A. Introduction

1.The purpose of this Banking Prudential Guideline (BPG) is to supplement the AIFC Banking Business Rules (BBR) in establishing the regulatory framework for Authorised Firms carrying out Banking Business. The BPG as well as the BBR Rules are based on the Basel Accords and on the Basel Core Principles for Effective BankingSupervision, issued by the Basel Committee on Banking Supervision. The Basel Committee is the primaryglobal standard-setter for the regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks and regulators worldwide and thereby enhance financial stability.

2.The BPG is aimed at Authorised Firms licensed to carry out Banking Business as defined in the BBR. Essentially, this category of Authorised Firms include Banks, Credit Providers and Broker Dealers as defined in chapter 1 of the BBR. Consistent with the BBR, all the Authorised Firms subject to BBR are referred to as Banks in this BPG.

3.The BPG aims to provide useful guidance to Banks in ensuring compliance with the BBR Rules. This guidance includes detailed calculation methodologies, technical information, formulae, parameters and supplementary information elaborating the supervisory expectations in respect of complying with the Rules in the BBR.

B. Application of BBR

1.The BBR Rules and this BPG apply to all Authorised Firms which meet the definition of Banking Business Firms as defined in BBR 1.4. The BankingBusiness firms includeBanks, Broker Dealers and Credit Providers, which are defined in BBR 1.5, 1.6 and 1.7 respectively. For sake of clarity, eligibility of an Authorised Firm as a Bank or a Broker Dealer subjects that firm to the BBR and the BPG. Authorised Firms licensed by the AFSA to carry out RegulatedActivities like ManagingAssets or Dealing in Investments as Agent are subject to the AIFC PRU (INV) Rules. However, if such firms are also licensed to Accept Depositsor Deal in Investments as Principal, they would meet the definition of Banking Business firms in BBR and consequently BBR and BPG will be applicable to such firms. However, other Rules of the AIFC like the AIFC Conduct of Business Rules or AIFC General Rules relating to the other licensed activities of that Authorised Firm will continue to be applicable to such Banking Business Firms.

Application of BBR chapters to different categories of Banking Business Firms

Application of BPG chapters to different categories of Banking Business Firms

Table with Banking Activities with reference to BBR Rules and BPG sections applicable to each type of activities

2.Consistent with BBR 1.8 (2), the term “Bank” is used in the BPG to refer to all Banking Business

firms, including Broker Dealers. This is consistent with the usage of this term in the BBR. For sake of clarity, all the Rules with reference to a Bank or applying to a Bank are applicable also to Credit Providers and Broker Dealers.

3.Credit Providers as defined in BBR 1.7 are not included in Banking Business firms according to BBR 1.4. A Credit Provider or an Authorised Firm licensed to provide credit will still be subject to BBR and BPG, if it also qualifies as a Bank, i.e. if that firm were also licensed to Accept Deposits orDeal in Investments as Principal. For the sake of clarity,Banks which are licensed to raise funds by way of Deposits would also be typically licensed to provide credit.

4.In case of Banks licensed to operate as branches in the AIFC, the BBR Rules requiring them to hold capital and meet Capital ratios and the Rules relating to the compliance with such Capital ratios are not applicable to such branches. However, Bank branches are required to comply with other BBR Rules including but not limited to Rules on risk management, role of governing body, systems and controls etc.

Table: Application of BBR Rules for Banks operating as branches in the AIFC

A. Introduction

1. Capital adequacy is critical to the safety and soundness of a Bank. This is reflected in the predominance of global regulatory standards addressing capital adequacy for banks, as established by the Basel Committee for Banking Supervision.

2. Capital supports a Bank’s operation by providing a buffer to absorb losses from its activities and, in the event of problems, it enables the Bank to continue to operate in a sound and viable manner while the problems are resolved. Capital management must be an integral part of a Bank’s Credit Risk management process and must align the Bank’s risk tolerance and risk profile with its capacity to absorb losses.

3. This chapter of the BPG sets out the standards, guidance, parameters and norms required to comply with the rules in respect of the Capital Adequacy as well as capital management framework and governance, as specified in Chapter 4 of BBR. These elements convey the supervisory expectations of the AFSA on Capital Adequacy and on capital management framework and its governance. Compliance with the standards, methods, norms, parameters and guidance detailed in this chapter of BPG, both in letter and in spirit, is required to demonstrate fulfillment of the regulatory obligations specified in Chapter 4 of BBR. The AFSA will use these standards, norms and key elements specified here to assess compliance with BBR Rules on Capital Adequacy and capital management.

B. Capital Management

4. In respect of BBR Rule 4.3 (2), the risk tolerance of a Bank is usually defined as part of the Bank’s risk management strategy. The terms ‘risk tolerance’ and ‘risk appetite’ embrace all relevant definitions used by different institutions and supervisory authorities. These two terms are used interchangeably to describe both the absolute risks a Bank is open to take (which some call risk appetite) and the actual limits within its risk appetite that a Bank pursues (which some call risk tolerance).

5. If a Bank is a member of a Financial Group, the AFSA expects the capital of the Financial Group to be apportioned among its members, based on the risk profile of the Group.

6. In relation to BBR Rule 4.4 (3), a Bank’s Internal Capital Adequacy Assessment Process (ICAAP) is the process by which the Bank continuously demonstrates that it has implemented methods and procedures to ensure that it has adequate capital resources to support the nature and level of its risks. ICAAP is a critical component of the Pillar 2 process forming part of the Basel III framework for prudential regulation of banks.

7. For BBR Rule 4.14, retained earnings and other comprehensive income include appropriated profit or loss. Share premium is also known as stock surplus and constitutes additional paid-in capital. An example of disclosed reserve is the foreign currency translation reserve referred in chapter 6 of the BBR.

8. In relation to BBR Rule 4.20, Conversion or write-off under this Rule would be limited to the extent necessary to enable the AFSA to conclude that the Bank is viable without further conversion or write-off.

9. While addressing permitted adjustments to regulatory capital as defined in BBR Rule 4.28, any deferred tax liability that may be netted must be allocated pro rata between deferred tax assets under this Rule and those under the threshold deduction Rule. For the treatment of deferred tax assets that relate to temporary differences (for example, allowance for credit losses), BBR Rule

4.30 defines deductions from CET1 Capital.

C. Capital Conservation Buffers

10. This section provides additional guidance and examples for the purpose of complying with BBR Rule 4.31, in respect of Capital Conservation Buffer. In this respect, a payment made by a Bank that does not reduce its CET 1 capital is not a distribution for the purposes of this Part. Distributions include, for example, dividends, share buybacks and discretionary bonus payments.

Examples of application of table 4A

1.Assume that a Bank’s minimum CET 1 Capital ratio is 4.5% and an additional 2.5% Capital Conservation Buffer (which must be made up of CET 1 capital) is required for a total of 7% CET 1 Capital ratio. Based on Table 4A of BBR:

(a)If a Bank’s CET 1 Capital ratio is 4.5% or more but less than or equal to 5.125%, the Bank needs to conserve 100% of its earnings.

(b)If a Bank’s CET 1 Capital ratio is more than 5.125% but less than 5.75%, the Bank needs to conserve 80% of its earnings and must not distribute more than 20% of those earnings by way of dividends, share buybacks and discretionary bonus payments.

(c)A Bank with a CET 1 Capital ratio of more than 7% can distribute 100% of its earnings.

2.Earnings in respect of BBR Rule 4.32 means distributable profits calculated before deducting elements subject to the restrictions on distributions. Earnings must be calculated after notionally deducting the tax that wouldhave been payablehad none of the distributable items been paid. The effect of calculating earnings after tax is that the tax consequence of the distribution is reversed out.

3.For the purpose of BBR Rule 4.34, the following are examples of ways to reduce capitalby a bank:

(a)a share buyback or the redemption, repurchase or repayment of capital instruments issued by the Bank

(b)trading in the Bank’s own shares or capital instruments outside an arrangement agreed with the AFSA

(c)a special dividend.

D. Leverage Ratio

14. This section provides the guidance, method and parameters required for calculation of the Leverage Ratio of a Bank in compliance with the formula provided in BBR Rule 4.37.

15. The Exposure Measure under Rule 4.37 should be calculated as the sum of:

(a) on-balance sheet items; and

(b) off-balance sheet items.

16. In relation to on-balance sheet items:

(a) for securities financing transactions, the exposure value should be calculated in accordance with IFRS and the netting requirements referred in Rules on Credit Risk Mitigation in Chapter 5 of BBR;

(b) for Derivatives, including credit protection sold, the exposure value should be calculated as the sum of the on-balance sheet value in accordance with IFRS and an add-on for potential future exposure calculated in accordance with Rules on Credit Risk Mitigation in Chapter 5 of BBR; and

(c) for other on-balance sheet items, the exposure value should be calculated based on their balance sheet values in accordance with Rules in Chapter 5 of BBR.

17. In relation to off-balance sheet items:

(a) for commitments that are unconditionally cancellable at any time by the Bank without prior notice, the exposure value should be the notional amount for the item multiplied by a Credit Conversion Factor of 10%; and

(b) for other off-balance sheet items, including:

(i) direct credit substitutes;

(ii) certain transaction-related contingent items;

(iii) short-term self-liquidating trade-related contingent items and commitments to underwrite debt and equity securities;

(iv) note issuance facilities and revolving underwriting facilities;

(v) transactions, other than SFTs, involving the posting of securities held by the Bank as collateral;

(vi) asset sales with recourse, where the credit risk remains with the Bank;

(vii) other commitments with certain drawdown;

(viii) any other commitments; and

(ix) unsettled transactions,

the exposure value should be the notional amount for each of the items multiplied by a CCF of 100%.

A. Introduction

1. Credit risk is:

(a) the risk of default by counterparties; and

(b) the risk that an asset will lose value because its credit quality has deteriorated.

2. Credit risk may result from on-balance-sheet and off-balance-sheet exposures, including loans and advances, investments, inter-bank lending, derivative transactions, securities financing transactions and trading activities. It can exist in a Bank’s Trading Book or in its Banking Book.

B. Credit Risk - Management Framework and Governance

1. This section of the BPG sets out the standards, guidance and norms required to comply with the Rules in respect of the Credit Risk management framework and governance, as specified in Chapter 5 of BBR. These elements convey the supervisory expectations of the AFSA on Credit risk management framework and its governance. Compliance with the standards and guidance detailed in this section of BPG, both in letter and in spirit, is required to demonstrate fulfillment of the regulatory obligations specified in Chapter 5 of BBR. The AFSA will use these standards, norms and key elements specified here to assess compliance with BBR Rules on Credit Risk management.

2. In order to comply with the requirements specified in BBR Rule 5.1, and considering the nature, scale and complexity of a Bank’s Credit Risk, and how often it provides credit or incurs Credit Risk, a Bank’s Credit Risk management policy is expected to include:

(a) how the Bank defines and measures Credit Risk;

(b) the Bank’s business aims in incurring Credit Risk, including:

(i) identifying the types and sources of Credit Risk that the Bank will permit itself to be exposed to (and the limits on that exposure) and those that it will not;

(ii) setting out the degree of diversification that the Bank requires, the Bank’s tolerance for risk concentrations and the limits on exposures and concentrations; and

(iii) stating the risk-return trade-off that the Bank is seeking to achieve;

(c) the kinds of credit to be offered, and ceilings, pricing, profitability, maximum maturities and ratios for each kind of credit;

(d) a ceiling for the total credit portfolio (in terms, for example, of loan-to- deposit ratio, undrawn commitment ratio, a maximum amount or a percentage of the Bank’s capital);

(e) portfolio limits for maximum gross exposures by region or country, by industry or sector, by category of counterparty (such as banks, non-bank financial entities and corporate counterparties), by product, by counterparty and by connected counterparties;

(f) limits, terms and conditions, approval and review procedures and records kept for lending to connected counterparties;

(g) types of collateral, loan-to-value ratios and criteria for accepting guarantees;

(h) the detailed limits for Credit Risk, and a Credit Risk structure, that:

(i) takes into account all significant risk factors, including intra- group exposures;

(ii) is commensurate with the scale and complexity of the Bank’s activities; and

(iii) is consistent with the Bank’s business aims, historical performance, and the amount of capital it is willing to risk;

(i) procedures for

(i) approving new products and activities that give rise to Credit Risk;

(ii) regular risk position and performance reporting; and

(iii) approving and reporting exceptions to limits

(j) allocating responsibilities for implementing the Credit Risk management policy and monitoring adherence to, and the effectiveness of, the policy; and

(k) the required information systems, staff and other resources.

3. Problem assets include impaired credits wherein the debt servicing payments are already overdue for a significant amount of time and also include assets, where there is material uncertainty about the collectability of the payments due in full or in part.

4. BBR Rule 5.1 (5) does not prevent arrangements such as an employee loan scheme, so long as the policy ensures that the scheme’s terms, conditions and limits are generally available to employees and adequately address the risks and conflicts that arise from loans under it.

5. The Credit Risk management policy of a Bank should clearly set out who has the authority to approve loans to employees. The authority of a credit committee or credit officer should be appropriate for the products or portfolio and should be commensurate with the committee’s or officer’s credit experience and expertise. Each authority to approve should be reviewed regularly to ensure that it remains appropriate for current market conditions and the committee’s or officer’s performance.

6. A Bank’s remuneration policy should be consistent with its Credit Risk management policy and should not encourage officers to attempt to generate short-term profits by taking an unacceptably high level of risk.

