Banks Act, 1990 (Act No. 94 of 1990)RegulationsRegulations relating to Banks' Financial Instrument TradingChapter 7 : Use of Internal Models27. Quantitative standards |
In devising the precise nature of their models, banks shall apply the following minimum standards for the purpose of calculating the capital-adequacy requirement:
| (1) | "Value at risk" shall be computed on a daily basis. |
| (2) | In the calculation of the value at risk, a 99th percentile, one-tailed confidence interval shall be used. |
| (3) | In the calculation of value at risk, an instantaneous price shock equivalent to a 10-day movement in prices shall be used, that is, the minimum "holding period" is ten trading days. A bank may use value-at-risk numbers calculated according to shorter holding periods, scaled up to ten days by the square root of time for the treatment of options (see subregulation (8) below). |
| (4) | The choice of historical observation period (sample period) for the calculation of value-at-risk is confined to a minimum period of one year. For banks that use a weighting scheme or other methods for the historical observation period, the "effective" observation period shall be at least one year (that is, the weighted average time lag of the individual observations shall not be less than six months). |
| (5) | A bank shall update its data sets every three months and shall also reassess them whenever market prices are subject to material changes. The Registrar may require a bank to calculate its value at risk using a shorter observation period if, in his judgement, this is justified by a significant upsurge in price volatility. |
| (6) | No particular type of model is prescribed. Each model used shall capture all the material risks run by a bank. A bank will be free to use models based, for example, on variance-covariance matrices, historical simulations, or Monte Carlo simulations. |
| (7) | A bank has a discretion to recognise empirical correlations within broad risk categories (for example, interest rates, exchange rates, equity prices and commodity prices, including related options volatilities in each risk-factor category). The Registrar may also recognise empirical correlations across broad risk factor categories, provided that he is satisfied that the bank's system for measuring correlations is sound and implemented with integrity. |
| (8) | A bank's model shall accurately capture the unique risks associated with options within each of the broad risk categories. The following criteria shall apply to the measurement of options risk: |
| (a) | A bank's model shall capture the non-linear price characteristics of options positions; |
| (b) | a bank shall ultimately move towards the application of a full 10-day price shock to options positions or positions that display option-like characteristics. In the interim, the Registrar may require a bank to adjust its capital measurement for options risk through other methods, for example, periodic simulations or stress testing; and |
| (c) | each bank's risk-measurement system shall have a set of risk factors that captures the volatilities of the rates and prices underlying option positions, that is, vega risk. A bank with large and/or complex option portfolios shall have detailed specifications of the relevant volatilities. This means that a bank shall measure the volatilities of option positions broken down by different maturities. |
| (9) | A bank shall meet, on a daily basis, a capital-adequacy requirement expressed as the higher of its previous day's value-at-risk measured according to the parameters specified in this regulation or the average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by a multiplication factor. |
| (10) | The multiplication factor is set by the Registrar on the basis of his assessment of the quality of a bank's risk-management system, subject to an absolute minimum of three. A bank shall add to this factor a "plus" directly related to the ex-post performance of the model, thereby introducing a built-in incentive to maintain the predictive quality of the model. The plus will range from 0 to 1, based on the outcome of "backtesting". If the backtesting results are satisfactory and the bank meets all of the qualitative standards set out in regulation 25, the plus factor could be zero. |
| (11) | A bank using internal models shall be subject to a separate capital-adequacy charge to cover the specific risk of interest-rate related instruments and equity securities as defined in the standardised approach to the extent that this risk is not incorporated into its models. For a bank using internal models, however, the total specific risk charge applied to interest-rate related instruments or to equities shall in no case be less than half the specific risk charges calculated according to the standardised methodology. |