CA-7.1.1

The framework outlined below presents two methods for calculating operational risk capital charges in a continuum of increasing sophistication and risk sensitivity:

CA-7.1.2

Banks are encouraged to move towards standardised approach as they develop more sophisticated operational risk measurement systems and practices.

CA-7.1.3

A bank will not be allowed to choose to revert to basic indicator approach once it has been approved for standardised approach without CBB's approval. However, if CBB determines that a bank using standardised approach no longer meets the qualifying criteria for standardised approach, it may require the bank to revert to basic indicator approach for some or all of its operations, until it meets the conditions specified by the CBB for returning to standardised approach.

Basic Indicator Approach

The Standardised Approach

CA-8.1.1

The following definition of the trading book replaces the previous definition. Chapters CA-9 to CA-14 deal with market risk rules.

CA-8.1.2

A trading book consists of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book. To be eligible for trading book capital treatment, financial instruments must either be free of any restrictive covenants on their tradability or able to be hedged completely. In addition, positions should be frequently and accurately valued, and the portfolio should be actively managed (at the present time, open equity stakes in hedge funds, private equity investments, positions in a securitisation warehouse and real estate holdings do not meet the definition of the trading book, owing to significant constraints on the ability of banks to liquidate these positions and value them reliably on a daily basis. Such holdings must therefore be held in the bank's banking book and treated as equity holding in corporates, except real estates which should be treated as per CA-3.2.29).

CA-8.1.3

A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments include both primary financial instruments (or cash instruments) and derivative financial instruments. A financial asset is any asset that is cash, the right to receive cash or another financial asset; or the contractual right to exchange financial assets on potentially favourable terms, or an equity instrument. A financial liability is the contractual obligation to deliver cash or another financial asset or to exchange financial liabilities under conditions that are potentially unfavourable.

CA-8.1.4

Positions held with trading intent are those held intentionally for short-term resale and/or with the intent of benefiting from actual or expected short-term price movements or to lock in arbitrage profits, and may include for example proprietary positions, positions arising from client servicing (e.g. matched principal broking) and market making. It is therefore possible that banks may sometimes not have a trading book as defined above. Nonetheless the bank's strategy and business plan must take account of the requirements of this Chapter in case a bank does take on positions with trading intent.

CA-8.1.5

Banks must have clearly defined policies and procedures for determining which exposures to include in, and to exclude from, the trading book for purposes of calculating their regulatory capital, to ensure compliance with the criteria for trading book set forth in this Section and taking into account the bank's risk management capabilities and practices. Compliance with these policies and procedures must be fully documented and subject to periodic internal audit.

CA-8.1.6

These policies and procedures must, at a minimum, address the following general considerations:

The list above is not intended to provide a series of tests that a product or group of related products must pass to be eligible for inclusion in the trading book. Rather, the list provides a minimum set of key points that must be addressed by the policies and procedures for overall management of a firm's trading book.

CA-8.1.7

The following will be the basic requirements for positions eligible to receive trading book capital treatment:

CA-8.1.8

When a bank hedges a banking book credit risk exposure using a credit derivative booked in its trading book (i.e. using an internal hedge), the banking book exposure is not deemed to be hedged for capital purposes unless the bank purchases from an eligible third party protection provider a credit derivative meeting the requirements of paragraph CA-4.5.3 vis-à-vis the banking book exposure. Where such third party protection is purchased and is recognised as a hedge of a banking book exposure for regulatory capital purposes, neither the internal nor external credit derivative hedge would be included in the trading book for regulatory capital purposes.

CA-8.1.9

Term trading-related repo-style transactions that a bank accounts for in its banking book may be included in the bank's trading book for regulatory capital purposes so long as all such repo-style transactions are included. For this purpose, trading-related repo-style transactions are defined as only those that meet the requirements of Paragraphs CA-8.1.4 and CA-8.1.7 and both legs are in the form of either cash or securities includable in the trading book.

CA-8.1.10

Regardless of where they are booked, all repo-style transactions are subject to a banking book counterparty credit risk charge.

