BIPRU 4.7 The IRB approach: Equity exposures

BIPRU 4.7 applies with respect to the exposures referred to in BIPRU 4.7.2 R.

The following exposures must be classed as equity exposures:

1. (1)

   non-debt exposures conveying a subordinated, residual claim on the assets or income of the issuer; and

2. (2)

   debt exposures the economic substance of which is similar to the exposures specified in (1).

[Note: BCD Article 86(2)]

Notwithstanding BIPRU 4.3.5 R (Relevant parameters), the calculation of risk weighted exposure amounts for credit risk for all exposures belonging to the equity exposure IRB exposure class must be calculated in accordance with one of the following ways:

1. (1)

   the simple risk weight approach (see BIPRU 4.7.8 R;

2. (2)

   the PD/LGD approach (see BIPRU 4.7.13 R); and

3. (3)

   the internal models approach (see BIPRU 4.7.23 R);

in accordance with BIPRU 4.7 and subject to the firm's IRB permission.

[Note: BCD Article 87(4) (part)]

Even if a firm's IRB permission would otherwise permit the use of the internal models approach as referred to in BIPRU 4.7.3 R (3), it may only use that approach if it meets the minimum requirements in BIPRU 4.7.27 R - BIPRU 4.7.35 R.

[Note: BCD Article 87(4) (part)]

A firm may employ different approaches to different portfolios where the firm itself uses different approaches internally. A firm must, if it uses different approaches in accordance with the previous sentence, be able to demonstrate to the appropriate regulator that the choice is made consistently and is not determined by regulatory arbitrage considerations.

[Note: BCD Annex VII Part 1 point 17]

Notwithstanding BIPRU 4.7.5 R a firm may, if its IRB permission permits it to do so, attribute the risk weighted exposure amounts for equity exposures to ancillary services undertakings according to the treatment of non credit-obligation assets.

[Note: BCD Annex VII Part 1 point 18]

The exposure value must be the value presented in the financial statements. Admissible equity exposure measures are the following:

1. (1)

   for investments held at fair value with changes in value flowing directly through income and into capital resources, the exposure value is the fair value presented in the balance sheet;

2. (2)

   for investments held at fair value with changes in value not flowing through income but into a tax-adjusted separate component of equity, the exposure value is the fair value presented in the balance sheet; and

3. (3)

   for investments held at cost or at the lower of cost or market value, the exposure value is the cost or market value presented in the balance sheet.

[Note: BCD Annex VII Part 3 point 12]

BIPRU 4.7.9 R to BIPRU 4.7.12 R set out the simple risk weight approach for calculating the risk weighted exposure amounts for equity exposures as referred to in BIPRU 4.7.3 R (1).

The risk weighted exposure amounts must be calculated according to the following formula:

risk-weighted exposure amounts = RW * exposure value;

where:

1. (1)

   risk weight (RW) = 190% for private equity exposures in sufficiently diversified portfolios;

2. (2)

   risk weight (RW) = 290% for exchange traded equity exposures; and

3. (3)

   risk weight (RW) = 370% for all other equity exposures.

[Note: BCD Annex VII Part 1 point 19]

Short cash positions and derivative instruments held in the non-trading book are permitted to offset long positions in the same individual stocks provided that these instruments have been explicitly designated as hedges of specific equity exposures and that they provide a hedge for at least another year. Other short positions must be treated as if they are long positions with the relevant risk weight assigned to the absolute value of each position. In the context of maturity mismatched positions, the method is that for corporate exposures as set out in BIPRU 4.4.70 R.

[Note: BCD Annex VII Part 1 point 20]

A firm may recognise unfunded credit protection obtained on an equity exposure in accordance with the methods set out in BIPRU 5 (Credit risk mitigation), as modified by BIPRU 4.10.

[Note: BCD Annex VII Part 1 point 21]

The expected loss amounts1 for equity exposures must be calculated according to the following formula:

1. (1)

   expected loss amount = EL × exposure value; and

2. (2)

   the EL values must be the following:

   1. (a)

      expected loss (EL) = 0.8% for private equity exposures in sufficiently diversified portfolios;

   2. (b)

      expected loss (EL) = 0.8% for exchange traded equity exposures; and

   3. (c)

      expected loss (EL) = 2.4% for all other equity exposures.

[Note: BCD Annex VII Part 1 point 32]

BIPRU 4.7.14 R to BIPRU 4.7.22 R set out the PD/LGD approach for calculating the risk weighted exposure amounts for equity exposures.

