• CA CA Capital Adequacy

    • CA-A CA-A Introduction

      • CA-A.1 CA-A.1 Application

        • 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 CA-A.2 Purpose

        • 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:

          (a) Licensing and Authorisation Requirements;
          (b) BMA Reporting Requirements;
          (c) Credit Risk Management;
          (d) Market Risk Management;
          (e) Operational Risk Management;
          (f) Liquidity Risk Management;
          (g) High Level Controls:
          (h) Relationship with Audit Firms; and
          (i) Penalties and Fines.

      • CA-A.3 CA-A.3 Key requirements

        • 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

          • CA-A.3.2

            Banks are allowed three classes of capital instruments (see section CA-2.2) to meet their capital requirements for credit risk and market risk, as set out below:

            Tier 1: Core capital — May be used to support credit risk and market risk;
            Tier 2: Supplementary capital — May be used to support credit risk and market risk; and
            Tier 3: Ancillary capital — May be used solely to support market risk.

        • Measuring credit risks

          • CA-A.3.3

            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.

        • Measuring market risks

          • CA-A.3.4

            For the measurement of their market risks, banks will have a choice, subject to the written approval of the Agency, between two broad methodologies. One alternative is to measure the risks in a standardised approach, using the measurement frameworks described in chapters CA-4 to CA-8 of these regulations. The second alternative methodology (i.e. the internal models approach) is set out in detail in chapter CA-9 including the procedure for obtaining the Agency's approval. This methodology is subject to the fulfilment of certain conditions. The use of this methodology is, therefore, conditional upon the explicit approval of the Agency.

        • Minimum capital ratio requirement

          • CA-A.3.5

            On a consolidated basis, the Agency has set a minimum Risk Asset Ratio ("RAR") of 12.0% for all locally incorporated banks. Furthermore, on a solo basis, the parent bank is required to maintain a minimum RAR of 8.0% (i.e. unconsolidated).

          • CA-A.3.6

            For banks that are required to complete only the PIR form, the Agency has set a minimum Risk Asset Ratio ("RAR") of 12.0%.

        • Maintaining minimum RAR

          • CA-A.3.7

            The Agency considers it a matter of basic prudential practice that, in order to ensure that these RARs are constantly met, banks set up internal "targets" of 12.5% (on a consolidated basis) and 8.5% (on a solo basis) to warn them of a potential fall by the bank below the Agency's required minimum RARs. Where a bank's capital ratio falls below its target ratio, the General Manager should notify the Agency immediately, however, no formal action plan will be necessary. The General Manager should explain what measures are being implemented to ensure that the bank will remain above its minimum RAR(s).

          • CA-A.3.8

            The bank will be required to submit form PIR (and PIRC where applicable) to the Agency on a monthly basis, until the RAR(s) exceeds its target ratio(s).

        • Gearing requirements

          • CA-A.3.9

            For Full Commercial Bank and Offshore Banking Unit licensees, deposit liabilities should not exceed 20 times the respective bank's capital and reserves.

          • CA-A.3.10

            For Investment Bank licensees, deposit liabilities should not exceed 10 times the respective bank's capital and reserves.

      • CA-A.4 CA-A.4 Regulation history

        • 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

          Module Ref. Change Date Description of Changes
               
               
               
               
               

        • Evolution of the Module

          • CA-A.4.2

            Prior to the development of the Rulebook, the Agency had issued various circulars representing regulations relating to capital adequacy requirements. These circulars have now been consolidated into this module covering the capital adequacy regulation. These circulars and their evolution into this module are listed below:

            Circular Ref. Date of Issue Module Ref. Circular Subject
            ODG/50/98 11 Sep 1998 CA-1CA-9 Market Risk Capital Regulations
            BC/07/02 26 Jun 2002 CA-1.4 Review of PIR by External Auditors
            OG/78/01 20 Feb 2001 CA-2.5 Monitoring of Capital Adequacy
            BC/01/98 10 Jan 1998 CA-2.5 Risk Asset Ratio

        • Effective date

          • CA-A.4.3

            The contents in this module are effective from the date depicted in the original circulars (see Paragraph CA-A.4.2) from which the requirements are compiled.

    • CA-B CA-B General guidance and best practice

      • CA-B.1 CA-B.1 Introduction

        • 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.

      • CA-B.2 CA-B.2 Guidance provided by other international bodies

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

          • CA-B.2.1

            In January 1996, the Basel Committee on Banking Supervision issued technical guidance on the "use of 'Backtesting' in Conjunction with the Internal Models Approach to Market Risk Capital Requirements" (see http://www.bis.org/publ/bcbs22.htm).

          • CA-B.2.2

            This technical guidance presents a methodology for testing the accuracy of the internal models used by banks to measure market risks.

          • CA-B.2.3

            Backtesting offers the best opportunity for incorporating suitable incentives into the internal models in a consistent manner.

          • CA-B.2.4

            The Agency will rely upon technical guidance for its assessment and review of bank's market risk capital requirements including, but not limited to, the determination of the add-on factor.

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

          • CA-B.2.5

            In March 1986, the Basel Committee on Banking Supervision issued a paper titled "The management of banks' off-balance-sheet exposures — a supervisory perspective" (see www.bis.org/publ/bcbsc134.pdf).

          • CA-B.2.6

            This paper examines off-balance-sheet risks from three angles: market/position risk, credit risk and operational/control risk. Part III of this paper examines credit risk (including control of large exposures, settlement risk and country risk), with particular emphasis given to the assessment of the relative risks of the different types of off-balance-sheet activity.

      • CA-B.3 CA-B.3 Enforceability

        • 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 CA-1 Scope and coverage of capital charges

      • CA-1.1 CA-1.1 Introduction

        • 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:

          (a) the risks pertaining to interest rate related instruments and equities in the trading book: and
          (b) foreign exchange and commodities risks throughout the bank.

      • CA-1.2 CA-1.2 Measuring credit risks

        • 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.

      • CA-1.3 CA-1.3 Measuring market risks

        • Trading book

          • CA-1.3.1

            The trading book means the bank's proprietary positions in financial instruments (including positions in derivative products and off-balance-sheet instruments) which are intentionally held for short-term resale and/or which are taken on by the bank with the intention of benefiting in the short-term from actual and/or expected differences between their buying and selling prices, or from other price or interest rate variations, and positions in financial instruments arising from matched principal brokering and market making, or positions taken in order to hedge other elements of the trading book.

          • CA-1.3.2

            Each bank should agree a written policy statement with the Agency on which activities are normally considered trading and which, therefore, constitute the trading book.

          • CA-1.3.3

            It is expected that the trading activities will be managed and monitored by a separate unit and that such activities should be identifiable because of their intent, as defined in paragraph CA-1.3.1 above.

        • Interest rate and equity risk

          • CA-1.3.4

            The capital charges for interest rate related instruments and equities will apply based on the current market values of items in a bank's trading book.

        • Foreign exchange and commodities risk

          • CA-1.3.5

            The capital charges for foreign exchange risk and for commodities risk will apply to a bank's total currency and commodity positions, with the exception of structural foreign exchange positions in accordance with section CA-6.3 of this module.

        • Exemptions

          • CA-1.3.6

            Banks will be allowed certain de minimis exemptions from the capital requirements for foreign exchange risk, as described in section CA-6.2. For the time being, there shall be no exemptions from the trading book capital requirements, or from the capital requirements for commodities risk.

        • Hedging instruments

          • CA-1.3.7

            A trading book exposure may be hedged, completely or partially, by an instrument that, in its own right, is not normally considered eligible to be a part of the trading book. Subject to the policy statement agreed by the bank with the Agency as explained in paragraph CA-1.3.2 above, and with the prior written approval of the Agency, banks will be allowed to include within their market risk measure non-trading instruments (on- or off-balance-sheet) which are deliberately used to hedge the trading activities. The positions in these instruments will attract counterparty risk capital requirements and general market risk, but not specific risk requirements.

          • CA-1.3.8

            Where a financial instrument which would normally qualify as part of the trading book is used to hedge an exposure in the banking book, it should be carved out of the trading book for the period of the hedge, and included in the banking book with the exposure it is hedging. Such instruments will be subject to the credit risk capital requirements.

          • CA-1.3.9

            It is possible that general market risk arising from the trading book may hedge positions in the banking book without reference to individual financial instruments. In such circumstances, there must nevertheless be underlying positions in the trading book. The positions in the banking book which are being hedged must remain in the banking book, although the general market risk exposure associated with them should be incorporated within the calculation of general market risk capital requirements for the trading book (i.e. the general market risk element on the banking book side of the hedge should be added to the trading book calculation, rather than that on the trading book side of the hedge being deducted from it). As no individual financial instruments are designated, there is no resultant specific risk requirement in the trading book and the risk-weighted assets in the banking book will not be reduced. Any such arrangement for the transfer of risk must be subject to the policy statement agreed with the Agency as explained in paragraph CA-1.3.2 above, and should have the specific prior written approval of the Agency.

        • Allocation of financial and hedging instruments

          • CA-1.3.10

            The allocation of a financial instrument between the trading book and the banking book, or the allocation of hedging instruments described in paragraph CA-1.3.7 above, or the transfer of general market risk as explained in paragraph CA-1.3.9 above, should be subject to appropriate and adequate documentation to ensure that it can be established through audit verification that the item is treated correctly for the purposes of capital requirements, in compliance with the bank's established criteria for allocating items to the trading or banking book, and subject to the policy statement agreed with the Agency.

          • CA-1.3.11

            The Agency intends to carefully monitor the way in which banks allocate financial instruments and will seek, in particular, to ensure that no abusive switching designed to minimise capital charges occurs and to prevent "gains trading" in respect of securities which are not marked to market.

        • Review of compliance by internal and external auditors

          • CA-1.3.12

            The bank's compliance with the established criteria for allocating items to the trading and banking books, and with the policy statement agreed with the Agency, should be reviewed by the bank's internal auditors at least on a quarterly basis, and by the external auditors at least once a year.

          • CA-1.3.13

            Any cases of non-compliance identified by the internal auditor should be immediately brought to the attention of the Agency, in writing, by the senior management of the bank. Any non-compliance identified by the external auditors, requires them to submit a written report directly to the Agency (in accordance with the requirements in section CA-9.8), in addition to a report to be submitted by the management.

        • Valuation requirements

          • CA-1.3.14

            To establish a relevant base for measuring the market risk in the trading book, all positions should be marked to market daily, including the recognition of accruing interest, dividends or other benefits as appropriate. Banks are required to have, and discuss with the Agency, a written policy statement on the subject of valuing trading book positions, which in particular should address the valuation process for those items where market prices are not readily available. This policy statement should have been developed in conjunction with the bank's internal and external auditors. Having arrived at a valuation mechanism for a single position or a group of similar positions, the valuation approach should be applied consistently. In addition to the considerations of prudence and consistency, the bank's valuation policy should reflect the points set out below:

            (a) A bank may mark to market positions using either a close-out valuation based on two-way prices (i.e., a long position shall be valued at its current bid price and a short position at its current offer price) or, alternatively, using a mid-market price but making a provision for the spread between bid and offer prices for different instruments. The bank must have due regard to the liquidity of the position concerned and any special factors which may adversely affect the closure of the position.
            (b) Where a bank has obtained the Agency's approval for the use of a risk assessment model in the calculation of the capital requirements for options (in accordance with chapter CA-9 of these regulations), it may value its options using the values derived from that model.
            (c) Where a bank does not use a model and the prices are not published for its options positions, it must determine the market value as follows:
            (i) For purchased options, the marked-to-market value is the product of the "in the money" amount and the quantity underlying the option; and
            (ii) For written options, the marked-to-market value is the initial premium received for the option plus the product of the amount by which the current "in the money" amount exceeds either the "in the money" amount at the time the contract was written, or zero if the contract was "out of the money" at the time that it was written; and the quantity underlying the option.
            (d) A bank must calculate the value of a swap contract or an FRA having regard to the net present value of the future cash flows of the contract, using current interest rates relevant to the periods in which the cash flows will arise.
            (e) Where a bank is a market maker in an instrument(s), the valuation should be the bank's own bid or offer price which should reflect the bank's exposure to the market as a whole and its views on future prices. Where the bank is the sole market maker in a particular instrument, it should take proper care to ensure that the valuation used is prudent in all circumstances.
            (f) In the event that a bank is only able to access indicative prices, having regard to the fact that they are only a guide, such prices may have to be adjusted to some degree in order to arrive at a prudent valuation.
            (g) In the event that the bank is only able to access mid-market or single values, it should have regard to the fact that these prices will have to be adjusted to some degree in order to arrive at a prudent valuation.

