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Basel ii Market Risk
The risk measurement framework 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-ŕvis the banking book exposure. Where such third party protection is purchased and is recognised as a hedge of a banking book exposure for regulatory capital purposes, neither the internal nor external credit derivative hedge would be included in the trading book for regulatory capital purposes. 689(ii). Positions in the bank’s own eligible regulatory capital instruments are deducted from capital. Positions in other banks’, securities firms’, and other financial entities’ eligible regulatory capital instruments, as well as intangible assets, will receive the same treatment 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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