Administrative Notice No. 7 Implementation of the Capital Adequacy Directive for Credit Institutions

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1 No. 7 Implementation of the Capital Adequacy Directive for Credit Institutions Date of Paper : 23 January 1998 Revised 5th May 2006 Version Number : V1.02 File Location : document2

2 Table of Contents Preface... 8 Scope 8 Chapter 1 - The Trading Book... 9 Explanation... 9 Trading Book And Related Definitions... 9 Trading Book Requirements Hedging Exposures Positions In Instruments Issued By Institutions Exemptions From The Trading Book Requirements Chapter 2 - Counterparty Risk Explanation Scope 17 Banking Book Trading Book Policy Applicable To Both Banking And Trading Books Counterparty Weights Investment Firms Recognised Clearing Houses and Exchanges Netting Of Off-Balance Sheet Instruments Settlement/Delivery Risk Unsettled transactions Free Deliveries Foreign exchange transactions Policy Applying Just To The Banking Book Repos/Reverse Repos Policy Applying Just To The Trading Book Counterparty Risk On OTC Derivatives Counterparty Risk On Forward Transactions Counterparty Risk On Documented Repos/Reverse Repos Collateralising Counterparty Exposures Annex I: Risk Cushion Factors Annex II: Example Calculations For Repos/Reverse Repos In The Trading Book Case 1: Properly documented transaction Case 2: Properly documented transactions calculated on portfolio basis Case 3: Inadequate documentation (or business of a type or volume which leads the Banking Supervisor to insist on this treatment even for documented transactions)

3 Case 4: As Case 3 except collateral and securities in differing currencies Chapter 3 - Large Exposures Explanation Scope 26 Policy Statements Measurement Of Exposure The bank s application of these principles must remain consistent Issuer Risk on Securities Counterparty Risk on Derivatives Repos and Reverse Repos Exclusions Underwriting Identity Of Counterparty Limits For Large Exposures Aggregate Limit on Large Exposures Single Exposure Limit Limits on Exposures to Connected Counterparties Notification Of Exposures Pre-notification of Exposures Exceeding 25% of Capital Base Post-notification of exposures Exempt Exposures Exposures to Banks, Investment Firms, Recognised Exchanges and Clearing Houses Exposures to Zone A central governments or central banks (which for the purpose of this chapter includes the European Communities) Exposures to Zone B central governments or central banks Secured Exposures Exempt Exposures to counterparties connected to the reporting bank Exposures undertaken by subsidiary banks which are guaranteed by a parent bank Capital Base Additional Capital Requirements Exposures To Countries Exposures To Economic Sectors Annex - Examples Chapter 4 - Foreign Currency Risk Explanation Calculating The Net Open Positions Calculating The Overall Net Foreign Exchange Position

4 Calculating The Capital Requirement Annex I - Calculating The Net Open Position Annex II Simple Method For Options (Carve Out) Definitions for currency options Formulae Annex III - Calculation Of The Capital Requirement For Foreign Exchange Chapter 5 - Interest Rate Position Risk Explanation Scope 53 Individual Net Positions Calculation Of Capital Requirements Specific Risk Calculation General Risk Calculation General Risk Calculation - Interest Rate Exposure Method General Risk Calculation - Interest Rate Exposure Method Derivatives FX Forwards Deposit Futures and FRAs Bond Futures And Forward Bond Transactions Repo/reverse repo (and similar transactions) Swaps 62 Options 62 Index Linked Gilts Netting Of General Market Risk Positions Annex I Simple Method For Options (Carve Out) Annex II Simplified Method For Calculation Of Capital Requirement Individual Net Positions Specific Risk Calculation General Market Risk Calculation Chapter 6 - Equity Position Risk Explanation Scope 70 Calculation Of Capital Requirements - Standard Method Netting 71 Specific Risk Calculation Qualifying countries Highly liquid instruments and diversified portfolios Simplified Method For Specific Risk

5 General Risk Calculation Equity Indices Derivatives Options 75 Annex I Simple Method For Options (Carve Out) Annex II Alternative Method Chapter 7 Commodity Position risk Explanation Scope 81 Calculation of the Capital Requirement Framework for calculating commodity risk capital charges Internal models approach Common issues for maturity ladder and simplified approaches Definition of a single commodity Treatment of derivative positions The maturity ladder approach The simplified approach Annex I: Illustrative Calculations Using Maturity Ladder and Simplified Approaches. 85 Annex II: Carve Out Method for Options Chapter 8- Underwriting Explanation Scope 89 Commitment...90 Capital Requirements - Commitment To Working Day Capital Requirements - From Working Day Chapter 9 - Eligible Models Chapter 10 - Own Funds Explanation Application Of Capital Definition Of Capital Tier 1: Core Capital Tier 2: Supplementary Capital Deductions from Tiers 1 & 2 Capital Tier 3: Trading Book Ancillary Capital Limits On The Use Of Different Forms Of Capital Calculation Of Capital Adequacy Reporting Requirements Annex: Calculation Of Capital Adequacy For Supervisory Purposes

6 Chapter 11 - Consolidation Explanation Scope Of Consolidation Exceptions To Consolidation Distribution Of Capital Resources Within The Group Groups Not Subject To Consolidation Techniques Of Consolidation a) Banks: Banking Books b) Banks: Trading Books (including foreign exchange exposure) c) Investment firms d) Other firms Other Issues Recognition for offsetting exposures amongst companies being consolidated Large Exposures Annex I: - A Consolidation Techniques Schematic Annex ii: Calculation Of Consolidated Capital Adequacy Chapter 12 - Lists Explanation Lists Applicable To Market Risk Currency Pairs Subject To Binding Inter-Governmental Agreements Multilateral Development Banks Relevant Credit Rating Agencies And Investment Grade Ratings Qualifying Countries For Equity Position Risk Highly Liquid Equity Indices Note on lists for equity position risk Lists Applicable To Counterparty Risk And Consolidation Third Country Equivalent Regimes For Investment Firms Recognised Clearing Houses & Exchanges Third Country Banking Supervisors with Equivalent Regimes Recognised Clearing Houses And Exchanges (Amendment) Recognised Exchanges Recognised Clearing Houses

7 Published by: Financial Services Commission PO Box 940, Suite 943, Europort, Gibraltar Tel (+350) Fax (+350)

8 Preface 1 Gibraltar, in common with EU member States, is required to implement the provisions of the Directive on Capital Adequacy of Credit Institutions and Investment Firms (93/6/EEC). 2 The Capital Adequacy Directive () sets out the minimum capital requirements for credit institutions and investment firms for the market and other risks associated with their trading activities. In some cases the Commissioner of Banking is proposing more stringent requirements than the Directive, in general reflecting either existing policies (such as those for counterparty risk and large exposures) or the experience of other supervisors domestically and internationally. While the applies to credit institutions and investment firms throughout EU/EEA Member States, this text applies only to Gibraltar-incorporated Licensed Institutions. In order to simplify the text, the term "banks" has been used throughout to describe credit institutions. 3 Amendments to the Capital Adequacy Directive (93/6/EEC) contained in Directives 98/31/EC and 98/33/EC are reflected in this Notice. 4 The requirements necessary to effect the supervisory regime promulgated by these Directives are described in the following chapters: Chapter Subject 1 The Trading Book, 2 Counterparty Risk, 4 Foreign Currency Risk, 5 Interest Rate Position Risk, 6 Equity Position Risk, 7 Commodity Position Risk 8 Underwriting, and 9 Eligible Models, Implications of the Directive for facets of supervisory existing policy in other areas are described in the following chapters: Chapter Subject 3 Large Exposures. 10 Own Funds, and 11 Consolidation, Scope 5 This notice is issued by the Commissioner of Banking under section 16(2) of the Banking Ordinance 1992 to facilitate compliance in Gibraltar with relevant Community obligations. 6 This notice applies only to Gibraltar incorporated licensees under the Banking Ordinance This notice was published originally on 23 January 1998 and came into effect on 1 March This revised notice will come into effect on 21 July

9 Chapter 1 - The Trading Book Explanation 1 The capital requirement calculation that banks must meet with effect from 1 March 1998 is based upon the allocation of positions between the trading book and the non-trading, or banking, book. Only certain types of instrument can be included in the trading book. Although a single instrument cannot simultaneously be in both books it is possible for some types of instrument to be in either the trading or the banking book, for example depending whether it is held for short-term gain, or whether it is held for the purposes of hedging exposures in the banking book. In addition it is possible in certain circumstances to transfer some of the general market risk exposure between the trading book and banking book where a bank has used part of its overall exposure in the trading book to hedge exposures in the banking book. In order to qualify for this treatment, the risk transfers must be documented and subject to audit verification. 2 The capital requirement for positions in the banking book is unchanged from the implementation of the Solvency Ratio Directive (Administrative Notice Number 1) apart from changes to the capital requirements for unsettled and deferred settlement transactions. These changes apply to all banks irrespective of whether they have a trading book for purposes or not. The counterparty exposure calculations for the trading book may be similar to the banking book, but there are some areas where the differences are substantial. 3 The capital requirements for foreign exchange positions are contained in Chapter 4: Foreign Exchange Risk. These are applicable irrespective of whether the exposures are incurred in the trading or banking book. 4 This chapter describes the procedures by which banks should allocate positions between the trading and banking books. Subject to satisfying certain criteria, a bank may be deemed not to have a trading book for the purposes of these capital requirements with the result that all its positions are subject to the Solvency Ratio Directive. 5 The contents of this chapter constitute new policy. There are no existing Administrative Notices relevant to the concept of a trading book. 6 This chapter covers the following sections of the Capital Adequacy Directive: Article 2.6, Article 4.1, Article 9. Trading Book And Related Definitions 7 The Capital Adequacy Directive (93/6/EEC) Article 2.6 provides the trading book definition, which is reproduced below. "The trading book of an institution shall consist of: a) its proprietary positions in financial instruments, commodities and commodity derivatives which are held for resale and/or which are taken on by the institution with the intention of benefiting in the short term from actual and/or expected differences between their buying and selling prices, or from other price or interest rate variations, and positions in financial instruments, commodities and commodity derivatives arising from matched principal broking, or positions taken in order to hedge other elements of the trading book. 9

10 b) the exposures due to the unsettled transactions, free deliveries and over-the-counter (OTC) derivative instruments referred to in paragraphs 1, 2, 3 and 5 of Annex II (of the ), the exposures due to repurchase agreements and securities or commodities lending which are based on securities or commodities included in the trading book as defined in (a) referred to in paragraph 4 of Annex II (of the ), those exposures due to reverse repurchase agreements and securities-borrowing and commodities-borrowing transactions described in the same paragraph, provided the competent authorities so approve, which meet either the conditions (i), (ii), (iii) and (v) or conditions (iv) and (v) as follows: i) the exposures are marked to market daily following the procedures laid down in Annex II (of the ); ii) the collateral is adjusted in order to take account of material changes in the value of the securities or commodities involved in the agreement or transaction in question, according to a rule acceptable to the competent authorities; iii) the agreement or transaction provides for the claims of the institution to be automatically and immediately offset against the claims of its counterparty in the event of the latter's defaulting; iv) the agreement or transaction in question is an interprofessional one; v) such agreements and transactions are confined to their accepted and appropriate use and artificial transactions, especially those not of a short term nature, are excluded; and c) those exposures in the form of fees, commission, interest, dividends, and margin on exchange-traded derivatives which are directly related to the items included in the trading book referred to in paragraph 6 of Annex II (of the ). Particular items shall be included in or excluded from the trading book in accordance with objective procedures including, where appropriate, accounting standards in the institution concerned, such procedures and their consistent implementation being subject to review by the competent authorities. 8 The financial instruments referred to in paragraph 7(a) above are defined in Section B of the Annex to the Investment Services Directive (93/22/EEC). These are: 1) a) Transferable securities; b) Units in collective investment undertakings. 2) Money-market instruments. 3) Financial-futures contracts, including equivalent cash settled instruments. 4) Forward interest rate agreements (FRAs). 10

11 5) Interest-rate, currency and equity swaps. 6) Options to acquire or dispose of any instruments falling within this section of the annex including equivalent cash-settled instruments. This category includes in particular options on currency and on interest rates. More detailed lists of instruments that may be included in the trading book in their own right can be found in the opening section of the Equity and Interest Rate Position Risk chapters below. In limited circumstances non-financial instruments may be included in the trading book, see paragraphs 15 to 18 (Hedging Exposures). 9 The Commissioner of Banking is a competent authority for the purposes of the Capital Adequacy Directive. 10 Positions and exposures which are not in the trading book are deemed to be in the banking book. Positions and exposures in the banking book will be subject to the risk weighting capital requirements based on the Solvency Ratio Directive. In addition to capital requirements for position risk, trading book positions may also give rise to counterparty risk requirements. (See Chapter 2 Counterparty Risk). 10a Wherever a bank or affiliate acts as principal (even in the context of activity described as broking or customer business ), positions should be allocated to the trading book where the underlying intent is trading. This applies even if the nature of the business means that the only risks deemed to be incurred by the bank or affiliate are counterparty risks (i.e. no market risk changes apply). Trading Book Requirements 11 A consistent approach must be adopted in relation to those positions in financial instruments which are capable of being included in the trading book in accordance with the definition contained in paragraphs 15 to 18. For this purpose positions may be considered as held with a trading intent if: a) they are marked-to-market on a daily basis as a part of the internal risk management processes; b) the position takers have autonomy in entering into transactions within predetermined limits; or c) they satisfy any other criteria which the bank applies to the composition of its trading book on a consistent basis. Each bank should agree a policy statement with the Banking Supervisor about which activities are normally considered trading and constitute part of the trading book. 12 All positions held in the trading book must be marked to market daily, including the recognition of accruing interest, dividends or other benefits as appropriate. (Some positions may be marked-to-market for internal purposes or to meet the requirements of statutory accounts, but nevertheless fail to meet the trading book criteria.) Where a market determined price is not available then the bank may generate its own mark-to-market valuation. Banks with trading books are required to have, and discuss with the Banking Supervisor, a policy statement on the subject of valuing positions, which in particular should address the valuation process for those items where market prices are not readily available. This policy statement should be devised in conjunction with the bank's internal auditors or another qualified independent group and, if necessary, external experts such as external auditors. Having arrived at a valuation mechanism for a single position or group of similar 11

12 positions then the valuation approach must be applied consistently. However, it should be noted that the mark-to-market valuations do not have to meet the requirements for statutory accounts, possibly due to the difference between historic cost accounting and the techniques associated with the mark to market requirement of the. 13 A bank must value its positions on a prudent and consistent basis; the applied policy must reflect the points noted below. a) A bank may mark to market positions using either a close out valuation based on two way prices (a long position shall be valued at its current bid price and a short position at its current offer price) or alternatively using a mid-market price but making a provision for the spread between bid and offer prices for different instruments. The bank must have due regard to the liquidity of the position concerned and any special factors which may adversely affect the closure of the position. b) Where a bank has been permitted to use a risk assessment model in the calculation of its capital requirements for options, it may value its options using the values derived from the model. (See Chapter 9.) c) Where a bank does not use a model and the prices are not published for its options positions, a bank must determine the market value as: i) for purchased options, the mark to market value must be the product of - the in the money amount; and - the quantity underlying the option; ii) for written options, the mark to market value must be the initial premium received for the option plus the product of - the amount by which the current in the money amount exceeds either the in the money amount at the time the contract was written, or zero if the contract was out of the money at the time that it was written; and - the quantity underlying the option. d) A bank must calculate the value of a swap contract, or an FRA, having regard to the net present value of the future cashflows of the contract, using current interest rates relevant to the periods in which the cashflows will arise. In the case of interest rate swaps, currency swaps and FRAs, a bank may apply to the Banking Supervisor to use the valuation under (a) above limited to its net position. (The Banking Supervisor does not consider it appropriate to stipulate a precise formula for calculating the value of swaps and FRAs. However, he will expect a firm to employ a valuation formula which accords with generally accepted market practice.) e) Where a bank is a market maker in the instruments then the valuation should be the bank's own bid or offer price which should reflect the bank's exposure to the market as a whole and its views on future prices. However, where the bank is the sole market maker in a particular instrument it should take care to ensure that the valuation used is prudent in all circumstances. 12

