CA-14 CA-14 Market Risk — Use of Internal Models
CA-14.1 CA-14.1 Introduction
CA-14.1.1
As stated in Chapter CA-1, as an alternative to the standardised approach to the measurement of
market risks (which is described in Chapters CA-9 through CA-13), and subject to the explicit prior approval of the CBB,conventional bank licensees will be allowed to use risk measures derived from their own internal models.January 2015CA-14.1.2
This Chapter describes the seven sets of conditions that should be met before a
conventional bank licensee is allowed to-use the internal models approach, namely:(a) General criteria regarding the adequacy of the risk management system;(b) Qualitative standards for internal oversight of the use of models, notably by senior management;(c) Guidelines for specifying an appropriate set ofmarket risk factors (i.e., the market rates and prices that affect the value of aconventional bank licensee's positions);(d) Quantitative standards setting out the use of common minimum statistical parameters for measuring risk;(e) Guidelines for stress testing;(f) Validation procedures for external oversight of the use of models; and(g) Rules forconventional bank licensees which use a mixture of the internal models approach and the standardised approach.January 2015CA-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 aconventional bank licensee's generalmarket risk exposure , typically leaving specific risk (i.e.,exposures to specific issuers of debtsecurities and equities) to be measured largely through separatecredit risk measurement systems.Conventional bank licensees applying models are subject to separate capital charges for the specific risk not captured by their models, which must be calculated by the standardised methodology.January 2015CA-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) andoption pricing models (for the calculation of the delta, gamma and vega sensitivities).January 2015CA-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.
Conventional bank licensees that are contemplating applying internal models must submit their detailed written proposals for the CBB's approval.January 2015CA-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
conventional bank licensee will automatically be recognised for another bank.January 2015CA-14.2 CA-14.2 General Criteria
CA-14.2.1
The CBB will give its approval for the use of internal models to measure
market risks only if, in addition to the detailed requirements described later in this chapter, it is satisfied that the following general criteria are met:(a) That theconventional bank licensee's risk management system is conceptually sound and is implemented with integrity;(b) That theconventional bank licensee has, in the CBB's view, sufficient numbers of staff skilled in the use of sophisticated models not only in the trading area but also in the risk control, audit and the back office areas;(c) That theconventional bank licensee's models have, in the CBB's judgement, a proven track record of reasonable accuracy in measuring risk. The CBB recognises that the use of internal models is, for most banks in Bahrain, a relatively new development and, therefore, it is difficult to establish a track record of reasonable accuracy. The CBB, therefore, will require a period of initial monitoring and live testing of aconventional bank licensee's internal model before it is used for supervisory capital purposes; and(d) That theconventional bank licensee regularly conducts stress tests as outlined in Section CA-14.7 and conducts back-testing as described in Section CA-14.6.January 2015CA-14.3 CA-14.3 Qualitative Standards
CA-14.3.1
In order to ensure that
conventional bank licensees using models havemarket risk management systems that are conceptually sound and implemented with integrity, the CBB has set the following qualitative criteria thatconventional bank licensees 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 aconventional bank licensee to use internal models, where such permission is granted, the extent to which theconventional bank licensee meets the qualitative criteria will further influence the level at which the CBB will set the multiplication factor for thatconventional bank licensee , referred to in Section CA-14.5. Only thoseconventional bank licensees whose models, in the CBB's judgement, are in full compliance with the qualitative criteria will be eligible for application of the minimum multiplication factor of 3. The qualitative criteria include the following:(a) Theconventional bank licensee must have an independent risk management unit that is responsible for the design and implementation of theconventional bank licensee's risk management system. The unit must produce and analyse daily reports on the output of theconventional bank licensee's risk measurement model, including an evaluation of the relationship between the measures of risk exposure and the trading limits. This unit must be independent from the business trading units and must report directly to the senior management of theconventional bank licensee ;(b) The independent risk management unit must conduct a regular back-testing programme, i.e. an ex-post comparison of the risk measure generated by the model against the actual daily changes in portfolio value over longer periods of time, as well as hypothetical changes based on static positions. See CA-14.5.1 (j);(c) The unit must also conduct the initial and on-going validation of the internal model. Further guidance on validation of internal models is given in Section CA-14.12;(d) The board of directors and senior management of theconventional bank licensee must be