(14) A bank that wishes—
| (a) | to adopt the internal model market-based approach for the measurement of the bank's exposure arising from equity instruments held in the bank's banking book— |
| (i) | shall have in place board approved policies, procedures and controls in order to ensure the integrity of the model and the modelling process used to measure the bank's exposure to risk, which board approved policies, procedures and controls shall be adequate— |
| (A) | to ensure a complete integration of the internal model into the bank's overall management information systems, particularly in respect of the ongoing management of the bank's banking book equity portfolio, including a complete integration in order— |
| (i) | to determine investment hurdle rates; |
| (ii) | to evaluate alternative investments; |
| (iii) | to measure and assess the performance of the bank's equity portfolio, including the risk-adjusted performance; |
| (iv) | to allocate economic capital to equity positions; |
| (v) | to evaluate the bank's capital adequacy, |
provided that the bank shall by way of, for example, investment committee minutes, demonstrate to the satisfaction of the Registrar that output from the internal model plays an essential role in the bank's investment management process.
| (B) | to ensure that the bank's internal model has good predictive power and will not produce materially incorrect capital requirements; |
| (C) | to establish a rigorous statistical process, including out-of-time and out-of-sample performance tests, in order to validate the bank's selection of explanatory variables; |
| (D) | to ensure that all elements of the internal modelling process, including systems, procedures and control functions, are subject to adequate periodic independent review, which independent review, as a minimum— |
| (i) | shall assess the approval process relating to any revision of the model; |
| (ii) | shall validate any proxies and mapping techniques used by the bank; |
| (iii) | shall assess the accuracy, completeness and appropriateness of model input and output; |
| (iv) | shall ensure that the model remains relevant based on the bank's equity portfolio and external conditions; |
| (v) | shall be adequate to detect and limit potential model weaknesses; |
| (vi) | shall be based on well established model review standards; |
| (vii) | may be conducted as part of the bank's internal or external audit programmes by an independent risk control unit or an external third party; |
| (E) | to monitor investment limits and risk exposures; |
| (F) | to ensure that the unit(s) responsible for the design and application of the model is functionally independent from the unit(s) responsible for the management of individual investments; |
| (G) | to ensure that the persons responsible for any aspect of the modelling process are adequately qualified; |
| (ii) | shall have in place a robust system in order to validate the accuracy and the consistency of the bank's internal model and the modelling process, including the input and the output of the model, which robust system and validation process— |
| (i) | to assess the performance of the bank's internal model and modelling processes in a consistent and meaningful manner; |
| (ii) | by way of backtesting, to regularly compare actual realised and unrealised gains and losses with modelled estimates; |
| (iii) | to demonstrate that the bank's actual returns are within the expected range for the portfolio and individual holdings; |
| (iv) | to backtest volatility estimates and the appropriateness of proxies used in the model; |
| (B) | shall make use of external data sources, which external data sources— |
| (i) | shall be appropriate for the bank's equity portfolio; |
| (ii) | shall be updated on a regular basis; |
| (iii) | shall cover a relevant observation period; |
| (i) | sufficiently long data histories, which data histories— |
| (aa) | shall include a range of economic conditions; |
| (bb) | shall preferably include one or more complete business cycles; |
| (ii) | appropriate databases of actual returns and modelled estimates; |
| (iii) | methods and data that are consistent through time. |
| (iii) | shall duly document all material elements of the bank's internal model and modelling process, which documentation— |
| (A) | shall include matters relating to the design and the operational details of the internal model; |
| (B) | shall provide a detailed outline of the theory, assumptions and/or mathematical and empirical basis of the parameters, variables, and data source(s) used; |
| (C) | shall clearly indicate the circumstances under which the model does not work effectively; |
| (D) | shall include the methods and data used in any comparison between actual realised and unrealised gains and losses, and modelled estimates; |