        • Consolidation

          • CA-1.3.15

            Both credit risk and market risk capital requirements will apply on a worldwide consolidated basis. Only a bank which is running a global consolidated book may apply the offsetting rules contained in the remainder of these regulations, on a consolidated basis with the prior written agreement of the Agency. However, where it would not be prudent to offset or net positions within the group as, for example, where there are obstacles to the quick repatriation of profits from a foreign subsidiary or where there are legal and procedural difficulties in carrying out the timely management of risks on a consolidated basis, the Agency will require the bank to take individual positions into account without any offsetting.

          • CA-1.3.16

            Notwithstanding that the market risk capital requirements will apply on a worldwide consolidated basis, the Agency retains the right to monitor the market risks of banks on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision. The Agency will be particularly vigilant to ensure that banks do not pass positions on reporting dates in such a way as to escape measurement.

        • Approach to measurement

          • CA-1.3.17

            For the measurement of their market risks, banks will have a choice, subject to the written approval of the Agency, between two broad methodologies. One alternative is to measure the risks in a standardised approach, using the measurement frameworks described in chapters CA-4 to CA-8 of these regulations. Chapters CA-4 to CA-7 deal with the four risks addressed by these regulations; namely interest rate risk, equity position risk, foreign exchange risk and commodities risk. Chapter CA-8 sets out a number of possible methods for measuring the price risk in options of all kinds. The capital charge under the standardised approach is the arithmetical sum of the risk measures obtained from the measurement frameworks in chapters CA-4 to CA-8.

          • CA-1.3.18

            The standardised approach uses a "building-block" approach in which the specific risk and the general market risk arising from interest rate and equity positions are calculated separately.

          • CA-1.3.19

            The second alternative methodology, which is subject to the fulfilment of certain conditions and the use of which is, therefore, conditional upon the explicit approval of the Agency, is set out in detail in chapter CA-9 including the procedure for obtaining the Agency's approval. This method allows banks to use risk measures derived from their own internal risk measurement models (Internal Models Approach), subject to seven sets of conditions which are described in detail in chapter CA-9.

          • CA-1.3.20

            The focus of most internal models currently used by banks is the general market risk exposure, typically leaving specific risk (i.e., exposures to specific issuers of debt securities or equities1) to be measured largely through separate credit risk measurement systems. Banks using internal models for the measurement of their market risk capital requirements will be subject to a separate capital charge for specific risk, to the extent that the model does not capture specific risk. The capital charge for banks which are modelling specific risk is set out in chapter CA-9.


            1 Specific risk includes the risk that an individual debt or equity security moves by more or less than the general market in day-to-day trading (including periods when the whole market is volatile) and event risk (where the price of an individual debt or equity security moves precipitously relative to the general market, e.g., on a take-over bid or some other shock event; such events would also include the risk of "default").

          • CA-1.3.21

            In measuring the price risk in options under the standardised approach, a number of alternatives with varying degrees of sophistication are allowed (see chapter CA-8). The more a bank is engaged in writing options, the more sophisticated its measurement method needs to be. In the longer term, banks with significant options business will be expected to move to comprehensive value-at-risk models and become subject to the full range of quantitative and qualitative standards set out in chapter CA-9.

          • CA-1.3.22

            All transactions, including forward sales and purchases, shall be included in the calculation of capital requirements as from the date on which they were entered into.

        • Monitoring

          • CA-1.3.23

            Banks are expected to manage their market risk in such a way that the capital requirements for market risk are being met on a continuous basis, i.e. at the close of each business day and not merely at the end of each calendar quarter, both in the case of banks that use the standardised approach and those that use internal models. Banks are also expected to maintain strict risk management systems to ensure that their intra-day exposures are not excessive.

          • CA-1.3.24

            Banks' daily compliance with the capital requirements for market risk shall be verified by the independent risk management department and the internal auditor. It is expected that the external auditors will perform appropriate tests of the banks' daily compliance with the capital requirements for market risk. Where a bank fails to meet the minimum capital requirements for market risk on any business day, the Agency should be informed in writing. The Agency will then seek to ensure that the bank takes immediate measures to rectify the situation.

          • CA-1.3.25

            Besides what is stated in paragraphs CA-1.3.2, CA-1.3.3, CA-1.3.10, CA-1.3.11, CA-1.3.19 and section CA-1.6, the Agency will consider a number of other appropriate and effective measures to ensure that banks do not "window-dress" by showing significantly lower market risk positions on reporting dates.

      • CA-1.4 CA-1.4 Reporting

        • 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-1.4.2

            The Agency requires all relevant banks to request their external auditors to conduct a review of the prudential returns on a quarterly basis in accordance with the requirements set out under section BR-3.1.

      • CA-1.5 CA-1.5 Summary of overall capital adequacy requirement

        • 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:

          (a) The capital charges for market risks calculated according to the measurement frameworks described in chapters CA-4 to CA-8, summed arithmetically: OR
          (b) The measure of market risk derived from the models approach set out in chapter CA-9 (with the prior written approval of the Agency for adopting this approach — see chapter CA-9); OR
          (c) A mixture of (a) and (b) above, summed arithmetically (with the prior written approval of the Agency for adopting a combination of the standardised approach and the internal models approach — see chapter CA-9).

      • CA-1.6 CA-1.6 Transitional provisions

        • 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 CA-2 The capital requirement

      • CA-2.1 CA-2.1 Introduction

        • 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:

          Tiers 1 and 2: May be used to support credit risk and market risk; and
          Tier 3: May be used solely to support market risk.

        • 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.

      • CA-2.2 CA-2.2 Definition of capital

        • Tier 1: Core capital

          • CA-2.2.1

            Tier 1 capital shall consist of the sum of items (a) to (c) below, less the sum of items (d) to (e) below:

            (a) Permanent shareholders' equity (including issued and fully paid ordinary shares / common stock and perpetual non-cumulative preference shares, but excluding cumulative preference shares);
            (b) Disclosed reserves, which are audited and approved by the shareholders, in the form of legal, general and other reserves created by appropriations of retained earnings, share premiums, capital redemption reserves and other surplus but excluding revaluation reserves; and
            (c) Minority interests, arising on consolidation, in the equity of subsidiaries which are less than wholly owned.

            LESS:
            (d) Goodwill; and
            (e) Current year's cumulative net losses which have been reviewed or audited as per the International Standards on Auditing (ISA) by the external auditors.

        • Tier 2: Supplementary capital

          • CA-2.2.2

            Tier 2 capital shall consist of the following items:

            (a) Interim retained profits which have been reviewed as per the ISA by the external auditors;
            (b) Asset revaluation reserves, which arise in two ways. Firstly, these reserves can arise from the revaluation of fixed assets from time to time in line with the change in market values, and are reflected on the face of the balance sheet as a revaluation reserve. Secondly, hidden values or "latent' revaluation reserves may be present as a result of long-term holdings of equity securities valued in the balance sheet at the historical cost of acquisition. Both types of revaluation reserve may be included in tier 2 capital, with the concurrence of the external auditors, provided that the assets are prudently valued, fully reflecting the possibility of price fluctuation and forced sale. In the case of "latent" revaluation reserves, a discount of 55% will be applied to the difference between the historical cost book value and the market value to reflect the potential volatility of this form of unrealised capital.
            (c) General provisions held against future, presently unidentified losses which are freely available to meet losses which subsequently materialise and, therefore, qualify for inclusion within supplementary elements of capital, subject to a maximum of 1.25% of total risk-weighted assets (both credit and market risk-weighted assets). Provisions ascribed to impairment of particular assets or known liabilities should be excluded.
            (d) Hybrid instruments, which include a range of instruments which combine characteristics of equity capital and of debt, and which meet the following requirements:
            •  They are unsecured, subordinated and fully paid-up;
            •  They are not redeemable at the initiative of the holder or without the prior consent of the Agency;
            •  They are available to participate in losses without the bank being obliged to cease trading (unlike conventional subordinated debt); and
            •  Although the capital instrument may carry an obligation to pay interest that cannot permanently be reduced or waived (unlike dividends on ordinary shareholders' equity), it should allow service obligations to be deferred (as with cumulative preference shares) where the profitability of the bank would not support payment.
            Cumulative preference shares, having the above characteristics, would be eligible for inclusion in tier 2 capital. Debt capital instruments which do not meet the above criteria may be eligible for inclusion in item (e) below.
            (e) Subordinated term debt, which comprises all conventional unsecured borrowing subordinated (in respect of both interest and principal) to all other liabilities of the bank except the share capital and limited life redeemable preference shares. To be eligible for inclusion in tier 2 capital, subordinated debt capital instruments should have a minimum original fixed term to maturity of over five years. During the last five years to maturity, a cumulative discount (or amortisation) factor of 20% per year will be applied to reflect the diminishing value of these instruments as a continuing source of strength. Unlike instruments included in item (d) above, these instruments are not normally available to participate in the losses of a bank which continues trading. For this reason, these instruments will be limited to a maximum of 50% of tier 1 capital.
            (f) 45% of unrealised gains on equity securities held as available-for-sale (on an aggregate net-basis).

        • Deduction from tiers 1 and 2 capital

          • CA-2.2.3

            The following item shall be deducted from tiers 1 and 2 capital on a pro-rata basis:

            —Investments in and lending of a capital nature to unconsolidated subsidiaries engaged in banking and financial activities. The assets representing the investments in subsidiary companies whose capital is deducted from that of the parent would not be included in total assets for the purpose of computing the capital ratio.

        • Tier 3: Trading book ancillary capital

          • CA-2.2.4

            Tier 3 capital will consist of short-term subordinated debt which, if circumstances demand, needs to be capable of becoming part of the bank's permanent capital and thus be available to absorb losses in the event of insolvency. It must, therefore, at a minimum meet the following conditions:

            (a) Be unsecured, subordinated and fully paid up;
            (b) Have an original maturity of at least two years;
            (c) Not be repayable before the agreed repayment date; and
            (d) Be subject to a lock-in clause which stipulates that neither interest nor principal may be paid (even at maturity) if such payment means that the bank falls below or remains below its minimum capital requirement.

      • CA-2.3 CA-2.3 Limits on the use of different forms of capital

        • Tier 1: Core capital

          • CA-2.3.1

            Tier 1 capital should represent at least half of the total eligible capital, i.e., the sum total of tier 2 plus tier 3 eligible capital should not exceed total tier 1 eligible capital.

        • Tier 2: Supplementary capital

          • CA-2.3.2

            Tier 2 elements may be substituted for tier 3 up to the tier 3 limit of 250% of tier 1 capital (as below) in so far as eligible tier 2 capital does not exceed total tier 1 capital, and long-term subordinated debt does not exceed 50% of tier 1 capital.

        • Tier 3: Ancillary capital

          • CA-2.3.3

            Tier 3 capital is limited to 250% of a bank's tier 1 capital that is required to support market risks. This means that a minimum of about 28.57% of market risks needs to be supported by tier 1 capital that is not required to support risks in the remainder of the book.

      • CA-2.4 CA-2.4 Calculation of the capital ratio

        • 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.

