40.The supervisory factor for credit derivatives depends on the credit rating of the underlying reference asset. The Basel framework does not provide a specific treatment of unrated reference assets. The Central Bank believes that credit derivatives on unrated reference entities are likely to be rare. However, for the sake of completeness, the Standards requires that any such credit derivatives be treated in a manner that is broadly consistent with the treatment of unrated entities in other aspects of the risk-based capital framework, through use of a Supervisory Factor corresponding to BBB or BB ratings as described in the Standards.

41.For an entity for which a credit rating is not available, a bank should use the Supervisory Factor corresponding to BBB. However, where the exposure is associated with an elevated risk of default, the bank should use the Supervisory Factor for BB. In this context, “elevated risk of default” should also be understood to include instances in which it is difficult or impossible to assess adequately whether the exposure has high risk of loss due to default by the obligor. A bank trading credit derivatives referencing unrated entities should conduct their own analysis to examine this risk.

42.Note that the Standards defines the term “commodity type” for purposes of calculation of exposure for CCR. A commodity type is defined as a set of commodities with broadly similar risk drivers, such that the prices or volatilities of commodities of the same commodity type may reasonably be expected to move with similar direction and timing and to bear predictable relationships to one another. For example, a commodity type such as coal might include several types of coal, and a commodity type such as oil might include oil of different grades from different sources. The prices of commodities of a given type may not move precisely in lock step, but they are likely to move in the same direction at roughly the same time, due to their dependence on common forces in commodity markets. Long and short trades within a single commodity type can be fully offset.

43.For commodity derivatives, defining individual commodity types is operationally difficult. In fact, it is generally not possible to fully specify all relevant distinctions between commodity types, and as a result, a single commodity type is likely to include individual commodities that in practice differ to some extent in the dynamic behaviour they exhibit. As a result, not all basis risk is likely to be captured. Nonetheless, banks should attempt to minimize unrecognized basis risk through sound definitions of commodity types.

44.The Standards requires a bank to establish appropriate governance processes for the creation and maintenance of the list of defined commodity types used by the bank for CCR calculations, with clear definitions and independent internal review or validation processes to ensure that commodities grouped as a single type are in fact similar. A bank can only use the specifically defined commodity types it has established through its adequately controlled internal processes.

45.Trades within the same commodity hedging set (Energy, Metals, Agriculture, and Other) enjoy partial offsetting through the use of correlation values established in the Standards, with correlation values varying by asset subclass. More specifically, partial offsetting applies only to the systematic component, not the issuer-specific or idiosyncratic component. Note that Electricity is a sub-class of the Commodity asset class, but is itself part of the broader Energy hedging set, rather than constituting a distinct hedging set.

46.For credit derivatives, there is one credit reference entity for each reference debt instrument that underlies a single-name transaction allocated to the credit risk category. Single-name transactions should be assigned to the same credit reference entity only where the underlying reference debt instrument of those transactions is issued by the same issuer.

47.The approach for establishing the reference entity for equity derivatives should correspond to the general approach for credit derivatives.

48.For credit derivatives with indices as the underlying instrument, there should be one reference entity for each group of reference debt instruments or single-name credit derivatives that underlie a multi-name transaction. Multi-name transactions should be assigned to the same credit reference entity only where the group of underlying reference debt instruments or single-name credit derivatives of those transactions has the same constituents. The determination of whether an index is investment grade or speculative grade should be based on the credit quality of the majority of its individual constituents.

49.Again, the approach for equity index derivatives should follow the general approach for credit index derivatives.

50.When multiple margin agreements apply to a single netting set, the netting set should be broken down into sub-netting sets that align with the respective margin agreement for calculating both RC and PFE.

51.When a single margin agreement applies to multiple netting sets, RC at any given time is determined by the sum of two terms. The first term is equal to the un-margined current exposure of the bank to the counterparty aggregated across all netting sets within the margin agreement reduced by the positive current net collateral (i.e. collateral is subtracted only when the bank is a net receiver of collateral). The second term is non-zero only when the bank is a net poster of collateral: it is equal to the current net posted collateral (if there is any) reduced by the un-margined current exposure of the counterparty to the bank aggregated across all netting sets within the margin agreement. Net collateral available to the bank should include both VM and NICA. Mathematically, RC for the entire margin agreement is:

where the summation NS ∈ MA is across the netting sets covered by the margin agreement (hence the notation), V_NS is the current mark-to-market value of the netting set NS and C_MA is the cash equivalent value of all currently available collateral under the margin agreement.

52.An alternative description of this calculation is as follows:

Step 1: Compute the net value, positive or negative, of each netting set. These calculated values correspond to the terms V_NS in the expression above.

Step 2: Sum the values of all netting sets with positive value, to get Total Positive Value (TPV). This corresponds to the term in the expression above:

Step 3: Sum the values of all of netting sets with negative value, to get Total Negative Value (TNV). This corresponds to the term in the expression above:

Step 4: Calculate the net current cash value of collateral, including NICA and VM. This corresponds to the term C_MA in the expression above. If the bank is net holder of collateral, then C_MA is positive; it is the net value held (NVH). If the bank is a net provider of collateral, then C_MA is negative, and its absolute value is the net value provided (NVP). Note that either NVH>0 and NVP=0, or NVP>0 and NVH=0.

One of the following cases then applies:

Step 5a: If NVH>0 (so NVP=0), then RC = TPV – NVH, but with a minimum of zero – that is, RC cannot be negative.
 

or
 

Step 5b: If NVH=0 (so NVP>0), then RC = TPV + NVP – TNV, but with a minimum of TPV – that is, RC cannot be less than TPV.

53.To calculate PFE when a single margin agreement applies to multiple netting sets, netting set level un-margined PFEs should be calculated and aggregated, i.e. PFE should be calculated as the sum of all the individual netting sets considered as if they were not subject to any form of margin agreement.

The replacement cost is calculated at the netting set level as a simple algebraic sum (floored at zero) of the derivatives’ market values at the reference date. Thus, using the market values indicated in the table (expressed in thousands):

RC = max {V - C; 0} = max {30 - 20 + 50; 0} = 60
 

Since V-C is positive (equal to V of 60,000), the value of the multiplier is 1, as explained in the Standards.

All the transactions in the netting set belong to the interest rate asset class. So the Add-on for interest rate class must be calculated as well as the multiplier since

PFE = multiplier × Add-on_agg
 

For the calculation of the interest rate add-on, the three trades must be assigned to a hedging set (based on the currency) and to a maturity category (based on the end date of the transaction). In this example, the netting set is comprised of two hedging sets, since the trades refer to interest rates denominated in two different currencies (USD and EUR). Within hedging set “USD”, Trade 1 falls into the third maturity category (>5 years) and Trade 2 falls into the second maturity category (1-5 years). Trade 3 falls into the third maturity category (>5 years) of hedging set “EUR”.

S and E represent the start date and end date, respectively, of the time period referenced by the interest rate transactions.

The following table illustrates the steps typically followed for the add-on calculation:

   Calculate Effective Notional Amount

The adjusted notional of each trade is calculated by multiplying the notional amount by the calculated supervisory duration SD as defined in the Standards.

d = Trade Notional × SD = Trade Notional × (exp(-0.05×S) – exp(-0.05 × E)) / 0.05

   Calculate Maturity Category Effective Notional

A supervisory delta is assigned to each trade in accordance with the Standards. In particular:

1. •Trade 1 is long in the primary risk factor (the reference floating rate) and is not an option so the supervisory delta is equal to 1.
2. •Trade 2 is short in the primary risk factor and is not an option; thus, the supervisory delta is equal to -1.
3. •Trade 3 is an option to enter into an interest rate swap that is short in the primary risk factor and therefore is treated as a purchased put option. As such, the supervisory delta is determined by applying the relevant formula using 50% as the supervisory option volatility and 1 (year) as the option exercise date. Assume that the underlying price (the appropriate forward swap rate) is 6% and the strike price (the swaption’s fixed rate) is 5%.

The trade-level supervisory delta is therefore:

Trade	Delta	nstrument Type
Trade 1	1	inear, long (forward and swap)
Trade 2	-1	inear, short (forward and swap)
Trade 3	$$$$	purchased put option

The Maturity Factor MF is 1 for all the trades since they are un-margined and have remaining maturities in excess of one year.

Based on the maturity categories, the Effective Notional D for the USE and EUR hedging sets at the level of the maturity categories are as shown in the table below:

In particular:

Hedging set USD, time bucket 3: D = 1 * 78,693,868 * 1 = 78,693,868

Hedging set USD, time bucket 2: D = -1 * 36,253,849 * 1 = -36,253,849

Hedging set EUR, time bucket 3: D = -0.27 * 37,427,961 * 1 = -10,105,550

   Apply Supervisory Factor

The add-on must be calculated for each hedging set.

For the USD hedging set there is partial offset between the two USD trades:

Effective notional^(IR) _{USD =} [D2² + D3² + 1.4 x D2 x D3]^1/2

   = [(-36,253,849)² + 78,693,868² + 1.4 × (-36,253,849) × 78,693,868]^1/2

   = 59,269,963

For the Hedging set EUR there is only one trade (and one maturity category):

  Effective notional^(IR)_EUR = 10,105,550

In summary:

Aggregation of the calculated add-ons across different hedging sets:

The asset class is interest rates; thus the applicable Supervisory factor is 0.50%. As a result:

 Add-on = SF × Effective Notional = 0.005 × 69,375,513 = 346,878

   Supervisory Correlation Parameters

Correlation is not applicable to the interest rate asset class, and there is no other asset class in the netting set in this example.

   Add-on Aggregation

For this netting set, the interest rate add-on is also the aggregate add-on because there are no trades assigned to other asset classes. Thus, the aggregate add-on = 346,878

   Multiplier

The multiplier is given by:

multiplier = min { 1; Floor+(1-Floor) × exp [(V-C) /(2 ×(1-Floor)×Add-on_agg)]}

   = min {1; 0.05 + 0.95 × exp [60,000 / (2 × 0.95 × 346,878]}

     =1

   Final Calculation of PFE

In this case the multiplier is equal to one, so the PFE is the same as the aggregate Add-On:

PFE = multiplier × Add-on_agg = 1 × 346,878 = 346,878
 

The exposure EAD to be risk weighted for counterparty credit risk capital requirements purposes is therefore

EAD = 1.4 * (RC + PFE) = 1.4 x (60,000 + 346,878) = 569,629
 

The replacement cost is calculated at the netting set level as a simple algebraic sum (floored at zero) of the derivatives’ market values at the reference date. Thus, using the market values indicated in the table (expressed in thousands):

RC = max {V - C; 0} = max {20 - 40 + 0; 0} = 0
 

Since V-C is negative (i.e. -20,000), the multiplier will be activated (i.e. it will be less than 1). Before calculating its value, the aggregate add-on needs to be determined.

The following table illustrates the steps typically followed for the add-on calculation:

   Effective Notional Amount

The adjusted notional of each trade is calculated by multiplying the notional amount with the calculated supervisory duration SD specified in the Standards.

d= Trade Notional × SD = Trade Notional × {exp(-0.05×S) – exp(-0.05 × E)} / 0.05

The appropriate supervisory delta must be assigned to each trade: in particular, since Trade 1 and Trade 3 are long in the primary risk factor (CDS spread), their delta is 1; in contrast, the supervisory delta for Trade 2 is -1.

