Source: https://www.scribd.com/doc/95857971/BASEL-II
Timestamp: 2017-12-12 06:53:57
Document Index: 170880449

Matched Legal Cases: ['art 2', 'aRt-1', 'aRt-1', 'art 4', 'art 2', 'art 2']

BASEL II | Basel Ii | Value At Risk
Uploaded by Krishanu Saha
Brussels Office of the Superintendent of Financial Institutions Canada French Banking Commission. Board of Governors of the Federal Reserve System. Bank for International Settlements. and Mr Thomas McGowan. Madrid Swiss Financial Market Supervisory Authority. Washington. Frankfurt Federal Financial Supervisory Authority. Amsterdam South African Reserve Bank. DC Brazil Belgium Canada France Germany Ms Kathleen Krause Mr Marc Peters Mr Greg Caldwell Mr Timothy Fong Mr Stéphane Boivin Mr Karsten Stickelmann Mr Rüdiger Gebhard Italy Japan Mr Filippo Calabresi Mr Masaki Bessho Mr Atsushi Kitano Netherlands South Africa Spain Switzerland United Kingdom Mr Maarten Hendrikx Mr Rob Urry Mr Federico Cabañas Lejarraga Ms Barbara Graf Mr Colin Miles Mr Martin Etheridge United States Mr Sean Campbell Mr David Jones Mr John Kambhu Ms Emily Yang Ms Gloria Ikosi Mr Karl Reitz Mr Roger Tufts Mr Jonathan D Jones Ms Christine Smith EU Financial Stability Institute Secretariat Mr Kai Gereon Spitzer Mr Stefan Hohl Mr Martin Birn Mr Karl Cordewener Central Bank of Brazil Banking. DC Office of Thrift Supervision. DC Federal Reserve Bank of New York Federal Deposit Insurance Corporation. Finance and Insurance Commission. London Board of Governors of the Federal Reserve System. Washington. Washington. DC European Commission. London Financial Services Authority. Bonn Bank of Italy. Paris Deutsche Bundesbank. Brussels Financial Stability Institute. Tokyo Netherlands Bank. Washington. Pretoria Bank of Spain. Tokyo Financial Services Agency. Bank for International Settlements. Rome Bank of Japan. Securities and Exchange Commission. Washington. Basel Revisions to the Basel II market risk framework iii . DC Office of the Comptroller of the Currency. Berne Bank of England. Basel Secretariat of the Basel Committee on Banking Supervision. DC. Washington.Trading Book Group of the Basel Committee on Banking Supervision Co-chairs: Ms Norah Barger.
Background and objectives 3. The additional stressed value-at-risk requirement will also help reduce the procyclicality of the minimum capital requirements for market risk. the capital charges of the banking book will apply with a limited exception for certain so-called correlation trading activities. Revisions to the Basel II market risk framework 1 . 4. Consequently. July 2005. based on the 1996 Amendment to the Capital Accord to incorporate market risks. which includes default risk as well as migration risk. the Committee has worked jointly with the International Organization of Securities Commissions (IOSCO) to consult with industry representatives and other supervisors on these matters. the Committee decided to expand the scope of the capital charge. A main contributing factor was that the current capital framework for market risk. An additional response to the crisis is the introduction of a stressed value-at-risk requirement. 2. does not capture some key risks. which must be calculated in addition to the value-at-risk based on the most recent one-year observation period. this text frequently refers to rules for banks. The Basel Committee/IOSCO Agreement reached in July 2005 1 contained several improvements to the capital regime for trading book positions. At its meeting in March 2008. banking groups. The Committee therefore requires banks to calculate a stressed value-at-risk taking into account a one-year observation period relating to significant losses. The Application of Basel II to trading activities and the treatment of double default effects. While this work was undertaken jointly by a working group from the Committee and IOSCO. In response. the resulting proposal represents an effort by the Committee to find prudential treatments for certain exposures held by banks under the Basel II Framework. For securitised products. Among the revisions was a new requirement for banks that model specific risk to measure and hold capital against default risk that is incremental to any default risk captured in the bank’s value-at-risk model.Revisions to the Basel II market risk framework 1. an important source of losses and of the build up of leverage occurred in the trading book. the Basel Committee on Banking Supervision (the Committee) supplements the current value-at-riskbased trading book framework with an incremental risk capital charge. These measures will reduce the incentive for regulatory arbitrage between the banking and trading books. and other firms subject to prudential banking regulations. for unsecuritised credit products. The Committee recognises 1 Basel Committee on Banking Supervision. Losses in most banks’ trading books during the financial crisis have been significantly higher than the minimum capital requirements under the former Pillar 1 market risk rules. where banks may be allowed by their supervisor to calculate a comprehensive risk capital charge subject to strict qualitative minimum requirements as well as stress testing requirements. Since the financial crisis began in mid-2007. to improve the internal value-at-risk models for market risk and to update the prudent valuation guidance for positions accounted for at fair value. The incremental default risk charge was incorporated into the trading book capital regime in response to the increasing amount of exposure in banks’ trading books to credit-risk related and often illiquid products whose risk is not reflected in value-at-risk. I. Given the interest of both banks and securities firms in the potential solutions to these particular issues.
to groups of investment firms and to combined groups of banks and investment firms that are subject to prudential banking or securities firms’ regulation. to reflect their comments in the present paper and the Guidelines. the elements of the 1988 Accord that were not revised during the Basel II process. consultative document. in close cooperation with representatives of the industry. 6 2 Basel Committee on Banking Supervision. as amended in January 1996. press release. July 2008. June 2006. 3 4 5 6 2 Revisions to the Basel II market risk framework . 30 comment letters have been provided by banks. In June 2006. comprehensive version. Basel II: International convergence of capital measurement and capital standards: a revised framework. According to the proposed changes to the Basel II market risk framework outlined below. Guidelines for computing capital for incremental risk in the trading book. Basel Committee on Banking Supervision. Basel Committee on Banking Supervision. This decision is reflected in the proposed revisions to the Basel II market risk framework. Additional guidance on the incremental risk capital charge is provided in a separate document. the 1996 Amendment to the Capital Accord to incorporate market risks. Most of them are available on the Committee’s website. in some cases. the Committee published a comprehensive version of the Basel II Framework 2 which includes the June 2004 Basel II Framework. A bank that has approval to model specific risk will also be subject to an incremental risk capital charge. national authorities may decide to apply these rules not just to banks and banking groups. The Committee and IOSCO worked diligently. industry associations. the trading book capital charge for a bank using the internal models approach for market risk will be subject to a general market risk capital charge (and a specific risk capital charge to the extent that the bank has approval to model specific risk) measured using a 10day value-at-risk at the 99 percent confidence level and a stressed value-at-risk.that. 7. The scope and implementation requirements for general market risk will remain unchanged from the current market risk regime. supervisory authorities and other interested institutions in the most recent consultation. 19 September 1997. 5. January 2009 Basel Committee on Banking Supervision. Basel Committee on Banking Supervision. Unless stated otherwise. paragraph numbers in this document refer to paragraphs in the comprehensive version of the Basel II Framework. the 10-day value-at-risk estimate will be subject to the same multiplier as for general market risk. The Committee and IOSCO wish to thank representatives of the industry for their fruitful comments. and the July 2005 paper on The application of Basel II to trading activities and the treatment of double default effects. July 2009. The separate surcharge for specific risk under the current framework 5 will be eliminated. Proposed revisions to the Basel II market risk framework. the Guidelines for computing capital for incremental risk in the trading book (referred to as “the Guidelines”). 6. The Committee has decided that the incremental risk capital charge should capture not only default risk but also migration risk. but also to investment firms. The Committee released consultative documents on the revisions to the Basel II market risk framework and the guidelines for computing capital for incremental risk in the trading book in July 2008 3 and more recently in January 2009 4. Proposed revisions to the Basel II market risk framework. For a bank that has approval to model specific risk. consultative document. Modification of the Basle Capital Accord of July 1988. 8.
