Prudential Guidelines on Capital Charge for Market Risks

Prudential Guidelines on Capital Charge for Market Risks

RBI/2009-10/309
UBD.BPD.(PCB).Cir.No. 42 /09.11.600/2009-10

February 8, 2010

The Chief Executive Officers of
Primary (Urban) Cooperative Banks having
AD Category I licence

Dear Sir / Madam

Prudential Guidelines on Capital Charge for Market Risks

As you are aware, the Basel Committee on Banking Supervision (BCBS) had issued an amendment to the Capital Accord in 1996 to incorporate market risks.  As an initial step towards prescribing capital requirement for market risks, Urban Cooperative Banks (UCBs) were advised to assign an additional risk weight of 2.5% on almost the entire investment portfolio.  These additional risk weights are clubbed wtih the risk weights prescribed for credit risk in respect of investment portfolio of UCBs.  Further, UCBs were advised to assign a risk weight of 100% on the open position limits on foreign exchange and gold and to build up Investment Fluctuation Reserve up to a minimum of 5% of the investments held in Held for Trading and Available for Sale categories in the investment portfolio. 

2.  The interim measures adopted by UCBs represent a broad brush and simplistic approach.  However, over a period of time, banks’ ability to identify and measure market risk has improved.  The Advisory Panel on Financial Regulation and Supervision to the Committee on Financial Sector Assessment (Chairman: Dr Rakesh Mohan and Co-Chairman: Shri Ashok Chawla) which looked into the present regulatory and supervisory framework for UCBs, had recommended assigning duration based capital charge for market risk for Scheduled UCBs that are systemically important and comparable in size to medium-sized commercial banks.

Accordingly, it was proposed in the Annual Policy Statement for the year 2009-10 to prescribe capital charge for market risk in respect of systemically important and large sized UCBs with effect from April 1, 2010. In this backdrop, it has been decided that UCBs having AD category I licence would provide capital for market risk with effect from April 1, 2010.  The guidelines on capital charge for market risk are enclosed. UCBs are advised to restrict their exposure only to the permitted category of investments / instruments as per the extant instructions and provide capital charge for market risk as per the guidelines.

Yours faithfully

(A.K. Khound)
Chief General Manager-In-Charge

Encl: As above

Guidelines on capital charge for Market Risks

Introduction

1.   Market risk is defined as the risk of losses in on-balance sheet and off  balance sheet positions arising out of movements in market prices. The market risk positions subject to capital charge requirement are as under:

(i) The risks pertaining to interest rate related instruments and equities in the trading book; and

(ii) Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading books).

2.  The guidelines in this regard are organized under the following five sections:

Section A

3. Scope and coverage of capital charge for market risks

3.1   These guidelines seek to address the issues involved in computing capital charges for interest rate related instruments in the trading book, equities in the  trading book and foreign exchange risk (including gold and other precious  metals) in both trading and banking books. Trading book for the purpose of capital adequacy will include:

(i) Securities included under the Held for Trading category
(ii) Securities included under the Available for Sale category
(iii) Open gold position limits
(iv) Open foreign exchange position limits
(v) Trading positions in derivatives, and
(vi) Derivatives entered into for hedging trading book exposures.

3.2   Banks are required to manage the market risks in their books on an ongoing basis and ensure that the capital requirements for market risks are being maintained on a continuous basis, i.e. at the close of each business day. Banks are also required to maintain strict risk management systems to monitor and control intra-day exposures to market risks.

3.3   Capital for market risk would not be relevant for securities which have already matured and remain unpaid. These securities will attract capital only for credit risk. On completion of 90 days delinquency, these will be treated on par with NPAs for deciding the appropriate risk weights for credit risk.

Section B

4   Measurement of capital charge for interest rate risk

4.1  This section describes the framework for measuring the risk of holding or  taking  positions in debt securities and other interest rate related instruments in the trading book.

