BIPRU 13.6 CCR internal model method

BIPRU 13.6 sets out the rules relating to the CCR internal model method.

A firm may only use the CCR internal model method if it has a CCR internal model method permission.

1. (1)

   A reference in the Handbook to a provision of the CCR internal model method, in relation to a firm:

   1. (a)

      excludes any provision of the CCR internal model method set out in the Handbook which is not applied to that firm by its CCR internal model method permission;

   2. (b)

      includes any additional provision contained in the CCR internal model method permission; and

   3. (c)

      takes into account any other amendments made to the provisions in the Handbook relating to the CCR internal model method made by the CCR internal model method permission.

2. (2)

   To the extent that a firm's CCR internal model method permission does not allow it to use a particular approach in the Handbook relating to the CCR internal model method, the Handbook provision does not apply to the firm.

A firm may determine the exposure value for:

1. (1)

   financial derivative instruments;

2. (2)

   repurchase transactions;

3. (3)

   securities or commodities lending or borrowing transactions;

4. (4)

   margin lending transactions; and

5. (5)

   long settlement transactions

using the CCR internal model method.

[Note: BCD Annex III Part 2 point 2]

A firm may use the CCR internal model method to calculate the exposure value for:

1. (1)

   the transactions in BIPRU 13.6.6 R (1); or

2. (2)

   the transactions in BIPRU 13.6.6 R (2), (3) and (4); or

3. (3)

   the transactions in BIPRU 13.6.6 R (1) to (4).

   [Note: BCD Annex III Part 6 point 1 (part)]

In each of BIPRU 13.6.7 R (1), (2) and (3), a firm may include long settlement transactions as well.

[Note: BCD Annex III Part 6 point 1 (part)]

For all financial derivative instruments and for long settlement transactions which are outside the scope of a firm's CCR internal model method permission, a firm must use the CCR mark to market method or the CCR standardised method.

[Note: BCD Annex III Part 6 point 3 first sentence]

Under BIPRU 13.6.10 R, combined use of the CCR mark to market method and the CCR standardised method is only permitted where one of the methods is used for the cases set out in BIPRU 13.5.9 R to BIPRU 13.5.10 R.

[Note: BCD Annex III Part 6 point 3 second sentence]

Notwithstanding 2BIPRU 13.3.10 R2 (Combined use), a firm may choose not to apply the CCR internal model method to exposures that are immaterial in size and risk.

[Note: BCD Annex III Part 6 point 1 third sentence]

If permitted by its CCR internal model method permission, and subject to its terms, a firm may carry out the implementation of the CCR internal model method sequentially across different transaction types; and during this period the firm may use the CCR mark to market method or the CCR standardised method.

[Note: BCD Annex III Part 6 point 2]

Subject to BIPRU 13.6.10 R to BIPRU 13.6.16 G, a firm that has a CCR internal model method permission must not use the CCR mark to market method or the CCR standardised method for transactions within the scope of the firm's CCR internal model method permission.

[Note: BCD Annex III Part 6 point 4 (part)]

If a firm ceases to comply with the requirements set out in BIPRU 13.6, it must either present to the appropriate regulator a plan for a timely return to compliance or demonstrate that the effect of non-compliance is immaterial.

[Note: BCD Annex III Part 6 point 4 (part)]

1. (1)

   A firm must measure the exposure value at the level of the netting set.

2. (2)

   The model must specify the forecasting distribution for changes in the market value of the netting set attributable to changes in market variables, such as interest rates, foreign exchange rates.

3. (3)

   The model must then compute the exposure value for the netting set at each future date given the changes in the market variables.

4. (4)

   For margined counterparties, the model may also capture future collateral movements.

   [Note: BCD Annex III Part 6 point 5]

A firm may include eligible financial collateral as defined in BIPRU 5.4.8 R (Eligible collateral under financial collateral comprehensive method) and BIPRU 14.2.15 R to BIPRU 14.2.17 R in its forecasting distributions for changes in the market value of the netting set, if the quantitative, qualitative and data requirements for the CCR internal model method are met for the collateral.

[Note: BCD Annex III Part 6 point 6]

A firm must calculate the exposure value as the product of alpha (), as set out in BIPRU 13.6.31 R, times effective EPE:

Exposure value = effective EPE

[Note: BCD Annex III Part 6 point 7 first part]

A firm must compute effective EPE by estimating expected exposure (EEt) as the average exposure at future date t, where the average is taken across possible future values of relevant market risk factors. The model estimates EE at a series of future dates t1, t2, t3, etc.

