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Basel ii Accord
Sections 684 to 706 |
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VI.
Trading book issues
A.
Definition of the trading
book
684.
The following definition of the trading book
replaces the present definition in
the
Market
Risk Amendment (see Introduction to the Market
Risk Amendment — Section I,
paragraph
2).
685.
A trading book consists of positions in
financial instruments and commodities
held
either
with trading intent or in order to hedge other
elements of the trading book. To
be
eligible
for trading book capital treatment, financial
instruments must either be free of
any
restrictive
covenants on their tradability or able to be
hedged completely. In addition,
positions
should be frequently and accurately valued, and
the portfolio should be
actively
managed.
686.
A financial instrument is any contract that
gives rise to both a financial asset of
one
entity
and a financial liability or equity instrument
of another entity. Financial
instruments
include
both primary financial instruments (or cash
instruments) and derivative
financial
instruments.
A financial asset is any asset that is cash, the
right to receive cash or
another
financial
asset; or the contractual right to exchange
financial assets on potentially
favourable
terms,
or an equity instrument. A financial liability
is the contractual obligation to deliver cash or
another financial asset or to exchange financial
liabilities under conditions that
are
potentially
unfavourable.
687.
Positions held with trading intent are those
held intentionally for short-term
resale
and/or
with the intent of benefiting from actual or
expected short-term price movements or to lock
in arbitrage profits, and may include for
example proprietary positions, positions arising
from client servicing (e.g. matched principal
broking) and market making.
687
(i). Banks must have clearly defined policies
and procedures for determining
which
exposures
to include in, and to exclude from, the trading
book for purposes of
calculating
their
regulatory capital, to ensure compliance with
the criteria for trading book set forth in this
Section and taking into account the bank’s risk
management capabilities and
practices.
Compliance
with these policies and procedures must be fully
documented and subject to
periodic
internal audit.
687
(ii). These policies and procedures should, at a
minimum, address the general
considerations
listed below. The list below is not intended to
provide a series of tests that
a
product
or group of related products must pass to be
eligible for inclusion in the trading
book.
Rather,
the list provides a minimum set of key points
that must be addressed by the
policies
and
procedures for overall management of a firm’s
trading book:
•
The
activities the bank considers to be trading and
as constituting part of the
trading
book
for regulatory capital
purposes;
•
The
extent to which an exposure can be
marked-to-market daily by reference to
an
active,
liquid two-way market;
•
For
exposures that are marked-to-model, the extent
to which the bank
can:
(i)
Identify the material risks of the
exposure;
(ii)
Hedge the material risks of the exposure and the
extent to which hedging
instruments
would have an active, liquid two-way
market;
(iii)
Derive reliable estimates for the key
assumptions and parameters used
in
the
model.
•
The
extent to which the bank can and is required to
generate valuations for the
exposure
that can be validated externally in a consistent
manner;
•
The
extent to which legal restrictions or other
operational requirements
would
impede
the bank’s ability to effect an immediate
liquidation of the exposure;
•
The
extent to which the bank is required to, and
can, actively risk manage
the
exposure
within its trading operations;
and
•
The
extent to which the bank may transfer risk or
exposures between the
banking
and
the trading books and criteria for such
transfers.
688.
The following will be the basic requirements for
positions eligible to receive
trading
book
capital treatment.
•
Clearly documented
trading strategy for the position/instrument or
portfolios,
approved
by senior management (which would include
expected holding horizon).
•
Clearly defined
policies and procedures for the active
management of the position,
which
must include:
–
positions are managed on a trading
desk;
–
position limits are set and monitored for
appropriateness;
–
dealers have the autonomy to enter into/manage
the position within agreed
limits
and according to the agreed
strategy;
–
positions are marked to market at least daily
and when marking to model
the
parameters must be assessed on a daily
basis;
–
positions are reported to senior management as
an integral part of the
institution’s
risk management process; and
–
positions are actively monitored with reference
to market information
sources
(assessment should be made of the market
liquidity or the ability to
hedge
positions or the portfolio risk profiles). This
would include assessing
the
quality and availability of market inputs to the
valuation process, level of
market
turnover, sizes of positions traded in the
market, etc.
•
Clearly defined
policy and procedures to monitor the positions
against the bank’s
trading
strategy including the monitoring of turnover
and stale positions in the
bank’s
trading
book.
689.
(deleted)
689
(i). When a bank hedges a banking book credit
risk exposure using a credit
derivative
booked
in its trading book (i.e. using an internal
hedge), the banking book exposure is
not
deemed
to be hedged for capital purposes unless the
bank purchases from an eligible
third
party
protection provider a credit derivative meeting
the requirements of paragraph 191 vis-ŕvis the
banking book exposure.
