The internal model approach is based on the use of value-at-risk (VaR) techniques. However, an ADI may seek APRA’s written approval to use a capital calculation methodology other than VaR.
In addition, an ADI must calculate a ‘stressed VaR’ measure according to the requirements set out in paragraph 34 of this Attachment.
An ADI using an internal model must meet, on a daily basis, a capital requirement expressed as:
the higher of:
an average of the daily VaR measures on each of the preceding sixty trading days, multiplied by a scaling factor (the total of the VaR multiplication factor and a plus factor); and
its previous day’s VaR number; and
the higher of:
an average of the stressed VaR measures calculated over the preceding sixty trading days, multiplied by a scaling factor (the total of the multiplication factor for stressed VaR and a plus factor); and
its latest available stressed VaR number; and
the incremental risk charge (IRC), where the VaR measures referred to in paragraph 1 of this Attachment include an estimation of the specific risk charge in accordance with paragraphs 43 to 45 of this Attachment; and
the comprehensive risk charge, where an ADI has approval to calculate capital for its correlation trading portfolio in accordance with paragraphs 77 to 79 of this Attachment.
Both the VaR multiplication factor and the multiplication factor for stressed VaR are set by APRA, subject to a minimum of three. If an ADI using an internal model for calculating its TFC capital requirement does not adequately satisfy the requirements set out in this Attachment and the trading book requirements set out in Attachment A, but APRA does not consider the failure to satisfy those requirements material enough to withdraw model approval, APRA may, in writing, determine a multiplication factor higher than three. The plus factor, which ranges between zero and one inclusive, will depend on the ex post performance of the ADI’s internal model, as determined by back-testing of the VaR measure (refer to paragraphs 81 to 87 of this Attachment).
An ADI that does not have approval from APRA to use an internal model to calculate its specific risk capital charge must calculate the specific risk capital charge using the standard method (refer to Attachment B).
If an ADI’s internal model does not fit the VaR framework, the ADI may seek approval under paragraph 1 of this Attachment to use an alternative approach. In deciding whether to approve an alternative approach, APRA will consider whether the internal model adequately captures the risks involved and identifies the capital needed to support those risks in a comparable manner.
Unless required to do otherwise by APRA:
an ADI that has market-related activities in Australia and offshore branches (offshore Level 1 sites) and manages those market-related activities centrally may, for the purpose of calculating its Level 1 TFC capital requirement using the internal model approach, allow for netting of positions that have been taken within the ADI, whether in Australia or an offshore Level 1 site, and risk diversification between positions that have been taken by the ADI, whether within Australia or an offshore Level 1 site (‘Level 1 globally diversified VaR calculation’); and
an ADI that has market-related activities in Australia and offshore Level 2 sites (offshore branches or offshore subsidiaries) and manages those market-related activities centrally may, for the purpose of calculating its Level 2 TFC capital requirement using the internal model approach, allow for netting of positions that have been taken within the group comprising the entities in Australia and the offshore Level 2 sites and risk diversification between positions that have been taken within the group comprising the entities in Australia and the offshore Level 2 sites (‘Level 2 globally diversified VaR calculation’);
subject to the following conditions:
positions taken in an offshore Level 2 site may only be included in a globally diversified VaR calculation if the position-taking of that site is monitored by the ADI’s Australian office on a daily basis;
positions must not be included in a globally diversified VaR calculation where there are obstacles to the quick repatriation of profits from a foreign subsidiary or branch or from offshore transactions taken by the ADI itself; and
positions must not be included in a globally diversified VaR calculation where there are legal and procedural difficulties in carrying out the timely management of risks on a consolidated basis.
Where the positions in an offshore Level 2 site are not included in a globally diversified VaR calculation, an ADI must calculate the VaR for that offshore Level 2 site separately. The ADI must calculate the total VaR as the sum of the globally diversified VaR and the VaRs for the offshore Level 2 site.
