VI. Market Risk

A. The risk measurement framework

683(i). Market risk is defined as the risk of losses in on and off-balance-sheet positions arising from movements in market prices.

The risks subject to this requirement are:

• The risks pertaining to interest rate related instruments and equities in the trading book;

• Foreign exchange risk and commodities risk throughout the bank.

1. Scope and coverage of the capital charges

683(ii). The capital charges for interest rate related instruments and equities will apply to the current trading book items prudently valued by banks, alongside paragraphs 690 to 701 below.

The definition of trading book is set out in paragraphs 685 to 689(iii) below.

683(iii). The capital charges for foreign exchange risk and for commodities risk will apply to banks’ total currency and commodity positions, subject to some discretion to exclude structural foreign exchange positions.

It is understood that some of these positions will be reported and hence evaluated at market value, but some may be reported and evaluated at book value.

683(iv). For the time being, the Committee does not believe that it is necessary to allow any de minimis exemptions from the capital requirements for market risk, except for those for foreign exchange risk set out in paragraph 718(xLii) below, because this Framework applies only to internationally active banks, and then essentially on a consolidated basis; all of these banks are likely to be involved in trading to some extent.

683(v). In the same way as for credit risk, the capital requirements for market risk are to apply on a worldwide consolidated basis.

Where appropriate, national authorities may permit banking and financial entities in a group which is running a global consolidated book and whose capital is being assessed on a global basis to report short and long positions in exactly the same instrument (e.g. currencies, commodities, equities or bonds), on a net
basis, no matter where they are booked.*

Moreover, the offsetting rules as set out in this section may also be applied on a consolidated basis.

Nonetheless, there will be circumstances in which supervisory authorities demand that the individual positions be taken into the measurement system without any offsetting or netting against positions in the remainder of the group.

This may be needed, for example, where there are obstacles to the quick repatriation of profits from a foreign subsidiary or where there are legal and procedural difficulties in carrying out the timely management of risks on a consolidated basis.

Moreover, all national authorities will retain the right to continue to monitor the market risks of individual
entities on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision.

Supervisory authorities will be especially vigilant in ensuring that banks do not pass positions on reporting dates in such a way as to escape measurement.

* The positions of less than wholly-owned subsidiaries would be subject to the generally accepted accounting principles in the country where the parent company is supervised.

684. (Deleted)

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-àvis 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 as that set down by the national supervisor for such assets held in the banking book, which 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.

2. 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:

(i). 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.

(ii). Valuation methodologies

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.

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).

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.

(iii). 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 in paragraph 718 (Lxxvi) (c) 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.

3. Methods of measuring market risks

701(i). In measuring their market risks, a choice between two broad methodologies (described in paragraphs 709 to 718(Lxix) and 718(Lxx) to 718(XCix), respectively) will be permitted, subject to the approval of the national authorities.

One alternative will be to measure the risks in a standardised manner, using the measurement frameworks described in paragraphs 709 to 718(Lxix) below.

Paragraphs 709 to 718(Lv) deal with the four risks addressed in this section, i.e. interest rate, equity position, foreign exchange and commodities risk.

Paragraphs 718(Lvi) to 718(Lxix) set out a number of possible methods for measuring the price risk in options of all kinds.

The capital charge under the standardised measurement method will be the measures of risk obtained from paragraphs 709 to 718(Lxix), summed arithmetically.

701(ii). The alternative methodology, which is subject to the fulfilment of certain conditions and the use of which is therefore conditional upon the explicit approval of the bank’s supervisory authority, is set out in 718(Lxx) to 718(XCix).

This method allows banks to use risk measures derived from their own internal risk management models, subject to seven sets of conditions, namely:

• certain general criteria concerning the adequacy of the risk management system;

• qualitative standards for internal oversight of the use of models, notably by management;

• guidelines for specifying an appropriate set of market risk factors (i.e. the market rates and prices that affect the value of banks’ positions);

• quantitative standards setting out the use of common minimum statisticalparameters for measuring risk;

• guidelines for stress testing;

• validation procedures for external oversight of the use of models;

• rules for banks which use a mixture of models and the standardised approach.

701(iii). The standardised methodology uses a “building-block” approach in which specific risk and the general market risk arising from debt and equity positions are calculated separately.

The focus of most internal models is a bank’s general market risk exposure, typically leaving specific risk (i.e. exposures to specific issuers of debt securities or equities*) to be measured largely through separate credit risk measurement systems.

Banks using models should be subject to capital charges for the specific risk not captured by their models.

Accordingly, a separate capital charge for specific risk will apply to each bank using a model to the extent that the model does not capture specific risk.

The capital charge for banks which are modelling specific risk is set out in paragraphs 718(Lxxxvii) to 718(XCviii) of this Framework. **

* Specific risk includes the risk that an individual debt or equity security moves by more or less than the general market in day-to-day trading (including periods when the whole market is volatile) and event risk (where the price of an individual debt or equity security moves precipitously relative to the general market, e.g. on a takeover bid or some other shock event; such events would also include the risk of “default”).

** Banks that already have received specific risk model recognition for particular portfolios or lines of business according to the original version of the 1996 Market Risk Amendment should agree a timetable with their supervisors to bring their model in line with the new standards in a timely manner as is practicable, with an end date of 1 January 2010.

Following that transition period, banks that have been unable to develop an acceptable methodology will have to use the standardised rules for specific risk.

701(iv). In measuring the price risk in options under the standardised approach, where a number of alternatives with varying degrees of sophistication are provided (see paragraphs 718(Lvi) to 718(Lxix)), supervisory authorities will apply the rule that the more a bank is engaged in writing options, the more sophisticated its measurement method needs to be.

In the longer term, banks which are significant traders in options will be expected to move to comprehensive value-at-risk models and become subject to the full range of quantitative and qualitative standards set out in paragraphs 718(Lxx) to 718(XCIX).

701(v). Each bank subject to capital charges for market risk will be expected to monitor and report the level of risk against which a capital requirement is to be applied.

The bank’s overall minimum capital requirement will be:

(a) the credit risk requirements laid down in this Framework, excluding debt and equity securities in the trading book and all positions in commodities, but including the credit counterparty risk on all over-the-counter derivatives whether in the trading or the banking books; plus

(b) the capital charges for operational risk described in paragraphs 644 to 683 of this Framework; plus

(c) either the capital charges for market risks described in paragraphs 709 to 718(Lxix), summed arithmetically; or

(d) the measure of market risk derived from the models approach set out in paragraphs 718(Lxx) to 718(XCix); or

(e) a mixture of (c) and (d) summed arithmetically.

701(vi). All transactions, including forward sales and purchases, shall be included in the calculation of capital requirements as from the date on which they were entered into.

Although regular reporting will in principle take place only at intervals (in most countries quarterly), banks are expected to manage the market risk in their trading book in such a way that the capital requirements are being met on a continuous basis, i.e. at the close of each business day.

Supervisory authorities have at their disposal a number of effective measures to ensure that banks do not “window-dress” by showing significantly lower market risk positions on reporting dates. Banks will also, of course, be expected to maintain strict risk management systems to ensure that intra-day exposures are not excessive.

If a bank fails to meet the capital requirements, the national authority shall ensure that the bank takes
immediate measures to rectify the situation.

4. Treatment of counterparty credit risk in the trading book

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. *

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 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)

707. The counterparty credit risk charge for single name credit derivative transactions in the trading book will be calculated using the following potential future exposure add-on factors:

708. Where the credit derivative is a first to default transaction, the add-on will be determined by the lowest credit quality underlying in the basket, i.e. if there are any non qualifying items in the basket, the non-qualifying reference obligation add-on should be used.

For second and subsequent to default transactions, underlying assets should continue to be allocated according to the credit quality, i.e. the second lowest credit quality will determine the add-on for a second to default transaction etc.

5. Transitional arrangements

708(i). Banks will on a transitional basis be free to use a combination of the standardised measurement method and the internal models approach to measure their market risks.

As a general rule, any such “partial” models should cover a complete risk category (e.g. interest rate risk or foreign exchange risk), i.e. a combination of the two methods will not be permitted within the same risk category. *

* This does not, however, apply to pre-processing techniques which are used to simplify the calculation and whose results become subject to the standardised methodology

However, as most banks are at present still implementing or further improving their risk management models, the Committee believes that the banks should be given – even within risk categories – some flexibility in including all their operations on a worldwide basis; this flexibility will be subject to approval by the national authority and reviewed by the Committee in the future (supervisory authorities will take precautions against
“cherry-picking” between the standardised approach and the models approach within a risk factor category).

Banks which adopt the modelling alternative for any single risk category will be expected over time to include all their operations, subject to the exceptions mentioned below, and to move towards a comprehensive model (i.e. one which captures all market risk categories).

Banks which adopt a model will not be permitted, save in exceptional circumstances, to revert to the standardised approach.

Notwithstanding these general principles, even banks using comprehensive models to measure their market risk may still incur risks in positions which are not captured by their internal trading risk management models, for example, in remote locations, in minor currencies or in negligible business  areas.*

Any such risks that are not included in a model should be separately measured and reported using the methodologies described in paragraphs 709 to 718(xviii) below.

* For example, if a bank is hardly at all engaged in commodities it would not necessarily be expected to model its commodities risk.

B. The capital requirement

1. Definition of capital

708(ii). The definition of capital to be used for market risk purposes is set out in paragraphs 49(xiii) and 49(xiv) of this Framework.

708(iii). In calculating eligible capital, it will be necessary first to calculate the bank’s minimum capital requirement for credit and operational risks, and only afterwards its market risk requirement, to establish how much Tier 1 and Tier 2 capital is available to support market risk.

Eligible capital will be the sum of the whole of the bank’s Tier 1 capital, plus all of its Tier 2 capital under the limits imposed in paragraph 49(iii) of this Framework.

Tier 3 capital will be regarded as eligible only if it can be used to support market risks under the conditions set out in paragraphs 49(xxi) and 49(xxii) above.

The quoted capital ratio will thus represent capital that is available to meet credit risk, operational risk, and market risk.

