Capital Adequacy Requirements (CAR) Chapter 9 – Market Risk

Document Properties

  • Type of Publication: Guideline
  • Effective Date: November 2023 / January 2024Footnote 1
  • Audiences: Banks / BHC/ T&L

The Capital Adequacy Requirements (CAR) for banks, bank holding companies, and trust and loan companies, collectively referred to as ‘institutions’, are set out in nine chapters, each of which has been issued as a separate document. This document, Chapter 9 – Market Risk, should be read in conjunction with the other CAR chapters which include:

  • Chapter 1 - Overview of Risk-based Capital Requirements
  • Chapter 2 - Definition of Capital
  • Chapter 3 - Operational Risk
  • Chapter 4 - Credit Risk – Standardized Approach
  • Chapter 5 - Credit Risk - Internal Ratings Based Approach
  • Chapter 6 - Securitization
  • Chapter 7 - Settlement and Counterparty Risk
  • Chapter 8 - Credit Valuation Adjustment (CVA) Risk
  • Chapter 9 - Market Risk

Please refer to OSFI's Corporate Governance Guideline for OSFI's expectations of institution Boards of Directors in regards to the management of capital and liquidity.

Table of Contents

Chapter 9 – Market Risk

Eligibility Requirements

  1. This chapter is drawn from the Basel Committee on Banking Supervision (BCBS) market risk framework, which includes Minimum capital requirements for market risk (January 2019)Footnote 2. For reference, the Basel text paragraph numbers that are associated with the text appearing in this chapter are indicated in square brackets at the end of each paragraph.Footnote 3

  2. These requirements apply only to internationally active institutions.

  3. OSFI retains the right to apply the framework to other institutions, on a case by case basis. All institutions designated by OSFI as domestic systemically important banks (D-SIBs) shall meet the requirements of this chapter.

9.1. Market Risk Terminology, Definition and Application

9.1.1 MARKET RISK TERMINOLOGY

This section provides a high-level description of terminologies used in the market risk frameworks.

General Terminology
  1. Market risk: the risk of losses in on- and off-balance sheet risk positions arising from movements in market prices. [Basel Framework, MAR10.1]

  2. Notional value: the notional value of a derivative instrument is equal to the number of units underlying the instrument multiplied by the current market value of each unit of the underlying. [Basel Framework, MAR10.2]

  3. Trading desk: a group of traders or trading accounts in a business line within an institution that follows defined trading strategies with the goal of generating revenues or maintaining market presence from assuming and managing risk. [Basel Framework, MAR10.3]

  4. Pricing model: a model that is used to determine the value of an instrument (mark-to-market or mark-to-model) as a function of pricing parameters or to determine the change in the value of an instrument as a function of risk factors. A pricing model may be the combination of several calculations; e.g. a first valuation technique to compute a price, followed by valuation adjustments for risks that are not incorporated in the first step. [Basel Framework, MAR10.4]

  5. Rating Agencies: OSFI conducted a process to determine which of the major international rating agencies would be recognized as an eligible external credit assessment institution under this chapter. As a result of this process, OSFI will permit institutions to recognize credit ratings from the following rating agencies for market risk capital adequacy purposes: DBRS; Moody’s Investor Service; Standard and Poor’s (S&P); Fitch Rating Services and; Kroll Bond Rating Agency, Inc.

Terminology for Financial Instruments
  1. Financial instrument: any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments include primary financial instruments (or cash instruments) and derivative financial instruments. [Basel Framework, MAR10.5]

  2. Instrument: the term used to describe financial instruments, instruments on foreign exchange (FX) and commodities. [Basel Framework, MAR10.6]

  3. Embedded derivative: a component of a financial instrument that includes a non-derivative host contract. For example, the conversion option in a convertible bond is an embedded derivative. [Basel Framework, MAR10.7]

  4. Look-through approach: an approach in which an institution determines the relevant capital requirements for a position that has underlyings (such as an index instrument, multi-underlying option, or an equity investment in a fund) as if the underlying positions were held directly by the institution. [Basel Framework, MAR10.8]

Terminology for Market Risk Capital Requirement Calculations
  1. Risk factor: a principal determinant of the change in value of an instrument (e.g. an exchange rate or interest rate). [Basel Framework, MAR10.9]

  2. Risk position: the portion of the current value of an instrument that may be subject to losses due to movements in a risk factor. For example, a bond denominated in a currency different to an institution’s reporting currency has risk positions in general interest rate risk, credit spread risk (non-securitization) and FX risk, where the risk positions are the potential losses to the current value of the instrument that could occur due to a change in the relevant underlying risk factors (interest rates, credit spreads, or exchange rates). [Basel Framework, MAR10.10]

  3. Risk bucket: a defined group of risk factors with similar characteristics. [Basel Framework, MAR10.11]

  4. Risk class: a defined list of risks that are used as the basis for calculating market risk capital requirements: general interest rate risk, credit spread risk (non-securitization), credit spread risk (securitization: non-correlation trading portfolio), credit spread risk (securitization: correlation trading portfolio), FX risk, equity risk and commodity risk. [Basel Framework, MAR10.12]

Terminology for Risk Metrics
  1. Sensitivity: an institution’s estimate of the change in value of an instrument due to a small change in one of its underlying risk factors. Delta and vega risks are sensitivities. [Basel Framework, MAR10.13]

  2. Delta risk: the linear estimate of the change in value of a financial instrument due to a movement in the value of a risk factor. The risk factor could be the price of an equity or commodity, or a change in an interest rate, credit spread or FX rate. [Basel Framework, MAR10.14]

  3. Vega risk: the potential loss resulting from the change in value of a derivative due to a change in the implied volatility of its underlying. [Basel Framework, MAR10.15]

  4. Curvature risk: the additional potential loss beyond delta risk due to a change in a risk factor for financial instruments with optionality. In the standardized approach in the market risk framework, it is based on two stress scenarios involving an upward shock and a downward shock to each regulatory risk factor. [Basel Framework, MAR10.16]

  5. Value at risk (VaR): a measure of the worst expected loss on a portfolio of instruments resulting from market movements over a given time horizon and a pre-defined confidence level. [Basel Framework, MAR10.17]

  6. Expected shortfall (ES): a measure of the average of all potential losses exceeding the VaR at a given confidence level. [Basel Framework, MAR10.18]

  7. Jump-to-default (JTD): the risk of a sudden default. JTD exposure refers to the loss that could be incurred from a JTD event. [Basel Framework, MAR10.19]

  8. Liquidity horizon: the time assumed to be required to exit or hedge a risk position without materially affecting market prices in stressed market conditions. [Basel Framework, MAR10.20]

Terminology for Hedging and Diversification
  1. Basis risk: the risk that prices of financial instruments in a hedging strategy are imperfectly correlated, reducing the effectiveness of the hedging strategy. [Basel Framework, MAR10.21]

  2. Diversification: the reduction in risk at a portfolio level due to holding risk positions in different instruments that are not perfectly correlated with one another. [Basel Framework, MAR10.22]

  3. Hedge: the process of counterbalancing risks from exposures to long and short risk positions in correlated instruments. [Basel Framework, MAR10.23]

  4. Offset: the process of netting exposures to long and short risk positions in the same risk factor. [Basel Framework, MAR10.24]

  5. Standalone: being capitalised on a stand-alone basis means that risk positions are booked in a discrete, non-diversifiable trading book portfolio so that the risk associated with those risk positions cannot diversify, hedge or offset risk arising from other risk positions, nor be diversified, hedged or offset by them. [Basel Framework, MAR10.25]

Terminology for Risk Factor Eligibility and Modellability
  1. Real prices: a term used for assessing whether risk factors pass the risk factor eligibility test. A price will be considered real if it is (i) a price from an actual transaction conducted by the institution, (ii) a price from an actual transaction between other arm’s length parties (e.g. at an exchange), or (iii) a price taken from a firm quote (i.e. a price at which the institution could transact with an arm’s length party). [Basel Framework, MAR10.26]

  2. Modellable risk factor: risk factors that are deemed modellable, based on the number of representative real price observations and additional qualitative principles related to the data used for the calibration of the ES model. Risk factors that do not meet the requirements for the risk factor eligibility test are deemed as non-modellable risk factors (NMRF). [Basel Framework, MAR10.27]

