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  • CA-14 CA-14 Market Risk — Use of Internal Models

    • CA-14.1 CA-14.1 Introduction

      • CA-14.1.1

        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-9 through CA-13), and subject to the explicit prior approval of the CBB, banks will be allowed to use risk measures derived from their own internal models.

        Apr 08

      • CA-14.1.2

        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.
        Amended: April 2011
        Apr 08

      • CA-14.1.3

        The standardised methodology, described in chapters CA-9 through CA-13, uses a "building-block" approach in which the specific risk and the general market risk arising from debt and equity positions are calculated separately. The focus of most internal models is a bank's general market risk exposure, typically leaving specific risk (i.e., exposures to specific issuers of debt securities and equities) to be measured largely through separate credit risk measurement systems. Banks applying 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-14.10.

        Amended: January 2012
        Apr 08

      • CA-14.1.4

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

        Apr 08

      • CA-14.1.5

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

        Apr 08

      • CA-14.1.6

        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.

        Apr 08

    • CA-14.2 CA-14.2 General Criteria

      • CA-14.2.1

        The CBB 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 CBB'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 CBB's judgement, a proven track record of reasonable accuracy in measuring risk. The CBB 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 CBB, 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-14.7 and conducts back-testing as described in Section CA-14.6.
        Amended: January 2012
        Amended: April 2011
        Apr 08

    • CA-14.3 CA-14.3 Qualitative Standards

      • CA-14.3.1

        In order to ensure that banks using models have market risk management systems that are conceptually sound and implemented with integrity, the CBB has set the following qualitative criteria that banks are required to meet before they are permitted to use the models-based approach for calculating capital charge. Apart from influencing the CBB'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 CBB will set the multiplication factor for that bank, referred to in Section CA-14.5. Only those banks whose models, in the CBB's judgement, are in full compliance with the qualitative criteria will be eligible for application of the minimum multiplication factor of 3. The qualitative criteria include the following:

        (a) The bank should have an independent risk management unit that is responsible for the design and implementation of the bank's risk management system. The unit should produce and analyse daily reports on the output of the bank's risk measurement model, including an evaluation of the relationship between the measures of risk exposure and the trading limits. This unit must be independent from the business trading units and should report directly to the senior management of the bank;
        (b) The independent risk management unit should conduct a regular back-testing 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. See CA-14.5.1 (j);
        (c) The unit should also conduct the initial and on-going validation of the internal model. Further guidance on validation of internal models is given in Section CA-14.12;
        (d) 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 devoted. In this regard, the daily reports prepared by the independent risk management unit must be reviewed by a level of management with sufficient seniority and authority to enforce both reductions of positions taken by individual traders and reductions in the bank's overall risk exposure;
        (e) 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;
        (f) The risk measurement system should be used in conjunction with the internal trading and exposure limits. In this regard, the trading limits should be related to the bank's risk measurement model in a manner that is consistent over time and that is well-understood by both traders and senior management;
        (g) A routine and rigorous programme of stress testing, along the general lines set out in Section CA-14.6, should be in place as a supplement to the risk analysis based on the day-to-day output of the bank's risk measurement model. The results of stress testing should be reviewed periodically by senior management and should be reflected in the policies and limits set by management and the board of directors. Where stress tests reveal particular vulnerability to a given set of circumstances, prompt steps should be taken to manage those risks appropriately (e.g., by hedging against that outcome or reducing the size of the bank's exposures);
        (h) 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; and
        (i) 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:
        •   The adequacy of the documentation of the risk management system and process;
        •   The organisation of the risk management unit;
        •   The integration of market risk measures into daily risk management;
        •   The approval process for risk pricing models and valuation systems used by front- and back-office personnel;
        •   The validation of any significant changes in the risk measurement process;
        •   The scope of market risks captured by the risk measurement model;
        •   The integrity of the management information system;
        •   The accuracy and completeness of position data;
        •   The verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources;
        •   The accuracy and appropriateness of volatility and correlation assumptions;
        •   The accuracy of valuation and risk transformation calculations;
        •   The verification of the model's accuracy through frequent back-testing as described in (b) above and in the Appendix 15.
        Amended: January 2012
        Amended: April 2011
        Apr 08