Where a bank has Tier 3 capital, within the limits set out in paragraph 49(xxi), which is not at present
supporting market risks, it may report that excess as unused but eligible Tier 3 alongside its standard ratio.

C. Market risk – The standardised measurement method

1. Interest rate risk

709. (Deleted)

709(i). This section describes the standard framework for measuring the risk of holding or taking positions in debt securities and other interest rate related instruments in the trading book.

The instruments covered include all fixed-rate and floating-rate debt securities and instruments that behave like them, including non-convertible preference shares.117

Convertible bonds, i.e. debt issues or preference shares that are convertible, at a stated price, into common shares of the issuer, will be treated as debt securities if they trade like debt securities and as equities if they trade like equities.

The basis for dealing with derivative products is considered in paragraphs 718(ix) to 718(xviii) below.

709(ii). The minimum capital requirement is expressed in terms of two separately calculated charges, one applying to the “specific risk” of each security, whether it is a short or a long position, and the other to the interest rate risk in the portfolio (termed “general market risk”) where long and short positions in different securities or instruments can be offset.

(i) Specific risk

709(iii). The capital charge for specific risk is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer.

In measuring the risk, offsetting will be restricted to matched positions in the identical issue (including positions in derivatives).

Even if the issuer is the same, no offsetting will be permitted between different issues since differences in coupon rates, liquidity, call features, etc. mean that prices may diverge in the short run.

Specific risk capital charges for issuer risk

710. The new capital charges for “government” and “other” categories will be as follows.

710(i). The category “government” will include all forms of government * paper including bonds, Treasury bills and other short-term instruments, but national authorities reserve the right to apply a specific risk weight to securities issued by certain foreign governments, especially to securities denominated in a currency other than that of the issuing government.

* Including, at national discretion, local and regional governments subject to a zero credit risk weight in this Framework.

711. When the government paper is denominated in the domestic currency and funded by the bank in the same currency, at national discretion a lower specific risk charge may be applied.

711(i). The “qualifying” category includes securities issued by public sector entities and multilateral development banks, plus other securities that are:

• rated investment-grade * by at least two credit rating agencies specified by the national authority; or

• rated investment-grade by one rating agency and not less than investment-grade by any other rating agency specified by the national authority (subject to supervisory oversight); or

• subject to supervisory approval, unrated, but deemed to be of comparable investment quality by the reporting bank, and the issuer has securities listed on a recognised stock exchange.

Each supervisory authority will be responsible for monitoring the application of these qualifying criteria, particularly in relation to the last criterion where the initial classification is essentially left to the reporting banks.

National authorities will also have discretion to include within the qualifying category debt securities issued by banks in countries which have implemented this Framework, subject to the express understanding that supervisory authorities in such countries undertake prompt remedial action if a bank fails to meet the
capital standards set forth in this Framework.

Similarly, national authorities will have discretion to include within the qualifying category debt securities issued by securities firms that are subject to equivalent rules.

* E.g. rated Baa or higher by Moody’s and BBB or higher by Standard and Poor’s.

711(ii). Furthermore, the “qualifying” category shall include securities issued by institutions that are deemed to be equivalent to investment grade quality and subject to supervisory and regulatory arrangements comparable to those under this Framework.

Specific risk rules for unrated debt securities

712. Unrated securities may be included in the “qualifying” category when they are subject to supervisory approval, unrated, but deemed to be of comparable investment quality by the reporting bank, and the issuer has securities listed on a recognised stock exchange.

This will remain unchanged for banks using the standardised approach.

For banks using the IRB approach for a portfolio, unrated securities can be included in the “qualifying” category if both of the following conditions are met:

• the securities are rated equivalent * to investment grade under the reporting bank’s internal rating system, which the national supervisor has confirmed complies with the requirements for an IRB approach; and

• the issuer has securities listed on a recognised stock exchange.

* Equivalent means the debt security has a one-year PD equal to or less than the one year PD implied by the long-run average one-year PD of a security rated investment grade or better by a qualifying rating agency.

Specific risk rules for non-qualifying issuers

712(i). Instruments issued by a non-qualifying issuer will receive the same specific risk charge as a non-investment grade corporate borrower under the standardised approach for credit risk under this Framework.

712(ii). However, 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, each national supervisor will have the discretion:

• To apply a higher specific risk charge to such instruments; and/or

• To disallow offsetting for the purposes of defining the extent of general market risk between such instruments and any other debt instruments.

In that respect, securitisation exposures that would be subject to a deduction treatment under the securitisation framework set forth in this Framework (e.g. equity tranches that absorb first loss), 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.

Specific risk capital charges for positions hedged by credit derivatives

713. Full allowance will be recognised when the values of two legs (i.e. long and short) always move in the opposite direction and broadly to the same extent.

This would be the case in the following situations:

(a) the two legs consist of completely identical instruments, or

(b) a long cash position is hedged by a total rate of return swap (or vice versa) and there is an exact match between the reference obligation and the underlying exposure (i.e. the cash position). *

In these cases, no specific risk capital requirement applies to both sides of the position.

* The maturity of the swap itself may be different from that of the underlying exposure.

714. An 80% offset will be recognised when the value of two legs (i.e. long and short) always moves in the opposite direction but not broadly to the same extent.

This would be the case when a long cash position is hedged by a credit default swap or a credit linked note (or
vice versa) and there is an exact match in terms of the reference obligation, the maturity of both the reference obligation and the credit derivative, and the currency of the underlying exposure.

In addition, key features of the credit derivative contract (e.g. credit event definitions, settlement mechanisms) should not cause the price movement of the credit derivative to materially deviate from the price movements of the cash position.

To the extent that the transaction transfers risk (i.e. taking account of restrictive payout provisions such as
fixed payouts and materiality thresholds), an 80% specific risk offset will be applied to the side of the transaction with the higher capital charge, while the specific risk requirement on the other side will be zero.

715. Partial allowance will be recognised when the value of the two legs (i.e. long and short) usually moves in the opposite direction. This would be the case in the following situations:

(a) the position is captured in paragraph 713 under (b), but there is an asset mismatch between the reference obligation and the underlying exposure. Nonetheless, the position meets the requirements in paragraph 191 (g).

(b) The position is captured in paragraph 713 under (a) or 714 but there is a currency or maturity mismatch * between the credit protection and the underlying asset.

(c) The position is captured in paragraph 714 but there is an asset mismatch between the cash position and the credit derivative.

However, the underlying asset is included in the (deliverable) obligations in the credit derivative documentation.

* Currency mismatches should feed into the normal reporting of foreign exchange risk.

716. In each of these cases in paragraphs 713 to 715, the following rule applies.

Rather than adding the specific risk capital requirements for each side of the transaction (i.e. the credit protection and the underlying asset) only the higher of the two capital requirements will apply.

717. In cases not captured in paragraphs 713 to 715, a specific risk capital charge will be assessed against both sides of the position.

718. With regard to banks’ first-to-default and second-to-default products in the trading book, the basic concepts developed for the banking book will also apply.

Banks holding long positions in these products (e.g. buyers of basket credit linked notes) would be treated as if they were protection sellers and would be required to add the specific risk charges or use the external rating if available.

Issuers of these notes would be treated as if they were protection buyers and are therefore allowed to off-set specific risk for one of the underlyings, i.e. theasset with the lowest specific risk charge.

(ii) General market risk

718(i). The capital requirements for general market risk are designed to capture the risk of loss arising from changes in market interest rates. A choice between two principal methods of measuring the risk is permitted, a “maturity” method and a “duration” method.

In each method, the capital charge is the sum of four components:

• The net short or long position in the whole trading book;

• A small proportion of the matched positions in each time-band (the “vertical
disallowance”);
• A larger proportion of the matched positions across different time-bands (the “horizontal disallowance”);

• A net charge for positions in options, where appropriate (see paragraphs 718(Lxvi) to 718(Lxix)).

718(ii). Separate maturity ladders should be used for each currency and capital charges should be calculated for each currency separately and then summed with no offsetting between positions of opposite sign. In the case of those currencies in which business is insignificant, separate maturity ladders for each currency are not required.

Rather, the bank may construct a single maturity ladder and slot, within each appropriate time-band, the net
long or short position for each currency.

However, these individual net positions are to be summed within each time-band, irrespective of whether they are long or short positions, to produce a gross position figure.

718(iii). In the maturity method (see paragraph 718(vii) for the duration method), long or short positions in debt securities and other sources of interest rate exposures including derivative instruments are slotted into a maturity ladder comprising thirteen time-bands (or fifteen time-bands in case of low coupon instruments).

Fixed rate instruments should be allocated according to the residual term to maturity and floating-rate instruments according to the residual term to the next repricing date.

Opposite positions of the same amount in the same issues (but not different issues by the same issuer), whether actual or notional, can be omitted from the interest rate maturity framework, as well as closely matched swaps, forwards, futures and FRAs which meet the conditions set out in paragraphs 718(xiii) and
718(xiv) below.

718(iv). The first step in the calculation is to weight the positions in each time-band by a factor designed to reflect the price sensitivity of those positions to assumed changes in interest rates.

The weights for each time-band are set out in the table below.

Zero-coupon bonds and deep-discount bonds (defined as bonds with a coupon of less than 3%) should be
slotted according to the time-bands set out in the second column of the table.

718(v). The next step in the calculation is to offset the weighted longs and shorts in each time-band, resulting in a single short or long position for each band.

Since, however, each band would include different instruments and different maturities, a 10% capital charge to reflect basis risk and gap risk will be levied on the smaller of the offsetting positions, be it long or short.

Thus, if the sum of the weighted longs in a time-band is $100 million and the sum of the weighted shorts $90 million, the so-called “vertical disallowance” for that timeband would be 10% of $90 million (i.e. $9.0 million).

718(vi). The result of the above calculations is to produce two sets of weighted positions, the net long or short positions in each time-band ($10 million long in the example above) and the vertical disallowances, which have no sign.

In addition, however, banks will be allowed to conduct two rounds of “horizontal offsetting”, first between the net positions in each of three zones (zero to one year, one year to four years and four years and over), * and subsequently between the net positions in the three different zones.

