| (h) | Matters specifically related to the treatment of specific risk |
| (i) | A bank that has in place a VaR model that measures and incorporates specific risk arising from equity positions, debt securities or other interest rate related instruments, other than securitisation or resecuritisation exposures and n-th-to-default credit derivative instruments, held in the bank's trading book, which model, in addition to the relevant requirements specified in this paragraph (h) and in regulation 39(14)(c) of these Regulations, to the satisfaction of the Registrar, meets all the relevant qualitative and quantitative requirements relating to general market risk models envisaged or specified in paragraphs (c) to (e) of this subregulation (8), may, subject to the prior written approval of and such conditions as may be specified in writing by the Registrar, base the bank's required amount of capital and reserve funds relating to specific risk on the bank's modelled estimate of specific risk, provided that— |
| (A) | a bank that is unable to comply with the additional criteria and requirements specified in this paragraph (h) shall calculate its relevant required amount of capital and reserve funds relating to specific risk in accordance with the relevant requirements specified in the standardised method, in subregulation (7); |
| (B) | unless specifically otherwise provided in this paragraph (h), in the case of securitisation or resecuritisation exposure and n-th-to-default credit derivative instruments, the bank shall calculate its relevant required amount of capital and reserve funds relating to specific risk in accordance with the relevant requirements specified in the standardised method, in subregulation (7); |
| (C) | as a minimum, the bank's model— |
| (i) | shall capture all relevant material components of price risk; |
| (ii) | shall be responsive to relevant changes in market conditions and compositions of portfolios; |
| (iii) | shall duly explain the historical price variation in the portfolio by way of, for example, the application of "goodness-of-fit" measures such as an R-squared measure from regression methodology, or such measure as may be approved in writing by the Registrar; |
| (iv) | shall duly capture concentrations that include magnitude and changes in composition, that is, the bank shall demonstrate to the satisfaction of the Registrar that the model is sensitive to changes in portfolio construction and reflects higher capital requirements in respect of portfolios with increasing concentrations relating to particular names or sectors; |
| (v) | shall be sufficiently robust to an adverse environment, that is, the bank shall demonstrate to the satisfaction of the Registrar that the model signals rising risk in an adverse environment, which, for example, may be achieved by incorporating in the historical estimation period of the model at least one full credit cycle and ensuring that the model duly reflects the impact of the downward portion of the cycle; |
| (vi) | shall duly capture name-related basis risk, that is, the bank shall demonstrate to the satisfaction of the Registrar that the model is sensitive to material idiosyncratic differences between similar but not identical positions such as, for example, debt positions with different levels of subordination or maturity mismatches, or credit derivative instruments that specify different default events; |
| (vii) | shall duly capture event risk which, in the case of debt positions, shall include migration risk, and, for example, in the case of equity positions, events that are reflected in large changes or jumps in prices, such as merger break-ups or takeovers; |
| (viii) | shall be validated through relevant and robust backtesting; |
| (ix) | shall conservatively assess risk arising from less liquid positions and/or positions with limited price transparency under realistic market scenarios; |
| (x) | shall only make use of proxies when available data is insufficient or not reflective of the actual volatility of a position or portfolio, and only when the said proxies are appropriately conservative; |
| (D) | when the bank is exposed to event risk that is not duly reflected in the bank's estimate of VaR due to the event, for example, being beyond the 10-day holding period or 99th per cent confidence interval, that is, low probability and high severity events, the bank shall factor into its internal assessment of economic capital the said impact, for example, through stress testing; |
| (E) | in the case of interest rate related instruments or positions, that is, instruments or positions subject to specific interest rate risk, other than securitisation or resecuritisation exposures and n-th-to-default credit derivative instruments, the bank's internally developed approach shall duly capture incremental default and migration risks, that is, risks that are incremental to the relevant risks specified in item (C) above, provided that— |