[Note: BCD Annex III Part 6 point 7 third part]

A firm must compute effective EE recursively as:

Effective EEtk = max(effective EEtk-1; EEtk)

where:

the current date is denoted as t0 and Effective EEt0 equals current exposure.

[Note: BCD Annex III Part 6 point 8]

For the purposes of 2BIPRU 13.6.25 R2 :

1. (1)

   effective EPE is the average effective EE during the first year of future exposure;

2. (2)

   if all contracts in the netting set mature within less than one year, effective EPE2 is the average of effective EE2 until all contracts in the netting set mature.

   22

[Note: BCD Annex III Part 6 point 9, first part]

A firm must compute effective EPE as a weighted average of effective EE:

Effective EPE = (_k=1^{min(1 year;maturity)})((Effective EE_tk)*(t_k))

where:

the weights ?tk = tk tk-1 allow for the case when future exposure is calculated at dates that are not equally spaced over time.

[Note: BCD Annex III Part 6 point 9, second part]

A firm must calculate EE or peak exposure measures based on a distribution of exposures1 that accounts for the possible non-normality of the distribution of exposures.

[Note: BCD Annex III Part 6 point 10]

For the purposes of BIPRU 13.6.24 R, alpha () is 1.4 or any higher amount specified in the firm's CCR internal model method permission.

[Note: BCD Annex III Part 6 point 7 second part]

If a firm's CCR internal model method permission permits it, the firm may use its own estimates of , subject to a floor of 1.2, where must equal the ratio of internal capital from a full simulation of CCR exposure across counterparties (numerator) and internal capital based on EPE (denominator).

[Note: BCD Annex III Part 6 point 12 (part)]

For the purposes of BIPRU 13.6.33 R:

1. (1)

   in the denominator, EPE must be used as if it were a fixed outstanding amount;

2. (2)

   a firm must be able to demonstrate that its internal estimates of capture in the numerator material sources of stochastic dependency of distribution of market values of transactions or of portfolios of transactions across counterparties;

3. (3)

   internal estimates of must take account of the granularity of portfolios.

   [Note: BCD Annex III Part 6 point 12 (part)]

A firm must ensure that the numerator and denominator of are computed in a consistent fashion with respect to the modelling methodology, parameter specifications and portfolio composition. The approach used must be based on the firm's internal capital approach, be well-documented and be subject to independent validation. In addition, a firm must review their estimates on at least a quarterly basis, and more frequently when the composition of the portfolio varies over time. A firm must also assess the model risk.

[Note: BCD Annex III Part 6 point 13]

3Where appropriate, volatilities and correlations of market risk factors used in the joint simulation of market risk and credit risk must be conditioned on the credit risk factor to reflect potential increases in volatility or correlation in an economic downturn.

If the netting set is subject to a margin agreement, a firm must use one of the following EPE measures:

1. (1)

   effective EPE without taking into account the margin agreement;

2. (2)

   the margin threshold, if positive, under the margin agreement plus an add-on that reflects the potential increase in exposure over the margin period of risk:

   1. (a)

      the add-on is computed as the expected increase in the netting set's exposure beginning from a current exposure of zero over the margin period of risk;

   2. (b)

      a floor of five business days for netting sets consisting only of repo-style transactions subject to daily remargining and daily mark-to-market, and ten business days for all other netting sets is imposed on the margin period of risk used for this purpose.

3. (3) 1

   if the model captures the effects of margining when estimating EE, the model's EE measure may be used directly in the equation in BIPRU 13.6.28 R (Computation of effective EE), unless the firm's CCR internal model method permission does not apply this provision or does not permit that use.

   [Note: BCD Annex III Part 6 point 15]

A firm's EPE model must meet the operational requirements set out in BIPRU 13.6.41 R to BIPRU 13.6.66 R.

[Note: BCD Annex III Part 6 point 16]

1. (1)

   The firm must have a control unit that is responsible for the design and implementation of its CCR management system, including the initial and on-going validation of the model.

2. (2)

   This unit must control input data integrity and produce and analyse reports on the output of the firm's risk measurement model, including an evaluation of the relationship between measures of risk exposure and credit and trading limits.

3. (3)

   This unit must be:

   1. (a)

      independent from units responsible for originating, renewing or trading exposures and free from undue influence;

   2. (b)

      it must be adequately staffed; and

   3. (c)

      it must report directly to the senior management of the firm.