      • CA-2.5 CA-2.5 Minimum capital ratio requirement

        • Banking group

          • CA-2.5.1

            On a consolidated basis, the Agency has set a minimum Risk Asset Ratio ("RAR") of 12.0% for all locally incorporated banks. Furthermore, on a solo basis, the parent bank of a group is required to maintain a minimum RAR of 8.0% (i.e. unconsolidated).

          • CA-2.5.2

            This means where a bank is required to complete both form PIR (Appendix BR 5) and form PIRC (Appendix BR 6), 8.0% is the minimum RAR necessary for the solo bank (PIR), and 12.0% for the consolidated bank (PIRC).

        • Individual bank

          • CA-2.5.3

            For banks that are required to complete only the PIR form, the Agency has set a minimum Risk Asset Ratio ("RAR") of 12.0%.

        • Maintaining minimum RAR

          • CA-2.5.4

            To clarify the effect of these minimum ratios (as identified in paragraphs CA-2.5.1 to CA-2.5.3) on differing banking groups and individual banks, four examples (see Appendix CA 1) are given. In the examples, the parent and the subsidiary are Bahrain incorporated banks, but the cases could apply to overseas incorporated subsidiaries (with adjustment to the minimum RAR where appropriate in individual cases).

            (a) Case One: Compliant solo bank—No subsidiaries (PIR only).
            (b) Case Two: Compliant parent bank, compliant group (PIR and PIRC).
            (c) Case Three: Compliant parent bank, compliant subsidiary bank, but non-compliant group.
            (d) Case Four: Non-compliant parent bank, compliant subsidiary bank and compliant group.

            For detailed workings of the above cases, refer to Appendix CA 1.

          • CA-2.5.5

            All locally incorporated banks must give the Agency, immediate written notification of any actual breach by such banks of either or both of the above RARs. Where such notification is given, the bank must also:

            (a) provide the Agency no later than one calendar week after the notification, with a written action plan setting out how the bank proposes to restore the relevant RAR(s) to the required minimum level(s) set out above and, further, describing how the bank will ensure that a breach of such RAR(s) will not occur again in the future; and
            (b) report on a weekly basis thereafter on the bank's relevant RAR(s) until such RAR(s) have reached the required target level(s) set out below.

          • CA-2.5.6

            In addition, the Agency considers it a matter of basic prudential practice that, in order to ensure that these RARs are constantly met, banks set up internal "targets" of 12.5% (on a consolidated basis) and 8.5% (on a solo basis) to warn them of a potential fall by the bank below the Agency's required minimum RARs as set out above.

          • CA-2.5.7

            Where a bank's capital ratio falls below its target ratio, the General Manager should notify the Director of Banking Supervision at the Agency immediately. No formal action plan will be necessary, however the General Manager should explain what measures are being implemented to ensure that the bank will remain above its minimum RAR(s).

          • CA-2.5.8

            The bank will be required to submit form PIR (and PIRC where applicable) to the Agency on a monthly basis, until the RAR(s) exceeds its target ratio(s).

          • CA-2.5.9

            The Agency will notify banks in writing of any action required of them with regard to the corrective and preventive action (as appropriate) proposed by the bank pursuant to the above, as well as of any other requirement of the Agency in any particular case.

          • CA-2.5.10

            Banks should note that the Agency considers the breach of RARs to be a very serious matter. Consequently, the Agency may (at its discretion) subject a bank which breaches its RAR(s) to a formal licensing reappraisal. Such reappraisal may be effected either through the Agency's own inspection function or through the use of Reporting Accountants, as appropriate. Following such appraisal, the Agency will notify the bank concerned in writing of its conclusions with regard to the continued licensing of the bank.

          • CA-2.5.11

            The Agency recommends that the bank's compliance officer supports and cooperates with the Agency in the monitoring and reporting of the capital ratios and other regulatory reporting matters. Compliance officers should ensure that their banks have adequate internal systems and controls to comply with these regulations.

    • CA-3 CA-3 Credit risk

      • CA-3.1 CA-3.1 Introduction

        • 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 CA-3.2 Risk weighting — On-balance-sheet asset category

        • CA-3.2.1

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

          Risk weights Category of on-balance-sheet assets/claims
          0%
          (a) Cash and balances with Central Banks
          (b) Holdings of Gold bullion and other commodities
          (c) Claims on & guaranteed by:

          (i) The Government of Bahrain & Bahrain public sector entities
          (ii) Government-owned GCC companies incorporated in Bahrain
          (d) Claims on & guaranteed by or collateralised by cash or securities issued by central governments and central banks of Group A countries; and
          (e) Claims on the central governments and central banks of Group B countries, where denominated in national currency and funded in that currency.
          20%
          (a) Claims on and guaranteed by or collateralised by securities issued by multilateral development banks
          (b) Claims on and guaranteed by banks and securities firms incorporated in Group A countries
          (c) Claims on and guaranteed by banks incorporated in Group B countries with a residual maturity of 1 year or less
          (d) Claims on and guaranteed by public sector entities in Group A countries
          (e) Claims on and guaranteed by government-owned GCC companies incorporated outside Bahrain; and
          (f) Cash items in process of collection
          50% Claims secured by mortgage on residential property
          100%
          (a) Claims on related parties
          (b) Holdings of other (non-subsidiary) banks' and securities firms' capital instruments
          (c) Claims on and guaranteed by banks incorporated in Group B countries with a residual maturity over one year
          (d) Claims on central governments and central banks of Group B countries (not included above)
          (e) Claims on and guaranteed by public sector entities of Group B countries
          (f) Claims on and guaranteed by government-owned companies in non-GCC countries
          (g) Claims on and guaranteed by private sector persons and entities in and outside Bahrain
          (h) Premises and equipment, real estate investments and assets not reported elsewhere

      • CA-3.3 CA-3.3 Risk weighting — Off-balance-sheet items

        • 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:

          Credit Conversion factors Off-balance-sheet items
          100% Direct credit substitutes, including general guarantees of indebtedness and acceptances
          50% Transaction-related contingent items (e.g. performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions)
          20% Short-term self-liquidating trade-related contingencies (such as documentary credits collateralised by the underlying shipments)
          100% Sale and repurchase agreements and asset sales with recourse, where the credit risk remains with the bank
          100% Forward asset purchases, forward forward deposits and the unpaid part of partly-paid shares and securities, which represent commitments with certain draw-down
          50% Underwriting commitments under note issuance and revolving underwriting facilities (minus own holdings of notes underwritten)
          50% Other commitments (e.g. formal standby facilities and credit lines) with an original maturity of 1 year and over
          0% Similar commitments with an original maturity of up to 1 year, or which can be unconditionally cancelled at any time

        • 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:

          Risk weights Counterparty
          0% Type (a)
          — The Government of Bahrain.
          — Bahrain public sector entities.
          — Government-owned (non-banking) GCC companies incorporated in Bahrain.
          — Central government and central banks of Group A countries.
          20% Type (b)
          — Banks incorporated in Bahrain or Group A countries and securities firms.
          — Banks incorporated in Group B countries (if the commitment has a residual life of 1 year or less).
          — Public sector entities in Group A countries.
          — Government-owned (non-banking) GCC companies incorporated outside Bahrain.
          100% Type (c)
          — Banks incorporated in Group B countries (if the commitment has a residual life of more than 1 year).
          — Central governments, central banks and public sector entities in Group B countries.
          — Government-owned companies incorporated in non-GCC countries.
          — Private sector persons and entities in Bahrain and abroad.

      • CA-3.4 CA-3.4 Treatment of derivatives contracts in the banking book

        • 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

          • CA-3.4.4

            Interest rate contracts are defined to include single-currency interest rate swaps, basis swaps, forward rate agreements, interest rate futures, interest rate options purchased and similar instruments.

        • Exchange rate contracts

          • CA-3.4.5

            Exchange rate contracts include cross-currency interest rate swaps, forward foreign exchange contracts, currency futures, currency options purchased and similar instruments.

          • CA-3.4.6

            Exchange rate contracts with an original maturity of 14 calendar days or less may be excluded.

        • Equity contracts

          • CA-3.4.7

            Equity contracts include forwards, swaps, purchased options and similar derivative contracts based on individual equities or on equity indices.

        • Gold contracts

          • CA-3.4.8

            Gold contracts are treated the same as foreign exchange contracts for the purpose of calculating credit risk except that contracts with original maturity of 14 calendar days or less are included.

          • CA-3.4.9

            Precious metals other than gold receive a separate treatment (see section BR-4.1) and include forwards, swaps, purchased options and similar derivative contracts that are based on precious metals (e.g. silver, platinum, and palladium).

        • Other commodities

          • CA-3.4.10

            Other commodities are also treated separately (see section BR-4.1) and include forwards, swaps, purchased options and similar derivative contracts based on energy contracts, agricultural contracts, base metals (e.g. aluminium, copper, and zinc), and any other non-precious metal commodity contracts.

        • General guidance on treatment of derivatives contracts

          • CA-3.4.11

            The following points should be noted for the treatment of certain derivatives contracts:

            (a) For contracts with multiple exchange of principal, the add-on factors are to be multiplied by the number of remaining payments in the contracts.
            (i) For contracts that are structured to settle outstanding exposure following specified payment dates and where the terms are reset such that the market value of the contract is zero on these specified dates, the residual maturity would be set equal to the time until the next reset date.
            (ii) Forwards, swaps, purchased options and similar derivative contracts not covered in any of the above mentioned categories should be treated as "other commodities".
            (iii) No potential future credit exposure (as referred to under paragraph CA-3.4.12) would be calculated for single currency floating/floating interest rate swaps.

        • Calculation of weighted derivative exposures

          • CA-3.4.12

            Banks should calculate their weighted exposure under the above mentioned contracts according to the Current Exposure Method, which involves calculating the current replacement cost by marking contracts to market, thus capturing the current exposure without any need for estimation, and then adding a factor (the "add-on") to reflect the potential future exposure over the remaining life of the contract.

            The 'add-on' factor table:

              Residual maturity of contracts
            1 year or less Over 1 year to 5 years Over 5 years
            Interest rate related contracts 0.000 0.005 0.015
            Foreign exchange & gold contracts 0.010 0.050 0.075
            Equity contracts 0.060 0.080 0.100
            Precious metals (except gold) 0.070 0.070 0.070
            Other commodities 0.120 0.120 0.150

          • CA-3.4.13

            In order to reflect counterparty risk, the total credit equivalent amount, which results from the calculation in paragraph CA-3.4.12 has to be broken down again according to type of counterparty, using the same classification into types (a), (b) and (c) given in section CA-3.3. Finally, the exposure to each type of counterparty has to be weighted as 0%, 20% or 50% respectively, and the total weighted exposure calculated.

    • CA-4 CA-4 Interest rate risk — Standardised approach

      • CA-4.1 CA-4.1 Introduction

        • 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:

          (a) bonds/loan stocks, debentures etc.;
          (b) non-convertible preference shares;
          (c) convertible securities such as preference shares and bonds, which are treated as debt instruments4;
          (d) mortgage backed securities and other securitised assets5;
          (e) Certificates of Deposit;
          (f) treasury bills, local authority bills, banker's acceptances;
          (g) commercial paper;
          (h) euronotes, medium term notes, etc.;
          (i) floating rate notes, FRCDs etc.;
          (j) foreign exchange forward positions;
          (k) derivatives based on the above instruments and interest rates; and
          (l) interest rate exposure embedded in other financial instruments.

          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 CA-4.2 Specific risk calculation

        • 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:

          (a) Eligible central government debt instrument 0.00%
          (b) Qualifying items with residual maturity up to 6 months 0.25%
          (c) Qualifying items with residual maturity between 6 and 24 months 1.00%
          (d) Qualifying items with residual maturity exceeding 24 months 1.60%
          (e) Non-qualifying items 8.00%

        • 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:

          (a) rated investment grade by at least two internationally recognised credit rating agencies (to be agreed with the Agency); or
          (b) deemed to be of comparable investment quality by the reporting bank, provided that the issuer is rated investment grade by at least two internationally recognised credit rating agencies (to be agreed with the Agency); or
          (c) rated investment grade by one credit rating agency and not less than investment grade by any internationally recognised credit rating agencies (to be agreed with the Agency); or
          (d) unrated (subject to the approval of the Agency), but deemed to be of comparable investment quality by the reporting bank and where the issuer has securities listed on a recognised stock exchange, may also be included.