actively involved in the risk management process and must regard such process as an essential aspect of the business to which significant resources need to be devoted. In this regard, the daily reports prepared by the independent risk management unit must be reviewed by a level of management with sufficient seniority and authority to enforce both reductions of positions taken by individual traders and reductions in theconventional bank licensee's overall risk exposure;(e) Theconventional bank licensee's internal model must be closely integrated into the day-to-day risk management process of theconventional bank licensee . Its output must, accordingly, be an integral part of the process of planning, monitoring and controlling theconventional bank licensee's market risk profile;(f) The risk measurement system must be used in conjunction with the internal trading and exposure limits. In this regard, the trading limits must be related to theconventional bank licensee's risk measurement model in a manner that is consistent over time and that is well-understood by both traders and senior management;(g) A routine and rigorous programme of stress testing, along the general lines set out in Section CA-14.6, must be in place as a supplement to the risk analysis based on the day-to-day output of theconventional bank licensee's s risk measurement model. The results of stress testing must be reviewed periodically by senior management and must be reflected in the policies and limits set by management and the board of directors. Where stress tests reveal particular vulnerability to a given set of circumstances, prompt steps must be taken to manage those risks appropriately (e.g., by hedging against that outcome or reducing the size of theconventional bank licensee's exposures );(h) Theconventional bank licensee must have a routine in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the risk measurement system. Theconventional bank licensee's risk measurement system must be well documented, for example, through a risk management manual that describes the basic principles of the risk management system and that provides an explanation of the empirical techniques used to measuremarket risk ; and(i) An independent review of the risk measurement system must be carried out regularly in theconventional bank licensee's own internal auditing process. This review must include both the activities of the business trading units and of the independent risk management unit. A review, by the internal auditor, of the overall risk management process must take place at regular intervals (ideally not less than once every six months) and must specifically address, at a minimum:(i) The adequacy of the documentation of the risk management system and process;(ii) The organisation of the risk management unit;(iii) The integration ofmarket risk measures into daily risk management;(iv) The approval process for risk pricing models and valuation systems used by front- and back-office personnel;(v) The validation of any significant changes in the risk measurement process;(vi) The scope ofmarket risks captured by the risk measurement model;(vii) The integrity of the management information system;(viii) The accuracy and completeness of position data;(ix) The verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources;(x) The accuracy and appropriateness of volatility and correlation assumptions;(xi) The accuracy of valuation and risk transformation calculations; and(xii) The verification of the model's accuracy through frequent back-testing as described in (b) above and in Appendix CA-15.January 2015CA-14.4 CA-14.4 Specification of Market Risk Factors
CA-14.4.1
An important part of a
conventional bank licensee's internalmarket risk measurement system is the specification of an appropriate set ofmarket risk factors, i.e. the market rates and prices that affect the value of theconventional bank licensee's trading positions. The risk factors contained in amarket risk measurement system must be sufficient to capture the risks inherent in theconventional bank licensee's portfolio of on- and off-balance-sheet trading positions.Conventional bank licensees must follow the CBB's guidelines, set out below, for specifying the risk factors for their internal models. Where aconventional bank licensee has difficulty in specifying the risk factors for any currency or market within a risk category, in accordance with the following guidelines, theconventional bank licensee must 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 theconventional bank licensee's model:(a) Factors that are deemed relevant for pricing must be included as risk factors in the value-at-risk model. Where a risk factor is incorporated in a pricing model but not in the value-at-risk model, theconventional bank licensees must justify this omission to the satisfaction of the CBB. In addition, the value-at-risk model must capture nonlinearities for options and other relevant products (e.g. mortgage backed securities, tranched exposures or n-th-to-default credit derivatives), as well as correlation risk and basis risk (e.g. between credit default swaps and bonds). Moreover, the CBB has to be satisfied that proxies are used which show a good track record for the actual position held (i.e. an equity index for a position in an individual stock).