Value-at-Risk (VaR) models, nevertheless, the same set of criteria will be applied, to the extent that it is appropriate, to other pre-processing or valuation models the output of which is fed into the standardised measurement system, e.g., interest rate sensitivity models (from which the residual positions are fed into the duration ladders) and option pricing models (for the calculation of the delta, gamma and vega sensitivities).

CA-9.1.5

As a number of strict conditions are required to be met before internal models can be recognised by the Agency, including external validation, banks which are contemplating using internal models should submit their detailed written proposals for the Agency's approval, immediately upon receipt of these regulations.

CA-9.1.6

As the model approval process will encompass a review of both the model and its operating environment, it is not the case that a commercially produced model which is recognised for one bank will automatically be recognised for another bank.

CA-9.2.1

The Agency will give its approval for the use of internal models to measure market risks only if, in addition to the detailed requirements described later in this chapter, it is satisfied that the following general criteria are met:

CA-9.3.1

In order to ensure that banks using models have market risk management systems that are conceptually sound and implemented with integrity, the Agency has set the following qualitative criteria that banks are required to meet before they are permitted to use the models-based approach. Apart from influencing the Agency's decision to permit a bank to use internal models, where such permission is granted, the extent to which the bank meets the qualitative criteria will further influence the level at which the Agency will set the multiplication factor for that bank, referred to in section CA-9.5. Only those banks whose models, in the Agency's judgement, are in full compliance with the qualitative criteria will be eligible for application of the minimum multiplication factor of 3. The qualitative criteria include the following:

¹⁸ The report, "Risk management guidelines for derivatives", issued by the Basel Committee in July 1994, further discusses the responsibilities of the Board of Directors and senior management.

CA-9.4.1

An important part of a bank's internal market risk measurement system is the specification of an appropriate set of market risk factors, i.e. the market rates and prices that affect the value of the bank's trading positions. The risk factors contained in a market risk measurement system should be sufficient to capture the risks inherent in the bank's portfolio of on- and off-balance-sheet trading positions. Banks should follow the Agency's guidelines, set out below, for specifying the risk factors for their internal models. Where a bank has difficulty in specifying the risk factors for any currency or market within a risk category, in accordance with the following guidelines, the bank should immediately contact the Agency. The Agency will review and discuss the specific circumstances of each such case with the concerned bank, and will decide alternative methods of calculating the risks which are not captured by the bank's model.

¹⁹ A "beta-equivalent" position would be calculated from a market model of equity (such as the CAPM model) by regressing the return on the individual stock or sector index or the risk-free rate of return and the return on the market index.

²⁰ The convenience yield reflects the benefits of direct ownership of the physical commodity (for example, the ability to profit from temporary market shortages), and is affected by both market conditions and factors such as physical storage costs.

CA-9.5.1

The following minimum quantitative standards will apply for the purpose of calculating the capital charge.

CA-9.6.1

The contents of this section outline the key requirements as set out in the Basel Committee's paper titled "Supervisory framework for the use of 'backtesting' in conjunction with the internal models approach to market risk capital requirements" (see http://www.bis.org/publ/bcbs22.htm). The paper presents in detail the approach to be followed for backtesting by banks.

Key requirements

CA-9.7.1

Banks that use the internal models approach for calculating market risk capital requirements must have in place a rigorous and comprehensive stress testing programme. Stress testing to identify events or influences that could greatly impact the bank is a key component of a bank's assessment of its capital position.

CA-9.7.2

Banks' stress scenarios need to cover a range of factors that can create extraordinary losses or gains in trading portfolios, or make the control of risk in those portfolios very difficult. These factors include low-probability events in all major types of risks, including the various components of market, credit and operational risks. Stress scenarios need to shed light on the impact of such events on positions that display both linear and non-linear characteristics (i.e., options and instruments that have option-like characteristics).

CA-9.7.3

Banks' stress tests should be both of a quantitative and qualitative nature, incorporating both market risk and liquidity aspects of market disturbances. Quantitative criteria should identify plausible stress scenarios to which banks could be exposed. Qualitative criteria should emphasise that two major goals of stress testing are to evaluate the capacity of the bank's capital to absorb potential large losses and to identify steps the bank can take to reduce its risk and conserve capital. This assessment is integral to setting and evaluating the bank's management strategy and the results of stress testing should be routinely communicated to senior management and, periodically, to the bank's Board of Directors.