13 f) In the event that a bank is only able to access indicative prices then, having regard to the fact that they are a guide only, such prices may have to be adjusted to some degree in order to arrive at a prudent valuation. g) In the event that the bank is only able to access mid market or single values it should have regard to the fact that these prices will have to be adjusted to some degree in order to arrive at a prudent valuation. h) Where a bank has a long (short) position and a short (or long) position in an exactly offsetting instrument, as in the case of a security and an American Depository Receipt representing the same security, they may both be valued on a mid-market basis subject to the following conditions: i) the strategy should have been entered into as a specific arbitrage opportunity and should have the certainty of a locked-in profit (or loss) representing a worst case outcome; ii) the profit (or loss) must be realisable instantly, subject to a reasonably short conversion period, and at any time. Thus at no time should there be restrictions on the ability to convert; iii) positions which are not part of the arbitrage should be valued at their respective bid or offer prices as appropriate; iv) the underlying positions should be of reasonable liquidity and held in quantities which are not so large that they would affect their marketability; and v) any conversion costs and foreign exchange costs should be provided for at the appropriate time and should be separately monitored over the life of the arbitrage. vi) A bank may apply to the Banking Supervisor to exempt cash items in the trading book from daily marking to market where they have a residual maturity of one month or less. For these purposes, cash items should be taken to include loans and deposits and also the cash legs of repo (stock lending) and reverse repo (stock borrowing) transactions. 14 For a repurchase, or equivalent, transaction to be considered to be part of the trading book the securities being repurchased, lent, or contributing collateral for such a transaction, must be in the trading book, (see Chapter 2 - Counterparty Risk). The treatment of fees and other sources of counterparty risk generated by trading book positions is also covered in that chapter. Hedging Exposures 15 A trading book exposure may be hedged, completely or partially, by an instrument that in its own right is not normally considered to be eligible to be part of the trading book, i.e. instruments other than those listed in paragraph 8 above. Any such trading book position, whether of financial or non-financial instruments, must be subject to the daily mark-to-market discipline, described in paragraph 11 and following. The trading book positions of non-financial instruments will attract both counterparty risk requirements (as may be adjusted for use in the trading book), and general market risk requirements on the mark to market valuation, but not specific risk requirements. 16 Where a financial instrument which would normally qualify as part of the trading book is being used to hedge an exposure in the banking book, it should 13

14 be carved out of the trading book for the period of the hedge, and included in the banking book. 17 In addition general market risk arising from the trading book may hedge positions in the banking book without reference to individual financial instruments. In such circumstances, there must nevertheless be underlying positions in the trading book. The positions in the banking book which are being hedged must remain in the banking book, although the general market risk exposure associated with them should be incorporated within the calculation of general market risk capital requirements for the trading book (i.e. the general market risk element on the banking book side of the hedge should be added to the trading book calculation, rather than that on the trading book side of the hedge be deducted from it). As no individual financial instruments are designated there is no resultant specific risk requirement in the trading book and the risk weighted assets in the banking book will not be reduced. This arrangement for the transfer of risk must be subject to a policy statement agreed with the Banking Supervisor. 18 The allocation or transfer of a final instrument or the transfer of general market risk should be subject to appropriate documentation to ensure that it can be established through audit verification that the item is being treated correctly for the purposes of capital requirements. The documentation should cover, as appropriate: a) The pricing of the transfer, which must be done at arms-length prices; b) Whether the financial instrument or the general market risk elements of a position is hedging a designated banking book exposure; c) Whether the intent (see paragraph 7.a) for having the position in the financial instrument has changed from short term gains to some other rationale; and d) The designated trading book exposure being hedged by the nonfinancial instrument in the trading book. Positions In Instruments Issued By Institutions 19 Institutions are defined in the Capital Adequacy Directive as being credit institutions and investment firms as defined by other directives. a) Credit Institution (First Banking Directive 77/780/EEC - Article 1) A Credit Institution means an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account. b) Investment Firm (Investment Services Directive 93/22/EEC - Article 1) An Investment Firm shall mean any legal or natural person the regular occupation or business of which is the provision of investment services for third parties on a professional basis. An investment service shall mean any of the services listed in Section A of the Annex to the Investment Services Directive relating to any of the instruments listed in Section B of that same Annex that are provided for a third party. 14

15 20 Double gearing of capital in the financial system may occur through the presence in bank portfolios of instruments issued by institutions that contribute to the issuer's capital base - for example, in the case of a Gibraltar bank the instruments that are eligible for inclusion in Tier 1 or 2 capital, (see Chapter 10 - Own Funds). Individual positions in capital raising instruments issued by institutions and positions generated via holdings of, or exposures to, broad based equity indices are to be treated as follows: i) Physical long positions of capital raising instruments (including those issued by the bank itself or by other group companies) will be deducted from a bank's capital base, but only after the recognition of any hedging benefits against other market exposures as might be generated by index arbitrage positions. In other words such holdings can be used to reduce risk elsewhere, but will nevertheless be treated as a deduction from capital. ii) However, in the event that there are no hedging benefits, or only partial hedging benefits, then that position without an offsetting exposure will be deducted from a bank's capital without generating any market related capital requirements. In other words, the total charge on the position can in no circumstances exceed the 100% deduction from capital. Note: A long stock position, even if hedged with a short futures position, will generally generate a capital deduction. However, long futures positions will not generate a capital deduction, whether or not it is hedged as it does not create a physical holding in the capital raising instrument: it may, of course, attract a market risk requirement. Options positions should be treated in the same way as futures; i.e. they do not generate a capital deduction. It should be noted that for firms making markets in these instruments deduction may not be required, although such concessions are subject to limits set out under the Own Funds Directive (89/299/EEC) Article 2.1(12) and (13). 21 Banks may raise funds by the issue of financial instruments, such as CDs or Commercial Paper. Such "short" positions may be considered to be part of the trading book if the instrument meets the trading book definition and other requirements, see paragraph 8. The treatment of these instruments must be applied consistently. (The treatment of capital raising instruments is covered in paragraph 20.) These fund raising financial instruments will only attract capital requirements for general market risk. Exemptions From The Trading Book Requirements 22 A bank may be exempted from the trading book capital requirements if its trading book activity is considered to be minimal. Even if a bank does not have a trading book the capital requirements for foreign exchange exposures are applicable, see Chapter 4 - Foreign Currency Risk. 23 The benchmarks that the Banking Supervisor will use to determine if a bank will be subject to the trading book capital requirements are given below. If in doubt banks should check with the Banking Supervisor to see whether they have to comply with the trading book treatment. The criteria used by the Banking Supervisor to indicate the appropriateness of applying the trading book capital requirements from the Article 4.6 will be: The trading book business of the bank on a solo or consolidated basis does not normally exceed 5% of its combined on- and off-balance sheet positions and its total "trading book" positions do not normally exceed ECU 15 Million. 15

16 Further: The trading book business of the bank on a solo or consolidated basis should never exceed 6% of its combined on- and off-balance sheet positions and its total "trading book" positions should never exceed ECU 20 Million. Where a banking group is above the threshold at a consolidated level, but has subsidiaries below the threshold it may apply to the Banking Supervisor to exclude such subsidiaries from the Capital Adequacy Directive regime. In order to calculate the proportion that trading book business bears in relation to total business the Banking Supervisor will refer to the size of the combined on- and off- balance sheet business. For these purposes debt instruments shall be valued at their market prices or principal values and equities at their market prices. Where a derivative is based on an underlying security, it will be valued according to the market value of that security. Otherwise the notional principal amount underlying the derivative should be used. Underwriting positions (which should always be included in the trading book) will be valued according to the full market value of the underlying securities. Long and short positions will be summed regardless of their signs. Forward foreign exchange contracts should (for these purposes only) be treated as if they were banking book business, although foreign exchange futures and options unless heeding the banking book are to be treated as trading book items. 24 In the event that a bank subject to an exemption from the trading book requirements exceeds the trading book benchmark it must discuss the situation with the Banking Supervisor as soon as possible. Unless the breach is regarded by the Banking Supervisor as being likely to exist for a short period, the bank will in such circumstances be required to comply with the trading book capital requirements. 16

17 Chapter 2 - Counterparty Risk Explanation 1 Licensees are required to allocate positions, securities, derivatives, assets and liabilities either to the trading book or the banking book. The basis of this allocation is described in Chapter 1 - The Trading Book. There is one change that applies to banking book assets: the treatment of unsettled transactions is amended to bring it into line with the trading book treatment. With these exceptions, the counterparty weights to be used for claims in the banking book are unchanged and remain as stated in Administrative Notice No.1. These same (amended) weights will also apply when there is counterparty risk in the trading book, although in this case the weighted amount is converted directly into a capital charge (called a haircut). 2 In general, counterparty risk will only be present in the trading book on deals that are not finally settled (i.e. including OTC derivative contracts), and this will be incurred with respect to the trading counterparty rather than the issuer of the security. (Issuer risk on securities in the trading book is captured by the specific risk requirements set out in Chapters 5 and 6.) 3 The current Administrative Notices governing counterparty risk are: Admin Notice No.1 Solvency Ratio Directive; Admin Notice No.6 Netting Directive. 4 This chapter covers the following parts of the Capital Adequacy Directive: Article 2 paragraphs 6, 9, 10 Annex II Scope Banking Book 5 The counterparty risk weights to be used by banks in calculating their banking book capital requirements are those laid down in the Banking Supervisor s Administrative Notice on the implementation of the Solvency Ratio Directive in Gibraltar. The treatment of unsettled transactions is being amended to bring the treatment in the banking book into line with that being introduced in the trading book. Trading Book 6 This chapter also covers counterparty exposures arising from positions reported in the trading book. In general capital must be assigned to counterparty risk on any trade that is not yet due for final settlement (e.g. OTC derivative exposures, margins and fees payable), and on trades where settlement is actually overdue. By comparison, a bank owning a security is exposed to specific risk - this is covered in chapters 5 and 6. The following examples illustrate the type of situation in which counterparty risk attracts capital in the trading book from Bank B s perspective and also how counterparty risk differs from specific risk: i) Bank A sells shares issued by Company C to Bank B, which places them in its trading book. Once the transaction has settled, Bank B has specific risk on Company C and no counterparty risk on Bank A. ii) The above example is repeated, but Bank A fails to settle on time. After 5 days, Bank B is required to hold capital (for counterparty risk) against Bank A in addition to specific risk on Company C, as if the 17

18 iii) iv) price moves in Bank B's favour, its profit can only be realised once Bank A has delivered the instruments it has failed to deliver to Bank B on time. Bank A enters into a forward contract to sell shares in Company C to Bank B. Bank B acquires specific risk on Company C, but also acquires counterparty risk on Bank A, as there is a risk that Bank A does not perform on its side of the transaction at the future delivery date. Bank A enters into a simple interest rate swap with Bank B. As there is no underlying instrument, there is no specific risk, but Bank B acquires counterparty risk on Bank A for the duration of the swap. Policy Applicable To Both Banking And Trading Books Counterparty Weights Investment Firms 7 Claims on investment firms, but not their unregulated affiliates, that are subject to the or a regulatory regime that is considered to be at least as stringent as the should be weighted at 20%. Regulatory regimes that meet this standard are listed in Chapter 12 - Lists. 8 Claims which are directly, explicitly, unconditionally, and irrevocably guaranteed by investment firms falling under the above paragraph will attract the weighting given to a direct non-tradable security claim on the guarantor. Indirect guarantees are not recognised for the purpose of reduced risk weights. 9 Exposures to discount houses, gilt-edged market makers, those Stock Exchange Money Brokers which operate in the gilt-edged market and any other institutions with a money-market dealing relationship with the Bank of England are weighted at 20%. However, where the counterparty exposures to these firms are secured on UK Treasury Bills, eligible local authority and eligible bank bills, gilt edged stocks or London CDs they are weighted at 10%. Recognised Clearing Houses and Exchanges 10 Claims on recognised clearing houses and exchanges are weighted at 20%. Such claims should include initial cash margins and surplus variation margin at futures exchanges or clearing houses. Recognised clearing houses and exchanges which qualify for this weighting are listed in Chapter 12 - Lists. 11 Claims which are directly, explicitly, unconditionally, and irrevocably guaranteed by those recognised clearing houses and exchanges falling under the above paragraph will attract the weighting given to a direct non-tradable security claim on the guarantor. Indirect guarantees are not recognised for the purpose of reduced risk weights. Netting Of Off-Balance Sheet Instruments 12 Further work on netting of swaps and similar products is taking place in the EU. Once this work has been completed the Banking Supervisor will issue further guidance on this question Settlement/Delivery Risk Unsettled transactions 13 In principle, banks systems should be set up in such a manner that, where a deal attracts a counterparty risk charge, this charge continues to apply when 18

19 settlements is due but has not actually been completed. Banks are expected to move towards this for all transactions. 13a Whether or not a transaction involving the delivery of an instrument against receipt of cash attracts a counterparty risk charge during its life, a capital charge applies in cases of unsettled transactions and free deliveries as defined below. 13b For transactions where delivery of the instrument takes place against receipt of cash, but which remain unsettled five business days after their due settlement date, the difference between the amount due and the current market value of the instrument, which could involve a loss for the bank, will be considered to be a claim on the counterparty. The capital requirement will be this potential loss multiplied b the factor in Column 1 of the table below. 14 With the explicit approval of the Banking Supervisor a bank may calculate the capital requirement for the counterparty risk on trading book transactions which are past their due date using Column 2 of the table below. The capital requirement will be the agreed settlement price multiplied by the factor in Column 2 below. Unless a bank accounts for such positions in this way in its own accounts and management information, the Banking Supervisor would expect the approach in Paragraph 13 above to be adopted. Number of Working Days after due Settlement Date Column 1 Column Nil Nil % 0.5% % 4.0% % 9.0% 46 or more 100% 100% of Potential Loss (as per Column 1) Free Deliveries 15 If a transaction in a tradable security or commodity involves the delivery of the securities (cash), but the cash (securities) is not received at the same time, this is termed a "free delivery". When the securities (cash) have been delivered this will be considered to be a claim on the counterparty equivalent to the current market value of the tradable security for the provider of the cash or the cash for the provider of the securities, whichever is outstanding. The resultant capital requirement in the Trading Book is the counterparty claim multiplied the counterparty risk weight by 8%. In the Banking Book the risk weighted amount is the counterparty claim multiplied by the counterparty risk weight. 16 If settlement of the transaction is effected across a national border, the capital requirement will only be triggered one business day after the securities (cash) have been delivered without the cash (securities) being received in return. Foreign exchange transactions 16a Implementation of the Capital Adequacy Directive does not require introduction of capital charges in respect of settlement/delivery risk on spot and forward foreign exchange transactions. 19

20 Policy Applying Just To The Banking Book Repos/Reverse Repos 17 Repos and reverse repos in the Banking Book will be treated as in Administrative Notice No.1. Policy Applying Just To The Trading Book Counterparty Risk On OTC Derivatives 18 As all trading book exposures must be marked to market, all banks are expected to adopt the replacement cost method (as opposed to the original exposure method) for calculating the credit exposure on OTC derivative contracts in the trading book (for details of this method see Administrative Notice No.1). Counterparty Risk On Forward Transactions 19 This section covers all forward sales and purchases of financial instruments (i.e. excluding foreign exchange forwards) or commodities, where these are defined as transactions that settle on a date beyond the market norm for that instrument. This includes the forward leg of repo/reverse repo (or stockborrowing/stock-lending or sell-buy/buy-sell) where such an arrangement fails to meet the documentation and margining requirements specified in paragraph 27 below. However, tradable securities which meet the conditions for new issues (see Chapter 8 - Underwriting) are excluded. 20 In the trading book, forward transactions are deemed to give rise to counterparty exposure. Furthermore the measure used takes account of both the current replacement cost of the contract, and its potential value. The latter is incorporated through use of risk cushion factors (RCF) which reflect the likely volatility of security prices. These are set out in Annex I to this Chapter. 21 It is important to note that, in addition to the counterparty risk requirements set out in this Chapter, transactions covered by this section attract capital charges for market risk (see Chapter 5 - Interest Rate Position Risk and Chapter 6 - Equity Position Risk). 22 Where the bank is receiving securities or commodities in exchange for cash (or collateral), the counterparty risk requirement will be: {replacement cost of forward + potential future credit exposure} x counterparty risk weight x 8% where replacement cost = higher of zero and the difference between market value of securities to be received and contracted value for forward delivery (in the case of forward purchases) or market value of collateral (in the case of repos); potential future credit exposure = the risk cushion factor applicable to the securities (or collateral if it is higher) multiplied by the contracted value for forward delivery; 23 Where the bank is receiving cash (or collateral) in exchange for securities, the counterparty risk requirement will be: {replacement cost of forward + potential future credit exposure} x counterparty risk weight x 8% 20