(b) For interest rates:(i) There must be a set of risk factors corresponding to interest rates in each currency in which theconventional bank licensee has interest-rate-sensitive on- or off-balance-sheet positions;(ii) The risk measurement system must model the yield curve using one of a number of generally accepted approaches, for example, by estimating forward rates of zero coupon yields. The yield curve must be divided into various maturity segments in order to capture variation in the volatility of rates along the yield curve; there will typically be one risk factor corresponding to each maturity segment. For material exposures to interest rate movements in the major currencies and markets,conventional bank licensees must model the yield curve using a minimum of six factors. However, the number of risk factors used must ultimately be driven by the nature of theconventional bank licensee's trading strategies. For instance, aconventional bank licensee which has a portfolio of various types of securities across many points of the yield curve and which engages in complex arbitrage strategies would require a greater number of risk factors to capture interest rate risk accurately;(iii) The risk measurement system must incorporate separate risk factors to capture spread risk (e.g. between bonds and swaps). A variety of approaches may be used to capture the spread risk arising from less than perfectly correlated movements between government and other fixed-income interest rates, such as specifying a completely separate yield curve for non-government fixed-income instruments (for instance, swaps or municipal securities) or estimating the spread over government rates at various points along the yield curve;(c) For exchange rates (which includes gold):(i) The risk measurement system should incorporate risk factors corresponding to the individual foreign currencies in which theconventional bank licensee's positions are denominated. Since the value-at-risk figure calculated by the risk measurement system will be expressed in theconventional bank licensee's reporting currency, any net position denominated in a currency other than the reporting currency will introduce a foreign exchange risk. Thus, there must be risk factors corresponding to the exchange rate between the reporting currency and each other currency in which theconventional bank licensee has a significant exposure;(d) For equity prices:(i) There must be risk factors corresponding to each of the equity markets in which theconventional bank licensee holds significant positions;(ii) At a minimum, there must be a risk factor that is designed to capture market-wide movements in equity prices (e.g., a market index). Positions in individual securities or in sector indices may be expressed in "beta-equivalents" relative to this market-wide index;(iii) A somewhat more detailed approach would be to have risk factors corresponding to various sectors of the overall equity market (for instance, industry sectors or cyclical and non-cyclical sectors). As above, positions in individual stocks within each sector could be expressed in "beta-equivalents" relative to the sector index;(iv) The most extensive approach would be to have risk factors corresponding to the volatility of individual equity issues; and(v) The sophistication and nature of the modelling technique for a given market must correspond to theconventional bank licensee's exposure to the overall market as well as its concentration in individual equity issues in that market; and(e) For commodity prices:(i) There must be risk factors corresponding to each of the commodity markets in which theconventional bank licensee holds significant positions (also see Section CA-12.1);(ii) Forconventional bank licensees with relatively limited positions in commodity-based instruments, a straightforward specification of risk factors is acceptable. Such a specification would likely entail one risk factor for each commodity price to which theconventional bank licensee is exposed. In cases where the aggregate positions are reasonably small, it may be acceptable to use a single risk factor for a relatively broad sub-category of commodities (for instance, a single risk factor for all types of oil). However,conventional bank licensees which propose to use this simplified approach must obtain the prior written approval of the CBB; and(iii) For more active trading, the model must also take account of variation in the "convenience yield" between derivatives positions such as forwards and swaps and cash positions in the commodity.January 2015CA-14.5 CA-14.5 Quantitative Standards
CA-14.5.1
The following minimum quantitative standards apply for the purpose of calculating the capital charge:
(a) "Value-at-risk " must be computed on a daily basis;(b) In calculating thevalue-at-risk , a 99th percentile, one-tailed confidence interval must be used;(c) In calculating thevalue-at-risk , an instantaneous price shock equivalent to a 10-day movement in prices must be used, i.e., the minimum "holding period" is ten trading days.Conventional bank licensees may usevalue-at-risk numbers calculated according to shorter holding periods scaled up to ten days, for example, by the square root of time (for the treatment ofoptions , also see (h) below). Aconventional bank licensee using this approach must justify the reasonableness of its approach to the satisfaction of the CBB during the annual model review process performed by the external auditor;(d) The minimum historical observation period (sample period) for calculatingvalue-at-risk is one year. Forconventional bank licensees which use a weighting scheme or other methods for the historical observation period, the "effective" observation period must be at least one year (i.e., the weighted average time lag of the individual observations cannot be less than 6 months), and the method results in a capital charge at least equivalent to a one year observation period.