7. The policy must state that decisions relating to the following are made at the appropriate level of the Bank’s senior management or governing body:

(a) exposures exceeding a stated amount or percentage of the Bank’s capital;

(b) exposures that, in accordance with criteria set out in the policy, are especially risky;

(c) exposures that are outside the Bank’s core business.

8. The level at which credit decisions are made should vary depending on the kind and amount of credit and the nature, scale and complexity of the Bank’s business. For some Banks, a credit committee with formal terms of reference might be appropriate; for others, individuals with pre- assigned limits would do.

9. A Bank should ensure, through periodic independent audits, that the credit approval function is properly managed and that credit exposures comply with prudential standards and internal limits. The results of audits should be reported directly to the governing body, credit committee or senior management, as appropriate.

C. Credit Risk Management

Credit Risk Assessment

10. A Bank must establish and implement appropriate policies to enable it to assess Credit Risk when the credit is granted or the risk is incurred and afterwards. In particular, the policies must enable the Bank:

(a) to measure Credit Risk (including the Credit Risk of off-balance- sheet items, such as derivatives, in credit equivalent terms);

(b) to effectively use its internal Credit Risk assessment;

(c) to rate and risk-weight a counterparty;

(d) to monitor the condition of individual credits;

(e) to administer its credit portfolio, including keeping the credit files current, getting up-to-date financial information on counterparties, and the electronic storage of important documents;

(f) to ensure that the value of collateral and the value of the other CRM techniques used by the Bank are assessed regularly;

(g) to assess whether its CRM techniques are effective; and

(h) to calculate its Credit Risk capital requirement.

11. A Bank involved in loan syndications or consortia should not rely on other parties’ assessments of the Credit Risk involved but should carry out a full assessment based on its own Credit Risk management policy.

12. The AFSA expects that a Bank’s Credit Risk strategy will set out the approach that the Bank will take to Credit Risk management, including various quantitative and qualitative targets. It should be communicated to all relevant functions and staff within the organisation and be set out in the Bank's Credit Risk policy.

13. The AFSA expects that a Bank’s Credit Risk management policy and strategy for managing Credit Risk will take into account the need to:

(a) develop a Credit management strategy, policies and processes in accordance with the Bank’s stated Credit Risk tolerance;

(b) ensure that the Bank maintains sufficient capital to support its Credit Risk exposure at all times;

(c) determine the structure, responsibilities and controls for managing Credit Risk and for overseeing the credit portfolio of all branches and subsidiaries in the jurisdictions in which the Bank is active, and outline these elements clearly in the Bank’s Credit Risk management policy;

(d) have in place adequate internal controls to ensure the integrity of its Credit Risk management processes;

(e) ensure that stress testing of the Credit Risk portfolio is effective and appropriate for the Bank;

(f) establish a set of reporting criteria, specifying the scope, manner and frequency of reporting to various recipients (such as the Governing Body, senior management and the asset/liability committee) and who is responsible for preparing the reports

(g) establish the specific procedures and approvals necessary for exceptions to policies and limits, including the escalation procedures and follow-up actions to be taken for breaches of limits;

(h) monitor closely current trends and potential market developments that may present significant, unprecedented and complex challenges for managing Credit Risk so that appropriate and prompt changes to the Credit management strategy can be made as needed; and

(i) continuously review information on the Bank’s Credit developments and report regularly to the Governing Body

14. In respect of managing the Bank’s Credit Risk, senior management are expected to:

(a) oversee the development, establishment and maintenance of procedures and practices that translate the goals, objectives and risk tolerances approved by the governing body into operating standards that are consistent with the governing body's intent and which are understood by the relevant members of a bank's staff;

(b) adhere to the lines of authority and responsibility that the governing body has established for managing Credit Risk;

(c) oversee the establishment and maintenance of management information and other systems that identify, assess, control and monitor the Bank's Credit Risk; and

(d) oversee the establishment of effective internal controls over the Credit Risk management process.

D. Problem Assets & Impaired Assets

15. Problem assets include impaired credits wherein the debt servicing payments are already overdue for a significant amount of time and also include assets, where there is material uncertainty about the collectability of the payments due in full or in part.

16. Impaired credit means a credit that is categorised as substandard, doubtful or loss. For the purpose of applying risk-weights, interest is suspended on an impaired credit. A credit is a restructured credit if it has been re-aged, extended, deferred, renewed, rewritten or placed in a workout program.

17. The Credit Risk management system and, in particular, the systems, policies and processes aimed at classification of credits, monitoring and identification of problem credits, management of problem credits and provisioning for them must include all the on-balance sheet and off-balance sheet credit Exposures of the Bank.

18. The review of impaired credits and other problem assets may be done individually, or by class, but must be done at least once a month. A large exposure that is an impaired credit must be managed individually in terms of its valuation, categorisation and provisioning.

19. Unless there is good reason to do so, a restructured credit can never be classified as performing. A restructured credit may be reclassified to a more favourable category, but only by one level of rating up from its category before the restructure. The credit may be reclassified one further category up after 180 days of satisfactory performance under the terms of the new contract.

E. Calculation of Credit Risk-Weighted Assets (RWAs)

Using external credit rating agencies (ECRAs)

20. This section provides additional information and guidance in respect of BBR Rule 5.5. A rating is a solicited rating if the rating was initiated and paid for by the issuer of the instrument, the rated counterparty or any other entity in the same corporate group as the issuer or rated counterparty.

21. A Bank that chooses to use ratings determined by an ECRA for exposures belonging to a class must consistently use those ratings for all the exposures belonging to that class. The Bank must not selectively pick between ECRAs or ratings in determining risk- weights.

22. A Bank may use an unsolicited rating, only if it receives AFSA’s written approval to do so or in accordance with a direction from the AFSA. The AFSA may give a written direction setting out conditions that must be satisfied before a Bank may use an unsolicited rating. The Bank must ensure that the relevant rating takes into account the total amount of the exposure (that is, the principal and any interest due).

Calculation of Risk-Weighted Assets (RWAs)

23. In order to comply with the Rules in BBR 5.6 in respect of calculation of Credit RWAs and to meet the expectations of the AFSA in this regard, a Bank is expected to consider and employ the guidance, interpretations and additional information provided in this section of the BPG. Risk- weights used in the calculation of RWAs as defined in BBR Rule 5.6, are based on credit ratings or fixed risk-weights and are broadly aligned with the likelihood of counterparty default. A Bank may use the ratings determined by an ECRA if allowed to do so by these Rules and subject to the provisions of BBR 5.5.

24. In respect of table 5B, investment property is land, a building or part of a building (or any combination of land and building) held to earn rentals or for capital appreciation or both. Investment property does not include property held for use in the production or supply of goods or services, for administrative purposes, or for sale in the ordinary course of business. A real estate asset owned by a Bank as a result of a counterparty default is treated as ‘other item’ and risk-weighted at 100% but only for a period of 3 years starting from the date when the Bank records the asset on its books.

25. In respect of table 5B, the list of multilateral development banks (Item 4 in Column 1) which qualify for a 0% risk weight, are published by the Basel Committee for Banking Supervision (BCBS). The list was originally included in the document Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework—Comprehensive Version¸ published by the BCBS on 30 June 2006, and has since been updated by BCBS newsletters. As at November 2016 the list is as follows:

● the African Development Bank

● the Asian Development Bank

● the Caribbean Development Bank

● the Council of Europe Development Bank

● the European Bank for Reconstruction and Development

● the European Investment Bank

● the European Investment Fund

● the Inter-American Development Bank

● the International Development Association

● the International Finance Facility for Immunization

● the Islamic Development Bank

● the Nordic Investment Bank

● the World Bank Group (comprising the International Bank for Reconstruction and Development, the International Finance Corporation and the Multilateral Investment Guarantee Agency).

Examples of multilateral development banks that do not qualify for 0% risk weight are:

● the Arab Bank for Economic Development in Africa

● the Asian Infrastructure Investment Bank

● the Black Sea Trade and Development Bank

● the Development Bank of Latin America

● the Central American Bank for Economic Integration

● the Development Bank of Central African States

● the East African Development Bank

● the Economic Cooperation Organization Trade and Development Bank

● the Eurasian Development Bank

● the International Finance Facility for Immunisation

● the International Fund for Agricultural Development

● the International Investment Bank

● the New Development Bank

● the OPEC Fund for International Development

● the West African Development Bank.

26. For the purposes of BBR Rule 5.8, specialised lending is a lending transaction that complies with the following requirements:

(a) the purpose of the loan is to acquire an asset;

(b) the cash flow generated by the collateral is the loan’s exclusive (or almost exclusive) source of repayment;

(c) the loan represents a significant liability in the borrower’s capital structure;

(d) the Credit Risk is determined primarily by the variability of the cash flow generated by the collateral (rather than the independent capacity of a broader commercial enterprise).

27. Specialised lending is associated with the financing of projects where the repayment depends on the performance of the underlying collateral. There are 5 sub-classes of specialised lending:

(a) project finance—financing industrial projects based on the projected cash flows of the project;

(b) object finance—financing physical assets based on the projected cash flows obtained primarily through the rental or lease of the assets;

(c) commodities finance—financing the reserves, receivables or inventories of exchange-traded commodities where the exposure is paid back based on the sale of the commodity (rather than by the borrower from independent funds);

(d) income-producing real estate finance—financing real estate that is usually rented or leased

out by the debtor to generate cash flow to repay the exposure; and

(e) high-volatility commercial real estate finance—financing commercial real estate which demonstrates a much higher volatility of loss rates compared to other forms of specialised lending.

28. For the purposes of BBR Rule 5.9, eligible residential mortgage means a mortgage on a residential property that is, or will be:

(a) occupied by the counterparty for residential use; or

(b) rented out (on a non-commercial basis) for residential use.

29. For the purposes of BBR Rule 5.11:

(a) Current credit exposure is the absolute mark-to-market value (or replacement cost) of the item.

(b) Potential future credit exposure (also known as ‘the add-on’) is the amount calculated by multiplying the notional principal amount of the item by the relevant credit conversion factor in table 5D. The notional principal amount is the reference amount used to calculate payment streams between counterparties to the item.

Table E1: Credit conversion factors for market-related off-balance-sheet items

30. For the purposes of BBR Rule 5.11 & 5.12:

(a) The credit conversion factors for a protection buyer in a single-name credit default swap or single-name total-rate-of-return swap are set out in column 3 of table E2. The credit conversion factors for a protection seller are set out in column 4 of that table.

(b) The protection seller in a single-name credit default swap or single- name total-rate-of-return swap is subject to the add-on factor for a closed-out single-name swap only if the protection buyer becomes insolvent while the underlying asset is still solvent. The add-on must not be more than the amount of unpaid premiums.

(c) In the table E2, qualifying reference obligation includes obligations arising from items relating to:

(i) securities that are rated investment grade by at least 2 ECRAs; or

(ii) securities that are unrated (or rated investment grade by only 1 ECRA), but:

(1) are approved by the AFSA, on application by the Bank, to be of comparable investment quality; and

(2) are issued by an issuer that has its equity included in a main index used in a regulated exchange.

Table E2        Credit conversion factors for single-name swaps

31. For the purposes of complying with BBR Rule 5.12, the credit equivalent amount of non-market related items is calculated by the following procedures:

(a) Unless the item is a default fund guarantee in relation to clearing through a central counterparty, the credit equivalent amount of a non-market-related off-balance-sheet item is calculated by multiplying the contracted amount of the item by the relevant credit conversion factor in table E3.

(b) If the Bank arranges a repurchase or reverse repurchase or a securities lending or borrowing transaction between a customer and a third party and provides a guarantee to the customer that the third party will perform its obligations, the Bank must calculate the Credit Risk capital requirement as if it were the principal.

Table E3         Credit conversion factors for non-market-related off-balance-sheet items

(c) For item 4 of table E3, an exposure from lending securities, or lodging securities as collateral, may be treated as a collateralised transaction.

32. An illustration of the operation of BBR Rule 5.12 (5) is as follows: An irrevocable commitment with an original maturity of 6 months with an associated facility that has a nine-month term is taken to have an original maturity of 15 months.

F. Credit Risk Mitigation (CRM)

33. A Bank is able to obtain capital relief by using Credit Risk Mitigation (CRM) techniques. CRM techniques must be viewed as complementary to, rather than a replacement for, thorough Credit Risk assessment.

34. According to BBR Rule 5.6 (2), if a claim or asset to which a risk-weight must be applied is secured by eligible financial collateral or guarantee (or there is a mortgage indemnity insurance, or a credit derivative instrument or netting agreement) this Part on Credit Risk Mitigation may be used to reduce the Credit Risk capital requirement of the Bank.

35. Available CRM techniques include:

(a) accepting collateral, standby letters of credit and guarantees;

(b) using credit derivatives or other derivative instruments;

(c) using netting agreements; and

(d) purchasing insurance.

36. CRM using collateral and guarantees is usually dealt with at the time credit is granted. In contrast, credit derivatives and netting agreements are often used after the credit is granted or used to manage the Bank’s overall portfolio risk. A Bank should not rely excessively on collateral or guarantees to mitigate Credit Risk. While collateral or guarantees may provide secondary protection to the Bank if the counterparty defaults, the primary consideration for credit approval should be the counterparty’s repayment ability.

