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  • CA-5.1 CA-5.1 Trading Book

    • Definition of the Trading Book

      • CA-5.1.1

        The following definition of the trading book replaces the previous definition.

        Apr 08

      • CA-5.1.2

        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 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 estate which should be treated as per Paragraph CA-4.2.27).

        Amended: January 2012
        Apr 08

      • CA-5.1.3

        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 forward 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.

        Apr 08

      • CA-5.1.4

        Positions held with trading intent are those held intentionally for short-term resale and/or with the intent of hedging proprietary or client positions.

        Apr 08

      • CA-5.1.5

        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.

        Apr 08

      • CA-5.1.6

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

        (a) The activities the bank considers to be trading and as constituting part of the trading book for regulatory capital purposes;
        (b) The extent to which an exposure can be marked-to-market daily by reference to an active, liquid two-way market;
        (c) For exposures that are marked-to-model, the extent to which the bank can:
        •   Identify the material risks of the exposure;
        •   Hedge (Sharia compliant hedging) the material risks of the exposure and the extent to which hedging instruments would have an active, liquid two-way market;
        •   Derive reliable estimates for the key assumptions and parameters used in the model.
        (d) The extent to which the bank can and is required to generate valuations for the exposure that can be validated externally in a consistent manner;
        (e) The extent to which legal restrictions or other operational requirements would impede the bank's ability to effect an immediate liquidation of the exposure;
        (f) The extent to which the bank is required to, and can, actively risk manage the exposure within its trading operations; and
        (g) The extent to which the bank may transfer risk or exposures between the banking and the trading books and criteria for such transfers.
        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.
        Apr 08

      • CA-5.1.7

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

        (a) Clearly documented trading strategy for the position/instrument or portfolios, approved by senior management (which would include expected holding horizon).
        (b) Clearly defined policies and procedures for the active management of the position, which must include:
        •   Positions are managed on a trading desk;
        •   Position limits are set and monitored for appropriateness;
        •   Dealers have the autonomy to enter into/manage the position within agreed limits and according to the agreed strategy;
        •   Positions are marked to market at least daily and when marking to model the parameters must be assessed on a daily basis;
        •   Positions are reported to senior management as an integral part of the institution's risk management process; and
        •   Positions are actively monitored with reference to market information sources (assessment should be made of the market liquidity or the ability to hedge positions or the portfolio risk profiles). This would include assessing the quality and availability of market inputs to the valuation process, level of market turnover, sizes of positions traded in the market, etc.
        (c) Clearly defined policy and procedures to monitor the positions against the bank's trading strategy including the monitoring of turnover and stale positions in the bank's trading book.
        Apr 08

    • Prudent Valuation Guidance

      • CA-5.1.8

        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.

        Apr 08

      • CA-5.1.8.A

        Positions in the bank's own eligible regulatory capital instruments are deducted from capital. Positions in other banks', securities firms', and other financial entities' eligible regulatory capital instruments, as well as intangible assets, are subject to the same treatment as that set down by the CBB for such assets held in the banking book (see Module PCD).

        Added: January 2012

      • CA-5.1.9

        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-5.1.18.A to CA-5.1.20 is the degree of consistency between the bank's valuation procedures and these guidelines.

        Added: January 2012

      • CA-5.1.9A

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

        Amended: January 2012
        Apr 08

    • Systems and Controls

      • CA-5.1.10

        Banks must establish and maintain adequate systems and controls sufficient to give management and CBB the confidence that their valuation estimates are prudent and reliable. These systems must be integrated with other risk management systems within the organisation (such as credit analysis). Such systems must include:

        (a) Documented policies and procedures for the process of valuation. This includes clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of market information and review of their appropriateness, guidelines for the use of unobservable inputs reflecting the bank's assumptions of what market participants would use in pricing position, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, end of the month and ad-hoc verification procedures; and
        (b) Clear and independent (i.e. independent of front office) reporting lines for the department accountable for the valuation process. The reporting line should ultimately be to a main board executive director.
        Amended: January 2012
        Apr 08

    • Valuation Methodologies

      • Marking to Market

        • CA-5.1.11

          Marking-to-market is at least the daily valuation of positions at readily available close out prices that are sourced independently. Examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers.

          Apr 08

        • CA-5.1.12

          Banks must mark-to-market as much as possible. The more prudent side of bid/offer must be used unless the institution is a significant market maker in a particular position type and it can close out at mid-market. Banks should maximise the use of relevant observable inputs and minimise the use of unobservable inputs when estimating fair value using a valuation technique. However, observable inputs or transactions may not be relevant, such as in a forced liquidation or distressed sale, or transactions may not be observable, such as when markets are inactive. In such cases, the observable data should be considered, but may not be determinative.