Terminology for Internal Model Validation
  1. Backtesting: the process of comparing daily actual and hypothetical profits and losses with model-generated VaR measures to assess the conservatism of risk measurement systems. [Basel Framework, MAR10.28]

  2. Profit and loss (P&L) attribution (PLA): a method for assessing the robustness of institutions’ risk management models by comparing the risk-theoretical P&L predicted by trading desk risk management models with the hypothetical P&L. [Basel Framework, MAR10.29]

  3. Trading desk risk management model: the trading desk risk management model (pertaining to in-scope desks) includes all risk factors that are included in the institution’s ES model with OSFI parameters and any risk factors deemed not modellable, which are therefore not included in the ES model for calculating the respective regulatory capital requirement, but are included in NMRFs. [Basel Framework, MAR10.30]

  4. Actual P&L (APL): the actual P&L derived from the daily P&L process. It includes intraday trading as well as time effects and new and modified deals, but excludes fees and commissions as well as valuation adjustments for which separate regulatory capital approaches have been otherwise specified as part of the rules or which are deducted from Common Equity Tier 1 (CET1). Any other valuation adjustments that are market risk-related must be included in the APL. As is the case for the hypothetical P&L, the APL should include FX and commodity risks from positions held in the banking book. [Basel Framework, MAR10.31]

  5. Hypothetical P&L (HPL): the daily P&L produced by revaluing the positions held at the end of the previous day using the market data at the end of the current day. Commissions, fees, intraday trading and new/modified deals, valuation adjustments for which separate regulatory capital approaches have been otherwise specified as part of the rules and valuation adjustments which are deducted from CET1 are excluded from the HPL. Valuation adjustments updated daily should usually be included in the HPL. Time effects should be treated in a consistent manner in the HPL and risk-theoretical P&L. [Basel Framework, MAR10.32]

  6. Risk-theoretical P&L (RTPL): the daily desk-level P&L that is predicted by the valuation engines in the trading desk risk management model using all risk factors used in the trading desk risk management model (i.e. including the NMRFs). [Basel Framework, MAR10.33]

Terminology for Credit Valuation Adjustment Risk
  1. Credit valuation adjustment (CVA): an adjustment to the valuation of a derivative transaction to account for the credit risk of contracting parties. [Basel Framework, MAR10.34]

  2. CVA risk: the risk of changes to CVA arising from changes in credit spreads of the contracting parties, compounded by changes to the value or variability in the value of the underlying of the derivative transaction. [Basel Framework, MAR10.35]

9.1.2 DEFINITIONS AND APPLICATION OF MARKET RISK

This section defines the methods available for calculating and the scope of application of market risk capital requirements.

Definition and Scope of Application
  1. Market risk is defined as the risk of losses arising from movements in market prices. The risks subject to market risk capital requirements include but are not limited to:

    1. default risk, interest rate risk, credit spread risk, equity risk, foreign exchange (FX) risk and commodities risk for trading book instruments; and

    2. FX risk and commodities risk for banking book instruments.

      [Basel Framework, MAR11.1]

  2. Derivative, repurchase/reverse repurchase, securities lending and other transactions booked in the trading book are subject to both the market risk and the counterparty credit risk capital requirements. This is because they face the risk of loss due to market fluctuations in the value of the underlying instrument and due to the failure of the counterparty to the contract. The counterparty risk weights used to calculate the credit risk capital requirements for these transactions are those used for calculating the capital requirements in the banking book.

  3. All transactions, including forward sales and purchases, shall be included in the calculation of capital requirements as of the date on which they were entered into. Although regular reporting will in principle take place only at intervals (quarterly in most countries), institutions are expected to manage their market risk in such a way that the capital requirements are being met on a continuous basis, including at the close of each business day. OSFI has at its disposal a number of effective measures to ensure that institutions do not window-dress by showing significantly lower market risk positions on reporting dates. Institutions will also be expected to maintain strict risk management systems to ensure that intraday exposures are not excessive. If an institution fails to meet the capital requirements at any time, OSFI shall ensure that the institution takes immediate measures to rectify the situation. [Basel Framework, MAR11.2]

  4. A matched currency risk position will protect an institution against loss from movements in exchange rates, but will not necessarily protect its capital adequacy ratio. If an institution has its capital denominated in its domestic currency and has a portfolio of foreign currency assets and liabilities that is completely matched, its capital/asset ratio will fall if the domestic currency depreciates. By running a short risk position in the domestic currency, the institution can protect its capital adequacy ratio, although the risk position would lead to a loss if the domestic currency were to appreciate. OSFI will allow institutions to protect their capital adequacy ratio in this way and exclude certain currency risk positions from the calculation of net open currency risk positions, subject to meeting each of the following conditions:

    1. The risk position is taken or maintained for the purpose of hedging partially or totally against the potential that changes in exchange rates could have an adverse effect on its capital ratio.

    2. The risk position is of a structural (i.e. non-dealing) nature such as positions stemming from:

      1. investments in affiliated but not consolidated entities denominated in foreign currencies; or

      2. investments in consolidated subsidiaries or branches denominated in foreign currencies.

    3. The exclusion is limited to the amount of the risk position that neutralizes the sensitivity of the capital ratio to movements in exchange rates.

    4. The exclusion from the calculation is made for at least six months.

    5. The establishment of a structural FX position and any changes in its position must follow the institution’s risk management policy for structural FX positions. This policy must be pre-approved by OSFI.

    6. Any exclusion of the risk position needs to be applied consistently, with the exclusionary treatment of the hedge remaining in place for the life of the assets or other items.

    7. The institution must document and have available for OSFI review the positions and amounts to be excluded from market risk capital requirements.

      [Basel Framework, MAR11.3]

  5. No FX risk capital requirement will apply to positions related to items that are deducted from an institution’s capital when calculating its capital base. [Basel Framework, MAR11.4]

  6. Holdings of capital instruments that are deducted from an institution’s capital or risk weighted at 1250% are not allowed to be included in the market risk framework. This includes:

    1. holdings of the institution’s own eligible regulatory capital instruments and, if applicable, own Other TLAC InstrumentsFootnote 4; and

    2. holdings of other institutions’, securities firms’ and other financial entities’ eligible regulatory capital instruments and in G-SIBs’ or D-SIBs’ Other TLAC Instruments, as well as intangible assets, where OSFI requires that such assets are deducted from capital.

    3. Where an institution demonstrates that it is an active market-maker, OSFI may establish a dealer exception for holdings of other institutions’, securities firms’, and other financial entities’ capital instruments in the trading book. In order to qualify for the dealer exception, the institution must have adequate systems and controls surrounding the trading of financial institutions’ eligible regulatory capital instruments and Other TLAC Instruments.

      [Basel Framework, MAR11.5]

  7. This dealer exception applies only to positions in another institution’s regulatory capital instruments and/or Other TLAC Instruments that do not exceed the 10% threshold or the 5% threshold on non-significant investments described in Chapter 2 – Definition of Capital, section 2.3. For the capital treatment of significant investments in capital and Other TLAC Instruments of banks, financial and insurance entities refer to Chapter 2 – Definition of Capital, section 2.3.

  8. In the same way as for credit risk and operational risk, the capital requirements for market risk apply on a worldwide consolidated basis.

    1. OSFI may permit banking and financial entities in a group which is running a global consolidated trading book and whose capital is being assessed on a global basis to include just the net short and net long risk positions no matter where they are booked.Footnote 5

    2. OSFI may grant this treatment only when the standardized approach in section 9.5 permits a full offset of the risk position (i.e. risk positions of the opposite sign do not attract a capital requirement).

    3. Nonetheless, there will be circumstances in which OSFI demands that the individual risk positions be taken into the measurement system without any offsetting or netting against risk positions in the remainder of the group. This may be needed, for example, where there are obstacles to the quick repatriation of profits from a foreign subsidiary or where there are legal and procedural difficulties in carrying out the timely management of risks on a consolidated basis.

    4. Moreover, OSFI will retain the right to continue to monitor the market risks of individual entities on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision. OSFI will be especially vigilant in ensuring that institutions do not conceal risk positions on reporting dates in such a way as to escape measurement.

      [Basel Framework, MAR11.6]

Methods of Measuring Market Risk
  1. In determining its market risk for regulatory capital requirements, an institution may choose between two broad methodologies: the standardized approach and internal models approach (IMA) for market risk, described in section 9.5 and section 9.6, respectively, subject to the approval of OSFI. [Basel Framework, MAR11.7]

  2. All institutions must calculate the capital requirements using the standardized approach. Institutions that are approved by OSFI to use the IMA for market risk capital requirements must also calculate and report the capital requirement values calculated as set out below.

