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BIPRU 13.1 Application and Purpose

Application

BIPRU 13.1.1 R RP

1 BIPRU 13 applies to a BIPRU firm.

BIPRU 13.1.2 R RP

  1. (1)

    BIPRU 13 applies to items in the non-trading book.

  2. (2)

    BIPRU 13 applies to trading book items for the purposes of BIPRU 14.

BIPRU 13.1.3 G RP

The requirement to calculate the counterparty credit risk capital charge for trading book items is set out in BIPRU 14.

Purpose

BIPRU 13.1.4 G RP

BIPRU 13 implements:

  1. (1)

    Article 78(2) and (4);

  2. (2)

    point 3 of Part 1, and Parts 2, 3, 5, 6 and 7 of Annex III; and

  3. (3)

    Annex IV;

of the Banking Consolidation Directive.

BIPRU 13.1.5 G RP

BIPRU 13.3 sets out the calculations of exposure values for financial derivative instrument, long settlement transactions and certain other transactions under the standardised approach and, subject to BIPRU 4, under the IRB approach. BIPRU 13.4, 13.5 and 13.6 set out the provisions relating to the CCR mark to market method, the CCR standardised method and the CCR internal model method in turn.

BIPRU 13.1.6 G RP

BIPRU 13.8 sets out a summary of the treatment of securities financing transactions.

BIPRU 13.2 Unusual Transactions

BIPRU 13.2.1 R RP

If the calculation of the amount of an exposure or of a combination of exposures under BIPRU 13 would materially understate the amount of the counterparty credit risk the firm must increase the amount of the credit risk capital requirement by an amount sufficient to compensate for that understatement.

BIPRU 13.2.2 R RP

If a firm in relation to an exposure covered by BIPRU 13:

  1. (1)

    has an exposure of a non-standard type; or

  2. (2)

    an exposure that is part of a non-standard arrangement; or

  3. (3)

    has an exposure that, taken together with other exposures (whether or not they are subject to BIPRU 13), gives rise to a non-standard counterparty credit risk; or

  4. (4)

    is subject to the rule in BIPRU 13.2.1 R;

it must notify the FSA as soon as practicable of that fact, the counterparty involved, the nature of the exposure or arrangement and the treatment of those exposures it has adopted for the purpose of the calculation of the credit risk capital requirement.

BIPRU 13.2.3 R RP

BIPRU 13.2.2 R does not apply to exposures which are within the scope of a firm'sCCR internal model method permission.

BIPRU 13.2.4 R RP

A firm must judge the question of what is non-standard for the purposes of BIPRU 13.2.2 R by reference to the standards:

  1. (1)

    prevailing at the time the rule is being applied; and

  2. (2)

    of firms generally who carry on business which might give rise to exposures covered by BIPRU 13 rather than merely by reference to the firm's own business.

BIPRU 13.2.5 G RP

The methodologies which have been developed assume instruments with standard characteristics. There are many examples, however, of instruments which, although based on a standard contract, contain structural features which make the rules, as stated, inappropriate. In such circumstances a firm should consult the FSA.

BIPRU 13.3 Calculation of exposure values for financial derivatives and long settlement transactions: General provisions

Financial derivative instruments

BIPRU 13.3.1 R RP

A firm must determine the exposure value of a financial derivative instrument in accordance with BIPRU 13, with the effects of contracts of novation and other netting agreements taken into account for the purposes of those methods in accordance with BIPRU 13.

[Note: BCD Article 78(2) first sentence]

BIPRU 13.3.2 R RP

Subject to BIPRU 13.3, a firm must determine the exposure value for financial derivative instruments with the CCR mark to market method, the CCR standardised method or the CCR internal model method.

[Note: BCD Annex III, Part 2 point 1]

Definition of financial derivative instrument

BIPRU 13.3.3 R RP

Each of the following is a financial derivative instrument:

  1. (1)

    an interest-rate contract, being:

    1. (a)

      a single-currency interest rate swap;

    2. (b)

      a basis-swap;

    3. (c)

      a forward rate agreement;

    4. (d)

      an interest-rate future;

    5. (e)

      a purchased interest-rate option; and

    6. (f)

      other contracts of similar nature.

  2. (2)

    a foreign currency contract or contract concerning gold, being:

    1. (a)

      a cross-currency interest-rate swap;

    2. (b)

      a forward foreign currency contract;

    3. (c)

      a currency future;

    4. (d)

      a currency option purchased;

    5. (e)

      other contracts of a similar nature; and

    6. (f)

      a contract concerning gold of a nature similar to (2)(a) to (e).

  3. (3)

    a contract of a nature similar to those in 1(a) to (e) and 2(a) to (d) concerning other reference items or indices, including as a minimum all instruments specified in points 4 to 7, 9 and 10 of Section C of Annex I to the MIFID not otherwise included in (1) or (2).

    [Note: BCD Annex IV]

Long settlement transactions

BIPRU 13.3.4 R RP

Long settlement transaction means a transaction where a counterparty undertakes to deliver a security, a commodity, or a foreign currency amount against cash, other financial instruments, or commodities, or vice versa, at a settlement or delivery date that is contractually specified as more than the lower of the market standard for this particular transaction and five business days after the date on which the firm enters into the transaction.

[Note: BCD Annex III Part 1 point 3]

BIPRU 13.3.5 R RP

A firm must calculate the exposure value of a long settlement transaction in accordance with either:

  1. (1)

    BIPRU 13; or

  2. (2)

    the master netting agreement internal models approach, if it has a master netting agreement internal models approachwaiver which permits it to apply that approach.

    [Note: BCD Article 78(2) second sentence, in respect of long settlement transaction]

BIPRU 13.3.6 R RP

A firm may determine exposures arising from long settlement transactions using any of the CCR mark to market method, the CCR standardised method and the CCR internal model method, regardless of the methods chosen for treating financial derivatives instruments and repurchase transactions, securities or commodities lending or borrowing transactions, and margin lending transactions. In calculating capital requirements for long settlement transactions, a firm that uses the IRB approach may apply the risk weights under the standardised approach on a permanent basis and irrespective of the materiality of such positions.

[Note: BCD Annex III Part 2 point 7]

BIPRU 13.3.7 G RP

A firm is not required to calculate the exposure value of a transaction as a long settlement transaction for the purposes of BIPRU 13 if the transaction is a financial derivative instrument or a securities financing transaction and the firm chooses to calculate the capital requirement for the transaction according to the methods applicable to those exposures.

