| 7.22. | If the netting set is subject to a margin agreement and the internal model captures the effects of margining when estimating EE, the model's EE measure may be used directly in (Equation 2) in 7.12. Such models are noticeably more complicated than models of EPE for unmargined counterparties.
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| 7.23. | An EPE model must also include transaction-specific information in order to capture the effects of margining. It must take into account both the current amount of margin and margin that would be passed between counterparties in the future. Such a model must account for the nature of margin agreements (unilateral or bilateral), the frequency of margin calls, the margin period of risk, the thresholds of unmargined exposure the bank is willing to accept, and the minimum transfer amount. Such a model must either model the mark-to-market change in the value of collateral posted or apply this Framework's rules for collateral.
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| 7.24. | For transactions subject to daily re-margining and mark-to-market valuation, a supervisory floor of five business days for netting sets consisting only of repo style transactions, and 10 business days for all other netting sets is imposed on the margin period of risk used for the purpose of modelling EAD with margin agreements. In the following cases a higher supervisory floor is imposed:
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| | (1) | For all netting sets where the number of trades exceeds 5000 at any point during a quarter, a supervisory floor of 20 business days is imposed for the margin period of risk for the following quarter.
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| | (2) | For netting sets containing one or more trades involving either illiquid collateral, or an OTC derivative that cannot be easily replaced, a supervisory floor of 20 business days is imposed for the margin period of risk. For these purposes, "Illiquid collateral" and "OTC derivatives that cannot be easily replaced" must be determined in the context of stressed market conditions and will be characterized by the absence of continuously active markets where a counterparty would, within two or fewer days, obtain multiple price quotations that would not move the market or represent a price reflecting a market discount (in the case of collateral) or premium (in the case of an OTC derivative). Examples of situations where trades are deemed illiquid for this purpose include, but are not limited to, trades that are not marked daily and trades that are subject to specific accounting treatment for valuation purposes (e.g. OTC derivatives or repo-style transactions referencing securities whose fair value is determined by models with inputs that are not observed in the market).
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| | (3) | In addition, a bank must consider whether trades or securities it holds as collateral are concentrated in a particular counterparty and if that counterparty exited the market precipitously whether the bank would be able to replace its trades.
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| 7.25. | If a bank has experienced more than two margin call disputes on a particular netting set over the previous two quarters that have lasted longer than the applicable margin period of risk (before consideration of this provision), then the bank must reflect this history appropriately by using a margin period of risk that is at least double the supervisory floor for that netting set for the subsequent two quarters.
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| 7.26. | For re-margining with a periodicity of N-days the margin period of risk should be at least equal to the supervisory floor, F, plus the N days minus one day. That is:
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| | Margin Period of Risk = F + N — 1
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| 7.27. | Banks using the internal models method must not capture the effect of a reduction of EAD due to any clause in a collateral agreement that requires receipt of collateral when counterparty credit quality deteriorates.
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| | Model validation
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| 7.28. | The extent to which banks meet the qualitative criteria may influence the level at which SAMA will set the multiplication factor referred to in 7.14 (Alpha) above. Only those banks in full compliance with the qualitative criteria will be eligible for application of the minimum multiplication factor. The qualitative criteria include:
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| | (1) | The bank must conduct a regular program of backtesting, i.e. an ex-post comparison of the risk measures generated by the model against realized risk measures, as well as comparing hypothetical changes based on static positions with realized measures. “Risk measures” in this context, refers not only to Effective EPE, the risk measure used to derive regulatory capital, but also to the other risk measures used in the calculation of Effective EPE such as the exposure distribution at a series of future dates, the positive exposure distribution at a series of future dates, the market risk factors used to derive those exposures and the values of the constituent trades of a portfolio.
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| | (2) | The bank must carry out an initial validation and an on-going periodic review of its IMM model and the risk measures generated by it. The validation and review must be independent of the model developers.