General criteria
An ADI using an internal model for regulatory capital purposes must:
have a market risk management strategy that is conceptually sound and implemented with integrity;
have sufficient numbers of staff skilled in the use of sophisticated models in the trading, risk control, audit and back-office areas;
have a proven track record of reasonable accuracy in measuring risk; and
regularly conduct stress tests.
An ADI must also be able to participate in testing exercises to provide any additional information required to satisfy APRA of the adequacy of the internal model (both prior to model approval and subsequently, if APRA wishes to review the internal model).
Qualitative standards
An ADI must have an independent risk control unit that is responsible for the design and implementation of the ADI’s market risk management system. The risk control unit must produce and analyse daily reports on the output of the ADI’s risk measurement model, including an evaluation of limit utilisation. This risk control unit must be independent from business trading and other risk-taking units and must report directly to senior management of the ADI.
The risk control unit must conduct a back-testing program at least quarterly that complies with the minimum requirements in paragraphs 81 to 87 of this Attachment.
The Board, or a Board committee, and senior management of an ADI must be actively involved in the risk control process and must treat risk control as an essential aspect of the business, to which significant resources need to be devoted. The daily reports prepared by the independent risk control unit must be reviewed by a level of management with sufficient seniority and authority to enforce both reductions of positions taken by individual traders and reductions in the ADI’s overall risk exposure.
An ADI’s internal market risk measurement model must be closely integrated into the day-to-day risk management process of the ADI. Accordingly, the output of the model must be an integral part of the process of planning, monitoring and controlling the ADI’s market risk profile.
An ADI’s market risk measurement system must be used in conjunction with internal trading and exposure limits. An ADI’s trading limits must be related to the ADI’s VaR measurement model in a manner that is consistent over time and that is well understood by both traders and senior management.
An ADI must have a routine and robust program of stress testing as a supplement to the risk analysis based on the day-to-day output of the risk measurement model. The results of stress testing exercises must be used in the internal assessment of capital adequacy and reflected in the policies and limits set by management and the Board, or Board committee. The results of stress testing must be routinely communicated to senior management and, periodically, to the ADI’s Board, or a Board committee.
An ADI’s risk measurement system must be well documented. An ADI must have a routine for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the risk measurement system.
An ADI must ensure that an independent review of the risk measurement system and overall risk management process is carried out initially (i.e. at the time when model approval is sought) and then regularly as part of the ADI’s internal audit process. This review must be conducted by functionally independent, appropriately trained and competent personnel, and must take place at least once every three years or when a material change is made to the framework. The review must cover the activities of both the business trading units and the independent risk control unit and must, at a minimum, specifically address the:
scope of market risks captured by the risk measurement model;
integrity of the management information system;
accuracy and completeness of position data;
verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources;
accuracy and appropriateness of volatility and correlation assumptions, proxy assumptions and (if using the historical simulation approach) calculations of historical rate movements;
accuracy of valuation and risk sensitivity calculations;
verification of the model’s accuracy through frequent back-testing;
approval process for risk pricing models and valuation systems used by front- and back‑office personnel;
validation of any significant change in the risk measurement process;
adequacy of the documentation of the risk management system and process;
organisation of the risk control unit;
integration of market risk measures into daily risk management; and
process used to produce the calculation of market risk capital.
Specification of market risk factors
An ADI must specify, in its risk management system, an appropriate set of market risk factors (market rates and prices that affect the value of the ADI’s market‑related positions) that are sufficient to capture the risks inherent in the ADI’s portfolio of on-balance sheet and off-balance sheet trading positions.
The VaR model must capture nonlinearities beyond those inherent in options and other relevant products (e.g. mortgage-backed securities, tranched exposures or nth loss positions), as well as correlation risk and basis risk (e.g. between credit default swaps and bonds).
Where a risk factor is incorporated in a pricing model but not in the VaR model, the ADI must justify this omission to APRA’s satisfaction. An ADI must also justify, to APRA’s satisfaction, that all proxies used in the VaR model show a good track record for the actual position held (i.e. an equity index for a position in an individual stock).