In the coming months. and the floor to the liquidity horizon specified in the Guidelines. This review will include the multipliers mc and ms to the current and stressed value-at-risk numbers as defined in the revised paragraph 718(Lxxvi) (k) of the Basel II Framework. Furthermore. as long as that method results in a capital charge at least as conservative as that calculated with an “effective” observation period of at least one year. Until the Committee can be satisfied that a methodology adequately captures incremental risks for all securitised products. for a bank to apply this exception it must regularly apply a set of specific. the capital charges of the standardised measurement method will in general be applied to these products. there will be a limited exception for certain correlation trading activities. The improvements in the Basel II Framework concerning internal value-at-risk models in particular require banks to justify any factors used in pricing which are left out in the calculation of value-at-risk. The Committee clarifies that regulators retain the ability to require adjustments to current value beyond those required by financial reporting standards. This evaluation will be based on a quantitative impact study to be conducted by 2010. The precise number and composition of stress scenarios to be applied will be determined by the Committee in consultation with the industry by March 2010. predetermined stress scenarios to the portfolio that receives internal model regulatory capital treatment. It has collected additional data in 2009 to assess the impact of changes to the trading book capital framework. in particular where there is uncertainty around the current realisable value of a position due to illiquidity. the 1. the Committee will evaluate a floor for the comprehensive risk capital charge which could be expressed as a percentage of the charge applicable under the standardised measurement method. the Committee will review the calibration of the market risk framework in light of the results of this impact assessment. To complement the incremental risk capital framework. 12.0 scaling factor to the incremental risk measure and the 1. Furthermore. II. This also applies to portfolios and products for which a bank has already received or applied for approval for using internal models for the calculation of market risk capital or specific risk model recognition before the implementation of these changes. However. Implementation date 13. In particular.0 scaling factor to the comprehensive risk measure defined in the revised paragraph 718(XCiv) of the Basel II Framework. Banks are expected to comply with the revised requirements by 31 December 2010.9. Revisions to the Basel II market risk framework 3 . The Committee has already conducted a preliminary analysis of the impact of an incremental risk capital charge only including default and migration risk. 11. to update market data at least monthly and to be in a position to update it in a more timely fashion if deemed necessary. This guidance focuses on the current valuation of the position and is a separate concern from the risk that market conditions and/or variables will change before the position is liquidated (or closed out) causing a loss of value to positions held. 10. where banks may be allowed by their supervisor to calculate a comprehensive risk capital charge subject to strict minimum requirements. the Committee extends the scope of the prudent valuation guidance to all positions subject to fair value accounting and make the language more consistent with existing accounting guidance. The Committee as a whole has not yet agreed that currently existing methodologies used by banks adequately capture incremental risks of all securitised products. They will also be required to use hypothetical backtesting at least for validation. largely relying on the data collected from its quantitative impact study on incremental default risk in late 2007. the Committee clarifies that it is permissible to use a weighting scheme for historical data that is not fully consistent with the requirement that the “effective” observation period must be at least one year.
However. at the present time. The additional guidance does not modify the definition of the trading book set forth in the revised Framework. the following definition of the correlation trading portfolio will be added: 689(iv). 709(ii). 16. private equity investments. and All reference entities are single-name products. A two-way market is deemed to exist where there are independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined within one day and settled at such price within a relatively short time conforming to trade custom. a residential mortgage exposure or a commercial mortgage exposure under the standardised approach to credit risk are not included in the correlation trading portfolio. for which a liquid two-way market exists. open equity stakes in hedge funds. Changed wording is underlined. Positions which reference a claim on a special purpose entity are not included either. After paragraph 689(iii) of the Basel II framework. This will include commonly traded indices based on these reference entities. 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. it focuses on policies and procedures that banks must have in place to includebook exposures in their trading books. Paragraph 709(ii) of the Basel II Framework will be changed as follows. Footnote 3 to paragraph 16 of the Basel II framework will be changed as follows. 3 IV. Rather. positions in a securitisation warehouse and real estate holdings do not meet the definition of the trading book. The minimum capital requirement is expressed in terms of two separately calculated charges.III. • Positions which reference an underlying that would be treated as a retail exposure. nor derivatives of securitisation exposures that do not provide a pro-rata share in the proceeds of a securitisation tranche (this therefore excludes options on a securitisation tranche. one applying to the “specific risk” of each security. it is the Committee’s view that. Changes to the introduction of the Basel II framework 14. For the purposes of this framework. owing to significant constraints on the ability of banks to liquidate these positions and value them reliably on a daily basis. the correlation trading portfolio incorporates securitisation exposures and n-th-to-default credit derivatives that meet the following criteria: • The positions are neither resecuritisation positions. Changed wording is underlined. Changes to the standardised measurement method for market risk 15. or a synthetically leveraged super-senior tranche). whether it is a short or a long position. and the other to the interest rate risk in the portfolio 4 Revisions to the Basel II market risk framework . including single-name credit derivatives.
Revisions to the Basel II market risk framework 5 . however. For positions with long-term ratings of B+ and below and short-term ratings other than A-1/P-1. 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. securitisation exposures that would be subject to a deduction treatment under the securitisation framework set forth in this Framework (e. To that effect. The specific risk capital charges for positions covered under the standardised approach for securitisation exposures are defined in the table below. 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. deduction from capital as defined in paragraph 561 is required. and/or To disallow offsetting for the purposes of defining the extent of general market risk between such instruments and any other debt instruments.g. Paragraph 712(ii) of the Basel II Framework will be changed as follows. each national supervisor will have the discretion: • • To apply a higher specific risk charge to such instruments. Deduction is also required for unrated positions with the exception of the circumstances described in paragraphs 571 to 575. the risk weight has to be calculated as specified below and applied to the net positions in securitisation instruments in the trading book. A-3/P-3. as well as securitisation exposures that are unrated liquidity lines or letters of credit should be subject to a capital charge that is no less than the charge set forth in the securitisation framework. equity tranches that absorb first loss). A-2/P-2. The total specific risk capital charge for the correlation trading portfolio is to be computed according to paragraph 718. and the total specific risk capital charge for securitisation exposures is to be computed according to paragraph 709(ii). The operational requirements for the recognition of external credit assessments outlined in paragraph 565 apply. 18. Deleted wording is struck out. These charges must be applied by banks using the standardised approach for credit risk. The larger of these total amounts is then the specific risk capital charge for the correlation trading portfolio. However. the treatment of specific risk will be amended as follows: Specific risk rules for positions covered under the securitisation framework 712(iii). 712(iv). The bank must. After paragraph 712(ii) of the Basel II Framework. The specific risk of securitisation positions as defined in paragraphs 538 to 542 which are held in the trading book is to be calculated according to the method used for such positions in the banking book unless specified otherwise below. 17. In that respect.(termed “general market risk”) where long and short positions in different securities or instruments can be offset. since this may in certain cases considerably underestimate the specific risk for debt instruments which have a high yield to redemption relative to government debt securities. 712(ii).
For positions with long-term ratings of B+ and below and short-term ratings other than A-1/P-1.2% A+ to AA-2/P-2 BBB+ to BBBA-3/P-3 8% 18% BB+ to BBBelow BB. A-3/P-3. deduction from capital as defined in paragraph 561 is required.Specific risk capital charges under the standardised approach based on external credit ratings External Credit Assessment AAA to AAA-1/P-1 1. A-2/P-2. as defined in paragraph 633) is 6 or more and the position is senior as defined in paragraph 613. banks may apply the capital charges defined in the table below for senior granular positions if the effective number of underlying exposures (N. The specific risk capital charges for rated positions covered under the internal ratings-based approach for securitisation exposures are defined in the table below. (b) 6 Revisions to the Basel II market risk framework . the capital charges for non-senior granular securitisation exposures of the table below apply. (a) For securitisation exposures. Resecuritisation exposures as defined in paragraph 541(i) are subject to specific risk capital charges depending on whether or not the exposure is senior as defined in paragraph 613. In all other cases.6% 3.and below A-3/P-3 or unrated Deduction Deduction Securitisation exposures Resecuritisation exposures 4% 8% 28% 52% 712(v). The operational requirements for the recognition of external credit assessments outlined in paragraph 565 apply. When N is less than 6. the capital charges for non-granular securitisation exposures of the table below apply.
