The Basel ii
Accord
From the Basel ii Compliance Professionals Association (BCPA)
the largest association of Basel ii Professionals in the
world
Minimum operational
requirements
493. A bank purchasing receivables has
to justify confidence that current and
future advances can be repaid from the liquidation of
(or collections against) the receivables pool.
To
qualify for the top-down treatment of default risk, the
receivable pool and overall lending relationship
should be closely monitored and controlled.
Specifically, a bank will have to demonstrate the
following:
Legal certainty
494. The structure of
the facility must ensure that under all foreseeable
circumstances the bank has effective ownership and
control of the cash remittances from the
receivables, including incidences of seller or
servicer distress and bankruptcy.
When the obligor
makes payments directly to a seller or servicer, the
bank must verify regularly that payments
are
forwarded completely and within the contractually
agreed terms.
As well, ownership over the receivables
and cash receipts should be protected against bankruptcy
‘stays’ or legal
challenges that could materially
delay the lender’s ability to liquidate/assign the
receivables or retain control over cash
receipts.
Effectiveness of monitoring systems
495.
The bank must be able to monitor both the quality of the
receivables and the financial condition of the seller
and servicer.
In particular:
• The bank must
(a)
assess the correlation among the quality of the
receivables and the financial condition of both the
seller and servicer, and
(b) have in place
internal policies and procedures that provide
adequate safeguards to protect against
such
contingencies, including the assignment of an
internal risk rating for each seller
and servicer.
• The bank must have clear and
effective policies and procedures for
determining seller and servicer eligibility.
The bank
or its agent must conduct periodic reviews of sellers
and servicers in order to verify the accuracy of reports
from the seller/servicer, detect fraud or operational
weaknesses, and verify the quality of the seller’s
credit policies and servicer’s collection policies and
procedures.
The findings of these reviews must be
well documented.
• The bank must have the ability to
assess the characteristics of the receivables
pool, including
(a) over-advances;
(b) history of the
seller’s arrears, bad debts, and baddebt allowances;
(c) payment terms, and
(d) potential contra
accounts.
• The bank must have effective policies and
procedures for monitoring on an aggregate basis
single-obligor concentrations both within and across
receivables pools.
• The bank must receive timely
and sufficiently detailed reports of receivables
ageings and dilutions to
(a) ensure compliance with
the bank’s eligibility criteria and advancing
policies governing purchased receivables, and
(b)
provide an effective means with which to monitor and
confirm the seller’s terms of sale (e.g. invoice
date
ageing) and dilution.
Effectiveness of
work-out systems
496. An effective programme requires
systems and procedures not only for
detecting deterioration in the seller’s financial
condition and deterioration in the quality of
the receivables at an early stage, but also for
addressing emerging problems pro-actively.
In particular,
• The bank should have clear
and effective policies, procedures, and
information systems to monitor compliance with
(a)
all contractual terms of the facility
(including covenants, advancing formulas,
concentration limits, early amortisation
triggers, etc.) as well as
(b) the bank’s internal
policies governing advance rates and receivables
eligibility.
The bank’s systems should track covenant
violations and waivers as well as exceptions to
established policies and procedures.
• To limit
inappropriate draws, the bank should have effective
policies and procedures for detecting, approving,
monitoring, and correcting over-advances.
• The bank
should have effective policies and procedures for
dealing with financially weakened sellers or
servicers and/or deterioration in the quality of
receivable pools.
These include, but are not
necessarily limited to, early termination triggers
in revolving facilities and other covenant
protections, a structured and disciplined approach to
dealing with covenant violations, and clear and
effective policies and procedures for initiating
legal actions and dealing with problem
receivables.
Effectiveness of systems for controlling
collateral, credit availability, and cash
497. The
bank must have clear and effective policies and
procedures governing the control of receivables,
credit, and cash.