Interest rates
An ADI must specify a set of risk factors corresponding to interest rates in each currency in which the ADI has interest rate sensitive on-balance sheet or off-balance sheet trading book positions. The number of risk factors used must be driven by the nature of the ADI’s trading strategies. For material exposures to interest rate movements in the major currencies and markets, an ADI must model the yield curves for those currencies using a minimum of six risk maturity segments.
An ADI must specify separate risk factors to capture credit spread risk (e.g. between government bonds, corporate bonds and swaps).
Equity prices
An ADI must specify risk factors corresponding to each of the equity markets to which it has material positions.
Exchange rates (including gold)
An ADI must specify risk factors corresponding to the exchange rate between the domestic currency and individual foreign currencies in which its positions are denominated.
Commodity prices
An ADI must specify risk factors corresponding to each of the commodity markets in which it holds material positions.
An ADI’s commodity risk factors must, at a minimum, encompass:
directional risk, to capture the exposure from changes in spot prices arising from net open positions;
forward gap and interest rate risks, to capture the exposure to changes in forward prices; and
basis risk, to capture the exposure to changes in the price relationships between two similar, but not identical, commodities.
For more active trading, an ADI’s model must also take into account the variation in the ‘convenience yield’[42] between derivatives positions, such as forwards and swaps, and cash positions in the commodity.
Option prices
An ADI that may take option positions must specify risk factors corresponding to the implied volatilities of those options, to capture the vega risk of those positions.
Quantitative standards
An ADI with approval to use an internal model must comply with the quantitative criteria outlined in paragraphs 29 to 34 of this Attachment for the purpose of calculating its capital charge. This does not preclude an ADI from imposing more stringent criteria if it wishes to do so.
VaR must be calculated on a daily basis, using a 99 per cent, one-tailed confidence interval and a 10-day holding period. An ADI which uses VaR numbers calculated according to a shorter holding period scaled up to ten days must justify the reasonableness of its approach to APRA’s satisfaction
The historical observation period (sample period) chosen for calculating VaR must have a minimum length of one year. An ADI using a weighting scheme or other method for the historical observation period cannot have a weighted-average time lag of the individual observations of less than six months[\[43\]](#_ftn43). APRA may require an ADI to calculate its VaR using a shorter observation period if APRA’s considers this is justified by a significant upsurge in price volatility.
An ADI must update its data sets at least monthly and must reassess them whenever market prices are subject to material changes. An ADI must have processes in place to update their data sets more frequently.
An ADI may only recognise empirical correlations within and across broad risk categories if approved in writing by APRA
An ADI’s model must accurately capture the unique risks associated with options within each of the broad risk categories, in particular the non-linear price characteristics of option positions.
The stressed VaR measure must be calculated using a 10-day, 99th percentile, one-tailed confidence interval value-at-risk measure of the current portfolio, with VaR model inputs calibrated to historical data from a continuous 12-month period of significant financial stress relevant to the ADI’s portfolio. The choice of historical period is subject to APRA approval, and the ADI must review the appropriateness of the choice as part of its regular model validation process. This stressed VaR must be calculated at least weekly.
Stress testing
An ADI that uses the internal model approach to meet market risk capital requirements must have a comprehensive stress testing program.
An ADI’s stress scenarios must cover a range of factors that can create extraordinary losses or gains in trading portfolios, or make the control of risk in those portfolios very difficult. Stress tests must shed light on the impact of such events on positions that display both linear and non-linear price characteristics (such as options and instruments that have option-like characteristics).
An ADI’s stress tests must be both quantitative and qualitative, incorporating both market risk and liquidity aspects of market disturbances. Quantitative criteria must identify plausible stress scenarios to which an ADI could be exposed. Qualitative criteria must emphasise that the two major goals of stress testing are to evaluate the capacity of the ADI’s capital to absorb potential large losses and to identify steps the ADI can take to reduce its risk and conserve capital.