      • CA-4.3 CA-4.3 General market risk calculation

        • 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:

          (a) the net short or long position in the whole trading book;
          (b) a small proportion of the matched positions in each time-band (the "vertical disallowance");
          (c) a larger proportion of the matched positions across different time-bands (the "horizontal disallowance"); and
          (d) a net charge for positions in options, where appropriate (see chapter CA-8).

        • 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 CA-4.4 Maturity method

        • 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:

          (a) Individual long or short positions in interest-rate related instruments, including derivatives, are slotted into a maturity ladder comprising thirteen time-bands (or fifteen time-bands in the case of zero-coupon and deep-discount instruments, defined as those with a coupon of less than 3%), on the following basis:
          (i) fixed rate instruments are allocated according to their residual term to maturity (irrespective of embedded puts and calls), and whether their coupon is below 3%;
          (ii) floating rate instruments are allocated according to the residual term to the next repricing date;
          (iii) positions in derivatives, and all positions in repos, reverse repos and similar products are decomposed into their components within each time band. Derivative instruments are covered in greater detail in sections CA-4.6 to CA-4.9;
          (iv) opposite positions of the same amount in the same issues (but not different issues by the same issuer), whether actual or notional, can be omitted from the interest rate maturity framework, as well as closely matched swaps, forwards, futures and FRAs which meet the conditions set out in section CA-4.8. In other words, these positions are netted within their relevant time-bands; and
          (v) the Agency's advice must be sought on the treatment of instruments that deviate from the above structures, or which may be considered sufficiently complex to warrant the Agency's attention.

          Maturity method: time-bands and risk weights

            Coupon > 3% Coupon < 3% Risk weight
          Zone 1 1 month or less 1 month or less 0.00%
            1 to 3 months 1 to 3 months 0.20%
            3 to 6 months 3 to 6 months 0.40%
            6 to 12 months 6 to 12 months 0.70%
          Zone 2 1 to 2 years 1 to 1.9 years 1.25%
            2 to 3 years 1.9 to 2.8 years 1.75%
            3 to 4 years 2.8 to 3.6 years 2.25%
          Zone 3 4 to 5 years 3.6 to 4.3 years 2.75%
            5 to 7 years 4.3 to 5.7 years 3.25%
            7 to 10 years 5.7 to 7.3 years 3.75%
            10 to 15 years 7.3 to 9.3 years 4.50%
            15 to 20 years 9.3 to 10.6 years 5.25%
            > 20 years 10.6 to 12 years 6.00%
              12 to 20 years 8.00%
              > 20 years 12.50%
          (b) The market values of the individual long and short net positions in each maturity band are multiplied by the respective risk weighting factors given in paragraph CA-4.4.2(a) above.
          (c) Matching of positions within each maturity band (i.e. vertical matching) is done as follows:
          •  Where a maturity band has both weighted long and short positions, the extent to which the one offsets the other is called the matched weighted position. The remainder (i.e. the excess of the weighted long positions over the weighted short positions, or vice versa, within a band) is called the unmatched weighted position for that band.
          (d) Matching of positions, across maturity bands, within each zone (i.e. horizontal matching—level 1), is done as follows:
          •  Where a zone has both unmatched weighted long and short positions for various bands, the extent to which the one offsets the other is called the matched weighted position for that zone. The remainder (i.e. the excess of the weighted long positions over the weighted short positions, or vice versa, within a zone) is called the unmatched weighted position for that zone.
          (e) Matching of positions, across zones (i.e. horizontal matching—level 2), is done as follows:
          (i) The unmatched weighted long or short position in zone 1 may be offset against the unmatched weighted short or long position in zone 2. The extent to which the unmatched weighted positions in zones 1 and 2 are offsetting is described as the matched weighted position between zones 1 and 2.
          (ii) After step (i) above, any residual unmatched weighted long or short position in zone 2 may be matched by offsetting the unmatched weighted short or long position in zone 3. The extent to which the unmatched positions in zones 2 and 3 are offsetting is described as the matched weighted position between zones 2 and 3.
          The calculations in steps (i) and (ii) above may be carried out in reverse order (i.e. zones 2 and 3, followed by zones 1 and 2).

          (i) After steps (i) and (iii) above, any residual unmatched weighted long or short position in zone 1 may be matched by offsetting the unmatched weighted short or long position in zone 3. The extent to which the unmatched positions in zones 1 and 3 are offsetting is described as the matched weighted position between zones 1 and 3.
          (f) Any residual unmatched weighted positions, following the matching within and between maturity bands and zones as described above, will be summed.
          (g) The general interest rate risk capital requirement is the sum of:

          (i) Matched weighted positions in all maturity bands x 10%
          (ii) Matched weighted positions in zone 1 x 40%
          (iii) Matched weighted positions in zone 2 x 30%
          (iv) Matched weighted positions in zone 3 x 30%
          (v) Matched weighted positions between zones 1 & 2 x 40%
          (vi) Matched weighted positions between zones 2 & 3 x 40%
          (vii) Matched weighted positions between zones 1 & 3 x 100%
          (viii) Residual unmatched weighted positions x 100%

          Item (i) is referred to as the vertical disallowance, items (ii) through (iv) as the first set of horizontal disallowances, and items (v) through (vii) as the second set of horizontal disallowances.

      • CA-4.5 CA-4.5 Duration method

        • 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

            Time-band Assumed change in yield
          Zone 1 1 month or less 1.00
            1 to 3 months 1.00
            3 to 6 months 1.00
            6 to 12 months 1.00
          Zone 2 1 to 1.9 years 0.90
            1.9 to 2.8 years 0.80
            2.8 to 3.6 years 0.75
          Zone 3 3.6 to 4.3 years 0.75
            4.3 to 5.7 years 0.70
            5.7 to 7.3 years 0.65
            7.3 to 9.3 years 0.60
            9.3 to 10.6 years 0.60
            10.6 to 12 years 0.60
            12 to 20 years 0.60
            > 20 years 0.60

        • 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:

          (a) The bank will determine the Yield-to-Maturity (YTM) for each individual net position in fixed rate and floating rate instruments, based on the current market value. The basis of arriving at individual net positions is explained in section CA-4.4 above. The YTM for fixed rate instruments is determined without any regard to whether the instrument is coupon bearing, or whether the instrument has any embedded options. In all cases, YTM for fixed rate instruments is calculated with reference to the final maturity date and, for floating rate instruments, with reference to the next repricing date.
          (b) The bank will calculate, for each debt instrument, the modified duration (M) on the basis of the following formula:

          M = D
            (1+r)
          where,  
          D (duration) =
          Σ m   t × C
          t=1   (1+r)t

          Σ m   C
          t=1   (1+r)t

          r = YTM % per annum expressed as a decimal

          C = Cash flow at time t

          t = time at which cash flows occur, in years

          m = time to maturity, in years
          (c) Individual net positions, at current market value, are allocated to the time-bands illustrated in paragraph CA-4.5.1, based on their modified duration.
          (d) The bank will then calculate the modified duration-weighted position for each individual net position by multiplying its current market value by the modified duration and the assumed change in yield.
          (e) Matching of positions within each time band (i.e. vertical matching) is done as follows:
          •  Where a time band has both weighted long and short positions, the extent to which the one offsets the other is called the matched weighted position. The remainder (i.e. the excess of the weighted long positions over the weighted short positions, or vice versa, within a band) is called the unmatched weighted position for that band.
          (f) Matching of positions, across time bands, within each zone (i.e. horizontal matching—level 1), is done as follows:
          •  Where a zone has both unmatched weighted long and short positions for various bands, the extent to which the one offsets the other is called the matched weighted position for that zone. The remainder (i.e. the excess of the weighted long positions over the weighted short positions, or vice versa, within a zone) is called the unmatched weighted position for that zone.
          (g) Matching of positions, across zones (i.e. horizontal matching—level 2), is done as follows:
          (i) The unmatched weighted long or short position in zone 1 may be offset against the unmatched weighted short or long position in zone 2. The extent to which the unmatched weighted positions in zones 1 and 2 are offsetting is described as the matched weighted position between zones 1 and 2.
          (ii) After step (i) above, any residual unmatched weighted long or short position in zone 2 may be matched by offsetting the unmatched weighted short or long position in zone 3. The extent to which the unmatched positions in zones 2 and 3 are offsetting is described as the matched weighted position between zones 2 and 3.
          The calculations in steps (i) and (ii) above may be carried out in reverse order (i.e. zones 2 and 3, followed by zones 1 and 2).

          (iii) After steps (a) and (b) above, any residual unmatched weighted long or short position in zone 1 may be matched by offsetting the unmatched weighted short or long position in zone 3. The extent to which the unmatched positions in zones 1 and 3 are offsetting is described as the matched weighted position between zones 1 and 3.
          (h) Any residual unmatched weighted positions, following the matching within and between maturity bands and zones as described above, will be summed.
          (i) The general interest rate risk capital requirement is the sum of:

          (i) Matched weighted positions in all maturity bands x 5%
          (ii) Matched weighted positions in zone 1 x 40%
          (iii) Matched weighted positions in zone 2 x 30%
          (iv) Matched weighted positions in zone 3 x 30%
          (v) Matched weighted positions between zones 1 & 2 x 40%
          (vi) Matched weighted positions between zones 2 & 3 x 40%
          (vii) Matched weighted positions between zones 1 & 3 x 100%
          (viii) Residual unmatched weighted positions x 100%

          Item (i) is referred to as the vertical disallowance, items (ii) through (iv) as the first set of horizontal disallowances, and items (v) through (vii) as the second set of horizontal disallowances.

      • CA-4.6 CA-4.6 Derivatives

        • 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 CA-4.7 Calculation of derivative positions

        • 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

          • CA-4.7.3

            A forward foreign exchange position is decomposed into legs representing the paying and receiving currencies. Each of the legs is treated as if it were a zero coupon bond, with zero specific risk, in the relevant currency and included in the measurement framework as follows:

            (a) If the maturity method is used, each leg is included at the notional amount.
            (b) If the duration method is used, each leg is included at the present value of the notional zero coupon bond.

        • Deposit futures and FRAs

          • CA-4.7.4

            Deposit futures, forward rate agreements and other instruments where the underlying is a money market exposure will be split into two legs as follows:

            (a) The first leg will represent the time to expiry of the futures contract, or settlement date of the FRA as the case may be.
            (b) The second leg will represent the time to expiry of the underlying instrument.
            (c) Each leg will be treated as a zero coupon bond with zero specific risk.
            (d) For deposit futures, the size of each leg is the notional amount of the underlying money market exposure. For FRAs, the size of each leg is the notional amount of the underlying money market exposure discounted to present value, although in the maturity method, the notional amount may be used without discounting.

            For example, under the maturity method, a single 3-month Euro$ 1,000,000 deposit futures contract expiring in 3 months' time will have one leg of $ 1,000,000 representing the 8 months to contract expiry, and another leg of $ 1,000,000 in the 11 months' time-band representing the time to expiry of the deposit underlying the futures contract.

        • Bonds futures and forwards bond transactions

          • CA-4.7.5

            Bond futures, forward bond transactions and the forward leg of repos, reverse repos and other similar transactions will use the two-legged approach. A forward bond transaction is one where the settlement is for a period other than the prevailing norm for the market.

