Back Custom print Link Text Only Rich Text Print

  • 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 Central Bank, banks will be allowed to use risk measures derived from their own internal models.

        October 07

      • 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.
        October 07

      • 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.

        October 07

      • 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).

        October 07

      • CA-9.1.5

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

        October 07

      • 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.

        October 07

    • CA-9.2 CA-9.2 General criteria

      • CA-9.2.1

        The Central Bank 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 Central Bank'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 Central Bank's judgement, a proven track record of reasonable accuracy in measuring risk. The Central Bank 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 Central Bank, 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.
        October 07

    • 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 Central Bank 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 Central Bank'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 Central Bank will set the multiplication factor for that bank, referred to in Section CA-9.5. Only those banks whose models, in the Central Bank'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.htm), 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 devoted19. 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.

        19 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.

        October 07

    • 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 Central Bank'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 Central Bank. The Central Bank 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'20relative 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 Central Bank.
        •  For more active trading, the model should also take account of variation in the 'convenience yield'21between derivatives positions such as forwards and swaps and cash positions in the commodity.

        20 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.

        21 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.

        October 07

    • 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 Central Bank may, as an exceptional case, require a bank to calculate its value-at-risk using a shorter observation period if, in the Central Bank'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 Central Bank. 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 Central Bank. Banks may apply, on a case-by-case basis, for empirical correlations across broad risk categories to be recognised by the Central Bank, 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 Central Bank, separately for each individual bank, on the basis of the Central Bank'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 Central Bank, 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.
        October 07

    • 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.

        October 07

      • 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').

          October 07

        • 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
          October 07

        • 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.

          October 07

        • 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.

          October 07

    • 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.

        October 07

      • 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).

        October 07

      • 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.

        October 07

      • CA-9.7.4

        Banks should combine the use of stress scenarios as advised under (a), (b) and (c) below by the Central Bank, with stress tests developed by the banks themselves to reflect their specific risk characteristics. The Central Bank 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 Central Bank. 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 Central Bank 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 Central Bank 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 Central Bank 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 Central Bank 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.
        October 07

      • 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.

        October 07

      • 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 Central Bank 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).

        October 07

    • 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 Central Bank will require that the models are validated by both the internal and external auditors of the bank. The Central Bank will review the validation procedures performed by the internal and external auditors, and may independently carry out further validation procedures.

        October 07

      • 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 Central Bank for its review.

        October 07

      • 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.
        October 07

      • 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 Central Bank. The mandatory annual review by the external auditors shall be carried out during the third quarter of the calendar year, and the Central Bank 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 Central Bank promptly.

        October 07

      • CA-9.8.5

        Banks are required to ensure that external auditors and the Central Bank'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.

        October 07

    • 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 Central Bank. The Central Bank 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.

        October 07

      • 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 Central Bank's prior written approval should be obtained for any modifications proposed to be made to the models previously recognised by the Central Bank. In cases where a bank proposes to apply the model to new but similar products, there will be a requirement to obtain the Central Bank's prior approval. In some cases, the Central Bank 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.

        October 07

      • CA-9.9.3

        The Central Bank 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.

        October 07

    • 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.

        October 07

      • CA-9.10.2

        A bank which has obtained the Central Bank'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 Central Bank 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 Central Bank after taking into account the relevant circumstances of the bank.

        October 07

      • 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)22;
        (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 Central Bank that they have a valid reason for doing so, and obtaining the Central Bank'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.

        22 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.

        October 07

    • 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).

        October 07

      • 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 portfolio23;
        •  Demonstrably capture concentration (magnitude and changes in composition)24;
        •  Be robust to an adverse environment25; 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.

        23 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 Central Bank to define an acceptable alternative measure which would meet this regulatory objective.

        24 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.

        25 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.

        October 07

      • 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.

        October 07

      • 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 isolated26; or, at the bank's option,
        (b) The value-at-risk measures of sub-portfolios of debt and equity positions that contain specific risk27.

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

        26Techniques 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.

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

        October 07

      • 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 Central Bank that it would make sense to change the structure.

        October 07

      • 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 Zone28. 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.

        October 07