The risk weighted exposure amounts must be calculated according to the formulas in BIPRU 4.4.58 R (Risk weighted exposure amounts for sovereigns, institutions and corporates). If a firm does not have sufficient information to use the definition of default a scaling factor of 1.5 must be assigned to the risk weights.

[Note: BCD Annex VII Part 1 point 22]

At the individual exposure level the sum of the expected loss amount multiplied by 12.5 and the risk weighted exposure amount must not exceed the exposure value multiplied by 12.5.

[Note: BCD Annex VII Part 1 point 23]

A firm may recognise unfunded credit protection obtained on an equity exposure in accordance with the methods set out in BIPRU 5 (Credit risk mitigation) as modified by BIPRU 4.10. This must be subject to an LGD of 90% on the exposure to the provider of the hedge. For private equity exposures in sufficiently diversified portfolios an LGD of 65% may be used.

[Note: BCD Annex VII Part 1 point 24]

The expected loss amounts for equity exposures must be calculated according to the following formulae:

1. (1)

   expected loss (EL) = PD × LGD; and

2. (2)

   expected loss amount = EL × exposure value.

[Note: BCD Annex VII Part 1 point 33]

PDs must be determined according to the methods for corporate exposures. The following minimum PDs must be applied:

1. (1)

   0.09% for exchange traded equity exposures where the investment is part of a long-term customer relationship;

2. (2)

   0.09% for non-exchange traded equity exposures where the returns on the investment are based on regular and periodic cash flows not derived from capital gains;

3. (3)

   0.40% for exchange traded equity exposures including other short positions as set out in BIPRU 4.7.10 R; and

4. (4)

   1.25% for all other equity exposures including other short positions as set out in BIPRU 4.7.10 R.

[Note: BCD Annex VII Part 2 point 24]

BIPRU 4.4.29 G (five year observation period) applies to the PD/LGD approach.

[Note: BCD Annex VII Part 4 point 66 (part)]

Private equity exposures in sufficiently diversified portfolios may be assigned an LGD of 65%.

[Note: BCD Annex VII Part 2 point 25]

All other exposures must be assigned an LGD of 90%.

[Note: BCD Annex VII Part 2 point 26]

M (maturity) assigned to all exposures must be 5 years.

[Note: BCD Annex VII Part 2 point 27]

BIPRU 4.7.24 R to BIPRU 4.7.35 R set out the internal models approach for calculating the risk weighted exposure amounts for equity exposures as referred to in BIPRU 4.7.3 R (3).

The risk weighted exposure amount is the potential loss on the firm's equity exposures as derived using internal value-at-risk models subject to the 99^th percentile, one-tailed confidence interval of the difference between quarterly returns and an appropriate risk-free rate computed over a long-term sample period, multiplied by 12.5. The risk weighted exposure amounts at the equity exposure portfolio2 level must not be less than the total of the sums2 of the minimum risk weighted exposure amounts required under the PD/LGD approach and the corresponding expected loss amounts1 multiplied by 12.5 and calculated on the basis of the PD values set out in BIPRU 4.7.18 R (1) and the corresponding LGD values set out in2 BIPRU 4.7.20 R and BIPRU 4.7.21 R.

[Note: BCD Annex VII Part 1 point 25]

A firm may recognise unfunded credit protection obtained on an equity position.

[Note: BCD Annex VII Part 1 point 26]

The expected loss amounts for equity exposures under the internal models approach must be 0%.

[Note: BCD Annex VII Part 1 point 34]

1. (1)

   A firm must meet the standards set out in (2) to (9) for the purpose of calculating capital requirements.

2. (2)

   The estimate of potential loss must be robust to adverse market movements relevant to the long-term risk profile of the firm's specific holdings. The data used to represent return distributions must reflect the longest sample period for which data is available and be meaningful in representing the risk profile of the firm's specific equity exposures. The data used must be sufficient to provide conservative, statistically reliable and robust loss estimates that are not based purely on subjective or judgmental considerations. A firm must be able to demonstrate to the appropriate regulator that the shock employed provides a conservative estimate of potential losses over a relevant long-term market or business cycle.

3. (3)

   A firm must combine empirical analysis of available data with adjustments based on a variety of factors in order to attain model outputs that achieve appropriate realism and conservatism. In constructing Value at Risk (VaR) models estimating potential quarterly losses, a firm may use quarterly data or convert shorter horizon period data to a quarterly equivalent using an analytically appropriate method supported by empirical evidence and through a well-developed and documented thought process and analysis. Such an approach must be applied conservatively and consistently over time. Where only limited relevant data is available a firm must add appropriate margins of conservatism.