The offsetting will be subject to a scale of disallowances expressed as a fraction of the matched positions, as set
out in the table below.

The weighted long and short positions in each of three zones may be offset, subject to the matched portion attracting a disallowance factor that is part of the capital charge.

The residual net position in each zone may be carried over and offset againstopposite positions in other zones, subject to a second set of disallowance factors.

* The zones for coupons less than 3% are 0 to 1 year, 1 to 3.6 years, and 3.6 years and over.

124 The zones for coupons less than 3% are 0 to 1 year, 1 to 3.6 years, and 3.6 years and over.

718(vii). Under the alternative duration method, banks with the necessary capability may, with their supervisors’ consent, use a more accurate method of measuring all of their general market risk by calculating the price sensitivity of each position separately.

Banks must elect and use the method on a continuous basis (unless a change in method is approved by the
national authority) and will be subject to supervisory monitoring of the systems used.

The mechanics of this method are as follows:

• First calculate the price sensitivity of each instrument in terms of a change in interest rates of between 0.6 and 1.0 percentage points depending on the maturity of the instrument (see the table below);

• Slot the resulting sensitivity measures into a duration-based ladder with the fifteen time-bands set out in the table below;

• Subject long and short positions in each time-band to a 5% vertical disallowance designed to capture basis risk;

• Carry forward the net positions in each time-band for horizontal offsetting subject to the disallowances set out in table paragraph 718(vi) above.

718(viii). In the case of residual currencies (see paragraph 718(ii) above) the gross positions in each time-band will be subject to either the risk weightings set out in paragraph 718(iv), if positions are reported using the maturity method, or the assumed change in yield set out in paragraph 718(vii), if positions are reported using the duration method, with no further offsets.

(iii) Interest rate derivatives

718(ix). The measurement system should include all interest rate derivatives and off balance- sheet instruments in the trading book which react to changes in interest rates, (e.g. forward rate agreements (FRAs), other forward contracts, bond futures, interest rate and cross-currency swaps and forward foreign exchange positions).

Options can be treated in a variety of ways as described in paragraphs 718(Lvi) to 718(Lxix) below.

A summary of the rules for dealing with interest rate derivatives is set out in paragraph 718(xviii) below.

Calculation of positions

718(x). The derivatives should be converted into positions in the relevant underlying and become subject to specific and general market risk charges as described above.

In order to calculate the standard formula described above, the amounts reported should be the market
value of the principal amount of the underlying or of the notional underlying resulting from the prudent valuation guidance set out in paragraphs 690 to 701 above. *

* For instruments where the apparent notional amount differs from the effective notional amount, banks must use the effective notional amount.

Futures and forward contracts, including forward rate agreements

718(xi). These instruments are treated as a combination of a long and a short position in a notional government security.

The maturity of a future or a FRA will be the period until delivery or exercise of the contract, plus - where applicable - the life of the underlying instrument.

For example, a long position in a June three month interest rate future (taken in April) is to be reported as a long position in a government security with a maturity of five months and a short position in a government security with a maturity of two months.

Where a range of deliverable instruments may be delivered to fulfil the contract, the bank has flexibility
to elect which deliverable security goes into the maturity or duration ladder but should take account of any conversion factor defined by the exchange.

In the case of a future on a corporate bond index, positions will be included at the market value of the notional underlying portfolio of securities.

Swaps

718(xii). Swaps will be treated as two notional positions in government securities with relevant maturities.

For example, an interest rate swap under which a bank is receiving floating rate interest and paying fixed will be treated as a long position in a floating rate instrument of maturity equivalent to the period until the next interest fixing and a short position in a fixed-rate instrument of maturity equivalent to the residual life of the swap.

For swaps that pay or receive a fixed or floating interest rate against some other reference price, e.g. a stock index, the interest rate component should be slotted into the appropriate repricing maturity category, with the equity component being included in the equity framework.

The separate legs of cross-currency swaps are to be reported in the relevant maturity ladders for the currencies concerned.

Calculation of capital charges for derivatives under the standardised methodology

Allowable offsetting of matched positions

718(xiii). Banks may exclude from the interest rate maturity framework altogether (for both specific and general market risk) long and short positions (both actual and notional) in identical instruments with exactly the same issuer, coupon, currency and maturity.

A matched position in a future or forward and its corresponding underlying may also be fully offset, * and thus excluded from the calculation.

When the future or the forward comprises a range of deliverable instruments offsetting of positions in the future or forward contract and its underlying is only permissible in cases where there is a readily identifiable underlying security which is most profitable for the trader with a short position to deliver.

The price of this security, sometimes called the “cheapest-to-deliver”, and the price of the future or forward contract should in such cases move in close alignment.

No offsetting will be allowed between positions in different currencies; the separate legs of cross-currency swaps or forward foreign exchange deals are to be treated as notional positions in the relevant
instruments and included in the appropriate calculation for each currency.

* The leg representing the time to expiry of the future should, however, be reported.

718(xiv). In addition, opposite positions in the same category of instruments* can in certain circumstances be regarded as matched and allowed to offset fully.

To qualify for this treatment the positions must relate to the same underlying instruments, be of the same
nominal value and be denominated in the same currency.**

* This includes the delta-equivalent value of options. The delta equivalent of the legs arising out of the treatment
of caps and floors as set out in paragraph 718(Lx) can also be offset against each other under the rules laid
down in this paragraph.
** The separate legs of different swaps may also be “matched” subject to the same conditions.

In addition:

(i) for futures: offsetting positions in the notional or underlying instruments to which the futures contract relates must be for identical products and mature within seven days of each other;

(ii) for swaps and FRAs: the reference rate (for floating rate positions) must be identical and the coupon closely matched (i.e. within 15 basis points); and

(iii) for swaps, FRAs and forwards: the next interest fixing date or, for fixed coupon positions or forwards, the residual maturity must correspond within the following limits:

• less than one month hence: same day;

• between one month and one year hence: within seven days;

• over one year hence: within thirty days.

718(xv). Banks with large swap books may use alternative formulae for these swaps to calculate the positions to be included in the maturity or duration ladder.

One method would be to first convert the payments required by the swap into their present values.

For that purpose, each payment should be discounted using zero coupon yields, and a single net figure for the present value of the cash flows entered into the appropriate time-band using procedures that apply to zero (or low) coupon bonds; these figures should be slotted into the general market risk framework as set out above.

An alternative method would be to calculate the sensitivity of the net present value implied by the change in yield used in the maturity or duration method and allocate these sensitivities into the time-bands set out in paragraph 718(iv) or paragraph 718(vii).

Other methods which produce similar results could also be used.

Such alternative treatments will, however, only be allowed if:

• the supervisory authority is fully satisfied with the accuracy of the systems being used;

• the positions calculated fully reflect the sensitivity of the cash flows to interest rate changes and are entered into the appropriate time-bands;

• the positions are denominated in the same currency.

Specific risk

718(xvi). Interest rate and currency swaps, FRAs, forward foreign exchange contracts and interest rate futures will not be subject to a specific risk charge.

This exemption also applies to futures on an interest rate index (e.g. LIBOR).

However, in the case of futures contracts where the underlying is a debt security, or an index representing a basket of debt securities, a specific risk charge will apply according to the credit risk of the issuer as set out in
paragraphs 709(iii) to 718 above.

General market risk

718(xvii). General market risk applies to positions in all derivative products in the same manner as for cash positions, subject only to an exemption for fully or very closely matched positions in identical instruments as defined in paragraphs 718(xiii) and 718(xiv).

The various categories of instruments should be slotted into the maturity ladder and treated according to
the rules identified earlier.

718(xviii). The table below presents a summary of the regulatory treatment for interest rate derivatives, for market risk purposes.

129 This is the specific risk charge relating to the issuer of the instrument. Under the existing credit risk rules, there remains a separate capital charge for the counterparty risk.

130 The specific risk capital charge only applies to government debt securities that are rated below AA- (see paragraphs 710 and 710 (i)).

2. Equity position risk

718(xix). This section sets out a minimum capital standard to cover the risk of holding or taking positions in equities in the trading book.

It applies to long and short positions in all instruments that exhibit market behaviour similar to equities, but not to non-convertible preference shares (which are covered by the interest rate risk requirements described in
paragraphs 709 to 718(xviii)).

Long and short positions in the same issue may be reported on net basis.

The instruments covered include common stocks, whether voting or non-voting, convertible securities that behave like equities, and commitments to buy or sell equity securities.

The treatment of derivative products, stock indices and index arbitrage is described in paragraphs 718(xxii) to 718(xxix) below.

(i). Specific and general market risk

718(xx). As with debt securities, the minimum capital standard for equities is expressed in terms of two separately calculated charges for the “specific risk” of holding a long or short position in an individual equity and for the “general market risk” of holding a long or short position in the market as a whole.

Specific risk is defined as the bank’s gross equity positions (i.e. the sum of all long equity positions and of all short equity positions) and general market risk as the difference between the sum of the longs and the sum of the shorts (i.e. the overall net position in an equity market).

The long or short position in the market must be calculated on a market-by-market basis, i.e. a separate calculation has to be carried out for each national market in which the bank holds equities.

718(xxi). The capital charge for specific risk will be 8%, unless the portfolio is both liquid and well-diversified, in which case the charge will be 4%. Given the different characteristics of national markets in terms of marketability and concentration, national authorities will have discretion to determine the criteria for liquid and diversified portfolios.

The general market risk charge will be 8%.

(ii). Equity derivatives

718(xxii). Except for options, which are dealt with in paragraphs 718(Lvi) to 718(Lxix), equity derivatives and off-balance-sheet positions which are affected by changes in equity prices should be included in the measurement system.*

This includes futures and swaps on both individual equities and on stock indices.

The derivatives are to be converted into positions in the relevant underlying.

The treatment of equity derivatives is summarised in paragraph 718(xxix) below.

* Where equities are part of a forward contract, a future or an option (quantity of equities to be received or to be delivered), any interest rate or foreign currency exposure from the other leg of the contract should be reported as set out in paragraphs 709 to 718(xviii) and 718(xxx) to 718(xLii).

