CA CA Capital Adequacy (October 2007)
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 basis (i.e. including their foreign
branches ), and on a consolidated group basis (i.e. including their subsidiaries and any other investments which are included or consolidated into the group accounts or are required to be consolidated for regulatory purposes by the CBB).October 07CA-A.1.2
In addition to licensees mentioned in Paragraph CA-A.1.1, certain of these regulations (in particular gearing and market risk requirements) are also applicable to Bahrain
branches of foreign retail bank licensees.October 07CA-A.2 CA-A.2 Purpose
Executive Summary
CA-A.2.1
The purpose of this Module is to set out the Central Bank's
capital adequacy regulations and provide guidance on the calculation of capital requirements by locally incorporated banks. This requirement is supported by Article 44(c) of the Central Bank of Bahrain and Financial Institutions Law (Decree No. 64 of 2006).October 07CA-A.2.2
Principle 9 of the Principles of Business requires that
conventional bank licensees maintain adequate human, financial and other resources, sufficient to run their business in an orderly manner (see Section PB-1.9). In addition, Condition 5 of CBB's Licensing Conditions (Section LR-2.5) requiresconventional bank licensees to maintain financial resources in excess of the minimum requirements specified in Module CA (Capital Adequacy).October 07CA-A.2.3
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.
October 07CA-A.2.4
The requirements specified in this Module vary according to the Category of
conventional bank licensee concerned, their inherent risk profile, and the volume and type of business undertaken. The purpose of such requirements is to ensure thatconventional bank licensees hold sufficient capital to provide some protection against unexpected losses, and otherwise allow conventional banks to effect an orderly wind-down of their operations, without loss to their depositors. The minimum capital requirements specified here may not be sufficient to absorb all unexpected losses.October 07CA-A.2.5
The Central Bank requires in particular that the relevant banks maintain adequate capital, in accordance with the requirements of this Module, against their risks.
October 07Legal Basis
CA-A.2.6
This Module contains the CBB's Directive relating to the capital adequacy of
conventional bank licensees , and is issued under the powers available to the CBB under Article 38 of the CBB Law. The Directive in this Module is applicable to allconventional bank licensees .October 07CA-A.2.7
For an explanation of the CBB's rule-making powers and different regulatory instruments, see Section UG-1.1.
October 07CA-A.3 CA-A.3 Module History
CA-A.3.1
This Module was first issued in July 2004 as part of the conventional principles volume. All requirements in this volume have been effective since this date. Any material changes that have subsequently been made to this Module are annotated with the calendar quarter date in which the change was made: Chapter UG 3 provides further details on Rulebook maintenance and version control. The most recent changes made to this Module are detailed in the table below:
Summary of changes
Module Ref. Change Date Description of Changes CA-A.2 10/07 Change categorising Module as a Directive October 07Evolution of the Module
CA-A.3.2
Prior to the development of the Rulebook, the Central Bank had issued various circulars representing regulations relating to
capital adequacy requirements. These circulars were consolidated into this Module. These circulars are listed below:Circular Ref. Date of Issue Module Ref. Circular Subject ODG/50/98 11 Sep 1998 CA-1 - CA-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 October 07Effective date
CA-A.3.3
The contents in this Module are effective from the date depicted in the original circulars (see Paragraph CA-A.3.2) from which the requirements are compiled or from the dates mentioned in the Summary of Changes.
October 07CA-B CA-B General guidance and best practice
CA-B.1 CA-B.1 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.1.1
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).October 07CA-B.1.2
This technical guidance presents a methodology for testing the accuracy of the internal models used by banks to measure market risks.
October 07CA-B.1.3
Backtesting offers the best opportunity for incorporating suitable incentives into the internal models in a consistent manner.
October 07CA-B.1.4
The Central Bank 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.
October 07Basel Committee: The management of banks' off-balance-sheet exposures – a supervisory perspective
CA-B.1.5
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).October 07CA-B.1.6
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.October 07CA-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.
October 07CA-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-sheetexposures .October 07CA-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 andcommodities risks throughout the bank.October 07CA-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.October 07CA-1.2.2
The framework of weights consists of four weights – 0%, 20%, 50% and 100% for on- and off-balance-sheet items, which based on a broad-brush judgement, are applied to the different types of assets and off-balance-sheet
exposures (with the exception of derivative transactions) within the banking book.October 07CA-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.October 07CA-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.October 07CA-1.3.2
Each bank should agree a written policy statement with the Central Bank on which activities are normally considered trading and which, therefore, constitute the trading book.