The CBB may, as an exceptional case, require aconventional bank licensee to calculate itsvalue-at-risk applying a shorter observation period if, in the CBB's judgement, this is justified by a significant upsurge in price volatility;(e)Conventional bank licensees must update their data sets no less frequently than once every week and must also reassess them whenever market prices are subject to material changes. The updating process must be flexible enough to allow for more frequent updates;(f) No particular type of model is prescribed by the CBB. So long as each model used captures all the material risks run by theconventional bank licensee , as set out in Section CA-14.4,conventional bank licensees is free to use models based, for example, on variance-covariance matrices, historical simulations, or Monte Carlo simulations;(g)Conventional bank licensees must have discretion to recognise empirical correlations within broad risk categories (i.e., interest rates, exchange rates, equity prices andcommodity prices, including relatedoptions volatilities in each risk factor category).Conventional bank licensees are not permitted to recognise empirical correlations across broad risk categories without the prior approval of the CBB.Conventional bank licensees may apply, on a case-by-case basis, for empirical correlations across broad risk categories to be recognised by the CBB, subject to its satisfaction with the soundness and integrity of theconventional bank licensee's system for measuring those correlations;(h)Conventional bank licensees' models must accurately capture the unique risks associated withoptions within each of the broad risk categories. The following criteria apply to the measurement ofoptions risk:(i)Conventional bank licensees' models must capture the non-linear price characteristics ofoptions positions;(ii)Conventional bank licensees must ultimately move towards the application of a full 10-day price shock tooptions positions or positions that displayoption -like characteristics. In the interim period,conventional bank licensees may adjust their capital measure foroptions risk through other methods, e.g., periodic simulations or stress testing;(iii) Eachconventional bank licensee's risk measurement system must have a set of risk factors that captures the volatilities of the rates and prices underlying theoption positions, i.e., vega risk.Conventional bank licensees with relatively large and/or complexoptions portfolios must have detailed specifications of the relevant volatilities. This means thatconventional bank licensees must measure the volatilities ofoptions positions broken down by different maturities;(i) In addition, aconventional bank licensee must calculate a 'stressed value-at-risk' measure. This measure is intended to replicate a value-at-risk calculation that would be generated on theconventional bank licensee's current portfolio if the relevant market factors were experiencing a period of stress; and must therefore be based on the 10-day, 99th percentile, one-tailed confidence interval value-at-risk measure of the current portfolio, with model inputs calibrated to historical data from a continuous 12-month period of significant financial stress relevant to theconventional bank licensee's portfolio. The period used must be approved by the CBB and regularly reviewed. As an example, for many portfolios, a 12-month period relating to significant losses in 2007/2008 would adequately reflect a period of such stress, although other periods relevant to the current portfolio must be considered by theconventional bank licensee; (j) As no particular model is prescribed under Subparagraph (f), different techniques might need to be used to translate the model used for value-at-risk into one that delivers a stressed value-at-risk. For example,conventional bank licensees must consider applying anti-thetic data, or applying absolute rather than relative volatilities to deliver an appropriate stressed value-at-risk. The stressed value-at-risk must be calculated at least weekly;(k) Eachconventional bank licensee must meet, on a daily basis, a capital requirement expressed as the sum of:(i) The higher of (1) its previous day's value-at-risk number measured according to the parameters specified in this Section (VaRt-1); and (2) an average of the daily value-at-risk measures on each of the preceding sixty business days (VaR avg), multiplied by a multiplication factor (mc); plus.(ii) The higher of (1) its latest available stressed-value-at-risk number calculated according to (i) above (sVaRt-1); and (2) an average of the stressed value-at-risk numbers calculated according to (i) above over the preceding sixty business days (sVaRavg), multiplied by a multiplication factor (ms).