CA-9.7.4

Banks should combine the use of stress scenarios as advised under (a), (b) and (c) below by the Agency, with stress tests developed by the banks themselves to reflect their specific risk characteristics. The Agency may ask banks to provide information on stress testing in three broad areas, as discussed below.

CA-9.7.5

Once a stress scenario has been identified, it should be used for conducting stress tests at least once every quarter, as long as the scenario continues to be relevant to the bank's portfolio.

CA-9.7.6

The results of all stress tests should be reviewed by senior management within 15 days from the time they are available, and should be promptly reflected in the policies and limits set by management and the Board of Directors. Moreover, if the testing reveals particular vulnerability to a given set of circumstances, the Agency would expect the bank to take prompt steps to manage those risks appropriately (e.g., by hedging against that outcome or reducing the size of its exposures).

CA-9.8.1

Before granting its approval for the use of internal models by a bank, the Agency will require that the models are validated by both the internal and external auditors of the bank. The Agency will review the validation procedures performed by the internal and external auditors, and may independently carry out further validation procedures.

CA-9.8.2

The internal validation procedures to be carried out by the internal auditors are set out in section CA-9.3. As stated in that paragraph, the internal auditor's review of the overall risk management process should take place at regular intervals (not less than once every six months). The internal auditor shall make a report to senior management and the Board of Directors, in writing, of the results of the validation procedures. The report shall be made available to the Agency for its review.

CA-9.8.3

The validation of the models by the external auditors should include, at a minimum, the following steps:

CA-9.8.4

The external auditors should carry out their validation/review procedures, at a minimum, once every year. Based on the above procedures, the external auditors shall make a report, in writing, on the accuracy of the bank's models, including all significant findings of their work. The report shall be addressed to the senior management and/or the Board of Directors of the bank, and a copy of the report shall be made available to the Agency. The mandatory annual review by the external auditors shall be carried out during the third quarter of the calendar year, and the Agency expects to receive their final report by 30 September each year. The results of additional validation procedures carried out by the external auditors at other times during the year, should be made available to the Agency promptly.

CA-9.8.5

Banks are required to ensure that external auditors and the Agency's representatives are in a position to have easy access, whenever they judge it necessary and under appropriate procedures, to the models' specifications and parameters as well as to the results of, and the underlying inputs to, their value-at-risk calculations.

CA-9.9.1

As stated in section CA-9.1, banks which propose to use internal models for the calculation of their market risk capital requirements should submit their detailed proposals, in writing, to the Agency. The Agency will review these proposals, and upon ensuring that the bank's internal models meet all the criteria for recognition set out earlier in this chapter, and after satisfying itself with the results of validation procedures carried out by the internal and external auditors and/or by itself, will issue a letter of model recognition to the bank.

CA-9.9.2

The letter of model recognition should be specific. It will set out the products covered, the method for calculating capital requirements on the products and the conditions of model recognition. In the case of pre-processing models, the bank will also be told how the output of recognised models should feed into the processing of other interest rate, equity, foreign exchange and commodities risk. The conditions of model recognition may include additional reporting requirements. The Agency's prior written approval should be obtained for any modifications proposed to be made to the models previously recognised by the Agency. In cases where a bank proposes to apply the model to new but similar products, there will be a requirement to obtain the Agency's prior approval. In some cases, the Agency may be able to give provisional approval for the model to be applied to a new class of products, in others it will be necessary to revisit the bank.

CA-9.9.3

The Agency may withdraw its approval granted for any bank's model if it believes that the conditions on which the approval was based are no longer valid or have changed significantly.

CA-9.10.1

Unless a bank's exposure to a particular risk factor is insignificant, the internal models approach will, in principle, require banks to have an integrated risk measurement system that captures the broad risk factor categories (i.e., interest rates, exchange rates (which includes gold), equity prices and commodity prices, with related options volatilities being included in each risk factor category). Thus, banks which start to use models for one or more risk factor categories will, over a reasonable period of time, be expected to extend the models to all their market risks.