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| | (3) | The board of directors and senior management should be actively involved in the risk control process and must regard credit and counterparty credit risk control as an essential aspect of the business to which significant resources need to be devoted. In this regard, the daily reports prepared by the independent risk control unit must be reviewed by a level of management with sufficient seniority and authority to enforce both reductions of positions taken by individual traders and reductions in the bank’s overall risk exposure.
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| | (4) | The bank’s internal risk measurement exposure model must be closely integrated into the day-to-day risk management process of the bank. Its output should accordingly be an integral part of the process of planning, monitoring and controlling the bank’s counterparty credit risk profile.
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| | (5) | The risk measurement system should be used in conjunction with internal trading and exposure limits. In this regard, exposure limits should be related to the bank’s risk measurement model in a manner that is consistent over time and that is well understood by traders, the credit function and senior management.
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| | (6) | Banks should have a routine in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the risk measurement system. The bank’s risk measurement system must be well documented, for example, through a risk management manual that describes the basic principles of the risk management system and that provides an explanation of the empirical techniques used to measure counterparty credit risk.
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| | (7) | An independent review of the risk measurement system should be carried out regularly in the bank’s own internal auditing process. This review should include both the activities of the business trading units and of the independent risk control unit. A review of the overall risk management process should take place at regular intervals (ideally no less than once a year) and should specifically address, at a minimum:
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| | | (a) | The adequacy of the documentation of the risk management system and process;
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| | | (b) | The organization of the risk control unit;
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| | | (c) | The integration of counterparty credit risk measures into daily risk management;
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| | | (d) | The approval process for counterparty credit risk models used in the calculation of counterparty credit risk used by front office and back office personnel;
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| | | (e) | The validation of any significant change in the risk measurement process;
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| | | (f) | The scope of counterparty credit risks captured by the risk measurement model;
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| | | (g) | The integrity of the management information system;
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| | | (h) | The accuracy and completeness of position data;
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| | | (i) | The verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources;
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| | | (j) | The accuracy and appropriateness of volatility and correlation assumptions;
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| | | (k) | The accuracy of valuation and risk transformation calculations; and
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| | | (l) | The verification of the model’s accuracy as described below in 7.29 to 7.33.
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| | (8) | The on-going validation of counterparty credit risk models, including backtesting, must be reviewed periodically by a level of management with sufficient authority to decide the course of action that will be taken to address weaknesses in the models.
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| 7.29. | Banks must document the process for initial and on-going validation of their IMM model to a level of detail that would enable a third party to recreate the analysis. Banks must also document the calculation of the risk measures generated by the models to a level of detail that would allow a third party to recreate the risk measures. This documentation must set out the frequency with which backtesting analysis and any other on-going validation will be conducted, how the validation is conducted with respect to dataflows and portfolios and the analyses that are used.
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| 7.30. | Banks must define criteria with which to assess their EPE models and the models that input into the calculation of EPE and have a written policy in place that describes the process by which unacceptable performance will be determined and remedied.
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| 7.31. | Banks must define how representative counterparty portfolios are constructed for the purposes of validating an EPE model and its risk measures.
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| 7.32. | When validating EPE models and its risk measures that produce forecast distributions, validation must assess more than a single statistic of the model distribution.
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| 7.33. | As part of the initial and on-going validation of an IMM model and its risk measures, the following requirements must be met:
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| | (1) | A bank must carry out backtesting using historical data on movements in market risk factors prior to SAMA approval. Backtesting must consider a number of distinct prediction time horizons out to at least one year, over a range of various start (initialization) dates and covering a wide range of market conditions.
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| | (2) | Banks must backtest the performance of their EPE model and the model’s relevant risk measures as well as the market risk factor predictions that support EPE. For collateralized trades, the prediction time horizons considered must include those reflecting typical margin periods of risk applied in collateralized/margined trading, and must include long time horizons of at least 1 year.