CA-8.1.11

For the purposes of this framework, the correlation trading portfolio incorporates securitisation exposures and n-th-to-default credit derivatives that meet the following criteria:

Positions which reference an underlying that would be treated as a retail exposure, a residential mortgage exposure or a commercial mortgage exposure under the standardised approach to credit risk are not included in the correlation trading portfolio. Positions which reference a claim on a special purpose entity are not included either. A bank may also include in the correlation trading portfolio positions that hedge the positions described above and which are neither securitisation exposures nor n-th-to-default credit derivatives and where a liquid two-way market as described above exists for the instrument or its underlyings.

CA-8.2.1

This section provides banks with guidance on prudent valuation for positions in the trading book. This guidance is especially important for less liquid positions which, although they will not be excluded from the trading book solely on grounds of lesser liquidity, raise CBB's concerns about prudent valuation.

CA-8.2.2

A framework for prudent valuation practices should at a minimum include the following:

Systems and Controls

Valuation Adjustments or Reserves

CA-8.3.1

Banks must calculate the counterparty credit risk charge for OTC derivatives, repo-style and other transactions booked in the trading book, separate from the capital charge for general market risk and specific risk.⁶² The risk weights to be used in this calculation must be consistent with those used for calculating the capital requirements in the banking book. Thus, banks applying the standardised approach in the banking book will use the standardised approach risk weights in the trading book and banks applying the IRB approach in the banking book will use the IRB risk weights in the trading book in a manner consistent with the IRB roll out situation in the banking book as described in Paragraphs CA-5.2.28 to CA-5.2.31. For counterparties included in portfolios where the IRB approach is being used the IRB risk weights will have to be applied. The 50% cap on risk weights for OTC derivative transactions is abolished.

⁶² The treatment for unsettled foreign exchange and securities trades is set forth in Paragraph CA-3.3.13.

CA-8.3.2

In the trading book, for repo-style transactions, all instruments, which are included in the trading book, may be used as eligible collateral. Those instruments which fall outside the banking book definition of eligible collateral shall be subject to a haircut at the level applicable to non-main index equities listed on recognised exchanges (as noted in Paragraph CA-4.3.7. Where banks are applying a VaR approach to measuring exposure for repo-style transactions, they also may apply this approach in the trading book in accordance with Paragraphs CA-4.3.22 to CA-4.3.25 and Appendix CA-2.

CA-8.3.3

The calculation of the counterparty credit risk charge for collateralised OTC derivative transactions is the same as the rules prescribed for such transactions booked in the banking book.

CA-8.3.4

The calculation of the counterparty charge for repo-style transactions will be conducted using the rules in Paragraphs CA-4.3.3 to CA-4.3.25 and Appendix CA-2 spelt out for such transactions booked in the banking book. The firm-size adjustment for SMEs as set out in Paragraph CA-5.3.4 shall also be applicable in the trading book.

Credit Derivatives

CA-9.1.1

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 includes exposure arising from interest-bearing and discounted financial instruments, derivatives which are based on the movement of interest rates, foreign exchange forwards, and interest rate exposure embedded in derivatives which are based on non-interest rate related instruments.

CA-9.1.2

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:

⁶³See Section CA-10.1 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.

⁶⁴Traded 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 mortgage securities and mortgage derivative products should discuss their proposed treatment with the CBB and obtain the CBB's prior written approval for it.

CA-9.1.3

A security which is the subject of a repurchase or securities lending agreement will be treated as if it were still owned by the lender of the security, i.e., it will be treated in the same manner as other securities positions.

CA-9.1.4

The minimum capital requirement is expressed in terms of two separately calculated charges, one applying to the "specific risk" of each security, whether it is a short or a long position, and the other to the interest rate risk in the portfolio (termed "general market risk") where long and short positions in different securities or instruments can be offset. The bank must, however, determine the specific risk capital charge for the correlation trading portfolio as follows: The bank computes (i) the total specific risk capital charges that would apply just to the net long positions from the net long correlation trading exposures combined, and (ii) the total specific risk capital charges that would apply just to the net short positions from the net short correlation trading exposures combined. The larger of these total amounts is then the specific risk capital charge for the correlation trading portfolio.

CA-9.1.4A

During a transitional period until 31 December 2013, the bank may exclude positions in securitisation instruments which are not included in the correlation trading portfolio from the calculation according to Paragraph CA-9.1.4 and determine the specific risk capital charge as follows: The bank computes (i) the total specific risk capital charge that would apply just to the net long positions in securitisation instruments in the trading book, and (ii) the total specific risk capital charge that would apply just to the net short positions in securitisation instruments in the trading book. The larger of these total amounts is then specific risk capital charge for the securitisation positions in the trading book. This calculation must be undertaken separately from the calculation for the correlation trading portfolio.