October 07CA-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.
October 07Interest 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.
October 07Foreign 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 andcommodity positions, with the exception of structural foreign exchange positions in accordance with Section CA-6.3 of this Module.October 07Exemptions
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.October 07Hedging instruments
CA-1.3.7
A trading book
exposure may behedged , 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 Central Bank as explained in Paragraph CA-1.3.2 above, and with the prior written approval of the Central Bank, banks will be allowed to include within their market risk measure non-trading instruments (on- or off-balance-sheet) which are deliberately used tohedge the trading activities. The positions in these instruments will attractcounterparty risk capital requirements and general market risk, but not specific risk requirements.October 07CA-1.3.8
Where a financial instrument which would normally qualify as part of the trading book is used to
hedge anexposure in the banking book, it should be carved out of the trading book for the period of thehedge , and included in the banking book with theexposure it ishedging . Such instruments will be subject to the credit risk capital requirements.October 07CA-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 beinghedged must remain in the banking book, although the general market riskexposure 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 thehedge should be added to the trading book calculation, rather than that on the trading book side of thehedge 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 Central Bank as explained in Paragraph CA-1.3.2 above, and should have the specific prior written approval of the Central Bank.October 07Allocation 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 Central Bank.October 07CA-1.3.11
The Central Bank 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.October 07Review 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 Central Bank, 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.
October 07CA-1.3.13
Any cases of non-compliance identified by the internal auditor should be immediately brought to the attention of the Central Bank, 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 Central Bank (in accordance with the requirements in Section CA-9.8), in addition to a report to be submitted by the management.
October 07Valuation 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 Central Bank, 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 Central Bank's approval for the use of a risk assessment model in the calculation of the capital requirements foroptions (in accordance with Chapter CA-9 of these regulations), it may value itsoptions using the values derived from that model.(c) Where a bank does not use a model and the prices are not published for itsoptions positions, it must determine the market value as follows:(i) For purchasedoptions , the marked-to-market value is the product of the 'in the money' amount and the quantity underlying theoption ; and(ii) For writtenoptions , the marked-to-market value is the initial premium received for theoption 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 theoption .(d) A bank must calculate the value of aswap 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'sexposure 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.October 07Consolidation
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 Central Bank. 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 Central Bank will require the bank to take individual positions into account without any offsetting.
October 07CA-1.3.16
Notwithstanding that the market risk capital requirements will apply on a worldwide consolidated basis, the Central Bank 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 Central Bank will be particularly vigilant to ensure that banks do not pass positions on reporting dates in such a way as to escape measurement.
October 07Approach 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 Central Bank, 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 theprice risk inoptions 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.October 07CA-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.
October 07CA-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 Central Bank, is set out in detail in Chapter CA-9 including the procedure for obtaining the Central Bank'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.
October 07CA-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 debtsecurities 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 equitysecurity 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 ').October 07CA-1.3.21
In measuring the
price risk inoptions 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 writingoptions , the more sophisticated its measurement method needs to be. In the longer term, banks with significantoptions business will be expected to move to comprehensivevalue-at-risk models and become subject to the full range of quantitative and qualitative standards set out in Chapter CA-9.October 07CA-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.
October 07Monitoring
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.October 07CA-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 Central Bank should be informed in writing. The Central Bank will then seek to ensure that the bank takes immediate measures to rectify the situation.
October 07CA-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 Central Bank 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.
October 07CA-1.4 CA-1.4 Reporting
CA-1.4.1
Formal reporting, to the Central Bank, of
capital adequacy shall be made in accordance with the requirements set out under Section BR-3.1.October 07Review of Prudential Information Returns by External Auditors
CA-1.4.2
The Central Bank 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.
October 07CA-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 Central Bank, excluding debt and equity
securities in the trading book and all positions incommodities , but including the creditcounterparty risk on allover-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 Central Bank 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 Central Bank for adopting a combination of the standardised approach and the internal models approach - see Chapter CA-9).October 07CA-1.6 CA-1.6 Transitional provisions
CA-1.6.1
Banks which start to use internal models for one or more market 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).
October 07CA-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 Category.2 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 Central Bank, and such approval will be given on a case-by-case basis and reviewed by the Central Bank from time to time.
2This does not, however, apply to pre-processing techniques which are used to simplify the calculation and whose results become subject to the standardised methodology.
October 07CA-1.6.3
The Central Bank 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.