    1. An institution that uses the IMA for any of its trading desks must also calculate the capital requirement under the standardized approach for all instruments across all trading desks, regardless of whether those trading desks are eligible for the IMA.

    2. In addition, an institution that uses the IMA for any of its trading desks must calculate the standardized approach capital requirement for each trading desk that is eligible for the IMA as if that trading desk were a standalone regulatory portfolio (i.e. with no offsetting across trading desks). This will:

      1. serve as an indication of the fallback capital requirement for those desks that fail the eligibility criteria for inclusion in the institution’s internal model as outlined in section 9.6;

      2. generate information on the capital outcomes of the internal models relative to a consistent benchmark and facilitate comparison in implementation between institutions and/or across jurisdictions;

      3. monitor over time the relative calibration of standardized and modelled approaches, facilitating adjustments as needed; and

      4. provide macroprudential insight in an ex ante consistent format.

        [Basel Framework, MAR11.8]

  3. All institutions must calculate the market risk capital requirement using the standardized approach for the following:

    1. securitization exposures; and

    2. equity investments in funds that cannot be looked through but are assigned to the trading book in accordance to the conditions set out in paragraph 65(5)(b).

      [Basel Framework, MAR11.9]

  4. With respect to securitization exposures, asset backed securities that do not involve “at least two different stratified risk positions or tranches reflecting different degrees of credit risk” but might involve other sorts of tranching associated with pre-payment, as an example, are not considered products under this framework. As a consequence, such products can be treated as non-securitized positions for the purposes of credit spread risk capital requirements based on either the standardized framework or internal models. If in the standardized framework, these positions could also be subject to the residual risk add on if they are exposed to prepayment risk.

Definitions of Trading Desk

This section defines a trading desk, which is the level at which model approval is granted.

  1. For the purposes of market risk capital calculations, a trading desk is a group of traders or trading accounts that implements a well-defined business strategy operating within a clear risk management structure. [Basel Framework, MAR12.1]

  2. Trading desks are defined by the institution but subject to the regulatory approval of OSFI for capital purposes.

    1. An institution should be allowed to propose the trading desk structure per their organizational structure, consistent with the requirements set out in paragraph 55.

    2. An institution must prepare a policy document for each trading desk it defines, documenting how the institution satisfies the key elements in paragraph 55.

    3. OSFI will treat the definition of the trading desk as part of the initial model approval for the trading desk, as well as ongoing approval.

      1. OSFI may determine, based on the size of the institution’s overall trading operations, whether the proposed trading desk definitions are sufficiently granular.

      2. OSFI will check that the institution’s proposed definition of trading desk meets the criteria listed in key elements set out in paragraph 55.

      [Basel Framework, MAR12.2]

  3. Within this OSFI-approved trading desk structure, institutions may further define operational subdesks without the need for OSFI approval. These subdesks would be for internal operational purposes only and would not be used in the market risk capital framework. [Basel Framework, MAR12.3]

  4. The key attributes of a trading desk are as follows:

    1. A trading desk for the purposes of the regulatory capital charge is an unambiguously defined group of traders or trading accounts.

      1. A trading account is an indisputable and unambiguous unit of observation in accounting for trading activity.

      2. The trading desk must have one head trader and can have up to two head traders provided their roles, responsibilities and authorities are either clearly separated or one has ultimate oversight over the other.

        1. The head trader must have direct oversight of the group of traders or trading accounts.

        2. Each trader or each trading account in the trading desk must have a clearly defined specialty (or specialties).

      3. Each trading account must only be assigned to a single trading desk. The desk must have a clearly defined risk scope consistent with its pre-established objectives. The scope should include specification of the desk’s overall risk class and permitted risk factors.

      4. There is a presumption that traders (as well as head traders) are allocated to one trading desk. An institution can deviate from this presumption and may assign an individual trader to work across several trading desks provided it can be justified to OSFI on the basis of sound management, business and/or resource allocation reasons. Such assignments must not be made for the only purpose of avoiding other trading desk requirements (e.g. to optimize the likelihood of success in the backtesting and profit and loss attribution tests).

      5. The trading desk must have a clear reporting line to institution senior management, and should have a clear and formal compensation policy clearly linked to the pre-established objectives of the trading desk.

    2. A trading desk must have a well-defined and documented business strategy, including an annual budget and regular management information reports (including revenue, costs and risk-weighted assets).

      1. There must be a clear description of the economics of the business strategy for the trading desk, its primary activities and trading/hedging strategies.

        1. Economics: what is the economics behind the strategy (e.g. trading on the shape of the yield curve)? How much of the activities are customer driven? Does it entail trade origination and structuring, or execution services, or both?

        2. Primary activities: what is the list of permissible instruments and, out of this list, which are the instruments most frequently traded?

        3. Trading/hedging strategies: how would these instruments be hedged, what are the expected slippages and mismatches of hedges, and what is the expected holding period for positions?

      2. The management team at the trading desk (starting from the head trader) must have a clear annual plan for the budgeting and staffing of the trading desk.

      3. A trading desk’s documented business strategy must include regular Management Information reports, covering revenue, costs and risk-weighted assets for the trading desk.

    3. A trading desk must have a clear risk management structure.

      1. Risk management responsibilities: the institution must identify key groups and personnel responsible for overseeing the risk-taking activities at the trading desk.

      2. A trading desk must clearly define trading limits based on the business strategy of the trading desk and these limits must be reviewed at least annually by senior management at the institution. In setting limits, the trading desk must have:

        1. well-defined trading limits or directional exposures at the trading desk level that are based on the appropriate market risk metric (e.g. sensitivity of credit spread risk and/or jump-to-default for a credit trading desk), or just overall notional limits; and

        2. well-defined trader mandates.

      3. A trading desk under the internal model approach must produce, at least weekly, appropriate risk management reports. This would include, at a minimum:

        1. profit and loss reports, which would be periodically reviewed, validated and modified (if necessary) by Product Control; and

        2. internal and regulatory risk measure reports, including trading desk VaR / ES, trading desk VaR/ES sensitivities to risk factors, backtesting and p-value.

      [Basel Framework, MAR12.4]

  5. The institution must prepare, evaluate, and have available for OSFI the following for all trading desks:

    1. inventory ageing reports;

    2. daily limit reports including exposures, limit breaches, and follow-up action;

    3. reports on intraday limits and respective utilization and breaches for institutions with active intraday trading; and

    4. reports on the assessment of market liquidity.

      [Basel Framework, MAR12.5]

  6. Any foreign exchange or commodity positions held in the banking book must be included in the market risk capital requirement as set out in paragraph 40. For regulatory capital calculation purposes, these positions will be treated as if they were held on notional trading desks within the trading book.

    In the context of banking book FX and commodities positions, a “notional trading desk” does not necessarily have traders or trading accounts assigned to it, nor does it need to meet the qualitative trading desk requirements set out in this section. Institutions that wish to use the IMA to measure the FX or commodity risk of such notional trading desks must take at least one of the following actions:

    1. Transfer all or part of banking book FX and commodity risks to another trading desk via intra-trading book internal risk transfers (IRTs) (where trading desk requirements would continue to apply as appropriate for that desk);

    2. Apply for IMA approval for the notional trading desk. In this case, the notional desk only needs to meet the quantitative trading desk requirements.

    Subject to certain conditions, certain traders can have ownership and responsibilities in both trading book and banking book portfolios.

    [Basel Framework, MAR12.6]

9.2. Boundary between the Banking Book and the Trading Book

This section sets out the instruments to be included in the trading book (which are subject to market risk capital requirements) and those to be included in the banking book (which are subject to credit risk capital requirements).

Scope of the Trading Book

  1. A trading book consists of all instruments that meet the specifications for trading book instruments set out in paragraphs 59 through 70. All other instruments must be included in the banking book. [Basel Framework, RBC25.1]

  2. Instruments comprise financial instruments, foreign exchange (FX), and commodities. A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments include primary financial instruments (or cash instruments) and derivative financial instruments. A financial asset is any asset that is cash, the right to receive cash or another financial asset or a commodity, or an equity instrument. A financial liability is the contractual obligation to deliver cash or another financial asset or a commodity. Commodities also include non-tangible (i.e. non-physical) goods such as electric power.