| (i) | the bank's incremental risk requirement (IRC) shall as a minimum estimate— |
| (aa) | the default risk, that is, the potential for direct loss due to an obligor's default as well as the potential for indirect losses that may arise from a default event, including losses caused by broader market-wide events affecting multiple issues or issuers; and |
| (bb) | the migration risks, that is, the potential for direct loss due to an internal or external rating downgrade or upgrade as well as the potential for indirect losses that may arise from a credit migration event, |
of all relevant unsecuritised credit products over a one-year capital horizon at a confidence level of 99.9 per cent, taking into account the liquidity horizons of all relevant positions or sets of positions;
| (ii) | the bank's approach and models used to capture incremental risks shall meet a soundness standard comparable to the standard specified in respect of the IRB approach for credit risk, specified in regulation 23 of these Regulations, under the assumption of a constant level of risk, and adjusted where appropriate to reflect the impact of liquidity, concentrations, hedging, and optionality; |
| (iii) | as stated hereinbefore, for each IRC-covered position, the bank's model shall capture the impact of rebalancing positions at the end of their liquidity horizons so as to achieve a constant level of risk over a one-year capital horizon, that is— |
| (aa) | the bank shall rebalance or roll over the relevant positions over the one-year capital horizon in a manner that maintains the initial risk level, as indicated by a metric such as VaR or the profile of exposure by credit rating and concentration. |
Rebalancing positions does not imply, as the IRB approach for the banking book does, that the same positions will be maintained throughout the capital horizon. Particularly for more liquid and more highly rated positions, this provides a benefit relative to the treatment under the IRB framework.
However, a bank may use a one-year constant position assumption, as long as it does so consistently across all relevant portfolios.
| (bb) | the bank shall incorporate the effect of replacing positions of which the credit characteristics have improved or deteriorated over the liquidity horizon with positions that have risk characteristics equivalent to those that the original position had at the start of the liquidity horizon; |
Provided that the frequency of the aforesaid assumed rebalancing shall be governed by the liquidity horizon for a given position;
| (iv) | the liquidity horizon— |
| (aa) | shall represent the time required to sell the relevant position or hedge all material risks covered by the IRC model in a stressed market; |
| (bb) | shall be measured under conservative assumptions, and shall be sufficiently long that the act of selling or hedging, in itself, does not materially affect market prices; |
| (cc) | shall be subject to a floor of three months for any relevant position or set of positions; |
| (dd) | shall be greater for positions that are concentrated— |
| (i) | to reflect the longer period needed to liquidate such positions; and |
| (ii) | to provide adequate capital against two types of concentration, namely issuer concentration and market concentration. |
Provided that a bank may assess liquidity by position or on an aggregated basis ("in buckets").
When an aggregated basis is used, such as investment-grade corporate exposures not part of a core CDS index, the aggregation criteria shall be defined in a way that meaningfully reflect differences in liquidity.
| (v) | the bank's incremental risk requirement shall include the impact of correlations between default and migration events among obligors since dependence among obligors may cause a clustering of default and migration events; |
| (vi) | consistent with the principle contained in these Regulations not to allow any diversification benefit when combining capital requirements for credit risk and market risk, the bank's incremental risk requirement shall not incorporate or reflect any diversification benefit between default or migration events and other market variables, that is, the capital requirement for incremental default and migration risk shall be added to the bank's VaR-based capital requirement for market risk; |
| (vii) | the bank's incremental risk requirement shall appropriately reflect issuer and market concentrations, including concentrations that can arise within and across product classes under stressed conditions. |
Therefore, other things being equal, a concentrated portfolio shall attract a higher incremental risk capital requirement than a more granular portfolio.