October 07CA-1.6.4
The Central Bank recognises that even a bank which uses a comprehensive model may still incur risks in positions which are not captured by their internal models3, for example, in remote locations, in minor currencies or in negligible business areas4. 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.
3Banks 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.
4 For example, if a bank is hardly engaged in commodities it will not necessarily be expected to model its commodities risk.
October 07CA-1.6.5
Transitioning banks are required to move towards a comprehensive internal model approach.
October 07CA-1.6.6
The Central Bank 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.
October 07CA-2 CA-2 The capital requirement
CA-2.1 CA-2.1 Introduction
CA-2.1.1
Regulatory Capital is the sum of the following three components (as defined in Rules CA-2.2.1 to CA-2.2.4), subject to the restrictions set out in Section CA-2.3:Tiers 1 and 2: May be used to support credit risk and market risk; andTier 3: May be used solely to support market risk.October 07CA-2.1.2
For a
branch of a foreign bank operating as a retail bank licensee, a designated amount of capital is required, as agreed between the CBB and the licensee, taking into consideration the gearing requirement stated in Section CA-10.1.October 07CA-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.October 07Tier 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 Central Bank;• 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).October 07Deduction 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.October 07Tier 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.October 07CA-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.
October 07Tier 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.
October 07Tier 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.
October 07CA-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.October 07CA-2.4.2
The bank should next calculate its credit risk-weighted assets in accordance with the regulations in this Module.
October 07CA-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-2.4.2above) 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.
October 07CA-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.
October 07CA-2.5 CA-2.5 Minimum capital ratio requirement
Banking group
CA-2.5.1
On a consolidated basis, the Central Bank 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).
October 07CA-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).
October 07Individual bank
CA-2.5.3
For banks that are required to complete only the PIR form, the Central Bank has set a minimum Risk Asset Ratio ('RAR') of 12.0%.
October 07Maintaining 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.
October 07CA-2.5.5
All locally incorporated banks must give the Central Bank, 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 Central Bank 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.October 07CA-2.5.6
In addition, the Central Bank 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 Central Bank's required minimum RARs as set out above.
October 07CA-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 Central Bank 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).
October 07CA-2.5.8
The bank will be required to submit form PIR (and PIRC where applicable) to the Central Bank on a monthly basis, until the RAR(s) exceeds its target ratio(s).
October 07CA-2.5.9
The Central Bank 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 Central Bank in any particular case.
October 07CA-2.5.10
Banks should note that the Central Bank considers the breach of RARs to be a very serious matter. Consequently, the Central Bank 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 Central Bank's own inspection function or through the use of Reporting Accountants, as appropriate. Following such appraisal, the Central Bank will notify the bank concerned in writing of its conclusions with regard to the continued licensing of the bank.
October 07CA-2.5.11
The Central Bank recommends that the bank's compliance officer supports and cooperates with the Central Bank 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.
October 07CA-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.October 07CA-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 othercommodities (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 orsecurities 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 bysecurities issued by multilateral development banks(b) Claims on and guaranteed by banks andsecurities 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 collection50% Claims secured by mortgage on residential property 100% (a) Claims on related parties(b) Holdings of other (non-subsidiary) banks' andsecurities 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 elsewhereOctober 07CA-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 ofderivatives ).October 07CA-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 theBasel 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.October 07CA-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 andsecurities , which represent commitments with certain draw-down50% 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 October 07CA-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 andsecurities 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.October 07CA-3.4 CA-3.4 Treatment of derivatives contracts in the banking book
CA-3.4.1
The treatment of forwards,
swaps , purchasedoptions 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 thecounterparty 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.October 07CA-3.4.2
Instruments traded on exchanges may be excluded where they are subject to daily receipt and payment of cash variation margins.
October 07CA-3.4.3
Options purchasedover-the-counter are included with the same conversion factors as other instruments.October 07Interest rate contracts
CA-3.4.4
Interest rate contracts are defined to include single-currency interest rate
swaps , basisswaps , forward rate agreements, interest rate futures, interest rate options purchased and similar instruments.October 07Exchange 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.October 07CA-3.4.6
Exchange rate contracts with an original maturity of 14 calendar days or less may be excluded.
October 07Equity contracts
CA-3.4.7
Equity contracts include forwards,
swaps , purchased options and similar derivative contracts based on individual equities or on equity indices.October 07Gold 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.