Therefore, the capital requirement (c) is calculated according to the following formula:
c =max {VaRt-1; mc · VaRavg} + max { sVaRt-1; ms · sVaRavg};(l) The multiplication factors mc and ms is set by the CBB, separately for each individualconventional bank licensee , on the basis of the CBB's assessment of the quality of theconventional bank licensee's risk management system, subject to an absolute minimum of 3 for mc and an absolute minimum of 3 for ms.Conventional bank licensees must add to these factors set by the CBB, a "plus" directly related to the ex-post performance of the model, thereby introducing a built-in positive incentive to maintain the predictive quality of the model. The plus will range from 0 to 1 based on the outcome of theconventional bank licensee's back-testing. The back-testing results applicable for calculating the plus are based on value-at-risk only and not stressed value-at-risk. If the back-testing results are satisfactory and theconventional bank licensee meets all of the qualitative standards referred in Section CA-14.3 above, the plus factor could be zero. Appendix 15 presents in detail the approach to be followed for back-testing and the plus factor.Conventional bank licensees must strictly comply with this approach; and(m) As stated earlier in Section CA-14.1,conventional bank licensees applying models are also subject to a capital charge to cover specific risk (as defined under the standardised approach) of interest rate related instruments and equity instruments. The manner in which the specific risk capital charge is to be calculated is set out in Section CA-14.10.January 2015CA-14.6 CA-14.6 Back-Testing
CA-14.6.1
The contents of this Section outline the key requirements as set out in Appendix 15. The appendix presents in detail the approach to be followed for back-testing by the
conventional bank licensees .January 2015Key Requirements
CA-14.6.2
The contents of this Section lay down recommendations for carrying out back-testing procedures in order to determine the accuracy and robustness of
conventional bank licensee's internal models for measuringmarket risk capital requirements. These back-testing procedures typically consist of a periodic comparison of theconventional bank licensee's dailyvalue-at-risk measures with the subsequent daily profit or loss ("trading outcome"). The procedure involves calculating and identifying the number of times over the prior 250 business days that observed daily trading losses exceed theconventional bank licensee's one-day, 99% confidence levelVaR estimate (so-called "exceptions").January 2015CA-14.6.3
Based on the number of exceptions identified from the back-testing procedures, the
conventional bank licensees will be classified into three exception categories for the determination of the "scaling factor" to be applied to theconventional bank licensees' market risk measure generated by its internal models. The three categories, termed as zones and distinguished by colours into a hierarchy of responses, are listed below:(a) Green zone;(b) Yellow zone; and(c) Red zone.January 2015CA-14.6.4
The green zone corresponds to back-testing results that do not themselves suggest a problem with the quality or accuracy of a
conventional bank licensee's internal model. The yellow zone encompasses results that do raise questions in this regard, but where such a conclusion is not definitive. The red zone indicates a back-testing result that almost certainly indicates a problem with aconventional bank licensee's risk model.January 2015CA-14.6.5
The corresponding "scaling factors" applicable to
conventional bank licensees falling into respective zones based on their back-testing results are shown in Table 2 of Appendix CA-15.January 2015CA-14.7 CA-14.7 Stress Testing
CA-14.7.1
Conventional bank licensees that use the internal models approach for calculatingmarket 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 theconventional bank licensee is a key component of aconventional bank licensee's assessment of its capital position.January 2015CA-14.7.2
Conventional bank licensees' stress scenarios must 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 andoperational risks . Stress scenarios must shed light on the impact of such events on positions that display both linear and non-linear characteristics (i.e.,options and instruments that haveoption -like characteristics).January 2015CA-14.7.3
Conventional bank licensees ' stress tests must be both of a quantitative and qualitative nature, incorporating bothmarket risk and liquidity aspects of market disturbances. Quantitative criteria must identify plausible stress scenarios to whichconventional bank licensees could be exposed. Qualitative criteria must emphasise that two major goals of stress testing are to evaluate the capacity of theconventional bank licensee's capital to absorb potential large losses and to identify steps theconventional bank licensee can take to reduce its risk and conserve capital. This assessment is integral to setting and evaluating theconventional bank licensee's management strategy and the results of stress testing must be routinely communicated to senior management and, periodically, to theconventional bank licensee's board of directors.January 2015CA-14.7.4
Conventional bank licensees must combine the use of stress scenarios as advised under Subparagraphs (a), (b) and (c) by the CBB, with stress tests developed by theconventional bank licensees themselves to reflect their specific risk characteristics. The CBB may askconventional bank licensees to provide information on stress testing in three broad areas, as follows:(a) Scenarios requiring no simulation by the bank:
Conventional bank licensees must have information on the largest losses experienced during the reporting period available for review by the CBB. This loss information will be compared with the level of capital that results from aconventional bank licensee's internal measurement system. For example, it could provide the CBB with a picture of how many days of peak day losses would have been covered by a givenvalue-at-risk estimate;(b) Scenarios requiring simulation by the bank:
Conventional bank licensees must subject their portfolios to a series of simulated stress scenarios and provide the CBB with the results. These scenarios could include testing the current portfolio against past periods of significant disturbance, for example, the 9/11 attacks on the USA, the 1987 equity market crash, the Exchange Rate Mechanism crises of 1992 and 1993 or the fall in the international bond markets in the first quarter of 1994, the 1998 Russian financial crisis, the 2000 bursting of the technology stock bubble or the 2007/2008 sub-prime crisis, incorporating both the large price movements and the sharp reduction in liquidity associated with these events. A second type of scenario would evaluate the sensitivity of theconventional bank licensee's market risk exposure to changes in the assumptions about volatilities and correlations. Applying this test would require an evaluation of the historical range of variation for volatilities and correlations and evaluation of theconventional bank licensee's current positions against the extreme values of the historical range. Due consideration must be given to the sharp variation that, at times, has occurred in a matter of days in periods of significant market disturbance. For example, the above-mentioned situations involved correlations within risk factors approaching the extreme values of 1 and -1 for several days at the height of the disturbance; and(c) Scenarios developed by the bank to capture the specific characteristics of its portfolio:
In addition to the general scenarios prescribed by the CBB under Subparagraphs (a) and (b), eachconventional bank licensee must also develop its own stress scenarios which it identifies as most adverse based on the characteristics of its portfolio (e.g., any significant political or economic developments that may result in a sharp move in oil prices).Conventional bank licensees must provide the CBB with a description of the methodology used to identify and carry out the scenarios as well as with a description of the results derived from these stress tests.January 2015CA-14.7.5
Once a stress scenario has been identified, it must be used for conducting stress tests at least once every quarter, as long as the scenario continues to be relevant to the
conventional bank licensee's portfolio.January 2015CA-14.7.6
The results of all stress tests must be reviewed by senior management within 15 days from the time they are available, and must 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 requires the
conventional bank licensee to take prompt steps to manage those risks appropriately (e.g., byhedging against that outcome or reducing the size of itsexposures ).January 2015CA-14.7.7
Conventional bank licensees 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.January 2015CA-14.8 CA-14.8 External Validation of Models
CA-14.8.1
Before granting its approval for the use of internal models by a
conventional bank licensee , the CBB requires that the models be validated by both the internal and external auditors of theconventional bank licensee . The CBB will review the validation procedures performed by the internal and external auditors, and may independently carry out further validation procedures.January 2015CA-14.8.2
The internal validation procedures to be carried out by the internal auditor are set out in Section CA-14.3. As stated in that Section, the internal auditor's review of the overall risk management process must take place at regular intervals (not less than once every six months). The internal auditor must make a report to senior management and the board of directors, in writing, of the results of the validation procedures. The report must be made available to the CBB for its review.
January 2015CA-14.8.3
The validation of the models by the external auditor must include, at a minimum, the following steps:
(a) Verifying and ensuring that the internal validation processes described in Section CA-14.3 are operating satisfactorily;(b) Ensuring that the formulae used in the calculation process as well as for the pricing ofoptions and other complex instruments are validated by a qualified unit, which in all cases must be independent from the trading area;(c) Checking and ensuring that the structure of the internal models is adequate with respect to theconventional bank licensee's activities and geographical coverage;(d) Checking the results of theconventional bank licensee's back-testing of its internal measurement system (i.e., comparingvalue-at-risk estimates with actual profits and losses) to ensure that the model provides a reliable measure of potential losses over time; and(e) Making sure that data flows and processes associated with the risk measurement system are transparent and accessible.January 2015CA-14.8.4
The external auditor must carry out their validation/review procedures, at a minimum, once every year. Based on the above procedures, the external auditor must make a report, in writing, on the accuracy of the
conventional bank licensee's models, including all significant findings of their work. The report must be addressed to the senior management and/or the board of directors of theconventional bank licensee , and a copy of the report must be made available to the CBB. The mandatory annual review by the external auditor must 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 auditor at other times during the year must be made available to the CBB promptly.January 2015CA-14.8.5
Conventional bank licensees 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, theirvalue-at-risk calculations.January 2015CA-14.9 CA-14.9 Letter of Model Recognition
CA-14.9.1
As stated in Section CA-14.1,
conventional bank licensees which propose to use internal models for the calculation of theirmarket risk capital requirements must submit their detailed proposals, in writing, to the CBB. The CBB will review these proposals, and upon ensuring that theconventional bank licensee'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 theconventional bank licensees .January 2015CA-14.9.2
The letter of model recognition is 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 preprocessing models, the