    The CSR capital requirement applies to money market instruments to the extent such instruments are covered instruments (i.e. they meet the definition of instruments to be included in the trading book as specified in paragraphs 59 through 70. [Basel Framework, RBC25.2]

  3. Institutions may only include a financial instrument, instruments on FX or commodity in the trading book when there is no legal impediment against selling or fully hedging it. [Basel Framework, RBC25.3]

  4. Institutions must fair value daily any trading book instrument and recognize any valuation change in the profit and loss (P&L) account.

    Instruments designated under the fair value option may be allocated to the trading book, but only if they comply with all the relevant requirements for trading book instruments set out in section 9.2. [Basel Framework, RBC25.4]

Standards for Assigning Instruments to the Regulatory Books

  1. Any instrument an institution holds for one or more of the following purposes must, when it is first recognised on its books, be designated as a trading book instrument, unless specifically otherwise provided for in paragraph 60 or paragraph 64:

    1. short-term resale;

    2. profiting from short-term price movements;

    3. locking in arbitrage profits; or

    4. hedging risks that arise from instruments meeting (1), (2) or (3) above.

    Evidence of periodic sale activity is insufficient on its own to consider such position as being held for short-term resale and, as such, is insufficient to meet sub-bullet (1).

    [Basel Framework, RBC25.5]

  2. Any of the following instruments is seen as being held for at least one of the purposes listed in paragraph 62 and must therefore be included in the trading book, unless specifically otherwise provided for in paragraph 60 or paragraph 65:

    1. instruments in the correlation trading portfolio;

    2. instruments that would give rise to a net short credit or equity position in the banking book;Footnote 6 or

    3. instruments resulting from underwriting commitments, where underwriting commitments refer only to securities underwriting, and relate only to securities that are expected to be actually purchased by the institution on the settlement dateFootnote 7.

    Institutions should have processes in place to manage and monitor their banking book positions to ensure that any instrument that individually has the potential to create a net short credit or equity position in the banking book is not actually creating a non-negligible net short position at any point in time. Such processes should include clear limit structures and an appropriate monitoring frequency. Institutions should be proactive in identifying potential non-negligible net short positions and limiting their occurrence.

    As a general principle, instruments that give rise to a net short credit or equity position in the banking book must be assigned to the trading book unless a trading book treatment is explicitly excluded for the specific type of position. For example, if a credit default swap (CDS) that hedges loans in the banking book gives rise to a net short credit position, the net short position resulting from such instruments (i.e. the amount which cannot be offset against any long positions) must be treated as a trading book position and be subject to market risk capital requirements. [Basel Framework, RBC25.6]

  3. Any instrument which is not held for any of the purposes listed in paragraph 62 at inception, nor seen as being held for these purposes according to paragraph 63, must be assigned to the banking book. [Basel Framework, RBC25.7]

  4. The following instruments must be assigned to the banking book:

    1. unlisted equities;

    2. instruments designated for securitization warehousing;

    3. real estate holdings, where in the context of assigning instrument to the trading book, real estate holdings relate only to direct holdings of real estate as well as derivatives on direct holdings;

    4. retail and small or medium-sized enterprise (SME) credit, including commitments;

    5. equity investments in a fund, unless the institution meets at least one of the following conditions:

      1. the institution is able to look through the fund to its individual components at least on a quarterly basis, and there is sufficient and frequent information, verified by an independent third party, provided to the institution regarding the fund’s composition; or

      2. the institution obtains daily price quotes for the fund and it has access to the information contained in the fund’s mandate or in the national regulations governing such investment funds;

    6. hedge funds;

    7. derivative instruments and funds that have the above instrument types as underlying assets; and

    8. instruments held for the purpose of hedging a particular risk of a position in the types of instrument above.

      [Basel Framework, RBC25.8]

  5. There is a general presumption that any of the following instruments are being held for at least one of the purposes listed in paragraph 62 and therefore are trading book instruments, unless specifically otherwise provided for in paragraph 60 or paragraph 65:

    1. instruments held as accounting trading assets or liabilities;Footnote 8

    2. instruments resulting from market-making activities;

    3. equity investments in a fund excluding those assigned to the banking book in accordance with paragraph 65(5);

    4. listed equities;Footnote 9

    5. trading-related repo-style transactions, which comprise those entered into for the purposes of market-making, locking in arbitrage profits or creating short credit or equity positions. Repo-style transactions that are (i) entered for liquidity management or (ii) valued at accrual for accounting purpose are not part of the presumptive list of paragraph 66. Institutions must have documentation for the definition of liquidity management and internal control processes to monitor these transactions, which should be made available to OSFI upon request; or

    6. options including embedded derivativesFootnote 10 from instruments that the institution issued out of its own banking book and that relate to credit or equity risk.

    Liabilities issued out of the institution’s own banking book that contain embedded derivatives and thereby meet the criteria of paragraph 66(6) should be bifurcated. This means that institutions should split the liability into two components: (i) the embedded derivative, which is assigned to the trading book; and (ii) the residual liability, which is retained in the banking book. No internal risk transfers are necessary for this bifurcation. Likewise, where such a liability is unwound, or where an embedded option is exercised, both the trading and banking book components are conceptually unwound simultaneously and instantly retired; no transfers between trading and banking book are necessary.

    An option that manages FX risk in the banking book is covered by the presumptive list of trading book instruments included in paragraph 66(6). Only with explicit OSFI approval may an institution include in its banking book an option that manages banking book FX risk.

    A floor to an equity-linked bond is an embedded option with an equity as part of the underlying, and therefore the embedded option should be bifurcated and included in the trading book.

    [Basel Framework, RBC25.9]

  6. Institutions are allowed to deviate from the presumptive list specified in paragraph 66 according to the process set out below.Footnote 11

    1. If an institution believes that it needs to deviate from the presumptive list established in paragraph 66 for an instrument, it must submit a request to OSFI and receive explicit approval. In its request, the institution must provide evidence that the instrument is not held for any of the purposes in paragraph 62.

    2. In cases where this approval is not given by OSFI, the instrument must be designated as a trading book instrument. Institutions must document any deviations from the presumptive list in detail on an on-going basis.

    Repo-style transactions not held for any of the purposes in paragraph 62 can be exempted from the list of presumptive trading book instruments in paragraph 66(5) and can be designated in the banking book for regulatory capital purposes.

    [Basel Framework, RBC25.10]

Supervisory Powers

  1. Notwithstanding the process established in paragraph 67 for instruments on the presumptive list, OSFI may require the institution to provide evidence that an instrument in the trading book is held for at least one of the purposes of paragraph 62. If OSFI is of the view that an institution has not provided enough evidence or if OSFI believes the instrument customarily would belong in the banking book, it may require the institution to assign the instrument to the banking book, except if it is an instrument listed under paragraph 63. [Basel Framework, RBC25.11]

  2. OSFI may require the institution to provide evidence that an instrument in the banking book is not held for any of the purposes of paragraph 62. If OSFI is of the view that an institution has not provided enough evidence, or if OSFI believes such instruments would customarily belong in the trading book, it may require the institution to assign the instrument to the trading book, except if it is an instrument listed under paragraph 65. [Basel Framework, RBC25.12]

Documentation of Instrument Designation

  1. An institution must have clearly defined policies, procedures and documented practices for determining which instruments to include in or to exclude from the trading book for the purposes of calculating their regulatory capital, ensuring compliance with the criteria set forth in this section, and taking into account the institution’s risk management capabilities and practices. An institution’s internal control functions must conduct an ongoing evaluation of instruments both in and out of the trading book to assess whether its instruments are being properly designated initially as trading or non-trading instruments in the context of the institution’s trading activities. Compliance with the policies and procedures must be fully documented and subject to periodic (at least yearly) internal audit and the results must be available for OSFI’s review. [Basel Framework, RBC25.13]