| (viii) | within the bank's IRC model, consistent with the principle relating to gross balances, contained in these Regulations, exposure amounts shall be captured on a gross basis, provided that long and short positions that relate to the same financial instrument may be netted, that is, hedging or diversification effects associated with long and short positions involving different instruments or different securities of the same obligor ("intra-obligor hedges"), as well as long and short positions in different issuers ("inter-obligor hedges"), shall not be recognised through the netting of exposure amounts; |
| (ix) | the bank's incremental risk requirement shall duly reflect significant basis risks by product, seniority in the capital structure, internal or external rating, maturity, vintage for offsetting positions as well as differences between offsetting instruments, such as different payout triggers and procedures; |
| (x) | for trading book risk positions that are hedged via dynamic hedging strategies, the bank may recognize a rebalancing of the hedge within the liquidity horizon of the hedged position, provided that— |
| (aa) | the bank shall model the rebalancing of the hedge consistently over the relevant set of trading book risk positions; |
| (bb) | the bank shall demonstrate to the satisfaction of the Registrar— |
| (i) | that the said inclusion of rebalancing results in a better risk measurement; |
| (ii) | that the markets for the instruments serving as a hedge are liquid enough to allow for this kind of rebalancing, even during periods of stress; |
| (iii) | that any residual risks resulting from the bank's dynamic hedging strategies are duly incorporated into the bank's capital requirement; |
| (xi) | the bank's IRC model shall reflect the impact of optionality, that is, the bank's models shall include the nonlinear impact of options and other positions with material nonlinear behavior with respect to price changes, and the bank shall duly consider and evaluate the model risk inherent in the valuation and estimation of price risks associated with such products; |
| (xii) | the bank's model may incorporate correlation effects among the modelled risk factors, subject to the validation standards specified in regulation 39(14)(c); |
| (xiii) | the bank's internally developed approach to capture incremental default and migration risks shall comply with the relevant additional qualitative requirements specified in regulation 39(14) (c); |
| (xiv) | the bank may choose to consistently include all listed equity and derivative positions based on listed equity in its incremental risk model when such inclusion is consistent with how the bank internally measures and manages this risk at the trading desk level, provided that when equity securities are included in the computation of incremental risk, default shall be deemed to occur when the related debt defaults; |
| (xv) | when computing the bank's incremental risk requirement, the bank shall in no case incorporate into its IRC model any securitisation positions, even when securitisation positions are regarded by the bank as hedging underlying credit instruments held in the bank's trading book; |
| (xvi) | the bank's internally developed approach and IRC model shall be subject to the "use test", that is, the bank's approach and model shall be consistent with the bank's internal risk management policies, processes, procedures and methodologies for identifying, measuring, and managing its trading risks; |
| (xvii) | a bank that does not capture the said incremental risks through its internal models shall calculate the relevant required amount of capital and reserve funds for specific risk in accordance with the relevant requirements specified in subregulation (7) above; |
| (F) | the bank's correlation trading portfolio shall be subject to the further conditions and requirements specified in subparagraph (ii) below; |
| (G) | the bank shall regularly conduct backtesting specifically aimed at assessing whether or not specific risk is duly captured, that is, the bank shall conduct separate backtests in respect of each relevant sub-portfolio approved by the Registrar using daily data in respect of the said sub-portfolio subject to specific risk; |
| (H) | the bank shall have in place a robust process in order to analyse exceptions identified through the backtesting of specific risk, which process, among other things, shall serve as a basis for correcting the bank's model for specific risk when the model becomes inaccurate. |
| (ii) | Subject to the prior written approval of and such conditions as may be specified in writing by the Registrar, a bank may incorporate in its internally developed approach and models, the bank's correlation trading portfolio, provided that— |
| (A) | the bank shall demonstrate to the satisfaction of the Registrar— |
| (i) | that the bank complies with the qualitative requirements specified or referred to in this paragraph (h); |
| (ii) | that the bank has sufficient market data to ensure that it fully captures the salient risks of all relevant exposures; |
| (iii) | that the bank's risk measures can appropriately explain, for example through backtesting, the historical price variation of the relevant instruments or products; |
| (iv) | that the bank is able to separate the instruments or positions for which it obtained approval to incorporate them in the bank's comprehensive risk measure from the instruments or positions for which the bank did not obtain the said approval; |
| (v) | that the bank regularly applies a set of specific predetermined stress scenarios— |
| (aa) | which stress scenarios shall be applied at least weekly; |
| (bb) | the results of which stress scenarios, including comparisons with the capital requirements implied by the banks' internal model for estimating comprehensive risks as envisaged in this subparagraph (ii), shall be reported in writing to the Registrar on a frequent basis, but not less frequently than once a quarter; |
Provided that any instances where the stress tests indicate a material shortfall of the comprehensive risk measure shall immediately be reported in writing to the Registrar.