Thus, the entity-level effective notional is equal to the adjusted notional times the supervisory delta times the maturity factor (where the maturity factor is 1 for all three derivatives).

   Supervisory Factor

The add-on must now be calculated for each entity. Note that all derivatives refer to different entities (single names/indices). A supervisory factor is assigned to each single-name entity based on the rating of the reference entity, as specified in Table 1 in the relevant Standards. This means assigning a supervisory factor of 0.38% for AA-rated firms (Trade 1) and 0.54% for BBB-rated firms (for Trade 2). For CDS indices (Trade 3), the supervisory factor is assigned according to whether the index is investment or speculative grade; in this example, its value is 0.38% since the index is investment grade.

Thus, the entity level add-ons are as follows:

Add-on(Entity) = SF × Effective Notional
 

Supervisory Correlation Parameters

The add-on calculation separates the entity level add-ons into systematic and idiosyncratic components, which are combined through weighting by the correlation factor. The correlation parameter ρ is equal to 0.5 for the single-name entities (Trade 1-Firm A and Trade 2-Firm B) and 0.8 for the index (Trade 3-CDX.IG) in accordance with the requirements of the Standards.

Add-on^(Credit) = [ [ ∑_k ρ_k ^CR × Add-on (Entity_k) ]² + ∑_k (1- (ρ_k ^CR)²) × (Add-on (Entity_k))²]^1/2

   Add-on Aggregation

For this netting set, the interest rate add-on is also the aggregate add-on because there are no trades assigned to other asset classes. Thus, the aggregate add-on = 346,878

Aggregation of entity-level add-ons with full offsetting in the systematic component and no offsetting benefit in the idiosyncratic component.

   Thus,

Add-on = [ (47,462)² + 77,344,042,776 ]^1/2 = 282,129

   Multiplier

   The multiplier is given by

multiplier = min {1; Floor+(1-Floor) × exp [(V-C)/(2×(1-Floor)×Add-on_agg)]}

   = min {1; 0.05 + 0.95 × exp [-20,000 / (2 × 0.95 × 282,129)]}

      =0.96521

   Final Calculation of PFE

PFE = multiplier × Add-on_agg = 0.96521 × 282,129= 272,313
 

The exposure that would be risk-weighted for the purpose of counterparty credit risk capital requirements is therefore:

EAD = 1.4 * (RC + PFE) = 1.4 x (0 + 272,313) = 381,238
 

The replacement cost is calculated at the netting set level as a simple algebraic sum (floored at zero) of the derivatives’ market values at the reference date, provided that value is positive. Thus, using the market values indicated in the table (expressed in thousands):

RC = max {V - C; 0} = max {100 - 30 - 50; 0} = 20
 

The replacement cost is positive and there is no exchange of collateral (so the bank has not received excess collateral), which means the multiplier will be equal to 1.

The following table illustrates the steps typically followed for the add-on calculation, for each of the four commodity hedging sets with non-zero exposure:

   Effective Notional Amount

Trade-level Adjusted Notional calculation for each commodity derivative trade:

d_i^(COM) = current price per unit × number of units in the trade
 

The appropriate supervisory delta must be assigned to each trade:

Since the remaining maturity of Trade 1 is less than a year, at nine months (approximately 187 business days), and the trade is un-margined, its maturity factor is scaled down by the square root of 187/250 in accordance with the requirements of the Standards. On the other hand, the maturity factor is 1 for Trade 2 and for Trade 3, since the remaining maturity of those two trades is greater than one year and they are un-margined.

The trade-level effective notional is equal to the adjusted notional times the supervisory delta times the maturity factor. The basic difference between the WTI and Brent forward contracts effectively is ignored since they belong to the same commodity type, namely “Crude Oil” within the “Energy” hedging set, thus allowing for full offsetting. (In contrast, if one of the two forward contracts were on a different commodity type within the “Energy” hedging set, such as natural gas, with the other on crude oil, then only partial offsetting would have been allowed between the two trades.) Therefore, Trade 1 and Trade 2 can be aggregated into a single effective notional, taking into account each trade’s supervisory delta and maturity factor.

   Supervisory Factor

For each commodity-type in a hedging set, the effective notional amount must be multiplied by the correct Supervisory Factor (SF). As described in the Standards, the Supervisory Factor for both the Crude Oil commodity type in the Energy hedging set and the Silver commodity type in the Metals hedging set is SF=18%.

Thus, the add-on by hedging set and commodity type is as follows:

Add-on(Type_k^j) = SF_Typek^(Com) × Effective Notional_Typek^(Com)
 

   Supervisory Correlation Parameters

The commodity-type add-ons in a hedging set are decomposed into systematic and idiosyncratic components. The commodity subclass correlations parameters are as stated in the Standards, in this case 40% for commodities.

Thus, the hedging set level add-ons are calculated for each commodity hedging set:

Add-on^(COM) = [( Σ_k ρ_j^(COM) × Add-on (Type_k^j) )² + Σ_k (1- (ρ_j^(COM) )²) × (Add-on (Type ^j))²]_k^1/2

However, in this example, since only one commodity type within the “Energy” hedging set is populated (i.e. all other commodity types within that hedging set have a zero add-on), the resulting add-on for the hedging set is the same as the add-on for the commodity type. This calculation shows that when there is only one commodity type within a commodity hedging set, the hedging-set add-on is equal to the absolute value of the commodity-type add-on. (The same comment applies to the commodity type “Silver” in the “Metals” hedging set.)

   Add-on Aggregation

Aggregation of commodity-type add-ons uses full offsetting in the systematic component and no offsetting benefit in the idiosyncratic component in each hedging set. As noted earlier, in this example there is only one commodity type per hedging set, which means no offsetting benefits. Computing the simple summation of absolute values of add-ons for the hedging sets:

Add-on = Σ_j Add-on_j

Add-On = 2,043 + 1,800 = 3,843

   Multiplier

The multiplier is given by

multiplier = min {1; Floor+(1-Floor) × exp [(V-C)/(2×(1-Floor)×Add-on_agg)]}

   = min {1; 0.05 + 0.95 × exp [20 / (2 × 0.95 × 3,843)]}

      = 1, since V-C is positive.

   Final Calculation of PFE

PFE = multiplier × Add-on_agg = 1 × 3,843 = 3,843
 

The exposure EAD to be risk weighted for counterparty credit risk capital requirements purposes is therefore

EAD = 1.4 * (RC + PFE) = 1.4 x (20 + 3,843) = 5,408
 

1.In December 2013, the Basel Committee on Banking Supervision (BCBS) published a revised framework for calculating the capital requirements for banks’ equity investments in funds held in the banking book. This followed a BCBS review of the risk-based capital requirements for banks’ exposures to funds, undertaken as part of the work of the Financial Stability Board (FSB) to strengthen the oversight and regulation of shadow banking. The BCBS review was undertaken to clarify the existing treatment of such exposures in the Basel II capital adequacy framework and to achieve a more internationally consistent and risk-sensitive capital treatment for banks’ investments in the equity of funds, reflecting both the risk of the fund’s underlying investments and its leverage.

2.Following the approach developed by the BCBS in Capital requirements for banks’ equity investments in funds, (BCBS 266, published December 2013), the Central Bank Standards for minimum required capital for banks’ equity investments in funds relies on a hierarchy of three successive approaches to risk weighting of fund assets, with varying degrees of risk sensitivity and conservatism:

1. •The “look-through approach” (LTA): The LTA is the most granular approach. Subject to meeting the conditions set out for its use, banks employing the LTA must apply the risk weight of the fund’s underlying exposures as if the exposures were held directly by the bank;
2. •The “mandate-based approach” (MBA): The MBA provides a degree of risk sensitivity, and can be used when banks do not meet the conditions for applying the LTA. Banks employing the MBA assign risk weights on the basis of the information contained in a fund’s mandate or in relevant regulations, national legislation, or other similar rules under which the fund is required to operate; and
3. •The “fall-back approach” (FBA): When neither of the above approaches is feasible, the FBA must be used. The FBA applies a 1250 percent risk weight to a bank’s equity investment in the fund.

To ensure that banks have appropriate incentives to enhance the risk management of their exposures, the degree of conservatism increases with each successive approach.

3.The capital framework for banks’ equity investments in funds also incorporates a leverage adjustment to the risk-weighted assets derived from the above approaches to appropriately reflect a fund’s leverage.

6.The Standards defines a securitisation as a contractual structure under which the cash flow from an underlying pool of exposures is used to service claims with at least two different stratified risk positions or tranches reflecting different degrees of credit risk. The creation of distinct tranches is the key feature of securitisation; similar structures that merely “pass through” the cash flows to the claims without modification are not considered securitisations.

7.For securitisation exposures, payments to the investors depend upon the performance of the specified underlying exposures, as opposed to being derived from an obligation of the entity originating those exposures. The stratified/tranched structures that characterize securitisations differ from ordinary senior/subordinated debt instruments in that junior securitisation tranches can absorb losses without interrupting contractual payments to more senior tranches, whereas subordination in a senior/subordinated debt structure is a matter of priority of rights to the proceeds of a liquidation.

8.In some cases, transactions that have some of the features of securitisations should not be treated as such for capital purposes. For example, transactions involving cash flows from real estate (e.g., in the form of rents) may be considered specialized lending exposures. Banks should consult with Central Bank when there is uncertainty about whether a given transaction should be considered a securitisation.

9.A securitisation exposure is considered a senior exposure if it is effectively backed or secured by a first claim on the entire amount of the assets in the underlying securitised pool.

10.While this generally includes only the most senior position within a securitisation tranche, in some instances there may be other claims that, in a technical sense, may be more senior in the waterfall (e.g., a swap claim) but may be disregarded for the purpose of determining which positions are treated as senior.

11.If a senior tranche is retranched or partially hedged (i.e., not on a pro rata basis), only the new senior part would be treated as senior for capital purposes.

12.In some cases, several senior tranches of different maturities may share pro rata in loss allocation. In that case, the seniority of these tranches is unaffected – they all are considered to be senior – since they all benefit from the same level of credit enhancement. (Note that in this case, the material effects of differing tranche maturities are captured by maturity adjustments to the risk weights assigned to the securitisation exposures, per the Standards.)

13.In a traditional securitisation where all tranches above the first-loss piece are rated, the most highly rated position should be treated as a senior tranche. When there are several tranches that share the same rating, only the most senior tranche in the cash flow waterfall should be treated as senior (unless the only difference among them is the effective maturity). In addition, when the different ratings of several senior tranches only result from a difference in maturity, all of these tranches should be treated as senior.

14.In a typical synthetic securitisation, an unrated tranche can be treated as a senior tranche provided that all of the conditions for inferring a rating from a lower tranche that meets the definition of a senior tranche are fulfilled.

15.Usually, a liquidity facility supporting an ABCP program would not be the most senior position within the program; instead, the commercial paper issued by the program, which benefits from the liquidity support, typically would be the most senior position. However, when a liquidity facility that is sized to cover all of the outstanding commercial paper and other senior debt supported by the pool is structured so that no cash flows from the underlying pool can be transferred to other creditors until any liquidity draws are repaid in full, the liquidity facility can be treated as a senior exposure. Otherwise, if these conditions are not satisfied, or if for other reasons the liquidity facility constitutes a mezzanine position in economic substance rather than a senior position in the underlying pool, the liquidity facility should be treated as a non-senior exposure.