Restrictions on Moving Instruments between the Regulatory Books

  1. Apart from moves required by paragraphs 62 to 67, there is a strict limit on the ability of institutions to move instruments between the trading book and the banking book by their own discretion after initial designation, which is subject to the process in paragraphs 72 and 73. Switching instruments for regulatory arbitrage is strictly prohibited. In practice, switching should be rare and will be allowed by OSFI only in extraordinary circumstances. Examples are a major publicly announced event, such as an institution restructuring that results in the permanent closure of trading desks, requiring termination of the business activity applicable to the instrument or portfolio or a change in accounting standardsFootnote 12 that allows an item to be fair-valued through P&L. Market events, changes in the liquidity of a financial instrument, or a change of trading intent alone are not valid reasons for reassigning an instrument to a different book. When switching positions, institutions must ensure that the standards described in paragraphs 62 to 67 are always strictly observed. [Basel Framework, RBC25.14]

  2. Without exception, a capital benefit as a result of switching will not be allowed in any case or circumstance. This means that the institution must determine its total capital requirement (across the banking book and trading book) before and immediately after the switch. If this capital requirement is reduced as a result of this switch, the difference as measured at the time of the switch will be imposed on the institution as a disclosed Pillar 1 capital surcharge. This surcharge will be allowed to run off as the positions mature or expire, in a manner agreed with OSFI. To maintain operational simplicity, it is not envisaged that this additional capital requirement would be recalculated on an ongoing basis, although the positions would continue to also be subject to the ongoing capital requirements of the book into which they have been switched. The disallowance of capital benefits as a result of switching positions from one book to another applies without exception and in any case or circumstance. It is therefore independent of whether the switch has been made at the discretion of the institution or is beyond its control, e.g. in the case of the delisting of an equity. [Basel Framework, RBC25.15]

  3. Any reassignment between books must be approved by senior management and OSFI as follows. Any reallocation of securities between the trading book and banking book, including outright sales at arm’s length, should be considered a reassignment of securities and is governed by requirements of this paragraph.

    1. Any reassignment must be approved by senior management; thoroughly documented; determined by internal review to be in compliance with the institution’s policies; subject to prior approval by OSFI based on supporting documentation provided by the institution; and publicly disclosed.

    2. Unless required by changes in the characteristics of a position, any such reassignment is irrevocable.

    3. If an instrument is reclassified to be an accounting trading asset or liability there is a presumption that this instrument is in the trading book, as described in paragraph 66. Accordingly, in this case an automatic switch without approval of OSFI is acceptable.

    The treatment specified for internal risk transfers applies only to risk transfers done via internal derivatives trades. The reallocation of securities between trading and banking book should be considered a re-assignment of securities and is governed by this paragraph.

    Moving instruments between the trading book and the banking book should be rare. The movement of an instrument from the trading book to the banking book requires OSFI approval. Where an instrument is reclassified as an accounting trading asset or liability and per sub-bullet (3) above, and is switched to a trading book instrument for capital requirement purposes without OSFI approval, the disallowance of capital requirement benefits specified in paragraph 72 will apply.

    [Basel Framework, RBC25.16]

  4. An institution must adopt relevant policies that must be updated at least yearly. Updates should be based on an analysis of all extraordinary events identified during the previous year. Updated policies with changes highlighted must be sent to OSFI. Policies must include the following:

    1. The reassignment restriction requirements in paragraphs 71 through 73, especially the restriction that re-designation between the trading book and banking book may only be allowed in extraordinary circumstances, and a description of the circumstances or criteria where such a switch may be considered.

    2. The process for obtaining senior management and OSFI approval for such a transfer.

    3. How an institution identifies an extraordinary event.

    4. A requirement that re-assignments into or out of the trading book be publicly disclosed at the earliest reporting date.

      Institutions are permitted to exclude the following from the restrictions on moving instruments between regulatory books noted in paragraphs 71 to 73:

      • CAD-denominated Level 1 and Level 2A High Quality Liquid Assets (HQLA); and
      • non CAD-currency denominated Level 1 and Level 2A HQLA issued by Canadian entitiesFootnote 13,
      as defined in Chapter 2 of OSFI’s Liquidity Adequacy Requirements Guideline.

      Where an institution’s Treasury purchases new issuances of the institution’s own stamped Bankers Acceptances from its dealer, such securities do not need to be included within the restrictions on moving instruments noted in paragraphs 71 to 73.

      [Basel Framework, RBC25.17]

Treatment of Internal Risk Transfers

  1. An internal risk transfer is an internal written record of a transfer of risk within the banking book, between the banking and the trading book or within the trading book (between different desks). [Basel Framework, RBC25.18]

  2. There will be no regulatory capital recognition for internal risk transfers from the trading book to the banking book. Thus, if an institution engages in an internal risk transfer from the trading book to the banking book (e.g. for economic reasons) this internal risk transfer would not be taken into account when the regulatory capital requirements are determined. [Basel Framework, RBC25.19]

  3. For internal risk transfers from the banking book to the trading book, paragraphs 78 to 84 apply. [Basel Framework, RBC25.20]

Internal risk transfer of credit and equity risk from banking book to trading book
  1. When an institution hedges a banking book credit risk exposure or equity risk exposure using a hedging instrument purchased through its trading book (i.e. using an internal risk transfer),

    1. The credit exposure in the banking book is deemed to be hedged for capital requirement purposes if and only if:

      1. the trading book enters into an external hedge with an eligible third-party protection provider that exactly matches the internal risk transfer; and

      2. the external hedge meets the requirements of paragraphs 265 to 270 of Chapter 4 vis-à-vis the banking book exposure.Footnote 14

    2. The equity exposure in the banking book is deemed to be hedged for capital requirement purposes if and only if:

      1. the trading book enters into an external hedge from an eligible third-party protection provider that exactly matches the internal risk transfer; and

      2. the external hedge is recognized as a hedge of a banking book equity exposure.

    3. External hedges for the purposes of paragraph 78(1) and 78(2) can be made up of multiple transactions with multiple counterparties as long as the aggregate external hedge exactly matches the internal risk transfer, and the internal risk transfer exactly matches the aggregate external hedge.

      The term ‘exactly matches’ implies that the external hedge is considered to be effective if changes in fair value of the external hedge and the internal hedge are within a range of 90% to 110%. This assessment of effectiveness is to be done at inception and on a monthly basis thereafter, and the external hedge must be identified within five business days of the internal hedge. Institutions are expected to capture any residual risks add-on between the internal and external hedge with respect to instruments with exotic underlying and instruments bearing other residual risks, consistent with section 9.5.4.

      [Basel Framework, RBC25.21]

  2. Where the requirements in the paragraph above are fulfilled, the banking book exposure is deemed to be hedged by the banking book leg of the internal risk transfer for capital purposes in the banking book. Moreover both the trading book leg of the internal risk transfer and the external hedge must be included in the market risk capital requirements. [Basel Framework, RBC25.22]

  3. Where the requirements in paragraph 78 are not fulfilled, the banking book exposure is not deemed to be hedged by the banking book leg of the internal risk transfer for capital purposes in the banking book. Moreover, the third-party external hedge must be fully included in the market risk capital requirements and the trading book leg of the internal risk transfer must be fully excluded from the market risk capital requirements. [Basel Framework, RBC25.23]

  4. A banking book short credit position or a banking book short equity position created by an internal risk transferFootnote 15 and not capitalised under banking book rules must be capitalised under the market risk rules together with the trading book exposure. [Basel Framework, RBC25.24]

Internal risk transfer of general interest rate risk from banking book to trading book
  1. When an institution hedges a banking book interest rate risk exposure using an internal risk transfer with its trading book on or after the beginning of the institution’s fiscal Q1-2024, the trading book leg of the internal risk transfer is treated as a trading book instrument under the market risk framework if and only if:

    1. the internal risk transfer is documented with respect to the banking book interest rate risk being hedged and the sources of such risk;

    2. the internal risk transfer is conducted with a dedicated internal risk transfer trading desk which has been specifically approved by OSFI for this purpose; and

    3. the internal risk transfer must be subject to trading book capital requirements under the market risk framework on a stand-alone basis for the dedicated internal risk transfer desk, separate from any other GIRR or other market risks generated by activities in the trading book.

    Similar to the notional trading desk treatment set out in paragraph 57 for foreign exchange or commodities positions held in the banking book, general interest rate (GIRR) internal risk transfers (IRT) may be allocated to a trading desk that may not have traders or trading account assigned to it. For a GIRR IRT trading desk, only the quantitative requirements (i.e. PLA test and backtesting) set out in section 9.6.3 apply, while the qualitative criteria for trading desks as set out in paragraph 55 do not apply. A GIRR IRT desk must not have any trading book positions allocated to it, except GIRR IRTs between the trading book and the banking book as well as any external hedges that meet the conditions specified in paragraph 84.