00% 16. the bank must meet the minimum requirements for the IRB approach.60% 2.64% 0.00% 12.44% 1.00% 12. consequently.00% 5. the bank may apply the supervisory formula approach (paragraphs 623 to 636).00% 52.5 or higher the position has to be deducted from capital as defined in paragraph 561. subject to supervisory approval.80% 0. granular 0.96% 1.60% 2.60% 2.80% Non-senior.00% 18.20% 4. This concentration ratio is equal to the sum of the nominal amounts of all the tranches divided by the sum of the nominal amounts of the tranches junior to or pari passu with the tranche in which the position is held including that tranche itself.80% 8.80% 3.20% 4.00% 20.80% 4.00% 52.00% 24.00% 2.96% 1.00% Nongranular 1. To the extent that a bank has approval to apply the internally developed approach referred to in paragraph 718(Lxxxvii-1-) to the underlying exposures and the bank derives estimates for PDs and LGDs from the internally developed approach specified in paragraphs 718(xcii) and 718(xciii) that are in line with the quantitative standards for the internal ratings-based approach.20% 8.00% 40. If the concentration ratio is 12. for applying the supervisory formula approach (paragraphs 623 to 636). The specific risk capital charges for unrated positions covered under the securitisation framework as defined in paragraphs 538 to 542 will be calculated as set out below.00% 68.80% 4.00% 6.20% 1.00% 2. (a) If a bank has approval for the internal ratings-based approach for the asset classes which include the underlying exposures.40% 3.00% Deduction 712(vi).00% 60.Specific risk capital charges based on external credit ratings External rating (illustrative) Securitisation exposures Resecuritisation exposures Senior Non-senior Senior.00% 40.00% 8. the bank may use these estimates for calculating KIRB and. When estimating PDs and LGDs for calculating KIRB.56% 0.00% 34. In all other cases the capital charge can be calculated as 8% of the weightedaverage risk weight that would be applied to the securitised exposures under the standardised approach.00% 28. multiplied by a concentration ratio. granular AAA/A-1/P-1 AA A+ A/A-2/P-2 ABBB+ BBB/A-3/P-3 BBBBB+ BB BBBelow BB-/ A-3/P-3 0.80% 1.00% 2.60% 2. (b) (c) Revisions to the Basel II market risk framework 7 .
Once the n-th default occurs the transaction terminates and is settled. Where a bank has multiple risk positions in reference credit instruments underlying a first-to-default credit derivative this offset is allowed only for that underlying reference credit instrument having the lowest specific risk capital charge. as applicable. national authorities will have discretion to determine the criteria for liquid and diversified portfolios. The general market risk charge will be 8%. The capital charge for specific risk for an n-th-to-default credit derivative with n greater than one is the lesser of (1) the sum of the specific risk capital charges for the individual reference credit instruments in the basket but disregarding the (n-1) obligations with the lowest specific risk capital charges. in which case the charge will be 4%. then the protection seller must calculate the specific risk capital charge using the rating of the derivative and apply the respective securitisation risk weights as specified in paragraphs 712(iv) or 712(v). Paragraph 718(xxi) with regard to the specific risk capital charge for equities of the Basel II Framework will be changed as follows. For n-th-to-default credit derivatives with n greater than 1 no offset of the capital charge for specific risk with any underlying reference credit instrument is allowed. Changed wording is underlined. 19. Given the different characteristics of national markets in terms of marketability and concentration. 718(xxi). Paragraph 718 of the Basel II Framework will be replaced as follows. unless the portfolio is both liquid and well-diversified. Where a bank has a risk position in one of the reference credit instruments underlying a first-to-default credit derivative and this credit derivative hedges the bank’s risk position. 712(vii). and (2) the maximum possible credit event payment under the contract. 718. obtains or provides protection. If a bank is unable to determine the specific risk capital charge as described above or prefers not to apply the treatment described above to a position.e. The capital charge for specific risk and for general market risk will each be 8%. it must deduct that position from capital. (a) The capital charge for specific risk for a first-to-default credit derivative is the lesser of (1) the sum of the specific risk capital charges for the individual reference credit instruments in the basket. The capital charge against each net n-th-to-default credit derivative position applies irrespective of whether the bank has a long or short position. the bank is allowed to reduce with respect to the hedged amount both the capital charge for specific risk for the reference credit instrument and that part of the capital charge for specific risk for the credit derivative that relates to this particular reference credit instrument. (b) (c) (d) 20. An n-th-to-default credit derivative is a contract where the payoff is based on the n-th asset to default in a basket of underlying reference instruments. A position subject to deduction according to paragraph 712(iv) to 712(vi) may be excluded from the calculation of the capital charge for general market risk whether the bank applies the standardised measurement method or the internal models method for the calculation of its general market risk capital charge. 8 Revisions to the Basel II market risk framework .The resulting specific risk capital charge must not be lower than any specific risk capital charge applicable to a rated more senior tranche. i. and (2) the maximum possible credit event payment under the contract. If a first or other n-th-to-default credit derivative is externally rated.
Changed wording is underlined. 718(Lxxiii). 1. 718(Lxxi). Qualitative standards 718(Lxxiv). Only those banks whose models are in full compliance with the qualitative criteria will be eligible for application of the minimum multiplication factor. including an evaluation of the relationship between measures of risk exposure and trading limits. 2. and if necessary. It is important that supervisory authorities are able to assure themselves that banks using models have market risk management systems that are conceptually sound and implemented with integrity. Revisions to the Basel II market risk framework 9 .D of Part 2 of the Basel II Framework outlining the internal models approach to market risk will be changed as follows. Home and host country supervisory authorities of banks that carry out material trading activities in multiple jurisdictions intend to work co-operatively to ensure an efficient approval process. audit. The qualitative criteria include: (a) The bank should have an independent risk control unit that is responsible for the design and implementation of the bank’s risk management system. The extent to which banks meet the qualitative criteria may influence the level at which supervisory authorities will set the multiplication factor referred to in paragraph 718(Lxxvi) (j) below. The bank’s models have in the supervisory authority’s judgement a proven track record of reasonable accuracy in measuring risk. back office areas. • • 718(Lxxii). Accordingly. banks using internal models for capital purposes will be subject to the requirements detailed in paragraphs 718(Lxxiv) to 718(xcix). The bank regularly conducts stress tests along the lines discussed in paragraphs 718(Lxxvii) to 718(Lxxxiv) below. The original footnote numbers of the Basel II Framework are provided in brackets. Supervisory authorities will have the right to insist on a period of initial monitoring and live testing of a bank’s internal model before it is used for supervisory capital purposes. The supervisory authority will only give its approval if at a minimum: • • It is satisfied that the bank’s risk management system is conceptually sound and is implemented with integrity. General criteria 718(Lxx). Changes to the internal models approach to market risk 21. In addition to these general criteria. This unit must be independent from business trading units and should report directly to senior management of the bank. Section VI. The bank has in the supervisory authority’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. The use of an internal model will be conditional upon the explicit approval of the bank’s supervisory authority. the supervisory authority will specify a number of qualitative criteria that banks would have to meet before they are permitted to use a models-based approach.V. The unit should produce and analyse daily reports on the output of the bank’s risk measurement model.
Where stress tests reveal particular vulnerability to a given set of circumstances. trading limits should be related to the bank’s risk measurement model in a manner that is consistent over time and that is well-understood by both traders and senior management. [161] Though banks will have some discretion as to how they conduct stress tests. The bank’s risk measurement system must be well documented.e. The bank’s internal risk measurement model must be closely integrated into the day-to-day risk management process of the bank. their supervisory authorities will wish to see that they follow the general lines set out in paragraphs 718(Lxxvii) to 718(Lxxxiiii). The risk measurement system should be used in conjunction with internal trading and exposure limits. A routine and rigorous programme of stress testing 9 should be in place as a supplement to the risk analysis based on the day-to-day output of the bank’s risk measurement model. used in the internal assessment of capital adequacy.(b) The unit should conduct a regular back-testing programme. for example. an ex-post comparison of the risk measure generated by the model against actual daily changes in portfolio value over longer periods of time.g. Banks should have a routine in place for ensuring compliance with a documented set of internal policies. 8 9 10 Revisions to the Basel II market risk framework . 7 Board of directors and senior management should be actively involved in the risk control process and must regard risk control as an essential aspect of the business to which significant resources need to be devoted. [160] The report. The results of stress testing should be reviewed periodically by senior management. by hedging against that outcome or reducing the size of the bank’s exposures. i. or increasing capital). 8 In this regard. The unit should also conduct the initial and on-going validation of the internal model. Risk management guidelines for derivatives. as well as hypothetical changes based on static positions. and reflected in the policies and limits set by management and the board of directors. monitoring and controlling the bank’s market risk profile. prompt steps should be taken to manage those risks appropriately (e. This review should include both the activities of the business trading units and of the independent risk control unit. A review of the overall risk management process should take (c) (d) (e) (f) (g) (h) (i) 7 [159] Further guidance regarding the standards that supervisory authorities will expect can be found in paragraph 718(xcix). In this regard. Its output should accordingly be an integral part of the process of planning. controls and procedures concerning the operation of the risk measurement system. issued by the Basel Committee in July 1994 further discusses the responsibilities of the board of directors and senior management. through a risk management manual that describes the basic principles of the risk management system and 74that provides an explanation of the empirical techniques used to measure market risk. the daily reports prepared by the independent risk control 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 the bank’s overall risk exposure. An independent review of the risk measurement system should be carried out regularly in the bank’s own internal auditing process.
