Internal Models Approach for
Capital Charge for Market Risk
B. Mahapatra
Reserve Bank of India
July 21, 2010
Structure
1. Introduction
2. Broad Principles for RBI Approval
3. Qualitative Criteria for IMA Approval and
Corporate Governance of Risk
4. Risk Measurement
5. Minimum Quantitative Criteria
6. Back Testing
7. Stress Testing
8. Validation of Models
1.1. Introduction - Time Schedule
for Advanced Approaches –
Circular July 7, 2009
Sl. No.
Approach
Earliest Date of
Application to RBI
Likely Date of
Approval by RBI
a.
IMA for Market Risk
April 1, 2010
March 31, 2011
b.
TSA for Operational Risk
April 1, 2010
September 30, 2010
c.
AMA for Operational Risk
April 1, 2012
March 31, 2014
d.
IRB for Credit Risk
Foundation & Advanced)
April 1, 2012
March 31, 2014
1.2. Guidelines Issued by RBI
• Guidelines for IMA for Market Risk – issued on
April 7, 2010 by RBI
• Banks’ boards to take a decision whether and
when to adopt IMA
• Banks can continue with simpler methods for
capital charge for credit and operational risks,
while adopting IMA for capital charge for
market risk
1.3. IMA for Market Risk Guidelines
• Based on
– BCBS 1996 Guidelines;
– Basel II Framework; and
– Updated with July 2009 enhancements/revisions
to Basel II Framework; and
– Indian position
1.4. Scope of Application
• Application at solo and consolidated levels
(other than insurance business)
• No off-set allowed among and between group
entities
• Solo – on net basis, except where repatriation
not possible
• To monitor market risk exposure of each entity
separately
1.5. Types of Risks Covered
• Interest rate-related instruments and equities
in trading book
• Exchange rate risk (including open position in
gold) both in banking and trading book
• Risk relating to investments in MFs in trading
book
1.5.1. Interest Rate Risk in Trading
Book
• General market risk – general level of
movement in prices in the market
• Specific risk – movement of price due to
factors related to specific issuer
– Default risk – potential of direct or indirect loss
– Credit migration risk – due to down(up)gradation
– Credit spread risk – variation due to change in
spread over risk free security
– Incremental risk – risks which are not captured in
VaR based estimates of specific risk
1.5.2. Equity Price Risk in Trading
Book
• General market risk
• Specific risk
1.5.3. Exchange Rate Risk – Both in
Banking and Trading Book
• Open positions, including in gold
1.5.4. Commodity Price Risk
• Not applicable in India
1.5.5. Trading Book Under IMA
• Only HFT
• AFS – to continue under SMM, as markets are
illiquid and market prices may not be available
(Indian position)
1.6. Combination of IMA and SMM
• If other group level entities are not ready, IMA
for parent, and those entities which are ready,
and SMM for others
• Insignificant positions, minor currencies,
negligible business areas, etc. can be under
SMM
• Expected to follow IMA to all market risk
positions and entities in due course
• Present plan of action to RBI
• Capital charge – summation of IMA and SMM,
where applied
• No reversal allowed from IMA to SMM, unless
RBI stops it on account of the IMA not working
properly
• Inform RBI any change in IMA as approved by
RBI
1.7. Prudential Floors - Indian
Stipulation
Years
Year 1
Year 2
Year 3
Prudential floor as percentage of
minimum capital requirement as per
SMM
100
90
80
2.0.Broad Principles for RBI
Approval
• Assessment of bank’s risk management
system – conceptual soundness and
implementation integrity
• Availability of skilled staff – trading, risk
control, audit, back office, etc.