In particular,
• Written internal
policies must specify all material elements of the
receivables purchase programme, including the
advancing rates, eligible collateral,
necessary documentation, concentration limits, and
how cash receipts are to be handled.
These elements
should take appropriate account of all relevant and
material factors, including the seller’s/servicer’s
financial condition, risk concentrations, and trends
in the quality of the receivables and the seller’s
customer base.
• Internal systems must ensure that
funds are advanced only against specified supporting
collateral and documentation (such as servicer
attestations, invoices, shipping documents,
etc.).
Compliance with the bank’s internal policies
and procedures
498. Given the reliance on monitoring
and control systems to limit credit risk, the
bank should have an effective internal process for
assessing compliance with all critical policies and
procedures, including
• regular internal and/or
external audits of all critical phases of the bank’s
receivables purchase programme.
• verification of
the separation of duties
(i) between the assessment of
the seller/servicer and the assessment of the obligor
and
(ii) between the assessment of the
seller/servicer and the field audit of the
seller/servicer.
499. A bank’s effective internal
process for assessing compliance with all critical
policies and procedures should also include
evaluations of back office operations, with
particular focus on qualifications, experience,
staffing levels, and supporting systems.
8.
Validation of internal estimates
500. Banks must have
a robust system in place to validate the accuracy and
consistency of rating systems, processes, and the
estimation of all relevant risk components.
A
bank must demonstrate to its supervisor that the
internal validation process enables it to assess the
performance of internal rating and risk estimation
systems consistently and meaningfully.
501.
Banks must regularly compare realised default rates with
estimated PDs for each grade and be able to
demonstrate that the realised default rates are within
the expected range for that grade.
Banks using the
advanced IRB approach must complete such analysis for
their estimates of LGDs and EADs.
Such comparisons must
make use of historical data that are over as long a
period as possible.
The methods and data used in such
comparisons by the bank must be clearly documented by
the bank.
This analysis and documentation must be
updated at least annually.
502. Banks must also use
other quantitative validation tools and comparisons
with relevant external data sources. The analysis
must be based on data that are appropriate to ortfolio, are updated regularly, and cover a relevant
observation period.
Banks’ internal assessments of
the performance of their own rating systems must be
based on long data histories, covering a range of
economic conditions, and ideally one or more
complete business cycles.
503. Banks must
demonstrate that quantitative testing methods and other
validation methods do not vary systematically with
the economic cycle.
Changes in methods and data (both
data sources and periods covered) must be clearly and
thoroughly documented.
504. Banks must have
well-articulated internal standards for situations where
deviations in realised PDs, LGDs and EADs from
expectations become significant enough to call
the validity of the estimates into question.
These
standards must take account of business cycles and
similar systematic variability in default experiences.
Where realised values continue to be higher than
expected values, banks must revise estimates upward to
reflect their default and loss experience.
505.
Where banks rely on supervisory, rather than internal,
estimates of risk parameters, they are encouraged to
compare realised LGDs and EADs to those set by the
supervisors.
The information on realised LGDs and
EADs should form part of the bank’s assessment
of economic capital.
9. Supervisory LGD and EAD
estimates
506. Banks under the foundation IRB
approach, which do not meet the requirements
for own-estimates of LGD and EAD, above, must meet
the minimum requirements described in the
standardised approach to receive recognition for
eligible financial collateral (as set out in Section
II.D: The standardised approach ─ credit risk
mitigation).
They must meet the following additional
minimum requirements in order to receive recognition for
additional
collateral types.
(i) Definition of
eligibility of CRE and RRE as collateral
507.
Eligible CRE and RRE collateral for corporate, sovereign
and bank exposures are defined as:
• Collateral
where the risk of the borrower is not materially
dependent upon the performance of the underlying
property or project, but rather on the
underlying capacity of the borrower to repay the debt
from other sources.
As such, repayment of the
facility is not materially dependent on any cash flow
generated by the underlying CRE/RRE serving as
collateral;* and
• Additionally, the value of the
collateral pledged must not be materially dependent
on the performance of the borrower.