October 07CA-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).October 07Other 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 metalcommodity contracts.October 07General 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 outstandingexposure 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 'othercommodities '.(iii) No potential future creditexposure (as referred to under Paragraph CA-3.4.12) would be calculated for single currency floating/floating interest rateswaps .October 07Calculation 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 currentexposure without any need for estimation, and then adding a factor (the 'add-on') to reflect the potential futureexposure 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 October 07CA-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 ofcounterparty , using the same classification into types (a), (b) and (c) given in Section CA-3.3. Finally, theexposure to each type ofcounterparty has to be weighted as 0%, 20% or 50% respectively, and the total weightedexposure calculated.October 07CA-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 includesexposure arising from interest-bearing and discounted financial instruments,derivatives which are based on the movement of interest rates, foreign exchange forwards, and interest rateexposure embedded inderivatives which are based on non-interest rate related instruments.October 07CA-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) Convertiblesecurities such as preference shares and bonds, which are treated as debt instruments5;(d) Mortgage backedsecurities and other securitised assets6;(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 rateexposure embedded in other financial instruments.
5See 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.6 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 mortgagesecurities and mortgage derivative products should discuss their proposed treatment with the Central Bank and obtain the Central Bank's prior written approval for it.October 07CA-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 Central Bank 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 Central Bank in cases of doubt, particularly when a bank is trading an instrument for the first time.
October 07CA-4.1.4
A
security which is the subject of a repurchase orsecurities lending agreement will be treated as if it were still owned by the lender of thesecurity , i.e., it will be treated in the same manner as othersecurities positions.October 07CA-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.
October 07CA-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 theyield curve , as well as the difficulty of constructing perfect hedges.October 07CA-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 judgement.October 07CA-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 Central Bank for those models. The Central Bank'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.
October 07CA-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.
October 07CA-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.October 07CA-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%October 07CA-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 Central Bank reserves the right to apply a specific risk weight to
securities issued by certain foreign governments, especially tosecurities denominated in a currency other than that of the issuing government.October 07CA-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).
October 07CA-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 othersecurities that are:(a) Rated investment grade by at least two internationally recognised credit rating agencies (to be agreed with the Central Bank); 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 Central Bank); 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 Central Bank); or(d) Unrated (subject to the approval of the Central Bank), but deemed to be of comparable investment quality by the reporting bank and where the issuer hassecurities listed on a recognised stock exchange, may also be included.October 07CA-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).October 07CA-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.
October 07CA-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.
October 07CA-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 Central Bank. It is expected that such approval will only be given in cases where a bank clearly demonstrates to the Central Bank, 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 Central Bank may, in future years, consider recognising the duration method as the approved method, and the use of the maturity method may be discontinued.
October 07CA-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.
October 07CA-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, includingderivatives , 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 inderivatives , 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 matchedswaps , 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 Central Bank'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 Central Bank's attention.Maturity method: time-bands and risk weightsCoupon > 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:(e) 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.(f) 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 (i) and (ii) 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.(g) Any residual unmatched weighted positions, following the matching within and between maturity bands and zones as described above, will be summed.(h) The general interest rate risk capital requirement is the sum of:(i) Matched weighted positions in all maturity bands × 10%(ii) Matched weighted positions in zone 1 × 40%(iii) Matched weighted positions in zone 2 × 30%(iv) Matched weighted positions in zone 3 × 50%(v) Matched weighted positions between zones 1&2 × 40%(vi) Matched weighted positions between zones 2&3 × 40%(vii) Matched weighted positions between zones 1&3 × 100%(viii) Residual unmatched weighted positions × 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.October 07CA-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 theyield 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 rateexposures includingderivatives . 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.October 07Duration 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 October 07CA-4.5.2
Banks should notify the Central Bank 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.
October 07CA-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 Central Bank 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.
October 07CA-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, Sigma m t = 1 t × C/(1+r) t D (duration) = Sigma m t = 1 C/(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 × 5%(ii) Matched weighted positions in zone 1 × 40%(iii) Matched weighted positions in zone 2 × 30%(iv) Matched weighted positions in zone 3 × 30%(v) Matched weighted positions between zones 1 & 2 × 40%(vi) Matched weighted positions between zones 2 & 3 × 40%(vii) Matched weighted positions between zones 1 & 3 × 100%(viii) Residual unmatched weighted positions × 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.October 07CA-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 Central Bank for using those models. The use of internal models to measure market risk, and the Central Bank's rules applicable to them, are discussed in detail in Chapter CA-9.October 07CA-4.6.2
Where a bank, with the prior written approval of the Central Bank, 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.