g. The scope of market risks captured by the risk measurement model. For interest rates. the value-at-risk model must capture nonlinearities for options and other relevant products (e. tranched exposures or n-th-to-default credit derivatives).place at regular intervals (ideally not less than once a year) and should specifically address. The integration of market risk measures into daily risk management.  The organisation of the risk control unit. including the independence of such data sources. The validation of any significant change in the risk measurement process.e. an equity index for a position in an individual stock). The verification of the consistency. The approval process for risk pricing models and valuation systems used by front and back-office personnel. (b) Revisions to the Basel II market risk framework 11 . The accuracy and appropriateness of volatility and correlation assumptions. i. The integrity of the management information system. the market rates and prices that affect the value of the bank’s trading positions.or offbalance sheet positions. the bank must justify this omission to the satisfaction of its supervisor. An important part of a bank’s internal market risk measurement system is the specification of an appropriate set of market risk factors. (a) Factors that are deemed relevant for pricing should 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. the following guidelines should be fulfilled. Although banks will have some discretion in specifying the risk factors for their internal models. The accuracy of valuation and risk transformation calculations. mortgagebacked securities. there must be a set of risk factors corresponding to interest rates in each currency in which the bank has interest-rate-sensitive on.and off-balance sheet 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. between credit default swaps and bonds). at a minimum: • • • • • • • • • The adequacy of the documentation of the risk management system and process. the supervisor has to be satisfied that proxies are used which show a good track record for the actual position held (i. Moreover. timeliness and reliability of data sources used to run internal models. 718(Lxxv). as well as correlation risk and basis risk (e. The verification of the model’s accuracy through frequent back-testing as described in 718(Lxxiv) (b) above and in the accompanying document: Supervisory framework for the use of backtesting in conjunction with the internal models approach to market risk capital requirements. In addition. Specification of market risk factors • • • 3.g. The accuracy and completeness of position data.e.
such as specifying a completely separate yield curve for non-government fixed-income instruments (for instance. there will typically be one risk factor corresponding to each maturity segment. positions in individual stocks within each sector could be expressed in beta-equivalents49 relative to the sector index. A somewhat more detailed approach would be to have risk factors corresponding to various sectors of the overall equity market (for instance. However.• The risk measurement system should model the yield curve using one of a number of generally accepted approaches. The yield curve should be divided into various maturity segments in order to capture variation in the volatility of rates along the yield curve. a bank with a portfolio of various types of securities across many points of the yield curve and that engages in complex arbitrage strategies would require a greater number of risk factors to capture interest rate risk accurately. there should be risk factors corresponding to each of the equity markets in which the bank holds significant positions: • At a minimum. For material exposures to interest rate movements in the major currencies and markets. for example.g. industry sectors or cyclical and non-cyclical sectors). the risk measurement system should incorporate risk factors corresponding to the individual foreign currencies in which the bank’s positions are denominated.g. swaps or municipal securities) or estimating the spread over government rates at various points along the yield curve. banks must model the yield curve using a minimum of six risk factors. • (c) For exchange rates (which may include gold). there should be a risk factor that is designed to capture market-wide movements in equity prices (e. For equity prices. 12 Revisions to the Basel II market risk framework . Since the value-atrisk figure calculated by the risk measurement system will be expressed in the bank’s domestic currency. Positions in individual securities or in sector indices could be expressed in “beta-equivalents” 10 relative to this market-wide index. As above. between bonds and swaps). Thus. The risk measurement system must incorporate separate risk factors to capture spread risk (e. there must be risk factors corresponding to the exchange rate between the domestic currency and each foreign currency in which the bank has a significant exposure. by estimating forward rates of zero coupon yields. The most extensive approach would be to have risk factors corresponding to the volatility of individual equity issues. For instance. 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. a market index). the number of risk factors used should ultimately be driven by the nature of the bank’s trading strategies. any net position denominated in a foreign currency will introduce a foreign exchange risk. The sophistication and nature of the modelling technique for a given market should correspond to the bank’s exposure to the overall (d) • • • 10 [162] A “beta-equivalent” position would be calculated from a market model of equity price returns (such as the CAPM model) by regressing the return on the individual stock or sector index on the risk-free rate of return and the return on the market index.
there should be risk factors corresponding to each of the commodity markets in which the bank holds significant positions (also see paragraph 718(xLvii) above): • For banks with relatively limited positions in commodity-based instruments. and is affected both by market conditions and by factors such as physical storage costs. 718(Lxxvi). Banks will have flexibility in devising the precise nature of their models. A bank may calculate the value-at-risk estimate using a weighting scheme that is not fully consistent with (d) as long as that method results in a capital charge at least as conservative as that calculated according to (d). for example. one-tailed confidence interval is to be used. a straightforward specification of risk factors would be acceptable. In calculating the value-at-risk. Quantitative standards • 4. The supervisory authority may also require a bank to (d) (e) 11 [163] The convenience yield reflects the benefits from direct ownership of the physical commodity (for example. also see 718(Lxxvi) (h) below). For banks that use a weighting scheme or other methods for the historical observation period. the “effective” observation period must be at least one year (that is. Such a specification would likely entail one risk factor for each commodity price to which the bank is exposed. In calculating value-at-risk. but the following minimum standards will apply for the purpose of calculating their capital charge. In cases where the aggregate positions are quite small. i. Banks may use value-at-risk numbers calculated according to shorter holding periods scaled up to ten days by. (a) (b) (c) “Value-at-risk” must be computed on a daily basis. the minimum “holding period” will be ten trading days. the ability to profit from temporary market shortages). a single risk factor for all types of oil). (e) For commodity prices. an instantaneous price shock equivalent to a 10 day movement in prices is to be used. the model must also take account of variation in the “convenience yield” 11 between derivatives positions such as forwards and swaps and cash positions in the commodity. the weighted average time lag of the individual observations cannot be less than 6 months). This updating process must be flexible enough to allow for more frequent updates. A bank using this approach must periodically justify the reasonableness of its approach to the satisfaction of its supervisor.market as well as its concentration in individual equity issues in that market. a 99th percentile. 12 Banks should must update their data sets no less frequently than once every three months and reassess them whenever market prices are subject to material changes. For more active trading. it might be acceptable to use a single risk factor for a relatively broad sub-category of commodities (for instance. The choice of historical observation period (sample period) for calculating value-at-risk will be constrained to a minimum length of one year. Individual banks or their supervisory authorities will have discretion to apply stricter standards. the square root of time (for the treatment of options. 12 Revisions to the Basel II market risk framework 13 .e.
