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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.