21 where replacement cost = higher of zero and the difference between the contracted value for forward delivery (in the case of forward sales) or market value of collateral (in the case of reverse repos) and the market value of the securities to be delivered; potential future credit exposure = the risk cushion factor applicable to the securities (or collateral if it is higher) multiplied by the contracted value for forward delivery; Note: Counterparty risk weights are those applying to OTC derivative exposures 24 Securities or commodities, and if appropriate collateral, must be marked-tomarket at least once a day. The amounts to be received or given need to include all cashflows related to the securities and the transactions - manufactured dividends, interest, fees. Thus the amount to be received would include payments which the counterparty should have made to the bank but which have not yet been received, and the amount to be given would include payments which should have been made to the counterparty but which have not yet been paid. Receivables need not be included on the day when they are due, but they must be included if not received the following business day. 25 Collateral received may be in the form of a guarantee, letter of credit, or similar instrument provided by a Zone A bank, but only if that bank would not be considered to be a connected lender if it was making a loan to the recipient of the securities. In the event that the guarantor is not a Zone A bank or is a connected bank, the capital requirement for the securities lender will be:- Market Value of Securities lent x Counterparty Risk Weight x 8% 26 Forward transactions also occur in situations where compensation is due to be paid in the future in exchange for a contract. Option premia to be paid on contingent premia options (i.e. where the option writer receives the premium upon exercise of the option) are an example of this type of deferred settlement. In such cases, the counterparty risk requirement will be: Current market value of the payment due x counterparty risk weight x 8% Counterparty Risk On Documented Repos/Reverse Repos 27 This section covers all arrangements where i) a bank has sold/bought (or lent/borrowed) trading book securities to/from a counterparty subject to buy back (or a return clause), and ii) the documentation (which, whether a master agreement or documentation used on specific occasions, should be written and legally enforceable) provides for the claims of the bank to be automatically and immediately set off against the claims of the counterparty in the event of the latter s default, and the Banking Supervisor has the right to call for variation margin daily when there is a material adverse market move against it. As long as arrangements meet these requirements, the capital charge for counterparty risk may be calculated in the manner set out below regardless of the terminology used - i.e. the arrangements may be called repo/reverse repo or stock-lending/stock-borrowing or sell-buy/buy-sell. Arrangements where the bank has lent a third party's securities at its own risk are also included. 28 It is important to note that, in addition to the counterparty risk requirements set out in this Chapter, transactions covered by this section attract capital 21

22 charges for market risk (see Chapter 5 - Interest Rate Position Risk and Chapter 6 - Equity Position Risk). 29 For repos, the capital charge for counterparty risk will be the higher of zero and: {Market value of securities sold or lent - Market value of collateral taken} x counterparty risk weight x 8% 30 For reverse repos, the capital charge for counterparty risk will be the higher of zero and: {Market value of collateral given - Market value of securities bought or borrowed} x counterparty risk weight x 8% 31 If it seems to the Banking Supervisor that the nature of a bank's repo/reverse repo business is such that the risks are significant (e.g. in terms of the volume or nature of activity), the Banking Supervisor may insist that all such transactions are treated as forwards (in the manner set out in paragraphs above). 32 Where there is a series of transactions with a single counterparty, the counterparty risk requirement may be calculated on a portfolio basis as long as banks first comply with the requirements of the Administrative Notice No.6 on netting of counterparty risk. (For an example, see Annex II.) 33 Securities or commodities, and if appropriate collateral, must be marked-tomarket at least once a day. The amounts to be received or given need to include all cashflows related to the securities and the transactions - manufactured dividends, interest, fees. Thus the amount to be received would include payments which the counterparty should have made to the bank but which have not yet been received, and the amount to be given would include payments which should have been made to the counterparty but which have not yet been paid. Receivables need not be included on the day when they are due, but they must be included if not received the following business day. 34 Collateral received may be in the form of a guarantee, letter of credit, or similar instrument provided by a Zone A bank, but only if that bank would not be considered to be a connected lender if it was making a loan to the recipient of the securities. In the event that the guarantor is not a Zone A bank or is a connected bank, the capital requirement for the securities lender will be:- Market Value of Securities lent x Counterparty Risk Weight x 8% Collateralising Counterparty Exposures 35 Collateral that may reduce the risk weight applicable to a counterparty exposure is as defined in Administrative Notice No The counterparty risk weight applicable to collateralised exposures in the trading book will (in the case of collateral in the form of securities) equal the specific risk weight applicable to the collateral instrument. However, the collateral must be marked to market daily and an add-on (equal to the market value of the collateral multiplied by the relevant risk cushion factor) deducted. The risk cushion factors are set out in Annex I. 36a Where a counterparty exposure arises in the trading book and is not otherwise covered in paragraphs or above, the capital charge will be calculated in accordance with Admin Notice No.1 ( implementation in Gibraltar of the Solvency Ratio Directive ). 22

23 Annex I: Notes: Risk Cushion Factors The table below gives risk cushion factors. They are derived from the matrix of add-ons used to calculate the capital requirements for potential future exposures on off-balance sheet contracts. In determining the size of the risk cushion factor, reference is made to the maturity of the securities and of the collateral, rather than to the maturity of the transaction. Interest rate products residual maturity less than one year 0.25% to five years 0.50% five years or over 1.50% Equities 6.00% Where one side of a transaction is denominated in a currency other than that of the other side, and circumstances are such that a risk cushion factor applies, the risk cushion factors are each increased by 1%. a) Where the collateral is in the form of Short Term Talisman Certificates (STCs) then they will have a risk cushion factor equivalent to equities. b) Where the collateral is provided in the form of cash, a guarantee, a letter of credit, or an instrument performing a similar function issued by a Zone A bank, a risk cushion factor of 0% applies. 23

24 Annex II: Example Calculations For Repos/Reverse Repos In The Trading Book Case 1: Properly documented transaction A lends 100 cash to B, and receives a 5 year bond (current mark to market value: 102) from B; A and B each have 20% counterparty risk weight. Counterparty Risk Requirement A = max { 0, { } x 20% x 8% } = Nil B = max { 0, { } x 20% x 8% } = Case 2: Properly documented transactions calculated on portfolio basis A lends 5 year bonds (current mark-to-market value: 100) and US equities (current mark-to-market value: 100) to B, and receives UK equities (current mark-to-market value: 97) and 2 year bonds (current mark-to-market value: 105) from B; A and B each have 20% counterparty risk weight; Counterparty Risk Requirement A Securities & Collateral paid away = Securities & Collateral received = Received > Paid Away Therefore, no counterparty risk requirement applies B Securities & Collateral paid away = Securities & Collateral received = Received < Paid Away A counterparty risk requirement therefore applies = ( ) x 20% x 8% = Case 3: Inadequate documentation (or business of a type or volume which leads the Banking Supervisor to insist on this treatment even for documented transactions) 24

25 A lends a 5 year bond (current mark to market value: 102) to B, and receives 100 cash from B; A and B each have 20% counterparty risk weight. Risk Cushion Factors for bond = 1.5% for cash = 0% Contracted value for forward delivery 100 Counterparty Risk Requirement A Replacement cost: max{ 0, ( )} Potential future exposure 100 x 1.5% Capital charge = { } x 20% x 8% = B Replacement cost: max{ 0, ( )} Potential future exposure 100 x 1.5% Capital charge = 1.50 x 20% x 8% = Case 4: As Case 3 except collateral and securities in differing currencies A lends a 5 year US government bond (current mark to market value: 102) to B, and receives 100 cash from B; A and B each have 20% counterparty risk weight. Risk Cushion Factors for bond = 2.5% for cash = 1.0% Contracted value for forward delivery 100 Counterparty Risk Requirement A Replacement cost: max{ 0, ( )} Potential future exposure 100 x 2.5% Capital charge = { } x 20% x 8% = B Replacement cost: max{ 0, ( )} Potential future exposure 100 x 2.5% Capital charge = 2.50 x 20% x 8% =

26 Chapter 3 - Large Exposures Explanation 1 Banks are required to adopt the necessary measures to comply with the Large Exposures Directive in both the banking and trading books and the treatment of Large Exposures under the Capital Adequacy Directive in the trading book. The requirements in this chapter apply to the banking and trading books on a consolidated and unconsolidated (solo) level. The limits and reporting requirements apply at a consolidated level and where institutions are supervised solely on an unconsolidated/solo consolidated level the requirements in this chapter will be applied at that level. For details on consolidation aspects see Chapter 11 - Consolidation. 2 A large exposure is defined as an exposure to a counterparty or group of closely related counterparties which is greater than or equal to 10% of capital base. The large exposure limit for a counterparty or group of closely related counterparties is set at 25% of capital base (see paragraph 31). In the case of traded securities, these limits in relation to capital may be exceeded, but if so, an additional capital requirement (see paragraph 60) is incurred. 3 This chapter details the way in which banks must monitor their Large Exposures, the reporting requirements associated with these exposures and the application of increased capital requirements in some circumstances when Large Exposure limits are breached. 4 The current Administrative Notices governing Large Exposures is Administrative Notice No.3 Implementation in Gibraltar of the Directive on the Monitoring and control of Large Exposures of Credit Institutions. 5 This chapter covers the following sections of the Capital Adequacy Directive: Article 5, annex VI Scope 6 The Banking Supervisor will apply his policy for the monitoring and control of large exposures at both the consolidated and unconsolidated (solo) level, unless there is a specific statement made to the contrary, and throughout this chapter the requirements which apply to 'banks' should be understood to apply also to consolidated 'banking groups' and vice versa. The limits and reporting requirements of the Large Exposures Directive apply at a consolidated level on an unconsolidated (solo) basis (see Annex). However, for banks which are supervised solely on an unconsolidated/solo-consolidated basis then the requirements of this chapter apply at that level. 7 In assessing a bank's exposures on a consolidated basis the companies to be consolidated with the bank (which may include sister companies and holding companies, as well as subsidiaries) will be agreed by the Banking Supervisor in accordance with the principles set out in the chapter on consolidated supervision. Where these principles determine that a sub group of a banking group should be separately assessed (including a requirement for separate consolidated returns to be provided) a bank's large exposures will also be assessed on that basis. 26

27 Policy Statements 8 The Banking Supervisor requires each bank to set out its policy on large exposures, including exposures to individual customers, banks, countries and economic sectors, in a policy statement. In the case of Gibraltar incorporated banks, this policy should be formally adopted by the bank's board of directors. The Banking Supervisor expects banks not to implement significant changes in these policies without prior discussion with the bank. Significant departures from a bank's stated policy, in particular those involving breaches of agreed levels, will lead the Banking Supervisor to consider whether the bank continues to meet the statutory minimum criteria for authorisation. 9 Each bank will be expected to justify to the Banking Supervisor its policy on exposures to individual counterparties, including the maximum size of an exposure contemplated. Relevant factors which the Banking Supervisor will expect a bank to have taken into account when setting its policy and considering the acceptability of particular exposures include, for example, the standing of the counterparty, the nature of the bank's relationship with the counterparty, the nature and extent of security taken against the exposure, the maturity of the exposure, and the bank's expertise in the particular type of transaction. Exposures to counterparties connected with the bank for example, subsidiaries or sister companies or companies with common directors will continue to be particularly closely examined. (Exposures to counterparties connected to the reporting bank are considered in paragraphs 25, 32 and 47 below.) 10 The necessary control systems to give effect to a bank's policy on large exposures must be clearly specified and monitored by its board. Banks will be required to detail how they intend to monitor the size of capital base to ensure that the limits detailed in this notice are not exceeded. Banks will also have to show that in the special circumstances where they exceed the limits and incremental capital is required that they have sufficient capital to cover the incremental charge. Measurement Of Exposure 11 The measure of exposure should reflect the maximum loss should a counterparty fail or the loss that may be experienced due to the realisation of assets or off-balance sheet positions. Consistent with this, an exposure encompasses the amount at risk arising from the reporting bank's: i) Claims on a counterparty including actual claims, and potential claims which would arise from the drawing down in full of undrawn advised facilities (whether revocable or irrevocable, conditional or unconditional) which the bank has committed itself to provide, and claims which the bank has committed itself to purchase or underwrite; and ii) Contingent liabilities arising in the normal course of business, and those contingent liabilities which would arise from the drawing down in full of undrawn advised facilities (whether revocable or irrevocable, conditional or unconditional) which the bank has committed itself to provide; and iii) Assets, and assets which the bank has committed itself to purchase or underwrite, whose value depends wholly or mainly on a counterparty performing his obligations, or whose value otherwise depends on that counterparty's financial soundness but which do not represent a claim on the counterparty. 27

28 12 In reporting large exposures for on-balance sheet positions credit balances should not be offset against debit balances. However, debit balances on accounts may be offset against credit balances on other accounts with the bank where all the following criteria have been met: a) A legal right of set-off exists, and the reporting institution has obtained an opinion from its legal advisers to the effect that its right to apply set off is legally well-founded in all of the relevant jurisdictions and would be enforceable in the default, liquidation or bankruptcy of the customer(s) or in the liquidation of the institution itself. For a group facility the arrangement must be supported by a full cross guarantee structure. b) The debit and credit balances relate to the same customer, or to customers in the same company group, e.g. a parent company and its subsidiary. For all customers, the netted accounts should be managed and controlled on a net basis, and in the case of a group facility, the facility should be advised in the form of a net amount. The bank s application of these principles must remain consistent. 13 Large exposures are calculated using the sum of the nominal amounts before the application of risk weightings and credit conversion factors for the following categories: a) Off [not on-] balance sheet claims whether in the trading or banking books; b) Guarantees and other contingent claims in the banking book; c) Potential claims and liabilities in the case of undrawn facilities in the banking book. (For note issuance facilities, etc in the trading book see paragraph 14 (b) below.) Issuer Risk on Securities 14 Issuer risk on securities should be calculated as follows: a) For the banking book, the exposure is calculated as the excess, where positive, of the current market value of all long positions over all short positions for each instrument issued by the counterparty. For the trading book, the position in each instrument issued by the counterparty is first calculated. The exposure is then calculated as the excess, where positive, of the current market value of all long positions over all short positions in all the financial instruments issued by the counterparty. (When netting long positions against short positions in different instruments, the short positions should be netted against the long positions in instruments with the highest specific risk charges.) b) Contingent liabilities in the trading book which arise from a commitment by a bank to an issuer under a note issuance facility to purchase at the request of the issuer securities which are unsold on the issue date are to be added to the long position in paragraph (a) above. Note issuance facilities include revolving underwriting facilities, euronote facilities and similar such arrangements. c) Commitments to buy securities at a future date should be included in the calculation of exposure to the issuer of the security. Forward sales should be regarded as short positions in the relevant security; 28

29 d) Options positions should be included in the calculation of issuer risk on the following basis: written puts should be included as a long position, purchased puts as a short position in the underlying security (in both cases using the notional principal valued at the strike price). Other options (written and purchased calls) should not be included in the calculation of issuer risk; e) Positions should not be netted between the banking book and trading book (unless the conditions in Chapter 1 for hedges between books are met). Counterparty Risk on Derivatives 15 The counterparty risk arising from interest rate contracts (including interest rate swaps, forward rate agreements and interest rate options purchased), foreign exchange contracts (including cross currency swaps, forward foreign exchange contracts and foreign exchange options purchased) and other derivative contracts such as those based on commodities and equities is not taken to be the nominal amount of a contract but rather a credit equivalent amount. For the banking book, the method for calculating the credit equivalent amount is the replacement cost or original exposure methods which are used in generating the counterparty risk requirement. For the trading book the replacement cost method must be used (see Chapter 2 Counterparty Risk). 16 The Banking Supervisor will allow limited use of a concessionary treatment for derivative products only (i.e. items covered by paragraph 15 above). Counterparty exposures to banks and building societies in these products, with a residual maturity of more than one, but not more than three years, may be scaled down by the application of a 20% weighting (i.e. a discount of 80%) before inclusion in the measure of exposure. This provision will be extended to include counterparty exposures to investment firms that are subject to the, or are subject to a regime that the Banking Supervisor deems to be equivalent to the, (see Chapter 12 - Lists for a list of recognised regimes). Repos and Reverse Repos 17 For repos in the banking book, banks should continue to report the issuer risk on the security for the period of the transaction. No exposure is reportable for reverse repos (either issuer risk or counterparty risk, although where business is significant line supervisors may decide to apply risk concentration limits). 18 For both repos and reverse repos in the trading book, issuer risk should be reported on the bank s asset in the transaction (in a repo the security sold, in a reverse repo the collateral provided, if a security). In addition, counterparty exposure should be reported on both repos and reverse repos (exposures are calculated using the rules set out in Chapter 2 before application of the counterparty weights). Exclusions 19 The following items will not be included in the measurement of exposure: i) Items deducted from capital base (both for the calculation of capital ratios and for large exposures purposes); ii) Claims arising in the course of settlement of a foreign exchange transaction where the reporting institution has settled its side of the transaction but has not yet received the countervalue, for a period of up to two working days after payment was made. After this period such claims will constitute an exposure; 29