16.The Standards requires that banks obtain a legal opinion to confirm true sale to demonstrate that the transferor does not maintain effective or indirect control over the transferred exposures and that the exposures are legally isolated from the transferor in such a way (e.g., through the sale of assets or through sub-participation) that the exposures are put beyond the reach of the transferor and its creditors, even in bankruptcy or receivership. However, that legal opinion need not be limited to legal advice from qualified external legal counsel; it may be in the form of written advice from in-house lawyers.

17.For synthetic securitisations, risk transference through instruments such as credit derivatives may be recognized only if the instruments used to transfer credit risk do not contain terms or conditions that limit the amount of credit risk transferred. Examples of terms or conditions that would violate this requirement include the following:

1. (a)Clauses that materially limit the credit protection or credit risk transference, such as an early amortization provision in a securitisation of revolving credit facilities that effectively subordinates the bank’s interest, significant materiality thresholds below which credit protection is deemed not to be triggered even if a credit event occurs, or clauses that allow for the termination of the protection due to deterioration in the credit quality of the underlying exposures.
2. (b)Clauses that require the originating bank to alter the underlying exposures to improve the pool’s average credit quality.
3. (c)Clauses that increase the bank’s cost of credit protection in response to deterioration in the pool’s quality.
4. (d)Clauses that increase the yield payable to parties other than the originating bank, such as investors and third-party providers of credit enhancements, in response to a deterioration in the credit quality of the reference pool.
5. (e)Clauses that provide for increases in a retained first-loss position or credit enhancement provided by the originating bank after the transaction’s inception.

18.The Standards requires banks to have a thorough understanding of all structural features of a securitisation transaction that would materially affect the performance of the bank’s exposures to the transaction. Common structural features that are particularly relevant include those related to the payment waterfall incorporated in the structure, which is the description of the order of payment for the securitisation, under which higher-tier tranches receive principal and interest first, before lower-tier tranches are paid. Credit enhancements and liquidity enhancements also are important structural features; these may take the form of cash advance facilities, letters of credit, guarantees, or credit derivatives, among others. Effective due diligence also should consider unusual or unique aspects of a particular securitisation structure, such as the specific nature of the conditions that would constitute default under the structure.

32.In general, to qualify for treatment as simple, transparent, and comparable (STC), a securitisation must meet all of the criteria specified in the Standards, including the Appendix to the Standards. The criteria include a requirement that the aggregated value of all exposures to a single obligor as of the acquisition date not exceed 2% of the aggregated outstanding exposure value of all exposures in the securitisation. However, the BCBS has permitted flexibility for jurisdictions with structurally concentrated corporate loan markets. In those cases, for corporate exposures only, the applicable maximum concentration threshold for STC treatment can be increased to 3%. This increase is subject to ex ante supervisory approval, and banks with such exposures should consult with the Central Bank regarding STC treatment. In addition, the seller or sponsor of such a pool must retain subordinated positions that provide loss-absorbing credit enhancement covering at least the first 10% of losses. These credit-enhancing positions retained by the sellers or sponsor are not eligible for STC capital treatment.

33.Consider a bank applying the SEC-SA to a securitisation exposure for which the underlying pool of assets has a required capital ratio of 9% under the standardised approach to credit risk. Suppose that the delinquency rate is unknown for 1% of the exposures in the underlying pool, but for the remaining 99% of the pool the delinquency rate is known to be 6%. The bank holds an investment of 100 million in a tranche that has an attachment point of 5% and a detachment point of 25%. Finally, assume that the pool does not itself contain any securitisation exposures, so the exposure is not a resecuritisation.

34.In this example, K_SA is given at 9%. To adjust for the known delinquency rate on the pooled assets, the bank computes an adjusted capital ratio:

(1 − W) × K_SA + (W × 0.5) = 0.94 × 0.09 + 0.06 × 0.5 = 0.1146
 

35.This calculated capital ratio must be further adjusted for the fact that the delinquency rate is unknown for a small portion (1%) of the underlying asset pool:

K_A = 0.99 × 0.1146 + 0.01 = 0.1235
 

36.Next, the bank applies the supervisory formula to calculate the capital required per unit of securitisation exposure, using the values of the attachment point A, the detachment point D, the calculated value of K_A, and the appropriate value of the supervisory parameter ρ, and noting that D>K_A:

where:

Note that because this is not a resecuritisation exposure, the appropriate value of the supervisory calibration parameter rho is 1 (ρ=1).

37.Substituting the values of a, U, and L into the supervisory formula gives:

38.This tranche represents a case in which the attachment point A is less than K_A but the detachment point D is greater than K_A. Thus, according to the Standards, the risk weight for the bank’s exposure is calculated as a weighted average of 12.5 and 12.5×K:

39.With a tranche risk weight of 954%, the bank’s risk-weighted asset amount for this securitisation would be 954% of the 100 million investment, or 954 million. If, for example, the bank chose to apply a capital ratio of 13% to this exposure, then the bank’s required capital would be 13% of 954 million, or approximately 85 million, on the investment of 100 million in this securitisation tranche.

40.Consider a non-senior securitisation tranche that has been assigned a rating by one of the eligible rating agencies corresponding to a rating of BB+. Suppose that the tranche has an attachment point A of 5%, a detachment point D of 30%, and effective tranche maturity of M_T = 2 years.

1. •From the look-up table for SEC-ERBA, a non-senior securitisation exposure rated BB+ with one-year maturity has a risk weight of 470%; the risk weight for a five-year maturity is 580%.
2. •The tranche maturity of 2 years is one-quarter of the way between one year and five years, so the relevant maturity-adjusted risk weight based on linear interpolation is one quarter of the way between 470% and 580%, or 497.5%.
3. •Because this is a non-senior tranche, it must also be adjusted for tranche thickness, which is the difference between D=30% and A=5%, a difference of 25%. The interpolated risk weight from the table should be multiplied by a factor of 1-(D-A)=0.75, which exceeds the floor of 50% and therefore should be used by the bank in the calculation (0.75 x 497.5%).
4. •The resulting tranche risk weight is 373%.

41.Banks using the SEC-ERBA for securitisation exposures may prefer to incorporate the main features of the ERBA look-up tables into formal calculations of risk weights, including the relevant adjustments for tranche maturity and tranche thickness. In that case, each pair of 1-year and 5-year risk weights can be viewed as coefficients for a formulaic calculation of the risk weight for a tranche of given maturity M_T, and in the case of non-senior tranches, thickness D-A.

42.For example, for a non-senior tranche rated BB+ with M_T between one year and five years, the tranche risk weight RW_T can be computed with a single formula as:

where the coefficients 4.7 and 5.8 correspond to the relevant values from the look-up table of 470% for one-year maturity and 580% for five-year maturity. Substituting in the values for A, D, and M_T from the example above:

43.Senior tranches are not adjusted for thickness; hence, the calculation of the tranche risk weight RW_T for a senior BB+ rated tranche would be computed as:

where again the coefficients 1.4 and 1.6 correspond to the relevant values from the senior tranche columns of the look-up table, specifically 140% for 1-year maturity and 160% for 5-year maturity.

6.Interest rate risk is the potential for losses in on- or off-balance sheet positions from adverse changes in interest rates. Instruments covered by the standardised approach for interest rate risk include all fixed rate and floating rate related instruments, such as debt securities, swaps, forwards and futures.

7.The standardised approach provides a framework for measuring interest rate risk. It takes into account the maturity or duration of the positions, basis risk, and certain correlations among risk factors.

8.Duration is a measure of the average maturity of a debt instrument's cash flows from both coupons and principal repayment. It is expressed in years and allows debt instruments with different coupons and maturities to be compared. Based on the duration, the sensitivity of a fixed income security's price with respect to a small change in its yield can be determined.

9.When hedging positions, basis risk is a key risk for the hedged position and needs to be managed and closely monitored.

Typically, two distinct components of market risk are recognised:

   1.General Market Risk

10.General market risk refers to changes in market prices resulting from general market behavior.

For example, in the case of an equity position, general market risk can arise from a change in a stock market index. In the case of a fixed income instrument, general market risk is driven by a change in the yield curve.

The capital charge for general market risk is designed to capture the risk of loss arising from adverse changes in market interest rates.

There are two steps for calculating the general market risk capital charge:

Step 1: Map each interest rate position to a time band

Interest rate positions have different price sensitivities to interest rate shifts depending on their residual maturity. Interest rate shifts are changes in the yield curve. Each interest rate position is mapped to a time band.

There are two methods for mapping interest rate positions:

a)Maturity method maps each position to a maturity ladder based on the residual maturity of each position.

Fixed weightings are used to adjust the positions for sensitivity to the changes in interest rates as per the relevant table under the standard.

Time Bands for the Maturity Method

1. •Fixed income instruments with low coupons have higher sensitivity to changes in the yield curve than fixed income instruments with high coupons, all other things being equal.
2. •Fixed income instruments with long maturities have higher sensitivity to changes in the yield curve than fixed income instruments with short maturities, all other things being equal.

This is why the maturity method uses a finer grid of time bands for low coupon instruments (less than 3%) with long maturities.

Fixed and Floating Rate Instruments

Fixed rate instruments are mapped according to the residual term to maturity. Floating rate instruments are allocated according to the residual term to the next repricing date.

b)Duration method

11.This method maps each position according to its duration to a duration ladder. Duration is a measure of the average maturity of a debt instrument’s cash flows from both coupons and principal repayment. It is expressed in years and allows debt instruments with different coupons and maturities to be compared. The duration method allows banks the necessary capability to calculate price sensitivity based on an instruments’ duration (with the supervisory consent).

Step 2: Calculate the capital charge

The capital charge is the sum of four components calculated from amounts in each time band:

:

1. •A charge on the net short or long position in the whole trading book:
2. •A vertical disallowance charge:

It is a charge, which is levied on the matched position in each time band. This charges accounts for basis risk and gap risk, which can arise because each time band includes different instruments with different maturities. Gap risk, or interest mismatch risk, is the risk of losses due to interest rate changes that arise when the periods over which assets and liabilities are priced, differs. This charge is levied on the matched position in each time band at:

1. •10% if the bank uses the maturity method
2. •5% of the bank uses the duration method

The matched position is the smaller absolute value of the long and short positions. For example: if you have a long position of 1,200 and a short position of 700, the matched position is 700 (the net open position is long 500).

1. •A horizontal disallowance charge:

It is a charge against correlation among the different time bands. It is allowed for correlation to offset positions across different time bands.

There are three rounds of horizontal disallowance:

1. •Round 1 levies a charge on the matched position in each zone. The charge is:
   1. o40% for zone 1
   2. o30% for zone 2 and zone 3
2. •Round 2 levies a charge of 40% on the matched positions between adjacent zones. The adjacent zones are:
   1. oZone 1 and zone 2
   2. oZone 2 and zone 3
3. •Round 3 levies a charge of 100% on the matched position between zone 1 and zone 3.
4. •Where applicable, a net charge for positions in options.

   2.Specific Risk

12.Specific risk refers to changes in market prices specific to an instrument owing to factors related to the issuer of that instrument.

13.Specific risk does not affect foreign exchange- and commodities-related instruments. This is because changes in FX rates and commodities prices are dependent on general market movements.

14.The charge for specific risk protects against price movements in a security owing to factors related to the individual issuer, that is, price moves that are not initiated by the general market.

a)Offsetting

15.When specific risk is measured, offsetting between positions is restricted.