718(xxiii). In order to calculate the standard formula for specific and general market risk, positions in derivatives should be converted into notional equity positions:

• Futures and forward contracts relating to individual equities should in principle be reported at current market prices;

• Futures relating to stock indices should be reported as the marked-to-market value of the notional underlying equity portfolio;

• Equity swaps are to be treated as two notional positions;*

• Equity options and stock index options should be either “carved out” together with the associated underlyings or be incorporated in the measure of general market risk described in this section according to the delta-plus method.

* For example, an equity swap in which a bank is receiving an amount based on the change in value of one particular equity or stock index and paying a different index will be treated as a long position in the former and a short position in the latter. Where one of the legs involves receiving/paying a fixed or floating interest rate, that exposure should be slotted into the appropriate repricing time-band for interest rate related instruments as set out in paragraphs 709 to 718(xviii).

The stock index should be covered by the equity treatment.

Calculation of capital charges

Measurement of specific and general market risk

718(xxiv). Matched positions in each identical equity or stock index in each market may be fully offset, resulting in a single net short or long position to which the specific and general market risk charges will apply. For example, a future in a given equity may be offset against an opposite cash position in the same equity. *

* The interest rate risk arising out of the future, however, should be reported as set out in paragraphs 709 to 718(xviii).

Risk in relation to an index

718(xxv). Besides general market risk, a further capital charge of 2% will apply to the net long or short position in an index contract comprising a diversified portfolio of equities.

This capital charge is intended to cover factors such as execution risk.

National supervisory authorities will take care to ensure that this 2% risk weight applies only to well-diversified
indices and not, for example, to sectoral indices.

Arbitrage

718(xxvi). In the case of the futures-related arbitrage strategies described below, the additional 2% capital charge described above may be applied to only one index with the opposite position exempt from a capital charge.

The strategies are:

• When the bank takes an opposite position in exactly the same index at different dates or in different market centres;

• When the bank has an opposite position in contracts at the same date in different but similar indices, subject to supervisory oversight that the two indices contain sufficient common components to justify offsetting.

718(xxvii). Where a bank engages in a deliberate arbitrage strategy, in which a futures contract on a broadly-based index matches a basket of stocks, it will be allowed to carve out both positions from the standardised methodology on condition that:

• The trade has been deliberately entered into and separately controlled;

• The composition of the basket of stocks represents at least 90% of the index when broken down into its notional components.

In such a case the minimum capital requirement will be 4% (i.e. 2% of the gross value of the positions on each side) to reflect divergence and execution risks.

This applies even if all of the stocks comprising the index are held in identical proportions. Any excess value of the stocks comprising the basket over the value of the futures contract or excess value of the futures contract over the value of the basket is to be treated as an open long or short position.

718(xxviii). If a bank takes a position in depository receipts against an opposite position in the underlying equity or identical equities in different markets, it may offset the position (i.e. bear no capital charge) but only on condition that any costs on conversion are fully taken into account. *

* Any foreign exchange risk arising out of these positions has to be reported as set out in paragraphs 718(xxx) to 718(xLvii).

718(xxix). The table below summarises the regulatory treatment of equity derivatives for market risk purposes.

135 This is the specific risk charge relating to the issuer of the instrument. Under the existing credit risk rules, there remains a separate capital charge for the counterparty risk.

3. Foreign exchange risk

718(xxx). This section sets out a minimum capital standard to cover the risk of holding or taking positions in foreign currencies, including gold. *

* Gold is to be dealt with as a foreign exchange position rather than a commodity because its volatility is more in line with foreign currencies and banks manage it in a similar manner to foreign currencies.

718(xxxi). Two processes are needed to calculate the capital requirement for foreign exchange risk. The first is to measure the exposure in a single currency position.

The second is to measure the risks inherent in a bank’s mix of long and short positions in different
currencies.

(i). Measuring the exposure in a single currency

718(xxxii). The bank’s net open position in each currency should be calculated by summing:

• The net spot position (i.e. all asset items less all liability items, including accrued interest, denominated in the currency in question);

• The net forward position (i.e. all amounts to be received less all amounts to be paid under forward foreign exchange transactions, including currency futures and the principal on currency swaps not included in the spot position);

• Guarantees (and similar instruments) that are certain to be called and are likely to be irrecoverable;

• Net future income/expenses not yet accrued but already fully hedged (at the discretion of the reporting bank);

• Depending on particular accounting conventions in different countries, any other item representing a profit or loss in foreign currencies;

• The net delta-based equivalent of the total book of foreign currency options. *

* Subject to a separately calculated capital charge for gamma and vega as described in paragraphs 718(Lix) to 718(Lxii); alternatively, options and their associated underlyings are subject to one of the other methods described in paragraphs 718(Lvi) to 718(Lxix).

718(xxxiii). Positions in composite currencies need to be separately reported but, for measuring banks’ open positions, may be either treated as a currency in their own right or split into their component parts on a consistent basis.

Positions in gold should be measured in the same manner as described in paragraph 718(xLix). *

* Where gold is part of a forward contract (quantity of gold to be received or to be delivered), any interest rate or foreign currency exposure from the other leg of the contract should be reported as set out in paragraphs 709 to 718(xviii) and 718(xxxii) above.

718(xxxiv). Three aspects call for more specific comment: the treatment of interest, other income and expenses; the measurement of forward currency positions and gold; and the treatment of “structural” positions.

The treatment of interest, other income and expenses

718(xxxv). Interest accrued (i.e. earned but not yet received) should be included as a position.

Accrued expenses should also be included.

Unearned but expected future interest and anticipated expenses may be excluded unless the amounts are certain and banks have taken the opportunity to hedge them.

If banks include future income/expenses they should do so on a consistent basis, and not be permitted to select only those expected future flows which reduce their position.

The measurement of forward currency and gold positions

718(xxxvi). Forward currency and gold positions will normally be valued at current spot market exchange rates. Using forward exchange rates would be inappropriate since it would result in the measured positions reflecting current interest rate differentials to some extent.

However, banks which base their normal management accounting on net present values are expected to use the net present values of each position, discounted using current interest rates and valued at current spot rates, for measuring their forward currency and gold positions.

The treatment of structural positions

718(xxxvii). A matched currency position will protect a bank against loss from movements in exchange rates, but will not necessarily protect its capital adequacy ratio.

If a bank has its capital denominated in its domestic currency and has a portfolio of foreign currency assets
and liabilities that is completely matched, its capital/asset ratio will fall if the domestic currency depreciates.

By running a short position in the domestic currency the bank can protect its capital adequacy ratio, although the position would lead to a loss if the domestic currency were to appreciate.

718(xxxviii). Supervisory authorities are free to allow banks to protect their capital adequacy ratio in this way. Thus, any positions which a bank has deliberately taken in order to hedge partially or totally against the adverse effect of the exchange rate on its capital ratio may be excluded from the calculation of net open currency positions, subject to each of the following conditions being met:

• Such positions need to be of a “structural”, i.e. of a non-dealing, nature (the precise definition to be set by national authorities according to national accounting standards and practices);

• The national authority needs to be satisfied that the “structural” position excluded does no more than protect the bank’s capital adequacy ratio;

• Any exclusion of the position needs to be applied consistently, with the treatment of the hedge remaining the same for the life of the assets or other items.

718(xxxix). No capital charge need apply to positions related to items that are deducted from a bank’s capital when calculating its capital base, such as investments in non-consolidated subsidiaries, nor to other long-term participations denominated in foreign currencies which are reported in the published accounts at historic cost.

These may also be treated as structural positions.

(ii). Measuring the foreign exchange risk in a portfolio of foreign currency positions and gold

718(xL). Banks will have a choice between two alternative measures at supervisory discretion; a “shorthand” method which treats all currencies equally; and the use of internal models which takes account of the actual degree of risk dependent on the composition of the bank’s portfolio.

The conditions for the use of internal models are set out in paragraphs 718(Lxx) to 718(xcix) below.

718(xLi). Under the shorthand method, the nominal amount (or net present value) of the net position in each foreign currency and in gold is converted at spot rates into the reporting currency.*

* Where the bank is assessing its foreign exchange risk on a consolidated basis, it may be technically impractical in the case of some marginal operations to include the currency positions of a foreign branch or subsidiary of the bank. In such cases the internal limit in each currency may be used as a proxy for the positions. Provided there is adequate ex post monitoring of actual positions against such limits, the limits should be added, without regard to sign, to the net open position in each currency.

 The overall net open position is measured by aggregating:

• The sum of the net short positions or the sum of the net long positions, whichever is the greater; ** plus

• The net position (short or long) in gold, regardless of sign.
 

** An alternative calculation, which produces an identical result, is to include the reporting currency as a residual and to take the sum of all the short (or long) positions.

The capital charge will be 8% of the overall net open position (see example below).

The capital charge would be 8% of the higher of either the net long currency positions or the net short currency positions (i.e. 300) and of the net position in gold (35) = 335 x 8% = 26.8.

718(xLii). A bank doing negligible business in foreign currency and which does not take foreign exchange positions for its own account may, at the discretion of its national authority, be exempted from capital requirements on these positions provided that:

• Its foreign currency business, defined as the greater of the sum of its gross long positions and the sum of its gross short positions in all foreign currencies, does not exceed 100% of eligible capital as defined in paragraphs 49(xxi) and 49(xxii); and

• Its overall net open position as defined in the paragraph above does not exceed 2% of its eligible capital as defined in paragraphs 49(xxi) and 49(xxii)

4. Commodities risk

718(xLiii). This section establishes a minimum capital standard to cover the risk of holding or taking positions in commodities, including precious metals, but excluding gold (which is treated as a foreign currency according to the methodology set out in paragraphs 718(xxx) to 718(xLii) above).

A commodity is defined as a physical product which is or can be traded on a secondary market, e.g. agricultural products, minerals (including oil) and precious metals.

718(xLiv). The price risk in commodities is often more complex and volatile than that associated with currencies and interest rates. Commodity markets may also be less liquid than those for interest rates and currencies and, as a result, changes in supply and demand can have a more dramatic effect on price and volatility. *

These market characteristics can make price transparency and the effective hedging of commodities risk more difficult.