• Track record of model’s accuracy
• Regular conduct of stress testing
• Period of initial monitoring and live testing
3.0. Qualitative Criteria for IMA
Approval – C. G. of Risk
• Board and senior management oversight of
risk management
• Documentation of policies, procedures and
model parameters – Risk Management
Manual
• Maintenance of market risk model (MRM)
dossier – records of details,
changes/refinements
3.1. Contents of MRM Dossier
• Full technical specifications of the model
• RBI approval, subsequent changes, and
conditions of RBI
• Complete detail of record of changes
3.2. Organisation of Market Risk
Function
•
•
•
•
Front office
Middle office/risk control unit
Model construction unit
Model validation unit – could be part of risk
control unit
• Back office
• Internal audit – required qualification, skills
and experience
3.3. Information Technology
System
• Feeder system; risk aggregation system; time
series data base, VaR model system; stress
testing system; back testing system; etc. are
appropriate; data quality; reconciliation and
checks on completeness of capture
• Systems development, change control and
documentation; security audit trails; systems
availability and contingency procedures;
network adequacy
• Operational statistics relating to the VaR
model production process, including statistics
relating to timeliness, number of re-runs
required and reliability of data feeds
4.1. Risk Measurement – General
Principles
• Internal risk measurement model closely integrated
into day-to-day risk management process of the bank
and in conjunction with internal trading and
exposure limits. Its out put integral part of planning,
monitoring and controlling bank’s market risk profile
• Robust model validation and internal approval
process and back test and stress testing for market
risk measurement
• VaR in INR – take appreciation / depreciation in
security into VaR input but not for accounting –
Indian position
• Market risk and exposure limit well understood by
traders and senior management
• Board and senior management understand the basis,
major assumptions, strengths and limitations of the
model
• Risk measurement system should be scalable –
volume increase, new valuation, new product, etc.,
particularly the IT capability
• Staff, vendor and consultants should have the
requisite skills
4.2. Use of Vendor Models
• Same validation standards as internally
developed model
• Obtain and keep on record all mathematical
and statistical basis of the model and ensure
that bank’s staff understand these
• Document the role of vendor model, bank’s
understanding of it, its appropriateness,
regularly review
• Proprietary vendor models not providing
documentation – not allowed
• For specific risk use SMM for now
4.3. Criteria for FX (and Gold) Net
Open Position Exposures
• For each currency separately
• Capture risk factor for each currency
4.4. Criteria for Equity Exposure
• General market risk
– Modelled with a single index or multi-factor
model (more complex)
– Use market indices, sector indices, or sub-sector
indices, in conjunction with market beta/sector
beta/sub-sector beta
– In each equity market where the bank has
significant position (>1% of NW)
– Capture volatility and correlation effect
– Depending on its position
• For specific risk - use SMM for now
4.5. Investment /Exposure to MFs
• Follow SMM for now
5.1. Minimum Quantitative Criteria
for VaR Models
• Capital charge will be a function of
– Normal VaR (for general market and specific risks)
– Stressed VaR (for general market and specific
risks)
– IRC (for interest rate specific-risk capital charge)
• General market risk and specific risk can be
modelled together while calculating Normal or
Stressed VaR or separately
• In combined measure, bank should isolate VaR
for general risk and specific risk for backtesting and use in day-to-day risk
management
• As modelling and isolating specific risk under
VaR will take some time, banks to start with:
– Normal VaR measure (for general market risk)
– Stressed VaR measure (for general market risk)
– Specific risk capital charge as per SMM (even if its
VaR model captures specific risk but not able to
isolate it)
5.2. Parameters for VaR Models
• Banks can use any model, subject to:
– VaR captured on daily basis
– 99th percentile, one tail confidence interval is used
– Minimum 10-day holding period – square root
rule can be used for linear positions – for nonlinear position periodically justify reasonbaleness
to RBI
– Minimum 1 year historical observation period or
weighted average time not less than 6 months
– Bank may use alternate weighing schemes so long
as it is conservative
– RBI may stipulate short holding period, say 3
months, if situation so warrants (regime shift due
to extreme volatility, etc.)