CA-9.1.5

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 the yield curve, as well as the difficulty of constructing perfect hedges.

CA-9.1.6

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 must 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 judgment.

CA-9.1.7

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 CBB for those models. The CBB's detailed rules for the recognition and use of internal models are included in chapter CA-14. 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.

CA-9.2.1

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.

CA-9.2.2

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.

CA-9.2.3

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 broad categories:

CA-9.2.4

When the government paper is denominated in the domestic currency and funded by the bank in the same currency, a 0% specific risk charge may be applied.

CA-9.2.5

Central "government" debt instruments will include all forms of government paper, including bonds, treasury bills and other short-term instruments.

CA-9.2.6

The CBB reserves the right to apply a specific risk weight to securities issued by certain foreign governments, especially to securities denominated in a currency other than that of the issuing government.

CA-9.2.7

The "qualifying" category includes securities issued by or fully guaranteed by public sector entities and multilateral development banks (refer to Paragraph CA-3.2.8), plus other securities that are:

Specific Risk Rules for Unrated Debt Securities

Specific Risk Rules for Non-qualifying Issuers

Specific Risk Rules for Positions Covered under the Securitisation Framework

Specific Risk Capital Charges for Positions Hedged by Credit Derivatives

CA-9.3.1

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:

CA-9.3.2

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.

CA-9.3.3

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.

CA-9.3.4

A combination of the two methods (referred to under Paragraph CA-9.3.1) is not permitted. Any exceptions to this rule will require the prior written approval of the CBB. It is expected that such approval will only be given in cases where a bank clearly demonstrates to the CBB, 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 CBB may, in future years, consider recognising the duration method as the approved method, and the use of the maturity method may be discontinued.

CA-9.4.1

A worked example of the maturity method is included in Appendix CA-11. The various time-bands and their risk weights, relevant to the maturity method, are illustrated in Paragraph CA-9.4.2(a) below.

CA-9.4.2

The steps in the calculation of the general market risk for interest rate positions, under this method, are set out below:

Maturity Method: Time-bands and Risk Weights

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.

CA-9.5.1

The duration method is an alternative approach to measuring the exposure to parallel and non-parallel shifts in the yield 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 rate exposures including derivatives. A worked example of the duration method is included in Appendix CA-12. The various time-bands and assumed changes in yield, relevant to the duration method, are illustrated below.

Duration Method: Time-bands and Assumed Changes in Yield

CA-9.5.2

Banks must notify the CBB 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-9.3.

CA-9.5.3

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 must seek the advice of the CBB or obtain approval for application of the maturity method to the specific category(ies) of instruments, in accordance with the provisions of Section CA-9.3.

CA-9.5.4

The steps in the calculation of the general market risk for interest rate positions, under this method, are set out below:

(b) The bank will calculate, for each debt instrument, the modified duration (M) on the basis of the following formula:


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

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.

CA-9.6.1

Banks which propose to use internal models to measure the interest rate risk inherent in derivatives will seek the prior written approval of the CBB for applying those models. The use of internal models to measure market risk, and the CBB's rules applicable to them, are discussed in detail in chapter CA-14.

CA-9.6.2

Where a bank, with the prior written approval of the CBB, 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-9.5.

CA-9.6.3

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 rate derivatives 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-currency swaps, options and forward foreign exchange contracts). Where a bank has obtained the approval of the CBB for the use of non-interest rate derivatives models, the embedded interest rate exposures should be incorporated in the standardised measurement framework described in Sections CA-9.7 to CA-9.9.

CA-9.6.4

Derivative positions will attract specific risk only when they are based on an underlying instrument or security. For instance, where the underlying exposure is an interest rate exposure, as in a swap based upon inter-bank rates, there will be no specific risk, but only counterparty risk. A similar treatment applies to FRAs, forward foreign exchange contracts and interest rate futures. However, for a swap based on a bond yield, or a futures contract based on a debt security or an index representing a basket of debt securities, the credit risk of the issuer of the underlying bond will generate a specific risk capital requirement. Future cash flows derived from positions in derivatives will generate counterparty risk requirements related to the counterparty in the trade, in addition to position risk requirements (specific and general market risk) related to the underlying security.