* Banks need also to guard against the risk that arises when the short position falls due before the long position. Owing to a shortage of liquidity in some markets it might be difficult to close the short position and the bank might be squeezed by the market.

718(xLv). For spot or physical trading, the directional risk arising from a change in the spot price is the most important risk. However, banks using portfolio strategies involving forward and derivative contracts are exposed to a variety of additional risks, which may well be larger than the risk of a change in spot prices.

These include:

• Basis risk (the risk that the relationship between the prices of similar commodities alters through time);

• Interest rate risk (the risk of a change in the cost of carry for forward positions and options);

• Forward gap risk (the risk that the forward price may change for reasons other than a change in interest rates);

In addition banks may face credit counterparty risk on over-the-counter derivatives, but this is captured by one of the methods set out in Annex 4 of this Framework.

The funding of commodities positions may well open a bank to interest rate or foreign exchange exposure
and if that is so the relevant positions should be included in the measures of interest rate and foreign exchange risk described in paragraphs 709 to 718(xviii) and paragraphs 718(xxx) to 718(xLii), respectively. *

* Where a commodity is part of a forward contract (quantity of commodities to be received or to be delivered),
any interest rate or foreign currency exposure from the other leg of the contract should be reported as set out
in paragraphs 709 to 718(xviii) and paragraphs 718(xxx) to 718(xLii). Positions which are purely stock
financing (i.e. a physical stock has been sold forward and the cost of funding has been locked in until the date
of the forward sale) may be omitted from the commodities risk calculation although they will be subject to
interest rate and counterparty risk requirements.

718(xLvi). There are three alternatives for measuring commodities position risk which are described in paragraphs 718(xLviii) to 718(Lv) below.

As with other categories of market risk, banks may use models subject to the conditions set out in paragraphs 718(Lxx) to 718(xcix).

Commodities risk can also be measured in a standardised manner, using either a verysimple framework (paragraphs 718(Liv) and 718(Lv) below) or a measurement system which captures forward gap and interest rate risk separately by basing the methodology on seven time-bands (paragraphs 718(xLix) to 718(Liii) below).

Both the simplified approach and the maturity ladder approach are appropriate only for banks which, in relative terms, conduct only a limited amount of commodities business.

Major traders would be expected over time to adopt a models approach subject to the safeguards set out in paragraphs 718(Lxx) to 718(xcix).

718(xLvii). For the maturity ladder approach and the simplified approach, long and short positions in each commodity may be reported on a net basis for the purposes of calculating open positions.

However, positions in different commodities will as a general rule not be offsettable in this fashion. Nevertheless, national authorities will have discretion to permit netting between different sub-categories * of the same commodity in cases where the subcategories are deliverable against each other.

They can also be considered as offsettable if they are close substitutes against each other and a minimum correlation of 0.9 between the price movements can be clearly established over a minimum period of one year.

However, a bank wishing to base its calculation of capital charges for commodities on correlations would
have to satisfy the relevant supervisory authority of the accuracy of the method which has been chosen and obtain its prior approval.

Where banks use the models approach they can offset long and short positions in different commodities to a degree which is determined by empirical correlations, in the same way as a limited degree of offsetting is allowed, for instance, between interest rates in different currencies.

* Commodities can be grouped into clans, families, sub-groups and individual commodities. For example, a clan might be Energy Commodities, within which Hydro-Carbons are a family with Crude Oil being a sub-group and West Texas Intermediate, Arabian Light and Brent being individual commodities.

(i) Models for measuring commodities risk

718(xLviii). Banks may choose to adopt the models approach as set out in paragraphs 718(Lxx) to 718(xcix). It is essential that the methodology used encompasses:

• Directional risk, to capture the exposure from changes in spot prices arising from net open positions;

• Forward gap and interest rate risk, to capture the exposure to changes in forward prices arising from maturity mismatches; and

• Basis risk, to capture the exposure to changes in the price relationships between two similar, but not identical, commodities.

It is also particularly important that models take proper account of market characteristics - notably delivery dates and the scope provided to traders to close out positions.

(ii) Maturity ladder approach

718(xLix). In calculating the capital charges under this approach banks will first have to express each commodity position (spot plus forward) in terms of the standard unit of measurement (barrels, kilos, grams etc.).

The net position in each commodity will then be  converted at current spot rates into the national currency.

718(L). Secondly, in order to capture forward gap and interest rate risk within a time-band (which, together, are sometimes referred to as curvature/spread risk), matched long and short positions in each time-band will carry a capital charge.

The methodology will be rather similar to that used for interest rate related instruments as set out in paragraphs 709 to 718(xviii).

Positions in the separate commodities (expressed in terms of the standard unit of measurement) will first be entered into a maturity ladder while physical stocks should be allocated to the first time-band.

A separate maturity ladder will be used for each commodity as defined in paragraph 718(xLvii) above. *

For each time-band, the sum of short and long positions which are matched will be multiplied first by the spot price for the commodity, and then by the appropriate spread rate for that band (as set out in the table below).

* For markets which have daily delivery dates, any contracts maturing within ten days of one another may be
offset.
 

718(Li). The residual net positions from nearer time-bands may then be carried forward tooffset exposures in time-bands that are further out.

However, recognising that such hedging of positions among different time-bands is imprecise, a surcharge equal to 0.6% of the net position carried forward will be added in respect of each time-band that the net position is carried forward.

The capital charge for each matched amount created by carrying net positions forward will be calculated as in paragraph 718(L) above.

At the end of this process a bank will have either only long or only short positions, to which a capital charge of 15% will apply.

718(Lii). Even though the Committee is aware that there are differences in volatility between different commodities, it has decided in the interest of simplicity, and given the fact that banks normally run rather small open positions in commodities, that one uniform capital charge for open positions in all commodities should apply.

Those banks which desire to be more precise in this area may choose to adopt the models approach.

718(Liii). All commodity derivatives and off-balance-sheet positions which are affected by changes in commodity prices should be included in this measurement framework.

This includes commodity futures, commodity swaps, and options where the “delta plus” method145
is used (see paragraphs 718(Lix) to 718(Lxii) below). In order to calculate the risk, commodity derivatives should be converted into notional commodities positions and assigned to maturities as follows:

• Futures and forward contracts relating to individual commodities should be incorporated in the measurement system as notional amounts of barrels, kilos etc. and should be assigned a maturity with reference to expiry date;

• Commodity swaps where one leg is a fixed price and the other the current market price should be incorporated as a series of positions equal to the notional amount of the contract, with one position corresponding with each payment on the swap and slotted into the maturity ladder accordingly.

The positions would be long positions if  the bank is paying fixed and receiving floating, and short positions if the bank is receiving fixed and paying floating; *

• Commodity swaps where the legs are in different commodities are to be incorporated in the relevant maturity ladder.

No offsetting will be allowed in this regard except where the commodities belong to the same sub-category as defined in paragraph 718(xLvii) above.

* If one of the legs involves receiving/paying a fixed or floating interest rate, that exposure should be slotted intothe appropriate repricing maturity band in the maturity ladder covering interest rate related instruments.

(iii) Simplified approach

718(Liv). In calculating the capital charge for directional risk, the same procedure will be adopted as in the maturity ladder approach above (see paragraphs 718(xLix) and 718(Liii)).

Once again, all commodity derivatives and off-balance-sheet positions which are affected by changes in commodity prices should be included. The capital charge will equal 15% of the net position, long or short, in each commodity.

718(Lv). In order to protect the bank against basis risk, interest rate risk and forward gap risk, the capital charge for each commodity as described in paragraphs 718(xLix) and 718(Liii) above will be subject to an additional capital charge equivalent to 3% of the bank’s gross positions, long plus short, in that particular commodity.

In valuing the gross positions in commodity derivatives for this purpose, banks should use the current spot price.

5. Treatment of options

718(Lvi). In recognition of the wide diversity of banks’ activities in options and the difficulties of measuring price risk for options, several alternative approaches will be permissible at the discretion of the national authority:

• Those banks which solely use purchased options * will be free to use the simplifiedapproach described in paragraph 718(Lviii) below;

• Those banks which also write options will be expected to use one of the intermediate approaches as set out in paragraphs 718(Lix) to 718(Lxix) or a comprehensive risk management model under the terms of paragraphs 718(Lxx) to 718(xcix) of this Framework.

The more significant its trading, the more the bank will be expected to use a sophisticated approach.

*  Unless all their written option positions are hedged by perfectly matched long positions in exactly the same options, in which case no capital charge for market risk is required.

718(Lvii). In the simplified approach, the positions for the options and the associated underlying, cash or forward, are not subject to the standardised methodology but rather are “carved-out” and subject to separately calculated capital charges that incorporate both general market risk and specific risk.

The risk numbers thus generated are then added to the capital charges for the relevant category, i.e. interest rate related instruments, equities, foreign exchange and commodities as described in paragraphs 709 to 718(Lv).

The deltaplus method uses the sensitivity parameters or “Greek letters” associated with options to measure their market risk and capital requirements.

Under this method, the delta-equivalent position of each option becomes part of the standardised methodology set out in paragraphs 709 to 718(Lv) with the delta-equivalent amount subject to the applicable general market risk charges.

Separate capital charges are then applied to the gamma and vega risks of the option positions.

The scenario approach uses simulation techniques to calculate changes in the value of an options portfolio for changes in the level and volatility of its associated underlyings.

Under this approach, the general market risk charge is determined by the scenario “grid” (i.e. the specified combination of underlying and volatility changes) that produces the largest loss. For the delta-plus method and the scenario approach the specific risk capital charges are determined separately by multiplying the delta-equivalent of each option by the specific risk weights set out in paragraphs 709 to 718(xxix).

(i) Simplified approach

718(Lviii). Banks which handle a limited range of purchased options only will be free to use the simplified approach set out in the table below for particular trades.

As an example of how the calculation would work, if a holder of 100 shares currently valued at $10 each holds an equivalent put option with a strike price of $11, the capital charge would be: $1,000 x 16% (i.e. 8% specific plus 8% general market risk) = $160, less the amount the option is in the money ($11 - $10) x 100 = $100, i.e. the capital charge would be $60.