| (E) | shall clearly indicate the use of explicit and assumptions relating to implicit correlations, which correlations shall be supported by empirical analysis; |
| (F) | shall be updated on a regular basis, but not less frequently than once a year; |
| (G) | shall comprehensively deal with any changes in respect of the internal model, the estimation method, data, data sources and periods covered; |
| (H) | shall be adequate to demonstrate the bank's compliance with the prescribed minimum quantitative and qualitative requirements envisaged in regulation 23(11)(b)(vii); |
| (I) | shall duly address matters relating to— |
| (i) | the application of the model to different segments of the portfolio; |
| (ii) | estimation methodologies; |
| (iii) | the responsibilities of persons involved in the modelling process; |
| (iv) | the model approval and model review processes; |
| (v) | the rationale for the bank's choice of a particular methodology; |
| (vi) | the history of major changes in the model over time; |
| (vii) | any changes made to the modelling process subsequent to supervisory review; |
| (viii) | proxies, mapping techniques or processes used by the bank during the modelling process, including all relevant and material factors relating to— |
| (bb) | balance sheet characteristics; |
| (ee) | industry sector and subsector; |
| (ff) | operating characteristics; |
| (iv) | shall in all cases in which the bank maps individual positions to proxies, market indices or risk factors— |
| (A) | ensure that the said mapping is plausible, intuitive, appropriate and conceptually sound; |
| (B) | perform rigorous analysis in order to demonstrate to the satisfaction of the Registrar that the said proxies and mappings are relevant based on historical economic and market conditions and the bank's underlying portfolio; |
| (C) | demonstrate that the said proxies are robust estimates of the potential risk of the bank's underlying exposure. |
| (v) | shall have in place a rigorous and comprehensive stress-testing programme in respect of the bank's internal model and estimation procedures, which stress-testing process— |
| (A) | shall include hypothetical or historical scenarios in order to reflect worst-case losses in respect of the bank's equity positions; |
| (B) | shall provide comprehensive information relating to the effect of tail events beyond the level of confidence specified in respect of the internal model approach. |
| (b) | to adopt the internal models approach for the measurement of the bank's exposure to market risk arising, inter alia, from positions held in the bank's trading book— |
| (i) | shall have in place an independent risk control unit, which risk control unit— |
| (A) | shall be responsible for the design and implementation of the bank's risk management system; |
| (B) | shall produce and analyse daily reports on the output of the bank's risk measurement model, including an evaluation of the relationship between measures of risk exposure and trading limits; |
| (C) | shall be functionally independent from all relevant business trading units; |
| (D) | shall report directly to the senior management of the bank; |
| (E) | shall conduct regular backtesting, that is, an ex-post comparison of the risk measure generated by the bank's model against actual daily changes in portfolio value over longer periods of time, as well as hypothetical changes based on static positions; |
| (F) | shall conduct the initial and ongoing validation of the internal model, which validation process shall be conducted in accordance with the relevant requirements specified in subparagraph (ix) below; |
| (G) | shall control the integrity relating to input data; |
| (H) | shall validate prices supplied by business units; |
| (I) | shall be adequately staffed; |
| (ii) | shall ensure the active involvement and oversight of the bank's board of directors and senior management in the bank's risk control processes; |
| (iii) | shall regard risk control as an essential aspect of the bank's business; |
| (iv) | shall devote adequate resources to the bank's risk control unit and risk control processes; |
| (v) | shall ensure that the daily reports prepared by the independent risk control unit are reviewed by a level of senior management with sufficient authority to enforce both reductions of positions taken by individual traders and reductions in the bank's overall risk exposure; |
| (vi) | shall ensure that the senior management of the bank is aware of the limitations and assumptions made in respect of the said internal model and the impact that such limitations and assumptions may have on the output of the model; |
| (vii) | shall have in place a robust risk measurement model, which model— |
