Related provisions for IFPRU 6.3.14

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To access the FCA Handbook Archive choose a date between 1 January 2001 and 31 December 2004 (From field only).

(1) In determining whether it is appropriate for a firm to use empirical correlations within risk categories and across risk categories within a model, the FCA expects certain features to be observed in assessing whether such an approach is sound and implemented with integrity. In general, the FCA expects a firm to determine the aggregate VaR measure by adding the relevant VaR measure for each category, unless the firm's permission provides for a different method of aggregating
The FCA, will review as part of a firm's VaR model permission application, the processes and documentation relating to the derivation of profit and loss used for back-testing. A firm's documentation should clearly set out the basis for cleaning profit and loss. To the extent that certain profit and loss elements are not updated every day (for example, certain reserve calculations) the documentation should clearly set out how such elements are included in the profit and loss s
In accordance with article 363(3) of the EU CRR (Permission to use internal models), the FCA expects a firm to provide and discuss with us details of any significant planned changes to the VaR model before those changes are implemented. These details must include detailed information about the nature of the change, including an estimate of the impact on VaR numbers and the incremental risk charge.
The use of overlapping intervals of 10-day holding periods for article 365 of the EU CRR (VaR and stressed VaR calculation) introduces an autocorrelation into the data that would not exist should truly independent 10-day periods be used. This may give rise to an under-estimation of the volatility and the VaR at the 99% confidence level. To obtain clarity on the materiality of the bias, a firm should measure the bias arising from the use of overlapping intervals for 10-day VaR
Article 365 of the EU CRR requires a firm that uses an internal model for calculating its own funds requirement to calculate, at least weekly, a stressed VaR (sVaR) of their current portfolio. When the FCA considers a firm's application to use a sVaR internal model it would expect the features in IFPRU 6.3.20 G to IFPRU 6.3.24 G to be present prior to permission being granted, as indicative that the conditions for granting permission have been met.
The firm should calculate the sVaR measure to be greater than or equal to the average of the 2nd and 3rd worst loss in a 12-month time series comprising of 250 observations. The FCA expects, as a minimum, that a corresponding linear weighting scheme should be applied if the firm uses a larger number of observations.
The firm should consider whether the use of antithetic data in the calculation of the sVaR measure is appropriate to the firm's portfolio. A justification for using or not using antithetic data should be provided to the FCA.
Article 372 of the EU CRR (Requirement to have an internal IRC model) requires a firm that use an internal model for calculating own funds requirements for specific risk of traded debt instruments to also have an internal incremental default and migration risk (IRC) model in place to capture the default and migration risk of its trading book positions that are incremental to the risks captured by its VaR model. When the FCA considers a firm's application to use an IRC internal
The FCA expects the IRC model to capitalise pre-default basis risk. In this respect, the model should reflect that in periods of stress the basis could widen substantially. The firm should disclose to the FCA its material basis risks that are incremental to those already captured in existing market risk capital measures (VaR-based and others). This must take actual close-out periods during periods of illiquidity into account.
To achieve a soundness standard comparable to those under the IRB approach, LGD estimates should reflect the economic cycle. Therefore, the FCA expects a firm to incorporate dependence of the recovery rate on the economic cycle into the IRC model. Should the firm use a conservative parameterisation to comply with the IRB standard of the use of downturn estimates, evidence of this should be submitted in quarterly reporting to the FCA, bearing in mind that for trading portfolios,
The FCA expects that an IPRE rating system will only be compliant if a firm is able to demonstrate the following in respect of its treatment of cash flows (except where the firm can demonstrate that this is not an appropriate risk driver):(1) the difference in deal ratings when tenant ratings are altered is intuitive;(2) the transformation of ratings into non-rent payment probability is intuitive. Even where tenants are rated by the firm the PD will not usually represent a direct
The FCA expects that firms will not be compliant with the calibration requirements relating to use of a long-run default rate, unless it can demonstrate that:(1) the internal data series is the longest relevant and accurate data series, on a EU CRR compliant definition of default, that is available;(2) the determination of long-run default rate includes reference to an appropriate source of downturn data (this may require the use of external data);(3) the relevance of any external
The FCA expects that a firm will only be compliant with the calibration requirements relating to model philosophy if it can demonstrate that:(1) the model philosophy is clearly articulated and justified. Justification should include analysis of the performance of assets, and the corresponding ratings assigned, over a change in economic conditions (ie, as long as period as possible); and(2) in addition to encapsulating this information in a coherent way in the calibration, the
IFPRU 4.11.12GRP
The FCA considers that, to meet the requirements referred to in IFPRU 4.11.1 G, it will be necessary for firms to demonstrate that a firm has a good understanding of PD models that are constructed theoretically and that the parameter estimates reflect a one-year PD. In addition, even if empirical data were not used to determine the PD estimate it should, where available, be used to back-test the estimates.
IFPRU 4.11.13GRP
The FCA expects that, as most models of this type will be able to produce one-year estimates of PD that correspond closely to point-in-time estimates, firms should conduct robust back-testing of such estimates by comparing them with realised default rates. Firms would need to demonstrate that the results of such back-testing meet pre-defined and stringent standards in order for the FCA to be satisfied that the IRB requirements are met.
IFPRU 4.11.14GRP
Because assumptions in the model build process are likely to materially impact the resulting PDs, the FCA would expect these choices to be clearly justified in the model documentation and to have been independently reviewed. To be satisfied that a firm is complying with article 176(1)(d) of the EU CRR, the FCA expects a firm to support justification for all assumptions with analysis of the sensitivity of the model outputs to changes in the assumptions.