    • CA-14.4 CA-14.4 Specification of Market Risk Factors

      • CA-14.4.1

        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 CBB'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 CBB. The CBB 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) Factors that are deemed relevant for pricing should be included as risk factors in the value-at-risk model. Where a risk factor is incorporated in a pricing model but not in the value-at-risk model, the bank must justify this omission to the satisfaction of the CBB. In addition, the value-at-risk model must capture nonlinearities for options and other relevant products (e.g. mortgage backed securities, tranched exposures or n-th-to-default credit derivatives), as well as correlation risk and basis risk (e.g. between credit default swaps and bonds). Moreover, the CBB has to be satisfied that proxies are used which show a good track record for the actual position held (i.e. an equity index for a position in an individual stock).
        (b) For interest rates:
        •   There should be a set of risk factors corresponding to interest rates in each currency in which the bank has interest-rate-sensitive on- or off-balance-sheet positions.
        •   The risk measurement system should model the yield curve using one of a number of generally accepted approaches, for example, by estimating forward rates of zero coupon yields. The yield curve should be divided into various maturity segments in order to capture variation in the volatility of rates along the yield curve; there will typically be one risk factor corresponding to each maturity segment. For material exposures to interest rate movements in the major currencies and markets, banks must model the yield curve using a minimum of six factors. However, the number of risk factors used should ultimately be driven by the nature of the bank's trading strategies. For instance, a bank which has a portfolio of various types of securities across many points of the yield curve and which engages in complex arbitrage strategies would require a greater number of risk factors to capture interest rate risk accurately.
        •   The risk measurement system must incorporate separate risk factors to capture spread risk (e.g. between bonds and swaps). A variety of approaches may be used to capture the spread risk arising from less than perfectly correlated movements between government and other fixed-income interest rates, such as specifying a completely separate yield curve for non-government fixed-income instruments (for instance, swaps or municipal securities) or estimating the spread over government rates at various points along the yield curve.
        (c) For exchange rates (which includes gold):
        •   The risk measurement system should incorporate risk factors corresponding to the individual foreign currencies in which the bank's positions are denominated. Since the value-at-risk figure calculated by the risk measurement system will be expressed in the bank's reporting currency, any net position denominated in a currency other than the reporting currency will introduce a foreign exchange risk. Thus, there must be risk factors corresponding to the exchange rate between the reporting currency and each other currency in which the bank has a significant exposure.
        (d) For equity prices:
        •   There should be risk factors corresponding to each of the equity markets in which the bank holds significant positions.
        •   At a minimum, there should be a risk factor that is designed to capture market-wide movements in equity prices (e.g., a market index). Positions in individual securities or in sector indices may be expressed in "beta-equivalents" relative to this market-wide index.
        •   A somewhat more detailed approach would be to have risk factors corresponding to various sectors of the overall equity market (for instance, industry sectors or cyclical and non-cyclical sectors). As above, positions in individual stocks within each sector could be expressed in "beta-equivalents" relative to the sector index.
        •   The most extensive approach would be to have risk factors corresponding to the volatility of individual equity issues.
        •   The sophistication and nature of the modelling technique for a given market should correspond to the bank's exposure to the overall market as well as its concentration in individual equity issues in that market.
        (e) For commodity prices:
        •   There should be risk factors corresponding to each of the commodity markets in which the bank holds significant positions (also see Section CA-12.1).
        •   For banks with relatively limited positions in commodity-based instruments, a straight-forward specification of risk factors is acceptable. Such a specification would likely entail one risk factor for each commodity price to which the bank is exposed. In cases where the aggregate positions are reasonably small, it may be acceptable to use a single risk factor for a relatively broad sub-category of commodities (for instance, a single risk factor for all types of oil). However, banks which propose to use this simplified approach should obtain the prior written approval of the CBB.
        •   For more active trading, the model should also take account of variation in the "convenience yield" between derivatives positions such as forwards and swaps and cash positions in the commodity.
        Amended: January 2012
        Amended: April 2011
        Apr 08

    • CA-14.5 CA-14.5 Quantitative Standards

      • CA-14.5.1

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

        (a) "Value-at-risk" must be computed on a daily basis;
        (b) In calculating the value-at-risk, a 99th percentile, one-tailed confidence interval is to be used;
        (c) In calculating the value-at-risk, an instantaneous price shock equivalent to a 10-day movement in prices is to be used, i.e., the minimum "holding period" will be ten trading days. Banks may use value-at-risk numbers calculated according to shorter holding periods scaled up to ten days, for example, by the square root of time (for the treatment of options, also see (h) below). A bank using this approach must justify the reasonableness of its approach to the satisfaction of the CBB during the annual model review process preformed by the external auditor;
        (d) The minimum historical observation period (sample period) for calculating value-at-risk is one year. For banks which use a weighting scheme or other methods for the historical observation period, the "effective" observation period must be at least one year (i.e., the weighted average time lag of the individual observations cannot be less than 6 months), and the method results in a capital charge at least equivalent to a one year observation period.

