CA-14.13.5

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

CA-14.13.6

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

CA-14.13.7

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

CA-14.13.8

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

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

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

CA-14.13.9

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

CA-14.13.10

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

CA-14.13.11

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

CA-14.13.12

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

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

CA-14.13.13

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

CA-14.13.14

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

CA-14.13.15

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

CA-14.13.16

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

(a) Correlations between Defaults and Migrations

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

CA-14.13.19

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

CA-14.13.20

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

CA-14.13.21

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

CA-14.13.22

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

CA-14.13.23

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

CA-14.13.24

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

CA-14.13.25

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

CA-14.13.26

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

CA-14.13.27

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

CA-14.13.28

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