1. •Offsetting is only permitted for matched positions in an identical issue.
2. •Offsetting is not allowed between different issues, even if the issuer is the same. This is because differences in coupon rates, liquidity, call features, and so on, mean that prices may diverge in the short run.

b)Specific Risk – Capital Charge

16.Under the standardised approach, market risk exposures are categorised according to external credit assessments (ratings) and based on those assessments a capital charge is assigned. This broad methodology for calculating the specific risk capital charge was not changed by Basel 2.5.

17.The capital charges assigned to those external credit assessments are similar to the credit risk charges under the standardised approach to credit risk.

Categorisation of Securities

18.Consistent with other sections, a lower specific risk charge can be applied to government paper denominated in the domestic currency and funded by the bank in the same currency. The national discretion is limited to GCC Sovereigns. This use of national discretion aligns the Market Risk Standards with the similar treatment under the credit risk standards. The Market Risk Standard is also aligned to the Credit Risk Standard when it comes to the transition period permitted for USD funded and denominated exposures of the individual Emirates.

Qualifying includes securities issued by public sector entities and multilateral development banks, plus other securities that are rated with investment grades by two rating agencies. Unrated securities can also be included, subject to supervisory approval (such as securities deemed to be of comparable investment quality).

Other securities comprise of securities that do not meet the definition of government or the definition of qualifying securities. This category receives the same risk charge as non-investment grade borrowers under the standardised approach to credit risk. However, it is recognised that for some high yielding debt instruments, an 8% specific risk charge may underestimate the specific risk.

Calculating the Capital Requirement for Market and Credit Risk

19.The standards contain different processes for calculating the capital requirement for market and credit risk. For credit risk, assets are first risk weighted (by multiplying them by a risk weight) and then a capital requirement is applied. In contrast, for market risk, exposures are simply multiplied by a specific risk capital charge. For an exposure with a given external credit assessment (rating), the specific risk capital charge is the same as the capital requirement calculated under the standardised approach for credit risk.

Specific Risk – Capital Charge for Positions Covered Under the Securitisation Framework

20.Following the 2009 enhancements to the BCF, the specific risk of securitisation positions held in the trading book are generally calculated in the same way as securitisation positions in the banking book.

21.Specific risk – the capital charges for positions covered under the standardised approach for securitisation exposures.

22.The default position for unrated securitisations can be thought of as a capital charge of 100 percent (that is, equivalent to a risk weight of 1250 percent where the capital charge is 8 percent).

23.Where the specific risk capital charge for an exposure is 100% such that capital is held for the full value of the exposure, it may be excluded from the calculation of the capital charge for general market risk. For further details, please refer to the securitisation framework.

Treatment of Interest Rate Derivatives

24.The interest rate risk measurement system should include all interest rate derivatives and off-balance sheet instruments assigned to the trading book that are sensitive to changes in interest rates.

25.The derivatives are converted into positions in the relevant underlying. These positions are subject to the general market risk charges and, where applicable, the specific risk charges for interest rate risk. The amounts reported should be the market value of the principal amount of the underlying or notional underlying.

26.For instruments where the apparent notional amount differs from the effective notional amount, banks will use the effective notional amount.

Interest rate derivatives include:

1. ▪forward rate agreements (FRAs)
2. ▪other forward contracts
3. ▪bond futures
4. ▪interest rate swaps
5. ▪cross currency swaps
6. ▪forward foreign exchange positions
7. ▪interest rate options

Refer to the examples below in this section for numerical illustrations

27.Market risk can be influenced by changes in equity prices, that is, equity risk.

28.Equity risk is the risk that movement in equity prices will have a negative effect on the value of equity positions. The capital charge for equity risk is the sum of the charges for general and specific market risk.

29.The Central Bank sets out a minimum capital standard to cover the risk of equity positions held in the trading book. It applies to long and short positions in all instruments that exhibit behavior similar to equities, with the exception of non-convertible preference shares, which fall under interest rate risk requirements.

   1.Capital Charges for Equity Risk

30.To calculate the minimum capital charge for equity risk, you must calculate two separate charges:

1. ▪A general market risk charge of 8% is applied to the net overall position.
2. ▪A specific risk charge of 8% is applied to the gross equity position. After offsetting long and short positions in the same issue, a bank's gross equity position is the sum of the absolute values of all long equity positions and all short equity positions.

31.Since banks may hold equities in different national markets, separate calculations for general and specific risk must be carried out for each of these markets.

Offsetting

Long and short positions in the same issue can be fully offset, resulting in a single net long or short position.

   2.Treatment of Equity Derivatives

32.Equity derivatives and off-balance-sheet positions that are affected by changes in equity prices should be included in the measurement system, with the exception of certain options positions. This includes futures and swaps on both individual equities and on stock indices.

33.Positions in these equity derivatives should be converted into notional positions in the relevant underlying stock or portfolio of stocks. For example, stock index futures should be reported as the marked-to-market value of the notional underlying equity portfolio. A stock index future is an agreement to buy or sell a standard quantity of a specific stock index, on a recognised exchange, at a price agreed between two parties, and with delivery to be executed on a standardised future settlement date. As it is obviously not feasible to deliver an actual stock index, stock index futures contracts are settled by cash, calculated with reference to the difference between the purchase price and the level of the index at settlement.

34.An equity swap is an agreement between two counterparties to swap the returns on a stock or a stock index for a stream of payments based on some other form of asset return. Often, one payment leg is determined by a stock index with the second leg determined by a fixed or floating rate of interest. Alternatively, the second leg may be determined by some other stock index (often referred to as a relative performance swap).

35.Equity swaps should be treated as two notional positions. For example, in an equity swap where a bank is receiving an amount based on the change in value of one stock index and paying an amount based on a different index, the bank is regarded as having a long position in the former index and a short position in the latter index.

36.In addition to the general market risk requirement, a further capital charge of 2% will be applied to the net long or short position in index contracts on a diversified portfolio of equities, to cover factors such as execution risk. As the standard stated.

Refer to the examples below in this section for numerical illustrations

37.Market risk can be influenced by changes in foreign exchange rates, that is, foreign exchange risk.

38.Foreign exchange risk is the risk that the value of foreign exchange positions may be adversely affected by movements in currency exchange rates. Foreign exchange positions or exposures incur only general market risk. The capital charge for foreign exchange risk also include a charge for positions in gold. For purposes of market risk capital requirements, the Central Bank takes into account the stable relationship between the AED and the US dollar, with the result that no capital is charged for open positions in USD. Foreign currency is any currency other than the bank's reporting currency.

39.Two steps are required to calculate the overall net open position:

Step 1: Determine the Exposure in Each Currency

The first step is to calculate the bank's open position, long or short in each currency.

The open position in each currency is the sum of:

1. ▪ the net spot FX position (Includes also all asset items less all liability items, including accrued interest, denominated in the currency)
2. ▪ the net forward FX position (Because forward FX rates reflect interest rate differentials, forward positions are normally valued at current spot exchange rates. The net forward position in an exposure should consist of all amounts to be received less all amounts to be paid under forward FX transactions, including currency futures and the principal on currency swaps not included in the spot position. For banks that base their management accounting on the net present values (NPVs), the NPV of each position should be used; discounted using current interest rates and valued at current spot rates)
3. ▪ guarantees and similar instruments that are certain to be called and are likely to be irrecoverable.
4. ▪ net future income and expenses not yet accrued but already fully hedged
5. ▪ any other item representing a profit or loss in foreign currencies
6. ▪ the net delta-based equivalent of the total book of foreign currency options

Step 2: Determine the Overall Net Open Position across FX Exposures

The second step in calculating the capital requirement for FX risk is to measure the risk in the bank's portfolio of foreign currency and gold positions.

You can determine the overall net open position of the portfolio by first converting the exposure in each foreign currency into the reporting currency at the spot rates. Then, calculate the overall net position by summing the following:

1. ▪ the greater of the sum of the net short positions or the sum of the net long positions (excluding the net open position in the US dollar
2. ▪ Take the larger of the two sums, from the step above, and add the absolute value of the net position (short or long) in gold.

The capital charge for foreign exchange market risk is 8% of the position resulting from the calculation above.

Foreign Exchange (FX) Exceptions

40.The Central Bank of UAE may allow banks to exclude certain FX positions from the capital charges calculation. Banks have to comply with both the requirement of para 70 of the Market Risk section of the standards.

41.Items that are deducted from a bank’s capital when calculating its capital base, such as investments in non-consolidated subsidiaries, or other long-term participations denominated in foreign currencies, which are reported in the published accounts at historic cost, do not need to be included as foreign currency exposures for the foreign exchange risk calculation.

42.Banks with negligible business in foreign currencies and with no FX positions taken for their own account may exclude their FX positions if they meet both of the following requirements:

1. ▪ their FX business (the greater of the sum of their gross long positions and the sum of their gross short positions) does not exceed 100% of total capital (Tier 1 + Tier 2)
2. ▪ their overall net open position does not exceed 2% of its total capital

43.Market risk can be influenced by changes in commodity prices, that is, commodity risk. Commodity risk is the risk that on- or off-balance sheet positions will be adversely affected by movements in commodity prices.

44.A commodity is defined as a physical product that can be traded on a secondary market, for example, agricultural products, minerals and precious metals. Gold; however, is covered under the framework for foreign exchange.

45.Price risk in commodities is often more complex and volatile than price risk associated with currencies and interest rates. One reason for this is that commodity prices are influenced by natural events such as floods and droughts. Changes in supply and demand also have more dramatic effects on price and volatility, and commodity markets often lack liquidity.

46.Commodity risk only has a general market risk component because commodity prices are not influenced by specific risk.

47.Banks using portfolio strategies involving forward and derivative contracts on commodities are exposed to a variety of additional risks, such as:

1. ▪ Basis risk. the risk of changes in the cost of carry for forward positions and options. Cost of carry is a margin and refers to the net effect of borrowing funds for a certain period of time and investing them in a financial instrument or commodity for the same period of time. If the interest earned on the instrument or commodity is greater than the cost of borrowing, then the cost of carry is positive. The cost of carry can also be negative if the cost of borrowing is greater than the interest earned.
2. ▪ Forward gap risk. This is the risk wherein forward prices may change for reasons other than a change in interest rates.

48.It is important to note that these risks could well exceed the risk associated with changes in spot prices of commodities.

   1.Treatment of Commodities

Offsetting

49.When measuring risk in commodities, offsetting between positions is restricted.

1. ▪ Offsetting is allowed between long and short positions in exactly the same commodity to calculate open positions.
2. ▪ In general, offsetting is not allowed between positions in different commodities. However, the Central Bank may permit offset between different sub-categories of the same commodity, for example, different categories of crude oil, if:
   1. ▪ they are deliverable against each other
   2. ▪ they are close substitutes for each other, with a minimum correlation of 0.9 between price movements over a period of at least one year

Correlations

50.Banks using correlations between commodities to offset commodity positions must have obtained prior approval from the Central bank of UAE.

   2.Calculating the Capital Charge

51.Two alternative approaches for calculating the capital charge for commodities are set out by the standardised measurement method:

a)Simplified Approach

52.Under the simplified approach, banks must express each commodity position, spot plus forward, in terms of the standard unit of measurement (barrels, kilos, grams, and so on).

