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Basel ii Market Risk
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.
Scope and coverage of the capital charges
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.
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.
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(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-āvis 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
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.
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