CA-9.10.2

A bank which has obtained the Agency's approval for the use of one or more models will no longer be able to revert to measuring the risk measured by those models according to the standardised methodology (unless the Agency withdraws its approval for the model(s), as explained in section CA-9.9). However, what constitutes a reasonable period of time for an individual bank which uses a combination of internal models and the standardised methodology to move to a comprehensive model, will be decided by the Agency after taking into account the relevant circumstances of the bank.

CA-9.10.3

Notwithstanding the goal of moving to comprehensive internal models as set out in paragraph CA-9.10.1 above, for banks which, for the time being, will be using a combination of internal models and the standardised methodology, the following conditions will apply:

²¹ However, banks may incur risks in positions which are not captured by their models, for example, in minor currencies or in negligible business areas. Such risks should be measured according to the standard methodology.

CA-9.11.1

Banks using models will be permitted to base their specific risk capital charge on modelled estimates if they meet all of the qualitative and quantitative requirements for general risk models as well as the additional criteria set out in paragraph CA-9.11.2. Banks which are unable to meet these additional criteria will be required to base their specific risk capital charge on the full amount of the specific risk charge calculated by the standardised methodology (as illustrated in chapters CA-4 to CA-8).

CA-9.11.2

The criteria for applying modelled estimates of specific risk require that a bank's model:

In addition, the bank must be able to demonstrate that it has methodologies in place which allow it to adequately capture event and default risk for its traded debt and equity positions.

²² The key measurement of model quality are "goodness-of-fit" measures which address the question of how much of the historical variation in price value is explained by the model. One measure of this type which can often be used is an R-squared measure from regression methodology. If this measure is to be used, the bank's model would be expected to be able to explain a high percentage, such as 90%, of the historical price variation or to explicitly include estimates of the residual variability not captured in the factors included in this regression. For some types of model, it may not be feasible to calculate a goodness-of-fit measure. In such an instance, a bank is expected to contact the Agency to define an acceptable alternative measure which would meet this regulatory objective.

²³ The bank should be expected to demonstrate that the model is sensitive to changes in portfolio construction and that higher capital charges are attracted for portfolios that have increasing concentrations.

²⁴ The bank should be able to demonstrate that the model will signal rising risk in an adverse environment. This could be achieved by incorporating in the historical estimation period of the model at least one full credit cycle and ensuring that the model would not have been inaccurate in modelling at least one full the downward portion of the cycle. Another approach for demonstrating this is through simulation of historical or plausible worst-case environments

CA-9.11.3

Banks which meet the criteria set out above for models but do not have methodologies in place to adequately capture event and default risk will be required to calculate their specific risk capital charge based on the internal model measurements plus an additional prudential surcharge as defined in paragraph CA-9.11.4. The surcharge is designed to treat the modelling of specific risk on the same basis as a general market risk model that has proven deficient during backtesting. That is, the equivalent of a scaling factor of four would apply to the estimate of specific risk until such time as a bank can demonstrate that the methodologies it uses adequately capture event and default risk. Once a bank is able to demonstrate this, the minimum multiplication factor of three can be applied. However, a higher multiplication factor of four on the modelling of specific risk would remain possible if future backtesting results were to indicate a serious deficiency in the model.

CA-9.11.4

For banks applying the surcharge, the total market risk measure will equal a minimum of three times the internal model's general and specific risk measure plus a surcharge in the amount of either:

Banks using option (b) above are required to identify their sub-portfolios structure ahead of time and should not change it without the Agency's prior written consent.

²⁵ Techniques for separating general market risk and specific risk would include the following:

Equities:

The market should be identified with a single factor that is representative of the market as a whole, for example, a widely accepted broadly based stock index for the country concerned.

Banks that use factor models may assign one factor of their model, or a single linear combination of factors, as their general market risk factor.

Bonds:

The market should be identified with a reference curve for the currency concerned. For example, the curve might be a government bond yield curve or a swap curve; in any case, the curve should be based on a well-established and liquid underlying market and should be accepted by the market as a reference curve for the currency concerned.

