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An Internal Model-Based Approach to Market Risk Capital Requirements

III. General elements of a supervisory framework for the use of internal models in the measurement of market risks

1. The results of the testing have confirmed the Committee's view that the type of methodology described in Section I could be considered as a basis for setting regulatory capital charges, subject to a number of quantitative and more generalised conditions which banks would have to observe if they are to be allowed to use in-house models for this purpose. The guiding principle of such an approach is the preservation of banks' incentives to measure market risks as accurately as possible and to continue to upgrade their internal models as financial markets and technology evolve. It is important to ensure, in particular, that the use of models as a basis for measuring capital requirements does not introduce a bias in favour of less rigorous assumptions in terms of measurement parameters. This section describes a number of more generalised criteria which banks using models will be expected to observe in calculating value-at-risk for capital purposes (this does not mean that they have to use the same parameters for measuring value-at-risk for internal risk management purposes). The following sections discuss the use of more specific criteria for the use of internal models in the measurement of market risk capital requirements.
    (a) Qualitative standards

2. When evaluating a bank's market risk measurement system, the first priority for supervisory authorities is to assure themselves that the system is conceptually sound and implemented with integrity. Consequently, supervisory authorities will specify a number of qualitative criteria that banks using a models-based approach must meet. These criteria are set out in Part B of the Supplement. In most cases, the qualitative standards are self-explanatory. However, one requirement, so-called stress testing, is addressed in Section V below.

    (b) Specification of market risk factors

3. The risk factors contained in a bank's market risk measurement systems should be sufficiently comprehensive to capture all of the material risks inherent in the portfolio of its on- and off-balance-sheet trading positions. The risk factors should cover interest rates, exchange rates, equity prices, commodity prices, and volatilities related to options positions. Although banks will have some discretion in specifying the risk factors for their internal models, the Committee believes that they should be subject to the series of guidelines set out in Part B of the Supplement.

4. Overall, these guidelines tend to be of a general character to allow for a number of possible approaches to measuring market risk. However, a common theme that runs throughout the proposed standard is that the level of sophistication of the risk factors used should be commensurate with the nature and scope of the risks taken. For example, in measuring exposure to interest rates, the Committee has concluded that a minimum of 6 maturity bands (each representing a separate risk factor) needs to be used for material positions in the various currencies and markets. However, institutions that hold a large number of positions of different maturities or that engage in complex arbitrage strategies require a greater number of risk factors to measure their exposure to interest rates effectively. In addition, all banks using the internal models approach should be in a position to measure spread risk (e.g. between bonds and swaps), with the sophistication of approach again being a function of the nature and scope of the bank's exposure to interest rates. In the case of options, where the risks are particularly complex, the specific conditions set out in Section IV(e) would apply.

    (c) Specific risk for models

5. The methodology for banks not using internal models is based on a "building-block" approach in which the specific risk and the general market risk arising from securities positions are measured separately. The focus of many internal models is on the bank's general market risk exposure, leaving specific risk (i.e. exposures to specific issuers) to be measured largely through separate credit risk measurement systems. However, this is not universally the case. Moreover, the extent to which specific risk is captured for one risk factor may differ from the extent to which it is captured for another risk factor, even within the same bank. As is stated in paragraph 11 of Section I of the accompanying Supplement, the Committee believes that a separate capital charge should apply to the extent that the model does not capture specific risk. However, for banks using models, the total specific risk charge applied to debt securities or to equities should in no case be less than half the specific risk charges calculated according to the standardised methodology. Banks are invited to express their views on how to calculate the extent to which a model is measuring specific risk in order to avoid possible double-counting.

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