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