Banks may select their own technique for identifying the specific risk component of the value-at-risk measure for purposes of applying the multiplier of 4. Techniques would include:

²⁶ This would apply to sub-portfolios containing positions that would be subject to specific risk under the standardised approach.

CA-9.11.5

Banks which apply modelled estimates of specific risk are required to conduct backtesting aimed at assessing whether specific risk is being accurately captured. The methodology a bank should use for validating its specific risk estimates is to perform separate backtests on sub-portfolios using daily data on sub-portfolios subject to specific risk. The key sub-portfolios for this purpose are traded debt and equity positions. However, if a bank itself decomposes its trading portfolio into finer categories (e.g., emerging markets, traded corporate debt, etc.), it is appropriate to keep these distinctions for sub-portfolio backtesting purposes. Banks are required to commit to a sub-portfolio structure and stick to it unless it can be demonstrated to the Agency that it would make sense to change the structure.

CA-9.11.6

Banks are required to have in place a process to analyse exceptions identified through the backtesting of specific risk. This process is intended to serve as the fundamental way in which banks correct their models of specific risk in the event they become inaccurate. There will be a presumption that models that incorporate specific risk are "unacceptable" if the results at the sub-portfolio level produce a number of exceptions commensurate with the Red Zone²⁷. Banks with "unacceptable" specific risk models are expected to take immediate action to correct the problem in the model and to ensure that there is a sufficient capital buffer to absorb the risk that, the backtest showed, had not been adequately captured.

²⁷ As defined in the Basel Committee's document titled "Supervisory framework for the use of backtesing in conjunction with the internal models approach to market risk capital requirements".

CA-10.1.1

The content of this chapter is applicable to locally incorporated banks and FCB branches (licensed by the Agency) of foreign banks.

Measurement

Gearing limit

CA-A.1.1

Regulations in this Module are applicable to locally incorporated banks on both a stand-alone basis (i.e. including their foreign branches), and on a consolidated group basis (i.e. including their subsidiaries and any other investments which are included or consolidated into the group accounts or are required to be consolidated for regulatory purposes by the CBB).

CA-A.1.2

In addition to licensees mentioned in Paragraph CA-A.1.1, certain of these regulations (in particular gearing and market risk requirements) are also applicable to Bahrain branches of foreign retail bank licensees.

Executive Summary

Legal Basis

CA-A.3.1

This Module was first issued in July 2004 as part of the conventional principles volume. All requirements in this volume have been effective since this date. Any material changes that have subsequently been made to this Module are annotated with the calendar quarter date in which the change was made: Chapter UG 3 provides further details on Rulebook maintenance and version control. The most recent changes made to this Module are detailed in the table below:

Summary of changes

Evolution of the Module

Effective date

Basel Committee: Use of 'Backtesting' in Conjunction with the Internal Models Approach to Market Risk Capital Requirements

Basel Committee: The management of banks' off-balance-sheet exposures – a supervisory perspective

CA-1.1.1

All locally incorporated banks are required to measure and apply capital charges in respect of their credit and market risk capital requirements.

CA-1.1.2

Credit risk is defined as the potential that a bank's borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk exists throughout the activities of a bank in the banking book and in the trading book including both on- and off-balance-sheet exposures.

CA-1.1.3

Market risk is defined as the risk of losses in on- or off-balance-sheet positions arising from movements in market prices. The risks subject to the capital requirement of this Module are:

CA-1.2.1

In measuring credit risk for the purpose of capital adequacy, banks are required to apply a simple risk-weighted approach through which claims of different categories of counterparties are assigned risk weights according to broad categories of relative riskiness.

CA-1.2.2

The framework of weights consists of four weights – 0%, 20%, 50% and 100% for on- and off-balance-sheet items, which based on a broad-brush judgement, are applied to the different types of assets and off-balance-sheet exposures (with the exception of derivative transactions) within the banking book.

CA-1.2.3

The resultant different weighted assets and off-balance-sheet exposures are then added together to calculate the total credit-risk-weighted assets of the bank.

Trading book

Interest rate and equity risk

Foreign exchange and commodities risk

Exemptions