        The CBB may, as an exceptional case, require a bank to calculate its value-at-risk applying a shorter observation period if, in the CBB's judgement, this is justified by a significant upsurge in price volatility;
        (e) Banks must update their data sets no less frequently than once every week and should also reassess them whenever market prices are subject to material changes. The updating process must be flexible enough to allow for more frequent updates;
        (f) No particular type of model is prescribed by the CBB. So long as each model used captures all the material risks run by the bank, as set out in Section CA-14.4, banks will be free to use models based, for example, on variance-covariance matrices, historical simulations, or Monte Carlo simulations;
        (g) Banks shall have discretion to recognise empirical correlations within broad risk categories (i.e., interest rates, exchange rates, equity prices and commodity prices, including related options volatilities in each risk factor category). Banks are not permitted to recognise empirical correlations across broad risk categories without the prior approval of the CBB. Banks may apply, on a case-by-case basis, for empirical correlations across broad risk categories to be recognised by the CBB, subject to its satisfaction with the soundness and integrity of the bank's system for measuring those correlations;
        (h) Banks' models must accurately capture the unique risks associated with options within each of the broad risk categories. The following criteria shall apply to the measurement of options risk:
        •  Banks' models must capture the non-linear price characteristics of options positions;
        •  Banks are expected to ultimately move towards the application of a full 10-day price shock to options positions or positions that display option-like characteristics. In the interim period, banks may adjust their capital measure for options risk through other methods, e.g., periodic simulations or stress testing;
        •  Each bank's risk measurement system must have a set of risk factors that captures the volatilities of the rates and prices underlying the option positions, i.e., vega risk. Banks with relatively large and/or complex options portfolios should have detailed specifications of the relevant volatilities. This means that banks must measure the volatilities of options positions broken down by different maturities.
        (i) In addition, a bank must calculate a 'stressed value-at-risk' measure. This measure is intended to replicate a value-at-risk calculation that would be generated on the bank's current portfolio if the relevant market factors were experiencing a period of stress; and should therefore be based on the 10-day, 99th percentile, one-tailed confidence interval value-at-risk measure of the current portfolio, with model inputs calibrated to historical data from a continuous 12-month period of significant financial stress relevant to the bank's portfolio. The period used must be approved by the CBB and regularly reviewed. As an example, for many portfolios, a 12-month period relating to significant losses in 2007/2008 would adequately reflect a period of such stress; although other periods relevant to the current portfolio must be considered by the bank.
        (j) As no particular model is prescribed under Paragraph (f) above, different techniques might need to be used to translate the model used for value-at-risk into one that delivers a stressed value-at-risk. For example, banks should consider applying anti-thetic data, or applying absolute rather than relative volatilities to deliver an appropriate stressed value-at-risk. The stressed value-at-risk should be calculated at least weekly.
        (k) Each bank must meet, on a daily basis, a capital requirement expressed as the sum of:
        •  The higher of (1) its previous day's value-at-risk number measured according to the parameters specified in this Section (VaRt-1); and (2) an average of the daily value-at-risk measures on each of the preceding sixty business days (VaRavg), multiplied by a multiplication factor (mc); plus.
        •  The higher of (1) its latest available stressed-value-at-risk number calculated according to (i) above (sVaRt-1); and (2) an average of the stressed value-at-risk numbers calculated according to (i) above over the preceding sixty business days (sVaRavg), multiplied by a multiplication factor (ms).
        Therefore, the capital requirement (c) is calculated according to the following formula:
        c =max {VaRt-1; mc · VaRavg} + max { sVaRt-1; ms · sVaRavg}
        (l) The multiplication factors mc and ms will be set by the CBB, separately for each individual bank, on the basis of the CBB's assessment of the quality of the bank's risk management system, subject to an absolute minimum of 3 for mc and an absolute minimum of 3 for ms. Banks must add to these factors set by the CBB, 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 back-testing. The back-testing results applicable for calculating the plus are based on value-at-risk only and not stressed value-at-risk. If the back-testing results are satisfactory and the bank meets all of the qualitative standards referred in Section CA-14.3 above, the plus factor could be zero. Appendix 15 presents in detail the approach to be followed for back-testing and the plus factor. Banks are expected to strictly comply with this approach; and
        (m) As stated earlier in Section CA-14.1, banks applying 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-14.10.
        Amended: January 2012
        Amended: April 2011
        Apr 08

    • CA-14.6 CA-14.6 Back-testing

      • CA-14.6.1

        The contents of this Section outline the key requirements as set out in Appendix 15. The appendix presents in detail the approach to be followed for back-testing by the banks.

        Amended: January 2012
        Apr 08

      • Key Requirements

        • CA-14.6.2

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

          Amended: January 2012
          Apr 08

        • CA-14.6.3

          Based on the number of exceptions identified from the back-testing 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; and
          (c) Red zone.
          Amended: April 2011
          Apr 08

        • CA-14.6.4

          The green zone corresponds to back-testing 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 back-testing result that almost certainly indicates a problem with a bank's risk model.

          Apr 08

        • CA-14.6.5

          The corresponding "scaling factors" applicable to banks falling into respective zones based on their back-testing results are shown in Table 2 of the Appendix 15.

          Apr 08

    • CA-14.7 CA-14.7 Stress Testing

      • CA-14.7.1

        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.

        Apr 08

      • CA-14.7.2

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

        Apr 08

      • CA-14.7.3

        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.

        Apr 08

      • CA-14.7.4

        Banks must combine the use of stress scenarios as advised under (a), (b) and (c) below by the CBB, with stress tests developed by the banks themselves to reflect their specific risk characteristics. The CBB 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 must have information on the largest losses experienced during the reporting period available for review by the CBB. 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 CBB with a picture of how many days of peak day losses would have been covered by a given value-at-risk estimate.
        (b) Scenarios requiring simulation by the bank:

        Banks must subject their portfolios to a series of simulated stress scenarios and provide the CBB with the results. These scenarios could include testing the current portfolio against past periods of significant disturbance, for example, the 9/11 attacks on the USA, the 1987 equity market crash, the Exchange Rate Mechanism crises of 1992 and 1993 or the fall in the international bond markets in the first quarter of 1994, the 1998 Russian financial crisis, the 2000 bursting of the technology stock bubble or the 2007/2008 sub-prime crisis, incorporating both the large price movements and the sharp reduction in liquidity associated with these events. A second type of scenario would evaluate the sensitivity of the bank's market risk exposure to changes in the assumptions about volatilities and correlations. Applying this test would require an evaluation of the historical range of variation for volatilities and correlations and evaluation of the bank's current positions against the extreme values of the historical range. Due consideration should be given to the sharp variation that, at times, has occurred in a matter of days in periods of significant market disturbance. For example, the above-mentioned situations 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 CBB under (a) and (b) above, each bank must 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 must provide the CBB 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.
        Amended: January 2012
        Amended: April 2011
        Apr 08

      • CA-14.7.5

        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.

        Apr 08

      • CA-14.7.6

        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 CBB would expect the bank to take prompt steps to manage those risks appropriately (e.g., by hedging against that outcome or reducing the size of its exposures).

        Apr 08

      • CA-14.7.7

        Banks must conduct, at least weekly, a set of pre-determined stress-tests for the correlation trading portfolio encompassing shocks to default rates, recovery rates, credit spreads, and correlations. Appendix CA-19 provides guidance on the stress testing that must be undertaken to satisfy this requirement.