General netting

BIPRU 13.3.8 R RP

Under the CCR mark to market method, the CCR standardised method and the CCR internal model method, a firm must determine the exposure value for a given counterparty as equal to the sum of the exposure values calculated for each netting set with that counterparty.

[Note: BCD Annex III Part 2 point 5]

BIPRU 13.3.9 R

A firm may only recognise netting for the purposes of BIPRU 13.4, BIPRU 13.5 and BIPRU 13.6 if the requirements in BIPRU 13.7 are met.

Combined use

BIPRU 13.3.10 R RP

The combined use of the CCR mark to market method, the CCR standardised method and the CCR internal model method is not permitted. The combined use of the CCR mark to market method and the CCR standardised method is 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 2 point 1(part)]

BIPRU 13.3.11 G

The combined use of different approaches may be used across a group as described in BIPRU 8.7.8 G and BIPRU 8.7.9 G.

Exposure to a central counterparty

BIPRU 13.3.12 R RP

Notwithstanding BIPRU 13.3.1 R and BIPRU 13.3.5 R, a firm may determine the exposure value of a credit risk exposure outstanding with a central counterparty in accordance with BIPRU 13.3.13 R, provided that the central counterparty'scounterparty credit riskexposure with all participants in its arrangements are fully collateralised on a daily basis.

[Note: BCD Article 78(4) in respect of financial derivatives and long settlement transactions]

BIPRU 13.3.13 R RP

A firm may attribute an exposure value of zero for CCR to derivative contracts and long settlement transactions, or to other exposures arising in respect of those contracts or transactions (but excluding an exposure arising from collateral held to mitigate losses in the event of the default of other participants in the central counterparty's arrangements) where they are outstanding with a central counterparty and have not been rejected by the central counterparty.

[Note: BCD Annex III Part 2 point 6 in respect of financial derivatives and long settlement transactions]

Exceptions

BIPRU 13.3.14 R RP

When a firm purchases credit derivative protection against a non-trading book ,exposure or against a CCRexposure, it must compute its capital requirement for the hedged asset in accordance with:

  1. (1)

    BIPRU 5.7.16 R to BIPRU 5.7.25 R and BIPRU 4.10.49 R (4) to (6) (Unfunded credit protection: Valuation and calculation of risk-weighted exposure amounts and expected loss amounts); or1

  2. (2)

    1where a firm calculates risk weighted exposure amounts in accordance with the IRB approach:1

    1. (a)

      1BIPRU 4.4.79 R (Double default); or

    2. (b)

      1BIPRU 4.10.40 R to BIPRU 4.10.48 R. (Unfunded credit protection: Minimum requirements for assessing the effect of guarantees and credit derivatives).

  3. (3)

    [deleted]1

    [Note: BCD Annex III Part 2 point 3 (part)]

    1
BIPRU 13.3.15 R RP
  1. (1)

    1In the cases in BIPRU 13.3.14R, and where the option in the second sentence of BIPRU 14.2.10 R is not applied, the exposure value for CCR for these creditderivatives is set to zero.

  2. (2)

    1However, a firm may choose consistently to include for the purposes of calculating capital requirements for counterparty credit risk all credit derivatives not included in the trading book and purchased as protection against a non-trading exposure or against a CCRexposure where the credit protection is recognised under the BCD.

    [Note: BCD Annex III Part 2 point 3 (part)]

BIPRU 13.3.16 R RP

A firm must set the exposure value for CCR from sold credit default swaps in the non-trading book, where they are treated as credit protection provided by the firm and subject to a capital requirement for credit risk for the full notional amount, to zero.

[Note: BCD Annex III Part 2 point 4]

BIPRU 13.4 CCR mark to market method

General

BIPRU 13.4.1 R RP
BIPRU 13.4.2 R RP

A firm must obtain the current replacement cost of all contracts with positive values by attaching current market values1 to contracts (marking to market).

[Note: BCD Annex III Part 3, Step (a)]

BIPRU 13.4.3 R RP

A firm must obtain a figure for potential future credit exposure by multiplying the notional principal amounts or underlying values by the percentages in the table in BIPRU 13.4.5 R.

[Note: BCD Annex III Part 3, Step (b) (part)]

BIPRU 13.4.4 R RP

BIPRU 13.4.3 R does not apply in the case of single-currency "floating/floating" interest rate swaps.

[Note: BCD Annex III Part 3, Step (b) (part)]

Table: multiples to be applied to notional principal amounts or underlying values

BIPRU 13.4.5 R RP

This table belongs to BIPRU 13.4.5 R

Residual maturity

Interest-rate contracts

Contracts concerning foreign currency rates and gold

Contracts concerning equities

Contracts concerning precious metals except gold

Contracts concerning commodities other than precious metals

One year or less

0%

1%

6%

7%

10%

Over one year, not exceeding five years

0,5%

5%

8%

7%

12%

Over five years

1.5%

7.5%

10%

8%

15%

[Note: BCD Annex III Part 3, Table 1]

BIPRU 13.4.6 R RP

A firm must treat a contract which does not fall within one of the five categories indicated in the table in BIPRU 13.4.5 R as a contract concerning commodities other than precious metals.

[Note: BCD Annex III Part 3, Table 1 footnote 25]

BIPRU 13.4.7 R RP

For contracts with multiple exchanges of principal, a firm must multiply the percentages in the table in BIPRU 13.4.5 R by the number of remaining payments still to be made according to the contract.

[Note: BCD Annex III Part 3, Table 1 footnote 26]

BIPRU 13.4.8 R RP

For contracts that are structured to settle outstanding exposure following specified payment dates and where the terms are reset such that the market value of the contract is zero on these specified dates, a firm must treat the residual maturity as equal to the time until the next reset date.

[Note: BCD Annex III Part 3, Table 1 footnote 27 (part)]

BIPRU 13.4.9 R RP

In the case of interest-rate contracts that meet the criteria in BIPRU 13.4.8 R and have a remaining maturity of over one year, a firm must apply a percentage no lower than 0.5%.

[Note: BCD Annex III Part 3, Table 1 footnote 27 (part)]

BIPRU 13.4.10 R RP

For the purpose of calculating the potential future credit exposure in accordance with BIPRU 13.4.3 R a firm may apply the percentages in the table in BIPRU 13.4.11 R instead of those prescribed in the table in BIPRU 13.4.5 R provided that it makes use of the commodity extended maturity ladder approach for contracts relating to commodities other than gold.