interest rates. This means that banks should measure the volatilities of options positions broken down by different maturities. provided that the supervisory authority is satisfied that the bank’s system for measuring correlations is sound and implemented with integrity. e. national authorities may require banks to adjust their capital measure for options risk through other methods. 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. The following criteria apply to the measurement of options risk: • • Banks’ models must capture the non-linear price characteristics of options positions. The period used must be approved by the supervisor and regularly reviewed. although other periods relevant to the current portfolio must be considered by the bank. So long as each model used captures all the material risks run by the bank. for example.e. one-tailed confidence interval value-at-risk measure of the current portfolio. As an example. periodic simulations or stress testing. a 12-month period relating to significant losses in 2007/2008 would adequately reflect a period of such stress. banks will be free to use models based. Banks are expected to ultimately move towards the application of a full 10 day price shock to options positions or positions that display option-like characteristics. this is justified by a significant upsurge in price volatility. (f) No particular type of model is prescribed. 99th percentile. The supervisory authority may also recognise empirical correlations across broad risk factor categories. a bank must calculate a ‘stressed value-at-risk’ measure.g. Each bank’s risk measurement system must have a set of risk factors that captures the volatilities of the rates and prices underlying option positions. 14 Revisions to the Basel II market risk framework . for many portfolios.calculate its value-at-risk using a shorter observation period if. equity prices and commodity prices. on variancecovariance matrices. (g) (h) • (i) In addition. or applying absolute rather than relative (j) 13 Firms should consider modelling valuation changes that are based on the magnitude of historic price movements. i. Banks will have discretion to recognise empirical correlations within broad risk categories (e. applied in both directions – irrespective of the direction of the historic movement. in the supervisor’s judgement. as set out in paragraph 718(Lxxv). As no particular model is prescribed under paragraph (f) above. banks should consider applying anti-thetic 13 data. with model inputs calibrated to historical data from a continuous 12-month period of significant financial stress relevant to the bank’s portfolio.g. vega risk. and should therefore be based on the 10-day. In the interim. including related options volatilities in each risk factor category). For example. or Monte Carlo simulations. Banks’ models must accurately capture the unique risks associated with options within each of the broad risk categories. This measure is intended to replicate a value-at-risk calculation that would be generated on the bank’s current portfolio if the relevant market factors were experiencing a period of stress. Banks with relatively large and/or complex options portfolios should have detailed specifications of the relevant volatilities. exchange rates. historical simulations.
mc ⋅ VaRavg } + max {sVaRt −1.e. 718(Lxxviii). Supervisors will have national discretion to require banks to perform backtesting on either hypothetical (i. the capital requirement (c) is calculated according to the following formula: c = max {VaRt −1.volatilities to deliver an appropriate stressed value-at-risk.” The backtesting results applicable for calculating the plus are based on value-at-risk only and not stressed value-at-risk. and net interest income) outcomes. plus. or make the control of risk in those Revisions to the Basel II market risk framework 15 . Banks’ stress scenarios need to cover a range of factors that can create extraordinary losses or gains in trading portfolios. the plus factor could be zero. Banks that use the internal models approach for meeting market risk capital requirements must have in place a rigorous and comprehensive stress testing program. Banks will be required to add to theseis factors a “plus” directly related to the ex-post performance of the model. and (2) an average of the stressed value-at-risk numbers calculated according to (i) above over the preceding sixty business days (sVaRavg). Stress testing (m) 5. If the backtesting results are satisfactory and the bank meets all of the qualitative standards set out in paragraph 718(Lxxiv) above. Banks using models will also be subject to a capital charge to cover specific risk (as defined under the standardised approach for market risk) of interest rate related instruments and equity securities. • The higher of (1) its latest available stressed-value-at-risk number calculated according to (i) above (sVaRt-1).e. The stressed valueat-risk should be calculated at least weekly. multiplied by a multiplication factor (ms). subject to an absolute minimum of 3 for mc and an absolute minimum of 3 for ms. 718(Lxxvii). or actual trading (i. using changes in portfolio value that would occur were end-of-day positions to remain unchanged). (k) Each bank must meet. ms ⋅ sVaRavg } (l) The multiplication factors mc and ms will be set by individual supervisory authorities on the basis of their assessment of the quality of the bank’s risk management system. multiplied by a multiplication factor (mc). Stress testing to identify events or influences that could greatly impact banks is a key component of a bank’s assessment of its capital position. thereby introducing a built-in positive incentive to maintain the predictive quality of the model. The manner in which the specific risk capital charge is to be calculated is set out in paragraphs 718(Lxxxvii) to 718(xcviii). The plus will range from 0 to 1 based on the outcome of so-called “backtesting. The Annex 10a of this Framework presents in detail the approach to be applied for backtesting and the plus factor. excluding fees. and (2ii) an average of the daily value-at-risk measures on each of the preceding sixty business days (VaRavg). a capital requirement expressed as the sum of: • The higher of (1i) its previous day’s value-at-risk number measured according to the parameters specified in this section (VaRt-1). commissions. or both. Therefore. on a daily basis.
(ii) Scenarios requiring a simulation by the bank 718(Lxxxii). These factors include low-probability events in all major types of risks. the above-mentioned situations involved correlations within risk factors approaching the extreme values of 1 or -1 for several days at the height of the disturbance. the suspension of the ERM. A second type of scenario would evaluate the sensitivity of the bank’s market risk exposure to changes in the assumptions about volatilities and correlations.e. Specifically. including the various components of market. credit. supervisory authorities may ask banks to provide information on stress testing in three broad areas. The 1987 equity crash. 718(Lxxx). for For example. incorporating both the large price movements and the sharp reduction in liquidity associated with these events. 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. Stress scenarios need to shed light on the impact of such events on positions that display both linear and nonlinear price characteristics (i. periodically. the 1987 equity crash. This loss information could be compared to the level of capital that results from a bank’s internal measurement system. which are discussed in turn below. Due consideration should be given to the sharp variation that at times has occurred in a matter of days in periods of significant market disturbance. and operational risks. 16 Revisions to the Basel II market risk framework .portfolios very difficult. For example. Quantitative criteria should identify plausible stress scenarios to which banks could be exposed. the Exchange Rate Mechanism (ERM) crises of 1992 and 1993 or. 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. the fall in bond markets in the first quarter of 1994. These scenarios could include testing the current portfolio against past periods of significant disturbance. to the bank’s board of directors. for example. incorporating both market risk and liquidity aspects of market disturbances. Applying this test would require an evaluation of the historical range of variation for volatilities and correlations and evaluation of the bank’s current positions against the extreme values of the historical range. Banks should combine the use of supervisory stress scenarios with stress tests developed by banks themselves to reflect their specific risk characteristics. Banks’ stress tests should be both of a quantitative and qualitative nature. Banks should subject their portfolios to a series of simulated stress scenarios and provide supervisory authorities with the results. (i) Supervisory scenarios requiring no simulations by the bank 718(Lxxxi). 718(Lxxix). or the fall in bond markets in the first quarter of 1994. the 1998 Russian financial crisis. options and instruments that have options-like characteristics). Banks should have information on the largest losses experienced during the reporting period available for supervisory review. it could provide supervisory authorities with a picture of how many days of peak day losses would have been covered by a given value-at-risk estimate. the 2000 bursting of the technology stock bubble or the 2007/2008 sub-prime crisis.
e. Thus. a bank should also develop its own stress tests which it identifies as most adverse based on the characteristics of its portfolio (e. exchange rates (which may include gold). Making sure that data flows and processes associated with the risk measurement system are transparent and accessible. This means that banks should make the results as well as the underlying inputs to their value-at-risk calculations available to their supervisory authorities and/or external auditors on request. is insignificant. which in all cases should be independent from the trading area. it is necessary that auditors or supervisory authorities are in a position to have easy access. 718(Lxxxiv). to the models’ specifications and parameters. The validation of models’ accuracy by external auditors and/or supervisory authorities should at a minimum include the following steps: (a) (b) Verifying that the internal validation processes described in paragraph 718(Lxxiv) (i) are operating in a satisfactory manner. Combination of internal models and the standardised methodology (c) (d) (e) 7. External validation 718(Lxxxv). be expected to extend the models to all their market risks. In addition to the scenarios prescribed by supervisory authorities under paragraphs 718(Lxxxi) and 718(Lxxxii) above. Banks should provide supervisory authorities 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 scenarios. comparing value-at-risk estimates with actual profits and losses) to ensure that the model provides a reliable measure of potential losses over time. by hedging against that outcome or reducing the size of its exposures). problems in a key region of the world combined with a sharp move in oil prices). banks which start to use models for one or more risk factor categories will. whenever they judge it necessary and under appropriate procedures. In particular. equity prices and commodity prices. 718(Lxxxvi).(iii) Scenarios developed by the bank itself to capture the specific characteristics of its portfolio. Checking that the structure of internal models is adequate with respect to the bank’s activities and geographical coverage. over time.e. with related options volatilities being included in each risk factor category). Checking the results of the banks’ back-testing of its internal measurement system (i. 718(Lxxxiii). Unless a bank’s exposure to a particular risk factor. A bank which has developed one or more models will no longer be able to revert to measuring the risk measured by those models according to the Revisions to the Basel II market risk framework 17 .g. if the testing reveals particular vulnerability to a given set of circumstances. such as commodity prices. the internal models approach will in principle require banks to have an integrated risk measurement system that captures the broad risk factor categories (i. Ensuring that the formulae used in the calculation process as well as for the pricing of options and other complex instruments are validated by a qualified unit. interest rates. the national authorities would expect the bank to take prompt steps to manage those risks appropriately (e. Moreover. 6. The results should be reviewed periodically by senior management and should be reflected in the policies and limits set by management and the board of directors.g.