37. In choosing a CRM technique, the Bank must consider:

(a) the Bank’s knowledge of, and experience in using, the technique;

(b) the cost-effectiveness of the technique;

(c) the type and financial strength of the counterparties or issuers;

(d) the correlation of the technique with the underlying credits;

(e) the availability, liquidity and realisability of the technique;

(f) the extent to which documents in common use (for example, the ISDA Master Agreement) can be adopted; and

(g) the degree of recognition of the technique by financial services regulators.

38. In respect of employing a CRM technique:

(a) a Bank accepting eligible financial collateral for CRM, must ensure that such collateral can be enforced and any necessary legal procedures have been followed.

(b) A Bank should consider whether independent legal opinion should be sought on the enforceability of documents. The documents should be ready before the Bank enters into a contractual obligation or releases funds.

39. If a CRM technique (other than a guarantee) and the exposure covered by it are denominated in different currencies (that is, there is a currency mismatch between them), the haircut that applies is:

(a) if the mismatched currencies are both pegged to the same reference currency, or 1 of them is pegged to the other—0; or

(b) in any other case—8%.

40. If there is a currency mismatch between a guarantee and the exposure covered by it, the amount of the exposure that is covered must be reduced using the following formula:

GA = G (1- HFX)

where:

G is the nominal amount of the guarantee.

Hfx is the haircut appropriate for the currency mismatch between the credit protection and the underlying obligation, as follows:

(a) if the guarantee is revalued every 10 business days—8%;

(b) if the guarantee is revalued at any longer interval—the factor H calculated using the formula in sub-Rule (5); or

(c) if the mismatched currencies are both pegged to the same reference currency, or if 1 of them is pegged to the other—0.

41. If the guarantee is revalued at intervals longer than 10 business days, the 8% haircut must be scaled up using the following formula:

H = 8

where:

H is the scaled-up haircut.

N is the number of business days between the revaluations.

42. In respect of cash collateral, the recourse may be in the form of a contractual right of set-off on credit balances. A common-law right of set-off is, on its own, insufficient to satisfy this Rule.

43. While using collateral as a CRM technique, the Bank should have clear and robust procedures for the liquidation of collateral to ensure that the legal conditions for declaring default and liquidating the collateral are observed. The Bank should also consider whether, in the event of default, notice to the party that lodged the collateral would be needed before the Bank could have recourse to it. In respect of using collateral as a CRM technique, under BBR Rule 5.16 (3) a Bank should have policies and procedures in place to identify, monitor, control and report general wrong way risk (positively correlated with general Market risk factors) and specific wrong way risk (positively correlated with a specific counterparty).

44. In respect of using collateral as a CRM technique, under BBR Rule 5.17, Collateral accepted by a Bank must be valued at its net realisable value, taking into account prevailing market conditions. That value must be monitored at appropriate intervals, and the collateral must be regularly revalued.

45. The net realisable value of some collateral may be readily available (for example, collateral that is marked-to-market regularly). Other collateral may be more difficult to value and may require knowledge and consideration of prevailing market conditions. The method and frequency of monitoring and revaluation depend on the nature and condition of the collateral. For example, securities accepted as collateral are usually marked to market daily.

G. Use of Netting Agreements for Credit Risk Mitigation (CRM)

46. In respect of using a netting agreement to obtain capital relief under BBR Rule 5.20, a Bank must follow the guidance and criteria specified in the following paragraphs of this section.

47. The following kinds of transactions may be netted:

(a) on-balance-sheet loans and deposits, but only if:

(i) the Bank is able to determine at all times the assets and liabilities that are subject to netting under the agreement; and

(ii) the deposits satisfy the criteria for eligible financial collateral;

(b) securities financing transactions;

(c) over the counter derivative transactions.

48. Securities financing transactions are not included as part of market related transactions. A netting agreement may include the netting of over the counter derivative transactions:

(a) across both the Banking and Trading Books of a Bank (if the netted transactions satisfy the criteria in this section); and

(b) across different market-related products to the extent that they are recognised as market- related transactions.

49. To be an eligible netting agreement, a netting agreement:

(a) must be in writing;

(b) must create a single obligation covering all transactions and collateral included in the agreement and giving the Bank the following rights:

(i) the right to terminate and close-out, in a timely way, all the transactions included in the netting agreement;

(ii) the right to net the gains and losses on those transactions (including the value of any collateral) so that the Bank either has a claim to receive, or an obligation to pay, only the net sum of the close-out values of the individual transactions;

(iii) the right to liquidate or set-off collateral if either party to the agreement fails to meet its obligations because of default, liquidation, bankruptcy or other similar circumstances;

(c) must not be subject to a walkaway clause; and

(d) must be supported by a written and reasoned legal opinion that complies with norms and criteria set out particularly in paragraphs 49, 52 to 55 of this section among other paragraphs.

(e) For forward contracts, swaps, options and similar derivative transactions, the right to net gains and losses will include the positive and negative mark-to-market values of the individual transactions.

50. A Bank must not recognise a netting agreement as an eligible netting agreement if it becomes aware that a financial services regulator of the counterparty is not satisfied that the agreement is enforceable under the laws of the regulator’s jurisdiction. This Rule applies regardless of any legal opinion obtained by the Bank. A netting agreement is not an eligible netting agreement if there is doubt about its enforceability.

51. A Bank must ensure that a netted transaction is covered by an appropriate legal opinion. In calculating the net sum due to or from a counterparty, the Bank must exclude netted transactions for which it has not obtained a satisfactory legal opinion applicable in the relevant jurisdiction. An excluded transaction must be reported on a gross basis.

52. For an eligible netting agreement which meets the requirements specified in paragraph 4 of this section, the legal opinion must conclude that, in the event of default, liquidation, bankruptcy or other similar circumstances of a party to the netting agreement, the Bank’s claims and obligations are limited to the net sum calculated under the netting agreement in accordance with the applicable law.

53. The AFSA expects the legal opinion to deal with the issue of which of the following laws applies to the netting:

(a) the law of the jurisdiction in which the counterparty is incorporated or formed (or, in the case of an individual, resides)

(b) if an overseas branch of the counterparty is involved—the law of the jurisdiction in which the branch is located

(c) the law that governs the individual transactions

(d) the law that governs any contract or agreement necessary to give effect to the netting.

54. In particular, the legal opinion must conclude that, in the event of insolvency or external administration of a counterparty, a liquidator or administrator of the counterparty will not be able to claim a gross amount from the bank while only being liable to pay a dividend in insolvency to the

Bank (as separate money flows).

55. In some countries, there are provisions for the authorities to appoint an administrator to a troubled bank. Under statutory provisions applying in those countries, the appointment of an administrator might not constitute a ground for triggering a netting agreement. Such provisions do not prevent the recognition of an affected netting agreement if the agreement can still take effect if the bank under administration does not meet its obligations as they fall due.

56. Before a Bank uses a legal opinion to support a netting agreement, the Bank:

(a) must ensure that the opinion is not subject to assumptions or qualifications that are unduly restrictive;

(b) must review the assumptions about the enforceability of the agreement and must ensure that they are specific, factual and adequately explained in the opinion; and

(c) must review and assess the assumptions, qualifications and omissions in the opinion to determine whether they give rise to any doubt about the enforceability of the agreement.

57. The Bank must have procedures to monitor legal developments and to ensure that its netting agreements continue to be enforceable. The Bank must update the legal opinions about the agreements, as necessary, to ensure that the agreements continue to be eligible.

58. The Bank may rely on a legal opinion obtained on a group basis by another member of the Financial Group of which it is a member if the Bank and the other member have satisfied themselves that the opinion covers a netting agreement to which the Bank is a counterparty. The Bank must report a transaction on a gross basis if there is any doubt about, or any subsequent legal development affects, the enforceability of the agreement.

59. A Bank may rely on a general legal opinion about the enforceability of netting agreements in a particular jurisdiction if the Bank is satisfied that the type of netting agreement is covered by the opinion. The Bank must satisfy itself that the netting agreement with a counterparty and the general legal opinion are applicable to each transaction and product type undertaken with the counterparty, and in all jurisdictions where those transactions are originated.

60. A Bank may net positions across its Banking and Trading Books only if:

(a) the netted transactions are marked-to-market daily; and

(b) any collateral used in the transactions satisfies the criteria for eligible financial collateral in the banking book.

61. If directed by the AFSA, a Bank must demonstrate that its netting policy is consistently implemented, and that its netting agreements continue to be enforceable. The Bank must keep adequate records to support its use of netting agreements and to be able to report netted transactions on both gross and net bases. The Bank must monitor its netting agreements and must report and manage:

(a) roll-off risks;

(b) exposures on a net basis; and

(c) termination risks;

for all the transactions included in a netting agreement.

62. A Bank may take collateral and guarantees into account in calculating the risk-weight to be applied to the net sum under a netting agreement. The Bank may assign a risk-weight based on collateral or a guarantee only if:

(a) the collateral or guarantee has been accepted or is otherwise subject to an enforceable agreement; and

(b) the collateral or guarantee is available for all the individual transactions that make up the net sum of exposures calculated.

63. The Bank must ensure that provisions for applying collateral or guarantees to netted exposures under a netting agreement comply with the requirements for eligible financial collateral and guarantees in these Rules.

H. Securitisation and Re-securitisation

64. In respect of obtaining capital relief under BBR Rule 5.21 for securitisation and re-securitisation arrangements, a Bank must follow the guidance and criteria specified in the following paragraphs of this section.

65. A Bank’s securitisation exposures may arise from the Bank being (or acting in the capacity of) party to a securitisation. Securitisation, in relation to a Bank, is the process of pooling various kinds of contractual debt or non-debt assets that generate receivables and selling their related cash flows to third party investors as securities. In a securitisation, payments to the investors depend on the performance of the underlying pool of assets, rather than on an obligation of the originator of the assets.

66. The underlying pool in a securitisation may include 1 or more exposures. The securities usually take the form of bonds, notes, pass-through securities, collateralised debt obligations or even equity securities that are structured into different classes (tranches) with different payment priorities, degrees of Credit Risk and return characteristics.

67. A securitisation (whether traditional or synthetic) must have at least 2 tranches. Re-securitisation is a securitisation in which at least one of the underlying assets is itself a securitisation or another re- securitisation. Exposures arising from re-tranching are not re-securitisation exposures if, after the re-tranching, the exposures act like direct tranching of a pool with no securitised assets. This means that the cash flows to and from the Bank as originator could be replicated in all circumstances and conditions by an exposure to the securitisation of a pool of assets that contains no securitisation exposures.

68. A reference in this Part to securitisation includes re-securitisation.

I. Provisioning requirements

124. In relation to the expectations about the provisioning policy of a Bank as set out in the BBR Rule

5.22 (2), a review of a Bank’s write-offs can help identify whether the Bank’s provisioning policy results in over-provisioning or under-provisioning. The AFSA regularly assesses trends and concentrations in risk and risk build-up across financial entities in relation to problem assets. In making the assessment, the AFSA takes into account any observed concentration in the CRM techniques used by Banks and the potential effect on the efficacy of those techniques in reducing loss. The AFSA would consider the adequacy of provisions for a Bank (and the industry in general) in the light of the assessment.

125. The AFSA might seek the opinion of external experts in assessing the adequacy of a Bank’s policies for grading and classifying its assets and the appropriateness and robustness of the levels of its provisions. If the AFSA considers that existing or anticipated deterioration in asset quality is of concern or if the provisions do not fully reflect expected losses, the authority may require the Bank to adjust its classifications of individual assets, increase its levels of provisions or capital and, if necessary, impose other remedial measures.

J. Transactions with related parties

126. The concept of parties being related to a Bank is used in the BBR Rule 5.23 in the context of parties over which the Bank exercises control or parties that exercise control over the Bank. The concept is primarily used in relation to the requirement that the Bank’s transactions be at arm’s length. In contrast, the concept of parties being connected to one another (which is discussed with concentration in Chapter 5 of BBR) is used in these Rules to measure concentration risk and large exposures. It is of course possible for connected counterparties to be related to the Bank holding the exposure concerned. Related party is wider than a Bank’s corporate group in that it includes individuals. Related parties include the Bank’s subsidiaries and major stock holders; members of its governing body; its senior management and key employees.

127. To guard against abuses in lending to related parties and to address conflicts of interest, this Rule requires transactions with related parties to be at arm’s length and subject to appropriate supervision and limits. Related-party transactions must be interpreted broadly. Related party transactions include on-balance-sheet and off-balance-sheet credit exposures, service contracts, asset purchases and sales, construction contracts, lease agreements, derivative transactions, borrowing and write-offs. For purposes of concentration risk, the Bank’s exposure to connected counterparties (whether related or not) is taken to be a single risk.

128. Favourable terms could relate to interest rate, credit assessment, tenor, fees, amortisation schedule and need for collateral. An exception for beneficial terms could be appropriate if it is part of an employee’s remuneration package (for example, more favourable loan rates to employees).

K. Concentration Risk

129. Parties would be connected if the same persons significantly influence the Governing Body of each of them. Parties would be connected if one of them has an exposure to the other that was not incurred for the clear commercial advantage of both of them and is not on arm’s length terms. Parties would be connected if they are so closely linked that:

(a) the insolvency or default of 1 is likely to be associated with the insolvency or default of the other;

(b) it would be prudent when assessing the financial condition or creditworthiness of 1 to consider that of the other; or

(c) there is, or is likely to be, a close relationship between their financial performance.