4.2   The capital charge for interest rate related instruments would apply to current market value of these items in bank's trading book. Since banks are required to maintain capital for market risks on an ongoing basis, they are required to mark to market their trading positions on a daily basis. The current market value will be determined as per extant RBI guidelines on valuation of investments.

 4.3   The minimum capital requirement is expressed in terms of two separately calculated charges, (i) "specific risk" charge for each security, which is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer, both for short (short position is not allowed in India except in derivatives) and long positions, and (ii) "general market risk" charges towards interest rate risk in the portfolio, where long and short positions (which is not allowed in India except in derivatives and Central Government securities) in different securities or instruments can be offset.

4.4   Capital Charge for Specific Risk

The capital charge for specific risk is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer. The specific risk charges for various kinds of exposures would be as applied as detailed below:

Note: Though the capital charge for specific risk in respect of various instruments has been mentioned in the table above, UCBs are not permitted to invest in many such instruments.  They should invest in securities that are permitted by the Reserve Bank from time to time.

The category 'claim on Government' will include all forms of Government securities including dated Government securities, Treasury bills and other short-term investments and instruments where repayment of both principal and interest are fully guaranteed by the Government. The category 'Claims on others' will include issuers of securities other than Government and banks.  Certain types of investments mentioned in the above table are not applicable for UCBs.

4.5  General Market Risk

The capital requirements for general market risk are designed to capture the risk of loss arising from changes in market interest rates. The capital charge is the sum of four components:

1. the net short  (which is not allowed in India except in derivatives) or long position in the whole trading book;
2. a small proportion of the matched positions in each time-band (the “vertical disallowance”);
3.  a larger proportion of the matched positions across different time bands (the “horizontal disallowance”), and
4. a net charge for positions in options, where appropriate.

4.6    The Basle Committee has suggested two broad methodologies for computation of capital charge for market risks. One is the standardized method and the other is the banks’ internal risk management models method. As banks in India are still in a nascent stage of developing internal risk management models, it has been decided that, to start with, banks may adopt the standardised method. Under the standardised method there are two principal methods of measuring market risk, a “maturity” method and a “duration” method.

A maturity / re-pricing schedule is used to evaluate the effects of changing interest rates on a bank’s economic value by applying sensitivity weights to each time band.  Typically, such weights are based on estimates of the duration of assets and liabilities that fall into each time band.  Duration is measure of the percentage change in the economic value of a position that will occur given a small change in the level of interest rates.  It reflects the timing and size of cash flows that occur before the instrument’s contractual maturity.  Generally, the longer the maturity or next repricing date of the instruments and smaller the payments that occur before maturity (eg coupon payments), the higher the duration (in absolute value).  Higher duration implies that a given change in the level of interest rates will have a larger impact on economic value.

As “duration” method is a more accurate method of measuring interest rate risk, it has been decided to adopt standardized duration method to arrive at the capital charge. Accordingly, banks are required to measure the general market risk charge by calculating the price sensitivity (modified duration) of each position separately. Modified duration which is a standard duration divided by 1 + r where r is the level of market interest rates – is an elasticity.  As such it reflects the percentage change in the economic value of the instrument for a given percentage change in 1 + r.  As with simple duration, it assumes a linear relationship between percentage changes in value and percentage changes in interest rates.  Under this method, the mechanics are as follows:

1. first calculate the price sensitivity (modified duration) of each instrument;
2. next apply the assumed change in yield to the modified duration of each instrument between 0.6 and 1.0 percentage points depending on the maturity of the instrument (see Table-1 below);
3. slot the resulting capital charge measures into a maturity ladder with the fifteen time bands as set out in Table-1;
4. subject long and short positions (which is not allowed in India except in derivatives) in each time band to a 5 per cent vertical disallowance designed to capture basis risk; and
5. carry forward the net positions in each time-band for horizontal offsetting subject to the disallowances set out in Table-2.

