18.A Bank using models must provide for initial and on-going validation by a risk management function independent of the risk-taking functions of the internal model and when any significant changes are made to the model. More frequent validation is required where there have been significant structural changes in the market or changes to the composition of the portfolio which might lead to the model no longer being adequate.
19.A Bank’s model validation must not be limited to profit or loss attribution and back-testing, but, at a minimum, also must include tests to demonstrate that any assumptions made within the internal model are appropriate and do not underestimate risk. This may include normal distribution assumption, the use of the square root of time to scale from a one day holding period to a 10 day holding period or where extrapolation or interpolation techniques are used, or pricing models.
20.Testing for model validation must use hypothetical changes in portfolio value that would occur were end-of-day positions to remain unchanged. It therefore excludes fees, commissions, bid-ask spreads, net interest income and intra-day trading.
21.Additional tests are required, which may include but are not limited to:
a.Testing carried out for longer than required for the regular back-testing program (for instance 3 years). The longer period generally improves the power of the back-testing. A longer time period may not be desirable if the model or market conditions have changed to the extent that historical data is no longer relevant;
b.Testing carried out using confidence intervals in addition to the 97.5 percent and 99 percent interval required under the Basel quantitative standards;
c.Testing of portfolios below the overall Bank level;
d.The use of hypothetical portfolios to ensure that the model is able to account for particular structural features that may arise, for example, where data histories for a particular instrument do not meet the quantitative standards and where the Bank has to map these positions to proxies;
e.Ensuring that material basis risks are adequately captured. This may include mismatches between long and short positions by maturity or by issuer; and
f.Ensuring that the model captures concentration risk that may arise in an undiversified portfolio.