    [Basel Framework, RBC25.25]

  2. Where the requirements in the paragraph above are fulfilled, the banking book leg of the internal risk transfer must be included in the banking book’s measure of interest rate risk exposures for regulatory capital purposes. [Basel Framework, RBC25.26]

  3. The OSFI-approved internal risk transfer desk may include instruments purchased from the market (i.e. external parties to the institution). Such transactions may be executed directly between the internal risk transfer desk and the market. Alternatively, the internal risk transfer desk may obtain the external hedge from the market via a separate non-internal risk transfer trading desk acting as an agent, if and only if the GIRR internal risk transfer entered into with the non-internal risk transfer trading desk exactly matches the external hedge from the market. In this latter case the respective legs of the GIRR internal risk transfer are included in the internal risk transfer desk and the non-internal risk transfer desk.

    External hedges for the purposes of this paragraph can be made up of multiple transactions with multiple counterparties as long as the aggregate external hedge exactly matches the internal risk transfer, and the internal risk transfer exactly matches the aggregate external hedge.

    The term ‘exactly matches’ implies that the external hedge is considered to be effective if changes in fair value of the external hedge and the internal hedge are within a range of 90% to 110%. This assessment of effectiveness is to be done at inception and on a monthly basis thereafter, and the external hedge must be identified within five business days of the internal hedge. Institutions are expected to capture any residual risks add-on between the internal and external hedge with respect to instruments with exotic underlying and instruments bearing other residual risks, consistent with section 9.5.4.

    [Basel Framework, RBC25.27]

Internal risk transfers within the scope of application of the market risk capital requirement
  1. Internal risk transfers between trading desks within the scope of application of the market risk capital requirements (including FX risk and commodities risk in the banking book) will generally receive regulatory capital recognition. Internal risk transfers between the internal risk transfer desk and other trading desks will only receive regulatory capital recognition if the constraints in paragraphs 82 to 84 are fulfilled.

    There are no constraints on IRTs between trading desks that have internal model approval and trading desks that do not. In order to ensure a sufficiently conservative aggregation of risks, the aggregation of the capital requirements calculated using the standardized approach and the internal models approach does not recognize portfolio effects between trading desks that use either the standardized approach or the internal models approach.

    [Basel Framework, RBC25.28]

  2. The trading book leg of internal risk transfers must fulfil the same requirements under paragraph 82 as instruments in the trading book transacted with external counterparties. [Basel Framework, RBC25.29]

Eligible hedges for the CVA capital requirement
  1. Eligible external hedges that are included in the credit valuation adjustment (CVA) capital requirement, and FX and commodity risk arising from CVA hedges that are eligible under the CVA standard, must be removed from the institution’s market risk capital requirement calculation. [Basel Framework, RBC25.30]

  2. Institutions may enter into internal risk transfers between the CVA portfolio and the trading book. Such an internal risk transfer consists of a CVA portfolio side and a non-CVA portfolio side. Where the CVA portfolio side of an internal risk transfer is recognised in the CVA risk capital requirement, the CVA portfolio side should be excluded from the market risk capital requirement, while the non-CVA portfolio side should be included in the market risk capital requirement. [Basel Framework, RBC25.31]

  3. In any case, such internal CVA risk transfers can only receive regulatory capital recognition if the internal risk transfer is documented with respect to the CVA risk being hedged and the sources of such risk. [Basel Framework, RBC25.32]

  4. Internal CVA risk transfers that are subject to curvature, default risk or residual risk add-on as set out in section 9.5 may be recognised in the CVA portfolio capital requirement and market risk capital requirement only if the trading book additionally enters into an external hedge with an eligible third-party protection provider that exactly matches the internal risk transfer. [Basel Framework, RBC25.33]

  5. Independent from the treatment in the CVA risk capital requirement and the market risk capital requirement, internal risk transfers between the CVA portfolio and the trading book can be used to hedge the counterparty credit risk exposure of a derivative instrument in the trading or banking book as long as the requirements of paragraph 78 are met. [Basel Framework, RBC25.34]

  6. The revised CVA framework (see Chapter 8) now captures both the risk and hedges of CVA (including both the credit risk and exposure components). As such, any other transactions related to the management of CVA risk will not be covered in the market risk framework. In addition, institutions are not permitted to include sensitivities to other valuation adjustment (commonly referred to as xVA) in the market risk framework. However, any market risk hedges of xVA risk must be included in the market risk framework with the following exceptions:

    • Any market risk hedges of collateral valuation adjustments (ColVA sometimes referred to as overnight indexed swap or OIS discounting) that meet the conditions for eligibility listed in the paragraph below; and,
    • Any market risk hedges of the exposure component of funding VA (FVA)Footnote 16.

    Hedges of ColVA and hedges of the exposure component of FVA can be excluded from the market risk framework if all of the following conditions are met:

    • Institutions have a well-defined and nominated trading desk that satisfies the organizational structure described in paragraph 55. That structure must include an independent risk control unit responsible for the design, documentation, and implementation of the measurement of FVA and ColVA risk. This unit should report directly to senior management of the institution.
    • The excluded hedges are evidenced to be risk reducing at their inception according to the documented measure of FVA and/or ColVA risk through the use of: (i) risk factor identification processes, (ii) regular assessment of risk capture between unhedged- and hedged-P&L, (iii) P&L attribution assessment and stress testing programs as described in paragraph 272 and; (iv) an independent model validation process as per paragraph 273.
    • The excluded hedges are initiated, tracked and managed as a hedge of either ColVA or the exposure component of FVA in accordance with internal protocols for compliance that are consistent with paragraph 278 and internal audit/validation functions in paragraph 281.

    Institutions must measure and monitor the effectiveness of the excluded hedges in normal conditions and in times of stress. Institutions should assess any material residual or basis risk as part of their stress testing programs (e.g., ICAAP, etc.) and account for this in Pillar 2 capital in excess of minimum requirements commensurate with their risk profile.

    OSFI will consider other regulatory frameworks as being adequate substitutes for meeting these requirements in order to mitigate duplication for institutions seeking these exemptions.

9.3. Counterparty Credit Risk in the Trading Book

  1. Institutions must calculate the counterparty credit risk charge for over-the-counter (OTC) derivatives, repo-style and other transactions booked in the trading book, separate from the capital requirement for market riskFootnote 17. The risk weights to be used in this calculation must be consistent with those used for calculating the capital requirements in the banking book. Thus, institutions using the standardized approach in the banking book will use the standardized approach risk weights in the trading book and institutions using the internal ratings-based (IRB) approach in the banking book will use the IRB risk weights in the trading book in a manner consistent with the IRB roll-out situation in the banking book as described in section 5.2.3 of Chapter 5. For counterparties included in portfolios where the IRB approach is being used, the IRB risk weights will have to be applied.

    In the trading book, for repo-style transactions, all instruments, which are included in the trading book, may be used as eligible collateral. Those instruments which fall outside the banking book definition of eligible collateral shall be subject to a haircut at the level applicable to non-main index equities listed on recognized exchanges (as noted in paragraph 239 of Chapter 4). Where institutions are using a value-at-risk approach to measuring exposure for securities financing transactions, they also may apply this approach in the trading book in accordance with paragraph 125 to 128 of Chapter 5 and Chapter 7. The calculation of the counterparty credit risk charge for collateralized OTC derivative transactions is the same as the rules prescribed for such transactions booked in the banking book (see Chapter 7).