130. Parties would be connected if a Bank has exposures to them and any loss to the Bank on any of the exposures to one of the parties is likely to be associated with a loss to the Bank with respect to at least one exposure to each of the others. Two or more individuals or legal persons would constitute a single risk if they are so connected that, if one of them were to experience financial problems, the other or others would be likely to encounter repayment difficulties. Connected counterparties should be identified and the procedures to manage the combined Credit Risk considered. A Bank may need to monitor and report the gross exposure to connected counterparties against combined limits in addition to monitoring the exposure to each counterparty.

Significant sources of concentration risk include:

(a) concentration of exposures to a single counterparty or connected counterparties;

(b) concentration of exposures to counterparties in the same industry, sector, region or country; and

(c) concentration of exposures to counterparties whose financial performance depends on the same activity or commodity.

131. A concentration of exposures would also arise if a Bank accepts collateral or credit protection provided by a single provider. A Bank’s policy should be flexible to help the Bank to identify risk concentrations. To achieve this, the systems should be capable of analysing the Bank’s credit portfolio by:

(a) size of exposure

(b) exposure to connected counterparties

(c) product

(d) geography

(e) industry or sector (for example, manufacturing and industrial)

(f) account performance management

(g) internal Credit Risk assessment

(h) funding

(i) outstandings versus commitments

(j) types and coverage of collateral.

A. Market Risk Management Policy

1. Market Risk refers to the risk of incurring losses on positions held by a Bank with trading intent (usually in its Trading Book), caused by adverse movements in market prices or in underlying value drivers. Market risk may result from on-balance-sheet and off-balance-sheet exposures arising from investments, inter-bank lending, derivative transactions, securities financing transactions and trading activities. It primarily arises from a Bank’s Trading Book while the foreign exchange risk component of the Market risk can arise in its Banking Book.

2. A Bank’s Market risk management policy is expected to address the following key elements:

(a) effective systems for the accurate and timely identification, measurement, evaluation, management and control or mitigation of Market risk, and reporting to the Bank’s governing body and senior management;

(b) prudent and appropriate Market risk limits that are consistent with the Bank’s risk tolerance, risk profile and capital, and with the management’s ability to manage;

(c) who is responsible for identifying, measuring and reporting Market risk;

(d) procedures for tracking and reporting exceptions to, and deviations from, limits or policies; and

(e) procedures for including positions and exposures in the Trading Book.

3. The policy must ensure that all of the Bank’s transactions are identified and recorded in a timely way and that their valuations are consistent and prudent. The Bank must use reliable market data that have been verified by a function that is independent of the function that assumed or incurred the risk.

B. Trading Book

4. In cases where a Bank acts as principal (even in the course of an activity normally described as ‘broking’ or ‘customer business’), the resulting positions should be included in its Trading Book. This applies even if the nature of the business means that the only risks being incurred by the Bank are counterparty risks where no Market risk capital requirements apply.

5. In respect of BBR Rule 6.3, the AFSA will grant approval for a switching of positions between the Trading Book and the Banking Book of the bank only in extraordinary cases. When such approval is granted, the AFSA is likely to mandate public disclosure of the approved switch.

6. A Bank’s Trading Book policy is expected to address the following key elements:

(a) positions to be included, or not to be included, in the Trading Book;

(b) managing and reporting trading positions;

(c) valuing positions, including:

(i) clearly defined responsibilities of staff involved in the valuation;

(ii) sources of market information, and review of their reliability;

(iii) frequency of independent valuations;

(iv) timing of closing prices;

(v) procedures for adjusting valuations between periods;

(vi) ad-hoc verification procedures; and

(vii) reporting lines for the valuation function that are independent of that function that gave rise to the position.

(d) distinguishing consistently between trading activities and banking activities

(e) monitoring the size of its Trading Book.

C. Valuation of positions

7. In relation to the requirements set out in the BBR Rule 6.4 on valuation of positions, a Bank must mark-to-market all the positions in its Trading Book, except for cases where it is not possible to do so (for example, unlisted securities, illiquid securities or positions). The AFSA expects a Bank to mark-to- market listed securities since there is a market with observable and reliable prices for such securities. It should use the prudent side of bid or offer unless the Bank is a significant market maker that can close at mid-market.

8. When estimating fair value, the Bank should maximise the use of relevant observable inputs and avoid the use of unobservable inputs. The Bank should be extra conservative when using the marking-to-model method. The AFSA will take into account the following in deciding if the Bank’s model is prudent:

(a) whether senior management is aware of the positions and exposures that are marked to model and whether it understands the uncertainty this might create in reporting the risk or performance of the business;

(b) the extent to which market inputs are sourced from market prices;

(c) the appropriateness of the assumptions used by the Bank;

(d) the availability of generally accepted valuation methods for particular products

(e) who developed the model;

(f) whether the Bank holds a secure copy of the model;

(g) the existence of formal control procedures for changing the model;

(h) how often the model is used to check valuations;

(i) how aware is the Bank’s risk management function of the weaknesses of the model and how those weaknesses are reflected in the valuation output;

(j) the results of comparisons between actual close out values and model outputs;

(k) the Bank’s procedures for reviewing the model.

9. Independent price verification is different from daily mark-to-market. The object of the verification is to regularly check the accuracy of market prices or model inputs and, thereby, eliminate inaccurate daily marks. The verification should be carried out by a unit independent of whoever marked the positions or exposures.

10. The independent marking in the verification process should reveal any error or bias in pricing. It entails a higher standard of accuracy in that the market prices or model inputs are used to determine profit and loss figures, whereas daily marks are used primarily for management reporting in between reporting dates. The Bank must consider the following valuation adjustments:

(a) unearned profit;

(b) close-out costs;

(c) Operational Risks;

(d) early termination;

(e) investing and funding costs;

(f) future administrative costs;

(g) model risk, if relevant;

(h) any other adjustment that the Bank considers appropriate

D. Use of Internal Models

11. This section sets out the conditions under which a Bank is permitted to use an internal model to calculate its Market Risk Capital Requirement or any component of its Market Risk Capital Requirement. A Bank that wishes to use an internal model to calculate any part of this requirement is required to apply to the AFSA. Internal models will commonly permit more extensive netting of long and short positions and have greater risk sensitivity.

12. In assessing whether to give approval, the AFSA will consider the effectiveness and coverage of the Bank’s risk management framework, governance of its model development and implementation processes, the stress-testing and back-testing standards and the process surrounding the calculation of capital requirements.

13. The AFSA will usually approve the use of an internal model if:

(a) the use of the model to calculate the Market Risk Capital Requirement has been approved by another appropriate regulator or the Bank has provided opinions from independent experts on the ability of the model to calculate Market Risk capital requirements, to the satisfaction of the AFSA;

(b) use of the methodology is integrated into the governance and risk management framework of the Bank. Specifically, the Governing Body and senior management of the Bank receives and reviews appropriate reports in respect of the model and its use;

(c) it is satisfied with the overall soundness and integrity of the Bank's enterprise-wide risk management system;

(d) the Bank has sufficient numbers of staff skilled in the use of sophisticated models specifically in the risk management, audit, and back office areas;

(e) the Bank's models have a proven track record of reasonable accuracy in measuring risk; and

(f) the Bank has a robust stress testing programme.

14. In determining whether an internal value at risk (VaR) model meets the standard for approval, the AFSA will apply the criteria set out in the section below, which are based on the Basel Market Risk Capital Amendment 1996 and Basel Revisions to the Basel II Market Risk framework 2009 and which can be grouped under the following headings:

(a) qualitative standards;

(b) specification of Market Risk factors;

(c) quantitative standards;

(d) adjustments to Market Risk Capital Requirements;

(e) stress testing; and

(f) combination of internally developed models and the Standardised Methodology.

15. In addition to VaR models, the AFSA is open to considering the use of option risk aggregation models and interest rate ‘pre-processing’ or sensitivity models, Option risk aggregation models analyse and aggregate options risks for interest rate, equity, foreign exchange and commodity options. Interest rate pre-processing models are used to calculate weighted positions for inclusion in a Bank’s interest rate Market Risk Capital Requirement calculation under the Duration Method.

16. Any internal model used for purposes of Chapter 6 of BBR should be conceptually sound and implemented with integrity and, in particular, all of the following qualitative requirements should be met:

(a) any internal model used to calculate Market Risk Capital Requirements for equity risk, interest rate risk, foreign exchange risk or commodities risk should be closely integrated into the daily risk management process and serve as the basis for reporting risk Exposures to senior management;

(b) the Bank should have a risk control unit that is independent from business trading units and reports directly to senior management. The unit should be responsible for designing and implementing any internal model used for purposes of Chapter 6 of BBR. The unit should conduct the initial and on-going validation of any such internal models. The unit should produce and analyse daily reports on the output of any internal model used for calculating Capital Requirements for position risk, foreign exchange risk and commodities risk, and on the appropriate measures to be taken in terms of trading limits;

(c) the Bank's Governing body and senior management should be actively involved in the risk control process and the daily reports produced by the risk control unit are reviewed by a level of management with sufficient authority to enforce both reductions of positions taken by individual traders as well as in the Bank's overall risk Exposure;

(d) the Bank should have established procedures for monitoring and ensuring compliance with a documented set of internal policies and controls concerning the overall operation of its internal models;

(e) the Bank should frequently conduct a rigorous programme of stress testing, including reverse stress tests, which encompasses any internal model used for purposes of Chapter 6 of BBR and the results of these stress tests should be reviewed by senior management and reflected in the policies and limits it sets. This process should particularly address illiquidity of markets in stressed market conditions, concentration, one way markets, event and jump-to-default risks, non-linearity of products, deep out-of-the-money positions, positions subject to the gapping of prices and other risks that may not be captured appropriately in the internal models. The shocks applied should reflect the nature of the portfolios and the time it could take to hedge out or manage risks under severe market conditions; and

(f) the Bank should conduct, as part of its regular internal auditing process, an independent review of its internal models.

17. The independent review of the internal models used by a Bank, must include the activities of both the business trading units and of the independent risk-control unit. At least once a year, the Bank should conduct a review of its overall risk management process. The review should consider the following:

(a) the adequacy of the documentation of the risk-management system and process and the organisation of the risk-control unit;

(b) the integration of risk measures into daily risk management and the integrity of the management information system;

(c) the process the Bank employs for approving risk-pricing models and valuation systems that are used by front and back-office personnel;

(d) the scope of risks captured by the risk-measurement model and the validation of any significant changes in the risk-measurement process;

(e) the accuracy and completeness of position data, the appropriateness of volatility and correlation assumptions, and the accuracy of valuation and risk sensitivity calculations;

(f) the verification process used to evaluate the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources; and

(g) the verification process used to evaluate back-testing for the internal models' accuracy.

18. As techniques and best practices evolve, Banks are expected to apply those new techniques and practices in any internal model used for purposes of Chapter 6 of BBR.

19. Any internal model used to calculate Capital Requirements for equity position risk, interest rate risk, foreign exchange risk, commodities risk and any internal model for correlation trading should meet all of the following requirements:

(a) the model must capture accurately reflect, on a continuous basis, all material price risks, including General Market Risks and, where approval has been granted in relation to specific Risk, specific risks arising on the underlying portfolio, and should ensure that sufficient risk factors are properly specified; and

(b) the model should capture a sufficient number of risk factors, depending on the level of activity of the Bank in the respective markets. The risk factors in the model should be sufficient to capture the risks inherent in the Bank’s portfolio of on and off-balance sheet trading positions. The Bank should at least incorporate those risk factors in its model that are incorporated into its pricing model.

(c) The risk-measurement model should capture nonlinearities for options and other products as well as correlation risk and basis risk. Where proxies for risk factors are used they should show a good track record for the actual position held. Although a Bank will have some discretion in specifying the risk factors for its internal models, the AFSA expects that such models will meet the criteria specified in this guideline.

20. Any internal model used to calculate Capital Requirements for position risk, foreign exchange risk or commodities risk should meet all of the following requirements:

(a) the model should incorporate a set of risk factors corresponding to the interest rates in each currency in which the Bank has interest rate sensitive on or off balance sheet positions. The Bank should model the yield curves using one of a number of generally accepted approaches, for example, by estimating forward rates of zero-coupon yields;

(b) for material Exposures to interest-rate risk in the major currencies and markets, the yield curve should be divided into a minimum of six maturity segments, to capture the variations of volatility of rates along the yield curve. The model should also capture the risk of less than perfectly correlated movements between different yield curves. The risk measurement system should incorporate separate risk factors to capture spread risk, for example, between bonds and swaps;

(c) the model should incorporate risk factors corresponding to gold and to the individual foreign currencies in which the Bank's positions are denominated.

(d) for Collective Investment Funds the actual foreign exchange positions of the Fund should be taken into account. Banks may rely on third party reporting of the foreign exchange position of the Fund, where the correctness of this report is adequately ensured. If a Bank is not aware of the foreign exchange positions of a Fund, this position should be carved out of the model and treated separately;

(e) the model should use a separate risk factor at least for each of the equity markets in which the Bank holds significant positions. At a minimum, this will include a risk factor that is designed to capture market-wide movements in equity prices, for example, a market index. Positions in individual securities or in sector indices could be expressed in “beta-equivalents” relative to this market-wide index. A relatively more- detailed approach would be to have risk factors corresponding to various sectors of the overall equity market, for instance, industry sectors or cyclical and non-cyclical sectors. The most extensive approach would be to have risk factors corresponding to the volatility of individual equity issues;

(f) the model should use a separate risk factor at least for each commodity in which the Bank holds significant positions. The model must also capture the risk of less than perfectly correlated movements between similar, but not identical, commodities and the Exposure to changes in forward prices arising from maturity mismatches. It should also take account of market characteristics, notably delivery dates and the scope provided to traders to close out positions; For more actively traded portfolios, the model should also take account of variation in the “convenience yield” between derivative positions such as forwards and swaps and cash positions in the commodity; and

(g) the Bank's internal model should conservatively assess the risk arising from less liquid positions and positions with limited price transparency under realistic market scenarios. In addition, the internal model should meet minimum data standards. Proxies should be appropriately conservative and should be used only where available data is insufficient or is not reflective of the true volatility of a position or portfolio.