14 All the criteria laid down in paragraphs 718(Lxx) to 718(xcix) of this Framework will apply to the models being used.e. in remote locations. i. The capital charges assessed under the standardised approach and under the models approach are to be aggregated according to the simple sum method. pending further experience regarding the process of changing to a models-based approach. 718(Lxxxvii). for example. For interest rate risk positions other than securitisation exposures and n-th-to-default credit derivatives.e. as well as the additional criteria and requirements set out in paragraphs 718(Lxxxviii) to 718(xci-2-) 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 718(xix) to 718(xxviii). when all of the following conditions hold: (a) The bank has a value-at-risk measure that incorporates specific risk and the supervisor has determined that the bank meets all the qualitative and quantitative requirements for general market risk models. Banks may not modify the combination of the two approaches they use without justifying to their supervisory authority that they have a good reason for doing so. as well as the additional criteria and requirements set out in paragraphs 718(Lxxxviii) to 718(xci-2-) below. No element of market risk may escape measurement. would have to be captured. 18 Revisions to the Basel II market risk framework . However. banks may incur risks in positions which are not captured by their models. The following conditions will apply to banks using such combinations: (a) Each broad risk factor category must be assessed using a single approach (either internal models or the standardised approach). and 14 [164] However. it may base its charge on modelled estimates. Where a bank has a VaR measure that incorporates specific risk from equity risk positions and where the supervisor has determined that the bank meets all the qualitative and quantitative requirements for general market risk models. i. no specific time limit will be set for banks which use a combination of internal models and the standardised methodology to move to a comprehensive model. 718(Lxxxvii-1-). the exposure for all the various risk factors. Treatment of specific risk (b) (c) (d) (e) 8. provided the measure is based on models that meet the additional criteria and requirements set out below. in minor currencies or in negligible business areas. as specified in paragraphs 709(ii) to 718. whether calculated according to the standardised approach or internal models.standardised methodology (unless the supervisory authority withdraws approval for that model). the bank will not be required to subject these positions to the standardised capital charge for specific risk. no combination of the two methods will in principle be permitted within a risk category or across banks’ different entities for the same type of risk (but see paragraph 708(i) above). Banks which are unable to meet these additional criteria and requirements will be required to base their specific risk capital charge on the full amount of the specific risk charge calculated under the standardised method. Such risks should be measured according to the standardised methodology.
with the exceptions noted in paragraphs 718(xcv) to 718(xcviii) below. The criteria for supervisory recognition of banks’ modelling of specific risk require that a bank’s model must capture all material components of price risk15 and be responsive to changes in market conditions and compositions of portfolios. maturity mismatches. a bank is expected to work with its national supervisor to define an acceptable alternative measure which would meet this regulatory objective. Another approach for demonstrating this is through simulation of historical or plausible worst-case environments. [165] The key ex ante measures 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 risk factors included within the model. firms must consider issues related to survivorship bias. Notwithstanding. 16 capture concentrations (magnitude and changes in composition). In particular. 18 capture name-related basis risk. of the historical price variation or the model should explicitly include estimates of the residual variability not captured in the factors included in this regression. 21 718(Lxxxix). 19 capture event risk. merger break-ups/takeovers. e. because it is beyond the 10-day holding period and 99 percent confidence interval (i. banks must ensure 15 Banks need not capture default and migration risks for positions subject to the incremental risk capital charge referred to in paragraphs 718(xcii) and 718(xciii). [168] Banks should be able to demonstrate that the model is sensitive to material idiosyncratic differences between similar but not identical positions. [166] The bank would 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 in particular names or sectors. [170] Aimed at assessing whether specific risk. 17 be robust to an adverse environment. 16 17 18 19 20 21 Revisions to the Basel II market risk framework 19 . (deleted) Where a bank is subject to event risk that is not reflected in its VaR measure. If this measure is to be used. such as 90%. In such instance. for example debt positions with different levels of subordination. 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 the downward portion of the cycle. it is still required to hold additional capital for these products according to the standardised measurement methodology. the model must: • • • • • • explain the historical price variation in the portfolio. as well as general market risk. 20 be validated through backtesting. it may not be feasible to calculate a goodness-of-fit measure. The bank is allowed to include its securitisation exposures and n-th-to-default credit derivatives in its value-at-risk measure. 718(Lxxxviii). [167] The bank should be able to demonstrate that the model will signal rising risk in an adverse environment. or credit derivatives with different default events. events that are reflected in large changes or jumps in prices must be captured. low probability and high severity events).g. [169] For equity positions. For some types of models.(b) The supervisor is satisfied that the bank’s internally developed approach adequately captures incremental default and migration risks for positions subject to specific interest rate risk according to the standards laid out in paragraphs 718(xcii) and 718(xciii) below. In particular. is being captured adequately. the risk factors included in the bank’s model would be expected to be able to explain a high percentage. One measure of this type which can often be used is an R-squared measure from regression methodology.e.
the bank must have an approach in place to capture in its regulatory capital default risk and migration risk of in positions its subject to a capital charge for specific interest rate risk. traded corporate debt. if a bank itself decomposes its trading portfolio into finer categories (e. 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 backtest showed had not been adequately captured. To avoid double counting a bank may. and only where they are appropriately conservative. However. Banks which apply modelled estimates of specific risk are required to conduct backtesting aimed at assessing whether specific risk is being accurately captured.that the impact of such events is factored in to its internal capital assessment. emerging markets.No specific approach for capturing the incremental default risks is prescribed. the model must meet minimum data standards. banks should avail themselves of these advances. trading book positions that is are incremental to the risks captured by the VaR-based calculation as specified in paragraph 718(Lxxxviii) above (“incremental risks”). 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 Zone as defined in Annex 10a of this Framework. etc. Further.).g. The key sub-portfolios for this purpose are tradeddebt and equity positions. The Committee provides guidelines to specify the positions and risks to be covered by this incremental risk capital charge. In addition. 718(Xci). In addition. 718(XCiii). Banks are required to commit to a sub-portfolio structure and stick to it unless it can be demonstrated to the supervisor that it would make sense to change the structure. especially for risk positions that could and would be closed within 10 days in the event of adverse market conditions or other indications of deterioration in the credit environment. 718(XCii). 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. Where a bank captures its incremental risk through a surcharge. although the bank should be able to demonstrate that the surcharge meets its aim. 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. for example through its stress testing. Banks are required to have in place a process to analyse exceptions identified through the backtesting of specific risk. Whichever approach is used. tThe bank must demonstrate that it the approach used to capture incremental risks meets a soundness standard 20 Revisions to the Basel II market risk framework . Proxies may be used only where available data is insufficient or is not reflective of the true volatility of a position or portfolio. it is appropriate to keep these distinctions for sub-portfolio backtesting purposes. the surcharge will not be subject to a multiplier or regulatory backtesting. The methodology a bank should use for validating its specific risk estimates is to perform separate backtests on sub-portfolios using daily data on subportfolios subject to specific risk. as techniques and best practices evolve. take into account the extent to which default risk has already been incorporated into the VaR calculation. 718(xc). 718(XCi-1-). 718(XCi-2-). when calculating its incremental default charge. it may be part of the bank's internal model or a surcharge from a separate calculation. with the exception of securitisation exposures and n-th-to-default credit derivatives.