4. (4)

   The work of this unit must be closely integrated into the day-to-day credit risk management process of the firm; its output must, accordingly, be an integral part of the process of planning, monitoring and controlling the firm's credit and overall risk profile.

   [Note: BCD Annex III Part 6 point 17]

1. (1)

   A firm must have CCR management policies, processes and systems that are conceptually sound and implemented with integrity.

2. (2)

   A sound CCR management framework must include the identification, measurement, management, approval and internal reporting of CCR.

   [Note: BCD Annex III Part 6 point 18]

1. (1)

   A firm's risk management policies must take account of market risk, liquidity risk, and legal and operational risk that can be associated with CCR.

2. (2)

   The firm must not undertake business with a counterparty without assessing its creditworthiness and must take due account of settlement and pre-settlement credit risk.

3. (3)

   These risks must be managed as comprehensively as practicable at the counterparty level (aggregating CCR exposures with other credit exposures) and at the firm-wide level.

   [Note: BCD Annex III Part 6 point 19]

A firm's governing body and senior management must be actively involved in the CCR control process and must regard this as an essential aspect of the business to which significant resources need to be devoted. Senior management must be aware of the limitations and assumptions of the model used and the impact these can have on the reliability of the output. Senior management must also consider the uncertainties of the market environment and operational issues and be aware of how these are reflected in the model.

[Note: BCD Annex III Part 6 point 20]

A firm must ensure that the daily reports prepared on its exposures to CCR are reviewed by a level of management with sufficient seniority and authority to enforce both reductions of positions taken by individual credit managers or traders and reductions in the firm's overall CCR exposure.

[Note: BCD Annex III Part 6 point 21]

1. (1)

   A firm's CCR management system must be used in conjunction with internal credit and trading limits.

2. (2)

   A firm must ensure that its credit and trading limits are related to its risk measurement model in a manner that is:

   1. (a)

      consistent over time; and

   2. (b)

      well understood by credit managers, traders and senior management.

      [Note: BCD Annex III Part 6 point 22]

1. (1)

   A firm's measurement of CCR must include measuring daily and intra-day usage of credit lines.

2. (2)

   The firm must measure current exposure gross and net of collateral.

3. (3)

   At portfolio and counterparty level, the firm must calculate and monitor peak exposure or potential future exposure (PFE) at the confidence interval chosen by the firm.

4. (4)

   The firm must take account of large or concentrated positions, including by groups of related counterparties, by industry, by market, etc.

   [Note: BCD Annex III Part 6 point 23]

1. (1)

   A firm must have a routine and rigorous program of stress testing in place as a supplement to the CCR analysis based on the day-to-day output of the firm's risk measurement model.

2. (2)

   The results of this stress testing must be reviewed periodically by senior management and must be reflected in the CCR policies and limits set by management and the governing body.

3. (3)

   Where stress tests reveal particular vulnerability to a given set of circumstances, prompt steps must be taken to manage those risks appropriately.

   [Note: BCD Annex III Part 6 point 24]

1. (1)

   A firm must have a routine in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the CCR management system.

2. (2)

   The firm's CCR management system must be well documented and must provide an explanation of the empirical techniques used to measure CCR.

   [Note: BCD Annex III Part 6 point 25]

A firm must conduct an independent review of the CCR management system regularly through its own internal auditing process. This review must include both the activities of the business units referred to in BIPRU 13.6.41 R and of the independent CCR control unit. A review of the overall CCR management process must take place at regular intervals and must specifically address, at a minimum:

1. (1)

   the adequacy of the documentation of the CCR management system and process;

2. (2)

   the organisation of the CCR control unit;

3. (3)

   the integration of CCR measures into daily risk management;

4. (4)

   the approval process for risk pricing models and valuation systems used by front and back-office personnel;

5. (5)

   the validation of any significant change in the CCR measurement process;

6. (6)

   the scope of CCR captured by the risk measurement model;

7. (7)

   the integrity of the management information system;

8. (8)

   the accuracy and completeness of CCR data;

9. (9)

   the verification of the consistency, timeliness and reliability of data sources used to run models, including the independence of such data sources;

10. (10)

    the accuracy and appropriateness of volatility and correlation assumptions;

11. (11)

    the accuracy of valuation and risk transformation calculations; and

12. (12)

    the verification of the model's accuracy through frequent back-testing.