        Added: January 2012

    • CA-14.8 CA-14.8 External Validation of Models

      • CA-14.8.1

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

        Apr 08

      • CA-14.8.2

        The internal validation procedures to be carried out by the internal auditors are set out in Section CA-14.3. As stated in that Section, 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 CBB for its review.

        Amended: January 2012
        Apr 08

      • CA-14.8.3

        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-14.3 are operating satisfactorily;
        (b) Ensuring that the formulae used in the calculation process as well as for the pricing of options and other complex instruments are validated by a qualified unit, which in all cases should be independent from the trading area;
        (c) Checking and ensuring that the structure of the internal models is adequate with respect to the bank's activities and geographical coverage;
        (d) Checking the results of the bank's back-testing of its internal measurement system (i.e., comparing value-at-risk estimates with actual profits and losses) to ensure that the model provides a reliable measure of potential losses over time; and
        (e) Making sure that data flows and processes associated with the risk measurement system are transparent and accessible.
        Amended: January 2012
        Amended: April 2011
        Apr 08

      • CA-14.8.4

        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 CBB. The mandatory annual review by the external auditors shall be carried out during the third quarter of the calendar year, and the CBB expects to receive their final report by 30 September of 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 CBB promptly.

        Apr 08

      • CA-14.8.5

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

        Apr 08

    • CA-14.9 CA-14.9 Letter of Model Recognition

      • CA-14.9.1

        As stated in Section CA-14.1, 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 CBB. The CBB 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.

        Amended: January 2012
        Apr 08

      • CA-14.9.2

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

        Apr 08

      • CA-14.9.3

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

        Apr 08

    • CA-14.10 CA-14.10 Combination of Internal Models and the Standardised Methodology

      • CA-14.10.1

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

        Apr 08

      • CA-14.10.2

        A bank which has obtained the CBB'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 CBB withdraws its approval for the model(s), as explained in Section CA-14.9). 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 CBB after taking into account the relevant circumstances of the bank.

        Amended: January 2012
        Apr 08

      • CA-14.10.3

        Notwithstanding the goal of moving to comprehensive internal models as set out in Paragraph CA-14.10.1 above, for banks which, for the time being, will be applying a combination of internal models and the standardised methodology, the following conditions will apply:

        (a) Each broad risk factor category must be assessed by applying 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-A.4)80;
        (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 applying, without justifying to the CBB that they have a valid reason for doing so, and obtaining the CBB's prior written approval;
        (d) No element of market risk may escape measurement, i.e. the exposure for all the various risk factors, whether calculated according to the standardised approach or internal models, would have to be captured; and
        (e) The capital charges assessed under the standardised approach and under the models approach should be aggregated applying the simple sum method.

        80 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.

        Amended: January 2012
        Amended: April 2011
        Apr 08

    • CA-14.11 CA-14.11 Treatment of Specific Risk

      • CA-14.11.1

        Where a bank has a VaR measure that incorporates specific risk from equity risk positions and where the CBB has determined that the bank meets all the qualitative and quantitative requirements for general market risk models, as well as the additional criteria and requirements set out in Paragraphs CA-14.11.1 to CA-14.11.6 below, the bank is not required to subject its equity positions to the capital charge according to the standardised measurement method as specified in Paragraphs CA-10.1.1 to CA-10.5.7.

        Amended: January 2012
        Apr 08

      • CA-14.11.1A

        For interest rate risk positions other than securitisation exposures and n-th-to-default credit derivatives, the bank will not be required to subject these positions to the standardised capital charge for specific risk, as specified in Paragraphs CA-9.1.4 to CA-9.3.1, when all of the following conditions hold:

        (a) The bank has a value-at-risk measure that incorporates specific risk and the CBB has determined that the bank meets all the qualitative and quantitative requirements for general market risk models, as well as the additional criteria and requirements set out in Paragraphs CA-14.11.2 to CA-14.11.6 below; and
        (b) The CBB is satisfied that the bank's internally developed approach adequately captures incremental default and migration risks for positions subject to specific interest rate risk according to the standards laid out in Paragraphs CA-14.11.7 and CA-14.11.8 below.

        The bank is allowed to include its securitisation exposures and n-th-to-default credit derivatives in its value-at-risk measure. Notwithstanding, it is still required to hold additional capital for these products according to the standardised measurement methodology, with the exceptions noted in Paragraphs CA-14.11.9 to CA-14.11.12 below.

        Added: January 2012

      • CA-14.11.2

        The criteria for supervisory recognition of banks' modelling of specific risk require that a bank's model must capture all material components of price risk81 and be responsive to changes in market conditions and compositions of portfolios. In particular, the model must:

        (a) Explain the historical price variation in the portfolio82;
        (b) Demonstrably capture concentration (magnitude and changes in composition)83;
        (c) Be robust to an adverse environment84;
        (d) Capture name-related basis risk85;
        (e) Capture event risk86; and
        (f) Be validated through back-testing87 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.

        81 Banks need not capture default and migration risks for positions subject to the incremental risk capital charge referred to in Paragraphs CA-14.11.7 and CA-14.11.8.

        82 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 CBB to define an acceptable alternative measure which would meet this regulatory objective.

        83 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.

        84 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 model 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.

        85 Banks should be able to demonstrate that the model is sensitive to material idiosyncratic differences between similar but not identical positions, for example debt positions with different levels of subordination, maturity mismatches, or credit derivatives with different default events.

        86 For equity positions, events that are reflected in large changes or jumps in prices must be captured, e.g. merger break-ups/takeovers. In particular, firms must consider issues related to survivorship bias.