            (a) The first leg is a zero coupon bond with zero specific risk. Its maturity is the time to expiry of the futures or forward contract. Its size is the cash flow on maturity discounted to present value, although in the maturity method, the cash flow on maturity may be used without discounting.
            (b) The second leg is the underlying bond. Its maturity is that of the underlying bond for fixed rate bonds, or the time to the next reset for floating rate bonds. Its size is as set out in (c) and (d) below.
            (c) For forward bond transactions, the underlying bond and amount is used at the present spot price.
            (d) For bond futures, the principal amounts for each of the two legs is reckoned as the futures price times the notional underlying bond amount.
            (e) Where a range of deliverable instruments may be delivered to fulfil a futures contract (at the option of the "short"), then the following rules are used to determine the principal amount, taking account of any conversion factors defined by the exchange:
            (i) The "long" may use one of the deliverable bonds, or the notional bond on which the contract is based, as the underlying instrument, but this notional long leg may not be offset against a short cash position in the same bond.
            (ii) The "short" may treat the notional underlying bond as if it were one of the deliverable bonds, and it may be offset against a short cash position in the same bond.
            (f) For futures contracts based on a corporate bond index, the positions will be included at the market value of the notional underlying portfolio of securities.
            (g) A repo (or sell-buy or stock lending) involving exchange of a security for cash should be represented as a cash borrowing — i.e. a short position in a government bond with maturity equal to the repo and coupon equal to the repo rate. A reverse repo (or buy-sell or stock borrowing) should be represented as a cash loan — i.e. a long position in a government bond with maturity equal to the reverse repo and coupon equal to the repo rate. These positions are referred to as "cash legs".
            (h) It should be noted that, where a security owned by the bank (and included in its calculation of market risk) is repo'd, it continues to contribute to the bank's interest rate or equity position risk calculation.

        • Swaps

          • CA-4.7.6

            Swaps are treated as two notional positions in government securities with the relevant maturities.

            (a) Interest rate swaps will be decomposed into two legs, and each leg will be allocated to the maturity band equating to the time remaining to repricing or maturity. For example, an interest rate swap in which a bank is receiving floating rate interest and paying fixed is treated as a long position in a floating rate instrument of maturity equivalent to the period until the next interest fixing and a short position in a fixed rate instrument of maturity equivalent to the residual life of the swap.
            (b) For swaps that pay or receive a fixed or floating interest rate against some other reference price, e.g. a stock index, the interest rate component should be slotted into the appropriate repricing or maturity category, with the equity component being included in the equity risk measurement framework as described in chapter CA-5.
            (c) For cross currency swaps, the separate legs are included in the interest rate risk measurement for the currencies concerned, as having a fixed/floating leg in each currency. Alternatively, the two parts of a currency swap transaction are split into forward foreign exchange contracts and treated accordingly.
            (d) Where a swap has a deferred start, and one or both legs have been fixed, then the fixed leg(s) will be sub-divided into the time to the commencement of the leg and the actual swap leg with fixed or floating rate. A swap is deemed to have a deferred start when the commencement of the interest rate calculation periods is more than two business days from the transaction date, and one or both legs have been fixed at the time of the commitment. However, when a swap has a deferred start and neither leg has been fixed, there is no interest rate exposure, albeit there will be counterparty exposure.
            (e) Where a swap has a different structure from those discussed above, it may be necessary to adjust the underlying notional principal amount, or the notional maturity of one or both legs of the transaction.

          • CA-4.7.7

            Banks with large swap books may use alternative formulae for these swaps to calculate the positions to be included in the maturity or duration ladder. One method would be to first convert the cash flows required by the swap into their present values. For this purpose, each cash flow should be discounted using the zero coupon yields, and a single net figure for the present value of the cash flows entered into the appropriate time-band using procedures that apply to zero or low coupon (less than 3%) instruments. An alternative method would be to calculate the sensitivity of the net present value implied by the change in yield used in the duration method (as set out in section CA-4.5), and allocate these sensitivities into the appropriate time-bands.

          • CA-4.7.8

            Banks which propose to use the approaches described in paragraph CA-4.7.7, or any other similar alternative formulae, should obtain the prior written approval of the Agency. The Agency will consider the following factors before approving any alternative methods for calculating the swap positions:

            (a) Whether the systems proposed to be used are accurate;
            (b) Whether the positions calculated fully reflect the sensitivity of the cash flows to interest rate changes and are entered into the appropriate time-bands; and
            (c) Whether the positions are denominated in the same currency.

      • CA-4.8 CA-4.8 Netting of derivative positions

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

          • CA-4.8.1

            Banks may exclude from the interest rate risk calculation, altogether, the long and short positions (both actual and notional) in identical instruments with exactly the same issuer, coupon, currency and maturity. A matched position in a future or a forward and its corresponding underlying may also be fully offset, albeit the leg representing the time to expiry of the future is included in the calculation.

          • CA-4.8.2

            When the future or the forward comprises a range of deliverable instruments, offsetting of positions in the futures or forward contract and its underlying is only permitted in cases where there is a readily identifiable underlying security which is most profitable for the trader with a short position to deliver. The price of this security, sometimes called the "cheapest-to-deliver", and the price of the future or forward contract should, in such cases, move in close alignment. No offsetting will be allowed between positions in different currencies. The separate legs of cross-currency swaps or forward foreign exchange contracts are treated as notional positions in the relevant instruments and included in the appropriate calculation for each currency.

        • Permissible offsetting of closely matched positions for general market risk only

          • CA-4.8.3

            For the purpose of calculation of the general market risk, in addition to the permissible offsetting of fully matched positions as described in paragraph CA-4.8.1 above, opposite positions giving rise to interest rate exposure can be offset if they relate to the same underlying instruments, are of the same nominal value and are denominated in the same currency and, in addition, fulfil the following conditions:

            (a) For futures:

            Offsetting positions in the notional or underlying instruments to which the futures contract relates should be for identical products and mature within seven days of each other.
            (b) For swaps and FRAs:

            The reference rate (for floating rate positions) must be identical and the coupons must be within 15 basis points of each other.
            (c) For swaps, FRAs and forwards:

            The next interest fixing date or, for fixed coupon positions or forwards, the residual maturity must correspond within the following limits:

            less than one month: same day;
            between one month and one year: within 7 days;
            over one year: within 30 days.

      • CA-4.9 CA-4.9 Calculation of capital charge for derivatives

        • 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

          Instrument Specific risk charge* General market risk charge
          Exchange-traded futures
          — Government** debt security No Yes, as two positions
          — Corporate debt security Yes Yes, as two positions
          — Index on interest rates (e.g. LIBOR) No Yes, as two positions
          — Index on basket of debt securities Yes Yes, as two positions
          OTC forwards
          — Government** debt security No Yes, as two positions
          — Corporate debt security Yes Yes, as two positions
          — Index on interest rates No Yes, as two positions
          FRAs No Yes, as two positions
          Swaps
          — Based on interbank rates No Yes, as two positions
          — Based on Government** bond yields No Yes, as two positions
          — Based on corporate bond yields Yes Yes, as two positions
          Forward foreign exchange No Yes, as one position in each currency
          Options
          — Government** debt security No Either (a) or (b) as below (see chapter CA-8 for a detailed description):
          (a) Carve out together with the associated hedging positions, and use:
          — simplified approach; or
          — scenario analysis; or
          — internal models (see chapter CA-9).
          (b) General market risk charge according to the delta-plus method (gamma and vega should receive separate capital charges).
          — Corporate debt security Yes
          — Index on interest rates No
          — FRAs, swaps No
          * This is the specific risk charge relating to the issuer of the instrument. Under the credit risk rules, there remains a separate capital charge for the counterparty risk.

          ** As defined in section CA-4.2.

    • CA-5 CA-5 Equity position risk — Standardised approach

      • CA-5.1 CA-5.1 Introduction

        • 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:

          (a) common stocks, whether voting or non-voting;
          (b) depository receipts (which should be included in the measurement framework in terms of the underlying shares);
          (c) convertible preference securities (non-convertible preference securities are treated as bonds);
          (d) convertible debt securities which convert into equity instruments and are, therefore, treated as equities (see paragraph CA-5.1.3 below);
          (e) commitments to buy or sell equity securities;
          (f) derivatives based on the above instruments.

        • CA-5.1.3

          Convertible debt securities must be treated as equities where:

          (a) the first date at which the conversion may take place is less than three months ahead, or the next such date (where the first date has passed) is less than a year ahead; and
          (b) the convertible is trading at a premium of less than 10%, where the premium is defined as the current marked-to-market value of the convertible less the marked-to-market value of the underlying equity, expressed as a percentage of the latter.

          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 CA-5.2 Calculation of equity positions

        • 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:

          (a) rank pari passu in all respects; and
          (b) become fungible within 180 days, and thereafter the equity instruments of one tranche can be delivered in settlement of the other tranche.

        • 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 CA-5.3 Specific risk calculation

        • 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:

          (a) The portfolio should be listed on a recognised stock exchange;
          (b) No individual equity position shall comprise more than 10% of the gross value of the country portfolio; and
          (c) The total value of the equity positions which individually comprise between 5% and 10% of the gross value of the country portfolio, shall not exceed 50% of the gross value of the country portfolio.

      • CA-5.4 CA-5.4 General risk calculation

        • 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 CA-5.5 Equity derivatives

        • 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.

          (a) Futures and forward contracts relating to individual equities should, in principle, be included in the calculation at current market prices.
          (b) Futures relating to stock indices should be included in the calculation, at the marked-to-market value of the notional underlying equity portfolio, i.e. as a single position based on the sum of the current market values of the underlying instruments.
          (c) Equity swaps are treated as two notional positions. For example, an equity swap in which a bank is receiving an amount based on the change in value of one particular equity or stock index, and paying a different index is treated as a long position in the former and a short position in the latter. Where one of the swap legs involves receiving/paying a fixed or floating interest rate, that exposure should be slotted into the appropriate time-band for interest rate related instruments as set out in chapter CA-4. The stock index leg should be covered by the equity treatment as set out in this chapter.
          (d) Equity options and stock index options are either "carved out" together with the associated underlying instruments, or are incorporated in the general market risk measurement framework, described in this chapter, based on the delta-plus method. The treatment of options, being a complex issue, is dealt with in detail in chapter CA-8.

        • 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

          • CA-5.5.4

            Positions in highly liquid equity indices whether they arise directly or through derivatives, attract a 2% capital charge in addition to the general market risk, to cover factors such as execution risk.

          • CA-5.5.5

            For positions in equity indices not regarded as highly liquid, the specific risk capital charge is the highest specific risk charge that would apply to any of its components, as set out in section CA-5.3.

          • CA-5.5.6

            In the case of the futures-related arbitrage strategies set out below, the specific risk capital charge described above may be applied to only one index with the opposite position exempt from a specific risk capital charge. The strategies are as follows:

            (a) where a bank takes an opposite position in exactly the same index, at different dates or in different market centres;
            (b) where a bank takes opposite positions in contracts at the same date in different but similar indices, provided the two indices contain at least 90% common components.

          • CA-5.5.7

            Where a bank engages in a deliberate arbitrage strategy, in which a futures contract on a broad-based index matches a basket of stocks, it will be allowed to carve out both positions from the standardised methodology on the following conditions:

            (a) the trade has been deliberately entered into, and separately controlled; and
            (b) the composition of the basket of stocks represents at least 90% of the index when broken down into its notional components.

            In such a case, the minimum capital requirement is limited to 4% (i.e. 2% of the gross value of the positions on each side) to reflect divergence and execution risks. This applies even if all of the stocks comprising the index are held in identical proportions. Any excess value of the stocks comprising the basket over the value of the futures contract or vice versa is treated as an open long or short position.

        • Counterparty risk

          • CA-5.5.8

            Derivative positions may also generate counterparty risk exposure related to the counterparty in the trade, in addition to position risk requirements (specific and general) related to the underlying instrument, e.g. counterparty risk related to OTC trades through margin payments, fees payable or settlement exposures. The credit risk capital requirements will apply to such counterparty risk exposure.

