IFPRU 4.14 Counterparty credit risk

A firm may apply to the FCA under section 138A of the Act to waive IFPRU 4.14.2 R if it wishes to use the residual maturity of the interest-rate contract.

1. (1)

   This guidance sets out the FCA's expectations for granting permission to a firm to use its own one-sided credit valuation adjustment internal models (an "internal CVA model") for the purpose of estimating the maturity factor "M", as proposed under article 162(2)(h) of the UK CRR1 (Maturity).

2. (2)

   In the context of counterparty credit risk, the maturity factor "M" is intended to increase the own funds requirements to reflect potential higher risks associated with medium and long-term OTC derivative portfolios, more specifically when the exposure profile of these contracts is significant beyond one year. This adjustment is only applicable to a firm using the Internal Model Method for the calculation of exposure values.

3. (3)

   A firm is permitted to replace the formula for the maturity factor "M", as set out in article 162(2)(g) of the UK CRR1 with the 'effective credit duration' derived by a firm's internal CVA model, subject to permission being granted by the FCA, as the competent authority.

4. (4)

   Internal CVA models are complex by nature and modelling practises vary significantly across the industry. The FCA considers the creation of an acceptable model resulting in an appropriate credit duration to be challenging, and so would require extensive review. Accordingly, the FCA expects a firm to demonstrate a strong case for the granting of such permission.

5. (5)

   A firm that wishes to make an application under article 162(2)(h) should provide a satisfactory justification for the use of an internal CVA model for estimating the maturity factor "M". The purpose of reducing the own funds requirements for counterparty credit risk will not, on its own, be considered as a reasonable justification. The FCA will also expect highly conservative modelling assumptions within a firm's internal CVA model for the purpose of article 162(2)(h).

1. (1)

   This guidance sets out the FCA's expectations for permitting a firm with the permission to use the Internal Model Method set out in Part Three, Title II, Chapter 6, Section 6 (Internal model method) and the permission to use an internal VaR model for specific risk set out in Part Three, Title IV, Chapter 5 (Use of internal models) associated with traded debt instruments to set to 1 the maturity factor "M" defined in article 162 of the UK CRR1.

2. (2)

   In the context of counterparty credit risk, the maturity factor "M" is intended to increase the own funds requirements to reflect the potential higher risks associated with medium and long-term OTC derivative portfolios, more specifically when the exposure profile of these contracts is significant beyond one year. This adjustment is only applicable to firms using the Internal Model Method for the calculation of exposure values.

3. (3)

   Article 162(2)(i) of the UK CRR1 allows a firm to set the maturity factor "M" to 1 for a firm using the Internal Model Method provided that the firm's internal value-at-risk (VaR) model for specific risk associated with traded debt instruments reflects the effect of rating migration and subject to the permission of the FCA, as the competent authority.

4. (4)

   Internal VaR models for specific risk associated with traded debt instruments are not specifically designed to capture the effects of rating migrations. The risk captured by these models is based on a 10-day time horizon which cannot appropriately reflect the dynamics of rating migrations, which occur on an irregular, infrequent basis. This deficiency was one of the main reasons underlying the introduction of a separate risk measure for the capture of both credit default and rating migration risks, based on a one-year time horizon (the IRC models in article 372 of the UK CRR1 (Internal IRC model)).

5. (5)

   Since the challenges of appropriately capturing credit-rating migrations in an internal VaR model are high, the FCA expects a firm to demonstrate a strong case for the granting of the permission set out in article 162(2)(i) of the UK CRR1.

6. (6)

   A firm that wishes to make an application under article 162(2)(i) of the UK CRR1 should provide a satisfactory justification for use of its internal VaR model to capture the risks associated with ratings migration. The purpose of reducing the own funds requirements for counterparty credit risk will not be considered as a reasonable justification.

7. (7)

   The FCA expects highly conservative modelling assumptions for the capture of rating migrations within a firm's internal VaR models for specific risk associated with traded debt instruments under article 162(2)(i) of the UK CRR1 (Maturity).