IFPRU 4.11.16GRP
The FCA expects that a firm will be compliant with the validation requirements only where1it can demonstrate, in respect of discriminatory power, that:11(1) appropriate minimum standards that the rating system is expected to reach are defined, together with reasoning behind the adoption of such standards and that the factors considered when determining the tests are clearly documented;(2) an objective rank-ordering metric, measured using an appropriate time horizon (eg, using
IFPRU 4.11.17GRP
The FCA expects that a firm will be compliant with the validation requirements only where1it can demonstrate in respect of the calibration that:11(1) observed default rate versus PD is considered at grade level and across a range of economic environments (ie, as long as period as possible);(2) where the PD does not relate to a pure point-in-time estimate, either the PD or the observed default rate is transformed such that comparison between the two is meaningful. This transformation
The FCA expects that, over time, the actual default rates incurred in each segment would form the basis of PD estimates for the segments. However, at the outset, the key calibration issue is likely to be the setting of the initial long-run default rate for each segment, as this will underpin the PD of the entire portfolio for some years to come. A firm should apply conservatism in this area and this is something on which the FCA is likely to focus on in model reviews.
To ensure that a rating system provides a meaningful differentiation of risk and accurate and consistent quantitative estimates of risk, the FCA expects a firm to develop country-specific mid-market PD models. Where a firm develops multi-country mid-market PD models, the FCA expects the firm to be able to demonstrate that the model rank orders risk and predicts default rates for each country where it is to be used for own funds requirements calculation.
The FCA expects a firm to have challenging standards in place to meaningfully assess whether a model rank orders risk and accurately predict default rates. These standards should specify the number of defaults that are needed for a meaningful assessment to be done.
The FCA expects a firm to assess the model's ability to predict default rates using a time series of data (ie, not only based on one year of default data).
In the FCA's view, a model is not likely to be compliant where the firm cannot demonstrate that it rank orders risk and predicts default rates for each country, regardless of any apparent conservatism in the model.
The FCA expects a firm to estimate PD for a rating system in line with this section where the firm's internal experience of defaults for that rating system was 20 defaults or fewer, and reliable estimates of PD cannot be derived from external sources of default data, including the use of market price-related data. In PD estimation for all exposures covered by the rating system, the FCA expects the firm to:(1) use a statistical technique to derive the distribution of defaults implied
Where a firm adjusts assumed house price values within its LGD models to take account of current market conditions (for example, appropriate house price indices), the FCA recognises that realised falls in market values may be captured automatically. A firm adopting such approaches may remove observed house price falls from its downturn house price adjustment so as not to double count. A firm wishing to apply such an approach must seek the consent of the FCA and be able to demonstrate
The FCA uses a framework for assessing the conservatism of a firm's wholesale LGD models for which there are a low number of defaults. This framework is set out in IFPRU 4 Annex 2G (Wholesale LGD and EAD framework) and does not apply to sovereign LGD estimates which are floored at 45%. This framework is also in the process of being used to assess the calibration of a firm's material LGD-models for low-default portfolios.
In the following cases, the FCA expects a firm to determine the effect of applying the framework in IFPRU 4 Annex 2G (Wholesale LGD and EAD framework) to models which include LGD values that are based on fewer than 20 'relevant' data points (as defined in IFPRU 4 Annex 2G):(1) the model is identified for review by the FCA; or(2) the firm submits a request for approval for a material change to its LGD model.
(1) The methodology for the identification of the risks in IFPRU 6.1.4 R and the calculation of those additional own funds for value-at-risk (VaR) and stressed value-at-risk (stressed VaR) models is called the "RNIV framework". A firm is responsible for identifying these additional risks and this should be an opportunity for risk managers and management to better understand the shortcomings of the firm's models. Following this initial assessment, the FCA will engage with the firm
In the following cases, the FCA expects firms to determine the effect of applying the framework in IFPRU 4 Annex 2G (Wholesale LGD and EAD framework) to models which include EAD values that are based on fewer than 20 'relevant' data points (as defined in IFPRU 4 Annex 2G):(1) the model is identified for review by the FCA; or(2) the firm submits a request for approval for a material change to its EAD model.
Article 331(2) of the EU CRR (Interest rate risk in derivative instruments) states conditions that must be met before a firm not using interest rate pre-processing models can fully offset interest-rate risk on derivative instruments. One of the conditions is that the reference rate (for floating-rate positions) or coupon (for fixed-rate positions) should be 'closely matched'. The FCA will normally consider a difference of less than 15 basis points as indicative of the reference
(1) The FCA's starting assumption is that all overshootings should be taken into account for the purpose of the calculation of addends. If a firm believes that an overshooting should not count for that purpose, then it should seek a variation of its VaR model permission under article 363 of the EU CRR (Permission to use internal models) in order to exclude that particular overshooting. The FCA would then decide whether to agree to such a variation. (2) One example of when a firm's
For purposes of repurchase transactions and securities lending or borrowing transactions, the FCA does not consider that there are any core market participants apart from those entities listed in article 227(3) of the EU CRR.
(1) This guidance sets out the FCA's expectations for permitting a firm with the permission to use the Internal Model Method set out in Part Three, Title II, Chapter 6, Section 6 (Internal model method) and the permission to use an internal VaR model for specific risk set out in Part Three, Title IV, Chapter 5 (Use of internal models) associated with traded debt instruments to set to 1 the maturity factor "M" defined in article 162 of the EU CRR.(2) In the context of counterparty