Minimum Capital Requirements for Market Risk

Default risk must be measured using a value-at-risk (VaR) model. (1) Banks must use a default simulation model with two types of systematic risk factors. (2) Default correlations must be based on credit spreads or on listed equity prices. Correlations must be based on data covering a period of 10 years that includes a period of stress as defined in [13.5] and based on a one-year liquidity horizon. (3) Banks must have clear policies and procedures that describe the correlation calibration process, documenting in particular in which cases credit spreads or equity prices are used. (4) Banks have the discretion to apply a minimum liquidity horizon of 60 days to the determination of default risk capital (DRC) requirement for equity sub-portfolios. (5) The VaR calculation must be conducted weekly and be based on a one-year time horizon at a one-tail, 99.9 percentile confidence level. Banks are permitted to calibrate correlations to liquidity horizons of 60 days in the case that a separate calculation is performed for equity sub-portfolios and these desks deal predominately in equity exposures. In the case of a desk with both equity and bond exposures, for which a joint calculation for default risk of equities and bonds needs to be performed, the correlations need to be calibrated to a liquidity horizon of one year. In this case, a bank is permitted to consistently use a 60-day probability of default (PD) for equities and a one-year PD for bonds. [13.20](2) states: “Default correlations must be based on credit spreads or on listed equity prices.” No additional data sources (eg rating time series) are permitted [13.20](1) specifies that banks must use a default simulation model with two types of systematic risk factors. To meet this condition, the model always have two random variables that correspond to the systematic risk factors. Systematic risk in a DRC requirement model must be accounted for via multiple systematic factors of two different types. The rando variable that determines whether an obligor defaults must be an obligor-specific function of the systematic factors of both types and of an idiosyncratic factor. For example, in a Merton-type model, obligor i defaults when its asset return X falls below an obligor-specific threshold that determines the obligor’s probability of default. Systematic risk can be described via M systematic regional factors Y j reglon ( j = 1, ... , M) and N systematic industry factors Y j industry ( j = 1, ... , N ). For each obligor i, region factor loadings B i,j region and industry factor loadings B i,j industry that describe the sensitivity of the obligor’s asset return to each systematic factor need to be chosen. There must be at least one non-zero factor loading for the region type and at least one non-zero factor loading for the industry type. The asset return of obligor i can be represented as X? =Σ Bi, j region ∙ Y j region +Σ Bi, j industry ∙ Y j industry +?? ∙??, where ε i is the idiosyncratic risk factor and γ i is the idiosyncratic factor loading. Banks are permitted to use a 60-day liquidity horizon for all equity positions but are permitted to use a longer liquidity horizon where appropriate 13.21 All positions subject to market risk capital requirements that have default risk as defined in [13.19], with the exception of those positions subject to the standardised approach, are subject to the DRC requirement model. (1) Sovereign exposures (including those denominated in the sovereign’s domestic currency), equity positions and defaulted debt positions must be included in the model. (2) For equity positions, the default of an issuer must be modelled as resulting in the equity price dropping to zero. 13.22 The DRC requirement model capital requirement is the greater of: (1) the average of the DRC requirement model measures over the previous 12 weeks; or (2) the most recent DRC requirement model measure.