This requirement
is not intended to preclude situations where purely
macro-economic factors affect both the value of
the collateral and the performance of the
borrower.
*
The
Committee recognises that in some countries where
multifamily housing makes up an important part of the
housing market and where public policy is supportive of
that sector, including specially established public
sector companies as major providers, the risk
characteristics of lending secured by mortgage on such
residential real estate can be similar to those of
traditional corporate exposures.
The
national supervisor may under such circumstances
recognise mortgage on multifamily residential real
estate as eligible collateral for corporate exposures.
508. In light of the generic description
above and the definition of corporate
exposures, income producing real estate that falls
under the SL asset class is specifically excluded
from recognition as collateral for corporate
exposures. *
*
As noted in footnote 73, in exceptional circumstances
for well-developed and long-established markets,
mortgages on office and/or multi-purpose commercial
premises and/or multi-tenanted commercial premises may
have the potential to receive recognition as collateral
in the corporate portfolio.
Please refer to footnote 29 of paragraph 74 for a
discussion of the eligibility criteria that would apply.
(ii) Operational requirements for
eligible CRE/RRE
509. Subject to meeting the
definition above, CRE and RRE will be eligible for
recognition as collateral for corporate claims only
if all of the following operational requirements are
met.
• Legal enforceability:
any claim on a
collateral taken must be legally enforceable in all
relevant jurisdictions, and any claim on collateral must
be properly filed on a timely basis.
Collateral
interests must reflect a perfected lien (i.e. all
legal requirements for establishing the claim have
been fulfilled).
Furthermore, the collateral
agreement and the legal process underpinning it must be
such that they
provide for the bank to realise the
value of the collateral within a
reasonable timeframe.
• Objective market value of
collateral: the collateral must be valued at or less
than the current fair value under which the property
could be sold under private contract between a
willing seller and an arm’s-length buyer on the date of
valuation.
• Frequent revaluation: the bank is
expected to monitor the value of the collateral on
a frequent basis and at a minimum once every year.
More frequent monitoring is suggested where the
market is subject to significant changes in
conditions.
Statistical methods of evaluation (e.g.
reference to house price indices, sampling) may be
used to update estimates or to identify collateral that
may have declined in value and that may need
re-appraisal.
A qualified professional must evaluate
the property when information indicates that the
value of the collateral may have declined materially
relative to general market prices or when a credit
event, such as default, occurs.
• Junior liens: In
some member countries, eligible collateral will be
restricted to situations where the lender has a first
charge over the property.*
*
In some of these jurisdictions, first liens are subject
to the prior right of preferential creditors, such as
outstanding tax claims and employees’ wages.
Junior liens may be taken
into account where there is no doubt that the claim for
collateral is legally enforceable and constitutes
an efficient credit risk mitigant.
When recognised,
junior liens are to be treated using the C*/C**
threshold, which is used for senior liens.
In such
cases, the C* and C** are calculated by taking into
account the sum of the junior lien and all more
senior liens.
510. Additional collateral management
requirements are as follows:
• The types of CRE and
RRE collateral accepted by the bank and lending
policies (advance rates) when this type of collateral
is taken must be clearly documented.
• The bank must
take steps to ensure that the property taken as
collateral is adequately insured against damage or
deterioration.
• The bank must monitor on an ongoing
basis the extent of any permissible prior claims
(e.g. tax) on the property.
• The bank must
appropriately monitor the risk of environmental
liability arising in respect of the collateral, such
as the presence of toxic material on a
property.
(iii) Requirements for recognition of
financial receivables
Definition of eligible
receivables
511. Eligible financial receivables are
claims with an original maturity of less than
or equal to one year where repayment will occur
through the commercial or financial flows related to
the underlying assets of the borrower.
This includes
both self-liquidating debt arising from the sale of
goods or services linked to a commercial transaction and
general amounts owed by buyers, suppliers, renters,
national and local governmental authorities, or
other
non-affiliated parties not related to the sale of goods
or services linked to a commercial transaction.