A similar methodology applies for options whose underlying is a foreign currency, an interest rate related instrument or a commodity.

148 In some cases such as foreign exchange, it may be unclear which side is the “underlying security”; this should be taken to be the asset which would be received if the option were exercised. In addition the nominal value should be used for items where the market value of the underlying instrument could be zero, e.g. caps and floors, swaptions etc.

149 Some options (e.g. where the underlying is an interest rate, a currency or a commodity) bear no specific risk but specific risk will be present in the case of options on certain interest rate related instruments (e.g. options on a corporate debt security or corporate bond index; see paragraphs 709 to 718(xviii) for the relevant capital charges) and for options on equities and stock indices (see paragraphs 718(xix) to 718(xxix)). The charge under this measure for currency options will be 8% and for options on commodities 15%.

150 For options with a residual maturity of more than six months the strike price should be compared with the
forward, not current, price. A bank unable to do this must take the in the money amount to be zero.

151 Where the position does not fall within the trading book (i.e. options on certain foreign exchange or
commodities positions not belonging to the trading book), it may be acceptable to use the book value instead.

(ii) Intermediate approaches

Delta-plus method

718(Lix). Banks which write options will be allowed to include delta-weighted options positions within the standardised methodology set out in paragraphs 709 to 718(Lv).

Such options should be reported as a position equal to the market value of the underlying multiplied by the
delta.

However, since delta does not sufficiently cover the risks associated with options positions, banks will also be required to measure gamma (which measures the rate of change of delta) and vega (which measures the sensitivity of the value of an option with respect to a change in volatility) sensitivities in order to calculate the total capital charge.

These sensitivities will be calculated according to an approved exchange model or to the bank’s proprietary options pricing model subject to oversight by the national authority. *

*National authorities may wish to require banks doing business in certain classes of exotic options (e.g. barriers, digitals) or in options at the money that are close to expiry to use either the scenario approach or the internal models alternative, both of which can accommodate more detailed revaluation approaches.

718(Lx). Delta-weighted positions with debt securities or interest rates as the underlying will be slotted into the interest rate time-bands, as set out in paragraphs 709 to 718(xviii), under the following procedure.

A two-legged approach should be used as for other derivatives, requiring one entry at the time the underlying contract takes effect and a second at the time the underlying contract matures.

For instance, a bought call option on a June three-month interest-rate future will in April be considered, on the basis of its delta-equivalent value, to be a long position with a maturity of five months and a short position with a maturity of two months. *

The written option will be similarly slotted as a long position with a maturity of two months and a short position with a maturity of five months.

Floating rate instruments with caps or floors will be treated as a combination of floating rate securities and a series of European-style options.

For example, the holder of a three-year floating rate bond indexed to six month LIBOR with a cap of 15% will treat it as:

(i) A debt security that reprices in six months; and

(ii) A series of five written call options on a FRA with a reference rate of 15%, each with a negative sign at the time the underlying FRA takes effect and a positive sign at the time the underlying FRA matures.**

* A two months call option on a bond future where delivery of the bond takes place in September would be considered in April as being long the bond and short a five months deposit, both positions being deltaweighted.

** The rules applying to closely matched positions set out in paragraph 718(xiv) will also apply in this respect.

718(Lxi). The capital charge for options with equities as the underlying will also be based on the delta-weighted positions which will be incorporated in the measure of market risk described in paragraphs 718(xix) to 718(xxix).

For purposes of this calculation each national market is to be treated as a separate underlying.

The capital charge for options on foreign exchange and gold positions will be based on the method set out in paragraphs 718(xxx) to 718(xLii).

For delta risk, the net delta-based equivalent of the foreign currency and gold options will be incorporated into the measurement of the exposure for the respective currency (or gold) position.

The capital charge for options on commodities will be based on the simplified or the maturity ladder approach set out in paragraphs 718(xLiii) to 718(Lv).

The delta-weighted positions will be incorporated in one of the measures described in that section.

718(Lxii). In addition to the above capital charges arising from delta risk, there will be further capital charges for gamma and for vega risk. Banks using the delta-plus method will be required to calculate the gamma and vega for each option position (including hedge positions) separately. The capital charges should be calculated in the following way:

(i) for each individual option a “gamma impact” should be calculated according to a Taylor series expansion as:

Gamma impact = ½ x Gamma x VU²

where VU = Variation of the underlying of the option.

(ii) VU will be calculated as follows:

• For interest rate options if the underlying is a bond, the market value of the underlying should be multiplied by the risk weights set out in paragraph

718(iv). An equivalent calculation should be carried out where the underlying is an interest rate, again based on the assumed changes in the corresponding yield in paragraph 718(iv);

• For options on equities and equity indices: the market value of the underlying should be multiplied by 8%;

[The basic rules set out here for interest rate and equity options do not attempt to capture specific risk when calculating gamma capital charges. However, national authorities may wish to require specific banks to do so.]

• For foreign exchange and gold options: the market value of the underlying should be multiplied by 8%;

• For options on commodities: the market value of the underlying should be multiplied by 15%.

(iii) For the purpose of this calculation the following positions should be treated as the same underlying:

• for interest rates, [Positions have to be slotted into separate maturity ladders by currency] each time-band as set out in paragraph 718(iv);[Banks using the duration method should use the time-bands as set out in paragraph 718(vii).]

• for equities and stock indices, each national market;

• for foreign currencies and gold, each currency pair and gold;

• for commodities, each individual commodity as defined in paragraph 718(xLvii).

(iv) Each option on the same underlying will have a gamma impact that is either positive or negative.

These individual gamma impacts will be summed, resulting in a net gamma impact for each underlying that is either positive or negative.

Only those net gamma impacts that are negative will be included in the capital calculation.

(v) The total gamma capital charge will be the sum of the absolute value of the net negative gamma impacts as calculated above.

(vi) For volatility risk, banks will be required to calculate the capital charges by multiplying the sum of the vegas for all options on the same underlying, as defined above, by a proportional shift in volatility of ± 25%.

(vii) The total capital charge for vega risk will be the sum of the absolute value of the individual capital charges that have been calculated for vega risk.

Scenario approach

718(Lxiii). More sophisticated banks will also have the right to base the market risk capital charge for options portfolios and associated hedging positions on scenario matrix analysis.

This will be accomplished by specifying a fixed range of changes in the option portfolio’s risk factors and calculating changes in the value of the option portfolio at various points along this “grid”.

For the purpose of calculating the capital charge, the bank will revalue the option portfolio using matrices for simultaneous changes in the option’s underlying rate or price and in the volatility of that rate or price.

A different matrix will be set up for each individual underlying as defined in paragraph 718(Lxii) above.

As an alternative, at the discretion of each national authority, banks which are significant traders in options will for interest rate options be permitted to base the calculation on a minimum of six sets of time-bands.

When using this method, not more than three of the time-bands as defined in paragraphs 718(iv) and 718(vii) should be combined into any one set.

718(Lxiv). The options and related hedging positions will be evaluated over a specified range above and below the current value of the underlying.

The range for interest rates is consistent with the assumed changes in yield in paragraph 718(iv).

Those banks using the alternative method for interest rate options set out in paragraph 718(Lxiii) above should use, for each set of time-bands, the highest of the assumed changes in yield applicable to the group to which the time-bands belong. *

The other ranges are ± 8% for equities155, ± 8% for foreign exchange and gold, and ± 15% for commodities.

For all risk categories, at least seven observations (including the current observation) should be used to divide the range into equally spaced intervals.

* If, for example, the time-bands 3 to 4 years, 4 to 5 years and 5 to 7 years are combined the highest assumed change in yield of these three bands would be 0.75.

718(Lxv). The second dimension of the matrix entails a change in the volatility of the underlying rate or price.

A single change in the volatility of the underlying rate or price equal to a shift in volatility of + 25% and - 25% is expected to be sufficient in most cases.

As circumstances warrant, however, the supervisory authority may choose to require that a different change in volatility be used and/or that intermediate points on the grid be calculated.

718(Lxvi). After calculating the matrix each cell contains the net profit or loss of the option and the underlying hedge instrument. The capital charge for each underlying will then be calculated as the largest loss contained in the matrix.

718(Lxvii). The application of the scenario analysis by any specific bank will be subject to supervisory consent, particularly as regards the precise way that the analysis is constructed.

Banks’ use of scenario analysis as part of the standardised methodology will also be subject to validation by the national authority, and to those of the qualitative standards listed in paragraphs 718(Lxxiv) and 718(Lxxv) which are appropriate given the nature of the business.

718(Lxviii). In drawing up these intermediate approaches the Committee has sought to cover the major risks associated with options. In doing so, it is conscious that so far as specific risk is concerned, only the delta-related elements are captured; to capture other risks would necessitate a much more complex regime.

On the other hand, in other areas the simplifying assumptions used have resulted in a relatively conservative treatment of certain options positions.

For these reasons, the Committee intends to keep this area under close review.

718(Lxix). Besides the options risks mentioned above, the Committee is conscious of the other risks also associated with options, e.g. rho (rate of change of the value of the option with respect to the interest rate) and theta (rate of change of the value of the option with respect to time). While not proposing a measurement system for those risks at present, it expects banks undertaking significant options business at the very least to monitor such risks closely.

Additionally, banks will be permitted to incorporate rho into their capital calculations for interest rate risk, if they wish to do so.

D. Market Risk – The Internal Models Approach

1. General criteria

718(Lxx). The use of an internal model will be conditional upon the explicit approval of the bank’s supervisory authority. 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.

718(Lxxi). 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;

• 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, audit, and if necessary, back office areas;

• The bank’s models have in the supervisory authority’s judgement a proven track record of reasonable accuracy in measuring risk;

• The bank regularly conducts stress tests along the lines discussed in paragraphs 718(Lxxvii) to 718(Lxxxiv) below.

718(Lxxii). 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.

718(Lxxiii). In addition to these general criteria, banks using internal models for capital purposes will be subject to the requirements detailed in paragraphs 718(Lxxiv) to 718(xcix).

2. Qualitative standards

718(Lxxiv). 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. Accordingly, 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.