An ADI must combine the use of supervisory stress scenarios with an internally developed stress testing program that reflects the risk characteristics of the ADI’s portfolio. The ADI must report to APRA information on stress testing as required under Reporting Standard ARS 116.0 Market Risk, and as outlined in paragraph 39 of this Attachment.
An ADI must also develop its own stress tests that it identifies as most adverse based on the characteristics of its portfolio. The ADI must provide APRA with a description of the methodology used to select and to carry out stress tests and include this in the description of the ADI’s management systems. The stress tests must also address:
illiquidity/gapping of prices;
concentrated positions (in relation to market turnover);
other risks that may not be captured appropriately in VaR (e.g. recovery rate uncertainty, implied correlations, or skew risk).
The market shocks applied in the tests must reflect the nature of portfolios and the time it could take to hedge or manage risks under severe market conditions.
An ADI must ensure that the results of the stress tests are reviewed periodically by senior management and reflected in the policies and limits set by management and the Board, or Board committee.
Model review
When reviewing an internal model (both prior to and after model approval), APRA will consider whether:
the internal validation processes are operating in a satisfactory manner;
the formulae used in the calculation process and for the pricing of options and other complex instruments are validated by qualified parties, who are independent from the trading area and not involved in the development or implementation of those formulae;
the structure of the internal model is adequate with respect to the ADI’s activities and geographical coverage;
the results of the ADI’s back-testing of its internal measurement system ensure the model provides a reliable measure of potential losses over time;
data flows and processes associated with the risk measurement system are transparent and accessible, in that the model’s specifications and parameters can be easily accessed; and
the ADI has processes to ensure that its internal models have been adequately validated by suitably qualified parties independent of the development process to ensure that they are conceptually sound and adequately capture all material risks. This validation must be conducted when the model is initially developed and when any significant changes are made to the model.
An ADI must validate its internal models on a periodic basis but especially where there have been any significant structural changes in the market or changes to the composition of the portfolio that might lead to the model no longer being adequate. As techniques and best practices evolve, an ADI must avail itself of these advances. Apart from back-testing, model validation must, at a minimum, also include:
tests to demonstrate that any assumptions made within the internal model are appropriate and do not underestimate or overestimate risk;
the use of additional back-tests; and
the use of hypothetical portfolios to ensure that the model can account for particular structural features that may arise.
Treatment of specific risk
An ADI that uses an internal model to calculate its regulatory capital in respect of general market risk may apply to APRA to use an internal model to calculate its specific risk capital requirement for equities and interest rate risk positions other than securitisation exposures and nth\-to-default credit derivatives. An ADI using an internal model to calculate its specific risk capital requirement must comply with the criteria set out in paragraphs 7 to 16, 28 to 34, and 44 to 48 of this Attachment. An ADI using an internal model to calculate its specific risk capital requirement for interest rate risk positions other than securitisation exposures and nth\-to-default credit derivatives must also comply with the criteria set out in paragraphs 49 to 80 of this Attachment.
An ADI’s internal model used to calculate the specific risk capital requirement must:
explain the historical price variation in the portfolios concerned;
capture concentrations, resulting in higher capital charges for portfolios with higher concentrations, and be sensitive to changes in portfolio composition;
be robust to an adverse environment;
be validated through back-testing designed to assess whether both specific and general market risks are being accurately captured;
An ADI's model must conservatively assess the risk arising from less liquid positions and/or positions with limited price transparency under realistic market scenarios. An ADI may only use proxies where available data are insufficient or do not reflect the true volatility of a position or portfolio, and only if the proxies are appropriately conservative.
Back-testing for specific risk models
An ADI using an internal model to measure specific risk must conduct back-testing to assess whether specific risk is being accurately captured. To validate its specific risk estimates, the ADI must perform separate back-tests using daily data on sub-portfolios subject to specific risk, being traded debt and equity positions. If an ADI decomposes its trading portfolio into finer categories (e.g. emerging markets and traded corporate debt), the ADI may retain these distinctions for sub-portfolio back-testing purposes. The ADI, however, is required to commit to a sub-portfolio structure; hence, changes to the sub-portfolio structure must be agreed with APRA and be made only where there is a business case for such a change.