    [Note: BCD Annex III Part 6 point 26]

The distribution of exposures1 generated by the model used to calculate effective EPE must be closely integrated into the day-to-day CCR management process of the firm. The model's output must accordingly play an essential role in the credit approval, CCR management, internal capital allocation, and corporate governance of the firm.

[Note: BCD Annex III Part 6 point 27]

A firm must have a track record in the use of models that generate a distribution of exposures1 to CCR. Thus, the firm must be able to demonstrate that it has been using a model to calculate the distribution of exposures1 upon which the EPE calculation is based that meets, broadly, the minimum requirements set out in BIPRU 13.6 for at least one year prior to the date of its CCR internal model method permission.

[Note: BCD Annex III Part 6 point 28]

1. (1)

   A firm must ensure that the model used to generate a distribution of exposures1 to CCR is part of a CCR management framework that includes the identification, measurement, management, approval and internal reporting of CCR. This framework must include the measurement of usage of credit lines (aggregating CCR exposures with other credit exposures) and internal capital allocation.

2. (2)

   In addition to EPE, a firm must measure and manage current exposures.

3. (3)

   Where appropriate, the firm must measure current exposure gross and net of collateral.

4. (4)

   The use test is satisfied if a firm uses other CCR measures, such as peak exposure or PFE (see BIPRU 13.6.47 R), based on the distribution of exposures1 generated by the same model to compute EPE.

   [Note: BCD Annex III Part 6 point 29]

A firm must have the systems capability to estimate EE daily if necessary, unless it is able to demonstrate to the appropriate regulator that its exposures to CCR warrant less frequent calculation. The firm must compute EE along a time profile of forecasting horizons that adequately reflects the time structure of future cash flows and maturity of the contracts and in a manner that is consistent with the materiality and composition of the exposures.

[Note: BCD Annex III Part 6 point 30]

1. (1)

   Exposure must be measured, monitored and controlled over the life of all contracts in the netting set (not just to the one year horizon).

2. (2)

   A firm must have procedures in place to identify and control the risks for counterparties where the exposure rises beyond the one-year horizon.

3. (3)

   A firm must input the forecast increase in exposure into the firm's internal capital model.

   [Note: BCD Annex III Part 6 point 31]

1. (1)

   A firm must have in place sound stress testing processes for use in the assessment of capital adequacy for CCR.

2. (2)

   These stress measures must be compared with the measure of EPE and considered by the firm as part of the process set out in GENPRU 1.2.42 R.

3. (3)

   Stress testing must also involve identifying possible events or future changes in economic conditions that could have unfavourable effects on a firm's credit exposures and an assessment of the firm's ability to withstand such changes.

   [Note: BCD Annex III Part 6 point 32]

1. (1)

   A firm must stress test its CCR exposures, including jointly stressing market risk and credit risk factors.

2. (2)

   In its stress tests of CCR, a firm must consider concentration risk (to a single counterparty or groups of counterparties), correlation risk across market risk and credit risk, and the risk that liquidating the counterparty's positions could move the market.

3. (3)

   In its stress tests a firm must also consider the impact on its own positions of such market moves and integrate that impact in its assessment of CCR.

   [Note: BCD Annex III Part 6 point 33]

A firm must give due consideration to exposures that give rise to a significant degree of general wrong-way risk.

[Note: BCD Annex III Part 6 point 34]

A firm must have procedures in place to identify, monitor and control cases of specific wrong-way risk, beginning at the inception of a transaction and continuing through the life of the transaction.

[Note: BCD Annex III Part 6 point 35]

A firm must ensure that:

1. (1)

   the model reflects transaction terms and specifications in a timely, complete, and conservative fashion;

2. (2)

   such terms include at least:

   1. (a)

      contract notional amounts;

   2. (b)

      maturity;

   3. (c)

      reference assets;

   4. (d)

      margining arrangements; and

   5. (e)

      netting arrangements;

3. (3)

   the terms and specifications are maintained in a database that is subject to formal and periodic audit;

4. (4)

   the process for recognising netting arrangements requires:

   1. (a)

      signoff by legal staff to verify the legal enforceability of netting and

   2. (b)

      input into the database by an independent unit;

5. (5)

   the transmission of transaction terms and specifications data to the model is also subject to internal audit; and

6. (6)

   formal reconciliation processes are in place between the model and source data systems to verify on an ongoing basis that transaction terms and specifications are being reflected in EPE correctly or at least conservatively.

