the internal risk‐measurement model is closely integrated into the daily risk‐management process of the institution and serves as the basis for reporting risk exposures to senior management of the institution;
the institution has a risk control unit that is independent from business trading units and reports directly to senior management. The unit must be responsible for designing and implementing the institution's risk‐management system. It shall produce and analyse daily reports on the output of the risk‐measurement model and on the appropriate measures to be taken in terms of trading limits. The unit shall also conduct the initial and on-going validation of the internal model;
the institution's board of directors and senior management are actively involved in the risk‐control process and the daily reports produced by the risk‐control unit are reviewed by a level of management with sufficient authority to enforce both reductions of positions taken by individual traders as well as in the institution's overall risk exposure;
the institution has sufficient numbers of staff skilled in the use of sophisticated models in the trading, risk‐control, audit and back‐office areas;
the institution has established procedures for monitoring and ensuring compliance with a documented set of internal policies and controls concerning the overall operation of the risk‐measurement system;
the institution's model has a proven track record of reasonable accuracy in measuring risks;
the institution frequently conducts a rigorous programme of stress testing and the results of these tests are reviewed by senior management and reflected in the policies and limits it sets. This process shall particularly address illiquidity of markets in stressed market conditions, concentration risk, one way markets, event and jump‐to‐default risks, non-linearity of products, deep out‐of‐the‐money positions, positions subject to the gapping of prices and other risks that may not be captured appropriately in the internal models. The shocks applied shall reflect the nature of the portfolios and the time it could take to hedge out or manage risks under severe market conditions; and
the institution must conduct, as part of its regular internal auditing process, an independent review of its risk‐measurement system.
The review referred to in point (h) of the first paragraph shall include both the activities of the business trading units and of the independent risk‐control unit. At least once a year, the institution must conduct a review of its overall risk‐management process.
The review shall consider the following:
the adequacy of the documentation of the risk‐management system and process and the organisation of the risk‐control unit;
the integration of market risk measures into daily risk management and the integrity of the management information system;
the process the institution employs for approving risk‐pricing models and valuation systems that are used by front and back‐office personnel;
the scope of market risks captured by the risk‐measurement model and the validation of any significant changes in the risk‐measurement process;
the accuracy and completeness of position data, the accuracy and appropriateness of volatility and correlation assumptions, and the accuracy of valuation and risk sensitivity calculations;
the verification process the institution employs to evaluate the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources; and
the verification process the institution uses to evaluate back‐testing that is conducted to assess the models' accuracy.
tests to demonstrate that any assumptions made within the internal model are appropriate and do not underestimate or overestimate the risk;
in addition to the regulatory back-testing programmes, institutions shall carry out their own internal model validation tests in relation to the risks and structures of their portfolios; and
the use of hypothetical portfolios to ensure that the internal model is able to account for particular structural features that may arise, for example material basis risks and concentration risk.
Competent authorities shall examine the institution's capability to perform back‐testing on both actual and hypothetical changes in the portfolio's value. Back‐testing on hypothetical changes in the portfolio's value is based on a comparison between the portfolio's end‐of‐day value and, assuming unchanged positions, its value at the end of the subsequent day. Competent authorities shall require institutions to take appropriate measures to improve their back‐testing programme if deemed deficient. Competent authorities may require institutions to perform back-testing on either hypothetical (using changes in portfolio value that would occur were end-of-day positions to remain unchanged), or actual trading (excluding fees, commissions, and net interest income) outcomes, or both.
it explains the historical price variation in the portfolio;
it captures concentration in terms of magnitude and changes of composition of the portfolio;
it is robust to an adverse environment;
it is validated through back‐testing aimed at assessing whether specific risk is being accurately captured. If competent authorities allow this back‐testing to be performed on the basis of relevant sub‐portfolios, these must be chosen in a consistent manner;
it captures name-related basis risk, that is institutions shall demonstrate that the internal model is sensitive to material idiosyncratic differences between similar but not identical positions; and
it captures event risk.
The institution shall also meet the following conditions:
where an institution is subject to event risk that is not reflected in its value‐at‐risk measure, because it is beyond the 10-day holding period and 99 percent confidence interval (low probability and high severity events), the institution shall ensure that the impact of such events is factored in to its internal capital assessment; and
the institution's internal model shall conservatively assess the risk arising from less liquid positions and positions with limited price transparency under realistic market scenarios. In addition, the internal model shall meet minimum data standards. Proxies shall be appropriately conservative and may be used only where available data is insufficient or is not reflective of the true volatility of a position or portfolio.
Further, as techniques and best practices evolve, institutions shall avail themselves of these advances.