    The calculation of the counterparty charge for repo-style transactions will be conducted using the rules in Chapter 7 spelt out for such transactions booked in the banking book. The firm-size adjustment for small or medium-sized entities as set out in paragraph 69 of Chapter 5 shall also be applicable in the trading book. [Basel Framework, CRE55]

9.4. Prudent Valuation Guidance

Introduction

  1. This section provides institutions with guidance on prudent valuation for positions that are accounted for at fair value, whether they are in the trading book or in the banking book. This guidance is especially important for positions without actual market prices or observable inputs to valuation, as well as less liquid positions which raise OSFI concerns about prudent valuation. The valuation guidance set forth below is not intended to require institutions to change valuation procedures for financial reporting purposes. OSFI will assess an institution’s valuation procedures for consistency with this guidance. One fact in OSFI’s assessment of whether an institution must take a valuation adjustment for regulatory purposes under paragraphs 104 to 107 should be the degree of consistency between the institution’s valuation procedures and these guidelines. [Basel Framework, CAP50.1]

  2. A framework for prudent valuation practices should at a minimum include the following. [Basel Framework, CAP50.2]

Systems and Controls

  1. Institutions must establish and maintain adequate systems and controls sufficient to give management and OSFI the confidence that their valuation estimates are prudent and reliable. These systems must be integrated with other risk management systems within the organization (such as credit analysis). Such systems must include:

    1. Documented policies and procedures for the process of valuation. This includes clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of market information and review of their appropriateness, guidelines for the use of unobservable inputs reflecting the institution’s assumptions of what market participants would use in pricing the position, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, end of the month and ad-hoc verification procedures; and

    2. Clear and independent (i.e. independent of front office) reporting lines for the department accountable for the valuation process. The reporting line should ultimately be to a main member of senior management.

    [Basel Framework, CAP50.3]

Valuation Methodologies

Marking to market
  1. Marking-to-market is at least the daily valuation of positions at readily available close out prices that are sourced independently. Examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers. [Basel Framework, CAP50.4]

  2. Institutions must mark-to-market as much as possible. The more prudent side of bid/offer should be used unless the institution is a significant market maker in a particular position type and it can close out at mid-market. Institutions should maximise the use of relevant observable inputs and minimise the use of unobservable inputs when estimating fair value using a valuation technique. However, observable inputs or transactions may not be relevant, such as in a forced liquidation or distressed sale, or transactions may not be observable, such as when markets are inactive. In such cases, the observable data should be considered, but may not be determinative. [Basel Framework, CAP50.5]

Marking to model
  1. Only where marking-to-market is not possible should institutions mark-to-model, but this must be demonstrated to be prudent. Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input. When marking to model, an extra degree of conservatism is appropriate. OSFI will consider the following in assessing whether a mark-to-model valuation is prudent:

    1. Senior management should be aware of the elements of the trading book or other fair-valued positions which are subject to mark to model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business.

    2. Market inputs should be sourced, to the extent possible, in line with market prices (as discussed above). The appropriateness of the market inputs for the particular position being valued should be reviewed regularly.

    3. Where available, generally accepted valuation methodologies for particular products should be used as far as possible.

    4. Where the model is developed by the institution itself, it should be based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. It should be independently tested. This includes validating the mathematics, the assumptions and the software implementation.

    5. There should be formal change control procedures in place and a secure copy of the model should be held and periodically used to check valuations.

    6. Risk management should be aware of the weaknesses of the models used and how best to reflect those in the valuation output.

    7. The model should be subject to periodic review to determine the accuracy of its performance (e.g. assessing continued appropriateness of the assumptions, analysis of profit and loss versus risk factors, comparison of actual close out values to model outputs).

    8. Valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation (see also valuation adjustments in paragraphs 102 to 107).

    [Basel Framework, CAP50.6]

Independent price verification
  1. Independent price verification is distinct from daily mark-to-market. It is the process by which market prices or model inputs are regularly verified for accuracy. While daily marking-to-market may be performed by dealers, verification of market prices or model inputs should be performed by a unit independent of the dealing room, at least monthly (or, depending on the nature of the market/trading activity, more frequently). It need not be performed as frequently as daily mark-to-market, since the objective, i.e. independent, marking of positions, should reveal any error or bias in pricing, which should result in the elimination of inaccurate daily marks. [Basel Framework, CAP50.7]

  2. Independent price verification 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. For independent price verification, where pricing sources are more subjective, e.g. only one available broker quote, prudent measures such as valuation adjustments may be appropriate. [Basel Framework, CAP50.8]

Valuation Adjustments

  1. As part of their procedures for marking to market, institutions must establish and maintain procedures for considering valuation adjustments. OSFI expects institutions using third-party valuations to consider whether valuation adjustments are necessary. Such considerations are also necessary when marking to model. [Basel Framework, CAP50.9]

  2. OSFI expects the following valuation adjustments/reserves to be formally considered at a minimum: unearned credit spreads, close-out costs, operational risks, early termination, investing and funding costs, and future administrative costs and, where appropriate, model risk. OSFI also expects that the valuation adjustment will be considered for positions individually (i.e. adjustments should be reflected in the valuation of the individual transactions) rather than on a portfolio level (i.e. adjustments are made in the form of a reserve for a portfolio of exposures and are not reflected in the valuation of the individual transactions). [Basel Framework, CAP50.10]

Adjustment to the Current Valuation of Less Liquid Positions for Regulatory Capital Purposes

  1. Institutions must establish and maintain procedures for judging the necessity of and calculating an adjustment to the current valuation of less liquid positions for regulatory capital purposes. This adjustment may be in addition to any changes to the value of the position required for financial reporting purposes and should be designed to reflect the illiquidity of the position. OSFI expects institutions to consider the need for an adjustment to a position’s valuation to reflect current illiquidity whether the position is marked to market using market prices or observable inputs, third-party valuations or marked to model. [Basel Framework, CAP50.11]

  2. Bearing in mind that the assumptions made about liquidity in the market risk capital requirement may not be consistent with the institution’s ability to sell or hedge out less liquid positions, where appropriate, institutions must take an adjustment to the current valuation of these positions, and review their continued appropriateness on an on-going basis. Reduced liquidity may have arisen from market events. Additionally, close-out prices for concentrated positions and/or stale positions should be considered in establishing the adjustment. Institutions must consider all relevant factors when determining the appropriateness of the adjustment for less liquid positions. These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market makers), the average and volatility of trading volumes (including trading volumes during periods of market stress), market concentrations, the aging of positions, the extent to which valuation relies on marking-to-model, and the impact of other model risks not included in the paragraph above. [Basel Framework, CAP50.12]

  3. For complex products including, but not limited to, securitization exposures and n-th-to-default credit derivatives, institutions must explicitly assess the need for valuation adjustments to reflect two forms of model risk: the model risk associated with using a possibly incorrect valuation methodology; and the risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model. [Basel Framework, CAP50.13]

  4. The adjustment to the current valuation of less liquid positions made under paragraph 105 must impact Common Equity Tier 1 regulatory capital and may exceed those valuation adjustments made under financial reporting standards and paragraphs 102 and 103. [Basel Framework, CAP50.14]

9.5. STANDARDIZED APPROACH

9.5.1 GENERAL PROVISIONS AND STRUCTURE

This section sets out the general provisions and the structure of the standardized approach for calculating risk-weighted assets for market risk.

General Provisions
  1. The risk-weighted assets for market risk under the standardized approach are determined by multiplying the capital requirements calculated as set out in this section by 12.5. [Basel Framework, MAR20.1]

  2. Capital requirements under the standardized approach must be calculated and reported to OSFI on a monthly basis. Subject to OSFI approval, capital requirements under the standardized approach for market risks arising from non-banking subsidiaries of an institution may be calculated and reported to OSFI on a quarterly basis. [Basel Framework, MAR20.2]

  3. An institution must also determine its regulatory capital requirements for market risk according to the standardized approach for market risk at the demand of OSFI. [Basel Framework, MAR20.3]

Structure of the Standardized Approach
  1. The standardized approach capital requirement is the simple sum of three components: the capital requirement under the sensitivities-based method, the default risk capital (DRC) requirement and the residual risk add-on (RRAO).

    1. The capital requirement under the sensitivities-based method must be calculated by aggregating three risk measures – delta, vega and curvature, as set out in section 9.5.2:

      1. Delta: a risk measure based on sensitivities of an instrument to regulatory delta risk factors.

      2. Vega: a risk measure based on sensitivities to regulatory vega risk factors.

      3. Curvature: a risk measure which captures the incremental risk not captured by the delta risk measure for price changes in an option. Curvature risk is based on two stress scenarios involving an upward shock and a downward shock to each regulatory risk factor.

      4. The above three risk measures specify risk weights to be applied to the regulatory risk factor sensitivities. To calculate the overall capital requirement, the risk-weighted sensitivities are aggregated using specified correlation parameters to recognize diversification benefits between risk factors. In order to address the risk that correlations may increase or decrease in periods of financial stress, an institution must calculate three sensitivities-based method capital requirement values, based on three different scenarios on the specified values for the correlation parameters as set out in paragraphs 118 and 119.