        87 Aimed at assessing whether specific risk, as well as general market risk, is being captured adequately.

        Amended: January 2012
        Amended: April 2011
        Apr 08

      • CA-14.11.3

        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-14.11.4. 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 back-testing. That is the equivalent of a scaling factor of four would apply to the estimate of specific risk until such time as a bank can demonstrate that the methodologies it uses adequately capture event and default risk. Once a bank is able to demonstrate this, the minimum multiplication factor of three can be applied. However, a higher multiplication factor of four on the modelling of specific risk would remain possible if future back-testing results were to indicate a serious deficiency in the model.

        Amended: January 2012
        Apr 08

      • CA-14.11.4

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

        (a) The specific risk portion of the value-at-risk measure which should be isolated84; or, at the bank's option; and
        (b) The value-at-risk measures of sub-portfolios of debt and equity positions that contain specific risk85.

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

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

        Equities:

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

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

        Bonds:

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

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

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

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

        Amended: April 2011
        Apr 08

      • CA-14.11.4A

        The bank's model must conservatively assess the risk arising from less liquid positions and/or positions with limited price transparency under realistic market scenarios. In addition, the model must meet minimum data standards. Proxies may be used only where available data is insufficient or is not reflective of the true volatility of a position or portfolio, and only where they are appropriately conservative.

        Added: January 2012

      • CA-14.11.4B

        Further, as techniques and best practices evolve, banks should avail themselves of theses advances.

        Added: January 2012

      • CA-14.11.5

        Banks which apply modelled estimates of specific risk are required to conduct back-testing aimed at assessing whether specific risk is being accurately captured. The methodology a bank must use for validating its specific risk estimates is to perform separate back-tests 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 back-testing purposes. Banks are required to commit to a sub-portfolio structure and stick to it unless it can be demonstrated to the CBB that it would make sense to change the structure.

        Apr 08

      • CA-14.11.6

        Banks are required to have in place a process to analyse exceptions identified through the back-testing 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 Zone86. 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 back-test showed, had not been adequately captured.

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

        Apr 08

      • CA-14.11.7

        In addition, the bank must have an approach in place to capture in its regulatory capital default risk and migration risk in positions subject to a capital charge for specific interest rate risk, with the exception of securitisation exposures and n-th-to-default credit derivatives, that are incremental to the risks captured by the VaR-based calculation as specified in Paragraph CA-14.11.2 above ("incremental risks"). No specific approach for capturing the incremental risks is prescribed. The Basel Committee provides guidelines to specify the positions and risks to be covered by this incremental risk capital charge which are incorporated in Section CA-14.13.

        Added: January 2012

      • CA-14.11.8

        The bank must demonstrate that the approach used to capture incremental risks meets a soundness standard comparable to that of the internal-ratings based approach for credit risk as set forth in this Framework, under the assumption of a constant level of risk, and adjusted where appropriate to reflect the impact of liquidity, concentrations, hedging, and optionality. A bank that does not capture the incremental risks through an internally developed approach must use the specific risk capital charges under the standardised measurement method as set out in Paragraphs CA-9.2.3 to CA-9.2.17 and CA-10.3.2.

        Added: January 2012

      • CA-14.11.9

        Subject to CBB approval, a bank may incorporate its correlation trading portfolio in an internally developed approach that adequately captures not only incremental default and migration risks, but all price risks ("comprehensive risk measure"). The value of such products is subject in particular to the following risks which must be adequately captured:

        (a) The cumulative risk arising from multiple defaults, including the ordering of defaults, in tranched products;
        (b) Credit spread risk, including the gamma and cross-gamma effects;
        (c) Volatility of implied correlations, including the cross effect between spreads and correlations;
        (d) Basis risk, including both
        (i) The basis between the spread of an index and those of its constituent single names; and
        (ii) The basis between the implied correlation of an index and that of bespoke portfolios;
        (e) Recovery rate volatility, as it relates to the propensity for recovery rates to affect tranche prices; and
        (f) To the extent the comprehensive risk measure incorporates benefits from dynamic hedging, the risk of hedge slippage and the potential costs of rebalancing such hedges.

        The approach must meet all of the requirements specified in Paragraphs CA-14.11.8, CA-14.11.10 and CA-14.11.11. This exception only applies to banks that are active in buying and selling these products. For the exposures that the bank does incorporate in this internally developed approach, the bank will be required to subject them to the capital charge for specific risk according to the standardised measurement method or the treatment according to Paragraph CA-14.11.8, as applicable. It must, however, incorporate them in both the value-at-risk and stressed value-at-risk measures.

        Added: January 2012

      • CA-14.11.10

        For a bank to apply this exception, it must:

        (a) Have sufficient market data to ensure that it fully captures the salient risks of these exposures in its comprehensive risk measure in accordance with the standards set forth above;
        (b) Demonstrate (for example, through backtesting) that its risk measures can appropriately explain the historical price variation of these products; and
        (c) Ensure that it can separate the positions for which it holds approval to incorporate them in its comprehensive risk measure from those positions for which it does not hold this approval.
        Added: January 2012

      • CA-14.11.11

        In addition to these data and modelling criteria, for a bank to apply this exception it must regularly apply a set of specific, predetermined stress scenarios to the portfolio that receives internal model regulatory capital treatment (i.e., the 'correlation trading portfolio'). These stress scenarios will examine the implications of stresses to (i) default rates, (ii) recovery rates, (iii) credit spreads, and (iv) correlations on the correlation trading desk's P&L. The bank must apply these stress scenarios at least weekly and report the results, including comparisons with the capital charges implied by the banks' internal model for estimating comprehensive risks, at least quarterly to the CBB. Any instances where the stress tests indicate a material shortfall of the comprehensive risk measure must be reported to the CBB in a timely manner. Based on these stress testing results, the CBB may impose a supplemental capital charge against the correlation trading portfolio, to be added to the bank's internally modelled capital requirement.