The capital charge is the sum of two charges:

1. ▪ 15% of the net position in each commodity. All commodity derivatives and off-balance sheet positions affected by changes in commodity prices should be included.
2. ▪ 3% of the bank's gross commodity positions, that is, the sum of the net long plus net short positions in each commodity, calculated using the current spot price. This charge addresses basis risk, interest rate risk and forward gap risk.

b)Maturity Ladder Approach

53.There are seven steps involved in calculating the capital charge for commodities using the maturity ladder approach. A separate maturity ladder must be used for each commodity.

   3.Treatment of Commodity Derivatives

54.All commodity derivatives and off-balance sheet positions affected by changes in commodity prices should be included in the commodities risk measurement framework. This includes commodity futures, commodity swaps, and options where the “delta plus” method is used.

Treatment of Options

55.There is a section of the market risk framework devoted to the treatment of options.

The market risk charge for options can be calculated using one of the following methods:

1. ▪ the simplified approach
2. ▪ an intermediate approach: the delta-plus method

56.The more significant a bank's trading activities, the more sophisticated the approach it should use. The following table shows which methods a bank can use:

57.Banks that solely use purchased options are free to use the simplified approach, whereas banks that also write options are expected to use the intermediate approach. If a bank has option positions, but all of those written options are hedged by perfectly matched long positions in exactly the same options, no capital is required for market risk on those options. However, banks need to report the hedged options in the respective sheet.

a)Simplified Approach

58.Option positions and their associated underlying (cash or forward) are 'carved out' from other risk types in the standardised approach. They are subject to separately calculated capital charges that incorporate both general market risk and specific risk. These charges are then added to the capital charges for the relevant risk categories: interest rate risk, equities risk, foreign exchange risk or commodities risk.

59.In some cases, such as foreign exchange, it may be unclear which side is the “underlying security.” In such cases, the asset that would be received if the option were exercised should be considered as the underlying. In addition, the nominal value should be used for items where the market value of the underlying instrument could be zero, such as caps and floors, swaptions, or similar instruments.

60.The capital charges under the simplified approach are as follows:

b)Intermediate Approach

61.The procedure for general market risk is explained below. The specific risk capital charges are determined separately by multiplying the delta-equivalent of each option by the specific risk charges for each risk category.

   The delta-plus method

62.The delta-plus method uses the sensitivity parameters or Greek letters associated with options to measure their market risk and capital requirements.

63.Options should be included in market risk calculations for each type of risk as a delta- weighted position equal to the market value of the underlying multiplied by the delta.

64.The delta-equivalent position of each option becomes part of the standardised approach, with the delta-equivalent amount subject to the applicable market risk capital charges. Separate capital charges are then applied to the gamma and Vega risks of the option positions.

Greek Letters: Five coefficients are used to help explain how option values behave in relation to changes in market parameters (price of the underlying asset, the strike price, the volatility of the underlying, the time to maturity and the risk-free interest rate). These are represented by the Greek letters delta, gamma, Vega, theta and rho, and are referred to as the 'option Greeks'.

1. •Delta (Δ) measures the rate of change in the value of an option with respect to a change in the price of the underlying asset.
2. •Gamma (Γ) measures the rate of change in the delta of an option with respect to a change in the price of the underlying asset.
3. •Vega (Λ) measures the rate of change in an option price with respect to a change in market volatility for the underlying asset price.

   1.Calculating the General Market risk charge

Calculate the general market risk capital charge for XYZ bank’s interest rate positions using the maturity method.

Long position in a qualifying bond: Market value AED 13.33m. Residual maturity 8 years & coupon 8%

Long position in a government bond: Market value AED 75m. Residual maturity 2 months & coupon 7%

Interest rate swap: Notional value AED 150m. Residual life of swap 8 years & bank receives floating rate interest and pays fixed. Next interest fixing after 9 months

Long position in interest rate government bond future: Contract size AED 50mn.

The treatment of interest rate future positions assume a bank is exposed to a long position in a 6-month interest rate future bought today and settled in two months' time. The long position in interest rates needs to be slotted into the 6-12 months’ time band because the maturity of the long position is considered to be eight months. This is because the position is taken on today and will be settled in two months with a maturity of six months.

Delivery date after 6 months & remaining maturity of the CTD government security 3.5 years.

Cheapest to deliver CTD refers to the underlying instrument that result in the greatest profit or the least loss when delivered in satisfaction of futures contracts.

Calculating the general market risk capital charge comprises two main steps and a number of sub-steps.

Step 1: Map each interest rate position

We are using the maturity method to map the positions. None of the bank’s positions have a coupon of less than 3%, so we will use a ladder of 13 time bands. Each position is mapped to the appropriate time band according to its residual maturity.

Step 2: calculate the total capital charge

Overall net open position

The net open position is the sum of all the positions across all the time bands. The net open position is AED 3m short, which leads to a capital charge at 100% of AED 3,000,000.

Calculation:

+75*0.2%=+0.15

-50*0.4%=-0.2

+150*0.7%=+1.05

+50*2.25%=+1.125

-150*3.75%=-5.625

+13.33*3.75%=+0.5

Vertical disallowance

The long position of AED 0.5m is offset against the short position of AED 5.625m as per the marked area. The matched position is AED 0.5m and the net open position is AED -5.125m.

This leads to a capital charge of 10% of AED 0.5m, or AED 50,000

Calculation

Matched position = 0.5

Net open position = -5.625+0.5= -5.125

Horizontal disallowance

The third part of the capital charge is a charge for the horizontal disallowance. There are three rounds of horizontal offsetting.

In round 1, the horizontal disallowance within each zone is calculated. In this example, charge applies to zone 1 only because it is the only zone with a long and a short position. (With more than one position). The short position, -0.2 is offset against the total long position, +1.2. The matched position is 0.2 and the net open position is +1.

The capital charge for the horizontal disallowance within zone 1 is 40% of AED 0.2m, or AED 80,000

In round 2, calculate the horizontal disallowance between adjacent zones, i.e., between:

Zone 1 and zone 2

Zone 2 and zone 3

In this example, zone 1 and zone 2 both contain long positions, so there is no matched position and therefore no offsetting between these zones. The long position of 1.125 in zone 2 is offset against the short position of -5.125 in zone 3. The matched position is 1.125 and the net open position is -4. The capital charge for the horizontal disallowance between zones 2 and 3 is 40% of AED 1.125m= AED 450,000.

In round 3, we calculate the horizontal disallowance between zones 1 and 3.

In this example, the long position of 1 in zone 1 is offset against the short position of -4 in zone 3. The matched position is 1 and the net open position is -3. The capital charge for the horizontal disallowance between zones 1 and 3 is 100% of AED 1m = AED 1m.

After the three rounds of horizontal offsetting, the total charge for the horizontal disallowance is AED 80,000 + AED 450,000 + AED 1,000,000 = AED 1,530,000

Having completed the horizontal and vertical offsetting, the remaining overall net open position is AED 3m, which is equivalent to the overall net open position we calculated across all time bands when we calculated the first part of the capital charge.

We have now calculated the total capital charge for general market risk for this example.

   2.Specific Market Risk – Example

Relate to the same example as above.

Given that, the government bonds are AAA-rated and that the qualifying bond is BBB-rated.

The interest rate swap does not incur a specific risk charge. The AAA-rate government bonds incur a 0% specific risk charge. The qualifying bond has a residual maturity of 8 years and is BBB-rated, so if has a specific risk charge of 1.6%

The capital charge is 1.6% of AED 13.33m, or AED 213,280.

Bank XYZ has the following positions in its equity portfolio for a particular national market.

To calculate the general market risk charge, we must first determine the overall net open position. The sum of the net long positions is AED 650,000 and the sum of the net short positions is AED 870,000. The overall net open position is short AED 220,000.

The capital charge for general market risk is 8% of AED 220,000, or AED 17,600.

Next, we must work out the specific risk charge.

The capital charge for specific risk is 8% of AED 1,520,000 or AED 121,600.

That lead to, overall capital charge for this portfolio is AED 17,600 + AED 121,000, or AED 139,200.

Below is an example of calculating the capital charge for FX risk.

A bank has the following positions that have been converted at spot rates into its reporting currency, United Arab dirhams (AED).

The higher of the sum of the net long and net short currency positions is AED 300m.

The capital charge is therefore calculated as 8% of AED 300m, plus the net position in gold (AED 35m):

Capital charge = 8% of AED 335m = AED 26.8m

Another example;

A bank has the following positions that have been converted at spot rates into its reporting currency (AED)

The sum of the net long positions is AED 225m and the sum of the net short positions is -AED 145m. The capital charge is calculated as 8% of the higher of these two positions, so the charge is 8% of AED 225m, or AED 18m.

   1.Simplified approach

XYZ bank is exposed to a number of positions in the same commodity. The bank’s reporting currency is AED. The following positions are held in EUR:

Firstly, calculate the current value for these positons in the reporting currency.

The following is the current situation:

Further calculation to the position after conversion to local reporting bank’s currency

640*4.25=2,720
-800*4.25=-3,400
480*4.25=2,040
-480*4.25=-2,040

Calculate the capital charge, first a capital charge of 15% of the overall net open position in the commodity is required.

The overall net position is the sum of the long and short positions:
AED 2,720 – AED 3,400 + AED 2,040 – AED 2,040 = - AED 680
The overall net positon is short AED 680. This leads to a capital charge of AED 102 (680 * 15%) Next, a capital charge of 3% of the bank’s gross positon in the commodity is required.
The gross position is the sum of the absolute values of the long and short positions:
AED 2,720 + AED 3,400 + AED 2,040 + AED 2,040 = AED 10,200

XYZ bank’s gross position is AED 10,200. This leads to a capital charge of AED 306 (10,200 * 3%).
Now, sum the charges to find the total capital charge for this commodity. The charge for the overall net open position is AED 102, and the charge for the bank’s gross position in the commodity is AED 306.
Therefore, XYZ bank’s total market risk capital charge for positions held in this commodity is AED 102 + AED 306, or AED 408.

   2.Maturity ladder approach

Recall that XYZ bank is exposed to a number of positions in the same commodity. The bank’s reporting currency is AED. The following positions are held in EUR:

Step 1:

First express each commodity position in terms of the standard unit of measurement, and value in the reporting currency at the current spot price.

The following is the current situation:

This is done the same way as for the simplified approach.

Step 2:

Slot each position into a time band in the maturity ladder according to its remaining maturity. Physical stocks should be allocated to the first time band.

Step 3:

Apply a capital charge: of 1.5% to the sum of the matched long and short positions in each time band to capture spread risk.

*start with the 3-6 months’ time band.
Multiply the sum of the ling and short matched positions by the spread rate 1.5%, to calculate the capital charge: (AED 2,720 + AED 2,720) * 1.5% = AED 81.6

Step 4:

Apply a capital charge of 0.6% to the residual net position carried forward to the next relevant time band, multiplied by the number of time bands it is carried forward.

The maturity ladder approach allows for netting between unmatched long and short positions across time bands. The residual net position in a time band can be carried forward to the next relevant time band, thus offsetting exposures in time bands further out. Because this is imprecise, resulting in an “imperfect hedge”; a capital charge is required.

The residual net position in the 3-6 months’ band is short AED 680. This net position is carried forward two time bands to offset exposures in the next relevant time band, the 1-2 years’ band.

*The capital charge is calculated as follows: AED 680 * 2 * 0.6% = AED 8.16

Step 5:

Repeat step 3 and step 4 for each time band.