    2. The DRC requirement captures the jump-to-default risk for instruments subject to credit risk as set out in paragraph 215. It is calibrated based on the credit risk treatment in the banking book in order to reduce the potential discrepancy in capital requirements for similar risk exposures across the institution. Some hedging recognition is allowed for similar types of exposures (corporates, sovereigns, and local governments/municipalities).

    3. Given recognition that not all market risks can be captured in the standardized approach so as to avoid an unduly complex regime, an RRAO ensures sufficient coverage of market risks for instruments specified in paragraph 259. The calculation method for the RRAO is set out in paragraph 265.

    [Basel Framework, MAR20.4]

Definition of Correlation Trading Portfolio
  1. For the purpose of calculating the credit spread risk capital requirement under the sensitivities based method and the DRC requirement, the correlation trading portfolio is defined as the set of instruments that meet the requirements of (1) or (2) below.

    1. The instrument is a securitization position that meets the following requirements:

      1. The instrument is not a re-securitization position, nor a derivative of securitization exposures that does not provide a pro rata share in the proceeds of a securitization tranche, where the definition of securitization position is identical to that used in the credit risk framework.

      2. All reference entities are single-name products, including single-name credit derivatives, for which a liquid two-way market exists,Footnote 18 including traded indices on these reference entities.

      3. The instrument does not reference an underlying that is treated as a retail exposure, a residential mortgage exposure, or a commercial mortgage exposure under the standardized approach to credit risk.

      4. The instrument does not reference a claim on a special purpose entity.

    2. The instrument is a non-securitization hedge to a position described above.

      [Basel Framework, MAR20.5]

9.5.2 SENSITIVITIES-BASED METHOD

This section sets out the calculation of the sensitivities-based method under the standardized approach for market risk.

Main Concepts of the Sensitivities-Based Method
  1. The sensitivities of financial instruments to a prescribed list of risk factors are used to calculate the delta, vega and curvature risk capital requirements. These sensitivities are risk-weighted and then aggregated, first within risk buckets (risk factors with common characteristics) and then across buckets within the same risk class as set out in paragraphs 120 to 127. The following terminology is used in the sensitivities-based method:

    1. Risk class: seven risk classes are defined in paragraphs 151 to 201.

      1. General interest rate risk (GIRR)

      2. Credit spread risk (CSR): non-securitizations

      3. CSR: securitizations (non-correlation trading portfolio, or non-CTP)

      4. CSR: securitizations (correlation trading portfolio, or CTP)

      5. Equity risk

      6. Commodity risk

      7. Foreign exchange (FX) risk

    2. Risk factor: variables (e.g. an equity price or a tenor of an interest rate curve) that affect the value of an instrument as defined in paragraphs 121 to 127.

    3. Bucket: a set of risk factors that are grouped together by common characteristics (e.g. all tenors of interest rate curves for the same currency), as defined in paragraphs 151 to 201.

    4. Risk position: the portion of the risk of an instrument that relates to a risk factor. Methodologies to calculate risk positions for delta, vega and curvature risks are set out in paragraph 115 to 117 and paragraphs 127 to 138.

      1. For delta and vega risks, the risk position is a sensitivity to a risk factor.

      2. For curvature risk, the risk position is based on losses from two stress scenarios.

    5. Risk capital requirement: the amount of capital that an institution should hold as a consequence of the risks it takes; it is computed as an aggregation of risk positions first at the bucket level, and then across buckets within a risk class defined for the sensitivities-based method as set out in paragraphs 115 to 119.

      [Basel Framework, MAR21.1]

Instruments Subject to Each Component of the Sensitivities-Based Method
  1. In applying the sensitivities-based method, all instruments held in trading desks as set out in paragraph 52 to 57 and subject to the sensitivities-based method (i.e. excluding instruments where the value at any point in time is purely driven by an exotic underlying as set out in paragraph 260), are subject to delta risk capital requirements. Additionally, the instruments specified in (1) to (4) are subject to vega and curvature risk capital requirements:

    1. Any instrument with optionalityFootnote 19.

    2. Any instrument with an embedded prepayment optionFootnote 20 – this is considered an instrument with optionality according to above (1). The embedded option is subject to vega and curvature risk with respect to interest rate risk and CSR (non-securitization and securitization) risk classes. When the prepayment option is a behavioural option the instrument may also be subject to the residual risk add-on (RRAO) as per section 9.5.4. The pricing model of the institution must reflect such behavioural patterns where relevant. For securitization tranches, instruments in the securitized portfolio may have embedded prepayment options as well. In this case the securitization tranche may be subject to the RRAO.

    3. Instruments whose cash flows cannot be written as a linear function of underlying notional. For example, the cash flows generated by a plain-vanilla option cannot be written as a linear function (as they are the maximum of the spot and the strike). Therefore, all options are subject to vega risk and curvature risk. Instruments whose cash flows can be written as a linear function of underlying notional are instruments without optionality (e.g. cash flows generated by a coupon bearing bond can be written as a linear function) and are not subject to vega risk nor curvature risk capital requirements.

    4. Curvature risks may be calculated for all instruments subject to delta risk, not limited to those subject to vega risk as specified in (1) to (3) above. For example, where an institution manages the non-linear risk of instruments with optionality and other instruments holistically, the institution may choose to include instruments without optionality in the calculation of curvature risk. This treatment is allowed subject to all of the following restrictions:

      1. Use of this approach shall be applied consistently through time.

      2. Curvature risk must be calculated for all instruments subject to the sensitivities-based method.

      [Basel Framework, MAR21.2]

Process to Calculate the Capital Requirement under the Sensitivities-Based Method
  1. As set out in paragraph 113, the capital requirement under the sensitivities-based method is calculated by aggregating delta, vega and curvature capital requirements. The relevant paragraphs that describe this process are as follows:

    1. The risk factors for delta, vega and curvature risks for each risk class are defined in paragraphs 120 to 126.

    2. The methods to risk weight sensitivities to risk factors and aggregate them to calculate delta and vega risk positions for each risk class are set out in paragraph 116 and paragraphs 127 to 207, which include the definition of delta and vega sensitivities, definition of buckets, risk weights to apply to risk factors, and correlation parameters.

    3. The methods to calculate curvature risk are set out in paragraph 117 and paragraphs 208 to 213, which include the definition of buckets, risk weights and correlation parameters.

    4. The risk class level capital requirement calculated above must be aggregated to obtain the capital requirement at the entire portfolio level as set out in paragraphs 118 and 119.

      [Basel Framework, MAR21.3]

Calculation of the delta and vega risk capital requirement for each risk class
  1. For each risk class, an institution must determine its instruments’ sensitivity to a set of prescribed risk factors, risk weight those sensitivities, and aggregate the resulting risk-weighted sensitivities separately for delta and vega risk using the following step-by-step approach:

    1. For each risk factor as defined in paragraphs 120 to 126, a sensitivity is determined as set out in paragraphs 127 to 150.

    2. Sensitivities to the same risk factor must be netted to give a net sensitivity sk across all instruments in the portfolio to each risk factor k. In calculating the net sensitivity, all sensitivities to the same given risk factor (e.g. all sensitivities to the one-year tenor point of the three-month Euribor swap curve) from instruments of opposite direction should offset, irrespective of the instrument from which they derive. For instance, if an institution’s portfolio is made of two interest rate swaps on three-month Euribor with the same fixed rate and same notional but of opposite direction, the GIRR on that portfolio would be zero.

    3. The weighted sensitivity WSk is the product of the net sensitivity sk and the corresponding risk weight RWk as defined in paragraphs 151 to 207.

      W S k = R W k s k

    4. Within bucket aggregation: the risk position for delta (respectively vega) bucket b, Kb, must be determined by aggregating the weighted sensitivities to risk factors within the same bucket using the prescribed correlation ρkl set out in the following formula, where the quantity within the square root function is floored at zero:

      K b = max ( 0 , k WS k 2 + k k l ρ kl WS k WS l )

    5. Across bucket aggregation: The delta (respectively vega) risk capital requirement is calculated by aggregating the risk positions across the delta (respectively vega) buckets within each risk class, using the corresponding prescribed correlations ϒbc as set out in the following formula, where:

      1. S b = k WS k for all risk factors in bucket b, and S c = k WS k in bucket c.

      2. If these values for Sb and Sc described in above sub paragraph 116(a) produce a negative number for the overall sum of b K b 2 + b c b