Procedures to be observed by universal banks and commercial banks applying for BSP recognition of their own internal models for calculating market risk capital charge under Circular No. 360 dated 3 December 2002, as amended.

MEMORANDUM Series of 2004

TO     :  All Universal Banks and Commercial Banks

The Monetary Board, in its Resolution No. 1844 dated 18 December 2003, approved the following procedures to be observed by universal banks and commercial banks applying for BSP recognition of their own internal models for calculating market risk capital charge under Circular No. 360 dated 3 December 2002, as amended.

A.  Bank’s Own Self-Assessment

A bank intending to use its own internal Value-at-Risk (VaR) models, in lieu of the standardized approach, for calculating market risk capital charge should conduct a self-assessment of its compliance with the requirements for the use of such models as prescribed in Appendix I, Annex “A” of Circular No. 360, using the attached Questionnaire (Annex “A”).

B.  Offsite Assessment by BSP

If a bank believes that it is in compliance with the abovementioned requirements for the use of internal models, it should submit a written application to the appropriate supervision and examination department of the BSP, together with the following:

1.  Accomplished Questionnaire;

2.  A listing of the products to be included in the risk models;

3.  Details as of end of the preceding quarter, by each product listed above, of:

a.   The size of positions in terms of market value; and

b.  The currencies in which it is traded,

4. Organizational structure and personnel;

The bank should submit latest organizational chart showing the names, reporting lines, and responsibilities of key personnel in-charge of trading, and of functions supporting the trading operations such as risk control, back office, internal audit, etc., and those at Board level to whom they report. For those responsible for trading, the bank should provide details of their relevant qualifications and experience in the area of trading. For those responsible for risk control, the bank should provide details of their relevant qualifications and experience, particularly on the use of bank’s models.

The bank should also provide information on the number of staff within the risk control unit [1], their internal reporting structure, responsibilities, qualifications and experience.

5.  Full technical description of the model, indicating, among others, the following:

a . the type of VaR model used (e.g., variance-covariance matrix, historical simulation or Monte Carlo simulation);

b.   the parameters which are integral to the VaR calculations, including  assumptions regarding:

1)   confidence interval;

2)   holding period;

3)   length of historical data used to calculate volatility parameters;

4)   scaling factors applied to VaR numbers to convert shorter holding periods to longer holding periods;

5)   weighting scheme applied to historical data (e.g., giving recent observations more weight than less recent observations);

6)   probability distribution functions of input variables to the Monte Carlo simulation model;

7)   the frequency of input data updates (e.g., how often are historical data series updated, when are variance-covariance matrices revised, etc.);

8)   the other models which are used as inputs to the VaR model (e.g., option pricing models, interest rate sensitivity models, etc.) and how they interface with the model; and

9)   the frequency of VaR calculation;

c.  an outline of the VaR risk measurement calculation and processes, including, where necessary, mathematical formulae.  This should also include:

1)   the manner in which non-linear products, like options, are incorporated in the model;

2)   the extent to which correlation is allowed both within and across risk categories (i.e., interest rates, equity prices, exchange rates); and

3)   the means by which specific risk is addressed within the VaR framework, if appropriate, and the explanation of the techniques by which this is achieved.

6.  Policies and procedures for backtesting;

The bank should describe the methods of backtesting employed, including the treatment of intra-day trading profits and loss and fee income within the daily profit and loss figures. While the formal implementation of the BSP prescribed backtesting program should begin on the quarter following the date of BSP’s recognition of the bank’s internal model and thus implies that the formal accounting of exceptions under the BSP prescribed backtesting program would be a year later, the bank should, at initial assessment, submit at least the latest backtesting result based on its own backtesting program, including the confidence level used in calculating the VaR numbers. The confidence level used shall dictate the number of daily observations on which the backtesting will be applied (e.g., 250 number of observations for a 99% confidence level, and a higher number of observations for a confidence level higher than 99%), subject to a minimum of 250 observations.

7.  Policies and procedures for stress testing;

8.  Internal validation reports which should include the following:

a.   the latest review of the overall risk management process by the applicant bank’s internal auditors; and

b.   the latest validation of the formulae used in the calculation process, as well as for the pricing of options and other complex instruments by a qualified unit which is independent from the trading area; and

9. Validation reports of external auditor.

The bank should stand ready to make a presentation to the BSP on its compliance with the abovementioned requirements for the use of internal models.

C.  On-site Assessment by BSP

The BSP shall conduct an on-site assessment of the models to review both the technical details of the models and the risk management practices that govern their use.

During the on-site assessment, the bank should give a brief demonstration of how its models work. The demonstration should cover the following:

1.  how model inputs are fed into the system including extent of manual inputs;

2.  how VaR numbers are calculated;

3.  how results are generated and interpreted;

4.  accuracy in terms of backtesting results;

5.  stress testing capability;

6.  use of model outputs in risk management; and

7.  limitations of the model.

The onsite assessment shall also include interview with the concerned officers and personnel of the bank.

D.  Assessment on an Ongoing Basis by the BSP

After initial recognition of the models by the BSP, the bank should inform the BSP of any material change to the models, including change in the methodology or scope to cover new products and instruments. The BSP shall determine whether the models remain acceptable for calculating the market risk capital charge.

The BSP shall likewise conduct a periodic assessment of the models and the controls surrounding the models at least annually to ensure that they remain compliant with the minimum qualitative and quantitative requirements prescribed under Circular No. 360 on an ongoing basis. Non-compliance with the minimum requirements shall be ground for disallowing the use of such models.

This Memorandum shall take effect fifteen (15) days after its publication either in the Official Gazette or in a newspaper of general circulation.

--------------------------------------------------------------------------------

[1] Referring generally to the risk management group functions in the BAP Financial Markets Risk Reference Manual.

RAFAEL B. BUENAVENTURA Governor