October 07CA-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 ratederivatives 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-currencyswaps , options and forward foreign exchange contracts). Where a bank has obtained the approval of the Central Bank for the use of non-interest ratederivatives models, the embedded interest rateexposures should be incorporated in the standardised measurement framework described in Sections CA-4.7 to CA-4.9.October 07CA-4.6.4
Derivative positions will attract specific risk only when they are based on an underlying instrument or
security . For instance, where the underlyingexposure is an interest rateexposure , as in aswap based upon interbank rates, there will be no specific risk, but onlycounterparty risk. A similar treatment applies to FRAs, forward foreign exchange contracts and interest rate futures. However, for aswap based on a bond yield, or a futures contract based on a debtsecurity or an index representing a basket of debtsecurities , the credit risk of the issuer of the underlying bond will generate a specific risk capital requirement. Future cash flows derived from positions inderivatives will generatecounterparty risk requirements related to thecounterparty in the trade, in addition to position risk requirements (specific and general market risk) related to the underlyingsecurity .October 07CA-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.October 07CA-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 Central Bank in writing.October 07Forward 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.October 07Deposit 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 marketexposure . For FRAs, the size of each leg is the notional amount of the underlying money marketexposure 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 thedeposit underlying the futures contract.October 07Bonds 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 theoption 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 ofsecurities .(g) Arepo (or sell-buy or stock lending) involving exchange of asecurity for cash should be represented as a cash borrowing - i.e. a short position in a government bond with maturity equal to therepo and coupon equal to therepo rate. A reverserepo (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 reverserepo and coupon equal to therepo rate. These positions are referred to as 'cash legs'.(h) It should be noted that, where asecurity owned by the bank (and included in its calculation of market risk) isrepo 'd, it continues to contribute to the bank's interest rate or equity position risk calculation.October 07Swaps
CA-4.7.6
Swaps are treated as two notional positions in governmentsecurities with the relevant maturities.(a) Interest rateswaps 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 rateswap 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 theswap .(b) Forswaps 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 currencyswaps , 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 currencyswap transaction are split into forward foreign exchange contracts and treated accordingly.(d) Where aswap 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 actualswap leg with fixed or floating rate. Aswap 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 aswap has a deferred start and neither leg has been fixed, there is no interest rateexposure , albeit there will becounterparty exposure .(e) Where aswap 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.October 07CA-4.7.7
Banks with large
swap books may use alternative formulae for theseswaps 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 theswap 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.October 07CA-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 Central Bank. The Central Bank 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.October 07CA-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.
October 07CA-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 thissecurity , 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-currencyswaps or forward foreign exchange contracts are treated as notional positions in the relevant instruments and included in the appropriate calculation for each currency.October 07Permissible 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) Forswaps 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) Forswaps , 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.October 07CA-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 ratederivatives are calculated in the same manner as for cash positions, as described earlier in this Chapter.Summary of treatment of interest rate derivative
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): • Corporate debt security• Index on interest rates• FRAs, swapsYes
No
No(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).*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.October 07CA-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.
October 07CA-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 preferencesecurities (non-convertible preferencesecurities are treated as bonds);(d) Convertible debtsecurities which convert into equity instruments and are, therefore, treated as equities (see Paragraph CA-5.1.3 below);(e) Commitments to buy or sell equitysecurities ;(f)Derivatives based on the above instruments.October 07CA-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 debtsecurities , based reasonably on their market behaviour.October 07CA-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 Central Bank 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 Central Bank in cases of doubt, particularly when a bank is trading an instrument for the first time.
October 07CA-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 currencyexposure from the other leg of the contract should be included in the measurement framework as described in Chapters CA-4 and CA-6, respectively.October 07CA-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.
October 07CA-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 Central Bank for those models. The Central Bank'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.
October 07CA-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.October 07CA-5.2.2
A bank may net long and short positions in one
tranche of an equity instrument against anothertranche only where the relevanttranches :(a) Rank pari passu in all respects; and(b) Become fungible within 180 days, and thereafter the equity instruments of onetranche can be delivered in settlement of the othertranche .October 07CA-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.
October 07CA-5.2.4
More detailed guidance on the treatment of equity
derivatives is set out in Section CA-5.October 07CA-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 Central Bank.October 07CA-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.
October 07CA-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.October 07CA-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.
October 07CA-5.4.2
The general market equity risk measure is 8% of the overall net position in each national market.
October 07CA-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 andswaps on both individual equities and on stock indices.October 07CA-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 Central Bank.(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) Equityswaps are treated as two notional positions. For example, an equityswap 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 theswap legs involves receiving/paying a fixed or floating interest rate, thatexposure 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.October 07CA-5.5.3
A summary of the treatment of equity
derivatives is set out in Paragraph CA-5.5.8.October 07Specific 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.October 07CA-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.