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. Only those banks whose models are in full compliance with the qualitative criteria will be eligible for application of the minimum multiplication factor.

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 unit should produce and analyse daily reports on the output of the bank’s risk measurement
model, including an evaluation of the relationship between measures of risk exposure and trading limits.

This unit must be independent from business trading units and should report directly to senior management of the bank.

(b) The unit should conduct a regular back-testing programme, i.e. an ex-post comparison of the risk measure generated by the model against actual daily changes in portfolio value over longer periods of time, as well as hypothetical changes based on static positions.

(c) The unit should also conduct the initial and on-going validation of the internal model. [Further guidance regarding the standards that supervisory authorities will expect can be found in paragraph 718(xcix).]

(d) 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. [The report, Risk management guidelines for derivatives, issued by the Basel Committee in July 1994 further
discusses the responsibilities of the board of directors and senior management.]

In this regard, 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.

(e) The bank’s internal risk measurement model must be closely integrated into the day to day risk management process of the bank. Its output should accordingly be an integral part of the process of planning, monitoring and controlling the bank’s market risk profile.

(f) The risk measurement system should be used in conjunction with internal trading and exposure limits.

In this regard, 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.

(g) A routine and rigorous programme of stress testing [Though banks will have some discretion as to how they conduct stress tests, their supervisory authorities will wish to see that they follow the general lines set out in paragraphs 718(Lxxvii) to 718(Lxxxiiii)] 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.

The results of stress testing should be reviewed periodically by senior management, used in the internal assessment of capital adequacy, and reflected in the policies and limits set by management and the board of directors.

Where stress tests reveal particular vulnerability to a given set of circumstances, prompt steps should be taken to manage those risks appropriately (e.g. by hedging against that outcome or reducing the size of the bank’s exposures, or increasing capital).

(h) Banks should have a routine in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the risk measurement system.

The bank’s risk measurement system must be well documented, for example, through a risk management manual that describes the basic principles of the risk management system and that provides an explanation of
the empirical techniques used to measure market risk.

(i) An independent review of the risk measurement system should be carried out regularly in the bank’s own internal auditing process.

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 place at regular intervals (ideally not less than once a year) and should specifically address, at a minimum:

• The adequacy of the documentation of the risk management system and process;

• The organisation of the risk control unit;

• The integration of market risk measures into daily risk management;

• The approval process for risk pricing models and valuation systems used by front and back-office personnel;

• The validation of any significant change in the risk measurement process;

• The scope of market risks captured by the risk measurement model;

• The integrity of the management information system;

• The accuracy and completeness of position data;

• The verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources;

• The accuracy and appropriateness of volatility and correlation assumptions;

• The accuracy of valuation and risk transformation calculations;

• 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.

3. Specification of market risk factors

718(Lxxv). An important part of a bank’s internal market risk measurement system is the specification of an appropriate set of market risk factors, i.e. the market rates and prices that affect the value of the bank’s 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- and off-balance sheet trading positions.

Although banks will have some discretion in specifying the risk factors for their internal models, the following guidelines should be fulfilled.

(a) For interest rates, there must be a set of risk factors corresponding to interest rates in each currency in which the bank has interest-rate-sensitive on- or off balance sheet positions.

• The risk measurement system should model the yield curve using one of a number of generally accepted approaches, for example, by estimating forward rates of zero coupon yields.

The yield curve should be divided into various maturity segments in order to capture variation in the volatility of rates along the yield curve; there will typically be one risk factor corresponding to each maturity segment.

For material exposures to interest rate movements in the major currencies and markets, banks must model
the yield curve using a minimum of six risk factors.

However, the number of risk factors used should ultimately be driven by the nature of the bank’s trading strategies.

For instance, 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.

• The risk measurement system must incorporate separate risk factors to capture spread risk (e.g. between bonds and swaps).

A variety of approaches may be used to capture the spread risk arising from less than perfectly correlated movements between government and other fixed income interest rates, such as specifying a completely separate yield curve for non-government fixed-income instruments (for instance, swaps or municipal securities) or estimating the spread over government rates at various points along the yield curve.

(b) For exchange rates (which may include gold), the risk measurement system should incorporate risk factors corresponding to the individual foreign currencies in which the bank’s positions are denominated. Since the value-at-risk figure calculated by the risk measurement system will be expressed in the bank’s domestic currency, any net position denominated in a foreign currency will introduce a foreign exchange risk.

Thus, 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.

(c) For equity prices, there should be risk factors corresponding to each of the equitymarkets in which the bank holds significant positions:

• At a minimum, there should be a risk factor that is designed to capture market-wide movements in equity prices (e.g. a market index).

Positions in individual securities or in sector indices could be expressed in “betaequivalents”* relative to this market-wide index;

*  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.
 

• A somewhat more detailed approach would be to have risk factors corresponding to various sectors of the overall equity market (for instance, industry sectors or cyclical and non-cyclical sectors).

As above, positions in individual stocks within each sector could be expressed in betaequivalents49
relative to the sector index;

• The most extensive approach would be to have risk factors corresponding e volatility of individual equity issues.

• The sophistication and nature of the modelling technique for a given market should correspond to the bank’s exposure to the overall market as well as its concentration in individual equity issues in that market.

(d) For commodity prices, 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, a straightforward specification of risk factors would be acceptable.

Such a specification would likely entail one risk factor for each commodity price to which the bank is exposed.

In cases where the aggregate positions are quite small, it might be acceptable to use a single risk factor for a relatively broad sub-category of commodities (for instance, a single risk factor for all types of oil);

• For more active trading, the model must also take account of variation in the “convenience yield”163 between derivatives positions such as forwards and swaps and cash positions in the commodity.

4. Quantitative standards

718(Lxxvi). Banks will have flexibility in devising the precise nature of their models, but the following minimum standards will apply for the purpose of calculating their capital charge.

Individual banks or their supervisory authorities will have discretion to apply stricter standards.

(a) “Value-at-risk” must be computed on a daily basis.

(b) In calculating the value-at-risk, a 99th percentile, one-tailed confidence interval is to be used.

(c) In calculating value-at-risk, an instantaneous price shock equivalent to a 10 day movement in prices is to be used, i.e. the minimum “holding period” will be ten trading days.

Banks may use value-at-risk numbers calculated according to shorter holding periods scaled up to ten days by the square root of time (for the treatment of options, also see 718(Lxxvi) (h) below).

(d) The choice of historical observation period (sample period) for calculating value at risk will be constrained to a minimum length of one year.

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, the weighted average time lag of the individual observations cannot be less than 6 months).

(e) Banks should update their data sets no less frequently than once every three months and should also reassess them whenever market prices are subject to material changes.

The supervisory authority may also require a bank to calculate its value-at-risk using a shorter observation period if, in the supervisor’s judgement, this is justified by a significant upsurge in price volatility.

(f) No particular type of model is prescribed. So long as each model used captures allthe material risks run by the bank, as set out in paragraph 718(Lxxv), banks will be free to use models based, for example, on variance-covariance matrices, historical simulations, or Monte Carlo simulations.

(g) Banks will have discretion to recognise empirical correlations within broad risk categories (e.g. interest rates, exchange rates, equity prices and commodity prices, including related options volatilities in each risk factor category).

The supervisory authority may also recognise empirical correlations across broad risk factor categories, provided that the supervisory authority is satisfied that the bank’s system for measuring correlations is sound and implemented with integrity.

(h) Banks’ models must accurately capture the unique risks associated with options within each of the broad risk categories.

The following criteria apply to the measurement of options risk:

• Banks’ models must capture the non-linear price characteristics of options positions;

• 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.

In the interim, national authorities may require banks to adjust their capital measure for options risk through other methods, e.g. periodic simulations or stress testing;

• 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, i.e. vega risk.

Banks with relatively large and/or complex options portfolios should have detailed specifications of the relevant volatilities.

This means that banks should measure the volatilities of options positions broken down by different maturities.

(i) Each bank must meet, on a daily basis, a capital requirement expressed as the higher of

(i) its previous day’s value-at-risk number measured according to the parameters specified in this section and

(ii) an average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by a
multiplication factor.

(j) The multiplication factor will be set by individual supervisory authorities on the basis of their assessment of the quality of the bank’s risk management system, subject to an absolute minimum of 3.

Banks will be required to add to this factor a “plus” directly related to the ex-post performance of the model, thereby introducing a built in positive incentive to maintain the predictive quality of the model.

The plus will range from 0 to 1 based on the outcome of so-called “backtesting.”

If the backtesting results are satisfactory and the bank meets all of the qualitative standards set out in
paragraph 718(Lxxiv) above, the plus factor could be zero.

The Annex 10a of this Framework presents in detail the approach to be applied for backtesting and the plus factor. Supervisors will have national discretion to require banks to perform backtesting on either hypothetical (i.e. using changes in portfolio value that would occur were end-of-day positions to remain unchanged), or actual trading (i.e. excluding fees, commissions, and net interest income) outcomes, or both.

(k) 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 manner in which the specific risk capital charge is to be calculated is set out in paragraphs 718(Lxxxvii) to 718(xcviii).

5. Stress testing

718(Lxxvii). Banks that use the internal models approach for meeting market risk capital requirements must have in place a rigorous and comprehensive stress testing program.

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.

718(Lxxviii). Banks’ stress scenarios need to cover a range of factors that can create extraordinary losses or gains in trading portfolios, or make the control of risk in those portfolios very difficult.

These factors include low-probability events in all major types of risks, including the various components of market, credit, and operational risks.

Stress scenarios need to shed light on the impact of such events on positions that display both linear and nonlinear price characteristics (i.e. options and instruments that have options-like characteristics).

718(Lxxix). Banks’ stress tests should be both of a quantitative and qualitative nature, incorporating both market risk and liquidity aspects of market disturbances.

Quantitative criteria should identify plausible stress scenarios to which banks could be exposed.

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.

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, periodically, to the bank’s board of
directors.

718(Lxxx). Banks should combine the use of supervisory stress scenarios with stress tests developed by banks themselves to reflect their specific risk characteristics.

Specifically, supervisory authorities may ask banks to provide information on stress testing in three broad
areas, which are discussed in turn below.