| (A) | shall be closely integrated into the day-to-day risk management processes of the reporting bank and the output of which model shall form an integral part of the process of planning, monitoring and controlling the bank's exposure to market risk; |
| (B) | shall be used in conjunction with internal trading and exposure limits in a manner that is consistent over time and that is well understood by traders and the senior management and relevant line functions of the reporting bank; |
| (viii) | shall have in place a routine and rigorous process or programme of stress testing, the results of which stress testing— |
| (A) | shall be duly documented; |
| (B) | shall periodically be reviewed by the senior management of the bank; |
| (C) | shall be used in the bank's internal assessment of capital adequacy; |
| (D) | shall be duly reflected in the bank's policies and limits set by management and the bank's board of directors; |
[Regulation 39(14)(b)(viii)(D) substituted by regulation 23(d) of Notice No. 297, GG 40002, dated 20 May 2016]
| (E) | as a minimum, where appropriate, shall demonstrate to the satisfaction of the Registrar that the bank's stress testing process factored in: |
| (i) | illiquidity/gapping of prices; |
| (ii) | concentrated positions (in relation to market turnover); |
| (iv) | non-linear products and deep out-of-the money positions; |
| (v) | events and jumps-to-defaults; |
| (vi) | significant shifts in correlations; and |
| (vii) | other risks that may not be captured appropriately in VaR, such as recovery rate uncertainty, implied correlations, or skew risk; |
[Regulation 39(14)(b)(viii)(E) inserted by regulation 8(e) of Notice No. R. 261 dated 27 March 2015]
| (F) | shall demonstrate to the satisfaction of the Registrar that the bank has sufficient capital and reserve funds to not only meet the relevant specified minimum required amount of capital and reserve funds, but also to withstand a range of severe but plausible market shocks. |
[Regulation 39(14)(b)(viii)(F) inserted by regulation 8(f) of Notice No. R. 261 dated 27 March 2015]
Provided that when the bank's stress tests reveal particular vulnerability to a particular set of circumstances, the bank shall take appropriate and prompt action in order to manage and control the relevant risks, which action may include hedging against a particular outcome, reducing the size of the bank's exposures or increasing the amount of capital and reserve funds.
| (ix) | shall have in place robust processes in order to ensure adequate validation of the bank's relevant models by suitably qualified persons independent from the development process, which validation— |
| (A) | shall ensure that all relevant and material risks are duly captured; |
| (B) | as a minimum, shall be conducted— |
| (i) | when the model is initially developed; |
| (ii) | when any significant changes are made to the model; |
| (iii) | on a periodic basis but especially when significant structural changes in the market or in the composition of the bank's portfolio took place, which changes might result in the model no longer being adequate; |
| (C) | shall in appropriate cases ensure compliance with the relevant requirements relating to specific risk, specified in regulation 28(8); |
| (D) | shall not be limited to backtesting; |
| (E) | as a minimum, shall include— |
| (i) | tests to demonstrate that any assumptions made within the internal model are appropriate and do not underestimate risk, including relevant tests relating to— |
| (aa) | the assumption of a normal distribution; |
| (bb) | the use of the square root of time to scale from a one day holding period to a ten day holding period; |
| (cc) | the use of extrapolation or interpolation techniques; |
| (dd) | the bank's pricing models; |
| (ii) | tests during which hypothetical changes in portfolio value is used when end-of-day positions remain unchanged, which tests therefore shall exclude fees, commissions, bid-ask spreads, net interest income and intra-day trading; |
| (iii) | tests conducted for periods longer than what is otherwise required in the bank's process of backtesting, which longer time period may improve the power of the backtesting process, provided that a longer time period may not be desirable when the bank's VaR model or market conditions have changed to an extent that makes historical data irrelevant or less relevant; |
| (iv) | tests based on confidence intervals other than the 99 per cent interval required in respect of quantitative standards specified in regulation 28(8)(e); |
| (v) | the use of hypothetical portfolios in order to ensure that the bank's model is able to account for particular structural features that may arise such as— |
| (aa) | when data histories for a particular instrument do not meet the quantitative standards specified in regulation 28(8) and the bank has to map positions to proxies, in which case the bank shall ensure that the proxies produce conservative results under relevant market scenarios; |