October 07CA-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.October 07CA-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.
October 07Counterparty risk
CA-5.5.8
Derivative positions may also generate
counterparty riskexposure related to thecounterparty in the trade, in addition to position risk requirements (specific and general) related to the underlying instrument, e.g.counterparty risk related toOTC trades through margin payments, fees payable or settlementexposures . The credit risk capital requirements will apply to suchcounterparty riskexposure .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• IndexYes
YesEither (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).* 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. October 07CA-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.October 07CA-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 gold7and, as a second step, the measurement of the risks inherent in the bank's mix of long and short positions in different currencies.
7 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 similar manner to foreign currencies.
October 07CA-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.
October 07CA-6.1.4
The open positions are calculated with reference to the bank's base currency, which will be either Bahrain Dinars or United States dollars.
October 07CA-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 Central Bank for those models. The Central Bank'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.
October 07CA-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.
October 07CA-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 Central Bank evidenced by the Central Bank's prior written approval, be exempted from calculating the capital requirements on these positions. The Central Bank 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.October 07CA-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 Central Bank 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.
October 07CA-6.2.3
The Central Bank may, at a future date, revoke an exemption previously granted to a bank, if the Central Bank is convinced that the conditions on which the exemption was granted no longer exist.
October 07CA-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 currencyswaps 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 anticipatoryhedging 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.
October 07CA-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.
October 07CA-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.
October 07CA-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.
October 07CA-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.October 07Structural 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 tohedge , partially or totally, against the adverse effects of exchange rate movements on the bank'scapital 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 Central Bank 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 Central Bank 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'scapital adequacy ratio. For this purpose, the Central Bank 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 thehedge remaining the same for the life of the associated assets or other items.October 07Derivatives
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.October 07CA-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 Central Bank'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, theoption delta value is incorporated in the net open position, the capital charges for the otheroption risks are calculated separately.October 07CA-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.October 07CA-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 thatbranch /subsidiary, in each currency, may be used as a proxy for the positions. Thebranch /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 thebranch /subsidiary against the limits, and revise the limits, if necessary, based on the results of the ex-post monitoring.October 07CA-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.
October 07CA-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 October 07CA-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).October 07CA-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.October 07CA-7.1.3
The
price risk incommodities 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 ofcommodities can make price transparency and the effectivehedging of risks more difficult.October 07CA-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 similarcommodities 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.October 07CA-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 creditcounterparty risk onover-the-counter derivatives , which must be incorporated into their credit risk capital requirements. Furthermore, the funding ofcommodities 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.8
8 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.
October 07CA-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 Central Bank for those models. The Central Bank'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.October 07CA-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 acommodity are reported on a net basis for the purpose of calculating the net open position in thatcommodity . For markets which have daily delivery dates, any contracts maturing within ten days of one another may be offset. The net position in eachcommodity is then converted, at spot rates, into the bank's reporting currency.October 07CA-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-categories9of 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 Central Bank, 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 Central Bank of the accuracy of the method which it proposes to adopt.
9 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.
October 07Derivatives
CA-7.2.3
All
commodity derivatives and off-balance-sheet positions which are affected by changes incommodity prices should be included in the measurement framework forcommodities risks. This includescommodity futures,commodity swaps , and options where the 'delta plus' method is used10. In order to calculate the risks,commodity derivatives are converted into notionalcommodities positions and assigned to maturities as follows:(a) Futures and forward contracts relating to individualcommodities 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 theswap 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, thatexposure 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 differentcommodities should be incorporated in the measurement framework of the respectivecommodities 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.
10 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.
October 07CA-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 .October 07CA-7.3.2
The steps in the calculation of the
commodities risk by the maturity ladder approach are:(a) The net positions in individualcommodities , 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 eachcommodity as defined in Section CA-7.2 earlier in this Chapter. The net positions incommodities 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 thecommodity , 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-bands11 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 suchhedging 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 Central Bank recognises that there are differences in volatility between differentcommodities , but has, nevertheless, decided that one uniform capital charge for open positions in allcommodities shall apply in the interest of simplicity of the measurement, and given the fact that banks normally run rather small open positions incommodities . Banks will be required to submit, in writing, details of theircommodities business, to enable the Central Bank to evaluate whether the models approach should be adopted by the bank, to capture the market risk on this business.
11 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.