– Update data sets no less than once in 3 months or
flexible enough to allow more frequent changes
– No particular type of model is prescribed –
variance-covariance, historical simulation or
Monte Carlo simulation
– RBI may recognize empirical correlation among
risk categories, if banks can demonstrate
– Must capture unique risks in options
• Gamma risk
• Full 10-day price shock
• Vega risk – volatility of rates and prices of the
underlying
5.3. Parameters for Computing
Stressed VaR
• 10-day, 99th percentile, one tailed confidence
interval VaR measure of the current portfolio
• Calculated at least weekly
• Model input calibrated to historical data from
a continuous 12-month period of significant
financial stress relevant to a bank’s portfolio
• Stress period requires RBI approval
• Choice of VaR model left to banks
5.4. Calculation of VaR, Stressed
VaR and Capital Requirement
• Normal VaR – higher of
– Previous day’s VaR (VaRt-1) and
– An average of the daily VaR of preceding 60
business days (VaRavg) * multiplication factor
(mc+pc)
• Stressed VaR – higher of
– Latest VaR calculated (weekly) (sVaRt-1)
– An average sVaR calculated over preceding 60
business days (sVaRavg) * multiplication factor
(ms+ps)
• Capital requirement
• C = max{VaRt-1;(mc+pc)*VaRavg} +
max{sVaRt-1;(ms+ps)*sVaRavg} where
• mc and ms = multiplication factors set by RBI
depending on quality of model, with minimum
3
• pc and ps = plus or add on factor, ranging from
0 to 1, decided by bank depending on backtesting of Normal VaR model (not stressed
VaR)
6.0. Back-testing under IMA
• Comparison of bank’s daily VaR measure with
subsequent daily profit or loss (trading
outcome) – the number times risk measures
were larger than trading outcomes
Zone
Number of exceptions
Increase in multiplication
factor over 3
Green
0
0.00
1
0.00
2
0.00
3
0.00
4
0.00
5
0.40
6
0.50
7
0.65
8
0.75
9
0.85
10
1.00
Yellow
Red
• If falls under red zone, RBI may require the
bank to discontinue the model or begin work
on improving the model
• RBI may require bank to increase capital if the
model is not capturing risk properly
• No exceptions means the model is
conservative or something wrong?
• Explanation for back-testing results
• Quarterly reporting of back-testing results to
Board
• Quarterly reporting of back-testing results to
RBI
7.0. Stress Testing for IMA
• General stress testing guidelines to be
followed, in addition to those for IMA
• Visualise low probability events, certain stress
events, extreme but plausible events
• Both quantitative and qualitative (whether
capital can withstand the stress)
• Communicated to senior management and
periodically to Board
• Provide information to RBI on general and
specific scenarios
• General scenario
– Need not confine to stress scenarios in India only
– Historical range of volatilities and correlations
– Extreme values based on hostorical volatilities and
correlations
• Specific scenarios
– Scenarios most adverse to its portfolio
– Should be reviewed periodically and reflected in
the policies and limits set by management and
Board
8.1. Internal Validation of Models
• By qualified parties independent of model
development to ensure conceptual soundness
and adequacy – initially and periodically
• At a minimum
– Review logical and conceptual soundness
– Compare the model with another model or
benchmark model
– Review the back-testing done on the model
• Responsibility of model validation unit
– Ensuring that current systems set up is capable
– All changes to models or modelling process should
be validated and approved
– Maintain previous version of model being altered
– Model subject to change control procedure –
computer codes can only be changed by
authorised staff
8.2. External Validation of Models
• At a minimum
– Verify that internal validation is satisfactory
– Formulae used in calculation and pricing are
validated by Risk Control Unit, independent of
traders
– Structure of model is adequate for bank’s
activities and geographical coverage
– Compare back-testing results
– Data flows are transparent and accessible to all
auditors
8.3. Documents for Application to
RBI
• Preliminary and detailed application to RBI for
prior approval
• Request letter
• Internal audit report of the model
• A MR File
• MR Model Dossier
8.4. Model Validation by RBI
• First give RBI notice of intention
• External auditor’s report
• RBI assessment
– Assessment and accuracy of documentation
– Assessment of model scope
– Qualitative review
– Assessment of technological environment and
information integrity
– Quantitative review
– Model monitoring – any modification proposed
need prior intimation and approval from RBI
8.5. Additional Pillar II
Requirements
• Policies and procedures for trading book
eligibility
• Valuation
• Stress testing under IMA – RBI to examine
under SREP whether bank has enough capital
for the IMA and take appropriate measure
8.6. Additional Disclosure under
Pillar III
• Qualitative – portfolio covered, characteristics
of models used, stress testing, back testing,
scope of acceptance by RBI, etc.
• Quantitative – high, mean,and low VaR and
stressed VaR over the reporting period and
period-end, comparison with actual
gains/losses experienced by the bank, outliers in back-testing, etc.
8.7. Capital Allocation for Market
Risk
• First allocate capital for credit and operational
risk and then surplus should be sufficient for
market risk
• Thank you