        Added: January 2012

      • CA-14.11.12

        A bank must calculate the incremental risk measure according to Paragraph CA-14.11.7 and the comprehensive risk measure according to Paragraph CA-14.11.9 at least weekly, or more frequently as directed by its supervisor. The capital charge for incremental risk is given by a scaling factor of 1.0 times the maximum of (i) the average of the incremental risk measures over 12 weeks; and (ii) the most recent incremental risk measure. Likewise, the capital charge for comprehensive risk is given by a scaling factor of 1.0 times the maximum of (i) the average of the comprehensive risk measures over 12 weeks; and (ii) the most recent comprehensive risk measure. Both capital charges are added up. There will be no adjustment for double counting between the comprehensive risk measure and any other risk measures.

        Added: January 2012

    • CA-14.12 CA-14.12 Model Validation Standards

      • CA-14.12.1

        It is important that banks have processes in place to ensure that their internal models have been adequately validated by suitably qualified parties independent of the development process to ensure that they are conceptually sound and adequately capture all material risks. This validation should be conducted when the model is initially developed and when any significant changes are made to the model. The validation should also be conducted on a periodic basis but especially where there have been any significant structural changes in the market or changes to the composition of the portfolio which might lead to the model no longer being adequate. More extensive model validation is particularly important where specific risk is also modelled and is required to meet the further specific risk criteria. As techniques and best practices evolve, banks must avail themselves of these advances. Model validation should not be limited to back-testing, but should, at a minimum, also include the following:

        (a) Tests to demonstrate that any assumptions made within the internal model are appropriate and do not underestimate risk. This may include the assumption of the normal distribution, the use of the square root of time to scale from a one day holding period to a 10 day holding period or where extrapolation or interpolation techniques are used, or pricing models;
        (b) Further to the regulatory back-testing programmes, testing for model validation must use hypothetical changes in portfolio value that would occur were end-of-day positions to remain unchanged. It therefore excludes fees, commissions, bid-ask spreads, net interest income and intra-day trading. Moreover, additional tests are required, which may include, for instance:
        (i) Testing carried out using hypothetical changes in portfolio value that would occur were end-of-day positions to remain unchanged. It therefore excludes fees, commissions, bid-ask spreads, net interest income and intra-day trading;
        (ii) Testing carried out for longer periods than required for the regular back-testing programme (e.g. 3 years). The longer time period generally improves the power of the back-testing. A longer time period may not be desirable if the VaR model or market conditions have changed to the extent that historical data is no longer relevant;
        (iii) Testing carried out using confidence intervals other than the 99 percent interval required under the quantitative standards;
        (iv) Testing of portfolios below the overall bank level;
        (c) The use of hypothetical portfolios to ensure that the model is able to account for particular structural features that may arise, for example:
        (i) Where data histories for a particular instrument do not meet the quantitative standards and where the bank has to map these positions to proxies, then the bank must ensure that the proxies produce conservative results under relevant market scenarios;
        (ii) Ensuring that material basis risks are adequately captured. This may include mismatches between long and short positions by maturity or by issuer;
        (iii) Ensuring that the model captures concentration risk that may arise in an undiversified portfolio.
        Amended: January 2012
        Apr 08

    • CA-14.13 CA-14.13 Principles for Calculating the Incremental Risk Charge (IRC)

      • IRC-covered Positions and Risks

        • CA-14.13.1

          According to Paragraph CA-14.11.7, the IRC encompasses all positions subject to a capital charge for specific interest rate risk according to the internal models approach to specific market risk but not subject to the treatment outlined in Paragraphs CA-9.2.11A, and CA-9.2.11B and C, regardless of their perceived liquidity.

          Added: January 2012

        • CA-14.13.2

          With CBB approval, a bank can choose consistently to include all listed equity and derivatives positions based on listed equity of a desk in its incremental risk model when such inclusion is consistent with how the bank internally measures and manages this risk at the trading desk level. If equity securities are included in the computation of incremental risk, default is deemed to occur if the related debt defaults (as defined in Paragraphs CA-5.8.63 and CA-5.8.64).

          Added: January 2012

        • CA-14.13.3

          However, when computing the IRC, a bank is not permitted to incorporate into its IRC model any securitisation positions, even when securitisation positions are viewed as hedging underlying credit instruments held in the trading account.

          Added: January 2012

        • CA-14.13.4

          For IRC-covered positions, the IRC captures:

          (a) Default risk. This means the potential for direct loss due to an obligor's default as well as the potential for indirect losses that may arise from a default event; and
          (b) Credit migration risk. This means the potential for direct loss due to an internal/external rating downgrade or upgrade as well as the potential for indirect losses that may arise from a credit migration event.
          Added: January 2012

      • Key Supervisory Parameters for Computing IRC

        • Soundness Standard Comparable to IRB

          • CA-14.13.5

            One of the underlying objectives of the IRB is to achieve broad consistency between capital charges for similar positions (adjusted for illiquidity) held in the banking and trading books. Since the Framework reflects a 99.9 percent soundness standard over a one-year capital horizon, the IRC is also described in these terms.

            Added: January 2012

          • CA-14.13.6

            Specifically, for all IRC-covered positions, a bank's IRC model must measure losses due to default and migration at the 99.9 percent confidence interval over a capital horizon of one year, taking into account the liquidity horizons applicable to individual trading positions or sets of positions. Losses caused by broader market-wide events affecting multiple issues/issuers are encompassed by this definition.

