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.