An ADI must have a process to analyse exceptions identified through the back-testing of specific risk to ensure that it can correct its models of specific risk in the event that they become inaccurate.
An ADI with an unacceptable specific risk model (i.e. where the back-testing results fall within the red zone described in paragraph 86 of this Attachment) must take immediate action to improve the model and to ensure that there is a sufficient capital buffer to absorb the risk that the back-test showed had not been adequately captured.
Incremental risk charge
An ADI that uses an internal model to calculate regulatory capital for interest rate specific risk must have an approach to capture the regulatory capital default and migration risks in positions subject to a capital charge for specific interest rate risk, with the exception of securitisation positions and nth\-to-default credit derivatives that are incremental to the risk captured by the VaR-based calculation, as specified in paragraph 1 of this Attachment.
An ADI using an internal model to calculate its incremental risk charge must comply with the criteria set out in paragraphs 51 to 76 and 80 of this Attachment. An ADI that does not capture the incremental default risk through an internally developed approach must use the specific risk capital charges under the standard method (refer to Attachments B and D).
The IRC encompasses all positions subject to a capital charge for specific interest rate risk according to the internal models approach to specific market risk but not subject to the treatment outlined in paragraphs 11 to 19 of Attachment B, regardless of their perceived liquidity.
With APRA approval, an ADI can choose consistently to include all listed equity, and derivatives positions based on listed equity, of a desk in its incremental risk model when such inclusion is consistent with how the ADI internally measures and manages this risk at the trading desk level. If equity securities are included in the computation of incremental risk, default is deemed to occur if the related debt defaults (as defined in paragraph 72 of Attachment D to APS 113).
An ADI is not permitted to incorporate into its IRC model any securitisation or re-securitisation positions, even when these positions are viewed as hedging underlying credit instruments held in the trading book.
For IRC-covered positions, the IRC captures:
Default risk. This means the potential for direct loss due to an obligor’s default as well as the potential for indirect losses that may arise from a default event;
Credit migration risk. This means the potential for direct loss due to an internal/external rating downgrade or upgrade as well as the potential for indirect losses that may arise from a credit migration event.
IRC soundness standard comparable to IRB
For all IRC-covered positions, an ADI’s IRC model must measure losses due to default and migration at the 99.9 per cent confidence interval over a capital horizon of one year, taking into account the liquidity horizons applicable to individual trading positions or sets of positions. Losses caused by broader market-wide events affecting multiple issues/issuers are encompassed by this definition.
For each IRC-covered position an ADI’s IRC model must also capture the impact of rebalancing positions at the end of their liquidity horizons so as to achieve a constant level of risk over a one-year capital horizon. The model may incorporate correlation effects among the modelled risk factors, subject to validation standards set forth in APS 113. The trading portfolio’s IRC equals the IRC model’s estimate of losses at the 99.9 per cent confidence level.
Constant level of risk over one-year capital horizon
An ADI’s IRC model must be based on the assumption of a constant level of risk over the one-year capital horizon.
This constant level of risk assumption implies that an ADI rebalances, or rolls over, its trading positions over the one-year capital horizon in a manner that maintains the initial risk level, as indicated by a metric such as VaR or the profile of exposure by credit rating and concentration. This means incorporating the effect of replacing positions whose credit characteristics have improved or deteriorated over the liquidity horizon with positions that have risk characteristics equivalent to those that the original position had at the start of the liquidity horizon. The frequency of the assumed rebalancing must be governed by the liquidity horizon for a given position.
Rebalancing positions does not imply, as the IRB approach for the banking book does, that the same positions will be maintained throughout the capital horizon. However, an ADI may elect to use a one-year constant position assumption, as long as it does so consistently across all portfolios.