Eligible receivables do not include those associated
with securitisations, subparticipations or credit
derivatives.
Operational requirements
Legal
certainty
512. The legal mechanism by which
collateral is given must be robust and ensure
that the lender has clear rights over the proceeds
from the collateral.
513. Banks must take all steps
necessary to fulfil local requirements in respect of
the enforceability of security interest, e.g. by
registering a security interest with a registrar.
There should be a framework that allows the potential
lender to have a perfected first priority claim over
the collateral.
514. All documentation used in
collateralised transactions must be binding on all
parties and legally enforceable in all relevant
jurisdictions. Banks must have conducted
sufficient legal review to verify this and have a
well founded legal basis to reach this conclusion,
and undertake such further review as necessary to
ensure continuing enforceability.
515. The collateral
arrangements must be properly documented, with a clear
and robust procedure for the timely collection of
collateral proceeds.
Banks’ procedures should
ensure that any legal conditions required for
declaring the default of the customer and
timely collection of collateral are observed.
In the
event of the obligor’s financial distress or
default, the bank should have legal authority to sell
or assign the receivables to other parties
without consent of the receivables’
obligors.
Risk management
516. The bank
must have a sound process for determining the credit
risk in the receivables.
Such a process should
include, among other things, analyses of the
borrower’s business and industry (e.g. effects of the
business cycle) and the types of customers with whom
the borrower does business.
Where the bank relies on the
borrower to ascertain the credit risk of the
customers, the bank must review the borrower’s credit
policy to ascertain its soundness and
credibility.
517. The margin between the amount of
the exposure and the value of the receivables must
reflect all appropriate factors, including the cost of
collection, concentration within the receivables pool
pledged by an individual borrower, and potential
concentration risk within the bank’s total
exposures.
518. The bank must maintain a continuous
monitoring process that is appropriate for
the specific exposures (either immediate or
contingent) attributable to the collateral to be
utilised as a risk mitigant.
This process may
include, as appropriate and relevant, ageing
reports, control of trade documents, borrowing base
certificates, frequent audits of
collateral, confirmation of accounts, control of the
proceeds of accounts paid, analyses of
dilution (credits given by the borrower to the
issuers) and regular financial analysis of both
the
borrower and the issuers of the receivables,
especially in the case when a small number
of large-sized receivables are taken as collateral.
Observance of the bank’s overall concentration limits
should be monitored.
Additionally, compliance with loan
covenants, environmental restrictions, and other
legal requirements should be reviewed on a
regular basis.
519. The receivables pledged by a
borrower should be diversified and not be
unduly correlated with the borrower. Where the
correlation is high, e.g. where some issuers of
the receivables are reliant on the borrower for their
viability or the borrower and the issuers belong to a
common industry, the attendant risks should be taken
into account in the setting of margins for the
collateral pool as a whole.
Receivables from affiliates
of the borrower (including subsidiaries and
employees) will not be recognised as risk
mitigants.
520. The bank should have a documented
process for collecting receivable payments
in distressed situations. The requisite facilities
for collection should be in place, even when the bank
normally looks to the borrower for
collections.
Requirements for recognition of other
collateral
521. Supervisors may allow for recognition
of the credit risk mitigating effect of certain other
physical collateral. Each supervisor will determine
which, if any, collateral types in its jurisdiction
meet the following two standards:
• Existence of
liquid markets for disposal of collateral in an
expeditious and economically efficient manner.
•
Existence of well established, publicly available market
prices for the collateral.
Supervisors will seek to
ensure that the amount a bank receives when collateral
is realised does not deviate significantly from these
market prices.
522. In order for a given bank to
receive recognition for additional physical collateral,
it must meet all the standards in paragraphs 509 and
510, subject to the following modifications.