Where
such third party protection is purchased and is
recognised as a hedge of a banking book exposure
for regulatory capital purposes, neither the
internal nor external credit derivative hedge
would be included in the trading book for
regulatory capital purposes.
689
(ii). Positions in the bank’s own eligible
regulatory capital instruments are deducted from
capital. Positions in other banks’, securities
firms’, and other financial entities’
eligible
regulatory
capital instruments, as well as intangible
assets, will receive the same
treatment
in
many cases is deduction from capital.
Where
a bank demonstrates that it is an active market
maker then a national supervisor may establish a
dealer exception for holdings of other banks’,
securities firms’, and other financial entities’
capital instruments in the trading book. In
order to qualify for the dealer exception, the
bank must have adequate systems and controls
surrounding the trading of financial
institutions’ eligible regulatory capital
instruments.
689
(iii). Term trading-related repo-style
transactions that a bank accounts for in its
banking
book
may be included in the bank’s trading book for
regulatory capital purposes so long
as
all
such repo-style transactions are included. For
this purpose, trading-related
repo-style
transactions
are defined as only those that meet the
requirements of paragraphs 687
and
688
and both legs are in the form of either cash or
securities includable in the trading
book.
Regardless
of where they are booked, all repo-style
transactions are subject to a
banking
book
counterparty credit risk
charge.
B.
Prudent valuation
guidance
690.
This section provides banks with guidance on
prudent valuation for positions in
the
trading
book. This guidance is especially important for
less liquid positions which,
although
they
will not be excluded from the trading book
solely on grounds of lesser liquidity,
raise
supervisory
concerns about prudent
valuation.
691.
A framework for prudent valuation practices
should at a minimum include the
following:
1. Systems and
controls
692.
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.
These systems must be integrated with other risk
management systems within the
organisation
(such as credit analysis). Such systems must
include:
•
Documented policies
and procedures for the process of valuation.
This includes
clearly
defined responsibilities of the various areas
involved in the determination
of
the
valuation, sources of market information and
review of their
appropriateness,
frequency
of independent valuation, timing of closing
prices, procedures for
adjusting
valuations, end of the month and ad-hoc
verification procedures; and
•
Clear
and independent (i.e. independent of front
office) reporting lines for
the
department
accountable for the valuation process. The
reporting line should
ultimately
be to a main board executive
director.
2. Valuation
methodologies
(i)
Marking to market
693.
Marking-to-market is at least the daily
valuation of positions at readily
available
close
out prices that are sourced independently.
Examples of readily available close
out
prices
include exchange prices, screen prices, or
quotes from several independent
reputable
brokers.
694.
Banks must mark-to-market as much as possible.
The more prudent side of
bid/offer
must
be used unless the institution is a significant
market maker in a particular position
type
and
it can close out at mid-market.
(ii)
Marking to model
695.
Where marking-to-market is not possible, banks
may mark-to-model, where this
can
be
demonstrated to be prudent. Marking-to-model is
defined as any valuation which has
to
be
benchmarked, extrapolated or otherwise
calculated from a market input. When marking to
model, an extra degree of conservatism is
appropriate. 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 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.
•
Market inputs should
be sourced, to the extent possible, in line with
market prices
(as
discussed above). The appropriateness of the
market inputs for the
particular
position
being valued should be reviewed
regularly.
•
Where
available, generally accepted valuation
methodologies for particular
products
should
be used as far as possible.
•
Where
the model is developed by the institution
itself, it should be based
on
appropriate
assumptions, which have been assessed and
challenged by suitably
qualified
parties independent of the development process.
The model should be
developed
or approved independently of the front office.
It should be independently
tested.
This includes validating the mathematics, the
assumptions and the software
implementation.
•
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.
•
Risk
management should be aware of the weaknesses of
the models used and how
best
to reflect those in the valuation
output.
•
The
model should be subject to periodic review to
determine the accuracy of
its
performance
(e.g. assessing continued appropriateness of the
assumptions,
analysis
of P&L versus risk factors, comparison of
actual close out values to
model
outputs).
•
Valuation adjustments
should be made as appropriate, for example, to
cover the
uncertainty
of the model valuation (see also valuation
adjustments in 698 to 701).
(iii)
Independent price
verification
696.