the risk of hedge slippage and the potential costs of rebalancing such hedges. concentrations. would be subject to a capital charge that is no less than that set forth in the securitisation framework. including both • • • • the basis between the spread of an index and those of its constituent single names. basis risk. 22 as well as securitisation exposures that are unrated liquidity lines or letters of credit. 22 [171] These include risk equivalent positions. as it relates to the propensity for recovery rates to affect tranche prices. hedging. It must. The value of such products is subject in particular to the following risks which must be adequately captured: • • • • the cumulative risk arising from multiple defaults. This exception only applies to banks that are active in buying and selling these products. volatility of implied correlations. under the assumption of a constant level of risk. including the ordering of defaults. in tranched products.g. 718(XCiv). e.g. A bank that does not capture the incremental default risks through an internally developed approach must use the specific risk capital charges under the standardised measurement method as set out in paragraphs 710 to 718 and 718(xxi) the fallback of calculating the surcharge through an approach consistent with that for credit risk as set forth in this Framework. 718(XCvi) and 718(xcvii). recovery rate volatility. as applicable. equity tranches that absorb first losses). and to the extent the comprehensive risk measure incorporates benefits from dynamic hedging.comparable to that of the internal-ratings based approach for credit risk as set forth in this Framework. including the cross effect between spreads and correlations. and the basis between the implied correlation of an index and that of bespoke portfolios. (deleted) Whichever approach is used. cash or synthetic exposures that would be subject to a deduction treatment under the securitisation framework set forth in this Framework (e. For the exposures that the bank does incorporate in this internally developed approach. The approach must meet all of the requirements specified in paragraphs 718(XCiii). credit spread risk. the bank will not be required to subject them to the capital charge for specific risk according to the standardised measurement method or the treatment according to paragraph 718(XCiii). inventories of credit exposures that the bank intends to sell through cash securitisations and for which it has in place tranched credit protections so that it retains an exposure that would be subject to deduction under the securitisation framework. Subject to supervisory approval. including the gamma and cross-gamma effects. Revisions to the Basel II market risk framework 21 . but all price risks (“comprehensive risk measure”). a bank may incorporate its correlation trading portfolio in an internally developed approach that adequately captures not only incremental default and migration risks. 718(XCv). and adjusted where appropriate to reflect the impact of liquidity. and optionality.
the supervisor may impose a supplemental capital charge against the correlation trading portfolio. and (iv) correlations on the correlation trading desk’s P&L. and Ensure that it can separate the positions for which it holds approval to incorporate them in its comprehensive risk measure from those positions for which it does not hold this approval. These stress scenarios will examine the implications of stresses to (i) default rates. and (ii) the most recent incremental risk measure. In addition to these data and modelling criteria. 718(XCvi). There will 22 Revisions to the Basel II market risk framework . Both capital charges are added up.0 times the maximum of (i) the average of the incremental risk measures over 12 weeks. An exception to this treatment could be afforded to banks that are dealers in the above exposures where they can demonstrate.e. For purposes of this section a two-way market is deemed to exist where there are independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined within one day and settled at such price within a relatively short time conforming to trade custom.0 times the maximum of (i) the average of the comprehensive risk measures over 12 weeks. Any instances where the stress tests indicate a material shortfall of the comprehensive risk measure must be reported to the supervisor in a timely manner. in addition to trading intent. predetermined stress scenarios to the portfolio that receives internal model regulatory capital treatment (i. (iii) credit spreads.. incorporate them in both the value-at-risk and stressed value-at-risk measures. it must • Have sufficient market data to ensure that it fully captures the salient risks of these exposures in its comprehensive risk measure in accordance with the standards set forth above. A bank must calculate the incremental risk measure according to paragraph 718(xcii) and the comprehensive risk measure according to paragraph 718(xcv) at least weekly. including comparisons with the capital charges implied by the banks’ internal model for estimating comprehensive risks. For a bank to apply this exception.The bank may also incorporate any position in this internally developed approach that are jointly managed with these positions. to be added to the bank’s internally modelled capital requirement. the ‘correlation trading portfolio’). through backtesting) that its risk measures can appropriately explain the historical price variation of these products. 718(xcvii). or more frequently as directed by its supervisor. Likewise. at least quarterly to its supervisor. Demonstrate (for example. in the case of synthetic securitisations that rely solely on credit derivatives. 718(xcviii). that a liquid two-way market exists. for the securitisation exposures or. The capital charge for incremental risk is given by a scaling factor of 1. • • Banks that already have received specific risk model recognition for particular portfolios or lines of business should agree a timetable with their supervisors to bring their model in line with the new standards in a timely manner as is practicable. Based on these stress testing results. for a bank to apply this exception it must regularly apply a set of specific. (ii) recovery rates. and (ii) the most recent comprehensive risk measure. The bank must apply these stress scenarios at least weekly and report the results. the capital charge for comprehensive risk is given by a scaling factor of 1.however. for the securitisation exposures themselves or all their constituent risk components.
Moreover. 9.g. net interest income and intra-day trading. then the bank must ensure that the proxies produce conservative results under relevant market scenarios. Ensuring that material basis risks are adequately captured. testing for model validation should must use additional tests. or pricing models. also include the following: (a) Tests to demonstrate that any assumptions made within the internal model are appropriate and do not underestimate risk. additional tests are required which may include. (b) • • (c) The use of hypothetical portfolios to ensure that the model is able to account for particular structural features that may arise. The longer time period generally improves the power of the backtesting. This may include the assumption of the normal distribution. Model validation standards 718(XCix). 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. More extensive model validation is particularly important where specific risk is also modelled and is required to meet the further specific risk criteria. banks should avail themselves of these advances. As techniques and best practices evolve. Testing of portfolios below the overall bank level. commissions. 3 years). for instance: • Testing carried out for longer periods than required for the regular backtesting programme (e. • Ensuring that the model captures concentration risk that may arise in an undiversified portfolio. Testing carried out using confidence intervals other than the 99 percent interval required under the quantitative standards. Model validation should not be limited to backtesting. It therefore excludes fees. which may include for instance: Testing carried out using hypothetical changes in portfolio value that would occur were end-of-day positions to remain unchanged. Revisions to the Basel II market risk framework 23 . Further to the regulatory backtesting programmes. but should. bid-ask spreads. at a minimum. This validation should be conducted when the model is initially developed and when any significant changes are made to the model. 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.be no adjustment for double counting between the comprehensive risk measure and any other risk measures. This may include mismatches between long and short positions by maturity or by issuer. 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. for example: • Where data histories for a particular instrument do not meet the quantitative standards in paragraph 718(Lxxvi) and where the bank has to map these positions to proxies. 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.
Changes to the supervisory review process for market risk 22. For banks wishing to model the specific risk arising from their trading activities. Where supervisors consider that limited liquidity or price transparency undermines the effectiveness of a bank’s model to capture the specific risk. In order to ensure consistency with the revised name of the incremental risk capital charge. and • commodity risk. Supervisors should review the adequacy of the bank’s measure of the default incremental risk surcapital charge. The capital requirements for: • interest rate risk. paragraph 778(iv) of the Basel II Framework will be changed as follows. 24 • equity position risk. they will take appropriate measures. 24 24 Revisions to the Basel II market risk framework . Changed wording is underlined. Separate disclosures are required for the capital requirements on securitisation positions under Table 9. of Part 4 of the Basel II Framework (Tables 10 and 11) are amended as follows. the use of the standardised specific risk charges will be required.3.D. Market risk Table 10 Market risk: disclosures for banks using the standardised approach 23 Qualitative disclosures Quantitative disclosures (a) The general qualitative disclosure requirement (paragraph 824) for market risk including the portfolios covered by the standardised approach. VII. additional criteria have been set out in paragraph 718(Lxxxix). including requiring the exclusion of positions from the bank’s specific risk model. Changes to the disclosure requirements for market risk 23. • foreign exchange risk. 778(iv). The disclosure requirements for market risk set out in Pillar 3.VI. including conservatively assessing the risk arising from less liquid positions and/or positions with limited price transparency under realistic market scenarios. Section II. (b) 23 The standardised approach here refers to the “standardised measurement method” as defined in Part 2. Changed wording is underlined. where the bank’s approach is inadequate. Section VI C. 3.
mean and low stressed VaR values over the reporting period and period-end. The discussion should include an articulation of the soundness standards on which the bank’s internal capital adequacy assessment is based. It should also include a description of the methodologies used to achieve a capital adequacy assessment that is consistent with the soundness standards. For each portfolio covered by the IMA: • the characteristics of the models used. with analysis of important “outliers” in backtest results. • The high.Table 11 Market risk: disclosures for banks using the internal models approach (IMA) for trading portfolios Qualitative disclosures (a) The general qualitative disclosure requirement (paragraph 824) for market risk including the portfolios covered by the IMA. For the incremental risk capital charge and the comprehensive risk capital charge the methodologies used and the risks measured through the use of internal models. mean and low VaR values over the reporting period and period-end. (b) (c) (d) (e) Quantitative disclosures (ef) For trading portfolios under the IMA: • The high. The scope of acceptance by the supervisor. and • the approaches used in the validation of the models. and • a description of the approach used for backtesting/validating the accuracy and consistency of the internal models and modelling processes. Included in the qualitative description should be: • the approach used by the bank to determine liquidity horizons. a discussion of the extent of and methodologies for compliance with the “Prudent valuation guidance” for positions held in the trading book (paragraphs 690 to 701). and • A comparison of VaR estimates with actual gains/losses experienced by the bank. • a description of stress testing applied to the portfolio. In addition. • The high. Revisions to the Basel II market risk framework 25 . mean and low incremental and comprehensive risk capital charges over the reporting period and period-end. • the methodologies used to achieve a capital assessment that is consistent with the required soundness standard.