•
First Claim: With the sole exception of permissible
prior claims specified in footnote 94, only first
liens on, or charges over, collateral are permissible.
As such, the bank must have priority over all other
lenders to the realised proceeds of the
collateral.
• The loan agreement must include
detailed descriptions of the collateral plus
detailed specifications of the manner and frequency
of revaluation.
• The types of physical collateral
accepted by the bank and policies and practices
in respect of the appropriate amount of each type of
collateral relative to the exposure amount must be
clearly documented in internal credit policies and
procedures and available for examination and/or audit
review.
• Bank credit policies with regard to the
transaction structure must address appropriate
collateral requirements relative to the exposure amount,
the ability to liquidate the collateral readily, the
ability to establish objectively a price or
market value, the frequency with which the value can
readily be obtained (including a professional
appraisal or valuation), and the volatility of the value
of the collateral.
The periodic revaluation process
must pay particular attention to
“fashion-sensitive” collateral to ensure that
valuations are appropriately adjusted downward of
fashion, or model-year, obsolescence as well as
physical obsolescence or deterioration.
• In cases of
inventories (e.g. raw materials, work-in-process,
finished goods, dealers’ inventories of autos) and
equipment, the periodic revaluation process must
include physical inspection of the collateral.
10.
Requirements for recognition of leasing
523. Leases
other than those that expose the bank to residual value
risk (see paragraph 524) will be accorded the same
treatment as exposures collateralised by the same type
of collateral.
The minimum requirements for the
collateral type must be met (CRE/RRE or
other collateral).
In addition, the bank must also
meet the following standards:
• Robust risk
management on the part of the lessor with respect to the
location of the asset, the use to which it is put,
its age, and planned obsolescence;
• A robust legal
framework establishing the lessor’s legal ownership of
the asset and its ability to exercise its rights as
owner in a timely fashion; and
• The difference
between the rate of depreciation of the physical asset
and the rate of amortisation of the lease payments
must not be so large as to overstate the
CRM attributed to the leased assets.
524. Leases
that expose the bank to residual value risk will be
treated in the following manner.
Residual value risk
is the bank’s exposure to potential loss due to the fair
value of the equipment declining below its residual
estimate at lease inception.
• The discounted lease
payment stream will receive a risk weight appropriate
for the lessee’s financial strength (PD) and
supervisory or own-estimate of LGD, which ever is
appropriate.
• The residual value will be
risk-weighted at 100%.
11. Calculation of capital
charges for equity exposures
(i) The internal models
market-based approach
525. To be eligible for the
internal models market-based approach a bank
must demonstrate to its supervisor that it meets
certain quantitative and qualitative
minimum requirements at the outset and on an ongoing
basis.
A bank that fails to demonstrate continued
compliance with the minimum requirements must develop a
plan for rapid return to compliance, obtain its
supervisor’s approval of the plan, and implement that
plan in a timely
fashion.
In the interim, banks would
be expected to compute capital charges using a
simple risk weight approach.
526. The
Committee recognises that differences in markets,
measurement methodologies, equity investments and
management practices require banks and supervisors to
customise their operational procedures.
It is not the
Committee’s intention to dictate the form or
operational detail of banks’ risk management policies
and measurement practices for their banking book
equity holdings.
However, some of the
minimum requirements are specific.
Each supervisor
will develop detailed examination procedures
to ensure that banks’ risk measurement systems and
management controls are adequate to serve as the
basis for the internal models approach.
(ii) Capital
charge and risk quantification
527. The following
minimum quantitative standards apply for the purpose of
calculating minimum capital charges under the
internal models approach.
(a) The capital charge is
equivalent to the potential loss on the institution’s
equity portfolio arising from an assumed
instantaneous shock equivalent to the
99th percentile, one-tailed confidence interval of
the difference between quarterly returns and an
appropriate risk-free rate computed over a long-term
sample period.
(b) The estimated losses should be
robust to adverse market movements relevant to the
long-term risk profile of the institution’s specific
holdings.