4. (4)

   The models used must be able to capture adequately all of the material risks embodied in equity returns including both the general market risk and specific risk exposure of the firm's equity exposure portfolio. The internal models must adequately explain historical price variation, capture both the magnitude and changes in the composition of potential concentrations, and be robust to adverse market environments. The population of risk exposures represented in the data used for estimation must be closely matched to or at least comparable with those of the firm's equity exposures.

5. (5)

   The internal model must be appropriate for the risk profile and complexity of a firm's equity exposure portfolio. Where a firm has material holdings with values that are highly non-linear in nature the internal models must be designed to capture appropriately the risks associated with such instruments.

6. (6)

   Mapping of individual positions to proxies, market indices, and risk factors must be plausible, intuitive, and conceptually sound.

7. (7)

   A firm must be able to demonstrate to the appropriate regulator through empirical analyses the appropriateness of risk factors, including their ability to cover both general market risk and specific risk.

8. (8)

   The estimates of the return volatility of equity exposures must incorporate relevant and available data, information, and methods. Independently reviewed internal data or data from external sources (including pooled data) must be used.

9. (9)

   A rigorous and comprehensive stress-testing programme must be in place.

[Note: BCD Annex VII Part 4 point 115]

1. (1)

   With regard to the development and use of internal models for capital requirement purposes, a firm must establish policies, procedures, and controls to ensure the integrity of the model and modelling process. These policies, procedures, and controls must include the ones set out in the rest of this paragraph.

2. (2)

   There must be full integration of the internal model into the overall management information systems of the firm and in the management of the non-trading book equity exposure portfolio. In particular they must be used in:

   1. (a)

      measuring and assessing equity exposure portfolio performance (including the risk adjusted performance);

   2. (b)

      allocating economic capital to equity exposures; and

   3. (c)

      evaluating overall capital adequacy and the investment management process.

3. (3)

   A firm must have established management systems, procedures, and control functions for ensuring the periodic and independent review of all elements of the internal modelling process, including approval of model revisions, vetting of model inputs, and review of model results, such as direct verification of risk computations. These reviews must assess the accuracy, completeness, and appropriateness of model inputs and results and focus on both finding and limiting potential errors associated with known weaknesses and identifying unknown model weaknesses. Such reviews may be conducted by an internal independent unit, or by an independent external third party.

4. (4)

   There must be adequate systems and procedures for monitoring investment limits and the risk exposures of equity exposures.

5. (5)

   The units responsible for the design and application of the model must be functionally independent from the units responsible for managing individual investments.

6. (6)

   Parties responsible for any aspect of the modelling process must be adequately qualified. Management must allocate sufficient skilled and competent resources to the modelling function.

[Note: BCD Annex VII Part 4 point 116]

A firm must have a robust system in place to validate the accuracy and consistency of its internal models and modelling processes. All material elements of the internal models and the modelling process and validation must be documented.

[Note: BCD Annex VII Part 4 point 117]

A firm must use the internal validation process to assess the performance of its internal models and processes in a consistent and meaningful way.

[Note: BCD Annex VII Part 4 point 118]

The methods and data used for quantitative validation must be consistent through time. Changes in estimation and validation methods and data (both data sources and periods covered) must be documented.

[Note: BCD Annex VII Part 4 point 119]

A firm must regularly compare actual equity exposure returns (computed using realised and unrealised gains and losses) with modelled estimates. Such comparisons must make use of historical data that cover as long a period as possible. A firm must document the methods and data used in such comparisons. This analysis and documentation must be updated at least annually.

[Note: BCD Annex VII Part 4 point 120]

A firm must make use of other quantitative validation tools and comparisons with external data sources. The analysis must be based on data that are appropriate to the portfolio, are updated regularly, and cover a relevant observation period. A firm's internal assessments of the performance of its models must be based on as long a period as possible.

[Note: BCD Annex VII Part 4 point 121]

A firm must have sound internal standards for situations where comparison of actual equity exposure returns with the models' estimates calls the validity of the estimates or of the models as such into question. These standards must take account of business cycles and similar systematic variability in equity exposure returns. All adjustments made to internal models in response to model reviews must be documented and consistent with the firm's model review standards.

[Note: BCD Annex VII Part 4 point 122]

The internal model and the modelling process must be documented, including the responsibilities of parties involved in the modelling, and the model approval and model review processes.

[Note: BCD Annex VII Part 4 point 123]