Liquidity horizon
The liquidity horizon represents the time required to sell the position or to hedge all material risks covered by the IRC model in a stressed market. The liquidity horizon must be measured under conservative assumptions and should be sufficiently long that the act of selling or hedging, in itself, does not materially affect market prices. The determination of the appropriate liquidity horizon for a position or set of positions may take into account an ADI’s internal policies relating to, for example, prudent valuation (as per the prudent valuation guidance of Attachment A to APS 111), valuation adjustments[\[45\]](#_ftn45) and the management of stale positions.
The liquidity horizon for a position or set of positions has a floor of three months.
An ADI must use conservative assumptions regarding the liquidity horizon for non-investment-grade positions until further evidence is gained regarding the market’s liquidity during systematic and idiosyncratic stress situations. An ADI must also apply conservative liquidity horizon assumptions for products, regardless of rating, where either (i) secondary market liquidity is not deep, particularly during periods of financial market volatility and investor risk aversion; or (ii) the product is from a rapidly growing class that has not been tested in a downturn.
An ADI can assess liquidity by position or on an aggregated basis (‘buckets’). If an aggregated basis is used[\[46\]](#_ftn46), the aggregation criteria would be defined in a way that meaningfully reflects differences in liquidity.
The liquidity horizon must be greater for positions that are concentrated, reflecting the longer period needed to liquidate such positions.
The liquidity horizon for a securitisation warehouse must be longer than three months, and reflect the time to build, sell and securitise the assets, or to hedge the material risk factors, under stressed market conditions.
Correlations and diversification
Correlations between defaults and migrations
An ADI’s IRC model must include the impact of clustering of default and migration events that may arise as a result of correlations between default and migration events among obligors.
Correlations between default or migration risks and other market factors
An ADI may not include the impact of diversification between default or migration events and other market variables in the computation of capital for incremental risk. Accordingly, the capital charge for incremental default and migration losses is added to the VaR-based capital charge for market risk.
Concentration
An ADI’s IRC model must appropriately reflect issuer and market concentrations. Thus, other things being equal, a concentrated portfolio should attract a higher capital charge than a more granular portfolio (refer to paragraph 64). Concentrations that can arise within and across product classes under stressed conditions must also be reflected.
Risk mitigation and diversification effects
Within an ADI’s IRC model, exposure amounts may be netted only when long and short positions refer to the same financial instrument. Otherwise, exposure amounts must be captured on a gross (i.e. non-netted) basis. Thus, hedging or diversification effects associated with long and short positions involving different instruments or different securities of the same obligor (‘intra-obligor hedges’), as well as long and short positions in different issuers (‘inter-obligor hedges’), may not be recognised through netting of exposure amounts. Rather, such effects may only be recognised by capturing and modelling separately the gross long and short positions in the different instruments or securities.
An ADI’s IRC model must include the impact of significant basis risks by product, seniority in the capital structure, internal or external rating, maturity, vintage for offsetting positions as well as differences between offsetting instruments, such as different payout triggers and procedures.
If an instrument has a maturity shorter than the liquidity horizon or if a maturity longer than the liquidity horizon is not contractually assured, an ADI’s IRC model must, where material, include the impact of potential risks that could occur during the interval between the maturity of the instrument and the liquidity horizon.
For trading book risk positions that are typically hedged via dynamic hedging strategies, a rebalancing of the hedge within the liquidity horizon of the hedged position may also be recognised. Such recognition is only admissible if the ADI (i) chooses to model rebalancing of the hedge consistently over the relevant set of trading book risk positions, (ii) demonstrates that the inclusion of rebalancing results in a better risk measurement, and (iii) demonstrates that the markets for the instruments serving as hedge are liquid enough to allow for this kind of rebalancing even during periods of stress. Any residual risks resulting from dynamic hedging strategies must be reflected in the capital charge. An ADI must validate its approach to capture such residual risks to APRA’s satisfaction.
Optionality
An ADI’s IRC model must include the nonlinear impact of options and other positions with material nonlinear behaviour with respect to price changes. The ADI must also have due regard to the amount of model risk inherent in the valuation and estimation of price risks associated with such products.