Table: alternative multiples to be applied to notional principal amounts or underlying values

BIPRU 13.4.11 R RP

This table belongs to BIPRU 13.4.10 R

Residual maturity

Precious metals (except gold)

Base metals

Agricultural products (softs)

Other, including energy products

One year or less

2%

2,5%

3%

4%

Over one year, not exceeding five years

5%

4%

5%

6%

Over five years

7.5%

8%

9%

10%

[Note: BCD Annex III Part 3, Table 2]

BIPRU 13.4.12 R RP

A firm must calculate the exposure value as the sum of:

  1. (1)

    the current replacement cost calculated under BIPRU 13.4.2 R; and

  2. (2)

    the potential future credit exposure calculated under BIPRU 13.4.3 R.

    [Note: BCD Annex III Part 3, Step (c)]

BIPRU 13.4.13 G RP

Contracts with a negative replacement cost should still be subject to an add-on if there is a possibility of the replacement costs becoming positive before maturity. Written options should therefore be exempt from add-ons.

BIPRU 13.4.14 G RP

For the purposes of calculating the replacement cost, where an exposure relates to collateral posted to cover a negative mark to market position on a derivative contract, the negative mark to market exposure may be offset against the collateral exposure if the requirements in BIPRU 5 are met.

Alternative approach

BIPRU 13.4.15 R RP

A firm must ensure that the notional amount to be taken into account is an appropriate yardstick for the risk inherent in the contract. Where, for instance, the contract provides for a multiplication of cash flows, a firm must adjust the notional amount in order to take into account the effects of the multiplication on the risk structure of that contract.

[Note: BCD Annex III Part 2 point 8]

Netting: Contracts for novation

BIPRU 13.4.16 R RP

The single net amounts fixed by contracts for novation, rather than the gross amounts involved, may be weighted. For the purposes of the CCR mark to market method, a firm may obtain:

  1. (1)

    in BIPRU 13.4.2 R, the current replacement cost; and

  2. (2)

    in BIPRU 13.4.3 R, the notional principal amounts or underlying values;

by taking account of the contract for novation.

[Note: BCD Annex III Part 7 point c(i)]

Netting: Other netting agreements

BIPRU 13.4.17 R RP

In application of the CCR mark to market method:

  1. (1)

    in BIPRU 13.4.2 R a firm may obtain the current replacement cost for the contracts included in a netting agreement by taking account of the actual hypothetical net replacement cost which results from the agreement; in the case where netting leads to a net obligation for the firm calculating the net replacement cost, the current replacement cost is calculated as "0"; and

  2. (2)

    in BIPRU 13.4.3 R a firm may reduce the figure for potential future credit exposure for all contracts included in a netting agreement according to the following formula:

    PCEred = 0.4 * PCEgross + 0.6 * NGR * PCEgross,

    where:

    1. (a)

      PCEred = the reduced figure for potential future credit exposure for all contracts with a given counterparty included in a legally valid bilateral netting agreement;

    2. (b)

      PCEgross =the sum of the figures for potential future credit exposure for all contracts with a given counterparty which are included in a legally valid bilateral netting agreement and are calculated by multiplying their notional principal amounts by the percentages set out in the table in BIPRU 13.4.5 R; and

    3. (c)

      NGR = "net-to-gross ratio": the quotient of the net replacement cost for all contracts included in a legally valid bilateral netting agreement with a given counterparty (numerator) and the gross replacement cost for all contracts included in a legally valid bilateral netting agreement with that counterparty (denominator).

      [Note: BCD Annex III Part 7 point c(ii) (part)]

BIPRU 13.4.18 R RP

For the calculation of the potential future credit exposure according to the formula in BIPRU 13.4.17 R perfectly matching contracts included in the netting agreement may be taken into account as a single contract with a notional principal equivalent to the net receipts.

[Note: BCD Annex III Part 7 point c(ii) (part)]

BIPRU 13.4.19 R RP

For the purposes of BIPRU 13.4.18 R a perfectly matching contract is a forward foreign currency contract or similar contract in which a notional principal is equivalent to cash flows if the cash flows fall due on the same value date and fully or partly in the same currency.

[Note: BCD Annex III Part 7 point c(ii) (part)]

BIPRU 13.5 CCR standardised method

Scope

BIPRU 13.5.1 R RP

A firm may use the CCR standardised method only for financial derivative instruments and long settlement transactions.

[Note: BCD Annex III Part 5 point 1 (part)]

Derivation of risk position: payment legs

BIPRU 13.5.2 R RP

  1. (1)

    When a financial derivative instrument transaction with a linear risk profile stipulates the exchange of a financial instrument for a payment, the payment Part is referred to as the payment leg.

  2. (2)

    Transactions that stipulate the exchange of payment against payment consist of two payment legs.

  3. (3)

    The payment legs consist of the contractually agreed gross payments, including the notional amount of the transaction.

  4. (4)

    A firm may disregard the interest rate risk from payment legs with a remaining maturity of less than one year for the purposes of the calculations in BIPRU 13.5.

  5. (5)

    A firm may treat transactions that consist of two payment legs that are denominated in the same currency, such as interest rate swaps, as a single aggregate transaction. The treatment for payment legs applies to the aggregate transaction.

    [Note: BCD Annex III Part 5 point 2]

Derivation of risk position: mapping

BIPRU 13.5.3 R RP

  1. (1)

    Transactions with a linear risk profile with equities (including equity indices), gold, other precious metals or other commodities as the underlying financial instruments must be mapped to a risk position in the respective equity (or equity index) or commodity (including gold and other precious metals) and an interest rate risk position for the payment leg.

  2. (2)

    If the payment leg is denominated in a foreign currency, it must be additionally mapped to a risk position in the respective currency.

    [Note: BCD Annex III Part 5 point 3]

BIPRU 13.5.4 R RP

  1. (1)

    Transactions with a linear risk profile with a debt instrument as the underlying instrument must be mapped to an interest rate risk position for the debt instrument and another interest rate risk position for the payment leg.

  2. (2)

    Transactions with a linear risk profile that stipulate the exchange of payment against payment, including foreign exchange forwards, must be mapped to an interest rate risk position for each of the payment legs.

  3. (3)

    If the underlying debt instrument is denominated in a foreign currency, the debt instrument must be mapped to a risk position in that foreign currency.

  4. (4)

    If a payment leg is denominated in foreign currency, the payment leg must be again mapped to a risk position in that foreign currency.

  5. (5)

    The exposure value to be assigned to a foreign exchange basis swap transaction is zero.