When determining the matched position in each time band, take into account the residual net position carried forward.

*(680+680)*1.5% = AED 20.4
**(1,360*2*0.6%) = AED 16.32
***(1,360+1360) *1.5% = AED 40.8

Step 6:

Apply a capital charge of 15% to the overall long or short net open position.

The net position in the final time band is subject to a capital charge of 15% as to say 680 * 15% = AED 102

Step 7:

Derive the total capital charge by summing the charges for spread risk, for positions carried forward and for the overall net open position.

In this example, the capital charge calculated using the maturity ladder approach; AED 269.28 is significantly lower than that calculated using the simplified approach, AED 408.

   Simplified approach

A bank holds 100 shares currently valued at USD 10, and also holds an equivalent number of put options with a strike price of USD 11 (each option entitles the bank to sell one share).
Since these are equity options, they are subject to the capital charges for general market risk and specific risk according to the standardised framework for equity risk. The capital charge is levied at 8% for general market risk and 8% for specific risk, giving a summed charge of 16%.

Market value of 100 shares = USD 1,000

First, multiply the market value by the sum of general market risk and specific risk charges.
USD 1,000 x 16% = USD 160
Then, calculate the amount the option is in-the-money.

(USD 11 - USD 10) x 100 = USD 100

The capital charge is the general market risk and specific risk charge less the amount the option is in-the-money.
USD 160 - USD 100 = USD 60

A similar methodology applies for options whose underlying is a foreign currency, an interest rate related instrument or a commodity.

Another example for simplified approach
A bank holds 500 shares currently valued at USD 25.50 and holds an equivalent number of put options with a strike price of USD 26.25 (each option entitles the bank to sell one share).

The capital charge is calculated as follows:
Market value of 500 shares = USD 12,750
USD 12,750 x 16% (that is, 8% specific plus 8% general market risk) = USD 2,040

The amount the option is in-the-money = (USD 26.25 - USD 25.50) x 500 = USD 375.
This gives a capital charge of USD 2,040 - USD 375 = USD 1,665

9.The Basic Indicator Approach (BIA) is a simple approach for calculating the capital charge for operational risk. It can be used by banks that are not internationally active, as well as by banks that are internationally active but may not yet have risk management systems in place for using the more advanced approaches for measuring operational risk.

10.While the approach is available for all banks as a 'point of entry', irrespective of their level of sophistication, Central Bank expects internationally active banks and banks with significant operational risk to discontinue indefinitely with the Basic Indicator Approach.

The Basic Indicator Approach Components

11.The operational risk capital charge under the BIA is based on two components:

1. 1.The exposure indicator, represented by the Gross Income (GI) of a bank as a whole.
2. 2.The fixed factor, alpha (α), set by the Basel Committee.

The formula for calculating the capital charge for operational risk under the BIA is as follows:

Where:

K_BIA = The capital charge under the BIA;

GI = Annual gross income, where positive, over the previous three years;

n = Number of the previous three years for which gross income is positive; and

α =15%, relating the industry wide level of required capital to the industry wide level of the indicator.

1.Gross Income of the Bank

12.Gross income is a broad indicator that serves as a proxy for the likely exposure of a bank to operational risk. It is the total of net interest income plus net non-interest income of a bank as a whole. Net interest income is defined as interest income of a bank (for example, from loans and advances) minus the interest expenses (for example, interest paid on deposits). Net non-interest income is defined as fees and commissions earned minus the non-interest expenses (that is, fees and commissions paid) and other income.

13.Gross income used in the calculation of the capital charge for operational risk should be:

1. -Gross of any provisions, for example, for unpaid interest. This is because such amounts should have normally formed part of a bank's income but have been set aside for likely credit losses.
2. -Gross of operating expenses, including fees paid to outsourcing service providers. This is because outsourcing of activities does not fully transfer operational risk to the service provider. Outsourcing is the strategic use of outside resources to perform business functions that are traditionally managed by internal staff. Outsourcing offers the advantage of access to specialised and experienced personnel that may not be available internally, and enables banks to concentrate on their core business and reduce costs.

14.Only sustainable, renewable and recurrent sources of income are to be used as the basis for calculating the operational risk capital charge. Banks should perform a reconciliation between the gross income reported on the capital adequacy return and the audited financial statements. This information should be available to the Central Bank upon request. As such, gross income should exclude:

1. -realised profits/losses from the sale of securities classified as 'held to maturity' and 'available for sale', which typically constitute items of the banking book under certain accounting standards. The intention is to hold such securities for some time or up to their full term and not for trading purposes. Their sale does not represent sustainable income from normal business.
2. -Held to maturity securities are those that the bank intends to hold indefinitely or until the security reaches its maturity. Available for sale securities includes securities that are neither held for trading purposes nor intended to be held till maturity. These are securities that the bank intends to hold in the short or medium term, but may ultimately sell. Banking book relates to positions that are held to maturity with no trading intent associated with them. Most loans and advances are included in the banking book as they are intended to be held until maturity. At times, there may also be liquid positions assigned to the banking book if they are intended to be held over a longer term or to maturity.
3. -Extraordinary or irregular items as well as income derived from insurance claims. Again, these items are to be excluded, as they are not sustainable sources of income for a bank.

15.Banks sometimes outsource certain activities, such as processing and maintaining data on loan collection services to external service providers. Alternatively, banks may act as service providers to other banks. This results in the payment or receipt of a fee for the outsourced service.

16.Basel provides the following guidance for the treatment of outsourcing fees paid or received, while calculating the gross income for the purpose of calculating the operational risk capital charge:

1. -Outsourcing fees paid by a bank to a service provider do not reduce the gross income of the bank.
2. -Outsourcing fees received by a bank for providing outsourcing services are included in the definition of gross income.

2.Alpha

17.Alpha is a fixed factor, set by the Basel Committee. It serves as a proxy for the industry-wide relationship between operational risk loss experience of a bank and the aggregate level of the operational risk exposure as reflected in its gross income.

Treatment of Negative Gross Income

18.The operational risk capital charge under the BIA is assumed that a bank has positive gross income for all of the previous three years. However, some banks may have negative gross income for some year(s), for example, resulting from poor financial performance. Figures for any year in which annual gross income is negative or zero shall be excluded from both the numerator and denominator when calculating the gross income average.

19.On this basis, the figures presented in the 3 years' calculations should reconcile (or be reconcilable) with the bank’s audited financial statements.

20.The Standardised Approach (SA) represents a refinement along the continuum of approaches for calculating the operational risk capital charge. While this approach also relies on fixed factors as a percentage of gross income, it allows banks to use up to eight such factors, called betas, depending upon their business lines.

21.The calculation of the operational risk charge under this approach is more risk sensitive than the BIA.

The Standardised Approach Capital Charge

22.Under the Standardised Approach (SA), the operational risk capital charge is based on the operational risk capital charges for individual business lines in a bank. The formula for calculating the operational risk capital charge under the SA is as follows:

Where:

K_TSA = the capital charge under the Standardised Approach

GI_1-8 = the annual gross income in a given year, as defined in the Basic Indicator Approach (BIA), for each of the eight business lines

β _1-8 = a fixed percentage, set by the committee, relating the level of required capital to the level of the gross income for each of the eight business lines

The Standardised Approach Components

23.The Standardised Approach identifies two main components to be used in calculating the operational risk capital charge:

1.Gross Income of Eight Business Lines

24.Eight business lines are recommended for use by the Basel Committee in calculating the operational risk charge under the SA. These business lines are considered as being representative of the various kinds of businesses undertaken by banks. The identified business lines briefed below are:

1. 1.Corporate finance: banking arrangements and facilities provided to large commercial enterprises, multinational companies, non-bank financial institutions, government departments etc.
2. 2.Trading and sales: treasury operations, buying and selling of securities, currencies and commodities for proprietary and client accounts.
3. 3.Retail banking: financing arrangements for private individuals, retail clients and small businesses such as personal loans, credit cards, auto loans, etc. as well as other facilities such as trust and estates and investment advice.
4. 4.Commercial banking: financing arrangements for commercial enterprises, including project finance, real estate, trade finance, factoring, leasing, guarantees, bills of exchange etc.
5. 5.Payment and settlement: activities relating to payments and collections, interbank funds transfer, clearing and settlement.
6. 6.Agency services: acting as issuing and paying agents for corporate clients, providing custodial services etc.
7. 7.Asset management: managing funds of clients on a pooled, segregated, retail, institutional, open or closed basis under a mandate.
8. 8.Retail brokerage: broking services provided to customers that are retail investors rather than institutional investors.

25.Under the SA, the gross income is calculated for each of the eight business lines. It serves as a proxy for the likely scale of exposure of that business line of the bank to operational risk. Since all income has to be allocated to a business line, the sum of the gross income of the eight business lines should equal the gross income for the bank as a whole

26. Just like in the Basic Indicator Approach, gross income for SA comprises net interest income plus net non-interest income as defined in the Operational Risk section of the Standards re Capital Adequacy.

2.Beta

27.Beta serves as a proxy for the industry-wide relationship between the operational risk loss experience and the level of operational risk exposure as reflected in the gross income for a business line. It is representative of the amount of loss that can be incurred by a bank given that level of exposure (represented by gross income) in a business line.

28.The beta factors for the eight business lines as set by the Basel Committee are as follows:

29.The beta factors have been set within a range of 12-18% depending upon the degree of operational risk perceived in a business line. Thus, a 12% beta factor for retail banking indicates that, in general, the operational risk in retail banking is lower than the operational risk in commercial banking. The latter, which has a beta of 15%, carries a lower operational risk than, for example, payment and settlement, which carries a beta factor of 18%.

Treatment of Negative Gross Income from Business lines

30.Some banks may have negative gross income for some years in some business lines. This will result in a negative capital charge for the business line for that year. If the gross income and the resulting capital charge of a specific business line is negative, the aggregate of the capital charges across business lines for that year could still be positive, so long as the gross income from other business lines is positive.

31.The following guidance applies for treatment of negative capital charges under the Standardised Approach:

1. -In any given year, negative charges in business lines may offset positive capital charges in other business lines without any limit.
2. -If the total capital charge, after offsetting negative and positive capital charges of business lines, is negative for a given year, then the numerator for that year will be set to zero.
3. -If negative gross income distorts the operational risk capital charge calculated under the SA, the Central Bank will consider appropriate supervisory action under Pillar 2.

Calculating the Operational risk capital charge under the Standardised Approach (SA)

The calculation of the capital charge for operational risk under the SA follows the following steps:

Step 1: Calculate the capital charge for each business line using its gross income and applicable beta factor in year 1.

If the gross income from a business line is negative, the capital charge for that business line in year 1 will be negative.

Step 2: Sum the eight capital charges of business lines for Year 1.

In a year, negative capital charges in some business lines may offset positive capital charges for other business lines without any limit.

Steps 3 and 4: Follow steps 1 and 2 for the other two years.

Step 5: Calculate the 3-year average of the aggregated capital charges. Where the aggregate capital charge across all business lines in a given year is negative, then the input to the numerator for that year will be zero. The denominator will remain 3, representing the three years included in the calculation.

Central Bank supports the use of the Beta given in the Standards re Capital Adequacy as well as here in this guidance above as the basis for the capital calculations under SA.
 

32.The Alternative Standardised Approach provides a different exposure indicator for two of the eight business lines, retail banking and commercial banking. These activities essentially comprise traditional banking business and still represent the main business of banks in several jurisdictions.