21. Banks may use empirical correlations within risk categories and across risk categories only if the Bank's approach for measuring correlations is sound and implemented with integrity.

22. The AFSA will usually approve an internal Value-at-Risk (VaR) model, for the purposes of Chapter 6 of the BBR only when that VaR model meets the following quantitative criteria:

(a) VaR should be computed at least on a daily basis;

(b) in calculating the value-at-risk, a 99th percentile, one-tailed confidence interval is to be used;

(c) in calculating VaR, an instantaneous price shock equivalent to a 10 day movement in prices is to be used, i.e., the minimum "holding period" will be 10 trading days;

(d) an effective historical observation period of at least one year except where a shorter observation period is justified by a significant upsurge in price volatility; and

(e) its data set is updated by the Bank no less frequently than once every month and is reassessed whenever market prices are subject to material changes.

23. A bank may use VaR numbers calculated according to shorter holding periods than 10 days scaled up to 10 days by an appropriate methodology.

24. The AFSA prescribes no particular type of model so long as the model used captures all the material exposures of the Bank. The Bank will be free to use models based, for example, on variance- covariance matrices, historical simulations, or Monte Carlo simulations. Banks have discretion to recognise empirical correlations within broad risk categories, for example, interest rates, exchange rates, equity prices and commodity prices, including related options volatilities in each risk factor category.

25. A Bank's internal models should accurately capture the unique risks associated with options within each of the broad risk categories. A Bank should calculate, on a daily basis, its Market Risk Capital Requirement or any component for which an internal model is used, expressed as the higher of (a)

its previous day's VaR number measured according to the parameters specified in this section and

(b) an average of the daily VaR measures on each of the preceding sixty business days, multiplied by a multiplication factor.

26. The AFSA will usually set a multiplication factor of 3 that must be used by the Bank where all the qualitative and quantitative criteria are satisfied. This will be imposed as a condition on the approval and may be varied by the AFSA should circumstances require.

27. A Bank using internal VaR models is expected to calculate a ‘Stressed VaR' of the current portfolio, at least on a weekly basis, in addition to the calculation of VaR in accordance with the requirements set out in this section. The VaR model inputs for calculation of Stressed VaR should ideally be calibrated to historical data from a continuous 12-month period of significant financial stress relevant to the Bank's portfolio. The choice of such historical data should be subject to review by the Bank, at least on an annual basis and the outcome of such a review must be notified to the AFSA promptly.

28. A Bank using an internal model should calculate Capital Requirement for the relevant risk categories, as the sum of points (a) and (b):

(a) the higher of:

i) its previous day's VaR number calculated in accordance with the guidance in this section; or

ii) an average of the daily VaR numbers calculated in accordance with the guidance in this section, on each of the preceding sixty business days (AvgVaR), multiplied by the multiplication factor referred in paragraph 26 above; plus

(b) the higher of:

i) its latest available stressed VaR number calculated in accordance with guidance in this section (sVaRt-1); or

ii) an average of the stressed VaR numbers calculated in accordance with the guidance in this section, over the preceding sixty business days (Avg sVaR), multiplied by the multiplication factor referred in Guidance note 16 above.

E. Incremental risk charge (IRC) model

37. A Bank that uses an internal model for calculating Capital Requirements for specific risk of interest rate risk Exposures should also have an internal incremental default and migration risk (incremental risk charge, or IRC) model in place to capture the default and migration risks of its Trading Book positions that are incremental to the risks captured by the VaR measure as specified in paragraph 22 above.

38. A Bank is expected to demonstrate that its internal model meets soundness standards comparable to that expected under the Basel III standard for the Internal Ratings Based (IRB) approach for Credit Risk under the assumption of a constant level of risk, and adjusted where appropriate to reflect the impact of liquidity, concentrations, hedging and optionality.

39. The internal IRC model should cover all positions subject to a Capital Requirement for specific interest rate risk, including those subject to a 0% specific Risk capital charge using the Standard method, but should not cover securitisation positions and n-th-to-default Credit Derivatives.

40. A Bank may, subject to approval by the AFSA, choose to include consistently all listed equity positions and derivatives positions based on listed equities. The permission will be granted only if such inclusion is consistent with how the Bank internally measures and manages risk.

41. Banks should use the internal model to calculate a number which measures losses due to default and internal or external ratings migration at the 99.9 % confidence interval over a time horizon of one year. Banks should calculate this number at least weekly. Correlation assumptions should be supported by analysis of objective data in a conceptually sound framework. The internal model should appropriately reflect issuer concentrations including those that can arise within and across product classes under stressed conditions.

42. The internal IRC model should reflect the impact of correlations between default and migration events. The impact of diversification between, on the one hand, default and migration events and, on the other hand, other risk factors should not be reflected.

43. The internal model should be based on the assumption of a constant level of risk over the one- year time horizon, implying that given individual Trading Book positions or sets of positions that have experienced default or migration over their liquidity horizon are re-balanced at the end of their liquidity horizon to attain the initial level of risk. Alternatively, a Bank may choose to consistently use a one-year constant position assumption.

44. The liquidity horizons should be set according to the time required to sell the position or to hedge all material relevant price risks in a stressed market, having particular regard to the size of the position. Liquidity horizons should reflect actual practice and experience during periods of both systematic and idiosyncratic stresses. The liquidity horizon should be measured under conservative assumptions and should be sufficiently long that the act of selling or hedging, in itself, would not materially affect the price at which the selling or hedging would be executed.

45. The appropriate liquidity horizon for a position or set of positions is subject to a floor of three months. The determination of the appropriate liquidity horizon for a position or set of positions should take into account a Bank's internal policies relating to valuation adjustments and the management of stale positions. When a Bank determines liquidity horizons for sets of positions rather than for individual positions, the criteria for defining sets of positions should be defined in a way that meaningfully reflects differences in liquidity. The liquidity horizons should be greater for positions that are concentrated, reflecting the longer period needed to liquidate such positions. The liquidity horizon for a securitisation warehouse should reflect the time to build, sell and securitise the assets, or to hedge the material risk factors, under stressed market conditions.

46. Hedges may be incorporated into a Bank's internal model to capture the incremental default and migration risks. Positions may be netted when long and short positions refer to the same financial instrument. Hedging or diversification effects associated with long and short positions involving different instruments or different securities of the same obligor, as well as long and short positions in different issuers, may only be recognised by explicitly modelling gross long and short positions in the different instruments. Banks should reflect the impact of material risks that could occur during the interval between the hedge's maturity and the liquidity horizon as well as the potential for significant basis risks in hedging strategies by product, seniority in the capital structure, internal or external rating, maturity, vintage and other differences in the instruments. A Bank should reflect a hedge only to the extent that it can be maintained even as the obligor approaches a credit or other event.

47. For positions that are hedged via dynamic hedging strategies, a rebalancing of the hedge within the liquidity horizon of the hedged position may be recognised, provided that the Bank:

(a) chooses to model rebalancing of the hedge consistently over the relevant set of Trading Book positions;

(b) demonstrates that the inclusion of rebalancing results in a better risk measurement; and

(c) demonstrates that the markets for the instruments serving as hedges are liquid enough to allow for such rebalancing even during periods of stress. Any residual risks resulting from dynamic hedging strategies must be reflected in the Capital Requirement.

48. The internal model to capture the incremental default and migration risks should reflect the nonlinear impact of options, structured credit derivatives and other positions with material nonlinear behaviour with respect to price changes. The Bank should also have due regard to the amount of model risk inherent in the valuation and estimation of price risks associated with such products.

49. The internal model should be based on data that are objective and up-to-date. As part of the independent review and validation of their internal models used for purposes of this Chapter, a bank should in particular do all of the following:

(a) validate that its modelling approach for correlations and price changes is appropriate for its portfolio, including the choice and weights of its systematic risk factors;

(b) perform a variety of stress tests, including sensitivity analysis and scenario analysis, to assess the qualitative and quantitative reasonableness of the internal model, particularly with regard to the treatment of concentrations. Such tests should not be limited to the range of events experienced historically; and

(c) apply appropriate quantitative validation, including relevant internal modelling benchmarks.

50. The internal model should be consistent with the Bank's internal risk management methodologies for identifying, measuring, and managing trading risks. The Bank should document its internal models so that their correlation and other modelling assumptions are transparent to the AFSA.

51. The internal model should conservatively assess the risk arising from less liquid positions and positions with limited price transparency under realistic market scenarios. In addition, the internal model should meet minimum data standards. Proxies should be appropriately conservative and may be used only where available data is insufficient or is not reflective of the true volatility of a position or portfolio.

52. If a Bank uses an internal model to capture incremental default and migration risks that does not comply with all requirements specified in this Guideline, but that is consistent with the Bank's internal methodologies for identifying, measuring and managing incremental default and migration risks, it should be able to demonstrate that its internal model results in a Capital Requirement that is at least as high as if it were based on a model in full compliance with the requirements of the Guidance notes referred above. The AFSA will review compliance with the previous sentence at least annually.

53. The AFSA will grant permission to use an internal model for calculating the Capital Requirement for a correlation trading portfolio only to Banks that have obtained the AFSA’s approval to use an internal model for specific risk of interest rate risk t Rate Risk Exposures and that meet the requirements for internal models specified earlier in this section.

54. Banks should use this internal model to calculate a number which adequately measures all price risks at the 99.9 % confidence interval over a time horizon of one year under the assumption of a constant level of risk, and adjusted where appropriate to reflect the impact of liquidity, concentrations, hedging and optionality. Banks should calculate this number at least weekly. The following risks should be adequately captured by the internal model for correlation trading:

(a) the cumulative risk arising from multiple defaults, including different ordering of defaults, in tranched products;

(b) credit spread risk, including the gamma and cross-gamma effects;

(c) volatility of implied correlations, including the cross effect between spreads and correlations;

(d) basis risk, including both of the following:

i) the basis between the spread of an index and those of its constituent single names; and

ii) the basis between the implied correlation of an index and that of bespoke portfolios;

(e) recovery rate volatility, as it relates to the propensity for recovery rates to affect tranche prices;

(f) to the extent the comprehensive risk measure incorporated benefits from dynamic hedging, the risk of hedge slippage and the potential costs of rebalancing such hedges; and

(g) any other material price risks of positions in the correlation trading portfolio.

55. A Bank should use sufficient market data within their internal model for correlation trading, in order to ensure that it fully captures the salient risks of those Exposures in its internal approach in accordance with the requirements set out in this guidance. The Bank should be able to demonstrate to the AFSA through back testing or other appropriate means that its model can appropriately explain the historical price variation of those products.

56. The Bank should have appropriate policies and procedures in place in order to separate the positions for which it holds permission to incorporate them in the Capital Requirement in accordance with this Guideline from other positions for which it does not hold such permission.

57. With regard to the portfolio of all the positions incorporated in the internal model for correlation trading, the Bank should regularly apply a set of specific, predetermined stress scenarios. Such stress scenarios should examine the effects of stress to default rates, recovery rates, credit spreads, basis risk, correlations and other relevant risk factors on the correlation trading portfolio. The Bank should apply stress scenarios at least weekly and report at least quarterly to the AFSA the results, including comparisons with the Bank's Capital Requirement in accordance with this point. Any instances where the stress test results materially exceed the Capital Requirement for the correlation trading portfolio should be reported to the AFSA in a timely manner.

58. The internal model should conservatively assess the risk arising from less liquid positions and positions with limited price transparency under realistic market scenarios. In addition, the internal model should meet minimum data standards. Proxies should be appropriately conservative and may be used only where available data is insufficient or is not reflective of the true volatility of a position or portfolio.

F. Stress testing

59. For the purposes of BBR Rule 6.7 (4), the AFSA will expect a Bank’s internal model to meet the following criteria:

(a) the Bank's stress scenarios must cover a range of factors that can create extraordinary losses or gains in trading portfolios, or make the control of risk in those portfolios very difficult. These factors include low-probability events in all major types of risks, including the various components of market, credit, and Operational Risks;

(b) the Bank's stress tests must be both of a quantitative and qualitative nature, incorporating both Market Risk and liquidity aspects of market disturbances. Quantitative criteria must identify plausible stress scenarios to which the Bank could be exposed. Qualitative criteria must emphasise that two major goals of stress testing are to evaluate the capacity of the Bank's capital to absorb potential large losses and to identify steps the Bank can take to reduce its risk and conserve capital; and

(c) the Bank must combine the use of supervisory stress scenarios with stress tests developed by the Bank itself to reflect their specific Risk characteristics. Information is required in three broad areas:

(i) supervisory scenarios requiring no simulations by the Bank - the Bank must have information on the largest losses experienced during the reporting period available for supervisory review. This loss information must be compared to the level of capital that results from a bank's internal measurement system;

(ii) supervisory scenarios requiring a simulation by the Bank – the Bank must subject its portfolio to a series of simulated stress scenarios and provide the AFSA with the results (e.g., the sensitivity of the Bank’s Market Risk Exposure to changes in the assumptions about volatilities and correlations); and

(iii) scenarios developed by the Bank itself to capture the specific characteristics of its portfolio.

