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         VI. External validation


An Internal Model-Based Approach to Market Risk Capital Requirements

VI. External validation

1. An independent review and validation of banks' market risk measurement systems is essential if supervisors are to be assured that banks' measurement systems not only meet the standards described above but also that the models are well designed and implemented with integrity. The main focus of this review should be on the adequacy of the internal validation process and of the documentation of the bank's policy and procedures. The generalised components of an adequate validation process are set out in the accompanying Supplement.

2. The Committee has considered a number of ways of enhancing the ability to validate the output of banks' internal risk measurement models. This discussion has focused on determining what sort of information would be useful (a) in understanding the factors determining a bank's estimate of its market risk exposure and (b) in gaining comfort that the estimates are a reasonable representation of the actual risks arising from the banks' trading activities.

3. The Committee is also considering conducting occasional further tests of the type conducted in the second half of 1994 and planned for the consultative period. Such exercises produce extremely useful comparative information about the results of banks' risk measurement models, although it is recognised that they require time, expertise and resources on the part of contributing banks. Nevertheless, it is inevitable that supervisors should wish to satisfy themselves that banks' models produce reasonably consistent results.

4. The Committee believes it essential that banks conduct back-testing (see paragraph IV.23), and that they make the results and the underlying inputs to the value-at-risk calculation available to their supervisors and/or external auditors on request. Such comparisons would provide the supervisors with a useful tool for evaluating how accurately banks' internal models are able to measure the market risk of their portfolio over time.

5. The development of rigorous stress tests, as set out in V above, is a key element of a meaningful validation scheme, since it is important to ensure that the capital generated by the market risk capital charge is sufficient to withstand losses that might result from unanticipated market movements (for instance, when correlation assumptions break down). It is a deliberate objective of the Committee to encourage banks to develop stress tests that are tailored to their individual risk profiles.

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