In addition, the institution shall have an approach in place to capture, in the calculation of its capital requirements, the default risk of its trading book positions that is incremental to the default risk captured by the value-at-risk measure as specified in the previous requirements of this point. To avoid double counting, an institution may, when calculating its incremental default risk charge, take into account the extent to which default risk has already been incorporated into the value‐at‐risk measure, especially for risk positions that could and would be closed within 10 days in the event of adverse market conditions or other indications of deterioration in the credit environment. Where an institution captures its incremental default risk through a surcharge, it shall have in place methodologies for validating the measure.
The institution shall demonstrate that its approach meets soundness standards comparable to the approach set out in Articles 84 to 89 of Directive 2006/48/EC, under the assumption of a constant level of risk, and adjusted where appropriate to reflect the impact of liquidity, concentrations, hedging and optionality.
An institution that does not capture the incremental default risk through an internally developed approach shall calculate the surcharge through an approach consistent with the either the approach set out in Articles 78 to 83 of Directive 2006/48/EC or the approach set out in Articles 84 to 89 of that Directive.
With respect to cash or synthetic securitisation exposures that would be subject to a deduction treatment under the treatment set out in Article 66(2) of Directive 2006/48/EC, or risk-weighted at 1,250 % as set out in Part 4 of Annex IX to that Directive, these positions shall be subject to a capital charge that is no less than set forth under that treatment. Institutions that are dealers in these exposures may apply a different treatment where they can demonstrate to their competent authorities, in addition to trading intent, that a liquid two-way market exists for the securitisation exposures or, in the case of synthetic securitisations that rely solely on credit derivatives, for the securitisation exposures themselves or all their constituent risk components. For the purposes of this section a two-way market is deemed to exist where there are independent good faith offers to buy and sell so that a price reasonably related to the last sales price or current good faith competitive bid and offer quotations can be determined within one day and settled at such a price within a relatively short time conforming to trade custom. For an institution to apply a different treatment, it shall have sufficient market data to ensure that it fully captures the concentrated default risk of these exposures in its internal approach for measuring the incremental default risk in accordance with the standards set out above.
| Number of overshootings | Plus-factor |
|---|---|
| Fewer than 5 | 0,0 |
| 5 | 0,4 |
| 6 | 0,5 |
| 7 | 0,65 |
| 8 | 0,75 |
| 9 | 0,85 |
| 10 or more | 1,0 |
The competent authorities may, in individual cases and owing to an exceptional situation, waive the requirement to increase the multiplication factor by the ‘plus‐factor’ in accordance with Table 1, if the institution has demonstrated to the satisfaction of the competent authorities that such an increase is unjustified and that the model is basically sound.
If numerous overshootings indicate that the model is not sufficiently accurate, the competent authorities shall revoke the model's recognition or impose appropriate measures to ensure that the model is improved promptly.
In order to allow competent authorities to monitor the appropriateness of the plus‐factor on an ongoing basis, institutions shall notify promptly, and in any case no later than within five working days, the competent authorities of overshootings that result form their back‐testing programme and that would according to the above table imply an increase of a plus‐factor.
its previous day's value‐at‐risk measure according to the parameters specified in this Annex plus, where appropriate, the incremental default risk charge required under point 5; or
an average of the daily value‐at‐risk measures on each of the preceding 60 business days, multiplied by the factor mentioned in point 7, adjusted by the factor referred to in point 8 plus, where appropriate, the incremental default risk charge required under point 5.
at least daily calculation of the value‐at‐risk measure;
a 99th percentile, one‐tailed confidence interval;
a 10‐day equivalent holding period;
an effective historical observation period of at least one year except where a shorter observation period is justified by a significant upsurge in price volatility; and
three‐monthly data set updates.
The risk‐measurement system shall incorporate a set of risk factors corresponding to the interest rates in each currency in which the institution has interest rate sensitive on- or off‐balance sheet positions. The institution shall model the yield curves using one of the generally accepted approaches. For material exposures to interest‐rate risk in the major currencies and markets, the yield curve shall be divided into a minimum of six maturity segments, to capture the variations of volatility of rates along the yield curve. The risk‐measurement system must also capture the risk of less than perfectly correlated movements between different yield curves.
The risk‐measurement system shall incorporate risk factors corresponding to gold and to the individual foreign currencies in which the institution's positions are denominated.
For CIUs the actual foreign exchange positions of the CIU shall be taken into account. Institutions may rely on third party reporting of the foreign exchange position of the CIU, where the correctness of this report is adequately ensured. If an institution is not aware of the foreign exchange positions of a CIU, this position should be carved out and treated in accordance with the fourth paragraph of point 2.1 of Annex III.
The risk‐measurement system shall use a separate risk factor at least for each of the equity markets in which the institution holds significant positions.
The risk‐measurement system shall use a separate risk factor at least for each commodity in which the institution holds significant positions. The risk‐measurement system must also capture the risk of less than perfectly correlated movements between similar, but not identical, commodities and the exposure to changes in forward prices arising from maturity mismatches. It shall also take account of market characteristics, notably delivery dates and the scope provided to traders to close out positions.