60. In addition to the scenarios prescribed under 52(c) above, a Bank must also develop its own stress tests which it identifies as most adverse, based on the characteristics of its portfolio, for example, problems arising in a key region of the world combined with a sharp move in oil prices. The Bank must also provide the AFSA with a description of the methodology used to identify and carry out the scenarios as well as with a description of the results derived from these scenarios.

G. Calculation of Foreign Exchange Risk Capital Requirement

61. This section of the BPG sets out the standards, methodology, formulae and parameters to be employed by a Bank in calculating the Foreign Exchange risk capital requirements, specified in BBR Rule 6.5 (1) (C). These elements constitute the framework which the AFSA would use to assess compliance with BBR Rules requiring a Bank to maintain adequate capital to support its foreign exchange risk exposures. In order to ensure compliance with the requirement under this Rule and to demonstrate adequacy of capital to address foreign exchange risk exposures, the AFSA expects a Bank to follow the methodology specified in this section.

62. In measuring its Market risk, a Bank must include the risk of holding or taking positions in foreign currencies and gold (foreign exchange risk). Foreign exchange risk may arise from the Bank’s trading in the foreign exchange market and other markets; it may also arise from non-trading activities that are denominated in a foreign currency.

63. If a Bank is exposed to interest rate risk on positions in foreign currencies and gold, the Bank must include the relevant interest rate positions in the calculation of interest rate risk. Gold is dealt with as a foreign exchange position (rather than as a commodity position) because the volatility of its prices is similar to that of a currency. If foreign currency is to be received or delivered under a forward contract, the Bank must report any interest rate exposure from the other leg of the contract in accordance with the section on traded interest rate risk in this BPG. If gold is to be received or delivered under a forward contract, the Bank must report any foreign currency or interest rate exposure from the other leg of the contract in accordance with this section or the section on traded interest rate risk in this BPG, respectively.

64. In calculating the capital charge for foreign exchange risk, a Bank must include in its exposure to each foreign currency:

(a) the net spot position (that is, all assets minus all liabilities denominated in the currency, including accrued interest and other accrued income and accrued expenses);

(b) the net forward position (that is, all amounts to be received less all amounts to be paid under forward foreign exchange transactions denominated in the currency, including currency futures and the principal on currency swaps not included in the spot position);

H. Calculation of Interest Rate Risk Capital Requirement

78. This section of the BPG sets out the standards, methodology, formulae and parameters to be employed by a Bank in calculating the Interest Rate risk capital requirements, specified in BBR Rule

6.5 (1) (a). These elements constitute the framework which the AFSA would use to assess compliance with BBR Rules requiring a Bank to maintain adequate capital to support its traded interest rate risk exposures. In order to ensure compliance with the requirement under this Rule and to demonstrate adequacy of capital to address foreign exchange risk exposures, the AFSA expects a Bank to follow the methodology specified in this section. In measuring its Market risk, a banking business Bank must include the risk of holding or taking positions in debt securities and other interest- rate-related instruments that are held in the Trading Book (interest rate risk).

79. The measurement of interest rate risk in the Trading Book applies to all fixed-rate and floating-rate debt securities and other interest-rate-related instruments that exhibit market behaviour similar to debt securities. Examples of such instruments would include non-convertible preference shares and convertible bonds that trade like debt securities. A debt security that is the subject of a repurchase or securities lending agreement is taken to be owned by the lender of the security.

80. In calculating the capital charge for interest rate risk, a banking business Bank must include interest rate exposures arising from forward foreign exchange transactions and forward sales and purchases of commodities and equities. The Bank must also include any interest rate exposures arising from foreign exchange, equity and commodity positions.

I. Calculation of Equity Risk Capital Requirement

103. This section of the BPG sets out the standards, methodology, formulae and parameters to be employed by a Bank in calculating the Equity risk capital requirements, specified in BBR Rule 6.5

(1) (b). These elements constitute the framework which the AFSA would use to assess compliance with BBR Rules requiring a Bank to maintain adequate capital to support its equity risk exposures. In order to ensure compliance with the requirement under this Rule and to demonstrate adequacy of capital to address equity risk exposures, the AFSA expects a Bank to follow the methodology specified in this section.

104. In measuring its Market risk, a Bank must include the risk of holding or taking positions in equities (equity position risk). In respect of options with equities as the underlying, Section I of this Chapter should be followed. If equities are to be received or delivered under a forward contract, the Bank must report any foreign currency or interest rate exposure from the other leg of the contract in accordance with the relevant section of this Chapter 6 of BPG dealing with Foreign exchange risk capital requirement or interest rate risk capital requirement. If a Bank is exposed to interest rate risk on equity positions, it must include the relevant interest rate positions in the calculation of interest rate risk according to the methodology specified in the section on interest rate risk capital requirement.

105. The measurement of equity position risk in the Trading Book applies to short and long positions in all instruments that exhibit market behaviour similar to equities.

J. Calculation of Option Risk Capital Requirement

121. This section of the BPG sets out the standards, methodology, formulae and parameters to be employed by a Bank in calculating the Option risk capital requirements, specified in BBR Rule 6.5

(1) (e). These elements constitute the framework which the AFSA would use to assess compliance with BBR Rules requiring a Bank to maintain adequate capital to support its option risk exposures. In order to ensure compliance with the requirement under this Rule and to demonstrate adequacy of capital to address equity risk exposures, the AFSA expects a Bank to follow the methodology specified in this section.

122. In measuring its Market risk, a Bank must include the risk of holding or taking positions in options contracts (options risk). If all the written option positions are hedged by perfectly matched long positions in exactly the same options, no capital charge for options risk is required. A Bank that does not write options must use the simplified approach. A Bank that writes options must use the delta-plus method.

K. Calculation of Commodities Risk Capital Requirement

143. This section of the BPG sets out the standards, methodology, formulae and parameters to be employed by a Bank in calculating the Commodities risk capital requirements, specified in BBR Rule 6.5 (1) (d). These elements constitute the framework which the AFSA would use to assess compliance with BBR Rules requiring a Bank to maintain adequate capital to support its commodities risk exposures. In order to ensure compliance with the requirement under this Rule and to demonstrate adequacy of capital to address equity risk exposures, the AFSA expects a Bank to follow the methodology specified in this section.

144. In measuring its Market risk, a Bank must include the risk of holding or taking positions in commodities and commodities options (commodities risk). Commodities means physical or energy products that may be traded. Commodities include precious metals (other than gold), base metals, agricultural products, minerals, oil, gas and electricity. A Bank must also include commodity derivatives and off-balance sheet positions that are affected by changes in commodity prices, having derived notional commodity positions; and other positions against which no other Market or Credit Risk Capital Requirement has been applied.

145. If a Bank is exposed to foreign exchange or interest rate risk from funding commodities positions, it must include the relevant positions in the measurement of interest rate or foreign exchange risk. Gold is dealt with as a foreign exchange position (rather than as a commodity position) because the volatility of its prices is similar to that of a currency. If a commodity is to be received or delivered under a forward contract, the Bank must report any foreign currency, equity or interest rate exposure from the other leg of the contract in accordance with the relevant section of this Chapter.

146. In calculating the capital charge for commodities risk, a Bank must include commodity derivatives and off-balance- sheet positions that are affected by changes in commodity prices (such as commodity futures and commodity swaps). Options on commodities for which the options risk is measured using the delta-plus method must also be included (with their underlying assets). Options for which the options risk is measured using the simplified approach must be excluded.

147. Commodity derivatives need to be converted into notional commodities positions and assigned to maturities. Futures and forward contracts relating to a particular commodity must be included in the measurement of commodities risk as notional amounts in terms of the standard unit of measurement multiplied by the spot price of the commodity.

148. A Bank must first state each commodity position (spot plus forward) in terms of the standard unit of measurement for the commodity (such as barrels, kilos or grams). The firm must then convert the net position in each commodity into the reporting currency at the current spot market exchange rates.

A. Operational Risk Management Framework & Governance

1. This section of the BPG sets out the standards, guidance and norms required to fulfil the regulatory requirements in respect of the Operational Risk management framework and governance, specified in Section 7.1 of Chapter 7 of BBR. These elements convey the supervisory expectations of the AFSA regarding Operational Risk management framework & governance in a Bank. The AFSA will use these standards, norms and key elements specified here to assess compliance with BBR Rules on Operational Risk management.

2. A Bank’s Operational Risk management policy is expected to address the following key elements:

(a) the governance structures used to manage Operational Risk, including reporting lines and accountabilities;

(b) risk assessment tools and how they are used;

(c) the Authorised Firm’s accepted Operational Risk appetite, permissible thresholds or tolerances for inherent and residual risk, and approved risk mitigation strategies and instruments;

(d) the Authorised Firm’s approach to establishing and monitoring thresholds or tolerances for inherent and residual risk Exposure;

(e) risk reporting and MIS; and

(f) appropriate independent review and assessment of the Authorised Firm’s Operational Risk framework.

3. An Authorised Firm’s Operational Risk policy should, amongst other things, include consideration of Principles for the Sound Management of Operational Risk, issued by the Basel Committee on Banking Supervision (BCBS) and the Guidelines on the management of Operational Risk in market- related activities issued by the European Banking Authority which are useful in relation to activities other than banking.

4. The GEN Module contains Rules and Guidance regarding corporate governance requirements for Authorised Firms, including the responsibilities of an Authorised Firm regarding risk management. In developing, implementing and maintaining an effective Operational Risk framework, an Authorised Firm’s Governing Body should:

(a) approve and review a risk appetite and tolerance for Operational Risk that articulates the nature, types and levels of Operational Risk that the Authorised Firm is willing to assume;

(b) consider all relevant risks, the Authorised Firm’s level of risk appetite, its current financial condition and its strategic direction. The Governing Body should monitor management adherence to the risk appetite and tolerance and provide for timely detection and remediation of breaches;

(c) encourage a management culture, and develop supporting processes, which help to engender within the Authorised Firm an understanding by relevant Employees of the nature and scope of the Operational Risk inherent in the Authorised Firm’s strategies and activities;

(d) provide senior management with clear guidance and direction regarding the principles underlying the Authorised Firm’s Operational Risk management framework and approve the corresponding policies developed by senior management;

(e) regularly review the Authorised Firm’s Operational Risk policy to ensure that the Authorised Firm has identified and is managing the Operational Risk arising from external market changes and other environmental factors, as well as those Operational Risks associated with new strategies, products, activities, or systems, including changes in risk profiles and priorities (e.g. changing business volumes). Such review should also take into account the Operational Risk loss experience, the frequency, volume or nature of limit breaches, the quality of the control environment and the effectiveness of risk management or mitigation strategies;

(f) ensure that the Authorised Firm’s Operational Risk policy and framework is subject to effective independent review by audit or other appropriately-trained Persons;

(g) ensure that management is incorporating industry best practice in managing Operational Risk; and

(h) establish clear lines of management responsibility and accountability for implementing a strong control environment. The control environment should provide appropriate independence/separation of duties between Operational Risk control functions, business lines and support functions.

B. Operational Risk Management Processes and standards

6. This section of the BPG sets out the standards, guidance, and best practices required to fulfil the regulatory requirements in respect of the Operational Risk management processes, specified in Section 7.5 of Chapter 7 of BBR. The AFSA will use these standards, norms and key elements to assess compliance with BBR Rules on Operational Risk management processes and procedures and the effectiveness of such processes.

7. A Bank should record all Operational Risk events, including near misses and events which result in a positive financial outcome. Tools that an Authorised Firm may employ for identifying and assessing Operational Risk include:

(a) internal loss data collection and analysis;

(b) external data collection and analysis;

(c) risk assessments;

(d) business process mapping;

(e) risk and performance indicators; and

(f) scenario analysis.

8. GEN Rules require an Authorised Person in the AIFC to establish and maintain arrangements to provide its Governing Body and senior management with the information necessary to organise and control its activities, to comply with legislation applicable in the AIFC and to manage risks.

9. BBR Rule 7.5 (1) (f) requires Banks to establish and maintain reporting mechanisms specifically addressing the Operational Risk matters. The frequency of internal reporting of Operational Risks required by BBR Rule 7.5 (1) (f) should reflect the risks involved and the pace and nature of changes in the Bank’s operating environment.

10. The following lists some of the items that an Authorised Firm should consider including in its internal reporting of Operational Risks:

(a) the results of monitoring activities;

(b) assessments of the Operational Risk framework performed by control functions such as internal audit, compliance, risk management and/or external audit;

(c) reports generated by (and/or for) supervisory authorities;

(d) material breaches of the Authorised Firm’s risk appetite and tolerance with respect to Operational Risk;

(e) details of recent significant internal Operational Risk events and losses, including near misses or events that resulted in a positive return; and

(f) relevant external events and any potential impact on the Authorised Firm and its Operational Risk framework, including Operational Risk capital.

11. Banks are required to establish and maintain systems and controls, including but not limited to financial and risk systems and controls that ensure that its affairs are managed effectively and responsibly by its senior management. In order to comply with the rules in BBR Chapter 7, Banks are expected to establish and maintain a strong control environment that uses policies, processes and systems, appropriate internal controls and appropriate risk mitigation and/or transfer strategies.