The data used to represent return
distributions should reflect the longest sample period
for which data are available and meaningful in
representing the risk profile of the bank’s
specific equity holdings.
The data used should be
sufficient to provide conservative, statistically
reliable and robust loss estimates that are not based
purely on subjective or judgmental considerations.
Institutions must demonstrate to supervisors that the
shock employed provides a conservative estimate of
potential
losses over a relevant long-term market or
business cycle.
Models estimated using data not
reflecting realistic ranges of long-run experience,
including a period of reasonably severe declines in
equity market values relevant to a bank’s
holdings, are presumed to produce optimistic results
unless there is credible evidence of appropriate
adjustments built into the model.
In the absence of
built-in adjustments, the bank must combine empirical
analysis of available data with adjustments based on
a variety of factors in order to attain model outputs
that achieve appropriate realism and conservatism.
In
constructing Value at Risk (VaR) models
estimating potential quarterly losses, institutions
may use quarterly data or convert shorter horizon
period data to a quarterly equivalent using an
analytically appropriate method supported by
empirical evidence.
Such adjustments must be
applied through a well-developed and well-documented
thought process and analysis.
In general, adjustments
must be applied conservatively and consistently over
time.
Furthermore, where only limited data are
available, or where technical limitations are such
that estimates from any single method will be of
uncertain quality, banks must add appropriate margins
of conservatism in order to avoid over-optimism.
(c)
No particular type of VaR model (e.g.
variance-covariance, historical simulation, or Monte
Carlo) is prescribed.
However, the model used must be
able to capture adequately all of the material risks
embodied in equity returns including both the general
market risk and specific risk exposure of the
institution’s equity portfolio.
Internal models must
adequately explain historical price variation, capture
both the magnitude and changes in the composition of
potential concentrations, and be robust to adverse
market environments.
The population of risk
exposures represented in the data used for estimation
must be closely matched to or at least
comparable
with those of the bank’s equity exposures.
(d)
Banks may also use modelling techniques such as
historical scenario analysis to determine minimum
capital requirements for banking book equity holdings.
The use of such models is conditioned upon the
institution demonstrating to its supervisor that the
methodology and its output can be quantified in the form
of the loss percentile specified under (a).
(e)
Institutions must use an internal model that is
appropriate for the risk profile and complexity of
their equity portfolio.
Institutions with material
holdings with values that are highly non-linear in
nature (e.g. equity derivatives, convertibles) must
employ an internal model designed to capture
appropriately the risks associated with
such
instruments.
(f) Subject to supervisory
review, equity portfolio correlations can be integrated
into a bank’s internal risk measures. The use of
explicit correlations (e.g. utilisation of
a variance/covariance VaR model) must be fully
documented and supported using empirical analysis.
The appropriateness of implicit correlation assumptions
will be evaluated by supervisors in their review of
model documentation and estimation techniques.
(g)
Mapping of individual positions to proxies, market
indices, and risk factors should be plausible,
intuitive, and conceptually sound. Mapping techniques
and processes should be fully documented, and
demonstrated with both theoretical and
empirical evidence to be appropriate for the specific
holdings.
Where professional judgement is combined
with quantitative techniques in estimating a holding’s
return volatility,
the judgement must take into
account the relevant and material information
not considered by the other techniques
utilised.
(h) Where factor models are used, either
single or multi-factor models are
acceptable depending upon the nature of an
institution’s holdings.
Banks are expected to ensure
that the factors are sufficient to capture the risks
inherent in the equity portfolio.
Risk factors should
correspond to the appropriate equity
market characteristics (for example, public, private,
market capitalisation industry sectors and
sub-sectors, operational characteristics) in which the
bank holds significant positions.
While banks will
have discretion in choosing the factors, they
must demonstrate through empirical analyses the
appropriateness of those factors, including their
ability to cover both general and specific risk.