CA-9.6.5

A summary of the rules for dealing with interest rate derivatives (other than options) is set out in Section CA-9.9. The treatment of options, being a complex issue, is dealt with in detail in chapter CA-13.

CA-9.7.1

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-9.2 and CA-9.3, 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 must use the latter.

CA-9.7.2

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 CBB in writing.

Forward Foreign Exchange Contracts

Deposit Futures and FRAs

Bond futures and Forward Bond Transactions

Swaps

Permissible Offsetting of Fully Matched Positions for Both Specific and General Market Risk

Permissible Offsetting of Closely Matched Positions for General Market Risk Only

CA-9.9.1

After calculating the derivatives positions, taking account of the permissible offsetting of matched positions, as explained in Section CA-9.8, the capital charges for specific and general market risk for interest rate derivatives are calculated in the same manner as for cash positions, as described earlier in this chapter.

Summary of Treatment of Interest Rate Derivatives

CA-10.1.1

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.

CA-10.1.2

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:

CA-10.1.3

Convertible debt securities must be treated as equities where:

In other instances, convertibles should be treated as either equity or debt securities, based reasonably on their market behaviour.

CA-10.1.4

For instruments that deviate from the structures described in Paragraphs CA-10.1.2 and CA-10.1.3 above, or which could be considered complex, each bank must agree on a written policy statement with the CBB 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 CBB in cases of doubt, particularly when a bank is trading an instrument for the first time.

CA-10.1.5

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 currency exposure from the other leg of the contract should be included in the measurement framework as described in chapters CA-9 and CA-11, respectively.

CA-10.1.6

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.

CA-10.1.7

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 CBB for those models. The CBB's detailed rules for the recognition and use of internal models are included in chapter CA-14. 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.

CA-10.2.1

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-9.

CA-10.2.2

A bank may net long and short positions in one tranche of an equity instrument against another tranche only where the relevant tranches:

CA-10.2.3

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-11.

CA-10.2.4

More detailed guidance on the treatment of equity derivatives is set out in Section CA-10.5.

CA-10.2.5

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 must discuss the appropriate country allocation with the CBB.

CA-10.3.1

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-10.2, irrespective of whether they are long or short positions, to produce the overall gross equity position for that market.

CA-10.3.2

The capital charge for specific risk is 8%.

CA-10.4.1

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 must sum the market value of its individual net positions for each national market, as determined in accordance with Section CA-10.2, taking into account whether the positions are long or short.

CA-10.4.2

The general market equity risk measure is 8% of the overall net position in each national market.

CA-10.5.1

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 and swaps on both individual equities and on stock indices.

CA-10.5.2

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 CBB:

CA-10.5.3

A summary of the treatment of equity derivatives is set out in Paragraph CA-10.5.8.

Specific Risk on Positions in Equity Indices

Counterparty Risk

CA-11.1.1

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.

CA-11.1.2

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 gold⁶⁸ and, as a second step, the measurement of the risks inherent in the bank's mix of long and short positions in different currencies.

⁶⁸ 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.

CA-11.1.3

The open positions and the capital requirements are calculated with reference to the entire business, i.e. the banking and trading books combined.

CA-11.1.4

The open positions are calculated with reference to the bank's base currency, which will be either BD or US$.

CA-11.1.5

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 CBB for those models. The CBB's detailed rules for the recognition and use of internal models are included in chapter CA-14. Banks which do not use internal models should adopt the standardised approach, as set out in detail in this chapter.

CA-11.1.6

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.

CA-11.1.7

For the purposes of calculating "Foreign Exchange Risk" only, positions in those GCC currencies which are pegged to US$, will be treated as positions in US$.

CA-11.2.1

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 CBB evidenced by the CBB's prior written approval, be exempted from calculating the capital requirements on these positions. The CBB is likely to be guided by the following criteria in deciding to grant exemption to any bank:

CA-11.2.2

The criteria listed in Paragraph CA-11.2.1 above are only intended to be guidelines, and a bank will not automatically qualify for exemptions upon meeting them. The CBB 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.

CA-11.2.3

The CBB may, at a future date, revoke an exemption previously granted to a bank, if the CBB is convinced that the conditions on which the exemption was granted no longer exist.