30 iii) Claims arising in the course of settlement of a securities transaction where neither the reporting institution nor the counterparty have settled their side of the transaction, for a period of five working days after settlement was due. After this period, such claims will constitute an exposure, the size of which should be calculated in accordance with Chapter 2 (paragraphs 13-14) but without multiplication by a scaling factor. However, claims arising in the course of settlement of a securities transaction where the reporting institution has settled its side of the transaction but not received the countervalue will count as an immediate exposure (but with a one working day window where the transaction is effected across a national border). In this case, the size of the exposure should be calculated in accordance with Chapter 2 (paragraphs 15-16) but without either application of a counterparty risk weighting or multiplication by 8%. 20 The measure of large exposure does not take account of all exposures arising in the course of settlement. However, the control of such exposures needs to be carefully considered by banks since inadequate controls could be a cause of substantial loss for a bank. Banks should therefore pay particular attention as to how they control such risks. Underwriting 21 For positions that are acquired as part of an underwriting process the measure of exposure shall be calculated from the time of initial commitment. From the date of initial commitment to Working Day 0, the measure of exposure shall be based upon the gross commitment, unless an institution has been granted the status of an expert underwriter, in which case the measurement of exposure shall be based upon the credit equivalent amount. At this stage (i.e. prior to Working Day 0) there is a notification requirement, but no specific risk capital requirement apart from the scaled factor of 10% applied to equity underwriting commitments (see Chapter 8 - Underwriting). From Working Day 0 onwards the measurement of a large exposure for notification purposes is as set out in paragraph 22 below. 22 Positions in securities that are acquired as part of an underwriting process and are part of the trading book will contribute to the large exposure for the issuer commencing Working Day 0 (as defined in Chapter 8 Underwriting). The exposure is based upon the net underwriting position which may be further reduced to form the net position exposure by the application of the following discount factors: Working Day 0 100% Working Day 1 90% Working Day 2 75% Working Day 3 75% Working Day 4 50% Working Day 5 25% after Working Day 5 0% Net Underwriting Position = Gross Underwriting Commitment + Purchases - Sales Sub Underwriting 30

31 Net Exposure = Net Underwriting Position * (100% - Discount Factor) The net exposure, being the net underwriting position adjusted for the discount factors, is then aggregated with other securities exposures for the same issuer generated in the trading book, paragraph 14(a). Although the threshold for incremental capital and related calculations (see paragraph 62) apply to these securities from Working Day 0 the bank must have systems to enable it to monitor the gross exposure, which is subject to the notification requirements (see paragraph 35), from the acquisition of the initial commitment. Identity Of Counterparty 23 The identity of a counterparty will generally be the borrower (customer), the person guaranteed, the issuer of a security in the case of a security held or the party with whom a contract was made in the case of a derivatives contract. Where a third party has provided an explicit unconditional irrevocable guarantee, banks may however be permitted to report the exposure as being to the guarantor. As a condition for allowing banks to report exposures in this way, the Banking Supervisor will require banks to include a section on guaranteed exposures in their large exposures policy statement. In particular the Banking Supervisor would expect a consistent approach to be adopted in the reporting of such exposures. The Banking Supervisor does not expect banks to report exposures to guarantors unless the banks have first approved the credit risk on the guarantor and the type of the exposure under the bank's normal credit approval procedures. 24 An individual counterparty comprises natural and legal persons and includes individual trusts, corporations, unincorporated business (whether as sole traders or partnerships) and non-profit making bodies. 25 A group of closely related counterparties exists where: i) Unless it can be shown otherwise, two or more individual counterparties constitute a single risk because one of them has, directly or indirectly, control over the other or others; or ii) Individual counterparties are connected in such a way that the financial soundness of any of them may affect the financial soundness of the other or others or the same factors may affect the financial soundness of both or all of them. In such cases the exposure to these individual counterparties should be aggregated and considered as a single exposure to a group of closely related counterparties. 26 Where there is doubt in a particular case whether a number of individual counterparties constitute a group of closely related counterparties or where, notwithstanding that the relationship between a number of counterparties identified in the reporting instructions exist, the counterparties do not share a common risk, the circumstances should be discussed with the Banking Supervisor to determine how the exposure(s) should be reported. 27 Parties connected to the reporting bank comprise: i) Group undertakings (including subsidiaries) as defined by section 5 of the Banking Ordinance and related companies as defined by section 2 of the Banking Ordinance; 31

32 ii) Associated companies as defined by the Statement of Standard Accounting Practice 1; iii) Directors, controllers and their associates as defined in the Banking Ordinance 1992; iv) Non-group companies with which the reporting bank's directors and controllers are associated. A director (including an alternate director) and controller of the reporting bank is deemed to be associated with another company, whether registered or domiciled in Gibraltar or overseas, if he holds the office of a director (or alternate director) with that company (whether in his own right, or as a result of a loan granted by, or financial interest taken by, the reporting bank to, or in, that company, or even by virtue of a professional interest unconnected with the reporting bank), or if he and/or his associates, as defined above, together hold 10% or more of the equity share capital of that company. For the purposes of the large exposures policy, an employee of the lending bank who is not a director but who is appointed by the lending bank to be a director of another company is also treated as a director of the lending bank. 28 For exposures to connected counterparties other than parent, subsidiary or sister companies, where the lending bank is able to demonstrate to the Banking Supervisor's satisfaction that, notwithstanding that a connection with a counterparty exists, the bank's relationship with that counterparty is at arm's length, its exposure to that counterparty will not be considered as an exposure to a counterparty connected to the lending bank. Limits For Large Exposures 29 There will be absolute limits on the size of exposures that may be undertaken by banks that generate counterparty risk requirements in either the banking book or the trading book, although certain exposures are exempt from these limits (see paragraph 40). The limits are of two sorts: an overall limit on the aggregate of large exposures and limits on the size of exposures to individuals or connected groups of counterparty. The Banking Supervisor may in exceptional circumstances agree to a waiver of any or all of these limits at the unconsolidated, solo-consolidated or consolidated sub-group level for institutions subject to further consolidated supervision by the Banking Supervisor. Risk exposures arising from traded securities (i.e. non-counterparty risk) in excess of this limit may occur in the trading book and exposures in excess of this trigger point (see paragraph 62) will generate incremental capital requirements. Aggregate Limit on Large Exposures 30 A banking group may not incur exposures which exceed 10% of capital base, to individual counterparties or groups of closely related counterparties, the aggregate of which exceeds 800% of the group's consolidated capital base and this applies whether the exposures arise in the banking or trading books. Banks supervised solely on an unconsolidated basis (and not part of a wider Gibraltar banking group) may also not incur aggregate large exposures which exceed 800% of capital base. Separate limits apply to exposures arising from traded securities in the trading book, see paragraph 63. Single Exposure Limit 31 In general, a banking group may not incur a non-exempt exposure to an individual counterparty which exceeds the 25% large exposure limit of the group's consolidated capital base, except where this limit is breached due only to holdings of securities in the trading book or, if specific supervisory consent 32

33 has been given, where the exposures relate to short-term counterparty exposures in the trading book of a subsidiary. This latter concession will not be given to banks at the unconsolidated (solo) level, as it is designed to accommodate the large exposure regimes of other supervisors. If the excesses breach the trigger point then an incremental capital requirement will be generated. Limits on Exposures to Connected Counterparties 32 Exposures to companies or persons connected with the lending bank, its managers, directors or controllers require special care to ensure a proper objective credit assessment is undertaken. Such exposures may be justified only when undertaken for the clear commercial advantage of the lending bank, and when they are negotiated and agreed on an arm's length basis. 33 A bank or banking group's non-exempt exposures to all connected entities outside the scope of consolidated returns, when taken together, may not exceed 25% of capital base. 34 The Banking Supervisor will examine particularly closely all exposures to companies or persons connected to a lending bank and will deduct them from the bank's capital base if they are of the nature of a capital investment or are made on particularly concessionary terms. Notification Of Exposures Pre-notification of Exposures Exceeding 25% of Capital Base 35 There are very limited circumstances in which a bank or banking group may enter into exposures which exceed 25% of capital. These include exempt exposures (see below for definition), exposures due to securities in the trading book (including underwriting exposures) and exposures at solo, soloconsolidated or consolidated sub-group level where the Banking Supervisor has agreed to waive the 25% limit. When a bank or banking group proposes to enter into an exposure, including exempt exposures and exposures due to securities in the trading book, which either alone or together with other existing exposures to the same counterparty exceeds 25% of capital, the fact must be notified to the Banking Supervisor before the bank become committed to the exposure. Pre-notification may take the form of notifying counterparty limits to the Banking Supervisor. Where limits have been pre-notified and the Banking Supervisor has agreed to the limits proposed, exposures which do not exceed these limits need not be further pre-notified to the Banking Supervisor. 36 Exposures to overseas countries, and economic sectors, which exceed 25% of the bank's capital are also not covered by the pre notification requirements. However, where a proposed transaction will result in an exposure which represents a significant departure from the bank's statement of policy on its large exposures agreed with the Banking Supervisor (see paragraph 8), the Banking Supervisor will expect the proposed transaction to be pre-notified to and discussed with it. Post-notification of exposures 37 Gibraltar incorporated banks and banking groups are required to report all large exposures on a quarterly basis. The more an individual exposure exceeds 10% the more rigorous the Banking Supervisor will be in requiring a bank's management to justify that exposure. In any case banks are expected to adopt policies which will not lead to 10% being exceeded as a matter of course. Although 10% of capital base is the minimum cut-off level that will be applied 33

34 for reporting purposes, for some banks the Banking Supervisor will determine it prudent to set a lower percentage. 38 Should any bank find that for reasons outside its control or otherwise (e.g. two counterparties merging to form a single counterparty) it has an exposure to an individual counterparty (other than an exempt exposure) which results in it exceeding any of the limits described above this should be reported immediately to the Banking Supervisor. The Banking Supervisor will discuss the circumstances of any such exposures to determine the appropriate means and time-frame for the bank to comply with the limits. 39 It may be impractical for some banks to introduce monitoring systems which would enable them to calculate precisely their exposure (in accordance with the definition of an exposure set out in this notice) to individual counterparties at all times. Such banks, which will usually have an extensive branch network or group structure, will typically have adopted a system of internal limits which are allocated to individual branches or group companies but which ensure that the overall exposure to a counterparty is controlled. For such banks the Banking Supervisor may agree that, for the purpose of post-notification, the maximum exposure to a counterparty occurring during a reporting period is not required to be reported; but they will be required to report their actual exposure at the reporting date and the control limit for that counterparty if either exceeds 10% of their capital base. The bank must have satisfied the Banking Supervisor that it can control the size of its exposures through the adoption and allocation of counterparty limits. The Banking Supervisor will need to be satisfied that the bank's control systems are such that its exposure to a counterparty may reliably be taken as being no higher than its adopted limit for that counterparty. Exempt Exposures 40 Certain types of exposure are exempt from the limits set above but the Banking Supervisor's requirements regarding pre- and post-notification as set out in paragraph continue to apply to these exposures. The exemptions fall into the following categories: - exposures of one year or less to banks, investment firms subject to the or an analogous regime, recognised exchanges and clearing houses; - exposures to, or guaranteed by, Zone A central governments and central banks (and limited exposures to Zone B central governments and central banks); - exposures secured on cash held by the lending bank or Zone A central government or central bank securities; - certain connected exposures, in particular those arising from a group Treasury function; and - exposures which are covered by a parental guarantee. These exemptions are made because of the particular nature of the exposures concerned. Exposures to Banks, Investment Firms, Recognised Exchanges and Clearing Houses 41 The Banking Supervisor will review with each bank at least once a year its policy on, and limits for, lending to other banks, investment firms, recognised exchanges and clearing houses including those overseas. The risks arising from some forms of exposure may, however, be significantly different in degree 34

35 from the risks involved in traditional short term interbank lending. The Banking Supervisor will expect banks to take account of these different types of exposure when setting their limits to individual institutions. 42 Exposures of over one year maturity to banks and investment firms will be considered in the same way as exposures to individual non bank counterparties and are subject to the large exposures limits. Exposures to banks and investment firms which are in the form of holdings of capital instruments (i.e. items eligible for inclusion in the capital base of the issuing bank) will normally be deducted in the calculation of capital base and excluded from the measure of exposure. In cases where such holdings are not deducted (i.e. where a bank has a market making concession) they will be subject to the limits on large exposures and where these securities are held in the trading book incremental capital requirements will be generated in the event of positions breaching the trigger point. Exposures to Zone A central governments or central banks (which for the purpose of this chapter includes the European Communities) 43 An exposure guaranteed by a central government or central bank may be treated as an exposure to that central government or central bank. Where, however, an exposure is covered by an ECGD bank guarantee (or an equivalent government department/agency in another Zone A country), the Banking Supervisor will require to be fully satisfied that the reporting bank has sufficient expertise and systems in place to ensure that its obligations under the guarantee are met fully. Unless the Banking Supervisor has notified the reporting bank that it is fully satisfied in this respect such exposures are not expected to exceed the 25% large exposures limit. Exposures to Zone B central governments or central banks 44 Exposures to Zone B central governments or central banks which are denominated and funded (if necessary) in the national currency of the borrower are exempt from the large exposure limits set out above irrespective of maturity. Secured Exposures 45 While the Banking Supervisor will take security into account when considering the acceptability of a bank's exposure up to 25% of its capital base, the presence of security on its own will generally not be considered by the Banking Supervisor to be an acceptable reason for an exposure to exceed 25%. However, where the security fully covers all exposures to a given counterparty and is in the form of Zone A central government or central bank securities or cash deposits (which in this context includes CDs issued by the lending bank) held with the lender, the existence of that security will be considered sufficient justification for an exposure to exceed 25% of the bank's capital base and such exposures are exempt from the limits set out above. In the case of: (i) an exposure secured by Zone A central government or central bank securities, the lender's legal title to the security should be fully protected. An appropriate margin over the amount of the exposure should be maintained to cover fluctuations in the market value of the securities. The margin should, inter alia, take account of the maturity of the exposure, in the case where the security is denominated in a different currency from the exposure, fluctuations in the exchange rate, and the arrangements for marking to market the security and for ensuring that any resultant deficiency in the margin is made up; 35

36 (ii) an exposure secured by a cash deposit (including CDs issued by the lending bank) held with the lender (or by a bank which is part of the same consolidated banking group as the lender and the requirements for consolidated supervision of the group and the requirements for the zero-weighting of intra-group exposures have been met). In such cases, the lender's legal title to the deposit should be fully protected. The deposit should have identical or longer maturity than the exposure. Where the cash deposit is in a different currency from the exposure, an appropriate margin over the amount of the exposure should be maintained to cover fluctuations in the relevant exchange rates. The margin should take account of the nature of the arrangements for ensuring that any resultant deficiency in the margin following an exchange rate change is made up. 46 Where part of the exposure is collateralised with eligible collateral (as in (i) and (ii) above) for the term of the exposure, that part of the exposure can be exempted from the calculation of the limits set out above, but must still be reported. However, the entire exposure, including the collateralised exemption, may only exceed the 25% limit when the bank has pre-notified the Banking Supervisor and obtained his written consent. Exposures that are partially collateralised in this way should not have an uncollateralised element that exceeds the 25 % limit. The Banking Supervisor does not condone the practice of top slicing, i.e., the practice by which a bank systematically collateralises only the element of the exposure that exceeds the 25% limit to bring it within the limit or collateralises only the element of the exposure that exceeds 10% of the bank s large exposures capital base in order to bring the sum of such exposures below the clustering limit. Exempt Exposures to counterparties connected to the reporting bank 47 Exposures to subsidiaries which are regarded within the Banking Supervisor s policy on consolidated supervision as, in effect, divisions of the parent bank, and are consolidated with the parent bank in the calculation of the bank s capital ratio on a solo basis (i.e. are subject to solo consolidation ), are excluded from the scope of the large exposures policy. 48 In respect of exposures to other group companies the Banking Supervisor's policy allows a bank to take on a Treasury role on behalf of the group (parent, subsidiaries and subsidiaries of the parent) as a whole (provided that the group is subject to consolidated supervision by its home supervisor). Appropriate levels for such exposures will be agreed on a case by case basis. It will be for the bank to satisfy the Banking Supervisor that it should fulfil such a role and has appropriate management and other group control systems in place to ensure that risk taking in those group companies is properly monitored and controlled. 49 The Banking Supervisor's policy regarding the taking on of a Treasury role is extended to cover exposures arising from a central risk management function, in particular in managing the exposures derived from derivative contracts. In certain cases the Banking Supervisor will be prepared to consider whether the scope of the Treasury concession should be extended to cover exposures of over one year's maturity arising from the operation of a central risk management function. In such cases the Banking Supervisor will have regard to whether this would lead to an overall reduction in the risks to which a group as a whole is exposed. 50 In certain exceptional cases, exposures of more than 25% of capital to a bank which controls the lending bank may be permitted, even where the lending 36