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| | (3) | The pricing models used to calculate counterparty credit risk exposure for a given scenario of future shocks to market risk factors must be tested as part of the initial and on-going model validation process. These pricing models may be different from those used to calculate Market Risk over a short horizon. Pricing models for options must account for the nonlinearity of option value with respect to market risk factors.
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| | (4) | An EPE model must capture transaction specific information in order to aggregate exposures at the level of the netting set. Banks must verify that transactions are assigned to the appropriate netting set within the model.
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| | (5) | Static, historical backtesting on representative counterparty portfolios must be a part of the validation process. At regular intervals as directed by SAMA, a bank must conduct such backtesting on a number of representative counterparty portfolios. The representative portfolios must be chosen based on their sensitivity to the material risk factors and correlations to which the bank is exposed. In addition, IMM banks need to conduct backtesting that is designed to test the key assumptions of the EPE model and the relevant risk measures, e.g. the modelled relationship between tenors of the same risk factor, and the modelled relationships between risk factors.
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| | (6) | Significant differences between realized exposures and the forecast distribution could indicate a problem with the model or the underlying data that SAMA would require the bank to correct. Under such circumstances, SAMA may require additional capital to be held while the problem is being solved.
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| | (7) | The performance of EPE models and its risk measures must be subject to good backtesting practice. The backtesting program must be capable of identifying poor performance in an EPE model’s risk measures.
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| | (8) | Banks must validate their EPE models and all relevant risk measures out to time horizons commensurate with the maturity of trades for which exposure is calculated using an internal models method.
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| | (9) | The pricing models used to calculate counterparty exposure must be regularly tested against appropriate independent benchmarks as part of the on-going model validation process.
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| | (10) | The on-going validation of a bank’s EPE model and the relevant risk measures include an assessment of recent performance.
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| | (11) | The frequency with which the parameters of an EPE model are updated needs to be assessed as part of the validation process.
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| | (12) | Under the IMM, a measure that is more conservative than the metric used to calculate regulatory EAD for every counterparty, may be used in place of alpha times Effective EPE with the prior approval of SAMA. The degree of relative conservatism will be assessed upon initial SAMA approval and at the regular supervisory reviews of the EPE models. The bank must validate the conservatism regularly.
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| | (13) | The on-going assessment of model performance needs to cover all counterparties for which the models are used.
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| | (14) | The validation of IMM models must assess whether or not the bank level and netting set exposure calculations of EPE are appropriate.
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| | Operational requirements for EPE models
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| 7.34. | In order to be eligible to adopt an internal model for estimating EPE arising from CCR for regulatory capital purposes, a bank must meet the following operational requirements. These include meeting the requirements related to the qualifying standards on CCR Management, a use test, stress testing, identification of wrong way risk, and internal controls.
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| | Qualifying standards on CCR Management
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| 7.35. | The bank must satisfy SAMA that, in addition to meeting the operational requirements identified in 7.36 to 7.60 below, it adheres to sound practices for CCR management, including those specified in Counterparty credit risks section of the Credit Risk chapter of the Supervisory Review Process in the Basel Framework.
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| | Use test
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| 7.36. | The distribution of exposures generated by the internal model used to calculate effective EPE must be closely integrated into the day-to-day CCR management process of the bank. For example, the bank could use the peak exposure from the distributions for counterparty credit limits or expected positive exposure for its internal allocation of capital. The internal model’s output must accordingly play an essential role in the credit approval, counterparty credit risk management, internal capital allocations, and corporate governance of banks that seek approval to apply such models for capital adequacy purposes. Models and estimates designed and implemented exclusively to qualify for the internal models method (IMM) are not acceptable.
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| 7.37. | A bank must have a credible track record in the use of internal models that generate a distribution of exposures to CCR. Thus, the bank must demonstrate that it has been using an internal model to calculate the distributions of exposures upon which the EPE calculation is based that meets broadly the minimum requirements for at least one year prior to SAMA approval.
