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  • 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.