Calculation of Operational Risk Capital Charge under Alternative Standardised Approach (ASA)

33.Using the ASA, the operational risk capital charge for retail banking and commercial banking will be based on the following formulas:

Where:

K_rb = is the capital charge for retail banking

m = 0.035

β _rb = is the beta factor for retail banking (12%)

LA_rb = is the total outstanding retail loans and advances (non-risk weighted and gross of provisions), averaged over the past three years

$${\mathrm{K}}_{\mathrm{CB}}={\mathrm{\beta }}_{\mathrm{CB}}\times \mathrm{m}\times {\mathrm{LA}}_{\mathrm{CB}}$$
 

Where:

K_CB = is the capital charge for commercial banking

m = 0.035

β_CB= is the beta factor for commercial banking (15%)

LA_CB = is the total outstanding commercial loans and advances (non-risk weighted and gross of provisions), averaged over the past three years

For the other six business lines, the calculation of the operational risk capital charge will be based on the gross income and beta factor of that business line, as prescribed under the SA.

Further Options under the Alternative Standardised Approach (ASA)

34.Further options are available at under the ASA for calculating the operational risk capital charge to address problems in disaggregation of the exposure indicator among business lines by banks. However, the greater the disaggregation, the better will be the alignment of the capital charge with a bank's operational risk profile.

35.Available options relate to using loans and advances in commercial and retail banking business lines and gross income in the other six business lines as the exposure indicators with different beta factor combinations:

1. -Option 1 – using a common beta factor of 15% for commercial loans and retail loans, and the SA beta factors for the other six business lines
2. -Option 2 – using the SA beta factors of 15% and 12%, respectively, for commercial loans and retail loans and a common beta factor of 18% for the other six business lines
3. -Option 3 – using a common beta of 15% for commercial loans and retail loans and a common beta factor of 18% for the other six business lines

For further details, kindly refer to the Appendix below.

Question 1: If a bank incurs a negative gross income in any of the previous three years, will it be taken into account under the Basic Indicator Approach (BIA)?
The basis for working out the capital charge for operational risk under the BIA is three-year average of positive gross income. If the gross income for any of the previous three years is negative or zero, the figures for that year will be excluded from both the numerator and the denominator when calculating the capital charge. The negative gross income will not be added to the numerator and the denominator will exclude the year in which the income is negative.
As mentioned under the Basic Indicator Approach, if negative gross income distorts a bank’s Pillar 1 capital charge under the Standardised Approach, supervisors will consider appropriate supervisory action under Pillar 2.

Question 2: Can the Central Bank detail or provide examples of the extraordinary or irregular items under the definition of Gross income. Does this cover the bank selling off certain part of its business?
An extraordinary or irregular item consists of gains or losses included on a bank's P&L statement (usually reported separately as these items are not predictors of future performance) from events that are unusual and infrequent in nature. Such items are the result of unforeseen and atypical events that are outside the normal course of the core banking business (i.e. outside the types of income described in paragraph 13 of the Operational Risk section of Standards re Capital Adequacy in the UAE). For example, income derived from non-core banking business; income from discontinued operations; extraordinary income (e.g. from the sale of certain part a banking business).

Question 3: Define business Segments under 'Retail Brokerage' and 'Asset Management'?

1. •Retail Brokerage - Examples of activities:
   Execution and full service, such as:
   1. i.Reception and transmission of orders in relation to one or more financial instruments
   2. ii.Execution of orders on behalf of clients
2. •Asset Management- Examples of activities:
   1. i.Portfolio management
   2. ii.Managing of Investments funds, including: pooled funds, segregated funds, retail funds, institutional funds, closed funds, open funds, private equity funds

Question 4: What is the objective mapping criteria for mapping ancillary business function that supports more than one business line?
Such objective mapping criteria depends on the business and ancillary business mix of a bank. These criteria are not preset by the Central Bank. A bank should establish internally such criteria, reflecting its internal organisation, and these should be subject to independent review as per point (ix) of paragraph 12 of the Operational Risk section of Standards re Capital Adequacy in the UAE. The allocation can be done pro-rata based on the chosen criteria.
Examples of objective criteria include:

1. 1.number of full-time equivalent members of staff,
2. 2.time sheet man-hours,
3. 3.number of clients or transactions originated from each business line,
4. 4.volume of business originated from each business line.

Question 5: Business Segments/ functions that are to be mapped to 'Payment and Settlement' can be clearly articulated, as currently Level 2 defines the business segment as 'External Clients'
There is no fixed definition of external clients but all clients that the bank deals with externally with regards to Payment and Settlements need to be incorporated in this business line.

Question 6: What exposure indicator is used in the ASA approach?
In the ASA, gross income is replaced by the credit volume in terms of outstanding loans and advances (L&A) multiplied by a factor m (fixed at 0.035), as the exposure indicator for retail and commercial banking business lines. The loans and advances are non-risk weighted and gross of provisions.

Question 7: Why is the volume-based indicator alternative provided?
This volume-based indicator is provided to avoid large differences in the operational risk requirement caused by differences in income margins across banks and jurisdictions in these business lines. Gross income is not an appropriate exposure indicator of the extent of operational risk in retail and commercial lending.

Question 8: Can a bank choose to adopt ASA on its own?
No, the Central Bank must be satisfied that the alternative approach provides an improved basis for calculating the capital charge for operational risk in the bank. Reverting to the SA after adopting ASA is only possible with the approval of the Central Bank.

Question 9: What comprises Commercial Loans and Advances?
Under the ASA, commercial loans and advances will include outstanding amounts (non-risk weighted and gross of provisions) averaged over the past three years, from the following credit portfolios:

Question 10: What comprises Retail Loans?
For the purpose of the ASA, retail loans will include total outstanding amounts (non-risk weighted and gross of provisions) averaged over the past three years in the following credit portfolios:

Question 11: What is the threshold to decide a large diversified bank in terms of assets book size/composition or any other indicators?
Currently, there is no such threshold. The Central Bank will perform an assessment for each bank applying to qualify for ASA. The qualifying criteria provided in paragraph 28 of the Operational Risk section of Standards re Capital Adequacy in the UAE, especially the first one (90% income from retail/commercial banking) are stringent. The Central Bank will review whether the bank meets the 90% standard to determine whether an additional size cut-off is appropriate.

Question 12: Retail or commercial banking activities shall account for at least 90% of its income. Please clarify whether this needs to be seen in the current year or an average of all the 3 years based on which the Operational Risk capital is being computed
Testing the 90% rule across a period of three consecutive years will be more appropriate.

Question 13: "The bank's operational risk management processes and assessment system shall be subject to validation and regular independent review". Can we get clarification on the difference between the validation and the review, and what are the scope and responsible party for each?
Validation of models and tables must be performed by the internal auditor or by the external auditor.

Question 14: In terms of the "regular reporting", is an official ORM meeting required? For example, Operational Risk Business/ Country / Group Committee meetings?
It is up to the bank how it conveys the regular reports to the senior management and the board of directors, but the evidence of these reports were submitted needs to be documented for example senior management signatures on the reports.

Question 15: Is operational risk capital charge revision a quarterly activity going forward or it remains as a yearly activity at the end of the year?
Will it be more adequate if we use current years’ gross income to compute operational risk rather last year's audited numbers only.
If the quarterly income is audited, the bank should use the quarterly data, which means the same quarter in the previous two years needs to be taken into consideration or else, the yearly audited data needs to be incorporated
The standards state only audited numbers need to be used and as such, if the current year’s income is audited, it can be used as part of the computation

Question 16: Elaboration of definition and scope of Operational Risk should be helpful. For example, whether Operational Risk includes other risk types such as Fraud Risk, Business Continuity Risk etc.
The definition and scope of Operational risk is sufficiently elaborated in the Operational Risk Standard of the Capital Adequacy Standards of Banks in the UAE and the Operational Risk Guidance. If operational risks were not sufficiently covered under Pillar I, then the uncovered risk should be part of the Pillar 2 ICAAP calculation.

Question 17: As per the definition of gross income, "income derived from insurance" is to be excluded from the income while computing Operational RWA.
We would request clarification if this also refers to bancassurance i.e.Bank's commission income earned on insurance products that are sold on behalf of insurance companies."
Any income which the bank earns out of the bancassurace should be treated as income derived from insurance.

The Basic Indicator Approach (BIA) is a simple approach for calculating the capital charge for operational risk. It can be used by banks that are not internationally active, as well as by banks that are internationally active but may not as yet have risk management systems in place for using the more advanced approaches for measuring operational risk. Below is an example of ABC bank and how the Operational risk capital charge is calculated on Basic Indicator Approach

1- Calculating gross income through the table shows part of the income statement of ABC bank for 2003.

The net interest income to be used in gross income for calculating the operational risk capital charge after provisions. Normally banks reduce this amount to arrive at the operating income, however, in the calculation of capital charge for operational risk, net interest income is gross of provisions.

In this example, net interest income is interest income minus interest expenses.

150 – 110 = 40

While for calculating net non-interest income for calculating operational risk capital charge, in this example:

Net non-interest income is fees and commissions received (80) minus fees and commissions paid, adjusted for outsourcing fees paid (50 – 12 = 38). Therefore, the amount will be 42.

2- Calculating operational risk capital charge under BIA

The following table shows how to calculate the operational risk capital charge under the BIA.

3- Treatment of Negative Gross Income

Below is the calculation of the operational risk capital charge when the bank has negative gross income for a year.

Since negative gross income leads to exclusion of data points for that year from both the numerator and the denominator of the BIA operational risk formula, it could at times result in some distortions. For example, a bank that has negative gross income for one of three years might end up with a higher operational risk capital charge than if it were to have positive gross income for that year, even if it was a small amount. To ensure that such distortions do not occur, the supervisor should review and consider appropriate actions under Pillar 2.

1- Below is small example indicated which to include and exclude in the gross income:

Gross income for each business line should:

1. -Be gross of any provisions (for example, for unpaid interest).
2. -Be gross of operating expenses, including fees paid to outsourcing service providers.
3. -Exclude realised profits/losses from the sale of securities in the banking book.
4. -Exclude extraordinary or irregular items as well as income derived from insurance claims.

2- The following table shows how to calculate the capital charge for operational risk using the Standardised Approach:

*Gross Income x Beta factor

**Sum of eight capital charges for the year – remember within a year negative capital charges can offset positive charges among business lines

***Three-year average capital charge

3- Another example to illustrate the negative Gross income:

*Total capital charge against all business lines for year 2 is negative (-17.1), so the numerator for year 2 is set to zero

**Capital charge averaged for three years, with the numerator for year 2 set to zero

The following table shows how to calculate the capital charge for operational risk using the Alternative Standardised Approach.