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| 7.38. | Banks employing the internal models method must have an independent control unit that is responsible for the design and implementation of the bank’s CCR management system, including the initial and on-going validation of the internal model. This unit must control input data integrity and produce and analyze daily reports on the output of the bank’s risk measurement model, including an evaluation of the relationship between measures of CCR risk exposure and credit and trading limits. This unit must be independent from business credit and trading units; it must be adequately staffed; it must report directly to senior management of the bank. The work of this unit should be closely integrated into the day-to-day credit risk management process of the bank. Its output should accordingly be an integral part of the process of planning, monitoring and controlling the bank’s credit and overall risk profile.
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| 7.39. | Banks applying the internal models method must have a collateral management unit that is responsible for calculating and making margin calls, managing margin call disputes and reporting levels of independent amounts, initial margins and variation margins accurately on a daily basis. This unit must control the integrity of the data used to make margin calls, and ensure that it is consistent and reconciled regularly with all relevant sources of data within the bank. This unit must also track the extent of reuse of collateral (both cash and non-cash) and the rights that the bank gives away to its respective counterparties for the collateral that it posts. These internal reports must indicate the categories of collateral assets that are reused, and the terms of such reuse including instrument, credit quality and maturity. The unit must also track concentration to individual collateral asset classes accepted by the banks. Senior management must allocate sufficient resources to this unit for its systems to have an appropriate level of operational performance, as measured by the timeliness and accuracy of outgoing calls and response time to incoming calls. Senior management must ensure that this unit is adequately staffed to process calls and disputes in a timely manner even under severe market crisis, and to enable the bank to limit its number of large disputes caused by trade volumes.
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| 7.40. | The bank's collateral management unit must produce and maintain appropriate collateral management information that is reported on a regular basis to senior management. Such internal reporting should include information on the type of collateral (both cash and non-cash) received and posted, as well as the size, aging and cause for margin call disputes. This internal reporting should also reflect trends in these figures.
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| 7.41. | A bank employing the internal models method must ensure that its cash management policies account simultaneously for the liquidity risks of potential incoming margin calls in the context of exchanges of variation margin or other margin types, such as initial or independent margin, under adverse market shocks, potential incoming calls for the return of excess collateral posted by counterparties, and calls resulting from a potential downgrade of its own public rating. The bank must ensure that the nature and horizon of collateral reuse is consistent with its liquidity needs and does not jeopardize its ability to post or return collateral in a timely manner.
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| 7.42. | The internal model used to generate the distribution of exposures must be part of a counterparty risk management framework that includes the identification, measurement, management, approval and internal reporting of counterparty risk.27 This Framework must include the measurement of usage of credit lines (aggregating counterparty exposures with other credit exposures) and economic capital allocation. In addition to EPE (a measure of future exposure), a bank must measure and manage current exposures. Where appropriate, the bank must measure current exposure gross and net of collateral held. The use test is satisfied if a bank uses other counterparty risk measures, such as peak exposure or potential future exposure (PFE), based on the distribution of exposures generated by the same model to compute EPE.
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| 7.43. | A bank is not required to estimate or report EE daily, but to meet the use test it must have the systems capability to estimate EE daily, if necessary, unless it demonstrates to SAMA that its exposures to CCR warrant some less frequent calculation. It must choose a time profile of forecasting horizons that adequately reflects the time structure of future cash flows and maturity of the contracts. For example, a bank may compute EE on a daily basis for the first ten days, once a week out to one month, once a month out to eighteen months, once a quarter out to five years and beyond five years in a manner that is consistent with the materiality and composition of the exposure.
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| 7.44. | Exposure must be measured out to the life of all contracts in the netting set (not just to the one year horizon), monitored and controlled. The bank must have procedures in place to identify and control the risks for counterparties where exposure rises beyond the one-year horizon. Moreover, the forecasted increase in exposure must be an input into the bank’s internal economic capital model.
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