    [Note: BCD Annex III Part 5 point 4]

Derivation of risk position: calculating the size of the risk position

BIPRU 13.5.5 R RP

A firm must calculate the risk position of the transaction or instrument in column 1 of the table in BIPRU 13.5.6 R in accordance with column 2 of that table.

BIPRU 13.5.6 R RP

This table belongs to BIPRU 13.5.5 R.

Transaction or instrument

Calculation of size of risk position

Transaction with linear risk profile except for debt instruments.

The effective notional value (market price multiplied by quantity) of the underlying financial instruments (including commodities) converted to the firm's domestic currency.

Debt instruments and payment legs.

The effective notional value of the outstanding gross payments (including the notional amount) converted to the firm'sbase currency, multiplied by the modified duration of the debt instrument, or payment leg, respectively.

Credit default swap

The notional value of the reference debt instrument multiplied by the remaining maturity of the credit default swap.

2Nth to default credit default swap

The effective notional value of the reference debt instrument, multiplied by the modified duration of the nth to default derivative with respect to a change in the credit spread of the reference debt instrument.

Subject to BIPRU 13.5.9 R to BIPRU 13.5.10 R, financial derivative instrument with a non-linear risk profile, including options and swaptions except in the case of an underlying debt instrument.

Equal to the delta equivalent effective notional value of the financial instrument that underlies the transaction.

Subject to BIPRU 13.5.9 R to BIPRU 13.5.10 R, financial derivative instrument with a non-linear risk profile, including options and swaptions, of which the underlying is a debt instrument or a payment leg.

Equal to the delta equivalent effective notional value of the financial instrument or payment leg multiplied by the modified duration of the debt instrument, or payment leg, respectively.

[Note: BCD Annex III Part 5 points 5 to 9 and 15 (part)2]

Derivation of risk position: effective notional value

BIPRU 13.5.7 R RP

A firm may use the following formulae to determine the size and sign of a risk position:

  1. (1)

    for all instruments other than debt instruments:

    effective notional value, or delta equivalent

    notional value = pref((V)/(p))

    where:

    1. (a)

      Pref = price of the underlying instrument, expressed in the reference currency;

    2. (b)

      V = value of the financial instrument (in the case of an option this is the option price; in the case of a transaction with a linear risk profile this is the value of the underlying instrument itself);

    3. (c)

      p = price of the underlying instrument, expressed in the same currency as V;

  2. (2)

    for debt instruments and the payment legs of all transactions:

    effective notional value multiplied by the modified duration, or delta equivalent in notional value multiplied by the modified duration

    (V)/(r)

    where:

    1. (a)

      V = value of the financial instrument (in the case of an option this is the option price; in the case of a transaction with a linear risk profile this is the value of the underlying instrument itself or of the payment leg, respectively);

    2. (b)

      r = interest rate level.

  3. (3)

    If V is denominated in a currency other than the reference currency, the derivative must be converted into the reference currency by multiplication with the relevant exchange rate.

    [Note: BCD Annex III Part 5 point 11]

Derivation of risk position: treatment of collateral

BIPRU 13.5.8 R RP

For the determination of risk positions, a firm must treat collateral received from a counterparty like a claim on the counterparty under a derivative contract (long position) that is due today, while collateral posted must be treated as an obligation to the counterparty (short position) that is due today.

[Note: BCD Annex III Part 5 point 10]

Derivation of risk position: non-linear risks

BIPRU 13.5.9 R RP

A firm must apply the CCR mark to market method to transactions with a non-linear risk profile or for payment legs and transactions with debt instruments as underlying if:

  1. (1)

    the firm does not have a CAD 1 model permission or a VaR model permission; or

  2. (2)

    where the firm does have a CAD 1 model permission or a VaR model permission but cannot determine the delta or the modified duration, respectively, with its CAD 1 model permission or VaR model permission.

    [Note: BCD Annex III Part 5 point 19 (part)]

BIPRU 13.5.10 R RP

A firm must not recognise netting for the purpose of applying the CCR mark to market method to an exposure treated under BIPRU 13.5.9 R (that is, the exposure value must be determined as if there were a netting set that comprises just the individual transaction).

[Note: BCD Annex III Part 5 point 19 (part)]

Hedging sets: assignment

BIPRU 13.5.11 R RP

A firm must group the risk positions into hedging sets and, for each hedging set, compute the absolute value amount of the sum of the resulting risk positions. This sum is termed the net risk position and is represented by:

((i)(RPTij) - (l)(RPClj))

in the formulae set out in BIPRU 13.5.24 R.

[Note: BCD Annex III Part 5 point 12]

Hedging sets: description

BIPRU 13.5.12 R RP

For interest rate risk positions from money deposits received from the counterparty as collateral, from payment leg and from underlying debt instruments, to which according to the table in BIPRU 7.2.44R1 a capital charge of 1.60% or less applies, there are six hedging sets for each currency, as set out in the table in BIPRU 13.5.13 R. Hedging sets are defined by a combination of the criteria maturity and referenced interest rates.

[Note: BCD Annex III Part 5 point 13]

Table: Hedging sets

BIPRU 13.5.13 R RP

This table belongs to BIPRU 13.5.12 R:

Government referenced interest rates

Non-government referenced interest rates

Maturity

<= 1 year

<= 1 year

Maturity

>1 <= 5 years

>1 <= 5 years

Maturity

> 5 years

> 5 years

[Note: BCD Annex III Part 5 Table 4]

BIPRU 13.5.14 R RP

For interest rate risk positions from underlying debt instruments or payment legs for which the interest rate is linked to a reference interest rate that represents a general market interest level, the remaining maturity is the length of the time interval up to the next re-adjustment of the interest rate. In all other cases, it is the remaining life of the underlying debt instrument, or in the case of a payment leg the remaining life of the transaction.

[Note: BCD Annex III Part 5 point 14]

BIPRU 13.5.15 R RP

There is one hedging set for each issuer of a reference debt instrument that underlies a credit default swap.Nth to default basket credit default swaps must be treated as follows:2

  1. (1)

    2the size of a risk position in a reference debt instrument in a basket underlying an nth to default credit default swap is the effective notional value of the reference debt instrument, multiplied by the modified duration of the nth to default derivative, with respect to a change in the credit spread of the reference debt instrument;

  2. (2)

    2there is one hedging set for each reference debt instrument in a basket underlying a given nth to default credit default swap; risk positions from different nth to default credit default swaps must not be included in the same hedging set; and

  3. (3)

    2the CCR multiplier applicable to each hedging set created for one of the reference debt instruments of an nth to default derivative is 0.3% for reference debt instruments that have a credit assessment from a recognised ECAI equivalent to credit quality step 1 to 3, and 0.6% for other debt instruments.