            Summary of treatment of equity derivatives

            Instrument Specific risk charge* General market risk charge
            Exchange-traded or OTC futures
            — Individual equity Yes Yes, as underlying
            — Index Yes
            (see section CA-5.5)
            Yes, as underlying
            Options
            — Individual equity Yes Either (a) or (b) as below (chapter CA-8 for a detailed description):
            (a) Carve out together with the associated hedging positions, and use:
            — simplified approach; or
            — scenario analysis; or
            — internal models (chapter CA-9).
            (b) General market risk charge according to the delta-plus method (gamma and vega should receive separate capital charges).
            — Index Yes
            * This is the specific risk charge relating to the issuer of the instrument. Under the credit risk rules, there remains a separate capital charge for the counterparty risk.

    • CA-6 CA-6 Foreign exchange risk — Standardised approach

      • CA-6.1 CA-6.1 Introduction

        • 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 CA-6.2 De minimis exemptions

        • 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:

          (a) the bank's holdings or taking of positions in foreign currencies, including gold, defined as the greater of the sum of the gross long positions and the sum of the gross short positions in all foreign currencies and gold, does not exceed 100% of its eligible capital; and
          (b) the bank's overall net open position, as defined in paragraph CA-6.3.1, does not exceed 2% of its eligible capital as defined in chapter CA-2.

        • 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 CA-6.3 Calculation of net open positions

        • 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:

          (a) the net spot position in the currency (i.e. all asset items less all liability items, including accrued interest, other income and expenses, denominated in the currency in question, assets are included gross of provisions for bad and doubtful debts, except in cases where the provisions are maintained in the same currency as the underlying assets);
          (b) the net forward position in the currency (i.e. all amounts to be received less all amounts to be paid under forward foreign exchange contracts, in the concerned currency, including currency futures and the principal on currency swaps not included in the spot position);
          (c) guarantees and similar off-balance-sheet contingent items that are certain to be called and are likely to be irrecoverable where the provisions, if any, are not maintained in the same currency;
          (d) net future income/expenses not yet accrued but already fully hedged by forward foreign exchange contracts may be included provided that such anticipatory hedging is part of the bank's formal written policy and the items are included on a consistent basis;
          (e) profits (i.e. the net value of income and expense accounts) held in the currency in question;
          (f) specific provisions held in the currency in question where the underlying asset is in a different currency, net of assets held in the currency in question where a specific provision is held in a different currency; and
          (g) the net delta-based equivalent of the total book of foreign currency options (subject to a separately calculated capital charge for gamma and vega as described in chapter CA-8, alternatively, options and their associated underlying positions are dealt with by one of the other methods described in chapter CA-8).

          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

          • CA-6.3.6

            Positions of a structural, i.e. non-dealing, nature as set out below, may be excluded from the calculation of the net open currency positions:

            (a) positions are taken deliberately in order to hedge, partially or totally, against the adverse effects of exchange rate movements on the bank's capital adequacy ratio;
            (b) positions related to items that are deducted from the bank's capital when calculating its capital base in accordance with the rules and guidelines in this module, such as investments in non-consolidated subsidiaries; and
            (c) Retained profits held for payout to parent.

            The Agency will consider approving the exclusion of the above positions for the purpose of calculating the capital requirement, only if the following conditions are met:

            (i) the concerned bank provides adequate documentary evidence to the Agency which establishes the fact that the positions proposed to be excluded are, indeed, of a structural, i.e. non-dealing, nature and are merely intended to protect the bank's capital adequacy ratio. For this purpose, the Agency may ask for written representations from the bank's management or Directors; and
            (ii) any exclusion of a position is consistently applied, with the treatment of the hedge remaining the same for the life of the associated assets or other items.

        • Derivatives

          • CA-6.3.7

            A currency swap is treated as a combination of a long position in one currency and a short position in the second currency.

          • CA-6.3.8

            There are a number of alternative approaches to the calculation of the foreign exchange risk in options. As stated in section CA-6.1, with the Agency's prior written approval, a bank may choose to use internal models to measure the options risk. Extra capital charges will apply to those option risks that the bank's internal model does not capture. The standardised framework for the calculation of options risks and the resultant capital charges is described, in detail, in chapter CA-8. Where, as explained in paragraph CA-6.3.1, the option delta value is incorporated in the net open position, the capital charges for the other option risks are calculated separately.

      • CA-6.4 CA-6.4 Calculation of the overall net open positions

        • 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:

          (a) The sum of the net short positions or the sum of the net long positions, whichever is greater; plus
          (b) The net position (short or long) in gold, regardless of sign.

        • 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 CA-6.5 Calculation of the capital charge

        • 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:

          Example of the calculation of the foreign exchange overall net open position and the capital charge
          GBP EURO SAR US$ JPY Gold
          +100 +150 +50 –180 –20 –20
          +300 –200 20
          The capital charge is 8% of the higher of either the sum of the net long currency positions or the sum of the net short positions (i.e. 300) and of the net position in gold (i.e. 20) = 320 x 8% = 25.6

    • CA-7 CA-7 Commodities risk — Standardised approach

      • CA-7.1 CA-7.1 Introduction

        • 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:

          (a) 'basis risk', i.e., the risk that the relationship between the prices of similar commodities alters through time;
          (b) 'interest rate risk', i.e., the risk of a change in the cost of carry for forward positions and options; and
          (c) 'forward gap risk', i.e., the risk that the forward price may change for reasons other than a change in interest rates.

        • 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.

      • CA-7.2 CA-7.2 Calculation of commodities positions

        • Netting

          • CA-7.2.1

            Banks should first express each commodity position (spot plus forward) in terms of the standard unit of measurement (i.e., barrels, kilograms, grams etc.). Long and short positions in a commodity are reported on a net basis for the purpose of calculating the net open position in that commodity. For markets which have daily delivery dates, any contracts maturing within ten days of one another may be offset. The net position in each commodity is then converted, at spot rates, into the bank's reporting currency.

          • CA-7.2.2

            Positions in different commodities cannot be offset for the purpose of calculating the open positions as described in paragraph CA-7.2.1 above. However, where two or more sub-categories8 of the same category are, in effect, deliverable against each other, netting between those sub-categories is permitted. Furthermore, if two or more sub-categories of the same category are considered as close substitutes for each other, and minimum correlation of 0.9 between their price movements is clearly established over a minimum period of one year, the bank may, with the prior written approval of the Agency, net positions in those sub-categories. Banks which wish to net positions based on correlations, in the manner discussed above, will need to satisfy the Agency of the accuracy of the method which it proposes to adopt.


            8 Commodities can be grouped into clans, families, sub-groups and individual commodities. For example, a clan might be Energy Commodities, within which Hydro-Carbons is a family with Crude Oil being a sub-group and West Texas Intermediate, Arabian Light and Brent being individual commodities.

        • Derivatives

          • CA-7.2.3

            All commodity derivatives and off-balance-sheet positions which are affected by changes in commodity prices should be included in the measurement framework for commodities risks. This includes commodity futures, commodity swaps, and options where the "delta plus" method is used9. In order to calculate the risks, commodity derivatives are converted into notional commodities positions and assigned to maturities as follows

            (a) futures and forward contracts relating to individual commodities should be incorporated in the measurement framework as notional amounts of barrels, kilograms etc., and should be assigned a maturity with reference to their expiry date;
            (b) commodity swaps where one leg is a fixed price and the other one is the current market price, should be incorporated as a series of positions equal to the notional amount of the contract, with one position corresponding to each payment on the swap and slotted into the maturity time-bands accordingly. The positions would be long positions if the bank is paying fixed and receiving floating, and short positions if vice versa. (If one of the legs involves receiving/paying a fixed or floating interest rate, that exposure should be slotted into the appropriate repricing maturity band for the calculation of the interest rate risk, as described in chapter CA-4);
            (c) commodity swaps where the legs are in different commodities should be incorporated in the measurement framework of the respective commodities separately, without any offsetting. Offsetting will only be permitted if the conditions set out in paragraphs CA-7.2.1 and CA-7.2.2 are met.

            9 For banks using other approaches to measure options risks, all Options and the associated underlying instruments should be excluded from both the maturity ladder approach and the simplified approach. The treatment of options is described, in detail, in chapter 8.

        • CA-7.3 CA-7.3 Maturity ladder approach

          • CA-7.3.1

            A worked example of the maturity ladder approach is set out in Appendix CA 5 and the table in paragraph CA-7.3.2 illustrates the maturity time-bands of the maturity ladder for each commodity.

          • CA-7.3.2

            The steps in the calculation of the commodities risk by the maturity ladder approach are:

            (a) The net positions in individual commodities, expressed in terms of the standard unit of measurement, are first slotted into the maturity ladder. Physical stocks are allocated to the first time-band. A separate maturity ladder is used for each commodity as defined in section CA-7.2 earlier in this chapter. The net positions in commodities are calculated as explained in section CA-7.2.
            (b) Long and short positions in each time-band are matched. The sum of the matched long and short positions is multiplied first by the spot price of the commodity, and then by a spread rate of 1.5% for each time-band as set out in the table below. This represents the capital charge in order to capture forward gap and interest rate risk within a time-band (which, together, are sometimes referred to as curvature/spread risk).

            Time-bands10
            0–1 months
            1–3 months
            3–6 months
            6–12 months
            1–2 years
            2–3 years
            over 3 years
            (c) The residual (unmatched) net positions from nearer time-bands are then carried forward to offset opposite positions (i.e. long against short, and vice versa) in time-bands that are further out. However, a surcharge of 0.6% of the net position carried forward is added in respect of each time-band that the net position is carried forward, to recognise that such hedging of positions between different time-bands is imprecise. The surcharge is in addition to the capital charge for each matched amount created by carrying net positions forward, and is calculated as explained in step (b) above.
            (d) At the end of step (c) above, there will be either only long or only short positions, to which a capital charge of 15% will apply. The Agency recognises that there are differences in volatility between different commodities, but has, nevertheless, decided that one uniform capital charge for open positions in all commodities shall apply in the interest of simplicity of the measurement, and given the fact that banks normally run rather small open positions in commodities. Banks will be required to submit, in writing, details of their commodities business, to enable the Agency to evaluate whether the models approach should be adopted by the bank, to capture the market risk on this business.

            10 For instruments, the maturity of which is on the boundary of two maturity time-bands, the instrument should be placed into the earlier maturity band. For example, instruments with a maturity of exactly one year are placed into the 6 to 12 months time-band.

        • CA-7.4 CA-7.4 Simplified approach

          • CA-7.4.1

            By the simplified approach, the capital charge of 15% of the net position, long or short, in each commodity is applied to capture directional risk. Net positions in commodities are calculated as explained in section CA-7.2.

          • CA-7.4.2

            An additional capital charge equivalent to 3% of the bank's gross positions, long plus short, in each commodity is applied to protect the bank against basis risk, interest rate risk and forward gap risk. In valuing the gross positions in commodity derivatives for this purpose, banks should use the current spot price.

    • CA-8 CA-8 Options risk — Standardised approach

      • CA-8.1 CA-8.1 Introduction

        • 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:

          (a) Banks which solely use purchased options are permitted to use the simplified (carve-out) approach described later in this chapter.
          (b) Banks which also write options should use either the delta-plus (buffer) approach or the scenario approach, or alternatively use a comprehensive risk management model. The Agency's detailed rules for the recognition and use of internal models are included in chapter CA-9.

        • 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 CA-8.2 Simplified approach (carve-out)

        • 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.

          Simplified approach: Capital charges
          Position Treatment
          Long cash and long put

          or

          Short cash and long call (i.e., hedged positions)
          The capital charge is:

          [Market value of underlying instrument13 x Sum of specific and general market risk charges14 for the underlying] minus [Amount, if any, the option is in the money15]

          The capital charge calculated as above is bounded at zero, i.e., it cannot be a negative number.
          Long call

          or

          Long put
          (i.e., naked option positions)
          The capital charge is the lesser of:

          i) Market value of the underlying instrument x Sum of specific and general market risk charges for the underlying; and

          ii) Market value of the option16.