CA-11.3.1

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:

CA-11.3.2

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.

CA-11.3.3

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.

CA-11.3.4

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.

CA-11.3.5

Forward currency and gold positions should be valued at current spot market exchange rates. Applying forward exchange rates is inappropriate as it will result in the measured positions reflecting current interest rate differentials, to some extent.

CA-11.3.6

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-9 or Section CA-11.1 above, respectively.

Structural Positions

Derivatives

CA-11.4.1

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:

CA-11.4.2

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 that branch/subsidiary, in each currency, may be used as a proxy for the positions. The branch/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 must adequately monitor the actual positions of the branch/subsidiary against the limits, and revise the limits, if necessary, based on the results of the ex-post monitoring.

CA-11.5.1

The capital charge is 8% of the overall net open position.

CA-11.5.2

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

CA-12.1.1

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-11).

CA-12.1.2

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.

CA-12.1.3

The price risk in commodities 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, of commodities, can make price transparency and the effective hedging of risks more difficult.

CA-12.1.4

For spot or physical trading, the directional risk arising from a change in the spot price is the most important risk. However, banks applying 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:

CA-12.1.5

The capital charges for commodities risk envisaged by the rules within this chapter are intended to cover the risks identified in Paragraph CA-12.1.4. In addition, however, banks face credit counterparty risk on over-the-counter derivatives, which must be incorporated into their credit risk capital requirements. Furthermore, the funding of commodities 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-9 and CA-11, respectively.⁶⁹

⁶⁹ 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 CA-9 and CA-11, 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.

CA-12.1.6

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 CBB for those models. The CBB's detailed rules for the recognition and use of internal models are included in chapter CA-14. 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-12.1.4. 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.

CA-12.1.7

Banks which do not propose to use internal models should adopt either the maturity ladder approach or the simplified approach to calculate their commodities risk and the resultant capital charges. Both these approaches are described in Sections CA-12.3 and CA-12.4, respectively.

Netting

Derivatives

CA-12.3.1

A worked example of the maturity ladder approach is set out in Appendix CA-13 and the table in Paragraph CA-12.3.2 illustrates the maturity time-bands of the maturity ladder for each commodity.

CA-12.3.2

The steps in the calculation of the commodities risk by the maturity ladder approach are:

⁷² 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.

CA-12.4.1

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 in commodities are calculated as explained in Section CA-12.2.

CA-12.4.2

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 in commodity derivatives for this purpose, banks must use the current spot price.

CA-13.1.1

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 CBB has decided that the following approaches should be adopted to the measurement of options risks:

CA-13.1.2

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 CBB will monitor the banks' options trading activities, and the adequacy of the risk measurement framework adopted.

CA-13.1.3

Where written option positions are hedged by perfectly matched long positions in exactly the same options, no capital charge for market risk is required in respect of those matched positions.

CA-13.2.1

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 and commodities as described in chapters CA-9, CA-10, CA-11 and CA-12 respectively.

CA-13.2.2

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 x 16%⁷³] minus [($ 11 - $ 10)⁷⁴ x 100] = $ 60

A similar methodology applies to options whose underlying is a foreign currency, an interest rate related instrument or a commodity.

Simplified Approach: Capital Charges

⁷³ 8% specific risk plus 8% general market risk.

⁷⁴ The amount the option is "in the money".

⁷⁵ 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.

⁷⁶ 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-9 for the relevant capital charges), and in the case of options on equities and stock indices (see chapter CA-10 for the relevant capital charges). The capital charge for currency options is 8% and for options on commodities is 15%.

⁷⁷ 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.

⁷⁸ 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.

CA-13.3.1

Banks which write options are allowed to include delta-weighted option positions within the standardised methodology set out in chapters CA-9 through CA-12. Each option 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 CBB to review such models, if considered necessary. A worked example of the delta-plus method is set out in Appendix CA-14.

CA-13.3.2

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 an option 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 proprietary options pricing model, with appropriate documentation of the process and controls, to enable the CBB to review such models, if considered necessary.