Validation
In designing, testing and maintaining their IRC models an ADI must evaluate conceptual soundness and conduct ongoing monitoring, including process verification and benchmarking, and outcomes analysis. Some factors that must be considered in the validation process include:
liquidity horizons must reflect actual practice and experience during periods of both systematic and idiosyncratic stresses;
the IRC model for measuring default and migration risks over the liquidity horizon must take into account objective data over the relevant horizon and include comparison of risk estimates for a rebalanced portfolio with that of a portfolio with fixed positions;
correlation assumptions must be supported by analysis of objective data in a conceptually sound framework. If an ADI uses a multi-period model to compute incremental risk, it must evaluate the implied annual correlations to ensure they are reasonable and in line with observed annual correlations. An ADI must validate that its modelling approach for correlations is appropriate for its portfolio, including the choice and weights of its systematic risk factors. An ADI must document its modelling approach so that its correlation and other modelling assumptions are transparent to supervisors; and
owing to the high confidence standard and long capital horizon of the IRC, robust direct validation of the IRC model through standard back-testing methods at the 99.9 per cent/one-year soundness standard will not be possible. Accordingly, validation of an IRC model necessarily must rely more heavily on indirect methods including, but not limited to, stress tests, sensitivity analyses and scenario analyses, to assess its qualitative and quantitative reasonableness, particularly with regard to the model’s treatment of concentrations. Such tests must not be limited to the range of events experienced historically. An ADI must agree its set of validation procedures with APRA.
Use of internal risk measurement models to compute the IRC
The approach that an ADI uses to measure the IRC is subject to the ‘use test’. Specifically, the approach must be consistent with the ADI’s internal risk management methodologies for identifying, measuring, and managing trading risks.
Where an ADI’s internal approach for measuring the IRC does not satisfy all requirements of paragraphs 49 to 75 of this Attachment, the ADI must demonstrate that the resulting internal capital charge would deliver a charge at least as high as the charge produced by a model that directly applies the supervisory principles set out in this Attachment.
Comprehensive risk measure
An ADI that is active in buying and selling products that meet the criteria for inclusion in the correlation trading portfolio (refer to paragraph 15 of Attachment B) may apply to APRA to use an internal model to calculate its specific risk capital requirement for its correlation trading portfolio in an internally developed approach that adequately captures not only incremental default and migration risks, but all price risks (‘the comprehensive risk approach’). The value of such products is subject in particular to the following risks which must be adequately captured:
the cumulative risk arising from multiple defaults, including the ordering of defaults, in tranched products;
credit spread risk, including the gamma and cross-gamma effects;
volatility of implied correlations, including the cross effect between spreads and correlations;
basis risk, including both:
the basis between the spread of an index and those of its constituent single names; and
the basis between the implied correlation of an index and that of bespoke portfolios;
recovery rate volatility, as it relates to the propensity for recovery rates to affect tranche prices; and
to the extent the comprehensive risk measure incorporates benefits from dynamic hedging, the risk of hedge slippage and the potential costs of rebalancing such hedges.
The approach must meet all of the requirements specified in paragraphs 55, 56, 78 and 79 of this Attachment. Exposures for which the ADI does not meet the due diligence requirements set out in paragraph 11 of Attachment B must be risk-weighted at 1250 per cent (i.e. a 100 per cent risk capital charge is applied) in accordance with that paragraph, and may not be included in the comprehensive risk approach. For the exposures that the ADI does incorporate in its comprehensive risk approach, the ADI will be required to subject them to a capital charge equal to the higher of the capital charge according to this internally developed approach and eight per cent of the capital charge for specific risk according to the standardised measurement. It will not be required to calculate an incremental risk charge for these positions. It must, however, incorporate them in both the VaR and stressed VaR measures.
For an ADI to apply the comprehensive risk approach for calculating capital, it must:
have sufficient market data to ensure that it fully captures the salient risks of these exposures in its comprehensive risk measure in accordance with the standards set forth above;
demonstrate (e.g. through back-testing) that its risk measures can appropriately explain the historical price variation of these products; and
ensure that it can separate the positions for which it holds approval to incorporate them in its comprehensive risk measure from those positions for which it does not hold this approval.