12. In order to establish such a strong control environment to address Operational Risk, a Bank should consider the following:

(a) clear segregation of duties and dual control;

(b) clearly established authorities and/or processes for approval;

(c) close monitoring of adherence to assigned risk limits or thresholds;

(d) safeguards for access to, and use of, the Authorised Firm’s assets and records;

(e) appropriate staffing level and training to maintain expertise;

(f) ongoing processes to identify business lines or products where returns appear to be out of line with reasonable expectations; and

(g) regular verification and reconciliation of transactions and accounts.

C. Specific elements of Operational Risk

A. IRRBB - Management Framework & Governance

1. This section of the BPG sets out the standards, guidance and norms required to fulfil the regulatory requirements in respect of the Risk management framework and governance addressing IRRBB, as specified in Section 8.1 of Chapter 8 of BBR. These elements convey the supervisory expectations of the AFSA regarding the framework for management of IRRBB and its governance. The AFSA will use these standards, norms and key elements specified here to assess compliance with BBR Rules on management of its IRRBB exposures.

2. A Bank’s IRRBB management policy is expected to address the following:

(a) effective systems for the accurate and timely identification, measurement, evaluation, management and control or mitigation of IRRBB, and reporting to the firm’s governing body and senior management;

(b) regular review, and independent internal or external validation, of any model used by the firm to manage IRRBB (including review of significant assumptions);

(c) prudent and appropriate limits that are consistent with the firm’s risk tolerance, risk profile and capital;

(d) procedures for tracking and reporting exceptions and deviations from limits;

(e) the use of the output of the risk measurement under the policy to report the level of that risk to the senior management and governing body of the Bank;

(f) the measurement to be capable of measuring the risk using the earnings approach;

(g) the measurement to be clearly defined and consistent with the nature and complexity of the structure of the firm’s balance sheet;

(h) provide for balancing cash flows as part of managing IRRBB; and

(i) approval by the governing body, or a committee of the governing body, of any major hedging or risk-management initiatives.

B. IRRBB Management Processes and standards

5. This section of the BPG sets out the standards, guidance, and best practices required to fulfil the regulatory requirements in respect of the IRRBB management processes, specified in Section 8.3 of Chapter 8 of BBR. The AFSA will use these standards, norms and key elements to assess compliance with BBR Rules on IRRBB management processes and procedures and the effectiveness of such processes. The risk of changes in the capital values of instruments resulting from changes in interest rates is taken to be Market Risk.

6. The AFSA expects a Bank to set quantitative and qualitative limits and targets for managing its exposure to IRRBB. The Bank should establish and enforce operating limits and other practices that maintain IRRBB exposures within levels consistent with their internal policies and that accord with their approach to measuring the risk. In particular, Banks should set a limit on the extent to which floating rate exposures are funded by fixed rate sources and vice versa to limit the risk. In floating rate lending, Banks are expected to limit the extent to which they run any basis risk that may arise if lending and funding are not based on precisely the same market interest rate (e.g. LIBOR). The AFSA also expects the internal independent validation to be done by a function that is independent of the function that assumed or incurred the risk.

7. The systems and processes for the measurement of IRRBB as required by the BBR Rule 8.1 (4) (

c) should encompass all material drivers of IRRBB. The measurement should evaluate the effect of rate changes on earnings or economic value meaningfully and accurately within the context and complexity of the Bank’s business activities. Depending on the size and complexity of its banking book, the Bank may also need to measure IRRBB using the economic value approach.

8. The IRRBB risk measurement systems and methodologies employed by a Bank to meet the requirements under BBR Rule 8.1 (4):

(a) should flag excessive exposures;

(b) should evaluate interest rate risk arising from the full range of the Bank’s assets, liabilities and off-balance-sheet positions, across both trading and banking books;

(c) should ensure that an integrated view of IRRBB across products and business lines is available to management, particularly when different measurement systems and methods are used across different business lines;

(d) should ensure accurate and timely data on all aspects of current positions.

(e) employ generally accepted financial models and ways of measuring risk; and

(f) ensure accurate and timely data on all aspects related to current positions.

C. Stress Testing & IRRBB

9. This section of the BPG provides useful guidance on the supervisory expectations of the AFSA in respect of the stress testing of exposure to IRRBB. In order to demonstrate full compliance with the stress testing requirements mandated in the Rules in section 8.4 of BBR, Banks are expected to comply with the standards, norms and guidance provided in this section, in an effective manner.

10. For the purposes of BBR Rule 8.4, a Bank should consider the standards for stress testing recommended in the paper published by the Basel Committee for Banking Supervision – Principles for management and supervision of interest rate risk – in July 2004. In particular, a Bank should include the technical specifications of a standardised interest rate shock detailed in Annex 3 of that paper as part of its systems for measurement of interest rate risk in its Banking Book.

11. A Bank should measure its vulnerability to loss in stressed market conditions, including market conditions in which significant assumptions are no longer met, and consider the results of that measurement when establishing and reviewing its IRRBB management policy. Stress scenarios for this exercise should include:

(a) historical scenarios such as the Asian crisis in the late 1990s;

(b) changes in the general level of interest rates (for example, changes in yields of 100 basis points or more in 1 year);

(c) changes in the relationships between significant market rates (basis risk), such as:

i) a rapid increase in term deposit rates, savings deposit rates and benchmark rates like LIBOR (but with no change in the prime rate); and

ii) a drop in the prime rate (but with no change in term deposit rates, savings deposit rates and benchmark rates);

(d) changes in interest rates in separate time bands to different relative levels (that is, yield curve risk or changes in how interest rates vary over time);

(e) changes in the liquidity of financial markets;

(f) changes in the volatility of market rates; and

(g) changes in business assumptions and parameters such as the correlation between 2 currencies. In particular, changes in assumptions used for illiquid instruments and instruments with uncertain contractual maturities help understanding of a Bank’s risk profile.

12. Chapter 8 of BBR dealing with IRRBB and its management does not impose an explicit Capital Requirement relating to IRRBB. Consistent with the approach prescribed under Basel III framework, the AFSA intends to address IRRBB as part of its Pillar II supervisory process. So, the AFSA expects a Bank to diligently carry out the evaluations and stress tests mandated in Chapter 8 of BBR and include the results as part of its annual ICAAP.

13. Following a Supervisory review of the annual ICAAP submission, the AFSA may impose an Individual Capital Requirement (ICR) on the Bank involved, if it is of the view that the Bank’s minimum Capital Requirement as defined in Chapter 4 of BBR is insufficient to address adequately all its risks, and in particular its exposure to IRRBB.

14. In order to comply with the BBR Rule 8.6 in an effective manner, a Bank’s approach to evaluating and managing IRRBB as part of its ICAAP should include the following:

(a) the internal definition of, and the boundary between, Banking Book and Trading Book;

(b) a definition of economic value showing that it is consistent with the method used to value assets and liabilities (e.g. discounted cashflows);

(c) the size and form of the different interest rate shocks to be used for stress- testing;

(d) the use of a dynamic or static approach in the application of interest rate shocks;

(e) the treatment of commonly called “pipeline transactions” (including any related hedging);

(f) the aggregation of multi-currency interest rate exposures;

(g) the inclusion (or not) of non-interest-bearing assets and liabilities (including capital and reserves)

(h) the treatment of current and savings accounts (that is, the maturity attached to exposures without a contractual maturity);

(i) the treatment of fixed-rate assets or liabilities, if customers have a right to repay or withdraw early;

(j) the extent to which sensitivities to small changes can be scaled up linearly without significant loss of accuracy (covering both convexity generally and the nonlinearity of pay-off associated with explicit option products);

(k) the degree of granularity employed (for example, offsets within a time band or zone);

(l) whether all future cash flows or only principal balances are included.

A. Introduction

1. Liquidity risk is the risk that a Bank may not be able to meet its financial obligations as they fall due. Funding Liquidity Risk of a Bank, is the risk that the Bank will not be able to efficiently meet:

(a) its expected and unexpected current and future cash flow; and

(b) its collateral needs;

without affecting its daily operations or financial condition.

2. Funding Liquidity Risk may arise because of unexpected withdrawals or transfers of funds by the Bank’s depositors and other account holders.

3. On the assets side, a Bank may face funding strain due to problems in its financing and investment portfolio. The Bank may also face Liquidity Risk because of counterparties’ operational and information system failures, or because problems in a payment and settlement system result in late payment or non-payment of funds.

4. Examples of problems that may lead to Liquidity Risk

➢ fall in the value of marketable assets held for trading or in the banking book

➢ lack of liquid markets for holdings

➢ impairment of assets due to the financial distress of customers

➢ large drawdowns under committed line-of-credit agreements

5. Market Liquidity Risk, of a Bank, is the risk that the Bank cannot offset or eliminate a position at the market price because of market disruption or inadequate market depth. In a period of crisis, problems with funding liquidity may lead to asset sales and may lower asset prices and affect the Bank’s market liquidity. Efforts by a Bank to sell a significant amount of its assets because of doubts about their quality and future performance can affect market liquidity by reducing the price of assets.

6. The collapse of market liquidity is also likely when market-makers are risk- averse or lack absorption capacity. The interaction can also become significant when Banks start stockpiling liquid assets because of pessimistic expectations about market conditions. Overall market confidence is an important factor in understanding the interrelationship between funding and market liquidity.

7. Liquidity risk tolerance refers to both the absolute risk a Bank is open to take and the actual limits that the Bank pursues. The Bank’s Liquidity Risk tolerance must be appropriate for its business and its role in the financial system and must be expressed in a way that clearly states that it is a trade- off between risks and profits.

8. The terms ‘risk tolerance’ and ‘risk appetite’ are used interchangeably to describe both the absolute risks a Bank is open to take (which some may call risk appetite) and the actual limits within its risk appetite that a Bank pursues (which some call risk tolerance). For example, a Bank may have set, as the absolute Liquidity Risk it is willing to take, a limit of 20% (risk tolerance) but at the same time prefer to keep to an actual level of 10% (risk appetite).

B. Liquidity Risk - Management Framework & Governance

9. This section of the BPG sets out the standards, guidance and norms required to fulfil the regulatory requirements in respect of the Liquidity Risk management framework and governance, as specified in Chapter 9 of BBR. These elements convey the supervisory expectations of the AFSA on Liquidity risk management framework and its governance. Compliance with the standards and guidance detailed in this section of BPG, both in letter and in spirit, is required to demonstrate fulfillment of the regulatory obligations specified in Chapter 9 of BBR. The AFSA will use these standards, norms and key elements specified here to assess compliance with BBR Rules on Liquidity Risk management.

10. A Bank’s Liquidity risk management policy is expected to address the following key elements:

(a) effective systems for the accurate and timely identification, measurement, evaluation, management and control or mitigation of Liquidity risk;

(b) the criteria and responsibility for reporting, and the scope, manner and frequency of reporting, to the governing body or a committee of the governing body;

(c) prudent and appropriate Liquidity risk limits that are consistent with the Bank’s risk tolerance, risk profile and capital, and with the management’s ability to manage;

(d) who is responsible for identifying, measuring and reporting Liquidity risk; and

(e) procedures for tracking and reporting exceptions to, and deviations from, limits or policies.

(f) the Bank’s approach to day-to-day (and, where appropriate, intraday) liquidity management;

(g) the Bank’s funding strategy and contingency funding plan; and

(h) effective information systems to enable the identification, measurement, monitoring and control of Liquidity Risk exposures and funding needs.

11. The AFSA expects that a Bank’s Liquidity Risk strategy will set out the approach that the Bank will take to Liquidity Risk management, including various quantitative and qualitative targets. It should be communicated to all relevant functions and staff within the organisation and be set out in the Bank's Liquidity Risk policy. The AFSA expects that a Bank’s Liquidity Risk policy and strategy for managing Liquidity Risk will take into account the need to:

(a) develop a liquidity management strategy, policies and processes in accordance with the Bank’s stated Liquidity Risk tolerance;

(b) ensure that the Bank maintains sufficient liquidity at all times;

(c) determine the structure, responsibilities and controls for managing Liquidity Risk and for overseeing the liquidity positions of all branches and subsidiaries in the jurisdictions in which the Bank is active, and outline these elements clearly in the Bank’s liquidity policies;

(d) have in place adequate internal controls to ensure the integrity of its Liquidity Risk management processes;

(e) ensure that stress tests, contingency funding plans and holdings of HQLA are effective and appropriate for the Bank;

(f) establish a set of reporting criteria, specifying the scope, manner and frequency of reporting to various recipients (such as the Governing Body, senior management and the asset/liability committee) and who is responsible for preparing the reports

(g) establish the specific procedures and approvals necessary for exceptions to policies and limits, including the escalation procedures and follow-up actions to be taken for breaches of limits;

(h) monitor closely current trends and potential market developments that may present significant, unprecedented and complex challenges for managing Liquidity Risk so that appropriate and prompt changes to the liquidity management strategy can be made as needed; and

(i) continuously review information on the Bank’s liquidity developments and report regularly to the Governing Body

12. A Bank’s liquidity management should take account of its liquidity needs under periods of liquidity stress (including those involving the loss or impairment of funding sources, whether secured or unsecured), as well as normal conditions. The source of liquidity stress could be specific, a Bank must ensure that its governing body is informed immediately of new and emerging liquidity concerns. Examples of concerns

➢ increasing funding costs, concentrations and requirements

➢ the lack of alternative sources of funding

➢ significant or persistent breaches of limits to control Liquidity Risk exposures

➢ any significant decline in the Bank’s holdings of unencumbered high-quality liquid assets

➢ changes in external market conditions that could signal potential difficulties.