          Amended: January 2012
          Apr 08

      • Marking to Model

        • CA-5.1.13

          Only where marking-to-market is not possible, should banks may mark-to-model, but this must be demonstrated to be prudent. Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input.

          Amended: January 2012
          Apr 08

        • CA-5.1.14

          When marking to model, an extra degree of conservatism is appropriate. The CBB will consider the following in assessing whether a mark-to-model valuation is prudent:

          (a) Senior management should be aware of the elements of the trading book or of other fair-valued positions which are subject to mark to model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business;
          (b) Market inputs should be sourced, to the extent possible, in line with market prices (as discussed above). The appropriateness of the market inputs for the particular position being valued should be reviewed regularly;
          (c) Where available, generally accepted valuation methodologies for particular products should be used as far as possible;
          (d) Where the model is developed by the institution itself, it should be based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. It should be independently tested. This includes validating the mathematics, the assumptions and the software implementation;
          (e) There should be formal change control procedures in place and a secure copy of the model should be held and periodically used to check valuations;
          (f) Risk management should be aware of the weaknesses of the models used and how best to reflect those in the valuation output;
          (g) The model should be subject to periodic review to determine the accuracy of its performance (e.g. assessing continued appropriateness of the assumptions, analysis of P&L versus risk factors, comparison of actual close out values to model outputs); and
          (h) Valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation.
          Amended: January 2012
          Apr 08

      • Independent Price Verification

        • CA-5.1.15

          Independent price verification is distinct from daily mark-to-market. It is the process by which market prices or model inputs are regularly verified for accuracy. While daily marking-to-market may be performed by dealers, verification of market prices or model inputs should be performed by a unit independent of the dealing room, at least monthly (or, depending on the nature of the market/trading activity, more frequently). It need not be performed as frequently as daily mark-to-market, since the objective, i.e. independent, marking of positions, should reveal any error or bias in pricing, which should result in the elimination of inaccurate daily marks.

          Apr 08

        • CA-5.1.16

          Independent price verification entails a higher standard of accuracy in that the market prices or model inputs are used to determine profit and loss figures, whereas daily marks are used primarily for management reporting in between reporting dates. For independent price verification, where pricing sources are more subjective, e.g. only one available broker quote, prudent measures such as valuation adjustments may be appropriate.

          Apr 08

    • Valuation Adjustments

      • CA-5.1.17

        As part of their procedures for marking to market, banks must establish and maintain procedures for considering valuation adjustments. The CBB expects banks using third-party valuations to consider whether valuation adjustments are necessary. Such considerations are also necessary when marking to model.

        Amended: January 2012
        Apr 08

      • CA-5.1.18

        The CBB expects the following valuation adjustments/reserves to be formally considered at a minimum: unearned profit, close-out costs, operational risks, early termination, investing and funding costs, and future administrative costs and, where appropriate, model risk.

        Apr 08

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

      • CA-5.1.18.A

        Banks must establish and maintain procedures for judging the necessity of and calculating an adjustment to the current valuation of less liquid positions for regulatory capital purposes. This adjustment may be in addition to any changes to the value of the position required for financial reporting purposes and should be designed to reflect the illiquidity of the position. The CBB expects banks to consider the need for an adjustment to a position's valuation to reflect current illiquidity whether the position is marked to market using market prices or observable inputs, third-party valuations or marked to model.

        Added: January 2012

      • CA-5.1.19

        Bearing in mind that the underlying 10-day assumptions made about liquidity in the market risk capital charge may not be consistent with the bank's ability to sell or hedge out less liquid positions, where appropriate, banks must take an adjustment to the current valuation of these positions, and review their continued appropriateness on an on-going basis. Reduced liquidity may have arisen from market events. Additionally, close-out prices for concentrated positions and/or stale positions should be considered in establishing the adjustment. Banks must consider all relevant factors when determining the appropriateness of the adjustments for less liquid positions. These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market makers), the average and volatility of trading volumes (including trading volumes during periods of market stress), market concentrations, the aging of positions, the extent to which valuation relies on marking-to-model, and the impact of other model risks not included in Paragraph CA-5.1.18.A.

        Amended: January 2012
        Apr 08

      • CA-5.1.20

        [This Paragraph was deleted in January 2012]

        Deleted: January 2012