37 bank does not perform a Treasury role. The Banking Supervisor envisages that such lending would be allowed only in a limited number of cases and would consist of short term lending of surplus liquid funds. 51 The inclusion within the connected lending limit of exposures to connected banks which are incorporated within the EU will be generally considered on a case by case basis. These may also fall within a Treasury concession. 52 Exposures to group banks, financial and non financial companies, not covered by paragraphs 47-51, above will be aggregated and considered as an exposure to an individual non bank counterparty (i.e. will be subject to a 25% large exposures limit). 53 Other forms of connected exposure (in particular, to companies with which directors are associated) will be considered on a case by case basis. Where the link with the connected company is fairly remote, for example, where a non executive director of a large bank is a director of the borrowing company, the exposure may be considered as acceptable up to the normal level for that bank. If, however, there is a particularly close connection, the exposure will be aggregated within the 25% large exposures limit for connected lending. Exposures undertaken by subsidiary banks which are guaranteed by a parent bank 54 Where exposures in a subsidiary bank are guaranteed by a parent bank the subsidiary bank may be deemed to have an exposure to the parent. Under the terms of the Large Exposures Directive, exposures to a parent bank may be exempt from the limits on large exposures detailed above where the group is subject to consolidated supervision. The Banking Supervisor may therefore allow such subsidiaries to take on exposures exceeding 25% of their own capital base but only if they are entered into within the terms of a policy agreed by the parent bank and provided that there are guarantees in place (acceptable to the Banking Supervisor) from the parent bank to protect the subsidiary should the exposure become non-performing or require to be written off. The guarantee, which may take a number of forms and should be legally enforceable by the subsidiary, should prevent a bank's capital from becoming deficient as a result of experiencing a loss on such an exposure. The Banking Supervisor will require written confirmation from the parent bank that the exposure is retained in the subsidiary's balance sheet at the parent bank's request in order to meet group objectives and will need to be satisfied as to the nature of the exposure concerned. These requirements recognise that it may be the policy in some bank groups to concentrate particular types of lending or other facilities in one subsidiary. 55 In the case of licensed bank subsidiaries of Gibraltar banks, in order for an exposure exceeding 25% of capital base to be acceptable in the subsidiary bank, the parent bank must at all times have room to take over the exposure without itself exceeding the large exposures limit of 25% of capital base. Also the total counterparty exposure of the banking group to the customer must be within 25% of the group's capital base. The Banking Supervisor will need to be satisfied that adequate control systems are in place to ensure that credit risk taken in the group as a whole is properly monitored and controlled. 56 In the case of licensed banks which are subsidiaries of overseas banks the Banking Supervisor will wish to agree with the supervisory authority of the parent bank the size of exposures which can be undertaken by the subsidiary within the terms of this policy. It will also require written assurance from the overseas supervisor that they are content for the subsidiary to undertake the level of exposure in question. Before agreeing a level for the subsidiary the 37

38 Banking Supervisor will take into account the degree and extent of the consolidated supervision of the banking group exercised by the parent supervisory authority. 57 Overseas bank subsidiaries of Gibraltar banks will be expected to conform to the regulatory requirements of the country in which they are located. Capital Base 58 The capital base used as the basis for monitoring and controlling large exposures should be calculated according to the methods set out in Chapter 10 - Own Funds (i.e. the same as that used in the calculation of the risk asset ratio), unless any breach of the 25% large exposures limit occurs due to holdings of securities in the trading book; in such cases an amended capital base is used (see paragraph 62). The figure will be agreed by the Banking Supervisor with the reporting bank on the basis of the bank's audited balance sheet for the latest financial year, and may be reset during the year, in agreement with the Banking Supervisor, to take account of audited interim profits. The Banking Supervisor will, however, adjust this figure for new issues of capital during the course of the year and take account of other significant changes to the capital base, either upwards or downwards. In either circumstance the amended figure will be agreed with the bank and advised to it in writing. Additional Capital Requirements 59 The Banking Supervisor may require a Gibraltar incorporated bank to maintain higher capital ratios than would otherwise be the case when it considers it to be exposed to particular concentrations of risk. It is the Banking Supervisor's practice, where a bank has a number of exposures, which are not exempt from the limits, of more than 10% of capital base and, in particular, where the aggregate total of those exposures exceeds 100% of capital base, to consider whether such measures are necessary. However in considering the amount of capital to be maintained the Banking Supervisor would have regard to the acceptability of the exposures when considered in the context of the bank's large exposures policy agreed with the Banking Supervisor; the particular characteristics of the individual bank, including the nature of its business and the experience of its management; and the number of such exposures, their individual size and nature. 60 In those cases where a counterparty exposure (which is not an exempt exposure) breaches the large exposures limit of 25% of capital base (see paragraph 31) the Banking Supervisor will require additional capital cover which will be significantly higher than would be required for an exposure of less than 25%, and this requirement will generally apply whether or not the Banking Supervisor agrees that the exposure has been incurred in the most exceptional circumstances. Unless due to exempt exposures or noncounterparty risk in the trading book, the undertaking of an exposure in excess of 25% other than in the most exceptional circumstances will also call into question whether the bank's authorisation should be revoked. However, special arrangements may apply to exposures in the trading book which at a consolidated level exceed 25% of a bank s capital base - see paragraphs 31 and Where a bank is a subsidiary of another Gibraltar bank and it has exposures exceeding the 25% large exposures limit but the parent bank has made arrangements (within the terms of the policy set out above) to protect the subsidiary if problems occur, the additional capital cover, if any, may be held in the parent bank rather than the subsidiary. The additional capital cover will be determined by the size of the exposure (together with other exposures to the 38

39 same counterparty entered into by the parent bank) in relation to the parent bank's capital base. 62 Where a non-exempt exposure to a single counterparty exceeds the 25% large exposure limit but this is only as a result of long securities positions in the trading book, then an amended capital base is used to measure the exposure. In such circumstances the capital base may be amended to include any tier 3 capital eligible for inclusion in the capital base available to support the trading book. If the exposure exceeds the trigger point of 25% of the amended capital base, incremental capital is required as set out below. 63 The calculation for determining the incremental capital requirement involves the following sequential steps: a) Net any short securities positions against long securities positions, netting the short items against the highest long specific risk weighted items (Note: the specific risk weights of netted items need not be identical). b) Rank the remaining net long securities positions in order according to specific risk weighting factors (i.e. lowest weighted items first, highest weighted items last). c) Taking the lowest weighted items first, apply these exposures to the difference between the non securities exposure to the counterparty and 25% of the amended capital base (i.e. the headroom up to 25% of the amended capital base is employed to cover the lowest weighted exposures). d) Incremental capital is required for remaining net long securities exposures as follows: i) if the excess exposure has been extant for 10 days or less, the specific risk weighting for exposures ranked in excess of 25% of the amended capital are multiplied by 200%. ii) if the excess exposure has been extant for more than 10 days, the specific risk weightings for exposures ranked in excess of 25% of the amended capital base are multiplied by the following factors. Excess exposure over 25% of Factor applied to amended capital base (acb) specific risk weighting Up to 40% of acb 200% From 40% to 60% of acb 300% From 60% to 80% of acb 400% From 80% to 100% of acb 500% From 100% to 250% of acb 600% Over 250% of acb 900% Note: The system set out in paragraphs 62 and 63 should be used to cover short term counterparty exposure in the trading book of certain subsidiaries where specific supervisory consent has been given for them to be treated thus at the consolidated level (see also paragraph 31). 39

40 Note: The period an exposure has been outstanding is calculated in relation to the time that the total has been above a particular threshold even though the components of the exposure may have changed within that time. 64 Where the trading book excess exposure has been extant for 10 days or less the trading book exposure to the counterparty must not exceed 500% of the amended capital base. 65 Any trading book excess exposures which have persisted for more than 10 days must not, in aggregate, exceed 600% of the bank s amended capital base. Exposures To Countries 66 The Banking Supervisor does not believe that a common limit should be applied to the aggregate of banks' exposures to counterparties in the same country; nor does it consider it appropriate to publish guideline percentages for the acceptable level of exposure to counterparties in particular countries. Banks will, however, be expected to set limits for country exposures on the basis of their own risk assessments. The nature of the exposure (for example, whether it is trade finance or longer term balance of payments finance) will be relevant in considering an acceptable level of exposure. The Banking Supervisor will continue to monitor closely banks' country risk exposures, and discuss them with banks' managements. Exposures To Economic Sectors 67 The extent to which a bank may be prudently exposed to a particular industrial sector or geographical region will vary considerably depending upon the characteristics of the bank and the sector or region concerned. Sectors and regions are difficult to define and the definitions for one bank may not be appropriate for another. The Banking Supervisor will not therefore apply common maximum percentages to banks' sectoral exposures. 68 The Banking Supervisor will continue to monitor banks' exposures to sectors and regions and will wish to discuss with all banks their internal monitoring systems and the appropriateness of the sectors identified in their management reports. The Banking Supervisor will wish to ensure that banks have prudent lending policies which take into account the dangers from over exposure to particular economic sectors both within Gibraltar and world-wide. The same considerations apply to regional concentrations. Such policies will need to be adjusted from time to time in order to take account of changing market conditions and economic trends. The Banking Supervisor will continue to obtain information on sectoral and regional exposures from banks' internal monitoring systems. 40

41 Annex - Examples Calculation of Incremental Trading Book Capital Requirements for Excess Large Exposures, see paragraph 63. The Capital Base Of The Institution Comprises Capital base (tier 1 and tier 2) 1000 Eligible tier 3 capital 100 Amended capital base 1100 THE COMPONENTS OF THE LARGE EXPOSURE COMPRISE: Counterparty exposure 200 Mark to market value of trading book securities % Specific risk weight Short: Qualifying bond 1.00 (20) Long: Qualifying commercial paper Long: Equity Long: Qualifying convertible Total Net large exposures position 460 o/w Net long securities position 260 Steps in calculation PARAGRAPH 63(A) The short position in qualifying bond is offset against the highest specific risk weight items - in this case equities: Net long equity position ( ) 130 PARAGRAPH 63(B) Rank remaining items according to specific risk weight. % Specific Risk 0.25 Qualifying commercial paper Qualifying convertible 30 41

42 4.00 Equity (net) 130 PARAGRAPH 63(C) i) Calculate headroom between non securities exposures and 25% of amended capital base. 25% of amended capital base (1100) 275 Non securities exposures 200 Headroom 75 Paragraph 63(d) (ii) Applying securities positions in ascending order of specific risk weight. 75 of the 100 qualifying commercial paper may be counted before 25% of the amended capital base is reached. The remaining 25 qualifying commercial paper, along with 30 qualifying convertible and 130 equity (net) are traded securities exposures in excess of the limit and require incremental capital. PARAGRAPH 63(D)(I) If the excess exposure has been extant for 10 days or less, the specific risk weights are doubled. Qualifying Commercial paper 25 x 0.25 x 200% = Qualifying convertible 30 x 1.60% x 200% = 0.96 Equity 130 x 4% x 200% = Additional capital requirement Paragraph 63(d)(ii) If the excess exposure has been extant for more than 10 days. [ 200 Counterparty exposure ] [ 75 Securities exposures (within limit) ] Excess exposures Up to 40% of amended capital base at 200% (40% of 1100 = 440) 42

43 25 x 0.25% x 200% = x 1.60% x 200% = x 4.00% x 200% = 8.80 Excess exposure 40% - 60% of amended capital base at 300% 20 x 4.00% x 300% = 2.40 Additional capital requirement [ 460 Total net large exposures position ] 43

44 Chapter 4 - Foreign Currency Risk Explanation 1 A firm which holds net open positions (whether long or short) in foreign currencies either because of FX trading positions or because of exposures caused by its overall assets and liabilities is exposed to the risk that exchange rates may move against it. The FX requirements set out below reflect the fact that movements in various currencies against sterling are likely to be partially correlated and therefore some allowance is made for offsetting long or short positions in different currencies. In particular, firms have the option of adopting a backtesting approach to the generation of the capital requirements which takes the correlation between currencies into account. 2 This chapter describes the way to calculate an institution's open foreign currency position, and the capital required against this position. The position will be calculated with reference to the entire business (i.e. banking and trading books combined). 3 Unlike interest rate and equity position risk (Chapters 5 and 6 respectively), there is no simple approach (i.e. an approach with simpler rules but a higher capital charge) for the calculation of foreign exchange risk. 4 This chapter covers the following parts of the Capital Adequacy Directive: Article 4, paragraph 1(ii) Annex III Calculating The Net Open Positions 5 The net open position in each currency (including gold, but excluding sterling ) should be calculated using the method set out in Annex I subject to the following: a) Coverage - All on and off balance sheet positions including irrevocable guarantees. With the agreement of the Banking Supervisor, net future income/expenses not yet entered in accounting records, but already fully hedged by forward foreign exchange, may be included where it is part of the bank's written policy and is done on a consistent basis. b) Valuation - When calculating the local currency value of instruments or positions that form part of the trading book, banks using midmarket prices need only create a provision for the bid-offer spread in cases they have not already done so in calculating the interest rate risk on the same positions. Where a bank has a trading book (and is therefore obliged to mark to market daily using valuation techniques agreed in advance with the Banking Supervisor), it may record the net forward position at net present value without further reference to the Banking Supervisor. Where a bank does not have a trading book, the prior agreement of the Banking Supervisor should be sought. Finally, when translating local currency amounts into sterling, closing midmarket spot rates should be used and a provision for the bid-offer is not required. c) Composite Currencies - Net positions in composite currencies may either be broken down into the component currencies according to the quotas in force and included in the net open position calculations for individual currencies, or treated as a separate currency. However, 44

45 the mechanism for treating composite currencies must be applied consistently. d) Swaps - Currency swaps should be treated as a combination of a long position in one currency and a short position in the second currency. e) Options - A number of approaches are possible. First, options (and their associated hedges) can be entirely omitted from the net open position, and capital charges calculated using either the simple carve out approach (set out in Annex II) or a model based on the scenario matrix approach to option risk. In the latter case, the Banking Supervisor must review and recognise the model prior to its use. Second, the option delta value can be incorporated into the net open position, and capital charges for other option risks calculated separately using a model based on the buffer approach to option risk. Such a model will also need to be reviewed and recognised by the Banking Supervisor prior to use. Third, where a bank has chosen to use the backtesting method to measure overall foreign exchange exposure (see paragraph 7(b) below), the model used may include several option risks. Where it is not only delta that is incorporated, the model must be reviewed and recognised by the Banking Supervisor. Extra capital charges will apply for those option risks that the model does not capture. Note that, subject to Banking Supervisor approval, netting of back-toback option positions is permitted. f) Structural Positions - Certain positions of a structural, or non-banking nature, as set out below, may be excluded, with the prior approval of the Banking Supervisor, from the calculation of the net open position : - positions taken deliberately to hedge against the effects of exchange rate movements on the capital adequacy of an institution - investments in overseas subsidiaries which are fully deducted from an institution's capital for capital adequacy purposes. Calculating The Overall Net Foreign Exchange Position 6 The institution should then convert each net long or short position into sterling at the prevailing spot rates. For foreign currencies, the total of the net long positions and the total of the net short positions should be calculated. The higher of these two totals is the institution's overall net foreign exchange position. (Gold should be treated separately - see paragraph 8 below.) Calculating The Capital Requirement 7 The possible methods of calculating the capital requirement on the overall foreign exchange position are set out below. Annex III summarises the manner in which institutions will arrive at their total capital requirement. a) Basic Method: The overall net foreign exchange position, calculated after excluding positions covered by method b) and c) below, carries a requirement of 8%. b) Backtesting Method: With the agreement of the Banking Supervisor a backtesting method can be used to calculate the capital requirements for either all or a subset of the currencies comprising an institution's foreign exchange position. The currencies to be included in the backtesting method should be agreed in advance with the Banking Supervisor and, where option risks other than delta are included in 45

46 the backtesting model, it will require prior recognition by the Banking Supervisor. (Occasionally, it will be appropriate for the position in one pre-determined currency to be split, with only a proportion of it included in the backtesting method. Such a treatment should be agreed in advance with the Banking Supervisor.) The capital requirement produced by the backtesting method for the portfolio is determined as follows:- i) Losses, which would have occurred in at least 95% of tenworking-day periods rolled on a daily basis over the preceding five years, are calculated. The 95% loss quintile will, where the observation period cover 1,300 valuations, correspond to the 65th largest loss. or Losses, which would have occurred in at least 99% of tenworking-day periods rolled on a daily basis over the preceding three years, are calculated. The 99% quintile will, where the observations cover 780 valuations, correspond to the 8th largest loss. [The losses must be calculated by assuming that the current portfolio of net open positions in the designated currencies was held at the start of each rolling period.] ii) The requirement is the higher of the losses calculated above, 7(b)(i), and 2% of the overall net foreign exchange position as calculated by applying the basic method to the net open positions in the portfolio of designated currencies. c) Currency Pairs Subject to Binding Inter-Governmental Agreements: Banks may apply a separate treatment to those currencies that are subject to binding inter-governmental agreements. The capital requirements for such currency pairs will be 50% of the maximum movement stipulated by the inter-governmental agreement on the matched net open positions of the individual currencies. At present, the only recognised binding inter-governmental agreement is that applying to the Belgian and Luxembourg francs. These currencies will be treated as one and incorporated in such a manner into either the basic or the backtesting method. d) Additional capital charges for options: As set out in paragraph 5(e) above, additional capital charges will apply where the bank is using: - the simple carve out method (Annex II); - a scenario or buffer based recognised model (see Chapter 9); - a backtesting model that incorporates some but not all option risks (see Chapter 9) 8 Gold (and other precious metals) should be treated separately. Under the basic method, the capital charge is 8% of the net open position (whether long or short). If the backtesting method is used, the net open position in gold (and other precious metals) can be incorporated into the same model as positions in foreign currencies. NOTE 46