[Note: BCD Annex III Part 5 point 15]

BIPRU 13.5.16 R RP

Underlying financial instruments other than debt instruments must be assigned by a firm to the same respective hedging sets only if they are identical or similar instruments. In all other cases a firm must assign them to separate hedging sets.

[Note: BCD Annex III Part 5 point 17 (part)]

BIPRU 13.5.17 R RP

  1. (1)

    The similarity of instruments for the purposes of BIPRU 13.5.16 R is established in accordance with (2) to (5).

  2. (2)

    For equities, similar instruments are those of the same issuer. An equity index is treated as a separate issuer.

  3. (3)

    For precious metals, similar instruments are those of the same metal. A precious metal index is treated as a separate precious metal.

  4. (4)

    For electric power, similar instruments are those delivery rights and obligations that refer to the same peak or off-peak load time interval within any 24 hour interval.

  5. (5)

    For commodities, similar instruments are those of the same commodity. A commodity index is treated as a separate commodity.

    [Note: BCD Annex III Part 5 point 17 (part)]

Hedging sets: collateral

BIPRU 13.5.18 R RP

  1. (1)

    For interest rate risk positions from money deposits that are posted with a counterparty as collateral when that counterparty does not have debt obligations of low specific risk outstanding and from underlying debt instruments, to which according to the table in BIPRU 7.2.44 R1 a capital charge of more than 1.60% applies, there is one hedging set for each issuer.

  2. (2)

    When a payment leg emulates such a debt instrument, there is also one hedging set for each issuer of the reference debt instrument.

  3. (3)

    A firm may assign risk positions that arise from debt instruments of a certain issuer, or from reference debt instruments of the same issuer that are emulated by payment legs, or that underlie a credit default swap, to the same hedging set.

    [Note: BCD Annex III Part 5 point 16]

BIPRU 13.5.19 R RP

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 modified, where relevant, by BIPRU 4.10.

[Note: BCD Annex III Part 5 point 21]

Hedging sets: netting

BIPRU 13.5.20 R RP

A firm must have internal procedures to verify that, prior to including a transaction in a hedging 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 5 point 20]

Credit conversion factors : Table

BIPRU 13.5.21 R RP

A firm must apply the CCR multipliers for the different hedging set categories according to the Table in BIPRU 13.5.22 R.

[Note: BCD Annex III Part 5 point 18]

BIPRU 13.5.22 R RP

This table belongs to BIPRU 13.5.21 R.

Hedging set categories

CCR Multiplier (CCRM)

(1)

Interest Rates

0.2%

(2)

Interest Rates for risk positions from a reference debt instrument that underlies a credit default swap and to which a capital charge of 1.60%, or less, applies under BIPRU 7.2.44 R1.

0.3%

(3)

Interest Rates for risk positions from a debt instrument or reference debt instrument to which a capital charge of more than 1.60% applies under BIPRU 7.2.44 R.

0.6%

(4)

Exchange Rates

2.5%

(5)

Electric power

4.0%

(6)

Gold

5.0%

(7)

Equity

7.0%

(8)

Precious Metals (except gold)

8.5%

(9)

Other commodities (excluding precious metals and electricity power)

10.0%

(10)

Reference debt instruments of an nth to default derivative that have a credit assessment from a recognised ECAI equivalent to credit quality step 1 to 32

2

0.3%2

2(11)

Reference debt instruments of an nth to default derivative that do not have a credit assessment from a recognised ECAI equivalent to credit quality step 1 to 3

0.6%

2(12)

Underlying instruments of financial derivative instrument that are not in any of the above categories.

10.0%

[Note: BCD Annex III Part 5 Table 5 and Part 5 point 15 (c)2]

BIPRU 13.5.23 R RP

A firm must assign underlying instruments of financial derivatives instruments (in line 10 of the Table in BIPRU 13.5.22 R) to separate individual hedging sets for each category of underlying instrument.

Exposure value

BIPRU 13.5.24 R RP

A firm must calculate the exposure value separately for each netting set.

[Note: BCD Annex III Part 5 point 1, second sentence]

BIPRU 13.5.25 R RP

A firm must determine the exposure value net of collateral, as follows:

exposure value = *max(CMV-CMC;(j)((i)(RPTij)-(l)(RPClj))*CCRMj)

where:

CMV = current market value of the portfolio of transactions within the netting set with a counterparty gross of collateral.

That is, where:

CMV = (i)(CMVi)

where:

CMVi = the current market value of transaction i;

CMC = the current market value of the collateral assigned to the netting set.

That is, where:CMC = (l)(CMCl)

where

CMCl = the current market value of collateral l;

i = index designating transaction;

l = index designating collateral;

j = index designating hedging set category. These hedging sets correspond to risk factors for which risk positions of opposite sign can be offset to yield a net risk position on which the exposure measure is then based;

RPTij = risk position from transaction i with respect to hedging set j;

RPClj = risk position from collateral l with respect to hedging set j;

CCRMj = CCR Multiplier set out in the Table in BIPRU 13.5.22R with respect to the hedging set j;

= 1.4.

[Note: BCD Annex III Part 5 point 1 (part)]

BIPRU 13.5.26 R RP

Collateral received from a counterparty has a positive sign; collateral posted to a counterparty has a negative sign.

[Note: BCD Annex III Part 5 point 1 (part)]

BIPRU 13.5.27 R RP

A firm may only recognise collateral for this method if it is collateral that is eligible under BIPRU 5.4.8 R1 and BIPRU 14.2.12 G to BIPRU 14.2.13 R.

[Note: BCD Annex III Part 5 point 1 (part)]

BIPRU 13.5.28 G RP

A worked example showing a US Dollar (USD)-based firm, single counterparty, single netting set, Risk-positions RPij by hedging sets j is set out in BIPRU 13 Annex 1 G

BIPRU 13.6 CCR internal model method

Introduction

BIPRU 13.6.1 R RP

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

BIPRU 13.6.2 R RP
BIPRU 13.6.3 G RP

BIPRU 1.3 sets out the process for applying for a CCR internal model method permission.

BIPRU 13.6.4 G RP

A firm'sCCR internal model method permission will modify BIPRU 13.6.2 R and will require the firm to use only the CCR internal model method, except to the extent that BIPRU 13 permits the firm to combine the use of the CCR internal model method with one or more other methods.

BIPRU 13.6.5 R RP

  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'sCCR 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.