4.7  Capital charge for interest rate derivatives

The measurement of capital charge for market risks should include all interest rate derivatives and off-balance sheet instruments in the trading book and derivatives entered into for hedging trading book exposures which would react to changes in the interest rates, like FRAs, interest rate positions etc.  The details of measurement of capital charge for interest rate derivatives are furnished in Attachment I.

Two examples for computing capital charge for market risks, including the vertical and horizontal disallowances are given in Attachment II & III.

4.8    Capital charge for interest rate risk in foreign currencies

Details of computing capital charges for interest rate risks in foreign currencies are as under:

1. Capital charges should be calculated for each currency separately and then summed with no offsetting between positions of opposite sign.
2. In the case of those currencies in which business is insignificant (where the turnover in the respective currency is less than 5% of overall foreign exchange turnover), separate calculations for each currency are not required. The bank may, instead, slot within each appropriate time-band, the net long or short position for each currency. However, these individual net positions are to be summed within each time-band, irrespective of whether they are long or short positions, to produce a gross position figure. The gross positions in each time-band will be subject to the assumed change in yield set out in Table-1 above (Ref: para 4.6) with no further offsets.

Section C

5.  Measurement of capital charge for equity risk

5.1  The capital charge for equities would apply on their current market value in bank’s trading book.  Minimum capital requirement to cover the risk of holding or taking positions in equities in the trading book is set out below. This is applied to all instruments that exhibit market behaviour similar to equities but not to non convertible preference shares (which are covered by the interest rate risk requirements). The instruments covered include equity shares, whether voting or non-voting, convertible securities that behave like equities, for example: units of mutual funds, and commitments to buy or sell equity.

Specific and general market risk

5.2  Capital charge for specific risk (akin to credit risk) will be 11.25% and specific risk is computed on the banks’ gross equity positions (i.e. the sum of all long equity positions and of all short equity positions – short equity position is, however, not allowed for banks in India. The general market risk charge will also be 9% on the gross equity positions.

5.3  UCBs are, however not permitted to take exposure in equities, except in investments in the shares of cooperatives, subject to certain limits and therefore, not exposed to equity risk.

Section D

6   Measurement of capital charge for foreign exchange and gold open positions

Foreign exchange open positions and gold open positions are at present risk-weighted at 100%. Thus, capital charge for market risks in foreign exchange and gold open position is 9%. These open positions, limits or actual whichever is higher, would continue to attract capital charge at 9%. This capital charge is in addition to the capital charge for credit risk on the on-balance sheet and off-balance sheet items pertaining to foreign exchange and gold transactions.

Section E

7  Aggregation of the capital charge for market risks

As explained earlier capital charges for specific risk and general market risk are to be computed separately before aggregation. For computing the total capital charge for market risks, the calculations may be plotted in the following table:

Proforma 1                                                 (Rs. in crore)                  

Calculation of total risk-weighted assets and capital ratio

a)    Arrive at the risk weighted assets for credit risk in the banking book (i.e., all exposures other than those specified in paragraph 3 of the guidelines) as per the extant guidelines on capital adequacy.

b)    Convert the capital charge for market risk to notional risk weighted assets by multiplying the capital charge arrived at as above in Proforma-1 by 100 ÷ 9 [the present requirement of CRAR is 9% and hence notional risk weighted assets are arrived at by multiplying the capital charge by (100 ÷ 9)]

c)    Add the risk-weighted assets for credit risk as at (a) above and notional risk-weighted assets of trading book as at (b) above to arrive at total risk weighted assets for the bank.

d)    Compute capital ratio on the basis of regulatory capital maintained and risk-weighted assets.

Computation of capital available for market risk:

Capital required for supporting credit risk should be deducted from total capital funds to arrive at capital available for supporting market risk. This is illustrated below:      

8.  Disclosure and Reporting requirements

The following section set out in tabular form is the disclosure requirement for the banks:

Market risk in trading book

Reporting

Banks should furnish data in the above format as on the last day of each calendar quarter to the Regional Office of the RBI. The reporting format for the purpose of monitoring the capital ratio is given as Annex 1.