(i)
Estimates of the return volatility of equity investments
must incorporate relevant and material available
data, information, and methods. A bank may utilise
independently reviewed internal data or data from
external sources (including pooled data).
The number
of risk exposures in the sample, and the data period
used for quantification must be sufficient to provide
the bank with confidence in the accuracy
and robustness of its estimates.
Institutions should
take appropriate measures to limit the potential of
both sampling bias and survivorship bias in estimating
return volatilities.
(j) A rigorous and
comprehensive stress-testing programme must be in place.
Banks are expected to subject their internal model
and estimation procedures, including volatility
computations, to either hypothetical or historical
scenarios that reflect worst-case losses given
underlying positions in both public and private
equities.
At a minimum, stress tests should be
employed to provide information about the effect
of tail events beyond the level of confidence assumed
in the internal models approach.
(iii) Risk
management process and controls
528. Banks’ overall
risk management practices used to manage their banking
book equity investments are expected to be consistent
with the evolving sound practice guidelines issued by
the Committee and national supervisors.
With regard to
the development and use of internal models for
capital purposes, institutions must have established
policies, procedures, and controls to ensure the
integrity of the model and modelling process used to
derive
regulatory capital standards. These policies,
procedures, and controls should include
the following:
(a) Full integration of the
internal model into the overall management
information systems of the institution and in the
management of the banking book equity portfolio.
Internal models should be fully integrated into the
institution’s risk management infrastructure
including use in:
(i) establishing investment hurdle
rates and evaluating alternative investments;
(ii)
measuring and assessing equity portfolio performance
(including the risk-adjusted performance); and
(iii)
allocating economic capital to equity holdings and
evaluating overall capital adequacy as required
under
Pillar 2.
The institution should be able to
demonstrate, through for example, investment
committee minutes, that internal model output plays an
essential role in the investment management
process.
(b) Established management systems,
procedures, and control functions for ensuring the
periodic and independent review of all elements of the
internal modelling process, including approval of
model revisions, vetting of model inputs, and
review of model results, such as direct verification
of risk computations.
Proxy and mapping techniques
and other critical model components should receive
special attention.
These reviews should assess the
accuracy, completeness, and appropriateness of model
inputs and results and focus on both finding and
limiting potential errors associated with known
weaknesses and identifying unknown model
weaknesses.
Such reviews may be conducted as part of
internal or external audit programmes, by an
independent risk control unit, or by an external third
party.
(c) Adequate systems and procedures for
monitoring investment limits and the risk
exposures
of equity investments.
(d) The units responsible for
the design and application of the model must
be functionally independent from the units
responsible for managing
individual investments.
(e) Parties responsible
for any aspect of the modelling process must be
adequately qualified.
Management must allocate
sufficient skilled and competent resources to the
modelling function.
(iv) Validation and
documentation
529. Institutions employing internal
models for regulatory capital purposes are
expected to have in place a robust system to validate
the accuracy and consistency of the model and its
inputs.
They must also fully document all material
elements of their internal models and modelling
process.
The modelling process itself as well as the
systems used to validate internal models including
all supporting documentation, validation results, and
the findings of internal and external reviews are
subject to oversight and review by the bank’s
supervisor.
Validation
530. Banks must have a
robust system in place to validate the accuracy and
consistency of their internal models and modelling
processes. A bank must demonstrate to its
supervisor that the internal validation
process enables it to assess the performance of its
internal model and processes consistently and
meaningfully.
531. Banks must regularly compare
actual return performance (computed using
realised and unrealised gains and losses) with
modelled estimates and be able to demonstrate
that such returns are within the expected range for
the portfolio and individual holdings.
Such comparisons must make use of historical data
that are over as long a period as possible.
The methods and data used in such comparisons must be
clearly documented by the bank.
This analysis and
documentation should be updated at least
annually.
532. Banks should make use of other
quantitative validation tools and comparisons
with external data sources.