| (bb) | ensuring that material basis risks are duly captured, which may include mismatches between long and short positions by maturity or by issuer; |
| (cc) | ensuring that the model captures concentration risk that may arise from an undiversified portfolio. |
| (x) | shall have in place a routine for ensuring the bank's continued compliance with a documented set of internal policies, controls and procedures concerning the operation of the bank's risk measurement system; |
| (xi) | shall duly document the bank's risk measurement system, for example, by maintaining an updated risk management manual that describes the basic principles of the risk management system and provides an explanation of the empirical techniques used to measure the bank's exposure to market risk; |
| (xii) | shall conduct an appropriate independent review of the bank's risk measurement system, for example, as part of the bank's internal auditing process, which review— |
| (A) | shall include the activities of the relevant business trading units, the independent risk control unit and the bank's overall risk management process; |
| (B) | shall be conducted at regular intervals but not less frequently than once a year; |
| (C) | as a minimum, shall include— |
| (i) | the adequacy of documentation relating to the bank's risk management policies, system and processes; |
| (ii) | the organisation of the risk control unit; |
| (iii) | the integration of market risk measures into daily risk management; |
| (iv) | the approval process relating to all relevant risk pricing models and valuation systems used by front and back-office personnel; |
| (v) | the validation of any significant changes made in respect of the bank's risk measurement process; |
| (vi) | the scope of market risk and market risk factors captured by the risk measurement model; |
| (vii) | the integrity of the bank's management information system; |
| (viii) | the accuracy and completeness of relevant market variables and position data; |
| (ix) | the verification of the consistency, timeliness and reliability of data sources used to operate the internal model, including the independence of the said data sources; |
| (x) | the accuracy and appropriateness of volatility and correlation assumptions; |
| (xi) | the accuracy of valuation and risk transformation calculations; |
| (xii) | the verification of the model's accuracy through frequent backtesting. |
| (c) | to adopt an internal approach and incremental risk capital (IRC) model for the measurement of the bank's exposure to incremental default and migration risks arising from instruments or positions subject to specific interest rate risk, other than securitisation or resecuritisation exposures and n-th-to-default credit derivative instruments, held in the bank's trading book, shall have in place a robust validation process, which validation process— |
| (i) | shall apply the validation principles specified in regulations 39(8), 39(14)(a) and 39(14)(b) when designing, testing and maintaining the bank's IRC models, including— |
| (A) | the evaluation of conceptual soundness; |
| (B) | ongoing monitoring that includes process verification and benchmarking; and |
| (A) | liquidity horizons reflect actual practice and experience during periods of both systematic and idiosyncratic stresses; |
| (B) | the bank's IRC model for measuring default and migration risks over the liquidity horizon takes into account objective data over the relevant horizon and includes a comparison of risk estimates for a rebalanced portfolio with that of a portfolio with fixed positions; |
| (C) | correlation assumptions are supported by analysis of objective data in a conceptually sound framework. |
When a bank uses a multi-period model to compute incremental risk, the bank shall evaluate the implied annual correlations to ensure they are reasonable and in line with observed annual correlations.
| (D) | the bank's modelling approach for correlations is appropriate for the bank's portfolio, including the choice and weights of systematic risk factors; |
| (iii) | shall include relevant stress tests, sensitivity analyses and scenario analyses, to assess its qualitative and quantitative reasonableness, particularly with regard to the model's treatment of concentrations; |
| (iv) | shall be an ongoing process that makes provision for the Registrar and the bank to jointly determine the exact set of validation procedures to be employed, that is, tests, for example, shall not be limited to the range of events experienced historically. |
Provided that the bank shall duly document its modelling approach in order to ensure that the correlation and other modelling assumptions, for example, are available and transparent.