          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 CA-8.3 Delta-plus method (buffer approach)

        • 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

          • CA-8.3.3

            The treatment of the delta-weighted positions, for the calculation of the capital charges arising from delta risk, is summarised in paragraphs CA-8.3.4 to CA-8.3.9.

        • Where the underlying is a debt security or an interest rate

          • CA-8.3.4

            The delta-weighted option positions are slotted into the interest rate time-bands as set out in chapter CA-4. A two-legged approach should be used as for other derivatives, as explained in chapter CA-4, requiring one entry at the time the underlying contract takes effect and a second at the time the underlying contract matures. A few examples to elucidate the two-legged treatment are set out below:

            (a) A bought call option on a June three-month interest rate future will, in April, be considered, on the basis of its delta-equivalent value, to be a long position with a maturity of five months and a short position with a maturity of two months.
            (b) A written option with the same underlying as in (a) above, will be included in the measurement framework as a long position with a maturity of two months and a short position with a maturity of five months.
            (c) A two months call option on a bond future where delivery of the bond takes place in September will be considered in April, as being long the bond and short a five months deposit, both positions being delta-weighted.

          • CA-8.3.5

            Floating rate instruments with caps or floors are treated as a combination of floating rate securities and a series of European-style options. For example, the holder of a three-year floating rate bond indexed to six month LIBOR with a cap of 10% will treat it as:

            (a) a debt security that reprices in six months; and
            (b) a series of five written call options on an FRA with a reference rate of 10%, each with a negative sign at the time the underlying FRA takes effect and a positive sign at the time the underlying FRA matures.

          • CA-8.3.6

            The rules applying to closely matched positions, set out in paragraph CA-4.8.2, will also apply in this respect.

        • Where the underlying is an equity instrument

          • CA-8.3.7

            The delta-weighted positions are incorporated in the measure of market risk described in chapter CA-5. For purposes of this calculation, each national market is treated as a separate underlying.

        • Options on foreign exchange and gold positions

          • CA-8.3.8

            The net delta-based equivalent of the foreign currency and gold options are incorporated in the measurement of the exposure for the respective currency or gold position, as described in chapter CA-6.

        • Options on commodities

          • CA-8.3.9

            The delta-weighted positions are incorporated in the measurement of the commodities risk by the simplified approach or the maturity ladder approach, as described in chapter CA-7.

        • Calculation of the gamma and vega buffers

          • CA-8.3.10

            As explained in paragraph CA-8.3.2, in addition to the above capital charges to cover delta risk, banks are required to calculate additional capital charges to cover the gamma and vega risks. The additional capital charges are calculated as follows:

            Gamma

            (a) For each individual option position (including hedge positions), a gamma impact is calculated according to the following formula derived from the Taylor series expansion:

            Gamma impact = 0.5 x Gamma x VU
            where VU = variation of the underlying of the option, calculated as in (b) below
            (b) VU is calculated as follows:
            (i) For interest rate options17, where the underlying is a bond, the market value of the underlying is multiplied by the risk weights set out in section CA-4.4. An equivalent calculation is carried out where the underlying is an interest rate, based on the assumed changes in yield as set out in the table in section CA-4.5;
            (ii) For options on equities and equity indices17, the market value of the underlying is multiplied by 8%;
            (iii) For foreign exchange and gold options, the market value of the underlying is multiplied by 8%;
            (iv) For commodities options, the market value of the underlying is multiplied by 15%.
            (c) For the purpose of the calculation of the gamma buffer, the following positions are treated as the same underlying:
            (i) For interest rates, each time-band as set out in the table in section CA-4.4. Positions should be slotted into separate maturity ladders by currency. Banks using the duration method should use the time-bands as set out in the table in section CA-4.5;
            (ii) For equities and stock indices, each individual national market;
            (iii) For foreign currencies and gold, each currency pair and gold; and
            (iv) For commodities, each individual commodity as defined in section CA-7.2.
            (d) Each option on the same underlying will have a gamma impact that is either positive or negative. These individual gamma impacts are summed, resulting in a net gamma impact for each underlying that is either positive or negative. Only those net gamma impacts that are negative are included in the capital calculation.
            (e) The total gamma capital charge is the sum of the absolute value of the net negative gamma impacts calculated for each underlying as explained in (d) above.

            Vega

            (f) For volatility risk (vega), banks are required to calculate the capital charges by multiplying the sum of the vegas for all options on the same underlying, as defined above, by a proportional shift in volatility of ±25%.
            (g) The total vega capital charge is the sum of the absolute value of the individual vega capital charges calculated for each underlying.

            17 For interest rate and equity options, the present set of rules do not attempt to capture specific risk when calculating gamma capital charges. See section CA-8.4 for an explanation of the Agency's views on this subject.

          • CA-8.3.11

            The capital charges for delta, gamma and vega risks described in paragraphs CA-8.3.1 through CA-8.3.10 are in addition to the specific risk capital charges which are 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-8.3.12

            To summarise, capital requirements for, say OTC options, using the delta-plus method are as follows:

            (a) Counterparty risk capital charges (on purchased options only), calculated in accordance with the credit risk regulations; PLUS
            (b) Specific risk capital charges (calculated as explained in paragraph CA-8.3.11); PLUS
            (c) Delta risk capital charges (calculated as explained in paragraphs CA-8.3.3 through CA-8.3.9) PLUS
            (d) Gamma and vega capital buffers (calculated as explained in paragraph CA-8.3.10).

      • CA-8.4 CA-8.4 Scenario approach

        • 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:

          (a) Interest rate related instruments — The range for interest rates is consistent with the assumed changes in yield set out in section CA-4.5. Those banks using the alternative method of grouping time-bands into sets, as explained in paragraph CA-8.4.2, should use, for each set of time-bands, the highest of the assumed changes in yield applicable to the individual time-bands in that group. If, for example, the time-bands 3 to 4 years, 4 to 5 years and 5 to 7 years are combined, the highest assumed change in yield of these three bands would be 0.75 which would be applicable to that set.
          (b) For equity instruments, the range is ±8%.
          (c) For foreign exchange and gold, the range is ±8%.
          (d) For commodities, the range is ±15%,

          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:

          (a) Counterparty risk capital charges (on purchased options only), calculated in accordance with the credit risk regulations; PLUS
          (b) Specific risk capital charges (calculated as explained in paragraph CA-8.4.7); PLUS
          (c) Directional and volatility risk capital charges (i.e., the worst case loss from a given scenario matrix analysis).

        • 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 CA-9 Use of internal models

      • CA-9.1 CA-9.1 Introduction

        • 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:

          (a) general criteria regarding the adequacy of the risk management system;
          (b) qualitative standards for internal oversight of the use of models, notably by senior management;
          (c) guidelines for specifying an appropriate set of market risk factors (i.e., the market rates and prices that affect the value of a bank's positions);
          (d) quantitative standards setting out the use of common minimum statistical parameters for measuring risk;
          (e) guidelines for stress testing;
          (f) validation procedures for external oversight of the use of models; and
          (g) rules for banks which use a mixture of the internal models approach and the standardised approach.

        • 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 CA-9.2 General criteria

        • 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:

          (a) that the bank's risk management system is conceptually sound and is implemented with integrity;
          (b) that the bank has, in the Agency's view, sufficient numbers of staff skilled in the use of sophisticated models not only in the trading area but also in the risk control, audit and the back office areas;
          (c) that the bank's models have, in the Agency's judgement, a proven track record of reasonable accuracy in measuring risk. The Agency recognises that the use of internal models is, for most banks in Bahrain, a relatively new development and, therefore, it is difficult to establish a track record of reasonable accuracy. The Agency, therefore, will require a period of initial monitoring and live testing of a bank's internal model before it is used for supervisory capital purposes; and
          (d) that the bank regularly conducts stress tests as outlined in section CA-9.7 and conducts backtesting as described in section CA-9.6.

      • CA-9.3 CA-9.3 Qualitative standards

        • 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:

          (a) The bank should have an independent risk management unit that is responsible for the design and implementation of the bank's risk management system. The unit should produce and analyse daily reports on the output of the bank's risk measurement model, including an evaluation of the relationship between the measures of risk exposure and the trading limits. This unit must be independent from the business trading units and should report directly to the senior management of the bank.
          (b) The independent risk management unit should conduct a regular backtesting programme, i.e. an ex-post comparison of the risk measure generated by the model against the actual daily changes in portfolio value over longer periods of time, as well as hypothetical changes based on static positions. The document issued by the Basel Committee on Banking Supervision in January 1996, 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.pdf), presents in detail the approach to be applied by banks for backtesting.
          (c) The Board of Directors and senior management of the bank should be actively involved in the risk management process and must regard such process as an essential aspect of the business to which significant resources need to be devoted18. In this regard, the daily reports prepared by the independent risk management unit must be reviewed by a level of management with sufficient seniority and authority to enforce both reductions of positions taken by individual traders and reductions in the bank's overall risk exposure.
          (d) The bank's internal model must be closely integrated into the day-to-day risk management process of the bank. Its output should, accordingly, be an integral part of the process of planning, monitoring and controlling the bank's market risk profile.
          (e) The risk measurement system should be used in conjunction with the internal trading and exposure limits. In this regard, the trading limits should be related to the bank's risk measurement model in a manner that is consistent over time and that is well-understood by both traders and senior management.
          (f) A routine and rigorous programme of stress testing, along the general lines set out in section CA-9.6, should be in place as a supplement to the risk analysis based on the day-to-day output of the bank's risk measurement model. The results of stress testing should be reviewed periodically by senior management and should be reflected in the policies and limits set by management and the Board of Directors. Where stress tests reveal particular vulnerability to a given set of circumstances, prompt steps should be taken to manage those risks appropriately (e.g., by hedging against that outcome or reducing the size of the bank's exposures).
          (g) The bank should have a routine in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the risk measurement system. The bank's risk measurement system must be well documented, for example, through a risk management manual that describes the basic principles of the risk management system and that provides an explanation of the empirical techniques used to measure market risk.
          (h) An independent review of the risk measurement system should be carried out regularly in the bank's own internal auditing process. This review should include both the activities of the business trading units and of the independent risk management unit. A review, by the internal auditor, of the overall risk management process should take place at regular intervals (ideally not less than once every six months) and should specifically address, at a minimum:
          (i) the adequacy of the documentation of the risk management system and process;
          (ii) the organisation of the risk management unit;
          (iii) the integration of market risk measures into daily risk management;
          (iv) the approval process for risk pricing models and valuation systems used by front- and back-office personnel;
          (v) the validation of any significant changes in the risk measurement process;
          (vi) the scope of market risks captured by the risk measurement model;
          (vii) the integrity of the management information system;
          (viii) the accuracy and completeness of position data;
          (ix) the verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources;
          (x) the accuracy and appropriateness of volatility and correlation assumptions;
          (xi) the accuracy of valuation and risk transformation calculations;
          (xii) the verification of the model's accuracy through frequent backtesting as described in (b) above and in the Basel Committee's document referred to therein.

          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 CA-9.4 Specification of market risk factors

        • 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.

