Market Risk Modelling: Risks-not-in-VAR

Introduction
 

This letter sets out APRA’s expectations for the market risk modelling of risks not in VAR (RNIV). The aim is to improve the consistency of the application, capitalisation and reporting of RNIV for ADIs accredited to use the internal model approach (IMA) to traded market risk.

RNIV modelling
 

APS 116 Market Risk, Attachment C Paragraphs 17-18 outlines requirements for IMA ADIs to include an appropriate set of risk factors in their market risk management system, sufficient to capture the risks inherent in the ADI’s trading positions. In particular, the standard specifies that the “VaR model must capture nonlinearities beyond those inherent in options and other relevant products (e.g. mortgage-backed securities, tranched exposures or nth loss positions), as well as correlation risk and basis risk”. 

APS 116 Attachment C Paragraph 19 recognises that there may be situations where an ADI’s risk system fails to capture in VaR risk factors that are incorporated in the pricing model. This may be due system weaknesses or model limitations. In such event, APS 116 requires that ADIs are to justify to APRA’s satisfaction the omission of risk factors from their risk system (risk factor gaps). Where risk factors are omitted from VaR framework, ADIs are still required to identify and capitalise those risk factors in a manner comparable to their VaR framework.¹   

An ADI’s RNIV framework encompasses methods and processes to identify, quantify, manage and, where appropriate, capitalise risk factor gaps. APRA expects IMA ADIs to use RNIV capital add-ons as temporary adjustments that remain in place until the ADI incorporates the corresponding risk factor gap into its internal model, in a manner compliant with APS 116. However, in some cases, obstacles to satisfactory modelling of some risk factors may result in their permanent capitalisation under the RNIV framework.

APRA has observed weaknesses in ADI RNIV frameworks and inconsistencies in the calculation of RNIV capital add-ons applied. As a result, this letter seeks to:

• Improve consistency in risk factor gap reporting and capitalisation across the industry, to promote a better market practice; and
• Clarify APRA’s expectations for the management of RNIV.

Identification of RNIV, Governance and Control processes
 

The RNIV framework is an important component of the APS 116 internal model approach (IMA). Therefore, the internal governance of the framework is to be commensurate with APS 116 (in line with the expectation in Attachment C paragraph 5). An ADI’s risk appetite towards RNIV should be at least as conservative as comparable risk factors under the IMA. 

APRA expects an ADI to hold sufficient capital for RNIV, to deal with risks which are not captured by the risk engine, as well as event risks that could adversely affect the relevant bank business. It is APRA’s expectation that ADIs continually monitor existing RNIV, as well as systematically identify and measure new risk factor gaps on an ongoing basis.

To meet these expectations, ADIs should independently validate their RNIV framework, both periodically and when the framework materially changes. Additionally, a change to the framework should be treated as a material change to an internal model and subject to the same requirements, governance and notifications to APRA that a material model change request would attract.

IMA ADIs should be able to explain how each risk factor gap is identified and defined through various means, including (but not limited to) profit attribution analysis and back-testing. Profit attribution test compares historical profits generated by the desk’s front-office pricing models and by the bank’s risk models. Measuring the gap between the two provides an insightful understanding of RNIV, both from a regulatory supervision and internal risk management point of view. 

Quantification of RNIV
 

At the reporting end date of each quarter, ADIs are required to capitalise all RNIV under APS 116, irrespective of their materiality. The capital add-on of RNIV for VaR and SVaR is to be calculated as the product of their aggregate RNIV impact on VaR (or SVaR) with the multiplication factors to be based on APS 116 Attachment C Paragraph 3 and 83-86. For further details, refer to the Technical Attachment.  

For ARF 116 regulatory reporting purposes, APRA requests ADIs to use the stand-alone RNIV method, defined in the Technical Attachment. This is for reporting purposes only. ADIs may choose to use the incremental RNIV approach in their internal models and then convert it to the stand-alone RNIV for reporting purposes. 

To reduce the operational burden of immaterial RNIV, APRA allows ADIs to define an immaterial set of risk factor gaps, which are updated at least triennially. However, RNIV within the immaterial set is to meet the following conditions:

• the aggregate impact of RNIV in an ADI’s immaterial set must not exceed 2.5% of VaR;
• ADIs are required to continuously monitor their exposure to each immaterial RNIV;
• If the ADI’s exposure to an individual RNIV in the immaterial set increases by 15% over four consecutive quarters, the RNIV impact is expected to be updated; and
• When new risk factor gaps are introduced (or re-introduced) to the immaterial set, their impacts are expected to be updated as of the inclusion date. 

Better practice is for ADIs to identify trigger points for review of their models that activate when an RNIV’s impact on VaR exceeds the bank’s internally defined threshold. Reviews would be independently validated according to the ADI’s Model Risk Policy. APRA expects IMA ADIs to treat trigger events as strong evidence that a model may not adequately satisfy the requirements of the internal model approach, as set out in Attachment C of APS 116.

IMA ADIs are to remove any offsetting benefit that may arise between risk factor gaps. Refer to the Technical Attachment for further information. 

Quarterly Reporting of RNIV
 

To improve consistency of regulatory reporting across the industry, IMA ADIs are requested to exclude reporting RNIV in their base VaR and SVaR figures in ARF 116.0.13, when reporting Traded Market Risk (TMR) capital. Instead, the relevant scaling multipliers should be calculated, according to Equation (4) of the Technical Attachment. These are to be added to the bank’s multiplication factor prescribed in APS 116 Attachment C Paragraphs 3 and 83-86. 

We also request that banks provide a detailed breakdown of their quarterly RNIV impact as part of the quarter-end Additional Market Risk Supplementary Information pack. At a minimum, the RNIV information should include: 

• For VaR and SVaR scalar multipliers greater than three, a breakdown of the attribution of the RNIV to the multiplier;
• A list of all risk factor gaps, regardless of materiality;
• Individual impact of each RNIV, according to the Technical Attachment;
• The total impact of RNIV in the immaterial set, according to the Technical Attachment; and
• The last estimation date for each RNIV.

For any queries in relation to this letter, please contact your Supervisor. 

Therese McCarthy-Hockey

Executive Director
Banking Division, APRA
 

Footnotes:

¹ APS 116 Market risk, Paragraph 5 of the Attachment C.

Technical Attachment 
 

Please, refer to the PDF document attached above for further information on the technical attachment.

For the full accessible version of this letter to ADIs, please contact us at APRAinfo.