An ADI applying the comprehensive risk approach must report to APRA information on comprehensive risk stress testing, including comparisons with the capital charges implied by the ADI’s internal model for estimating comprehensive risks, as required under Reporting Standard ARS 116.0 Market Risk. The ADI must also apply these stress scenarios at least weekly, and any instances where the stress tests indicate a material shortfall of the comprehensive risk measure must be reported to APRA in a timely manner. Based on these stress testing results, or if an ADI does not adequately meet the requirements of paragraphs 77 and 78, APRA may impose a supplemental capital charge against the correlation trading portfolio, to be added to the ADI’s internally modelled capital requirement.
Frequency of calculation
An ADI that uses an internal model to calculate regulatory capital for the incremental risk measure and/or the comprehensive risk approach must calculate the measure(s) at least weekly, or more frequently as directed by APRA. The capital charge for incremental risk is given by the maximum of:
the average of the incremental risk measures over 12 weeks; and
the most recent incremental risk measure.
The capital charge for comprehensive risk is given by the maximum of:
the average of the comprehensive risk measures over 12 weeks; and
the most recent comprehensive risk measure.
Framework for the use of back-testing
An ADI’s back-testing program must consist of a periodic comparison of its daily VaR measure (based on a one-day holding period) with the realised daily profit or loss (‘trading outcome’). The program must include a formal evaluation of instances where trading outcomes are not covered by the risk measures (termed ‘exceptions’) on at least a quarterly basis, using the most recent twelve months of VaR and profit data. The ADI must document all of the exceptions generated from its ongoing back-testing program, including an explanation for the exceptions. An ADI must have the capacity to perform back-testing analysis both at the level of the whole portfolio and at the level of sub-portfolios or books or that contain material risk.
An ADI must perform back-tests using both actual trading outcomes and hypothetical trading outcomes. Hypothetical trading outcomes are calculated by applying the day’s price movements to the previous day’s end-of-day portfolio. When performing back-tests using actual trading outcomes, an ADI must use clean trading outcomes, i.e. actual trading outcomes adjusted to remove the impact of income arising from factors other than market movements alone, such as fees and commissions, brokerage, additions to and releases from reserves which are not directly related to [market risk](http://fsahandbook.info/FSA/glossary-html/handbook/Glossary/M?definition=G1564) (e.g. administration reserves).
An ADI must calculate the number of exceptions for use by APRA in developing its supervisory response. For this purpose, the ADI must use either the hypothetical trading outcomes or clean trading outcomes as determined, in writing, by APRA. The plus factor to be added to the multiplication factor will be based on the number of exceptions out of the most recent 250 trading days. These plus factors are outlined in Table 11.
If the results of an ADI’s back-testing fall within zero to four exceptions (the green zone), the ADI is not required to add a plus factor to the multiplication factor.
If the results of the ADI’s back-testing fall within five to nine exceptions (the yellow zone), APRA may, in writing, require the ADI to add a plus factor in accordance with Table 11.
If an ADI’s back-testing results in 10 or more exceptions (the red zone), the ADI must submit to APRA analysis which identifies the causes for each of the exceptions, and must also add a plus factor of one to the multiplication factor, unless otherwise directed by APRA.
APRA, in writing, may also require the ADI to take appropriate action in addition to the plus factor, depending on the nature of the exceptions. Where the exceptions arise from:
issues with the basic integrity of the model, APRA may require the ADI to make appropriate corrections to the model or, if there are severe problems relating to the basic integrity of the model, APRA may revoke the ADI’s model approval under paragraph 20 of this Prudential Standard;
the need for improvement in the accuracy of the model, APRA may require the ADI to improve its risk measurement techniques; and
unanticipated market movements, APRA may require the ADI to recalculate its VaR using volatilities and correlations based on a shorter historical observation period if the shifts in volatilities and/or correlations are deemed to be permanent.