Scope

BIPRU 13.6.7 R RP

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)]

BIPRU 13.6.8 R RP

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)]

Use of other models

BIPRU 13.6.9 G RP

Point 2 of Part 6 of Annex III of the Banking Consolidation Directive provides that a firm using the CCR internal model method may use a type of model other than the type set out in BIPRU 13.6. If the FSA agrees to this the details of the model and the necessary calculations will be set out in the CCR internal model method permission, which will modify BIPRU 13.6 to the extent necessary. The FSA would not expect to agree to such a request unless the firm was able to satisfy the FSA that the method was at least as conservative as the method set out in BIPRU 13.6 and in particular that, for every counterparty, any method was more conservative than alpha multiplied by effective EPE calculated according to the equation in BIPRU 13.6.27 R.

[Note: BCD Annex III Part 6 point 2 (second sentence) and point 11]

Partial use

BIPRU 13.6.10 R RP

For all financial derivative instruments and for long settlement transactions which are outside the scope of a firm'sCCR 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]

BIPRU 13.6.11 R RP

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]

BIPRU 13.6.12 R RP

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]

BIPRU 13.6.13 R RP

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]

BIPRU 13.6.14 G RP

After the initial period following the granting of its CCR internal model method permission, as referred to in BIPRU 13.6.13 R, a firm should extend the use of the CCR internal model method to cover any new business within a product category covered by its CCR internal model method permission. Subject to BIPRU 13.6.10 R to BIPRU 13.6.13 R, the firm should do so within a reasonable period of time. If the firm decides to exclude any business on, for example, the basis of materiality, it should document its reasons clearly.

BIPRU 13.6.15 G RP

In principle, the use of different measures of exposure within the CCR internal model method is possible within the same product category, including on a permanent basis. The FSA may allow a firm, through the CCR internal model method permission, to use a more conservative measure of exposure that is less risk sensitive (for instance a measure based on conservative haircuts) for certain parts of the business if justified on a cost-benefit basis. However, a firm would still need to meet the use test for these more conservative measures and would need to demonstrate that the aggregation of CCRexposures that come from different approaches and have different degrees of conservatism makes sense and is used for its CCR management purposes.

BIPRU 13.6.16 G RP

The FSA may, through the CCR internal model method permission, require a firm to apply a multiplier to the measures of exposures coming out of a less risk-sensitive approach to calculating exposures as referred to in BIPRU 13.6.15 G where the FSA considers this to be appropriate due to the complexity of the business or the nature of the risks involved.

Use of CCR internal model method

BIPRU 13.6.17 R RP

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'sCCR internal model method permission.

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

BIPRU 13.6.18 G RP

A firm which wishes to revert to the CCR mark to market method or the CCR standardised method will need to request the FSA to revoke or vary its CCR internal model method permission.

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

BIPRU 13.6.19 G RP

The FSA will not agree to a firm's request to revoke or vary its CCR internal model method permission except for demonstrated good cause.

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

BIPRU 13.6.20 R RP

If a firm ceases to comply with the requirements set out in BIPRU 13.6, it must either present to the FSA 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)]

BIPRU 13.6.21 G RP

If a firm ceases to comply with the requirements set out in BIPRU 13.6, the FSA may revoke the CCR internal model method permission or take other appropriate supervisory action.

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

Exposure value

BIPRU 13.6.22 R RP

  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]

BIPRU 13.6.23 R RP

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]

BIPRU 13.6.24 R RP

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]

Effective EPE

BIPRU 13.6.25 R RP

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]

BIPRU 13.6.26 R RP

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]

BIPRU 13.6.27 R RP

For the purposes of 2BIPRU 13.6.25 R2 :

2
  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]

BIPRU 13.6.28 R RP

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

Effective EPE = (k=1min(1 year;maturity))((Effective EEtk)*(tk))

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]

BIPRU 13.6.29 R RP

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]

BIPRU 13.6.30 R

[deleted]3

3

Alpha

BIPRU 13.6.31 R RP

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

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

BIPRU 13.6.32 G RP

If the FSA does specify an alpha greater than 1.4, the reasons will be set out in the firm'sCCR internal model method permission.

BIPRU 13.6.33 R RP

If a firm'sCCR 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 CCRexposure across counterparties (numerator) and internal capital based on EPE (denominator).

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

BIPRU 13.6.34 R RP

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)]

BIPRU 13.6.35 R RP

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]

BIPRU 13.6.35A R RP

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.

[Note: BCD Annex III Part 6 point 14]

BIPRU 13.6.36 G RP

In reviewing its estimate of , a firm may not need to perform a full recalculation each quarter if it can demonstrate by other means that the estimate would not be materially different. A full recalculation should however be performed at least annually. If there is a structural change in the firm's portfolio that is likely to have the effect that the existing estimate of will be inappropriate, the firm should also recalculate it. A firm should have procedures in place to identify any such structural changes.

Maturity adjustment

BIPRU 13.6.37 G RP

A firm using the IRB approach for risk weighting of exposures arising from a CCR internal model method should also apply a different maturity adjustment as set out in BIPRU 4.4.67 RBIPRU 4.4.70 R.

Margin agreement

BIPRU 13.6.38 R RP

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'sexposure 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'sCCR internal model method permission does not apply this provision or does not permit that use.

    [Note: BCD Annex III Part 6 point 15]

BIPRU 13.6.39 G RP

Where the effects of margining are captured by the model itself, the FSA does not prescribe any floors for the margin period of risk but will challenge a firm that looks to use periods shorter than 5 days for repurchase agreements or reverse repurchase agreements or 10 days for financial derivative instruments.

Operational requirements: General

BIPRU 13.6.40 R RP

A firm'sEPE 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]

Operational requirements: CCR control

BIPRU 13.6.41 R RP

  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]

BIPRU 13.6.42 R RP

  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]

BIPRU 13.6.43 R RP

  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 CCRexposures with other credit exposures) and at the firm-wide level.

    [Note: BCD Annex III Part 6 point 19]

BIPRU 13.6.44 R RP

A firm'sgoverning 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]

BIPRU 13.6.45 R RP

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 CCRexposure.