          (a) For interest rates:
          There should be a set of risk factors corresponding to interest rates in each currency in which the bank has interest-rate-sensitive on- or off-balance-sheet positions.
          The risk measurement system should model the yield curve using one of a number of generally accepted approaches, for example, by estimating forward rates of zero coupon yields. The yield curve should be divided into various maturity segments in order to capture variation in the volatility of rates along the yield curve; there will typically be one risk factor corresponding to each maturity segment. For material exposures to interest rate movements in the major currencies and markets, banks must model the yield curve using a minimum of six factors. However, the number of risk factors used should ultimately be driven by the nature of the bank's trading strategies. For instance, a bank which has a portfolio of various types of securities across many points of the yield curve and which engages in complex arbitrage strategies would require a greater number of risk factors to capture interest rate risk accurately.
          The risk measurement system must incorporate separate risk factors to capture spread risk (e.g. between bonds and swaps). A variety of approaches may be used to capture the spread risk arising from less than perfectly correlated movements between government and other fixed-income interest rates, such as specifying a completely separate yield curve for non-government fixed-income instruments (for instance, swaps or municipal securities) or estimating the spread over government rates at various points along the yield curve.
          (b) For exchange rates (which includes gold):
          The risk measurement system should incorporate risk factors corresponding to the individual foreign currencies in which the bank's positions are denominated. Since the value-at-risk figure calculated by the risk measurement system will be expressed in the bank's reporting currency, any net position denominated in a currency other than the reporting currency will introduce a foreign exchange risk. Thus, there must be risk factors corresponding to the exchange rate between the reporting currency and each other currency in which the bank has a significant exposure.
          (c) For equity prices:
          There should be risk factors corresponding to each of the equity markets in which the bank holds significant positions.
          At a minimum, there should be a risk factor that is designed to capture market-wide movements in equity prices (e.g., a market index). Positions in individual securities or in sector indices may be expressed in "beta-equivalents"19 relative to this market-wide index.
          A somewhat more detailed approach would be to have risk factors corresponding to various sectors of the overall equity market (for instance, industry sectors or cyclical and non-cyclical sectors). As above, positions in individual stocks within each sector could be expressed in "beta-equivalents" relative to the sector index.
          The most extensive approach would be to have risk factors corresponding to the volatility of individual equity issues.
          The sophistication and nature of the modelling technique for a given market should correspond to the bank's exposure to the overall market as well as its concentration in individual equity issues in that market.
          (d) For commodity prices:
          There should be risk factors corresponding to each of the commodity markets in which the bank holds significant positions (also see section CA-7.1).
          For banks with relatively limited positions in commodity-based instruments, a straight-forward specification of risk factors is acceptable. Such a specification would likely entail one risk factor for each commodity price to which the bank is exposed. In cases where the aggregate positions are reasonably small, it may be acceptable to use a single risk factor for a relatively broad sub-category of commodities (for instance, a single risk factor for all types of oil). However, banks which propose to use this simplified approach should obtain the prior written approval of the Agency.
          For more active trading, the model should also take account of variation in the "convenience yield"20 between derivatives positions such as forwards and swaps and cash positions in the commodity.

          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 CA-9.5 Quantitative standards

        • CA-9.5.1

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

          (a) "Value-at-risk" must be computed on a daily basis.
          (b) In calculating the value-at-risk, a 99th percentile, one-tailed confidence interval is to be used.
          (c) In calculating the value-at-risk, an instantaneous price shock equivalent to a 10-day movement in prices is to be used, i.e., the minimum "holding period" will be ten trading days. Banks may use value-at-risk numbers calculated according to shorter holding periods scaled up to ten days by the square root of time (for the treatment of options, also see (h) below).
          (d) The minimum historical observation period (sample period) for calculating value-at-risk is one year. For banks which use a weighting scheme or other methods for the historical observation period, the "effective" observation period must be at least one year (i.e., the weighted average time lag of the individual observations cannot be less than 6 months).

          The Agency may, as an exceptional case, require a bank to calculate its value-at-risk using a shorter observation period if, in the Agency's judgement, this is justified by a significant upsurge in price volatility.
          (e) Banks should update their data sets no less frequently than once every week and should also reassess them whenever market prices are subject to material changes.
          (f) No particular type of model is prescribed by the Agency. So long as each model used captures all the material risks run by the bank, as set out in section CA-9.4, banks will be free to use models based, for example, on variance-covariance matrices, historical simulations, or Monte Carlo simulations.
          (g) Banks shall have discretion to recognise empirical correlations within broad risk categories (i.e., interest rates, exchange rates, equity prices and commodity prices, including related options volatilities in each risk factor category). Banks are not permitted to recognise empirical correlations across broad risk categories without the prior approval of the Agency. Banks may apply, on a case-by-case basis, for empirical correlations across broad risk categories to be recognised by the Agency, subject to its satisfaction with the soundness and integrity of the bank's system for measuring those correlations.
          (h) Banks' models must accurately capture the unique risks associated with options within each of the broad risk categories. The following criteria shall apply to the measurement of options risk:
          banks' models must capture the non-linear price characteristics of options positions;
          banks are expected to ultimately move towards the application of a full 10-day price shock to options positions or positions that display option-like characteristics. In the interim period, banks may adjust their capital measure for options risk through other methods, e.g., periodic simulations or stress testing;
          each bank's risk measurement system must have a set of risk factors that captures the volatilities of the rates and prices underlying the option positions, i.e., vega risk. Banks with relatively large and/or complex options portfolios should have detailed specifications of the relevant volatilities. This means that banks should measure the volatilities of options positions broken down by different maturities.
          (i) Each bank must meet, on a daily basis, a capital requirement expressed as the higher of (i) and (ii) below, multiplied by a multiplication factor (see (j) below):
          (i) its previous day's value-at-risk number measured according to the parameters specified in (a) to (h) above; and
          (ii) an average of the daily value-at-risk measures on each of the preceding sixty business days.
          (j) The multiplication factor will be set by the Agency, separately for each individual bank, on the basis of the Agency's assessment of the quality of the bank's risk management system, subject to an absolute minimum of 3. Banks will be required to add to the factor set by the Agency, a "plus" directly related to the ex-post performance of the model, thereby introducing a built-in positive incentive to maintain the predictive quality of the model. The plus will range from 0 to 1 based on the outcome of the bank's backtesting. If the backtesting results are satisfactory and the bank meets all of the qualitative standards set out in section CA-9.3 above, the plus factor could be zero. The Basel Committee's document 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), referred to earlier in section CA-9.3, presents in detail the approach to be followed for backtesting and the plus factor. Banks are expected to strictly comply with this approach.
          (k) As stated earlier in section CA-9.1, banks using models will also be subject to a capital charge to cover specific risk (as defined under the standardised approach) of interest rate related instruments and equity instruments. The manner in which the specific risk capital charge is to be calculated is set out in section CA-9.10.

      • CA-9.6 CA-9.6 Backtesting

        • 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-9.6.2

            The contents of this paper lay down recommendations for carrying out backtesting procedures in order to determine the accuracy and robustness of bank's internal models for measuring market risk capital requirements. These backtesting procedures typically consist of a periodic comparison of the bank's daily value-at-risk measures with the subsequent daily profit or loss ("trading outcome"). The procedure involves calculating and identifying the number of times over the prior 250 business days that observed daily trading losses exceed the bank's one-day, 99% confidence level VaR estimate (so-called "exceptions").

          • CA-9.6.3

            Based on the number of exceptions identified from the backtesting procedures, the banks will be classified into three exception categories for the determination of the "scaling factor" to be applied to the banks' market risk measure generated by its internal models. The three categories, termed as zones and distinguished by colours into a hierarchy of responses, are listed below:

            (a) Green zone
            (b) Yellow zone
            (c) Red zone

          • CA-9.6.4

            The green zone corresponds to backtesting results that do not themselves suggest a problem with the quality or accuracy of a bank's internal model. The yellow zone encompasses results that do raise questions in this regard, but where such a conclusion is not definitive. The red zone indicates a backtesting result that almost certainly indicates a problem with a bank's risk model.

          • CA-9.6.5

            The corresponding "scaling factors" applicable to banks falling into respective zones based on their backtesting results are shown in Table 2 of the paper mentioned in paragraph CA-9.6.1.

      • CA-9.7 CA-9.7 Stress testing

        • 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.

          (a) Scenarios requiring no simulation by the bank

          Banks should have information on the largest losses experienced during the reporting period available for review by the Agency. This loss information will be compared with the level of capital that results from a bank's internal measurement system. For example, it could provide the Agency with a picture of how many days of peak day losses would have been covered by a given value-at-risk estimate.
          (b) Scenarios requiring simulation by the bank

          Banks should subject their portfolios to a series of simulated stress scenarios and provide the Agency with the results. These scenarios could include testing the current portfolio against past periods of significant disturbance, for example, the 1987 equity crash, the ERM crises of 1992 and 1993 or the fall in the international bond markets in the first quarter of 1994, the Far East and ex-Soviet bloc equity crises of 1997–99 and the collapse of the TMT equities market of 2000–01 incorporating both the large price movements and the sharp reduction in liquidity associated with these events. A second type of scenario would evaluate the sensitivity of the bank's market risk exposure to changes in the assumptions about volatilities and correlations. Applying this test would require an evaluation of the historical range of variation for volatilities and correlations and evaluation of the bank's current positions against the extreme values of the historical range. Due consideration should be given to the sharp variation that, at times, has occurred in a matter of days in periods of significant market disturbance. The four market events, cited above as examples, all involved correlations within risk factors approaching the extreme values of 1 and –1 for several days at the height of the disturbance.
          (c) Scenarios developed by the bank to capture the specific characteristics of its portfolio

          In addition to the general scenarios prescribed by the Agency under (a) and (b) above, each bank should also develop its own stress scenarios which it identifies as most adverse based on the characteristics of its portfolio (e.g. any significant political or economic developments that may result in a sharp move in oil prices). Banks should provide the Agency with a description of the methodology used to identify and carry out the scenarios as well as with a description of the results derived from these stress tests.

        • 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 CA-9.8 External validation of models

        • 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:

          (a) verifying and ensuring that the internal validation processes described in section CA-9.3 are operating satisfactorily;
          (b) ensuring that the formulae used in the calculation process as well as for the pricing of options and other complex instruments are validated by a qualified unit, which in all cases should be independent from the trading area;
          (c) checking and ensuring that the structure of the internal models is adequate with respect to the bank's activities and geographical coverage;
          (d) checking the results of the bank's backtesting of its internal measurement system (i.e., comparing value-at-risk estimates with actual profits and losses) to ensure that the model provides a reliable measure of potential losses over time; and
          (e) making sure that data flows and processes associated with the risk measurement system are transparent and accessible.

        • 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 CA-9.9 Letter of model recognition

        • 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 CA-9.10 Combination of internal models and the standardised methodology

        • 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:

          (a) each broad risk factor category must be assessed using a single approach (either internal models or the standardised approach), i.e., no combination of the two methods will, in principle, be permitted within a risk factor category or across a bank's different entities for the same type of risk (see, however, the transitional provisions in section CA-1.6)21;
          (b) all of the criteria laid down in this chapter will apply to the models being used;
          (c) banks may not modify the combination of the two approaches which they are using, without justifying to the Agency that they have a valid reason for doing so, and obtaining the Agency's prior written approval;
          (d) no element of market risk may escape measurement, i.e. the exposure for all the various risk factors, whether calculated according to the standardised approach or internal models, would have to be captured; and
          (e) the capital charges assessed under the standardised approach and under the models approach should be aggregated using the simple sum method.

          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 CA-9.11 Treatment of specific risk

        • 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:

          •  explain the historical price variation in the portfolio22;
          •  demonstrably capture concentration (magnitude and changes in composition)23;
          •  be robust to an adverse environment24; and
          •  be validated through backtesting aimed at assessing whether specific risk is being accurately captured.

          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:

          (a) the specific risk portion of the value-at-risk measure which should be isolated25; or, at the bank's option,
          (b) the value-at-risk measures of sub-portfolios of debt and equity positions that contain specific risk26.

          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:
          •  Using the incremental increase in value-at-risk arising from the modelling of specific risk factors;
          •  Using the difference between the value-at-risk measure and a measure calculated by substituting each individual equity position by a representative index; or
          •  Using an analytic separation between general market risk and specific risk by a particular model.

          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 CA-10 Gearing requirements

      • CA-10.1 CA-10.1 Gearing

        • 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

          • CA-10.1.2

            Gearing ratio is measured with reference to the ratio of deposit liabilities against the bank's capital and reserves as reported in its PIR.

        • Gearing limit

          • CA-10.1.3

            For Full Commercial Bank and Offshore Banking Unit licensees, deposit liabilities should not exceed 20 times the respective bank's capital and reserves.

          • CA-10.1.4

            For Investment Bank licensees, deposit liabilities should not exceed 10 times the respective bank's capital and reserves.