47 9 In addition to foreign exchange risk, certain foreign exchange positions may be subject to interest rate risk and/or counterparty risk requirements and should be treated under the relevant sections. For the treatment of interest rate risk on foreign exchange positions see Chapter 5 - Interest Rate Position Risk. For the treatment of counterparty risk on foreign exchange positions see Chapter 2 - Counterparty Risk. (In calculating charges for interest rate and counterparty risk, all foreign exchange positions are deemed to be part of the trading book.) 47

48 Annex I - Calculating The Net Open Position Local Currency Value Net spot position: all assets (gross of provisions for bad and doubtful debts) less all liabilities, including accrued interest, in the currency in question; + Net forward position: all amounts to be received less all amounts to be paid under forward exchange transactions, including currency futures and the principal on currency swaps not included in the spot position; + Irrevocable guarantees (and similar instruments) which are certain to be called; + Net future income/expenses not yet accrued but already fully hedged; + Profits (net value of income and expense accounts) held in the currency in question; + The market value of other derivatives (i.e., non-fx and non-gold) that are denominated in a foreign currency; +/- With the agreement of the Banking Supervisor, certain positions of a structural capital nature may be excluded; - Assets held in currency in question where a 48

49 specific provision is held in a different currency; + The net delta (or delta-based) equivalent of options book, if this is the approach taken to measurement of option risk; = Net open position 49

50 Annex II Simple Method For Options (Carve Out) Where a bank uses this approach, the table below must be used to calculate the capital requirements for market risk on options plus any related hedges. These figures may only be used for options with a residual maturity of less than six months. Advice must be sought for options with a residual maturity of over six months. (Banks that have models which have been recognised by the Banking Supervisor may not use the method prescribed below for those option models that have been recognised.) Options Posit ion In the money by more than 8% Naked Long NL In the money by less than 8% Out of the Money Short NSI NSO Hedged Long 0% LCI HO Short 0% SHI HO Definitions for currency options Long and short: As with all the carve-outs, a long option position is one where an option has been purchased, while a short option position is one where an option has been written/sold. Underlying: currency bought by bank if option is exercised Hedged: An option will be deemed to be hedged for the purposes of these calculations when the offsetting positions (short in the underlying, and long in the currency to be sold) match the amounts into which the option is exercisable. When the amounts underlying the option are larger than the offsetting positions, the residual option will be treated as a separate naked option. Market exchange rate and exercise price should each be expressed as unit of currency to be sold by bank per unit of currency to be bought (if option is exercised). In principle, the market exchange rate used should be the forward rate. However, for short dated options (up to six months residual maturity) banks may use the spot rate if necessary. Given this specification, the money is defined differently for long and short positions: (a) For long positions In the money: market exchange rate exceeds exercise price Out of the money: exercise price exceeds market exchange rate (b) For short option positions In the money: exercise price exceeds market exchange rate Out of the money: market exchange rate exceeds exercise price Formulae P% is 8% 50

51 NL The lesser of : a) the market value of the underlying instrument multiplied by p% and b) the current value of the option on the bank s books. NSI The market value of the underlying position multiplied by P% NSO The market value of the underlying position multiplied by P% minus 0.5 multiplied by the amount by which the option is Out of the Money (subject to a maximum reduction to zero) LPI The market value of the underlying position minus (1-P%) multiplied by the underlying position valued at the exercise price HO The market value of the underlying position multiplied by P% Where expressions are to be interpreted as below: Market value of underlying instrument/position: value of currency to be acquired if option exercised, converted at the exercise/strike price into currency to be sold; Underlying position valued at the exercise/strike price: value of currency to be acquired if option exercised, converted at the exercise/strike price into currency to be sold; Amount by which option is out of the money: difference between market value of underlying instrument and underlying position valued at the exercise price; Mark to market value of an option: value of option in market; Current value of option on the bank s books: this will reflect the valuation policy of the bank. 51

52 Annex III - Calculation Of The Capital Requirement For Foreign Exchange Calculate the net open position in each currency, excluding sterling. Convert into sterling at spot rates. For Foreign Currencies Subject To The Basic Method: The sum of all the net short positions W (each converted into the reporting currency) The sum of all the net long positions X (each converted into the reporting currency) The overall net foreign exchange position = Y = the larger of W and X Capital charge = Y x 8% = Z For Currencies Subject To The Backtesting Method: The capital charge sufficient to cover losses = A that might have been incurred over the relevant past period (subject to a floor) + Any extra capital charges incurred if = B backtesting does not take account of all option risks Extra Capital Charges For Options Options treated using the carve-out = C Options treated using a recognised model = D FOR GOLD (And Other Precious Metals) Net open position = g (long or short) Capital charge under basic method = g x 8% =G Capital charge under backtesting method = G* (subject to a floor) TOTAL CAPITAL REQUIREMENT = Z + A + B + C + D + (G or G*) 52

53 Chapter 5 - Interest Rate Position Risk Explanation 1 Any bank has some degree of interest rate exposure in its trading book. This chapter determines the way in which capital requirements for this type of exposure are calculated. The interest rate exposure captured includes exposures arising from interest-bearing and discounted financial instruments, derivatives based on the movement of interest rates, foreign exchange forwards, and interest rate exposures embedded in derivatives based on noninterest related derivatives. In all cases where positions give rise to interest rate risk there is general market interest rate risk. This may be accompanied by specific interest rate risk, or counterparty risk, or equity or foreign exchange risk, depending on the nature of the position. Banks should consider carefully which risks are generated by each individual source of exposure. 2 The specific risk capital requirement recognises that individual instruments may change in value for reasons other than movements in the yield curve of a given currency. The general risk capital requirement reflects the price change of these products caused by parallel and non-parallel shifts in the yield curve, as well as the difficulty of constructing perfect hedges. 3 Annex II to this chapter outlines a simplified method, which banks may choose to adopt, for the calculation of trading book capital requirements for interest rate risk. The capital requirement generated by application of the simplified method will be higher than that which would result from applying the normal methods. If banks choose to apply this method they should seek permission from their line supervisor and, in most circumstances, they would be expected to adopt the simplified method for both interest rate and equity position risk (see Chapter 6 - Equity Position Risk). 4 This chapter describes the way in which a bank will calculate its capital requirements for interest rate positions held in the trading book. 5 The following sections of the are covered by this chapter: Annex 1 Position Risk Introduction section Annex 1 Position Risk Traded Debt Instruments section Scope 6 This chapter will apply to trading book positions and exposures of the following instruments whether or not they carry coupons: a) bonds, loan stocks, debentures etc.; b) non-convertible preference securities; c) convertible securities such as preference shares and bonds and bonds with embedded options; (see paragraph 17) d) mortgage backed securities and other securitised assets; e) certificates of deposit; f) treasury bills, bank bills (bankers acceptances), local authority bills; g) commercial paper; h) euronotes, medium term notes, etc; i) floating rate notes, FRCDs etc j) foreign exchange forward positions; 53

54 k) derivatives based upon the above instruments and interest rates; l) interest rate exposure embedded in other financial instruments. This list may be amended periodically. For instruments that deviate from the above structures, or could be considered complex, each bank should agree a policy statement with the Banking Supervisor about the intended treatment. In some circumstances the treatment of an instrument may be uncertain, for example bonds whose coupon payments are linked to equity indices. Where possible the position risk of such instruments should be broken down into its components and allocated appropriately between the equity, interest rate and foreign exchange risks categories. Advice must be sought from the Banking Supervisor in cases of doubt, and when a bank is trading an instrument for the first time. 7 Where a trading book position results from underwriting activities the capital requirement should be considered in accordance with the parameters described in Chapter 8 - Underwriting. 8 In addition to interest rate position risk certain debt instruments and related derivatives may also be subject to foreign exchange and/or counterparty risk and the exposures should be treated as required in relevant chapters (Chapter 4 - Foreign Currency Risk and Chapter 2 - Counterparty Risk). Individual Net Positions 9 A bank may net, by value, long and short positions in the same debt instrument to generate the individual net position in that instrument. Instruments will be considered to be the same where the issuer is the same, they have the equivalent ranking in a liquidation, and the currency, the coupon, and the maturity are the same. When a bank does not have a relevant recognised model (see Chapter 9 - Eligible Models), positions in derivatives, and all positions in repos, reverse repos and similar products should be decomposed into their components within each time band (see paragraphs 27 to 31) prior to calculating individual net positions for general market risk. 10 A bank may net by value a long or short position in one tranche of a debt instrument against another tranche only where the relevant tranches - a) rank pari passu in all respects; and b) become fungible within 180 days and thereafter the debt instruments of one tranche can be delivered in settlement of the other tranche. Calculation Of Capital Requirements 11 Banks should calculate the general market risk arising from interest rate risk and the specific risk arising from debt instruments. The aggregate capital requirement for interest rate risk will be the sum of the general market risk capital requirements across currencies and the specific risk capital requirements. Specific Risk Calculation 12 In determining its specific risk capital requirement for positions in debt instruments a bank must weight the current market value of each of its individual net positions, whether long or short, according to its allocation amongst the following categories: Weighting a) Certain Central Government debt instruments; 0.00% b) Qualifying Items up to 6 months residual maturity 0.25% 54

55 c) Qualifying Items over 6 and up to 24 months residual maturity1.00% d) Qualifying Items over 24 months residual maturity 1.60% e) Non-Qualifying Items 8.00% 13 Debt instruments will be given a 0% specific risk weighting if: a) they are issued by, fully guaranteed by, or fully collateralised by securities issued by Zone A central governments and central banks, including the European Communities; or b) they are issued by, or fully guaranteed by, Zone B central governments and central banks with a residual maturity of 1 year or less and are denominated in local currency and funded by liabilities in the same currency. 14 A list of Zone A countries was originally provided in Admin Notice No.1 (Implementation in Gibraltar of the Solvency Ratio Directive). All other countries not included in Zone A are in Zone B. 15 Debt instruments will be treated as qualifying if any of the following conditions apply: a) they are issued by, or fully guaranteed by, Zone B central governments and central banks with a residual maturity of over 1 year and are denominated in local currency and funded by liabilities in the same currency. b) They are securities issued by, or fully collateralised by claims on, a multilateral development bank listed in the Solvency Ratio Directive. (See Chapter 12 - Lists for a list of these institutions). The European Commission may amend this list periodically. c) They are issued, guaranteed, endorsed, or accepted, by a credit institution incorporated in a Zone A country; d) They are issued, or guaranteed, endorsed, or accepted, by a credit institution incorporated in a Zone B country and have a residual maturity of 1 year or less; e) They are issued, or guaranteed, by an investment firm that is subject to the Capital Adequacy Directive, or a regime that the Bank deems to be as stringent; f) They are issued by, or guaranteed by, Zone A public sector entities; g) They are issued by, or guaranteed by, a company whose equity is eligible for 2% equity specific risk weighting (see Chapter 6 - Equity Position Risk). h) They are given a 50% risk weight in the implementation of the Solvency Ratio Directive (Admin Notice No.1). 16 Debt items issued by entities not covered by the descriptions in the preceding paragraph may still be treated as qualifying if the issue, or an issue of equivalent ranking in a liquidation, or an issue of equivalent ranking in a liquidation of the guarantor, is rated investment grade (or its equivalent for money market obligations), or above and provided that the reporting bank is unaware of any sub investment grade rating issued by any relevant credit rating agency. When the reporting bank is aware of an announcement that the issue may be downgraded to below investment grade, by at least one relevant credit rating agency, that debt will cease to be qualifying unless it meets the criteria of the preceding paragraphs. 55

56 17 Convertible securities, such as bonds and preference shares, that are treated as debt instruments will be given a specific risk weighting identical to other debt items for the same issuer as described in the preceding paragraphs. Convertible securities must be treated as equities (see Chapter 6 - Equity Position Risk) when: a) the first date at which conversion may take place is less than three months ahead, or the next such date (where the first has passed) is less than a year ahead, and: b) the convertible is trading at a premium of less than 10%, where the premium is defined as the current mark to market value of the convertible less the mark to market value of the underlying equity, expressed as a percentage of the mark to market value of the underlying equity. 18 Debt instruments where the issuer does not meet the requirements established above (paragraphs 13 to 16 inclusive) are deemed to be non qualifying. 19 Derivatives positions will attract specific risk only when they are based upon an underlying instrument or security. For instance, where the underlying exposure is an interest rate exposure, as in a swap based upon interbank rates, there will be no specific risk, just counterparty risk. However, for a swap based upon a bond yield, the underlying bond will generate a specific risk requirement. For options the specific risk will be based upon the delta weighted value, calculated via an approved model. Future cash flows derived from positions in derivatives will generate counterparty risk requirements related to the counterparty in the trade in addition to position risk requirements related to the issuer of the underlying security. General Risk Calculation 20 A separate general market interest rate risk calculation is calculated for each currency irrespective of where the individual instruments are physically traded or listed. The resultant capital requirements must be converted into the reporting currency by applying the prevailing foreign exchange spot rates. These capital requirements are summed arithmetically to give the total general market risk requirement. 21 The Banking Supervisor does not intend to distinguish explicitly between the level of general market risk capital requirement for different currencies. However, it recognises that yield curves in some currencies are more volatile and that their markets are less liquid with fewer hedging mechanisms available. When a bank has a portfolio with interest risk in such currencies, this will be taken fully into account when setting the target and trigger capital ratios (see Chapter 10 - Own Funds). General Risk Calculation - Interest Rate Exposure Method 1 22 The capital requirements for general market risk are intended to recognise the risk of parallel and non-parallel shifts in the yield curve. The steps in calculating the general risk requirement for interest rate positions under method 1 are set out below. a) Individual net positions (see paragraphs 9 and 10) will be allocated to one of the maturity bands, on the following basis: i) Fixed-rate instruments will be allotted their maturity bands based upon the residual time to maturity - irrespective of 56

57 embedded puts and calls - and whether their coupon is below 3%. ii) Floating rate instruments will be allocated to maturity bands based upon the time remaining to the re-determination of the coupon. iii) Advice must be sought from the Banking Supervisor on the treatment of instruments that deviate from these structures, or may be considered complex. Note that the bands are grouped into zones. b) Multiply the market value of the individual long and short net positions (as defined in paragraph 9 and 10) in each maturity band by the weighting factors. c) To calculate matched and unmatched positions per maturity band: where a maturity band has both weighted long and short positions, the extent to which the one offsets the other is called the matched weighted position. The remainder (i.e. the excess of the weighted long positions over the weighted short positions, or vice versa, within a band) is called the unmatched weighted position for that band. d) To calculate matched and unmatched positions per zone: where a zone has both unmatched weighted long and short positions for various bands, the extent to which the one offsets the other is called the matched weighted position for that zone. The remainder (i.e. the excess of the weighted long positions over the weighted short positions, or vice versa, within a zone) is called the unmatched weighted position for that zone. e) Unmatched weighted positions for a zone may be offset against positions in other zones as follows: i) The unmatched weighted long (short) position in zone 1 may offset the unmatched weighted position short (long) in zone 2. The extent to which the unmatched weighted positions in zones 1 & 2 are offsetting is described as the matched weighted position between zones 1 & 2. ii) After i), any residual unmatched weighted long (short) positions in zone 2 may then be matched by offsetting unmatched weighted short (long) positions in zone 3. The extent to which the unmatched positions in zones 2 & 3 are offsetting is described as the matched weighted position between zones 2 & 3. The calculations in i) & ii) may be carried out in reverse order (i.e. zones 2 & 3 followed by zones 1 & 2). iii) After i) & ii) any residual unmatched weighted long (short) positions in zone 1 may then be matched by offsetting unmatched weighted short (long) positions in zone 3. The extent to which the unmatched positions in zones 1 & 3 are offsetting is described as the matched weighted position between zones 1 & 3. f) Any residual unmatched weighted positions following the matching within a band, within a zone, and between zones will be summed. 57