October 07CA-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 incommodities are calculated as explained in Section CA-7.2.October 07CA-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 incommodity derivatives for this purpose, banks should use the current spot price.October 07CA-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 Central Bank 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 Central Bank's detailed rules for the recognition and use of internal models are included in Chapter CA-9.October 07CA-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 Central Bank will monitor the banks' options trading activities, and the adequacy of the risk measurement framework adopted.
October 07CA-8.1.3
Where written
option positions arehedged by perfectly matched long positions in exactly the sameoptions , no capital charge for market risk is required in respect of those matched positions.October 07CA-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 andcommodities as described in Chapters CA-4, CA-5, CA-6 and CA-7 respectively.October 07CA-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 × 16%12] minus [($ 11 - $ 10)13 × 100] = $ 60
A similar methodology applies to
options whose underlying is a foreign currency, an interest rate related instrument or acommodity .
128% specific risk plus 8% general market risk.
13 The amount the option is 'in the money'.
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 instrument14 x Sum of specific and general market risk charges15 for the underlying] minus [Amount, if any, theoption is in the money16]
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. nakedoption 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 theoption 17.
14 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.
15 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%.
16 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.
17 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.
October 07CA-8.3 CA-8.3 Delta-plus method (buffer approach)
CA-8.3.1
Banks which write
options are allowed to include delta-weightedoption positions within the standardised methodology set out in Chapters CA-4 through CA-7. Eachoption 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 Central Bank to review such models, if considered necessary. A worked example of the delta-plus method is set out in Appendix CA-6.October 07CA-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 anoption 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 proprietaryoptions pricing model, with appropriate documentation of the process and controls, to enable the Central Bank to review such models, if considered necessary.October 07Treatment of delta
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 otherderivatives , 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 calloption 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 writtenoption 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 calloption 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 monthsdeposit , both positions being delta-weighted.October 07CA-8.3.5
Floating rate instruments with caps or floors are treated as a combination of floating rate
securities and a series of European-styleoptions . 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 debtsecurity that reprices in six months; and(b) A series of five written calloptions 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.October 07CA-8.3.6
The rules applying to closely matched positions, set out in Paragraph CA-4.8.2, will also apply in this respect.
October 07Where 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.
October 07Options 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 theexposure for the respective currency or gold position, as described in Chapter CA-6.October 07Options 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.October 07Calculation 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 individualoption position (includinghedge positions), a gamma impact is calculated according to the following formula derived from the Taylor series expansion:
Gamma impact = 0.5 × Gamma × VU
where VU = variation of the underlying of theoption , calculated as in (b) below(b) VU is calculated as follows:(i) For interest rateoptions 18, 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) Foroptions on equities and equity indices18, the market value of the underlying is multiplied by 8%;(iii) For foreign exchange and goldoptions , the market value of the underlying is multiplied by 8%;(iv) Forcommodities 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(d) Eachoption 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 alloptions 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.
18 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 Central Bank's views on this subject.
October 07CA-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.October 07CA-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 purchasedoptions 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).October 07CA-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 complexoptions trading strategies, are expected to use more sophisticated methods for measuring and monitoring theoptions risks. Banks with the appropriate capability will be permitted, with the prior approval of the Central Bank, to base the market risk capital charge foroptions portfolios and associatedhedging positions on scenario matrix analysis. Before giving its approval, the Central Bank 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.October 07CA-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 theoption portfolio at various points along this 'grid' or 'matrix'. For the purpose of calculating the capital charge, the bank will revalue theoption portfolio using matrices for simultaneous changes in theoption '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 rateoptions , banks which are significant traders in suchoptions 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.October 07CA-8.4.3
The first dimension of the matrix involves a specified range of changes in the
option 's underlying rate or price. The Central Bank 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) Forcommodities, 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.
October 07CA-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.
October 07CA-8.4.5
The Central Bank 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).