            Added: January 2012

          • CA-14.13.7

            As described immediately below, for each IRC-covered position the model must also capture the impact of rebalancing positions at the end of their liquidity horizons so as to achieve a constant level of risk over a one-year capital horizon. The model may incorporate correlation effects among the modeled risk factors, subject to validation standards set forth in Section III. The trading portfolio's IRC equals the IRC model's estimate of losses at the 99.9 percent confidence level.

            Added: January 2012

        • Constant Level of Risk over One-Year Capital Horizon

          • CA-14.13.8

            An IRC model must be based on the assumption of a constant level of risk over the one-year capital horizon88.

            88This assumption is consistent with the capital computations in the IRB Framework. In all cases (loans, derivatives and repos), the IRB Framework defines EAD in a way that reflects a roll-over of existing exposures when they mature.

            The combination of the constant level of risk assumption and the one-year capital horizon reflects supervisors' assessment of the appropriate capital needed to support the risk in the trading portfolio. It also reflects the importance to the financial markets of banks having the capital capacity to continue providing liquidity to the financial markets in spite of trading losses. Consistent with a "going concern" view of a bank, this assumption is appropriate because a bank must continue to take risks to support its income-producing activities. For regulatory capital adequacy purposes, it is not appropriate to assume that a bank would reduce its VaR to zero at a short-term horizon in reaction to large trading losses. It also is not appropriate to rely on the prospect that a bank could raise additional Tier 1 capital during stressed market conditions.

            Added: January 2012

          • CA-14.13.9

            This constant level of risk assumption implies that a bank rebalances, or rolls over, its trading positions over the one-year capital horizon in a manner that maintains the initial risk level, as indicated by a metric such as VaR or the profile of exposure by credit rating and concentration. This means incorporating the effect of replacing positions whose credit characteristics have improved or deteriorated over the liquidity horizon with positions that have risk characteristics equivalent to those that the original position had at the start of the liquidity horizon. The frequency of the assumed rebalancing must be governed by the liquidity horizon for a given position.

            Added: January 2012

          • CA-14.13.10

            Rebalancing positions does not imply, as the IRB approach for the banking book does, that the same positions will be maintained throughout the capital horizon. Particularly for more liquid and more highly rated positions, this provides a benefit relative to the treatment under the IRB framework. However, a bank may elect to use a one-year constant position assumption, as long as it does so consistently across all portfolios.

            Added: January 2012

        • Liquidity Horizon

          • CA-14.13.11

            Stressed credit market events have shown that market participants cannot assume that markets remain liquid under those conditions. Banks experienced significant illiquidity in a wide range of credit products held in the trading book, including leveraged loans. Under these circumstances, liquidity in many parts of the securitisation markets dried up, forcing banks to retain exposures in securitisation pipelines for prolonged periods of time. The CBB therefore expects banks to pay particular attention to the appropriate liquidity horizon assumptions within their IRC models.

            Added: January 2012

          • CA-14.13.12

            The liquidity horizon represents the time required to sell the position or to hedge all material risks covered by the IRC model in a stressed market. The liquidity horizon must be measured under conservative assumptions and should be sufficiently long that the act of selling or hedging, in itself, does not materially affect market prices. The determination of the appropriate liquidity horizon for a position or set of positions may take into account a bank's internal policies relating to, for example, prudent valuation (as per the prudent valuation guidance of Chapter CA-16), valuation adjustments89 and the management of stale positions.

            89 For establishing prudent valuation adjustments, see also Paragraphs CA-8.2.10 to CA-8.2.13.

            Added: January 2012

          • CA-14.13.13

            The liquidity horizon for a position or set of positions has a floor of three months.

            Added: January 2012

          • CA-14.13.14

            In general, within a given product type a non-investment-grade position is expected to have a longer assumed liquidity horizon than an investment-grade position. Conservative assumptions regarding the liquidity horizon for non-investment-grade positions are warranted until further evidence is gained regarding the market's liquidity during systematic and idiosyncratic stress situations. Banks also need to apply conservative liquidity horizon assumptions for products, regardless of rating, where secondary market liquidity is not deep, particularly during periods of financial market volatility and investor risk aversion. The application of prudent liquidity assumptions is particularly important for rapidly growing product classes that have not been tested in a downturn.

            Added: January 2012

          • CA-14.13.15

            A bank can assess liquidity by position or on an aggregated basis ("buckets"). If an aggregated basis is used (e.g. investment-grade European corporate exposures not part of a core CDS index), the aggregation criteria would be defined in a way that meaningfully reflect differences in liquidity.

            Added: January 2012

          • CA-14.13.16

            The liquidity horizon is expected to be greater for positions that are concentrated, reflecting the longer period needed to liquidate such positions. This longer liquidity horizon for concentrated positions is necessary to provide adequate capital against two types of concentration: issuer concentration and market concentration.

            Added: January 2012

        • Correlations and Diversification

          • (a) Correlations between Defaults and Migrations

            • CA-14.13.17

              Economic and financial dependence among obligors causes a clustering of default and migration events. Accordingly, the IRC charge includes the impact of correlations between default and migration events among obligors and a bank's IRC model must include the impact of such clustering of default and migration events.

              Added: January 2012

          • (b) Correlations between Default or Migration Risks and other Market Factors

            • CA-14.13.18

              The impact of diversification between default or migration risks in the trading book and other risks in the trading book is not currently well understood. Therefore, for the time being, the impact of diversification between default or migration events and other market variables would not be reflected in the computation of capital for incremental risk. This is consistent with the IRB Framework, which does not allow for the benefit of diversification when combining capital requirements for credit risk and market risk. Accordingly, the capital charge for incremental default and migration losses is added to the VaR-based capital charge for market risk.

