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.

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:

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.

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:

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.

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.

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:

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:

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

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.

CA-14.11.4B

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

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.

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".

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.

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.

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:

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.

CA-14.11.10

For a bank to apply this exception, it must:

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.

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.