conventional bank licensee will also be told how the output of recognised models must feed into the processing of other interest rate, equity, foreign exchange andcommodities risk. The conditions of model recognition may include additional reporting requirements. The CBB's prior written approval must be obtained for any modifications proposed to be made to the models previously recognised by the CBB. In cases where aconventional bank licensee proposes to apply the model to new but similar products, it must 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 theconventional bank licensee .January 2015CA-14.9.3
The CBB may withdraw its approval granted for any
conventional bank licensee's model if it believes that the conditions based on which the approval was granted are no longer valid or have changed significantly.January 2015CA-14.10 CA-14.10 Combination of Internal Models and the Standardised Methodology
CA-14.10.1
Unless a
conventional bank licensee's exposure to a particular risk factor is insignificant, the internal models approach, in principle, requireconventional bank licensees to have an integrated risk measurement system that captures the broad risk factor categories (i.e., interest rates, exchange rates (which includes gold), equity prices andcommodity prices, with relatedoptions volatilities being included in each risk factor category). Thus,conventional bank licensees which start to use models for one or more risk factor categories, over a reasonable period of time, must extend the models to all theirmarket risks .January 2015CA-14.10.2
A
conventional bank licensee which has obtained the CBB's approval for the use of one or more models is no longer 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 individualconventional bank licensee 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 theconventional bank licensee .January 2015CA-14.10.3
Notwithstanding the goal of moving to comprehensive internal models as set out in Paragraph CA-14.10.1, for
conventional bank licensees which, for the time being, will be applying a combination of internal models and the standardised methodology, the following conditions apply:(a) Each broad risk factor category must be assessed by applying a single approach (either internal models or the standardised approach), i.e., no combination of the two methods will, in principle, be permitted within a risk factor category or across aconventional bank licensee's different entities for the same type of risk;(b) All of the criteria laid down in this Chapter apply to the models being used;(c)Conventional bank licensees may not modify the combination of the two approaches which they are applying, without justifying to the CBB that they have a valid reason for doing so, and obtaining the CBB's prior written approval;(d) No element ofmarket risk may escape measurement, i.e. theexposure for all the various risk factors, whether calculated according to the standardised approach or internal models, would have to be captured; and(e) The capital charges assessed under the standardised approach and under the models approach must be aggregated applying the simple sum method.January 2015CA-14.11 CA-14.11 Treatment of Specific Risk
CA-14.11.1
The
conventional bank licensee is allowed to include its securitisation exposures and n-th-to-default credit derivatives in the trading book in its value-at-risk measure. Notwithstanding, it is still required to hold additional capital for these products according to the standardised measurement methodology.[Paragraphs CA-14.11.1A to CA-14.11.12 were deleted in January 2015.]
January 2015CA-14.12 CA-14.12 Model Validation Standards
CA-14.12.1
It is important that
conventional bank licensees 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 must be conducted when the model is initially developed and when any significant changes are made to the model. The validation must 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,conventional bank licensees must avail themselves of these advances. Model validation must not be limited to back-testing, but must, at a minimum, also include the following:(a) Tests to demonstrate that any assumptions made within the internal model are appropriate and do not underestimate risk. This may include the assumption of the normal distribution, the use of the square root of time to scale from a one day holding period to a 10 day holding period or where extrapolation or interpolation techniques are used, or pricing models;(b) Further to the regulatory back-testing programmes, testing for model validation must use hypothetical changes in portfolio value that would occur were end-of-day positions to remain unchanged. It therefore excludes fees, commissions, bid-ask spreads, net interest income and intra-day trading. Moreover, additional tests are required, which may include, for instance:(i) Testing carried out using hypothetical changes in portfolio value that would occur were end-of-day positions to remain unchanged. It therefore excludes fees, commissions, bid-ask spreads, net interest income and intra-day trading;(ii) Testing carried out for longer periods than required for the regular back-testing programme (e.g. 3 years). The longer time period generally improves the power of the back-testing. A longer time period may not be desirable if the VaR model or market conditions have changed to the extent that historical data is no longer relevant;(iii) Testing carried out using confidence intervals other than the 99 percent interval required under the quantitative standards; and(iv) Testing of portfolios below the overall bank level; and(c) The use of hypothetical portfolios to ensure that the model is able to account for particular structural features that may arise, for example:(i) Where data histories for a particular instrument do not meet the quantitative standards and where theconventional bank licensee has to map these positions to proxies, then theconventional bank licensee must ensure that the proxies produce conservative results under relevant market scenarios;(ii) Ensuring that material basis risks are adequately captured. This may include mismatches between long and short positions by maturity or by issuer; and(iii) Ensuring that the model captures concentration risk that may arise in an undiversified portfolio.January 2015CA-14.13 Principles for Calculating the Incremental Risk Charge (IRC)
This section was deleted with effect from January 2015 as it is no longer required.
January 2015