The analysis must be
based on data that are appropriate to the portfolio,
are updated regularly, and cover a relevant observation
period.
Banks’ internal assessments of the
performance of their own model must be based on long
data histories,
covering a range of economic
conditions, and ideally one or more complete business
cycles.
533. Banks must demonstrate that quantitative
validation methods and data are consistent through
time. Changes in estimation methods and data (both data
sources and periods covered) must be clearly and
thoroughly documented.
534. Since the evaluation of
actual performance to expected performance over
time provides a basis for banks to refine and adjust
internal models on an ongoing basis, it is expected
that banks using internal models will have established
well-articulated model review standards.
These
standards are especially important for situations where
actual results significantly deviate from
expectations and where the validity of the internal
model is called into question.
These standards must
take account of business cycles and
similar systematic variability in equity returns.
All
adjustments made to internal models in response to
model reviews must be well documented and consistent
with the bank’s model review standards.
535. To
facilitate model validation through backtesting on an
ongoing basis, institutions using the internal model
approach must construct and maintain appropriate
databases on the actual quarterly performance of
their equity investments as well on the estimates
derived using their internal models.
Institutions
should also backtest the volatility estimates
used within their internal models and the
appropriateness of the proxies used in the
model.
Supervisors may ask banks to scale their
quarterly forecasts to a different, in
particular shorter, time horizon, store performance
data for this time horizon and perform backtests
on this basis.
Documentation
536. The burden is
on the bank to satisfy its supervisor that a model has
good predictive power and that regulatory capital
requirements will not be distorted as a result of its
use.
Accordingly, all critical elements of an
internal model and the modelling process should
be fully and adequately documented.
Banks must
document in writing their internal model’s design and
operational details.
The documentation should
demonstrate banks’ compliance with the minimum
quantitative and qualitative standards, and should
address topics such as the application of the model
to different segments of the portfolio, estimation
methodologies, responsibilities of parties involved
in the modelling, and the model approval and
model
review processes.
In particular, the
documentation should address the following
points:
(a) A bank must document the rationale for
its choice of internal modelling methodology and must
be able to provide analyses demonstrating that the model
and modelling procedures are likely to result in
estimates that meaningfully identify the risk of
the bank’s equity holdings.
Internal models and
procedures must be periodically reviewed to
determine whether they remain fully applicable to the
current portfolio and to external conditions.
In
addition, a bank must document a history of
major changes in the model over time and changes made
to the modelling process subsequent to the last
supervisory review.
If changes have been made in
response to the bank’s internal review standards, the
bank must document that these changes are consistent
with its internal model review standards.
(b) In
documenting their internal models banks should:
•
provide a detailed outline of the theory, assumptions
and/or mathematical and empirical basis of the
parameters, variables, and data source(s) used to
estimate the model;
• establish a rigorous
statistical process (including out-of-time and
out-of-sample performance tests) for validating the
selection of explanatory variables; and
• indicate
circumstances under which the model does not work
effectively.
(c) Where proxies and mapping are
employed, institutions must have performed
and documented rigorous analysis demonstrating that
all chosen proxies and mappings are sufficiently
representative of the risk of the equity holdings to
which they correspond.
The documentation should show,
for instance, the relevant and material factors (e.g.
business lines, balance sheet characteristics,
geographic location, company age, industry sector and
subsector, operating characteristics) used in
mapping
individual investments into proxies. In summary,
institutions must demonstrate that the proxies and
mappings employed:
• are adequately comparable to the
underlying holding or portfolio;
• are derived using
historical economic and market conditions that are
relevant and material to the underlying holdings or,
where not, that an appropriate adjustment has been
made; and,
• are robust estimates of the potential
risk of the underlying holding.
12. Disclosure
requirements
537. In order to be eligible for the IRB
approach, banks must meet the disclosure
requirements
set out in Pillar 3. These are minimum requirements for
use of IRB: failure to
meet these will render banks
ineligible to use the relevant IRB
approach.
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