Treatment of Delta

Where the Underlying is a Debt Security or an Interest Rate

Where the Underlying is an Equity Instrument

Options on Foreign Exchange and Gold Positions

Options on Commodities

Calculation of the Gamma and Vega Buffers

CA-13.4.1

As stated in Section CA-13.1, banks which have a significant level of options trading activities, or have complex options trading strategies, are expected to use more sophisticated methods for measuring and monitoring the options risks. Banks with the appropriate capability will be permitted, with the prior approval of the CBB, to base the market risk capital charge for options portfolios and associated hedging positions on scenario matrix analysis. Before giving its approval, the CBB 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-14 which are appropriate given the nature of the business.

CA-13.4.2

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 the option portfolio at various points along this "grid" or "matrix". For the purpose of calculating the capital charge, the bank will revalue the option portfolio using matrices for simultaneous changes in the option'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-13.3 above. As an alternative, in respect of interest rate options, banks which are significant traders in such options are permitted to base the calculation on a minimum of six sets of time- bands. When applying this alternative method, not more than three of the time-bands as defined in chapter CA-9 should be combined into any one set.

CA-13.4.3

The first dimension of the matrix involves a specified range of changes in the option's underlying rate or price. The CBB has set the range, for each risk category, as follows:

For all risk categories, at least seven observations (including the current observation) should be used to divide the range into equally spaced intervals.

CA-13.4.4

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.

CA-13.4.5

The CBB 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-13.4.10 to CA-13.4.12).

CA-13.4.6

After calculating the matrix, each cell contains the net profit or loss of the option and the underlying hedge instrument. The general market risk capital charge for each underlying is then calculated as the largest loss contained in the matrix.

CA-13.4.7

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-9 through CA-12.

CA-13.4.8

To summarise, capital requirements for, say OTC options, applying the scenario approach are as follows:

CA-13.4.9

Banks doing business in certain classes of complex exotic options (e.g. barrier options involving discontinuities in deltas etc.), or in options 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 CBB 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.

CA-13.4.10

In drawing up the delta-plus and the scenario approaches, the CBB'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-13.4.7 and CA-13.4.11). The CBB 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.

CA-13.4.11

In addition to the options risks described earlier in this chapter, the CBB is conscious of the other risks also associated with options, e.g., rho or interest rate risk (the rate of change of the value of the option with respect to the interest rate) and theta (the rate of change of the value of the option with respect to time). While not proposing a measurement system for those risks at present, the CBB expects banks undertaking significant options 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.

CA-13.4.12

The CBB will closely review the treatment of options for the calculation of market risk capital charges, particularly in the light of the aspects described in Paragraphs CA-13.4.10 and CA-13.4.11.

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.

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:

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.

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).

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.

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.

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:

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:

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:

CA-14.5.1

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

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.

Key Requirements

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.

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).

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.

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:

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.

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).

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.

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.

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.

CA-14.8.3

The validation of the models by the external auditors should include, at a minimum, the following steps:

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.

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.

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.

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.

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.

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.

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.

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:

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.

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.

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:

IRC-covered Positions and Risks

Key Supervisory Parameters for Computing IRC

CA-15.1.1

The content of this Chapter is applicable to all locally incorporated banks and retail bank branches of foreign banks.

CA-15.1.2

The Gearing ratio is measured with reference to the ratio of deposit liabilities against the bank's capital and reserves as reported in the PIR.

CA-15.1.3

For retail and wholesale bank licensees, deposit liabilities should not exceed 20 times the respective bank's capital and reserves.

CA-16.1.1

This Section provides banks with guidance on prudent valuation for positions that are accounted for at fair value, whether they are in the trading book or in the banking book. This guidance is especially important for positions without actual market prices or observable inputs to valuation, as well as less liquid positions which, although they will not be excluded from the trading book solely on grounds of lesser liquidity, raise supervisory concerns about prudent valuation. The valuation guidance set forth below is not intended to require banks to change valuation procedures for financial reporting purposes. The CBB will assess a bank's valuation procedures for consistency with this guidance. One factor in the CBB's assessment of whether a bank must take a valuation adjustment for regulatory purposes under Paragraphs CA-16.1.11A to CA-16.1.13 is the degree of consistency between the bank's valuation procedures and these guidelines.

CA-16.1.2

A framework for prudent valuation practices must at a minimum include the following:

Systems and Controls

Valuation Methodologies

Valuation Adjustments

Adjustment to the Current Valuation of Less Liquid Positions for Regulatory Capital Purposes