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Part B - Use of internal models to measure market risks

B.4 Quantitative Standards

Banks will have flexibility in devising the precise nature of their models, but the following minimum standards will apply for the purpose of calculating their capital charge. Individual banks or their supervisory authorities will have discretion to apply stricter standards.
  1. "Value-at-risk" must be computed on a daily basis.

  2. In calculating the value-at-risk, a 99th percentile, one-tailed confidence interval is to be used.

  3. In calculating value-at-risk, an instantaneous price shock equivalent to a 10 day movement in prices is to be used, i.e., the minimum "holding period" will be ten trading days. Banks 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, also see (h) below).

  4. The choice of historical observation period (sample period) for calculating value-at-risk will be constrained to a minimum length of one year. For banks that use a weighting scheme or other methods for the historical observation period, the "effective" observation period must be at least one year (that is, the weighted average time lag of the individual observations cannot be less than 6 months).

  5. Banks should update their data sets no less frequently than once every three months and should also reassess them whenever market prices are subject to material changes. The supervisory authority may also require a bank to calculate its value-at-risk using a shorter observation period if, in the supervisor's judgement, this is justified by a significant upsurge in price volatility.

  6. No particular type of model is prescribed. So long as each model used captures all the material risks run by the bank, as set out in B.3, banks will be free to use models based, for example, on variance-covariance matrices, historical simulations, or Monte Carlo simulations.

  7. Banks will have discretion to recognise empirical correlations within broad risk categories (e.g., interest rates, exchange rates, equity prices and commodity prices, including related options volatilities in each risk factor category). The supervisory authority may also recognise empirical correlations across broad risk factor categories, provided that the supervisory authority is satisfied that the bank's system for measuring correlations is sound and implemented with integrity.

  8. Banks' models must accurately capture the unique risks associated with options within each of the broad risk categories. The following criteria apply to the measurement of options risk:

    • banks' models must capture the non-linear price characteristics of options positions;
    • banks are expected to 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, national authorities may require banks to adjust their capital measure for options risk through other methods, e.g., periodic simulations or stress testing;
    • each bank's risk measurement system must have a set of risk factors that captures the volatilities of the rates and prices underlying option positions, i.e., vega risk. Banks with relatively large and/or complex options portfolios should have detailed specifications of the relevant volatilities. This means that banks should measure the volatilities of options positions broken down by different maturities.

  9. Each bank must meet, on a daily basis, a capital requirement expressed as the higher of (i) its previous day's value-at-risk number measured according to the parameters specified in this section and (ii) an 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 will be set by individual supervisory authorities on the basis of their assessment of the quality of the bank's risk management system, subject to an absolute minimum of 3. Banks will be required to add to this factor a "plus" directly related to the ex-post performance of the model, thereby introducing a built-in positive incentive to maintain the predictive quality of the model. The plus will range from 0 to 1 based on the outcome of so-called "backtesting." If the backtesting results are satisfactory and the bank meets all of the qualitative standards set out in B.2 above, the plus factor could be zero. The accompanying document, Supervisory framework for the use of backtesting in conjunction with the internal models approach to market risk capital requirements, presents in detail the approach to be applied for backtesting and the plus factor.

  11. Banks using models will also be subject to a capital charge to cover specific risk (as defined under the standardised approach) of interest rate related instruments and equity securities. The manner in which the specific risk capital charge is to be calculated is set out in Section B.8 below.

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