(i) Supervisory scenarios requiring no simulations by the bank

718(Lxxxi). Banks should have information on the largest losses experienced during the reporting period available for supervisory review.

This loss information could be compared to the level of capital that results from a bank’s internal measurement system.

For example, 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.

(ii) Scenarios requiring a simulation by the bank

718(Lxxxii). Banks should subject their portfolios to a series of simulated stress scenarios and provide supervisory authorities with the results.

These scenarios could include testing the current portfolio against past periods of significant disturbance, for example, the 1987 equity crash, the ERM crises of 1992 and 1993 or the fall in bond markets in the first quarter
of 1994, incorporating both the large price movements and the sharp reduction in liquidity associated with these events.

A second type of scenario would evaluate the sensitivity of the bank’s market risk exposure to changes in the assumptions about volatilities and correlations.

Applying this test would require an evaluation of the historical range of variation for volatilities and correlations and evaluation of the bank’s current positions against the extreme values of the historical range.

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.

The 1987 equity crash, the suspension of the ERM, or the fall in bond markets in the first quarter of 1994, for example, all involved correlations within risk factors approaching the extreme values of 1 or -1 for several days at the height of the disturbance.

(iii) Scenarios developed by the bank itself to capture the specific characteristics of its portfolio.

718(Lxxxiii). In addition to the scenarios prescribed by supervisory authorities under ragraphs 718(Lxxxi) and 718(Lxxxii) above, a bank should also develop its own stress tests which it identifies as most adverse based on the characteristics of its portfolio (e.g. problems in a key region of the world combined with a sharp move in oil prices).

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.

718(Lxxxiv). 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.

Moreover, if the testing reveals particular vulnerability to a given set of circumstances, thenational authorities would expect the bank to take prompt steps to manage those risks appropriately (e.g. by hedging against that outcome or reducing the size of its exposures).

6. External validation

718(Lxxxv). The validation of models’ accuracy by external auditors and/or supervisory authorities should at a minimum include the following steps:

(a) Verifying that the internal validation processes described in paragraph 718(Lxxiv) (i) are operating in a satisfactory manner;

(b) 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, which in all cases should be independent from the trading area;

(c) Checking that the structure of internal models is adequate with respect to the bank’s activities and geographical coverage;

(d) Checking the results of the banks’ back-testing of its internal measurement system (i.e. comparing value-at-risk estimates with actual profits and losses) to ensure that the model provides a reliable measure of potential losses over time.

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;

(e) Making sure that data flows and processes associated with the risk measurement system are transparent and accessible.

In particular, it is necessary that auditors or supervisory authorities are in a position to have easy access, whenever they judge it necessary and under appropriate procedures, to the models’ specifications and
parameters.

7. Combination of internal models and the standardised methodology

718(Lxxxvi). Unless a bank’s exposure to a particular risk factor, such as commodity prices, is insignificant, the internal models approach will in principle require banks to have an integrated risk measurement system that captures the broad risk factor categories (i.e. interest rates, exchange rates (which may include gold), equity prices and commodity prices, with related options volatilities being included in each risk factor category).

Thus, banks which start to use models for one or more risk factor categories will, over time, be expected
to extend the models to all their market risks.

A bank which has developed one or moremodels will no longer be able to revert to measuring the risk measured by those models according to the standardised methodology (unless the supervisory authority withdraws approval for that model).

However, pending further experience regarding the process of changing to a models-based approach, 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.

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), i.e. 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);164

(b) All the criteria laid down in paragraphs 718(Lxx) to 718(xcix) of this Framework will apply to the models being used;

(c) 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;

(d) No element of market risk may escape measurement, i.e. the exposure for all the various risk factors, whether calculated according to the standardised approach or internal models, would have to be captured;

(e) The capital charges assessed under the standardised approach and under the models approach are to be aggregated according to the simple sum method.

8. Treatment of specific risk

718(Lxxxvii). Where a bank has a VaR measure that incorporates specific risk and that meets all the qualitative and quantitative requirements for general risk models, it may base its charge on modelled estimates, provided the measure is based on models that meet the additional criteria and requirements set out below.

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.

718(Lxxxviii). The criteria for supervisory recognition of banks’ modelling of specific risk require that a bank’s model must capture all material components of price risk and be responsive to changes in market conditions and compositions of portfolios.

In particular, the model must:

• explain the historical price variation in the portfolio;*
• capture concentrations (magnitude and changes in composition);**
• be robust to an adverse environment;***
• capture name-related basis risk;****
• capture event risk;*****
• be validated through backtesting.*******

* 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. One measure of this type which can often be used is an R-squared measure from regression methodology.

If this measure is to be used, the risk factors included in the bank’s model would be expected to be able to explain a high percentage, such as 90%, 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.

For some types of models, it may not be feasible to calculate a goodness-of-fit measure. In such instance, a bank is expected to work with its national supervisor to define an acceptable alternative measure which would meet this regulatory objective.

** 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.

*** The bank should be able to demonstrate that the model will signal rising risk in an adverse environment. 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. Another approach for demonstrating this is through simulation of historical or plausible worst-case environments.

**** Banks should be able to demonstrate that the model is sensitive to material idiosyncratic differences between similar but not identical positions, for example debt positions with different levels of subordination, maturity mismatches, or credit derivatives with different default events.
 

*****For debt positions, this should include migration risk. For equity positions, events that are reflected in large changes or jumps in prices must be captured, e.g. merger break-ups/takeovers. In particular, firms must
consider issues related to survivorship bias.
 

******Aimed at assessing whether specific risk, as well as general market risk, is being captured adequately.

718(Lxxxix). Where a bank is subject to event risk that is not reflected in its VaR measure, because it is beyond the 10-day holding period and 99 percent confidence interval (i.e. low probability and high severity events), banks must ensure that the impact of such events is factored in to its internal capital assessment, for example through its stress testing.

718(xc). 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.

In addition, the model must meet minimum data standards.

Proxies may be used only where available data is insufficient or is not reflective of the true volatility of a position or portfolio, and only where they are appropriately conservative.

718(Xci). Further, as techniques and best practices evolve, banks should avail themselves of these advances.

718(XCii). In addition, the bank must have an approach in place to capture in its regulatory capital default risk of its trading book positions that is incremental to the risk captured by the VaR-based calculation as specified in paragraph 718(Lxxxviii) above.

To avoid double counting a bank may, when calculating its incremental default charge, take into account the extent to which default risk has already been incorporated into the VaR calculation, 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.

No specific approach for capturing the incremental default risk is prescribed; it may be part of the
bank's internal model or a surcharge from a separate calculation.

Where a bank captures its incremental risk through a surcharge, the surcharge will not be subject to a multiplier or regulatory backtesting, although the bank should be able to demonstrate that the surcharge
meets its aim.

718(XCiii). Whichever approach is used, the bank must demonstrate that it meets a soundness standard comparable to that of the internal-ratings based approach for credit risk as set forth in this Framework, under the assumption of a constant level of risk, and adjusted where appropriate to reflect the impact of liquidity, concentrations, hedging, and optionality.

A bank that does not capture the incremental default risk through an internally developed approach must use the fallback of calculating the surcharge through an approach consistent with that for credit risk as set forth in this Framework.

718(XCiv). 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.g. equity tranches that absorb first losses),171 as well as securitisation exposures that are unrated liquidity lines or letters of credit, would be subject to a capital charge that is no less than that set forth in the securitisation framework.

718(XCv). An exception to this treatment could be afforded to banks that are dealers in the above exposures where they can demonstrate, in addition to trading intent, that a liquid two way market exists for the securitisation exposures or, in the case of synthetic securitisations that rely solely on credit derivatives, for the securitisation exposures themselves or all their constituent risk components.

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.

In addition, for a bank to apply this exception, it must have sufficient market data to ensure that it fully captures the concentrated default risk of these exposures in its internal approach for measuring the incremental default risk in accordance with the standards set forth above.

718(XCvi). 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.

718(XCvii). Banks which apply modelled estimates of specific risk are required to conduct backtesting aimed at assessing whether specific risk is being accurately captured.

The methodology a bank should use for validating its specific risk estimates is to perform separate backtests on sub-portfolios using daily data on sub-portfolios subject to specific risk.

The key sub-portfolios for this purpose are traded-debt and equity positions.

However, if a bank itself decomposes its trading portfolio into finer categories (e.g. emerging markets, traded corporate debt, etc.), it is appropriate to keep these distinctions for sub-portfolio backtesting purposes. 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.

718(XCviii). Banks are required to have in place a process to analyse exceptions identified through the backtesting of specific risk. 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.

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.

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.

9. 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.

This validation should be conducted when the model is initially developed and when any significant changes are made to the model.

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.

More extensive model validation is particularly important where specific risk is also modelled and is required to meet the further specific risk criteria.

As techniques and best practices evolve, banks should avail themselves of these advances.

Model validation should not be limited to backtesting, but should, at a minimum, also include the following:

(a) Tests to demonstrate that any assumptions made within the internal model are appropriate and do not underestimate risk.

This may include the assumption of the normal distribution, the use of the square root of time to scale from a one day holding period to a 10 day holding period or where extrapolation or interpolation techniques are used, or pricing models;

(b) Further to the regulatory backtesting programmes, testing for model validation should be carried out using additional tests, 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.

It therefore excludes fees, commissions, bid-ask spreads, net interest income and intra-day trading;

• Testing carried out for longer periods than required for the regular backtesting programme (e.g. 3 years).

The longer time period generally improves the power of the back testing.

A longer time period may not be desirable if the VaR model or market conditions have changed to the extent
that historical data is no longer relevant;

• Testing carried out using confidence intervals other than the 99 percent interval required under the quantitative standards;

• Testing of portfolios below the overall bank level;

(c) The use of hypothetical portfolios to ensure that the model is able to account for particular structural features that may arise, 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, then the bank must ensure that the proxies produce conservative results under relevant market scenarios;

• Ensuring that material basis risks are adequately captured.

This may include mismatches between long and short positions by maturity or by issuer;

• Ensuring that the model captures concentration risk that may arise in an undiversified portfolio.

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