Minimum Capital Requirements for Market Risk

The bank’s model must reflect the non-linear impact of options and other positions with material non-linear behaviour with respect to default. In the case of equity derivatives positions with multiple underlyings, simplified modelling approaches (for example modelling approaches that rely solely on individual jump-to-default sensitivities to estimate losses when multiple underlyings default) may be applied (subject to SAMA approval). The simplified treatment applies only to equity derivatives. 13.33 Default risk must be assessed from the perspective of the incremental loss from default in excess of the mark-to-market losses already taken into account in the current valuation. 13.34 Owing to the high confidence standard and long capital horizon of the DRC requirement, robust direct validation of the DRC model through standard backtesting methods at the 99.9%/one-year soundness standard will not be possible. (1) Accordingly, validation of a DRC model necessarily must rely more heavily on indirect methods including but not limited to stress tests, sensitivity analyses and scenario analyses, to assess its qualitative and quantitative reasonableness, particularly with regard to the model’s treatment of concentrations. (2) Given the nature of the DRC soundness standard, such tests must not be limited to the range of events experienced historically. (3) The validation of a DRC model represents an ongoing process in which supervisors and firms jointly determine the exact set of validation procedures to be employed. 13.35 Banks should strive to develop relevant internal modelling benchmarks to assess the overall accuracy of their DRC models. 13.36 Due to the unique relationship between credit spread and default risk, banks must seek SAMA approval for each trading desk with exposure to these risks, both for credit spread risk and default risk. Trading desks which do not receive SAMA approval will be deemed ineligible for internal modelling standards and be subject to the standardised capital framework. 13.37 Where a bank has approved PD estimates as part of the internal ratings-based (IRB) approach, this data must be used. Where such estimates do not exist, or SAMA determines that they are not sufficiently robust, PDs must be computed using a methodology consistent with the IRB methodology and satisfy the following conditions. (1) Risk-neutral PDs should not be used as estimates of observed (historical) PDs. (2) PDs must be measured based on historical default data including both formal default events and price declines equivalent to default losses. Where possible, this data should be based on publicly traded securities over a complete economic cycle. The minimum historical observation period for calibration purposes is five years. (3) PDs must be estimated based on historical data of default frequency over a one-year period. The PD may also be calculated on a theoretical basis (eg geometric scaling) provided that the bank is able to demonstrate that such theoretical derivations are in line with historical default experience. (4) PDs provided by external sources may also be used by banks, provided they can be shown to be relevant for the bank’s portfolio.