PIB A5.9.2 Guidance

1. An Authorised Firm that uses an internal model for calculating Capital Requirements for Specific Risk of interest rate risk Exposures should also have an internal incremental default and migration risk (incremental risk charge, or IRC) model in place to capture the default and migration risks of its Trading Book positions that are incremental to the risks captured by the VaR measure as specified in Guidance note 7 of PIB A5.9.1. An Authorised Firm should demonstrate that its internal model meets soundness standards comparable to the Internal Ratings Based (IRB) approach for Credit Risk under the assumption of a constant level of risk, and adjusted where appropriate to reflect the impact of liquidity, concentrations, hedging and optionality.

Scope of the internal IRC model

2. The internal IRC model should cover all positions subject to a Capital Requirement for specific interest rate risk, including those subject to a 0% Specific Risk capital charge under PIB Rule A5.2.13, but should not cover securitisation positions and n-th-to-default Credit Derivatives.
3. The Authorised Firm may, subject to approval by the DFSA, choose to include consistently all listed equity positions and derivatives positions based on listed equities. The permission will be granted only if such inclusion is consistent with how the Authorised Firm internally measures and manages risk.

Parameters of the internal IRC model

4. Authorised Firms should use the internal model to calculate a number which measures losses due to default and internal or external ratings migration at the 99.9 % confidence interval over a time horizon of one year. Authorised Firms should calculate this number at least weekly.
5. Correlation assumptions should be supported by analysis of objective data in a conceptually sound framework. The internal model should appropriately reflect issuer concentrations. Concentrations that can arise within and across product classes under stressed conditions should also be reflected.
6. The internal IRC model should reflect the impact of correlations between default and migration events. The impact of diversification between, on the one hand, default and migration events and, on the other hand, other risk factors should not be reflected.
7. The internal model should be based on the assumption of a constant level of risk over the one-year time horizon, implying that given individual Trading Book positions or sets of positions that have experienced default or migration over their liquidity horizon are re-balanced at the end of their liquidity horizon to attain the initial level of risk. Alternatively, an Authorised Firm may choose to consistently use a one-year constant position assumption.
8. The liquidity horizons should be set according to the time required to sell the position or to hedge all material relevant price risks in a stressed market, having particular regard to the size of the position. Liquidity horizons should reflect actual practice and experience during periods of both systematic and idiosyncratic stresses. The liquidity horizon should be measured under conservative assumptions and should be sufficiently long that the act of selling or hedging, in itself, would not materially affect the price at which the selling or hedging would be executed.
9. The determination of the appropriate liquidity horizon for a position or set of positions is subject to a floor of three months.
10. The determination of the appropriate liquidity horizon for a position or set of positions should take into account an Authorised Firm's internal policies relating to valuation adjustments and the management of stale positions. When an Authorised Firm determines liquidity horizons for sets of positions rather than for individual positions, the criteria for defining sets of positions should be defined in a way that meaningfully reflects differences in liquidity. The liquidity horizons should be greater for positions that are concentrated, reflecting the longer period needed to liquidate such positions. The liquidity horizon for a securitisation warehouse should reflect the time to build, sell and securitise the assets, or to hedge the material risk factors, under stressed market conditions.

Recognition of hedges in the internal IRC model

11. Hedges may be incorporated into an Authorised Firm's internal model to capture the incremental default and migration risks. Positions may be netted when long and short positions refer to the same financial instrument. Hedging or diversification effects associated with long and short positions involving different instruments or different securities of the same obligor, as well as long and short positions in different issuers, may only be recognised by explicitly modelling gross long and short positions in the different instruments. Authorised Firms should reflect the impact of material risks that could occur during the interval between the hedge's maturity and the liquidity horizon as well as the potential for significant basis risks in hedging strategies by product, seniority in the capital structure, internal or external rating, maturity, vintage and other differences in the instruments. An Authorised Firm should reflect a hedge only to the extent that it can be maintained even as the obligor approaches a credit or other event.
12. For positions that are hedged via dynamic hedging strategies, a rebalancing of the hedge within the liquidity horizon of the hedged position may be recognised, provided that the Authorised Firm:
a. chooses to model rebalancing of the hedge consistently over the relevant set of Trading Book positions;
b. demonstrates that the inclusion of rebalancing results in a better risk measurement; and
c. demonstrates that the markets for the instruments serving as hedges are liquid enough to allow for such rebalancing even during periods of stress. Any residual risks resulting from dynamic hedging strategies must be reflected in the Capital Requirement.

Additional content of the internal IRC model

13. The internal model to capture the incremental default and migration risks should reflect the nonlinear impact of options, structured Credit Derivatives and other positions with material nonlinear behaviour with respect to price changes. The Authorised Firm should also have due regard to the amount of model risk inherent in the valuation and estimation of price risks associated with such products.
14. The internal model should be based on data that are objective and up-to-date.
15. As part of the independent review and validation of their internal models used for purposes of this chapter, an Authorised Firm should in particular do all of the following:
a. validate that its modelling approach for correlations and price changes is appropriate for its portfolio, including the choice and weights of its systematic risk factors;
b. perform a variety of stress tests, including sensitivity analysis and scenario analysis, to assess the qualitative and quantitative reasonableness of the internal model, particularly with regard to the treatment of concentrations. Such tests should not be limited to the range of events experienced historically; and
c. apply appropriate quantitative validation, including relevant internal modelling benchmarks.
16. The internal model should be consistent with the Authorised Firm's internal risk management methodologies for identifying, measuring, and managing trading risks.
17. Authorised Firms should document their internal models so that their correlation and other modelling assumptions are transparent to the DFSA.
18. The internal model should conservatively assess the risk arising from less liquid positions and positions with limited price transparency under realistic market scenarios. In addition, the internal model should meet minimum data standards. Proxies should be appropriately conservative and may be used only where available data is insufficient or is not reflective of the true volatility of a position or portfolio.

Not fully compliant IRC approaches

19. If an Authorised Firm uses an internal model to capture incremental default and migration risks that does not comply with all requirements specified in Guidance notes 4 to 18 of PIB A5.9.2, but that is consistent with the Authorised Firm's internal methodologies for identifying, measuring and managing incremental default and migration risks, it should be able to demonstrate that its internal model results in a Capital Requirement that is at least as high as if it were based on a model in full compliance with the requirements of the Guidance notes referred above. The DFSA will review compliance with the previous sentence at least annually.
Derived from RM111/2012 (Made 15th October 2012). [VER20/12-12]