              Added: January 2012

        • Concentration

          • CA-14.13.19

            A bank's IRC model must appropriately reflect issuer and market concentrations. Thus, other things being equal, a concentrated portfolio should attract a higher capital charge than a more granular portfolio (see also Paragraph CA-14.13.23). Concentrations that can arise within and across product classes under stressed conditions must also be reflected.

            Added: January 2012

        • Risk Mitigation and Diversification Effects

          • CA-14.13.20

            Within the IRC model, exposure amounts may be netted only when long and short positions refer to the same financial instrument. Otherwise, exposure amounts must be captured on a gross (i.e. non-netted) basis. Thus, hedging or diversification effects associated with long and short positions involving different instruments or different securities of the same obligor ("intra-obligor hedges"), as well as long and short positions in different issuers ("interobligor hedges"), may not be recognised through netting of exposure amounts. Rather, such effects may only be recognised by capturing and modelling separately the gross long and short positions in the different instruments or securities.

            Added: January 2012

          • CA-14.13.21

            Significant basis risks by product, seniority in the capital structure, internal or external rating, maturity, vintage for offsetting positions as well as differences between offsetting instruments, such as different payout triggers and procedures, should be reflected in the IRC model.

            Added: January 2012

          • CA-14.13.22

            If an instrument has a shorter maturity than the liquidity horizon or a maturity longer than the liquidity horizon is not contractually assured, the IRC must, where material, include the impact of potential risks that could occur during the interval between the maturity of the instrument and the liquidity horizon.

            Added: January 2012

          • CA-14.13.23

            For trading book risk positions that are typically hedged via dynamic hedging strategies, a rebalancing of the hedge within the liquidity horizon of the hedged position may also be recognised. Such recognition is only admissible if the bank (i) chooses to model rebalancing of the hedge consistently over the relevant set of trading book risk positions, (ii) demonstrates that the inclusion of rebalancing results in a better risk measurement, and (iii) demonstrates that the markets for the instruments serving as hedge are liquid enough to allow for this kind of rebalancing even during periods of stress. Any residual risks resulting from dynamic hedging strategies must be reflected in the capital charge. A bank must validate its approach to capture such residual risks to the satisfaction of the CBB.

            Added: January 2012

        • Optionality

          • CA-14.13.24

            The IRC model must reflect the impact of optionality. Accordingly, banks' models should include the nonlinear impact of options and other positions with material nonlinear behaviour with respect to price changes. The bank should also have due regard to the amount of model risk inherent in the valuation and estimation of price risks associated with such products.

            Added: January 2012

        • Validation

          • CA-14.13.25

            Banks must apply the validation principles (see Section CA-14.12) in designing, testing and maintaining their IRC models. This includes evaluating conceptual soundness, ongoing monitoring that includes process verification and benchmarking, and outcomes analysis. Some factors that should be considered in the validation process include:

            (a) Liquidity horizons should reflect actual practice and experience during periods of both systematic and idiosyncratic stresses;
            (b) The IRC model for measuring default and migration risks over the liquidity horizon should take into account objective data over the relevant horizon and include comparison of risk estimates for a rebalanced portfolio with that of a portfolio with fixed positions;
            (c) Correlation assumptions must be supported by analysis of objective data in a conceptually sound framework. If a bank uses a multi-period model to compute incremental risk, it should evaluate the implied annual correlations to ensure they are reasonable and in line with observed annual correlations. A bank must validate that its modelling approach for correlations is appropriate for its portfolio, including the choice and weights of its systematic risk factors. A bank must document its modelling approach so that its correlation and other modelling assumptions are transparent to the CBB;
            (d) Owing to the high confidence standard and long capital horizon of the IRC, robust direct validation of the IRC model through standard back-testing methods at the 99.9%/one-year soundness standard will not be possible. Accordingly, validation of an IRC model necessarily must rely more heavily on indirect methods including but not limited to stress tests, sensitivity analyses and scenario analyses, to assess its qualitative and quantitative reasonableness, particularly with regard to the model's treatment of concentrations. Given the nature of the IRC soundness standard such tests must not be limited to the range of events experienced historically. The validation of an IRC model represents an ongoing process in which the CBB and banks jointly determine the exact set of validation procedures to be employed; and
            (e) Banks should strive to develop relevant internal modelling benchmarks to assess the overall accuracy of their IRC models.
            Added: January 2012

        • Use of Internal Risk Measurement Models to Compute the IRC

          • CA-14.13.26

            As noted above, these guidelines do not prescribe any specific modelling approach for capturing incremental risk. Because a consensus does not yet exist with respect to measuring risk for potentially illiquid trading positions, it is anticipated that banks will develop different IRC modelling approaches.

            Added: January 2012

          • CA-14.13.27

            The approach that a bank uses to measure the IRC is subject to the "use test". Specifically, the approach must be consistent with the bank's internal risk management methodologies for identifying, measuring, and managing trading risks.

            Added: January 2012

          • CA-14.13.28

            Ideally, the supervisory principles set forth in this document would be incorporated within a bank's internal models for measuring trading book risks and assigning an internal capital charge to these risks. However, in practice a bank's internal approach for measuring trading book risks may not map directly into the above supervisory principles in terms of capital horizon, constant level of risk, rollover assumptions or other factors. In this case, the bank must demonstrate that the resulting internal capital charge would deliver a charge at least as high as the charge produced by a model that directly applies the supervisory principles.

            Added: January 2012