13. In accordance with BBR Rule 9.1, a Bank is required to ensure that there is no significant risk that liabilities cannot be met as they fall due. With specific reference to liquidity, a Bank may meet its obligations in a number of ways, including:

(a) by holding sufficient immediately available cash or readily marketable assets;

(b) by securing an appropriate matching future profile of cashflows; and

(c) by further borrowing.

“future profile of cashflows” refers to the pattern of cashflows including, for example, in the terms of source, maturity date, amounts and nature of cashflows.

14. In order to comply with BBR Rule 9.1 and 9.2 the senior management and the governing body of a Bank are expected to demonstrate a thorough understanding of the links between funding Liquidity Risk and market Liquidity Risk, as well as how other risks, including credit, market, operational and reputation risks, affect the Bank’s overall Liquidity Risk strategy. In respect of this, senior management are expected to:

(a) oversee the development, establishment and maintenance of procedures and practices that translate the goals, objectives and risk tolerances approved by the governing body into operating standards that are consistent with the governing body's intent and which are understood by the relevant members of a Bank's staff;

(b) adhere to the lines of authority and responsibility that the governing body has established for managing Liquidity Risk;

(c) oversee the establishment and maintenance of management information and other systems that identify, assess, control and monitor the Bank's Liquidity Risk; and

(d) oversee the establishment of effective internal controls over the Liquidity Risk management process.

C. Liquidity Risk management

15. In respect of BBR Rule 9.3, Liquidity Risk tolerance of a Bank defines the level of Liquidity Risk that the Bank is willing to assume. A Bank’s risk management strategy usually refers to risk tolerance although risk appetite may also be used. The two terms are used interchangeably to describe both the absolute risks a Bank is open to take (by some called risk appetite) and the actual limits within its risk appetite that a Bank pursues (by some called risk tolerance).

16. In order to implement and maintain a comprehensive Liquidity Risk management framework to comply with the requirements imposed by BBR Rules 9.1 & 9.2, such a framework implemented by a Bank is expected to include:

(a) a statement of the Bank’s Liquidity Risk tolerance, approved by the Bank’s governing body;

(b) a statement of the Bank’s Liquidity Risk management strategy and policy, approved by the governing body;

(c) a statement of the Bank’s operating standards (in the form of policies, procedures and controls) for identifying, measuring, monitoring and controlling its liquidity risk in accordance with its Liquidity risk tolerance;

(d) a statement of the Bank’s funding strategy, approved by the governing body; and

(e) a contingency funding plan.

17. The framework must clearly set out the Bank’s organisational structure as it relates to Liquidity Risk management, and must define the responsibilities and roles of senior management involved in managing Liquidity Risk. The framework must be formulated to ensure that the Bank maintains sufficient liquidity to withstand a range of liquidity stress events (whether specific to the Bank, market-wide, or a combination of the two), including the loss or impairment of both unsecured and secured funding sources. The framework must be well integrated into the Bank’s overall risk management process.

18. The Liquidity Risk management framework must be subject to ongoing effective and comprehensive independent review. In most cases, the independent reviews could be facilitated by the Bank’s internal audit function but may require the engagement of independent experts outside that function. A Bank’s Liquidity Risk management oversight function must be operationally independent. It must be staffed with personnel who have the skills and authority to challenge the Bank’s treasury and other liquidity management functions.

19. The Bank must have adequate policies, procedures and controls to ensure that the Bank’s governing body and senior management are informed immediately of new and emerging liquidity concerns. Such concerns could include:

(a) increasing funding costs or concentrations

(b) increases in funding requirements

(c) shortage of other sources of liquidity

(d) material or persistent breaches of limits

(e) significant decline in the Bank’s holdings of unencumbered liquid assets

(f) changes in market conditions that could signal future difficulties.

20. The Bank’s senior management must be satisfied that all of the Bank’s business units whose activities affect the Bank’s liquidity:

(a) are fully aware of the Bank’s Liquidity Risk management strategy; and

(b) operate in accordance with the Bank’s approved policies, procedures, limits and controls.

21. If a Bank delegates its day-to-day Liquidity Risk management to another member of its group, in accordance with BBR Rule 9.3, ultimate responsibility for the Liquidity Risk management function and the responsibility for its effectiveness will remain with the Bank’s Governing Body.

D. Funding Strategy

34. In order to meet the requirements in BBR Rule 9.5 on funding strategy, a Bank must:

(a) identify the main factors that affect its ability to raise funds and must monitor those factors closely to ensure that its estimates of its fund-raising capacity remain valid.

(b) take into account how other risks affect its overall liquidity.

(c) Employ robust assumptions that are consistent with the Bank’s Liquidity Risk management strategy and business objectives.

35. The funding strategy implemented to fulfill BBR Rule 9.5 must include:

(a) an analysis of funding requirements under various scenarios;

(b) the maintenance of a reserve of unencumbered high-quality liquid assets that can be used, without impediment, to obtain funding in times of liquidity stress;

(c) the regular review of, and diversification in, the sources and tenor of funding;

(d) regular efforts to establish and maintain relationships with liability holders and funding sources; and

(e) the regular assessment of the Bank’s capacity to sell assets and raise funds quickly.

36. In preparing its strategy, the Bank must be aware that sources of funding such as guarantees and other commitments that may be readily available to the Bank in normal conditions may not be available in times of stress, even if the guarantee or commitment is described as irrevocable. A Bank should maintain an ongoing presence in its chosen funding markets and strong relationships with funds providers.

E. Stress Testing

37. A Bank is required to conduct stress tests regularly. The frequency with which a Bank should conduct stress tests will depend on the risks to the particular Bank. For some Banks, it may be adequate to conduct tests annually, but, for others, it may be necessary to conduct tests more frequently e.g. quarterly

38. A Bank should consider carefully the design of stress scenarios and the variety of shocks used in its liquidity stress testing programme. Regardless of how strong its current liquidity situation appears to be, it should take a conservative approach when setting stress testing assumptions. It should consider the potential impact of severe stress scenarios including, but not limited to:

(a) a simultaneous drying up of market liquidity in several previously highly liquid markets;

(b) severe constraints in accessing secured and unsecured funding;

(c) restrictions on currency convertibility; and

(d) severe operational or settlement disruptions affecting one or more payment or settlement systems.

39. The identification of the possible balance sheet and off-balance sheet impact referred to in BBR Rule 9.9 (2)(c) should take into account:

(a) possible changes in the market’s perception of the Bank and the effects that this might have on the Bank’s access to the markets, including:

(i) where the Bank funds its holdings of assets in one currency with liabilities in another, access to foreign exchange markets, particularly in less frequently traded currencies;

(ii) access to secured funding, including by way of repurchase agreement transactions; and

(iii) the extent to which the Bank may rely on committed facilities made available to it;

(b) whenever applicable the possible effect of each scenario tested on currencies whose exchange rates are currently pegged or fixed; and

(c) general market turbulence may trigger a substantial increase in the extent to which persons exercise rights against the Bank under off-balance sheet instruments to which the Bank is party;

(d) access to OTC derivative and foreign exchange markets is sensitive to credit- ratings;

(e) Early Amortisation in asset securitisation transactions with which the Bank has a connection may be triggered;

(f) its ability to securitise assets may be reduced; and

(g) there may be a potential need to buy back debt or honour non-contractual obligations to mitigate reputational risk.

40. A Bank must ensure that stress tests conducted to comply with BBR Rule 9.5, enable it to analyse the impact of stress scenarios on its liquidity positions, as well as on the liquidity positions of its individual business lines. A Bank must ensure that results of the stress tests are integrated into its strategic planning process and its day-to-day risk management practices. The Bank must also apply the results of the stress tests:

(a) to adjust its liquidity management strategy, policies and positions, including to determine an appropriate buffer of HQLA;

(b) in assessing and planning for potential funding shortfalls as part of its Contingency Funding Plan;

(c) for the setting of internal limits; and

(d) for the purpose of the IRAP and ICAAP assessments under Chapter 10, where applicable.

41. A Bank must ensure that the stress test results and vulnerabilities and any resulting actions are reported to, and discussed with, its Governing Body and the AFSA. If the AFSA considers that a Bank has not carried out effective stress tests under BBR Rules 9.5, it may use its power under AIFC Financial Services Framework Regulations to require the Bank to maintain a buffer of liquid assets in excess of that required under LCR and liquid assets buffer Rules.

F. Contingency Funding Plan (CFP)

42. A Contingency Funding Plan, or CFP, is a compilation of policies, procedures and action plans for responding to severe disruptions to a Bank’s ability to meet its liabilities as they fall due or its ability to fund some or all of its activities quickly and at a reasonable cost. In order to comply with the requirements in BBR Rule 9.10 on Contingency Funding Plan, a bank’s CFP must:

(a) list the events or circumstances that will lead the Bank to put any part of the plan into action;

(b) set out available potential contingency funding sources and the amount of funds a Bank estimates can be derived from these sources;

(c) estimate the lead time needed to tap additional funds from each of the contingency sources;

(d) set out the extent to which the plan relies upon:

(i) asset sales, using assets as Collateral on secured funding (including repurchase agreements), securitising its assets or otherwise reducing its assets;

(ii) modifying the structure of, or increasing, its liabilities; and

(iii) the use of committed facilities; and

(e) contain clear administrative policies and procedures that will enable the Bank to manage the implementation of the plan, including:

(i) the roles and responsibilities of senior management, including who has the authority to invoke the CFP;

(ii) the names, location and contact details of members of the team responsible for implementing the plan;

(iii) the details of who is responsible for contact with the Bank’s head office (if appropriate), analysts, investors, external auditors, media, significant customers, regulators and others; and

(iv) the mechanisms that enable senior management and the Governing Body to receive relevant, accurate, comprehensive, timely and reliable management information.

43. The CFP should provide a framework with a high degree of flexibility so that a Bank can respond quickly in a variety of situations. The CFP should assist the Bank to manage a range of scenarios of severe liquidity stress that include both Bank-specific and more generalised market-wide stress, as well as the potential interaction between them

44. The CFP's design, plans and procedures should be closely integrated with the Bank’s ongoing analysis of Liquidity Risk and with the results of the scenarios and assumptions used in stress tests. The CFP should, for each of the tested scenarios, demonstrate that the Bank has sufficient liquid financial resources to meet its liabilities over a range of different time periods, including intraday. A Bank must ensure that its CFP accounts for:

(a) the impact of stressed market conditions on its ability to sell or securitise assets;

(b) the link between asset liquidity and funding liquidity;

(c) second round and reputational effects related to execution of contingency funding measures; and

(d) the potential to transfer liquidity across Group entities, borders and lines of business, taking into account legal, regulatory, operational and time zone constraints.

45. Key aspects of CFP testing include ensuring that roles and responsibilities are appropriate and understood, confirming that contact information is up to date, proving the transferability of cash and collateral (especially across borders and entities) and ensuring that the necessary legal and operational documentation is in place to execute the plan at short notice. The Bank should also test key assumptions regularly, such as its ability to sell or repo certain assets or periodically draw down credit lines.

46. A Bank should ensure effective coordination between teams managing issues surrounding liquidity crises and business continuity. Liquidity crisis team members and alternates should have ready access to CFPs on-site and off-site.

G. Liquidity Coverage Ratio

48. The objective of the LCR is to promote short-term resilience of a Bank’s Liquidity Risk profile. The LCR aims to ensure that a Bank maintains an adequate level of unencumbered HQLA that can be converted into cash to meet its liquidity needs for a 30 calendar day period under a severe liquidity stress scenario.

49. The purpose of requiring Banks to maintain the HQLA portfolio and to meet the LCR requirement, is to ensure that such Banks are resilient, in the short term, to Liquidity Risk. The LCR requirement is intended to ensure that such a Bank always holds unencumbered assets that can be readily converted into sufficient cash to meet the Bank’s liquidity needs for 30 calendar days even under severe liquidity stress.

50. The LCR is calculated under Rule 9.16 using the following formula:

Value of stock of HQLA

____________________________________________________

Total Net Cash Outflows over the next 30 calendar days

51. The LCR has two components:

(a) Value of the stock of HQLA in stressed conditions; and

(b) Total Net Cash Outflows, calculated according to the stressed scenario parameters outlined in this section

52. The stress scenario entails both institution-specific and systemic shocks including:

(a) the run-off of a proportion of retail deposits;

(b) a partial loss of unsecured wholesale funding capacity;

(c) a partial loss of secured, short-term financing with certain collateral and counterparties;

(d) additional contractual outflows that would arise from a downgrade in the Bank’s public credit rating, where applicable, by up to and including three notches, including collateral posting requirements;

(e) increases in market volatility that affect the quality of collateral or potential future exposure of derivative positions and so require larger collateral haircuts or additional collateral, or lead to other liquidity needs;

(f) unscheduled draws on committed but unused credit and liquidity facilities that the Bank has provided to its clients; and

(g) the potential need for the Bank to buy back debt or honour non-contractual obligations to mitigate reputational risk.

53. For the purposes of complying with BBR Rule 9.16 (4), a currency is considered material to a Bank, if the aggregate liabilities denominated in that currency amount to 5% or more of the Bank’s total liabilities.