58 23 The general interest rate risk capital requirements will be the sum of: a) Matched Weighted Positions in all Maturity Bands x10% b) Matched Weighted Positions in zone 1 x40% c) Matched Weighted Positions in zone 2 x30% d) Matched Weighted Positions in zone 3 x30% e) Matched Weighted Positions between zones 1 & 2 x40% f) Matched Weighted Positions between zones 2 & 3 x40% g) Matched Weighted Positions between zones 1 & 3 x150% h) Residual Unmatched Weighted Positions x100% General Risk Calculation - Interest Rate Exposure Method 2 24 This approach to measuring the exposure to parallel and non parallel shifts of the yield curves recognises the use of duration as an indicator of the sensitivity of individual positions to changes in market yields. As a result banks may use a duration based system for determining their general interest rate risk capital requirements for traded debt instruments and other sources of interest rate exposures including derivatives. It is likely that certain instruments may not be suitable for the duration method and advice must be sought for complex instrument types which must be subjected to the maturity method, and possibly additional capital requirements. 25 Banks should notify their supervisor of the circumstances in which they intend to adopt this method. Once chosen, it must be applied consistently to categories of instruments within trading units. Banks may elect to use a different method in, for instance, an overseas branch to the method adopted in their Head Office. This could result in a bank applying both methods 1 & 2 to a single currency but the capital requirements generated by the two methods must be added arithmetically together. The steps in calculating the general risk requirement for interest rate positions under method 2 are set out below. a) The bank will take the market value, for each individual net position (see paragraphs 9 and 10) of each fixed rate instrument - whether or not it is coupon bearing - and determine its Yield-To-Maturity (Redemption Yield). For each individual net position (see paragraphs 9 and 10) in floating rate instruments the bank will take the market value and treat as its final maturity the date on which the coupon is next re-determined. The bank will then derive a Yield-To-Maturity. b) For each debt instrument the bank will calculate the modified duration of each instrument on the basis of the following formula according to the deemed maturity in a) above : 58

59 r = Yield-To-Maturity %pa expressed as a decimal C = Cashflow at time t t = time at which cashflows occur in years m = time to maturity in years c) Individual net positions, at current market value, will be allocated to one of the three zones described in Table 5.4, below, based upon the modified duration. d) The bank will then calculate the modified duration weighted position for each individual net position by multiplying its current market value by the modified duration and the assumed change in rates to form the weighted positions. e) To calculate the matched and unmatched positions per zone: where a zone has both weighted long and short positions, the extent to which the one offsets the other is called the matched weighted position for that zone. The remainder (i.e. the excess of the weighted long positions over the weighted short positions, or vice versa) is called the unmatched weighted position for that zone. f) Unmatched weighted positions for a zone may be offset against positions in other zones as follows: i) The unmatched weighted long (short) position for zone 1 may offset the unmatched weighted short (long) position in zone 2. The extent to which the unmatched weighted positions in zones 1 & 2 are offsetting is described as the matched weighted position between zones 1 & 2. ii) After i), any residual unmatched weighted long (short) positions in zone 2 may then be matched by the unmatched weighted short (long) positions in zone 3. The extent to which the unmatched positions in zones 2 & 3 are offsetting is described as the matched weighted position between zone 2 & 3. The calculations in i) & ii) may be carried out in reverse order (i.e. zones 2 & 3 followed by zones 1 & 2). iii) After i) & ii) any residual unmatched weighted long (short) positions in zone 1 may then be matched by offsetting unmatched weighted short (long) positions in zone 3. The extent to which the unmatched positions in zones 1 & 3 are offsetting is described as the matched weighted position between zone 1 & 3. g) Any residual unmatched weighted positions following the matching within a zone and between zones will be summed. 26 The general interest rate risk capital requirements will be the sum of: a) Matched Weighted Positions in all zones x 2% 59

60 Derivatives b) Matched Weighted Positions between zones 1 & 2 x40% c) Matched Weighted Positions between zones 2 & 3 x40% d) Matched Weighted Positions between zones 1 & 3 x150% e) Residual Unmatched Weighted Positions x100% 27 Many banks will seek approval to use individual models to assess the interest rate risk inherent in derivatives. The output of recognised interest rate sensitivity models will be fed into Interest Rate Exposure Method 2 above. Banks may also seek approval of risk management models for options. If the buffer approach is adopted for options, the delta will be incorporated in Interest Rate Exposure Method 2 above and there will be add-ons for the other greek risks. The scenario method for options will give rise to a single figure for interest rate risk, that will not be fed into the maturity ladders. For more detail on the recognition of models see Chapter 9 - Eligible Models. Where a bank does not propose to use models, it must use the techniques described below for exchange or OTC traded derivatives (including the simple method for options). Model review is intended for large, dynamically managed portfolios; rather than one-off deals. The business to which the model pertains should be a significant component of the bank's activities. Where a bank has express written approval for the use of non-interest rate derivatives models then the embedded interest rate exposures may also be incorporated into the treatments described below. FX Forwards 28 FX Forwards are captured by this chapter and the position is decomposed into legs representing the paying and receiving currencies. a) Each of these legs will be treated as if they were zero coupon bonds with zero specific risk in their respective currencies. b) If the forward positions are not consistently revalued using discounting or present value techniques, the notional [not present] value of the payment is inserted into the maturity band approach, Interest Rate Exposure Method 1. c) If the forward positions are consistently revalued using discounting or present value techniques then they may be inserted into the duration band approach, Interest Rate Exposure Method 2. Deposit Futures and FRAs 29 Deposit futures, FRAs (Forward Rate Agreements) and other instruments where the underlying is a money market exposure will be split into two legs. a) The first leg will represent the time to the expiry of the futures contract or the settlement date of the FRA. b) The second leg will represent the time to the expiry of the underlying instrument. c) Each leg will be treated as a zero coupon bond with zero specific risk. d) For deposit futures, the size of each leg is the notional amount of the underlying money market exposure. For FRAs the size of each leg is the notional amount of the underlying money market exposure discounted to present value, although in Interest Rate Exposure Method 1 the notional amount may be used without discounting. 60

61 For example under Interest Rate Exposure Method 1 a single 3 month Euro$ deposit futures contract expiring in 8 months time will have one leg of $1,000,000 representing the 8 months to contract expiry and another leg of $1,000,000 in the 11 months time band representing the time to expiry of the deposit underlying the futures contract. Given the way in which futures contracts are traded care should be taken in deciding upon the long and short legs. These positions may benefit from the application of netting (see paragraph 35). Bond Futures And Forward Bond Transactions 30 Bond futures, forward bond transactions are decomposed into two legs. a) The first leg is a zero coupon bond with zero specific risk. Its maturity is the time to expiry of the futures or forward contract. Its size is the cashflow on maturity discounted to present value, although in Interest Rate Exposure Method 1 the cashflow on maturity may be used without discounting. b) The second leg is the underlying bond. Its maturity is that of the underlying bond for fixed rate bonds, or the time to the next reset for floating rate bonds. Its size is as set out in (c) and (d) below. c) For bond forward transactions the underlying bond and amount is used at the present spot price. d) For bond futures the principal amounts in each of these two legs may be generated by one of two processes: i) It may be treated as the notional underlying bond upon which the contract is based using the futures price times the notional underlying amount; or ii) Subject to e) & f) below it may be one of the deliverable bonds for that contract using the futures price and the conversion factors. e) Under the terms of the futures contract where the "short" has a choice of deliverable bonds then the "long" may use one of the deliverable bonds, or the notional bond on which the contract is based, as the underlying instrument, but this notional long leg may not be offset against a short cash position in the same bond. f) Under the terms of the futures contract where the "short" has a choice of deliverable bonds then the "short" may treat the notional underlying bond as if it were one of the deliverable bonds which may be netted against a long cash position in the same bond. Care must be taken in the use of conversion factors to transform the bond futures into equivalent cash positions. Repo/reverse repo (and similar transactions) 30a A repo (or sell-buy or stock lending) involving exchange of a security for cash should be represented as a cash borrowing - i.e. a short position in a government bond with maturity equal to the repo and coupon equal to the repo rate. A reverse repo (or buy-sell or stock borrowing) should be represented as a cash loan - i.e. a long position in a government bond with maturity equal to the reverse repo and coupon equal to the repo rate. These positions are referred to as cash legs. 61

62 30b It should be noted that, where a security owned by the bank (and included in its calculation of market risk) is repo d, it continues to contribute to the bank s interest rate or equity position risk calculation. (See Chapter 2 for capital charges for counterparty risk on repo/reverse repo.) Swaps 31 Swaps will be decomposed into two legs and each of the legs may benefit from the application of netting, see paragraph 35. a) For Currency swaps the two parts of the transaction will be split into FX forward contracts and treated accordingly. Alternatively such swaps may be treated as having a fixed/floating leg in each currency. b) Interest Rate swaps will also be split into two legs. Each leg will be allocated to the maturity band equating to the time remaining to refixing. However, for complex swaps involving the use of constant maturity bonds for example, then advice must be sought. For example a $10 Million 5 year fixed - floating swap against 3 month LIBOR would have notional positions of $10 Million in the 5 year maturity band and $10 Million in the 3 month band. The 5 year leg will be weighted according to whether its notional coupon is over or under 3%. Where a swap has a deferred start it may also be subject to the two leg treatment. A swap will be considered to have a deferred start when the commencement of the interest rate calculation periods is more than two business days from the transaction date and one or both legs have been fixed at the time of commitment. When one or more legs has been fixed then that leg will be sub-divided into the time to the commencement of the leg and the actual swap leg fixed or floating rate. Where the swap has a deferred start and neither leg has been set then there is no interest rate exposure, but there will be counterparty exposure. When a rate has yet to be set, the swap will be treated as having a zero add on and by definition, the mark to market must be zero. The treatment in this paragraph is distinct from a swap that arises from the exercise of a Swaption. Where a swap has a different structure such as multiplier or constant maturity based cashflows, then it may be necessary to adjust the underlying notional principal amount, or the notional maturity of one or both legs of the transaction. Options 32 Subject to the Banking Supervisor s approval, netting of back-to-back options positions may be permitted. 33 Banks which do not have an approved model for options should apply the simple method (carve out) for options. Details of this method are in Annex I to this Chapter. The specific risk arising from bond options will be based on the delta weighted amount of the underlying debt instrument. Index Linked Gilts 34 Index linked gilts will be subject to a special treatment for general market risk. The capital requirement must be calculated as if they were a separate currency of issue and different weights will apply to each of the matched and unmatched positions. This treatment is identical to that proposed by the Bank s Wholesale Markets Supervision Division. Banks wishing for more details on 62

63 how to calculate the capital requirement on such gilts should contact their Banking Supervisor. Netting Of General Market Risk Positions 35 Where a bank does not use a recognised model to assess the interest rate risk inherent in derivatives, it may nevertheless choose to net notional positions in government bonds (i.e. notional bond legs) that arise from the decomposition of foreign currency forwards, deposit futures, FRAs, swaps and other derivatives. For netting of notional government bond positions to be recognised the positions must be: i) in the same currency; and ii) their coupons, if any, must be within fifteen basis points, and iii) the next interest fixing date or residual maturity corresponds with the following limits: - for positions less than one month hence: same day - for positions between one month and one year hence: within seven days; - for positions over one year hence: within thirty days Interest rate exposures arising from cash borrowing and lending and from cash legs or fepo/reverse repo may also be netted against one another (on the same basis as above), but they may not be netted against positions in notional government bonds. 63

64 Annex I Simple Method For Options (Carve Out) 1 The table below should be used to calculate the market risk requirements for options or warrants on the following: bonds; interest rates and their futures; and swaps; their variants; plus any related hedges. These figures may only be used for options with a residual maturity of less than six months; for longer maturity options advice must be sought. (Banks that have models which have been recognised by the Banking Supervisor should not use the method prescribed below for those option models that have been recognised.) Option position In the Money by more than P% or Q% In the Money by less than P% or Q% Out of the Money Naked Long Call NL NL NL Long Put NL NL NL Short Call NSI NSI NSO Short Put NSI NSI NSO Long in Long Put 0% LPI HO Underlying Short Call 0% SHI HO Short in Long Call 0% LCI HO Underlying Short Put 0% SHI HO In the Money means that the exercise level of a call option or warrant is less than the current mark to market value of the underlying instrument and, for put options or warrants that the current mark to market value of the underlying is less than the exercise level of the put option or warrant. Out of the Money means those options and warrants that are not In the Money. For bond options (where the strike is based upon a price) P% is the sum of the specific and general market risk, under Method 1, for that underlying instrument as if it was the only component in a portfolio. For options where the strike is based on a yield we determine Q%, the "assumed interest rate change" from Table 2 in Annex 1 of the (see Annex 1 to Chapter 9 - Eligible Models) based upon the life of the instrument underlying the option. Y% is then Q% multiplied by the period of the underlying. Thus, for example, a two year option on a three month rate would have Q=1.00% and Y=0.25%. A three month option on a two year swap would have Q=0.90% and Y=1.80%. The capital requirements for price based options and their associated hedges are: NL The lesser of: a) the market value of the underlying instrument multiplied by P% and b) the current value of the option on the bank's books. NSI The market value of the underlying position multiplied by P%. 64

65 NSO The notional amount of the underlying position multiplied by Y% minus 0.5 multiplied by the amount by which the option is Out of the Money (subject to a maximum reduction to zero). This Out of the Money amount should reflect the period of the underlying. Thus an option on a three month rate for 1mn notional which is 50bp out of the money corresponds to a reduction of 1,000,000 x 0.5% x 0.25 = 1250 and not LPI The market value of the underlying position minus (1-P%) multiplied by the underlying position valued at the exercise price HO The market value of the underlying position multiplied by P% SHI The market value of the underlying position multiplied by P% minus the mark to market value of the option (subject to a maximum reduction to zero) LCI (1+P%) multiplied by the underlying position valued at the exercise price minus the market value of the underlying position The capital requirements for yield based options and their associated hedges are: NL The lesser of: a) the notional amount of the underlying instrument multiplied by Y% and b) the current value of the option on the bank's books. NSI The notional amount of the underlying position multiplied by Y% NSO The notional amount of the underlying position multiplied by Y% minus 0.5 multiplied by the amount by which the option is Out of the Money (subject to a maximum reduction to zero) LPI As for SHI below HO The notional amount of the underlying position multiplied by Y% SHI The notional amount of the underlying position multiplied by Y% minus the mark to market value of the option (subject to a maximum reduction to zero) LCI As for SHI above If a bank is unable to determine whether an option is in or out of the money, then the capital charge is the notional amount of underlying multiplied by Y%. Example Of Carve-Out Approach 2 Consider the example of a 1mn notional cap at 7.00% with four remaining semi-annual caplets and three months to exercise of the first of these. Treating these four caplets in the standard way as individual options on FRAs we get: Option Underlying Q% Y% Caplet 1 3 months 6 months 100bp 50bp Caplet 2 9 months 6 months 100bp 50bp Caplet 3 15 months 6 months 100bp 50bp 65

66 Caplet 4 21 months 6 months 100bp 50bp 3 Now consider, for example, that the current 6 month rate 9 months forward is 7.50%. The second caplet is "in the money" by 50bp, but thus by less than Q%, which is 100bp. The capital charge for each caplet can thus be determined from the forward rates and definitions above. 4 Alternatively, an institution might treat the cap as a single item, where in this case Q=100bp still (since the underlying is a six month rate) and Y=2% (the combined period of the string of FRAs). The "at the money level" is now the single cap level at which owning all four of the FRAs has neither positive nor negative net present value (often referred to as the par rate for a cap). 5 The Banking Supervisor is aware that these calculations are only approximate, and tend to overstate the market risk of options. Institutions whose option positions are large so that this overstatement puts them at a significant disadvantage are encouraged to apply for model recognition as described in Chapter 9 - Eligible Models. 66

67 Annex II Simplified Method For Calculation Of Capital Requirement 1 As the figure for the capital requirement generated by this simplified method is less precise than that generated by the above methods, it will generate a higher capital requirement. Banks which intend to adopt this method should discuss their intention with their line supervisor. 2 One general market risk calculation is required for each currency irrespective of where the individual instruments are physically traded or listed. Specific risk requirements are determined on an instrument by instrument basis. The resulting capital requirements must be converted into the reporting currency by applying the prevailing foreign exchange spot rates. For a list of the positions, instruments and exposures captured in this section see the main introduction to this chapter. The main body of the chapter should be referred to for detail on the treatment of derivative instruments. Individual Net Positions 3 A bank may net, by value, long and short positions in the same debt instrument to generate the individual net position in that instrument. Instruments will be considered to be the same where the issuer is the same, and the equivalent ranking in a liquidation, and the currency, the coupon, and the maturity are the same. 4 A bank may net by value a long or short position in one tranche of a debt instrument against another tranche only where the relevant tranches - a) rank pari passu in all respects; and b) become fungible within 180 days and thereafter the debt instruments of one tranche can be delivered in settlement of the other tranche. Specific Risk Calculation 5 In determining its specific risk capital requirement for positions in debt instruments a bank must calculate the sum of the weighted current market value of each of its individual net positions, whether long or short, according to the following weights: Weighting a) Certain Central Government debt instruments 0.00% b) Qualifying Items up to 6 months residual maturity 0.25% c) Qualifying Items over 6 months residual maturity 1.60% d) Non-Qualifying Items 8.00% 6 Debt instruments will be given a 0% specific risk weighting if: a) they are issued by, fully guaranteed by, or fully collateralised by securities issued by Zone A central governments and central banks, including the European Communities; or b) they are issued by, or fully guaranteed by, Zone B central governments and central banks with a residual maturity of 1 year or less and are denominated in local currency and funded by liabilities in the same currency. 7 A list of Zone A countries was originally provided in Administrative Notice Number 1. All other countries not included in Zone A are in Zone B. 67

