Minimum Capital Requirements for Market Risk

Banks must maintain a process to ensure that their internal models have been adequately validated by suitably qualified parties independent of the model development process to ensure that each model is conceptually sound and adequately reflects all material risks. Model validation must be conducted both when the model is initially developed and when any significant changes are made to the model. The bank must revalidate its models periodically, particularly when there have been significant structural changes in the market or changes to the composition of the bank’s portfolio that might lead to the models no longer being adequate. Model validation must include PLA and backtesting, and must, at a minimum, also include the following: (1) Tests to demonstrate that any assumptions made within internal models are appropriate and do not underestimate risk. This may include reviewing the appropriateness of assumptions of normal distributions and any pricing models. (2) Further to the regulatory backtesting programmes, model validation must assess the hypothetical P&L (HPL) calculation methodology. (3) The bank must use hypothetical portfolios to ensure that internal models are able to account for particular structural features that may arise. For example, where the data history for a particular instrument does not meet the quantitative standards in [13.1] to [13.12] and the bank maps these positions to proxies, the bank must ensure that the proxies produce conservative results under relevant market scenarios, with sufficient consideration given to ensuring: (a) that material basis risks are adequately reflected (including mismatches between long and short positions by maturity or by issuer); and (b) that the models reflect concentration risk that may arise in an undiversified portfolio. External Validation 10.18 The model validation conducted by external auditors and/or supervisory authorities of a bank’s internal model to determine market risk capital requirements should, at a minimum, include the following steps: (1) Verification that the internal validation processes described in [10.17] are operating in a satisfactory manner; (2) Confirmation that the formulae used in the calculation process, as well as for the pricing of options and other complex instruments, are validated by a qualified unit, which in all cases should be independent from the bank’s trading area; (3) Confirmation that the structure of internal models is adequate with respect to the bank’s activities and geographical coverage; (4) Review of the results of both the bank’s backtesting of its internal models (ie comparison of value-at-risk with actual P&L and HPL) and its PLA process to ensure that the models provide a reliable measure of potential losses over time. On request, a bank should make available to SAMA and/or to its external auditors the results as well as the underlying inputs to ES calculations and details of the PLA exercise; and (5) Confirmation that data flows and processes associated with the risk measurement system are transparent and accessible. On request and in accordance with procedures, the bank should provide SAMA and its external auditors access to the models’ specifications and parameters. Stress Testing 10.19 Banks that use the IMA for determining market risk capital requirements must have in place a rigorous and comprehensive stress testing programme both at the trading desk level and at the bank-wide level.