Independent price verification is distinct from
daily mark-to-market. It is the
process
by
which market prices or model inputs are
regularly verified for accuracy. While
daily
marking-to-market
may be performed by dealers, verification of
market prices or model
inputs
should be performed by a unit independent of the
dealing room, at least monthly
(or,
depending
on the nature of the market/trading activity,
more frequently). It need not
be
performed
as frequently as daily mark-to-market, since the
objective, i.e. independent,
marking
of positions, should reveal any error or bias in
pricing, which should result in
the
elimination
of inaccurate daily marks.
697.
Independent price verification entails a higher
standard of accuracy in that
the
market
prices or model inputs are used to determine
profit and loss figures, whereas
daily
marks
are used primarily for management reporting in
between reporting dates. For
independent
price verification, where pricing sources are
more subjective, e.g. only one
available
broker quote, prudent measures such as valuation
adjustments may be
appropriate.
3. Valuation
adjustments or reserves
698.
Banks must establish and maintain procedures for
considering valuation
adjustments/reserves.
Supervisory authorities expect banks using
third-party valuations to
consider
whether valuation adjustments are necessary.
Such considerations are also
necessary
when marking to model.
699.
Supervisory authorities expect the following
valuation adjustments/reserves to
be
formally
considered at a minimum: unearned credit
spreads, close-out costs,
operational
risks,
early termination, investing and funding costs,
and future administrative costs
and,
where
appropriate, model risk.
700.
Bearing in mind that the underlying 10-day
assumption of the Market Risk
Amendment
may not be consistent with the bank’s ability to
sell or hedge out positions under normal market
conditions, banks must make downward valuation
adjustments/reserves for these less liquid
positions, and to review their continued
appropriateness on an on-going basis.
Reduced
liquidity could arise from market events.
Additionally, close-out prices
for
concentrated
positions and/or stale positions should be
considered in establishing
those
valuation
adjustments/reserves. Banks must consider all
relevant factors when
determining
the
appropriateness of valuation
adjustments/reserves for less liquid positions.
These
factors may include, but are not limited to, the
amount of time it would take to hedge out the
position/risks within the position, the average
volatility of bid/offer spreads, the
availability of independent market quotes
(number and identity of market makers), the
average and volatility of trading volumes,
market concentrations, the aging of positions,
the extent to which valuation relies on
marking-to-model, and the impact of other model
risks.
701.
Valuation adjustments/reserves made under
paragraph 700 must impact Tier
1
regulatory
capital and may exceed those made under
financial accounting standards.
C.
Treatment of counterparty credit risk in the
trading book
702.
Banks will be required to calculate the
counterparty credit risk charge for
OTC
derivatives,
repo-style and other transactions booked in the
trading book, separate from the
capital charge for
general market risk and specific
risk.
(111) The risk weights to
be used in this
calculation must be consistent with those used
for calculating the capital requirements in the
banking book.
Thus,
banks using the standardised approach in the
banking book will use the standardised approach
risk weights in the trading book and banks using
the IRB approach in the banking book will use
the IRB risk weights in the trading book in a
manner consistent with the IRB roll out
situation in the banking book as described in
paragraphs 256 to 262. For counterparties
included in portfolios where the IRB approach is
being used the IRB risk weights will have to be
applied. The 50% cap on risk weights for OTC
derivative transactions is abolished (see
paragraph 82).
(111)
The treatment for unsettled foreign exchange and
securities trades is set forth in paragraph
88.
703.
In the trading book, for repo-style
transactions, all instruments, which are
included in
the
trading book, may be used as eligible
collateral. Those instruments which fall outside
the
banking
book definition of eligible collateral shall be
subject to a haircut at the
level
applicable
to non-main index equities listed on recognised
exchanges (as noted in
paragraph
151).
However, where banks are using the own estimates
approach to haircutting they
may
also
apply it in the trading book in accordance with
paragraphs 154 and 155.
Consequently,
for
instruments that count as eligible collateral in
the trading book, but not in the
banking
book,
the haircuts must be calculated for each
individual security.
Where
banks are using a VaR approach to measuring
exposure for repo-style transactions, they also
may apply this approach in the trading book in
accordance with paragraphs 178 to 181 (i) and
Annex 4.
704.
The calculation of the counterparty credit risk
charge for collateralised OTC
derivative
transactions is the same as the rules prescribed
for such transactions booked in
the
banking book.
705.
The calculation of the counterparty charge for
repo-style transactions will be
conducted
using the rules in paragraphs 147 to 181 (i) and
Annex 4 spelt out for such
transactions
booked in the banking book. The firm-size
adjustment for SMEs as set out
in
paragraph
273 shall also be applicable in the trading
book.
Credit
derivatives
706.
(deleted)
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