| (cc) | which stress scenarios, as a minimum, shall examine the implications of stresses— |
| (iv) | to correlations on the correlation trading desk's profit and loss; |
| (dd) | based on which stress testing results, the Registrar may impose a supplemental capital requirement against the bank's correlation trading portfolio, which requirement shall be in addition to the bank's relevant internally calculated capital requirement; |
| (B) | the said approach and models shall duly capture not only incremental default and migration risks as stated hereinbefore, but all relevant components of price risk, that is, the bank shall have in place a comprehensive risk measurement approach in respect of its correlation trading portfolio that captures all relevant components of price risk that impact the value of the relevant instruments or products, including— |
| (i) | the cumulative risk arising from multiple defaults, including the ordering of defaults, in tranched products; |
| (ii) | credit spread risk, including the relevant gamma and crossgamma effects; |
| (iii) | volatility of implied correlations, including the relevant cross effect between spreads and correlations; |
| (iv) | basis risk, including both— |
| (aa) | the basis between the spread of an index and those of its constituent single names; and |
| (bb) | the basis between the implied correlation of an index and that of bespoke portfolios; |
| (v) | recovery rate volatility, as it relates to the propensity for recovery rates to affect tranche prices; and |
| (vi) | to the extent that the comprehensive risk measure incorporates the benefits from dynamic hedging, the risk of hedge slippage and the potential cost of rebalancing such hedges. |
| (C) | this exception shall be available only to banks that actively buy and sell the relevant instruments or products; |
| (D) | the bank's required amount of capital and reserve funds relating to exposures included in the bank's internally developed approach and models shall not be less than eight per cent of the specific risk requirement calculated in accordance with the relevant requirements specified in subregulation (7); |
| (E) | the relevant exposures shall be incorporated into both the value-at-risk and stressed value-at-risk measures of the bank; |
| (F) | the bank shall at least weekly, or more frequently when directed in writing by the Registrar, calculate the incremental risk measure according to the relevant requirements specified in subparagraph (i)(E) above, and the comprehensive risk measure according to the requirements specified in this subparagraph (ii); |
| (G) | the bank's capital requirement— |
| (i) | for incremental risk shall be equal to the higher of— |
| (aa) | the average of the incremental risk measures over 12 weeks; and |
| (bb) | the most recent incremental risk measure, |
multiplied by a scaling factor of 1.0.
| (ii) | for comprehensive risk shall be equal to the higher of— |
| (aa) | the average of the comprehensive risk measures over 12 weeks; and |
| (bb) | the most recent comprehensive risk measure, |
multiplied by a scaling factor of 1.0.
| (iii) | shall be the sum of the aforesaid two amounts, calculated in accordance with the requirements specified in sub-items (i) and (ii) of this item (F). |
Provided that for the purposes of these Regulations no adjustment shall be made in respect of any potential double counting between the comprehensive risk measure and any other relevant risk measure.
| (iii) | For the purposes of these Regulations the presumption shall be that models that incorporate specific risk are not eligible for approval when the stress-testing and backtesting results of the model, at sub-portfolio level, produce a number of exceptions commensurate with the red zones specified in writing by the Registrar in respect stress-testing and backtesting from time to time. |