Changed wording compared to the previous paragraphs 690 to 699 is underlined. whether they are in the trading book or in the banking book.VIII. Treatment for illiquid positions 24. One factor in a supervisor’s assessment of whether a bank must take a valuation adjustment for regulatory purposes under paragraphs 718(cx) to 718(cxii) should be the degree of consistency between the bank’s valuation procedures and these guidelines. Section VI. timing of closing prices. end of the month and ad-hoc verification procedures. The valuation guidance set forth below is not intended to require banks to change valuation procedures for financial reporting purposes.A. This guidance is especially important for positions without actual market prices or observable inputs to valuation. guidelines for the use of unobservable inputs reflecting the bank’s assumptions of what market participants would use in pricing the position. Supervisors should assess a bank’s valuation procedures for consistency with this guidance. VII. These systems must be integrated with other risk management systems within the organisation (such as credit analysis). frequency of independent valuation. although they will not be excluded from the trading book solely on grounds of lesser liquidity. 718(ci). Systems and controls 718(cii). This section provides banks with guidance on prudent valuation for positions that are accounted for at fair value. raise supervisory concerns about prudent valuation. whether they are in the trading book or in the banking book. Treatment for illiquid positions Prudent valuation guidance 718(c). and Clear and independent (ie independent of front office) reporting lines for the department accountable for the valuation process. • 26 Revisions to the Basel II market risk framework . The paragraphs are changed as follows. A. This includes clearly defined responsibilities of the various areas involved in the determination of the valuation.2 of Part 2 of the Basel II Framework outlining the prudent valuation guidance will be moved to a new Section VII since the scope has been expanded from positions in the trading book to all positions that are accounted for at fair value. A framework for prudent valuation practices should at a minimum include the following: 1. This captures the original objective of the requirement which was defined when only instruments in the trading book were accounted for at fair value. Such systems must include: • Documented policies and procedures for the process of valuation. Banks must establish and maintain adequate systems and controls sufficient to give management and supervisors the confidence that their valuation estimates are prudent and reliable. as well as less liquid positions which. sources of market information and review of their appropriateness. The reporting line should ultimately be to a main board executive director. procedures for adjusting valuations.
When marking to model. Marking-tomodel is defined as any valuation which has to be benchmarked. Market inputs should be sourced. 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. Banks should maximise the use of relevant observable inputs and minimise the use of unobservable inputs when estimating fair value using a valuation technique. screen prices. or quotes from several independent reputable brokers. generally accepted valuation methodologies for particular products should be used as far as possible. The model should be subject to periodic review to determine the accuracy of its performance (eg assessing continued appropriateness of the • • • • • • Revisions to the Basel II market risk framework 27 . In such cases. the assumptions and the software implementation. Risk management should be aware of the weaknesses of the models used and how best to reflect those in the valuation output. which have been assessed and challenged by suitably qualified parties independent of the development process. the observable data should be considered. The appropriateness of the market inputs for the particular position being valued should be reviewed regularly. but may not be determinative. an extra degree of conservatism is appropriate. This includes validating the mathematics. should banks may mark-to-model. such as when markets are inactive. to the extent possible. Where the model is developed by the institution itself. it should be based on appropriate assumptions. extrapolated or otherwise calculated from a market input. in line with market prices (as discussed above). such as in a forced liquidation or distressed sale. Banks must mark-to-market as much as possible.2. Supervisory authorities will consider the following in assessing whether a mark-to-model valuation is prudent: • 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. but where this can must be demonstrated to be prudent. However. 718(civ). Marking-to-market is at least the daily valuation of positions at readily available close out prices in orderly transactions that are sourced independently. or transactions may not be observable. The model should be developed or approved independently of the front office. The more prudent side of bid/offer must should be used unless the institution is a significant market maker in a particular position type and it can close out at mid-market. Where Only where marking-to-market is not possible. Where available. Marking to model 718(cv). Examples of readily available close out prices include exchange prices. It should be independently tested. observable inputs or transactions may not be relevant. Valuation methodologies Marking to market 718(ciii).
analysis of P&L versus risk factors. Banks As part of their procedures for marking to market. model risk. Valuation adjustments or reserves 718(cviii). While daily marking-to-market may be performed by dealers. Supervisory authorities expect banks using third-party valuations to consider whether valuation adjustments are necessary. Independent price verification 718(cvi). Such considerations are also necessary when marking to model. where appropriate. ie independent. operational risks. more frequently). where pricing sources are more subjective. Adjustment to the current valuation of less liquid positions for regulatory capital purposes 718(cx). Supervisory authorities expect 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. since the objective. It is the process by which market prices or model inputs are regularly verified for accuracy. comparison of actual close out values to model outputs). 28 Revisions to the Basel II market risk framework . investing and funding costs. eg only one available broker quote. 718(cix). 718(cvii). For independent price verification. early termination. marking of positions should reveal any error or bias in pricing. to cover the uncertainty of the model valuation (see also valuation adjustments in paragraphs 718 (cviii) to 718 (cxii)).assumptions. banks must establish and maintain procedures for considering valuation adjustments/reserves. 3. at least monthly (or. 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. Supervisory authorities expect the following valuation adjustments/ reserves to be formally considered at a minimum: unearned credit spreads. which should result in the elimination of inaccurate daily marks. 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. and future administrative costs and. whereas daily marks are used primarily for management reporting in between reporting dates. It need not be performed as frequently as daily mark-to-market. third-party valuations or marked to model. depending on the nature of the market/trading activity. for example. B. closeout costs. verification of market prices or model inputs should be performed by a unit independent of the dealing room. Independent price verification is distinct from daily mark-to-market. 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. prudent measures such as valuation adjustments may be appropriate. • Valuation adjustments should be made as appropriate.
Revisions to the Basel II market risk framework 29 . and the impact of other model risks not included in paragraph 718 (cx). Additionally. Reduced liquidity could may have arisen from market events. securitisation exposures and n-th-to-default credit derivatives. and the risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model. Valuation adjustments/reserves The adjustment to the current valuation of less liquid positions made under paragraph 718 (cxi) must impact Tier 1 regulatory capital and may exceed those valuation adjustments made under financial reporting accounting standards and paragraphs 718 (cviii) and 718 (cix). and to review their continued appropriateness on an on-going basis. but are not limited to. 718(cxi-1-) For complex products including. the availability of independent market quotes (number and identity of market makers). banks must make downward valuation adjustments/reserves take an adjustment to the current valuation of these less liquid positions. Bearing in mind that the underlying 10-day assumptions made about liquidity in the market risk capital charge in paragraph 718(Lxxvi) (c) may not be consistent with the bank’s ability to sell or hedge out less liquid positions under normal market conditions. These factors may include. the aging of positions. close-out prices for concentrated positions and/or stale positions should be considered in establishing those valuation adjustments/reserves the adjustment. the average and volatility of trading volumes (including trading volumes during periods of market stress). the extent to which valuation relies on marking-to-model. Banks must consider all relevant factors when determining the appropriateness of valuation adjustments/reserves the adjustment for less liquid positions. 718(cxii). the average volatility of bid/offer spreads. banks must explicitly assess the need for valuation adjustments to reflect two forms of model risk: the model risk associated with using a possibly incorrect valuation methodology. where appropriate.718(cxi). the amount of time it would take to hedge out the position/risks within the position. market concentrations. but not limited to.
Documents Similar To Basel_Market_Risk_Framework
Pprofessional Banking Course
Andrew Haldane - The Dog and the Frisbee.pdf
2007 Meltdown of Structured Finance
Assessing the Disconnection Between Banks Financial and Regulatory Reporting Paper by P Klumpes
More From Satya Jit
Draft Notice (1920 London) - 8th May 2014
Competitor Intelligence)
Customer Analysis in Mkting Mgt