October 07CA-8.4.6
After calculating the matrix, each cell contains the net profit or loss of the
option and the underlyinghedge instrument. The general market risk capital charge for each underlying is then calculated as the largest loss contained in the matrix.October 07CA-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.October 07CA-8.4.8
To summarise, capital requirements for, say
OTC options , using the scenario approach are as follows:(a)Counterparty risk capital charges (on purchasedoptions 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).October 07CA-8.4.9
Banks doing business in certain classes of complex exotic
options (e.g. barrieroptions involving discontinuities in deltas etc.), or inoptions 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 Central Bank 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.October 07CA-8.4.10
In drawing up the delta-plus and the scenario approaches, the Central Bank'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 Central Bank 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.October 07CA-8.4.11
In addition to the
options risks described earlier in this Chapter, the Central Bank is conscious of the other risks also associated withoptions , e.g. rho or interest rate risk (the rate of change of the value of theoption with respect to the interest rate) and theta (the rate of change of the value of theoption with respect to time). While not proposing a measurement system for those risks at present, the Central Bank expects banks undertaking significantoptions 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.October 07CA-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 07CA-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 07CA-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 debtsecurities 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 07CA-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) andoption pricing models (for the calculation of the delta, gamma and vega sensitivities).October 07CA-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 07CA-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 07CA-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 07CA-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 riskexposure 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 theBasel 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 riskexposure .(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 andexposure 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. byhedging against that outcome or reducing the size of the bank'sexposures ).(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 theBasel Committee 's document referred to therein.
19 The report, 'Risk management guidelines for
derivatives ', issued by theBasel Committee in July 1994, further discusses the responsibilities of the board of Directors and senior management.October 07CA-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 theyield curve using one of a number of generally accepted approaches, for example, by estimating forward rates of zero coupon yields. Theyield curve should be divided into various maturity segments in order to capture variation in the volatility of rates along theyield curve ; there will typically be one risk factor corresponding to each maturity segment. For materialexposures to interest rate movements in the major currencies and markets, banks must model theyield 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 ofsecurities across many points of theyield 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 andswaps ). 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 separateyield curve for non-government fixed-income instruments (for instance,swaps or municipalsecurities ) or estimating the spread over government rates at various points along theyield 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 thevalue-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 significantexposure .(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 individualsecurities 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'sexposure to the overall market as well as its concentration in individual equity issues in that market.(d) Forcommodity prices:• There should be risk factors corresponding to each of thecommodity markets in which the bank holds significant positions (also see Section CA-7.1).• For banks with relatively limited positions incommodity -based instruments, a straight-forward specification of risk factors is acceptable. Such a specification would likely entail one risk factor for eachcommodity 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 ofcommodities (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'21betweenderivatives positions such as forwards andswaps and cash positions in thecommodity .
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 07CA-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 thevalue-at-risk , a 99th percentile, one-tailed confidence interval is to be used.(c) In calculating thevalue-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 usevalue-at-risk numbers calculated according to shorter holding periods scaled up to ten days by the square root of time (for the treatment ofoptions , also see (h) below).(d) The minimum historical observation period (sample period) for calculatingvalue-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 itsvalue-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 andcommodity prices, including relatedoptions 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 withoptions within each of the broad risk categories. The following criteria shall apply to the measurement ofoptions risk:• Banks' models must capture the non-linear price characteristics ofoptions positions;• Banks are expected to ultimately move towards the application of a full 10-day price shock tooptions positions or positions that displayoption -like characteristics. In the interim period, banks may adjust their capital measure foroptions 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 theoption positions, i.e. vega risk. Banks with relatively large and/or complexoptions portfolios should have detailed specifications of the relevant volatilities. This means that banks should measure the volatilities ofoptions 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'svalue-at-risk number measured according to the parameters specified in (a) to (h) above; and(ii) An average of the dailyvalue-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. TheBasel 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 07CA-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 07Key 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 levelVaR estimate (so-called 'exceptions').October 07CA-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 zoneOctober 07CA-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 07CA-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 07CA-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 07CA-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 haveoption -like characteristics).October 07CA-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 07CA-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 givenvalue-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 riskexposure 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 07CA-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 07CA-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 itsexposures ).October 07CA-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 07CA-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 07CA-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 ofoptions 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. comparingvalue-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 07CA-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 07CA-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 07CA-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 07CA-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 07CA-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 07CA-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 andcommodity prices, with relatedoptions 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 07CA-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 07CA-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. theexposure 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 07CA-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 07CA-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 07CA-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 anddefault 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 07CA-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 thevalue-at-risk measure which should be isolated26; or, at the bank's option,(b) Thevalue-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 aswap 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 invalue-at-risk arising from the modelling of specific risk factors;• Using the difference between thevalue-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 07CA-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 07CA-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 07CA-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 Bahrain retail bank
branches of foreign banks.October 07Measurement
CA-10.1.2
The Gearing ratio is measured with reference to the ratio of
deposit liabilities against the bank's capital and reserves as reported in its PIR.October 07Gearing limit
CA-10.1.3
For Retail Bank and Wholesale Bank licensees,
deposit liabilities should not exceed 20 times the respective bank's capital and reserves.October 07