*Gross income/loans & advances ^x m
**Exposure indicator (GI or LA ^x m) ^x β
***Outstanding loans and advances ^x m (0.035)
# Sum of eight capital charges for the year
## Three year average capital charge

5.ECAI’s should have a methodology for assigning credit ratings that is rigorous and systematic, and is subject to validation based on historical experience. Ratings assessments should be based on methodologies combining qualitative and quantitative approaches. Moreover, assessments must be subject to ongoing review and responsive to changes in financial condition. To establish that an ECAI fulfils this primary component of eligibility criteria, it must demonstrate that it meets the following minimum standards:

1. (i)The ECAI has established rating definitions, criteria, and methodologies, and apply them consistently;
2. (ii)The ECAI should have a robust procedure of rating assignment based on published information, market data, interviews with management, and/or other sources of information that provide a sound basis for purposes of assigning the ratings;
3. (iii)When assigning risk ratings, the ECAI should take into account all major features of credit quality that are relevant under the ECAI’s applicable methodology, and should ensure that the ratings are assigned taking into account all risk factors of the rated entity or issue relevant under the ECAI’s applicable methodology;
4. (iv)The ECAI should demonstrate that rating methodologies are subject to quantitative back testing. For this purpose, the ECAI should calculate and publish default studies, recovery studies, rating transition matrices, or other analyses as relevant to the ECAI’s rating methodology. The analysis should reflect a definition of default that is consistent with international standards, subject to possible adjustments to take into account local practices or institutional or market conditions;
5. (v)The rating methodology for each market segment, including rigorous back testing, must have been established for at least one year and preferably three years;
6. (vi)All rating decisions should be made based on the ECAI’s established criteria and methodologies, subject to documented variations approved in accordance with the ECAI’s procedures;
7. (vii)The ECAI should have a mechanism to review its procedures and methodologies to adapt them to a potentially changing environment; and
8. (viii)The ECAI should maintain adequate systems and internal records to support its assigned ratings.

6.The ECAI should be free from any economic or external political pressures that may influence its credit ratings. In particular, an ECAI should not delay or refrain from taking a rating action based on its potential effect (economic, political or otherwise). The independence of an ECAI shall be assessed on the basis of the following five parameters:

1. (i)Ownership: The ownership structure should not be such that it could jeopardize the objectivity of the rating process. For example, the owners should not hold 10 percent or more of the equity of any entity rated by the ECAI.
2. (ii)Organizational Structure and Corporate Governance: The ECAI should demonstrate that its organizational structure minimizes the scope for external influences to influence the rating process inappropriately. The ECAI should have in place effective corporate governance that safeguards the independence of its credit ratings, promotes integrity, and ensures that internal disagreements over ratings are resolved in ways that do not compromise the overall effectiveness of the rating process.
3. (iii)Financial Resources: The ECAI must demonstrate that its business is financially viable and is able to sustain any commercial pressure that might be exerted by external entities, including the entities being rated. The ECAI’s financial position should not depend significantly on the provision of other services to the rated entities.
4. (iv)External Conflict of Interest: The credit rating process of the ECAI should have the ability to withstand external pressures. The ECAI should demonstrate that it is free from any type of external conflicts of interest, or that conflicts of interest are disclosed and managed.
5. (v)Separation: An ECAI should separate its rating business operationally, legally, and if practicable, physically from its other business operations that may present a conflict of interest, such as advisory services.

7.The individual ratings, the key elements underlying the ratings, and whether the issuer participated in the rating process should be information that is publicly available on a non-selective basis.

8.In order to promote transparency and enable stakeholders to make decisions about the appropriateness of its credit rating methods, an ECAI should disclose sufficient information (e.g., rating definition, methods of arriving at the rating, rating process, time horizon of the rating, and the surveillance and review procedure) to facilitate such decisions. The ECAI’s general procedures, methodologies, and assumptions for arriving at ratings should be publicly available.

9.A rating should be disclosed as soon as practicably possible after issuance. When disclosing a rating, the information should be clearly worded, and should indicate the nature of the rating and relevant limitations, while providing appropriate warning to users of the potential danger of unduly relying on the rating to make investment or other decisions.

10.To promote transparency and market discipline, an ECAI should demonstrate that it provides access to information that enables stakeholders to make decisions about the appropriateness of ratings for the intended use or uses. At a minimum, the ECAI is expected to make public the following information:

1. •Code of conduct;
2. •Definition of default;
3. •The time horizons reflected in ratings;
4. •Rating definitions;
5. •Rating methods;
6. •Actual default rates experienced in each rating category;
7. •Rating transition matrices;
8. •Whether particular ratings are solicited or unsolicited;
9. •The date of last review and update of ratings;
10. •The general nature of compensation arrangements with rated entities; and
11. •Any actual or potential conflicts of interest.

11.At a minimum, the following conflict-of-interest situations and their influence on the ECAI’s credit rating methodologies or credit rating actions must be disclosed:

1. (i)The ECAI is being paid to issue a credit rating by a rated entity or by the obligor, originator, underwriter, or arranger of a rated obligation;
2. (ii)The ECAI is being paid by subscribers with a financial interest that could be affected by a credit rating action of the ECAI;
3. (iii)The ECAI is being paid by rated entities, obligors, originators, underwriters, arrangers, or subscribers for services other than issuing credit ratings or providing access to the ECAI’s credit ratings;
4. (iv)The ECAI is providing a preliminary indication or similar indication of credit quality to an entity, obligor, originator, underwriter, or arranger prior to being hired to determine the final credit rating for the entity, obligor, originator, underwriter, or arranger; and
5. (v)The ECAI has a direct or indirect ownership interest in a rated entity or obligor, or a rated entity or obligor has a direct or indirect ownership interest in the ECAI.

12.An ECAI should disclose the general nature of its compensation arrangements with rated entities, obligors, lead underwriters, or arrangers. When the ECAI receives compensation unrelated to its credit rating services from a party such as a rated entity, obligor, originator, lead underwriter, or arranger, the ECAI should disclose such compensation as a percentage of the total annual compensation received from that party in the relevant credit rating report or elsewhere, as appropriate. An ECAI should disclose in the relevant credit rating report or elsewhere, as appropriate, if it receives 10% or more of its annual revenue from a single party (e.g., a rated entity, obligor, originator, lead underwriter, arranger, or subscriber, or any of their affiliates).

13.ECAI should possess sufficient human and technical resources to produce high quality credit ratings. Evidence of resource sufficiency includes:

1. (i)Technical expertise of the people should be sufficient to conduct the analysis to support the assignment of ratings, and to maintain contact with senior and operational levels within the entities that are rated. In particular, ECAIs should assign analysts with appropriate knowledge and experience to assess the creditworthiness of the type of entity or obligation being rated; and
2. (ii)With respect to technical resources, an ECAI is expected to apply quantitative techniques and models that can appropriately process and analyze the quantities of data required to support the rating process.

14.The ECAI must demonstrate that it enjoys credibility in the markets in which it operates. Such credibility is gauged on the basis of:

1. (i)The extent to which it meets the resources requirements stated above;
2. (ii)The extent to which independent parties (investors, insurers etc.) rely on the ECAI’s risk ratings; and
3. (iii)The existence of internal procedures to prevent misuse of confidential information.

15.The Central Bank may request the ECAI to demonstrate that it has not used unsolicited ratings to put pressure on entities to obtain solicited ratings. If the Central Bank becomes aware of an ECAI using unsolicited ratings to put pressure on entities to obtain solicited ratings, the Central Bank may consider whether it is appropriate to revoke the recognition of the ECAI as eligible for capital adequacy purposes.

16.Eligible ECAIs should notify the Central Bank of significant changes to methodologies, and should provide the Central Bank with sufficient access to external ratings and other relevant data to support initial and ongoing determination of eligibility.

17.The ECAI must adopt and adhere to a code of conduct that is consistent with the IOSCO CRA Code. The ECAI must be subject to effective supervision on an ongoing basis by a competent regulatory authority that has adopted a regulatory regime consistent with the IOSCO CRA Code, and that incorporates a registration system for ECAIs.

23.For the purpose of applying ECAI ratings to derive risk-weights for exposures, banks should apply the following process:

1. (i)Identify an ECAI (the “nominated ECAI”) whose assigned ratings the bank intends to use to derive risk weights for some type of exposure that is subject to an external ratings-based approach under Central Bank standards;
2. (ii)Confirm that the nominated ECAIs can provide reasonable coverage of the bank’s exposures in terms of the types of counterparties and the geographical regions covered;
3. (iii)Document the selection of the ECAI and the analysis demonstrating that the ratings of ECAI are appropriate for the specific use;
4. (iv)Notify the Central Bank of the nominated ECAI and of the intended application of the ratings of that ECAI to the bank’s external ratings-based calculations; and
5. (v)Use the ratings of the ECAI within external ratings-based calculations consistently.

24.Banks must use the chosen ECAIs and their ratings consistently for each type of claim for which the ECAI and its ratings are approved, and must seek the consent of the Central Bank on any subsequent changes to the application of those ratings. Banks may not “cherry-pick” the ratings provided by different ECAIs, and must maintain records of which ECAIs they use for various purposes within capital adequacy calculations. Banks may not use unsolicited ratings that may be provided by any ECAI.

25.When banks use external ratings to assign risk weight to securitisation exposures under the Central Bank’s Standards on Capital for Securitisation Exposures, additional operational requirements apply to the ratings and the ECAI that is the source of the ratings.

26.If there is only one rating by a nominated ECAI for a particular claim, that rating should be used to determine the risk weight of the exposure.

27.If there are two ratings by nominated ECAIs that map to different risk weights, the higher risk weight must be applied.

28.If there are three or more ratings with different risk weights, the ratings corresponding to the two lowest risk weights should be referred to. If these give rise to the same risk weight, that risk weight should be applied. If different, the higher risk weight should be applied.

29.External ratings for one entity within a corporate group cannot be used to risk weight other entities within the same group.

30.A bank must treat a relevant exposure or the person to whom the bank has a relevant exposure as “unrated” for risk weighting purposes if that exposure or that person does not have a rating assigned to it by the ECAI otherwise used by the bank.

31.Where a bank is applying external ratings to an exposure that corresponds to a particular issue with an issue-specific rating, the risk weight of the claim must be based on this issue-specific rating. In other cases, the following requirements apply:

1. (i)In circumstances where the borrower has a specific rating for an issued debt claim, but the bank’s exposure does not relate to this particular rated claim, a high-quality credit rating (that is, one that maps to a risk weight lower than the risk weight that would apply to an unrated claim) on that specific issue may only be applied to the bank’s un-assessed exposure if the exposure ranks pari passu with or senior to the rated issue in all respects. If not, the credit rating cannot be used, and the un-assessed claim exposure should receive the risk weight for unrated claims.
2. (ii)In circumstances where the borrower has an issuer rating, this rating typically applies to senior unsecured claims on that issuer. Consequently, only senior claims on that issuer will benefit from a high-quality issuer rating if one exists. Other un-assessed claims of a highly assessed issuer will be treated as unrated. If either the issuer, or a particular issue from that issuer, has a low-quality rating (that is, one that would map to a risk weight equal to or higher than would apply to an unrated exposure), then a bank with an unrated exposure to the same counterparty that ranks pari passu with or is subordinated to senior unsecured (in the case of an issuer rating) or to the specific issue (in the case of an issue-specific rating) should risk-weight that exposure using the low-quality rating.

32.Where a bank intends to rely on an issuer or an issue-specific rating, the rating must take into account and reflect the entire amount of credit risk exposure a bank has with regard to all amounts owed to it.

33.Where exposures are risk-weighted based on the rating of an equivalent exposure to that borrower, foreign currency ratings should be used for exposures in foreign currency. If there is a separate domestic currency rating, it should be used only to risk-weight exposures denominated in the domestic currency.

34.In order to avoid double counting of credit enhancement factors, no supervisory recognition of credit risk mitigation techniques will be taken into account if the credit enhancement is already reflected in the rating of a specific issue.