   [Note: BCD Annex III Part 6 point 36]

A firm must ensure that:

1. (1)

   the model employs current market data to compute current exposures;

2. (2)

   when using historical data to estimate volatility and correlations, at least three years of historical data are used and updated quarterly or more frequently if market conditions warrant;

3. (3)

   the data covers a full range of economic conditions, such as a full business cycle;

4. (4)

   a unit independent from the business unit validates the price supplied by the business unit;

5. (5)

   the data is acquired independently of the lines of business, fed into the model in a timely and complete fashion, and maintained in a database subject to formal and periodic audit;

6. (6)

   it has a well-developed data integrity process to clean the data of erroneous and/or anomalous observations; and

7. (7)

   to the extent that the model relies on proxy market data, including for new products where three years of historical data may not be available, internal policies identify suitable proxies and the firm demonstrates empirically that the proxy provides a conservative representation of the underlying risk under adverse market conditions.

   [Note: BCD Annex III Part 6 point 37]

If the model includes the effect of collateral on changes in the market value of the netting set, a firm must have adequate historical data to model the volatility of the collateral.

A firm must ensure that the model is subject to a validation process which:

1. (1)

   is clearly articulated in firms' policies and procedures;

2. (2)

   specifies the kind of testing needed to ensure model integrity

3. (3)

   identifies conditions under which assumptions are violated and may result in an understatement of EPE; and

4. (4)

   includes a review of the comprehensiveness of the model.

   [Note: BCD Annex III Part 6 point 38]

A firm must monitor the appropriate risks and have processes in place to adjust its estimation of EPE when those risks become significant. This includes the following:

1. (1)

   the firm must identify and manage its exposures to specific wrong-way risk;

2. (2)

   for exposures with a rising risk profile after one year, the firm must compare on a regular basis the estimate of EPE over one year with EPE over the life of the exposure; and

3. (3)

   for exposures with a residual maturity below one year, the firm must compare on a regular basis the replacement cost (current exposure) and the realised exposure profile, and/or store data that would allow such a comparison.

   [Note: BCD Annex III Part 6 point 39]

A firm must have internal procedures to verify that, prior to including a transaction in a netting set, the transaction is covered by a legally enforceable netting contract that meets the requirements set out in BIPRU 13.7.

[Note: BCD Annex III Part 6 point 40]

A firm that makes use of collateral to mitigate its CCR must have internal procedures to verify that, prior to recognising the effect of collateral in its calculations, the collateral meets the legal certainty standards set out in BIPRU 5 as modified, where relevant, by BIPRU 4.10.

[Note: BCD Annex III Part 6 point 41]

1. (1)

   A firm's CCR internal model method model must meet the validation requirements in (2) to (8).

2. (2)

   The qualitative validation requirements set out in BIPRU 7.10 must be met.

3. (3)

   Interest rates, foreign currency rates, equity prices, commodities, and other market risk factors must be forecast over long time horizons for measuring CCR exposure. The performance of the forecasting model for market risk factors must be validated over a long time horizon.

4. (4)

   The pricing models used to calculate CCR exposure for a given scenario of future shocks to market risk factors must be tested as part of the CCR internal model method model validation process. Pricing models for options must account for the nonlinearity of option value with respect to market risk factors.

5. (5)

   The CCR internal model method model must capture transaction-specific information in order to aggregate exposures at the level of the netting set. A firm must verify that transactions are assigned to the appropriate netting set within the model.

6. (6)

   The CCR internal model method model must also include transaction-specific information to capture the effects of margining. It must take into account both the current amount of margin and margin that would be passed between counterparties in the future. Such a model must account for the nature of margin agreements (unilateral or bilateral), the frequency of margin calls, the margin period of risk, the minimum threshold of unmargined exposure the firm is willing to accept, and the minimum transfer amount. Such a model must either model the mark-to-market change in the value of collateral posted or apply the rules set out in BIPRU 5 as modified, where relevant, by BIPRU 4.10.

7. (7)

   Static, historical backtesting on representative counterparty portfolios must be part of the CCR internal model method model validation process. At regular intervals, a firm must conduct such backtesting on a number of representative counterparty portfolios (actual or hypothetical). These representative portfolios must be chosen based on their sensitivity to the material risk factors and correlations to which the firm is exposed.

8. (8)

   If backtesting indicates that the CCR internal model method model is not sufficiently accurate, a firm must increase the credit risk capital component and, where BIPRU 13 is applied for the purposes of BIPRU 14, the counterparty risk capital component by an amount which is conservatively estimated to compensate for the inaccuracy of the model.

   [Note: BCD Annex III Part 6 point 42 (part)]