[Note: BCD Annex III Part 6 point 21]

BIPRU 13.6.46 R RP

  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]

BIPRU 13.6.47 R RP

  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]

BIPRU 13.6.48 R RP

  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]

BIPRU 13.6.49 R RP

  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]

BIPRU 13.6.50 R RP

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]

Operational requirements: Use test

BIPRU 13.6.51 R RP

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]

BIPRU 13.6.52 R RP

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]

BIPRU 13.6.53 R RP

  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 CCRexposures 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]

BIPRU 13.6.54 R RP

A firm must have the systems capability to estimate EE daily if necessary, unless it is able to demonstrate to the FSA 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]

BIPRU 13.6.55 R RP

  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]

Operational requirements: Stress testing

BIPRU 13.6.56 R RP

  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]

BIPRU 13.6.57 R RP

  1. (1)

    A firm must stress test its CCRexposures, 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]

Operational requirements: Wrong-way risk

BIPRU 13.6.58 R RP

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]

BIPRU 13.6.59 R RP

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]

Operational requirements: Integrity of modelling process

BIPRU 13.6.60 R RP

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]

BIPRU 13.6.61 R RP

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]

BIPRU 13.6.62 R RP

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.

BIPRU 13.6.63 R RP

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]

BIPRU 13.6.64 R RP

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]

BIPRU 13.6.65 R RP

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]

BIPRU 13.6.66 R RP

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]

Validation requirements

BIPRU 13.6.67 R RP

  1. (1)

    A firm'sCCR 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 CCRexposure. 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 CCRexposure 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)]

BIPRU 13.6.68 G RP

If backtesting indicates that the CCR internal model method model is not sufficiently accurate, the FSA may revoke a firm'sCCR internal model method permission or take appropriate measures to ensure that the model is improved promptly. Measures taken by the FSA may include the use of its own-initiative power to require the firm to hold more capital resources.

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

BIPRU 13.7 Contractual netting

Scope

BIPRU 13.7.1 R RP

Types of netting recognised

BIPRU 13.7.2 R RP

For the purpose of BIPRU 13.7:

  1. (1)

    counterparty means any entity (including natural persons) that has the power to conclude a contractual netting agreement; and

  2. (2)

    contractual cross product netting agreement means a written bilateral agreement between a firm and a counterparty which creates a single legal obligation covering all included bilateral master agreements and transactions belonging to different product categories.

    [Note: BCD Annex III Part 7 point (a) (part)]

BIPRU 13.7.3 R RP

Contractual cross product netting agreements do not cover netting other than on a bilateral basis.

[Note: BCD Annex III Part 7 point (a) (part)]

BIPRU 13.7.4 R RP

For the purposes of cross product netting, the following are considered different product categories:

  1. (1)

    repurchase transactions, reverse repurchase transactions, securities or commodities lending or borrowing transactions;

  2. (2)

    margin lending transactions; and

  3. (3)

    financial derivative instruments.

    [Note: BCD Annex III Part 7 point (a) (part)]

BIPRU 13.7.5 R RP

A firm may recognise as risk-reducing the following types of contractual netting:

  1. (1)

    bilateral contracts for novation between a firm and its counterparty under which mutual claims and obligations are automatically amalgamated in such a way that this novation fixes one single net amount each time novation applies and thus creates a legally binding, single new contract extinguishing former contracts;

  2. (2)

    other bilateral agreements between a firm and its counterparty; and

  3. (3)

    a firm that has a CCR internal model method permission may recognise Contractual cross product netting agreements for transactions falling within the scope of its CCR internal model method permission; netting across transactions entered by members of a group is not recognised for the purposes of calculating capital requirements.

    [Note: BCD Annex III Part 7 point (a) (part)]

Conditions for recognition

BIPRU 13.7.6 R RP

A firm may treat contractual netting as risk-reducing only under the following conditions:

  1. (1)

    the firm must have a contractual netting agreement with its counterparty which creates a single legal obligation, covering all included transactions, such that, in the event of a counterparty's failure to perform owing to default, bankruptcy, liquidation or any other similar circumstance, the firm would have a claim to receive or an obligation to pay only the net sum of the positive and negative mark-to-market values of included individual transactions;

  2. (2)

    the firm must be in a position to provide to the FSA, if requested, written and reasoned legal opinions to the effect that, in the event of a legal challenge, the relevant courts and administrative authorities would, in the cases described under (1), find that the firm's claims and obligations would be limited to the net sum, as described in (1), under:

    1. (a)

      the law of the jurisdiction in which the counterparty is incorporated and, if a foreign branch of an undertaking is involved, also under the law of the jurisdiction in which the branch is located; or

    2. (b)

      the law that governs the individual transactions included; or

    3. (c)

      the law that governs any contract or agreement necessary to effect the contractual netting;

  3. (3)

    the firm must have procedures in place to ensure that the legal validity of its contractual netting is kept under review in the light of possible changes in the relevant laws;

  4. (4)

    the firm must maintain all required documentation in its files;

  5. (5)

    the effects of netting must be factored into the firm's measurement of each counterparty's aggregate credit risk exposure and the firm must manage its CCR on such a basis; and

  6. (6)

    the firm must aggregate credit risk to each counterparty to arrive at a single legal exposure across transactions; this aggregation must be factored into credit limit purposes and internal capital purposes.

    [Note: BCD Annex III Part 7 point (b) (part)]

BIPRU 13.7.7 R RP

If any of the competent authorities concerned is not satisfied that the contractual netting is legally valid under the law of each of the relevant jusrisdictions, the firm must not treat the contractual netting agreement as risk-reducing.

[Note: BCD Annex III Part 7 point (b) (part)]

BIPRU 13.7.8 R RP

A legal opinion required under BIPRU 13.7.6 R (2) may be in the form of a reasoned legal opinion drawn up by type of contractual netting.

[Note: BCD Annex III Part 7 point (b) (part)]

BIPRU 13.7.9 R RP

A firm must not recognise as risk-reducing any contract containing a provision which permits a non-defaulting counterparty to make limited payments only, or no payments at all, to the estate of the defaulter, even if the defaulter is a net creditor (a "walkaway" clause).

[Note: BCD Annex III Part 7 point (b) (part)]

BIPRU 13.7.10 R RP

In addition to the requirements in BIPRU 13.7.2 R to BIPRU 13.7.9 R, for contractual cross product netting agreements the following criteria must be met:

  1. (1)

    the net sum referred to in BIPRU 13.7.6 R (1) must be the net sum of the positive and negative close out values of any included individual bilateral master agreement and of the positive and negative mark-to-market value of the individual transactions (the Cross-Product Net Amount);

  2. (2)

    the written and reasoned legal opinions referred to in BIPRU 13.7.6 R (2) must address the validity and enforceability of the entire contractual cross product netting agreement under its terms and the impact of the netting arrangement on the material provisions of any included individual bilateral master agreement; a legal opinion must be generally recognised as such by the legal community in the United Kingdom or a memorandum of law that addresses all relevant issues in a reasoned manner;

  3. (3)

    the firm must have procedures in place under BIPRU 13.7.6 R (3) to verify that any transaction which is to be included in a netting set is covered by a legal opinion; and

  4. (4)

    taking into account the contractual cross product netting agreement, the firm must continue to comply with the requirements for the recognition of bilateral netting and the requirements of BIPRU 4.10 and BIPRU 5 for the recognition of credit risk mitigation, as applicable, with respect to each included individual bilateral master agreement and transaction.

    [Note: BCD Annex III Part 7 point (b) (part)]

Effects of recognition

BIPRU 13.7.11 R RP

For the purposes of the CCR mark to market method, the CCR standardised method and the CCR internal model method a firm must recognise netting as set out in BIPRU 13.3 and BIPRU 13.6.

[Note: BCD Annex III Part 7 point (b) (part)]

BIPRU 13.8 Securities financing transactions

Purpose

BIPRU 13.8.1 G RP

BIPRU 13.8 summarises the treatment for securities financing transactions.

Calculation of exposure value for SFTs

BIPRU 13.8.2 R RP

Subject to BIPRU 13.8.3 R, in respect of a securities financing transaction, if a firm:

  1. (1)

    has a CCR internal model method permission which covers the transaction; or

  2. (2)

    has a master netting agreement internal models approach permission which covers the transaction;

then the firm must use the CCR internal model method approach or the master netting agreement internal models approach, as applicable, to calculate the exposure value for that transaction unless an exception in BIPRU 13 or BIPRU 5 allows the firm to use another method.

[Note: BCD Article 78(2), second sentence, in respect of SFTs]

BIPRU 13.8.3 R RP

If a firm has a CCR internal model method permission and a master netting agreement internal models approach permission, and both cover a securities financing transaction, then the firm may choose which of those approaches it wishes to use to calculate the exposure value for that transaction.

BIPRU 13.8.4 R RP

Where BIPRU 13.8.2 R does not apply, a firm must use one of the following approaches to determine the exposure value of a securities financing transaction, as appropriate:

  1. (1)

    if the transaction is covered by a master netting agreement which satisfies the requirements for recognition set out in BIPRU 5.6.1 R to BIPRU 5.6.3 R, a firm may calculate the exposure value under the master netting agreement method set out in BIPRU 5.6.5 R to BIPRU 5.6.11 R (Calculation of the fully adjusted exposure value: the supervisory volatility adjustments approach and the own estimates of volatility adjustments approach);

  2. (2)

    otherwise, a firm must calculate the exposure value of the transaction as its on-balance sheet value.

BIPRU 13.8.5 G RP

A firm calculating risk weighted exposure amounts under the standardised approach to credit risk will not be eligible to use the approach in BIPRU 13.8.4 R (1) if it is using the financial collateral simple method to determine the effects of credit risk mitigation, as set out in BIPRU 5.4.16 R.

BIPRU 13.8.6 G RP

If a firm calculates the exposure value of a securities financing transaction as its on-balance sheet value, in accordance with BIPRU 13.8.4 R (2), it may recognise the effects of financial collateral in the same way as for its other exposures, for example by using either the financial collateral simple method or the financial collateral comprehensive method. However firms should note that the financial collateral simple method is not available:

  1. (1)

    to a firm using the IRB approach (BIPRU 5.4.16 R); or

  2. (2)

    for securities financing transactions in the trading book (BIPRU 14.2.11 R).

Exposure to a central counterparty

BIPRU 13.8.7 R RP

Notwithstanding BIPRU 13.8.2 R, a firm must determine the exposure value of a credit risk exposure outstanding with a central counterparty in accordance with BIPRU 13.8.8 R1, provided that the central counterparty'scounterparty credit riskexposures with all participants in its arrangements are fully collateralised on a daily basis.

[Note: BCD Article 78(4) in respect of SFTs]

BIPRU 13.8.8 R RP

A firm may attribute an exposure value of zero for CCR to a securities financing transaction or to any other exposures in respect of that transaction (but excluding an exposure arising from collateral held to mitigate losses in the event of the default of other participants in the central counterparty's arrangements) which is outstanding with a central counterparty and has not been rejected by the central counterparty.

[Note: BCD Annex III Part 2 point 6 in respect of SFTs]

BIPRU 13 Annex 1

Interest rate risk hedging sets

FX risk hedging sets

Equity risk

i

Trans-action type

Effective notional

Modified duration

CMV

USD non-gov M<1

USD non-gov M>5

EUR non-gov M<1

EUR non-gov M>5

JPY non-gov M>5

EUR/USD

JPY/USD

DAX

$ million

years

$ million

effective notional x modified

effective notional x modified duration

effective notional x modified duration

effective notional x modified duration

effective notional x modified duration

effective notional (+ = long, - = short)

effective notional (+ = long, - = short)

effective notional (+ = long, - = short)

1

USD

IR swap

receiver leg

80

8

-6

640

1

USD

IR swap

payer leg

80

-0.25

-20

2

USD

IR swap

receiver leg

300

0.125

37.5

2

USD

IR swap

payer leg

300

-6

2

-1800

3

EUR

FX swap

receiver leg

100

15

0

1500

100

3

USD

FX swap

payer leg

100

-0.125

-12.5

4

EUR

cross ccy swap

receiver leg

60

7

1

420

60

4

JPY

cross ccy swap

payer leg

60

-7

-420

-60

5

DAX

Total return swap in EUR

receiver leg

150

0.125

4

18.75

150

5

DAX

Total return swap in EUR

payer leg

150

not applicable

-150

Sum of risk positions RPTij by hedging setj

5

-1160

18.75

1920

-420

310

-60

-150

Absolute amount |sum of RPTij| of risk positions by hedging setj

5

1160

18.75

1920

420

310

60

150

Credit conversion factors CCFj by hedging setj

0.20%

0.20%

0.20%

0.20%

0.20%

2.50%

2.50%

7%

CCFj x |sum of RPTij|: CCF-weighted absolute amounts of risk positions by hedging set

0.0100

2.3200

0.0375

3.8400

0.8400

7.7500

1.5000

10.5000

Sum of (CCFj x |sum of RPTij|)

26.7975

CMV: sum of current market values CMVi of the transactions

1.000

Max(CMV, sum of (CCFj x |sum of RPTij))

26.7975

Beta:

1.4000

EAD

37.5165