68 8 Debt instruments will be treated as qualifying if any of the following conditions apply: a) they are issued by, or fully guaranteed by, Zone B central governments and central banks with a residual maturity of over 1 year and are denominated in local currency and funded by liabilities in the same currency. b) They are securities issued by, or fully collateralised by claims on, a multilateral development bank listed in the Solvency Ratio Directive. (See Chapter 12 - Lists for a list of these institutions). The European Commission may amend this list periodically. c) They are issued, guaranteed, endorsed, or accepted, by a credit institution incorporated in a Zone A country; d) They are issued, or guaranteed, endorsed, or accepted, by a credit institution incorporated in a Zone B country and have a residual maturity of 1 year or less; e) They are issued, or guaranteed, by an investment firm that is subject to the Capital Adequacy Directive, or a regime that the Bank deems to be as stringent; f) They are issued by, or guaranteed by, Zone A public sector entities; g) They are issued by, or guaranteed by, a company whose equity is eligible for 2% equity specific risk weighting (see Chapter 6 - Equity Position Risk). 9 Debt items issued by entities not covered by the descriptions in the preceding paragraph may still be treated as qualifying if the issue, or an issue of equivalent ranking in a liquidation, or an issue of equivalent ranking in a liquidation of the guarantor, is rated investment grade (or its equivalent for money market obligations), or above and provided that the reporting bank is unaware of any sub investment grade rating issued by any relevant credit rating agency. When the reporting bank is aware of an announcement that the issue may be downgraded to below investment grade, by at least one relevant credit rating agency, that debt will cease to be qualifying unless it meets the criteria of the preceding paragraphs. 10 Debt instruments where the issuer does not meet the requirements established above (paragraphs 6 to 9 inclusive) are deemed to be non qualifying. General Market Risk Calculation 11 A separate general market interest rate risk calculation is calculated for each currency irrespective of where the individual instruments are physically traded or listed. The resultant capital requirements must be converted into the reporting currency by applying the prevailing foreign exchange spot rates. These capital requirements are summed arithmetically to give the total general market risk requirement. 12 The Banking Supervisor does not intend to distinguish explicitly between the level of general market risk capital requirement for different currencies. However, it recognises that yield curves in some currencies are more volatile and that their markets are less liquid with fewer hedging mechanisms available. When a bank has a portfolio with interest risk in such currencies, this will be taken fully into account when setting the target and trigger capital ratios (see Chapter 10 - Own Funds). 68

69 13 The capital requirements for general market risk are intended to recognise the risk of parallel and non-parallel shifts in the yield curve. The bank must allocate individual net positions to one of the maturity bands in Table 5.3 below, on the following basis: i) Fixed-rate instruments will be allotted their maturity bands based upon the residual time to maturity - irrespective of embedded puts and calls - and whether their coupon is below 3%. ii) Floating rate instruments will be allocated to maturity bands based upon the time remaining to the re-determination of the coupon. 14 The bank must then sum the market value of its individual net positions within each band irrespective of whether they are long or short positions to produce a gross position figure. This figure should then be multiplied by the weighting factor for the relevant maturity band. These weighted figures should then be summed to give the capital requirement for general market risk. 69

70 Chapter 6 - Equity Position Risk Explanation 1 A bank which holds equity positions (whether long or short) in the trading book is exposed to the risk that the equity market as a whole may move against it - general risk - and that the value of individual equity positions relative to the market may move against the bank - specific risk. The general risk requirements set out in this chapter recognise offsetting positions within national markets. The specific risk requirements recognise that individual equities are subject to issuer risk and liquidity risk, and that these risks may be reduced by portfolio diversification. The chapter also sets out the treatment for related derivative positions. 2 This chapter describes three methods by which banks may calculate their capital requirements for equity positions held in the trading book: the standard method; a simplified method; and an alternative method. 3 Paragraph 21 of this chapter outlines a simplified method for the calculation of trading book capital requirements for equity position risk, which banks may choose to adopt. The capital requirement generated by application of the simplified method will usually be higher than that which would result from applying the standard method. If banks choose to apply this method they should seek permission from the Banking Supervisor and, in most circumstances, they would be expected to adopt the simplified method also for interest rate position risk (see Chapter 5 - Interest Rate Position Risk). 4 The following section of the Capital Adequacy Directive is covered by this Chapter: Annex I, paragraphs Scope 5 This Chapter applies to positions and exposures (including forward positions) in the trading book of the following instruments: a) shares; b) depository receipts (see paragraph 6); c) convertible preference securities (non-convertible preference securities should be treated as bonds); d) convertible debt securities which convert into other instruments in this list and are treated as equities (see paragraph 7): and e) derivatives based on the above. 6 Depository receipts should be converted into the underlying shares and allocated to the same country as the underlying shares. 7 Convertibles as defined in paragraph 5 (d) must be treated as equities where a) the first date at which conversion may take place is less than three months ahead, or the next such date (where the first has passed) is less than a year ahead, and: b) the convertible is trading at a premium of less than 10%, where the premium is defined as the current mark to market value of the convertible less the mark to market value of the underlying equity, expressed as a percentage of the mark to market value of the underlying equity. 70

71 Convertibles other than those defined above may be treated as equity or debt securities (see Chapter 5 - Interest Rate Position Risk). 8 For instruments which deviate from the structures listed in paragraphs 5 to 7 above, or which could be considered complex, each bank should agree a policy statement with their supervisor about the intended treatment. The treatment of some instruments may be uncertain, (for example, bonds whose coupon payments are linked to equity indices): where possible the position risk of such instruments should be broken down into its components and allocated appropriately between the equity, interest rate and foreign exchange risk categories. Advice must be sought from supervisors in cases of doubt, and when a bank is trading an instrument for the first time. 9 Where a trading book position results from underwriting activities, the capital requirement may be reduced in accordance with the parameters described in Chapter 8 Underwriting. 10 Where a bank has physical long equity positions in its trading book composed of capital instruments issued by other institutions, the current market value of these positions must be deducted from its capital base, unless the bank has permission to treat the position under a market-maker s concession. Recognition will be given, however, for any hedging benefits of such positions against other market exposures in calculating capital requirements for position risk (see Chapter 1 - The Trading Book). Calculation Of Capital Requirements - Standard Method 11 Equity positions, arising either directly or through derivatives, should be allocated to the country in which each equity is listed and the calculations described below applied to each country. Where an equity is listed in more than one country, banks should discuss the appropriate country allocation with the Banking Supervisor. Capital requirements should be converted into sterling at the closing mid-market spot rate. Annex II describes an alternative to the basic method. Netting 12 A bank may net long and short positions in the same equity instrument, arising either directly or through derivatives, to generate the individual net position in that instrument. Positions in depository receipts may only be netted against positions in the underlying stock if the stock is freely deliverable against the depository receipt. Interest rate exposure arising from derivatives must, however, be treated as set out in paragraphs below. For the treatment of equity indices, see paragraphs 26 and A bank may net long and short positions in one tranche of an equity instrument against another tranche only where the relevant tranches : a) rank pari passu in all respects; and b) become fungible within 180 days, and thereafter the equity instruments of one tranche can be delivered in settlement of the other tranche. Specific Risk Calculation 14 For each country, the bank should sum the market value of its individual net positions, as determined in paragraphs 11-13, irrespective of whether they are long or short positions to produce the overall gross equity position for that country. 71

72 Qualifying countries 15 Chapter 12 sets out the current list of qualifying countries for equity specific risk. The list may be amended periodically, and information likely to be considered in doing so is given in Chapter For equity instruments that are not listed in one of the qualifying countries, the specific risk capital requirement is 8% of the overall gross equity position. For equity instruments that are listed in one of the qualifying countries the specific risk requirement is 4% of the overall gross equity position, unless the conditions in paragraphs 17 and 18 are met. Highly liquid instruments and diversified portfolios 17 For equity instruments listed in a qualifying country which are also deemed to be highly liquid (see paragraph 18), the specific risk capital requirement may be further reduced to 2% of the overall gross position of those highly liquid equities, providing that the following portfolio diversification requirements are met: a) No individual highly liquid equity position shall comprise more than 10% of the gross value of the country portfolio; and b) The total value of gross highly liquid equity positions which individually comprise between 5% and 10% of the gross value of the country portfolio shall not exceed 50% of the gross value of that country portfolio. If a country portfolio can be split into two sub-portfolios such that one of the sub-portfolios would meet the diversification requirements, the lower specific risk requirement may be applied to the diversified sub-portfolio (individual positions may be sub-divided between sub portfolios). Portfolios or subportfolios which do not meet the above requirements will continue to attract the 4% specific risk weight. For the purposes of these tests, the gross value of the country portfolio include positions in indices listed in Chapter 12 (although they themselves attract specific risk requirement); it must exclude, however, any positions or parts positions which have been removed in attempting to identify a diverse sub-portfolio (i.e. the tests must be repeated after positions are removed). 18 Individual equities included in the indices listed in Chapter 12 are considered to be highly liquid. This list of indices may be amended periodically, and the information likely to be used in doing so is set out in Chapter A stock of a UK incorporated company traded on the London Stock Exchange, but not a component of an index listed in Chapter 12, will also be considered to be highly liquid if it has: I) at least 6 registered market makers; and ii) has a Normal Market Size (NMS) of at least 5,000 shares. Equities listed in a qualifying country which are included in the FT-Actuaries World Indices are also considered to be highly liquid. 20 The criteria for defining highly liquid equities in other EU/EEA countries may be reviewed in the light of decisions by supervisors in those countries concerning the definitions they employ for highly liquid equities in their domestic markets when implementing the Capital Adequacy Directive. 72

73 Simplified Method For Specific Risk 21 The capital requirement generated by this simplified method is less precise than that generated by the standard method, and it will usually, therefore, result in a higher capital requirement. Banks which intend to adopt this method should discuss their intention with their line supervisor. Under this method banks may choose not to apply the tests in paragraphs 17 and 18 above. Further, they may choose simply to assign a specific risk requirement of 8% to all equity instruments. General Risk Calculation 22 For the general risk calculation, the bank should sum the market value of its individual net positions for each country, as determined in paragraphs 11-13, taking into account long and short positions, to produce the overall net equity position for that country. The general risk capital requirement for each country will be 8% of the overall net position, unless the provisions of paragraphs 23 or 24 apply. 23 Where an individual net position represents more than 20% of the gross equity position of that country (as defined in paragraph 14), the amount of the individual net position in excess of 20% must be removed from the calculation of the overall net equity position for that country. There is a separate general risk capital requirement of 8% for this excess amount. 24 Subject to certain criteria listed below, inter-market offsets are recognised between country portfolios with indices listed in Chapter 12, such that the total general market risk requirement for these portfolios is calculated as: where ω represents the general market risk component from each portfolio. The criteria which must be met to qualify for the above treatment are: a) The calculation must involve the general market risk requirements of at least 4 country portfolios; b) The sum of the general market risk components in the calculation must equal 0 (ie Σω = 0), where an overall long position in a country portfolio has a positive sign and an overall short position a negative sign; and c) The general market risk component from each country must not account for more than 30% of the overall gross general market risk in the calculation. The general market risk requirement for a particular country may be divided, so that one part is used in the above calculation and the remainder is added directly into the general risk sum in paragraph The equity general market risk capital requirement for the trading book is the sum of the general market risk requirement calculated in paragraph 24 and the general risk requirements for all countries or parts of countries not included in the calculation in paragraph 24. Equity Indices 26 The treatments described below apply to positions in equity indices, whether they arise directly or through derivatives. Positions in indices listed in Chapter 12 attract no specific risk requirement. They should be included in the general 73

74 market risk calculation for the relevant country as a single position based on the sum of current market values of the underlying instruments. 27 Positions in indices not listed in Chapter 12, or positions in notional indices or baskets of stocks may either be decomposed into their component stocks, or they may be treated as a single position based on the sum of current market values of the underlying instruments: if treated as a single position, the specific risk requirement is the highest specific risk charge which would apply to any of its components, as set out in paragraphs 14-20, and the general risk charge is as set out in paragraphs Derivatives 28 Derivative positions, in equity futures, forwards, and swaps, based on individual equities, portfolios of equities or equity indices, must be converted into notional underlying instruments, whether long or short. The resultant notional instruments should be treated under the relevant Chapters (see paragraphs above for equity position risk; see Chapter 4 - Foreign Exchange Risk; see Chapter 5 - Interest Rate Position Risk subject to paragraph 30 below). For equity swaps, the equity exposure must be treated separately from the interest rate exposure. 29 Derivative positions may also generate counterparty exposures, for example, to counterparties in OTC trades, through margin payments, through fees payable, or through settlement exposures. Capital is required against such counterparty risk for derivatives, as set out in Chapter 2 - Counterparty Risk. 30 For interest rate position risk, the notional underlying instruments should be included as government securities with a coupon below 3% in the currency concerned in the interest rate treatments in Chapter 5, but only if the Banking Supervisor is satisfied, and has given express written agreement, that sufficient controls are in place to monitor this interest rate exposure and to take account of dividend exposures and liquidity risk. If a bank has an interest rate sensitivity model approved (see Chapter 9 - Eligible Models), the interest rate exposure may be incorporated into that model. 31 Without such permission from the Banking Supervisor, embedded interest rate exposures in equity derivatives will be subject to capital requirements based on the following: Time to expiration Percentage 0-3 months months months years years years years 2.75 over 5 years 3.75 Positions with maturity of exactly 3 months, 6 months, etc, should be assigned to the shorter maturity band. The capital requirement is calculated for each notional position before any netting permitted under paragraphs 12 and 13, as the mark to market value of the underlying position multiplied by the percentage in column 2. The capital requirement for all notional interest rate positions under this treatment is the 74

75 Options sum of the absolute values of the individual capital requirements calculated above. 32 Capital requirements for options or warrants on equities, plus any related hedging positions, must be calculated using either: a) the simple method (carve out) set out in Annex I to this Chapter (for options with residual maturity under six months only); or b) one of the option risk management models described in Chapter 9 - Eligible Models. Advice should be sought from the Banking Supervisor on options or warrants with residual maturity over six months. 33 Banks which have a recognised option pricing model may, with express written agreement of the Banking Supervisor, use the delta value of options calculated from this model in the determination of the net positions for individual instruments, as set out in paragraphs 12 and 13. Where these delta values represent stock indices or stock index futures, they should be treated as set out in paragraphs 26 and

76 Annex I Simple Method For Options (Carve Out) 1 The table below may be used to calculate the market risk requirements for options or warrants on equities, with residual maturity under six months, plus any related hedging positions. 2 The Banking Supervisor is aware that these calculations are approximate, and tend to overstate the market risk of options. Institutions whose option positions are large, so that this overstatement puts them at a significant disadvantage, are encouraged to apply for model recognition as described in Chapter 9 - Eligible Models. 3 An option will be deemed to be hedged for the purposes of the calculations when the size of the offsetting underlying position matches the amounts into which the option is exercisable. Where the amount underlying the option is larger than the offsetting position, the residual options will be treated as Naked Option Positions. Advice should be sought from the Bank on the treatment of options with residual maturity over six months. Option position In the Money by more than P% In the Money by less than P% Naked Long Call NL NL NL Long Put NL NL NL Short Call NSI NSI NSO Short Put NSI NSI NSO Long in Long Put 0% LPI HO Underlying Short Call 0% SHI HO Short in Long Call 0% LCI HO Underlying Short Put 0% SHI HO Out of the Money In the Money means that the exercise level of a call option or warrant is less than the current mark to market value of the underlying instrument, and for put options or warrants that the current mark to market value of the underlying is less than the exercise level of the put option or warrant. Out of the Money means those options and warrants that are not In the Money. P% is the sum of the specific and general market risk for the underlying equity instrument as if it were the only component in a portfolio. The capital requirements for options and warrants and their associated hedges under this method are as set out overleaf: NL The lesser of: a) the market value of the underlying instrument multiplied by P% and b) the current value of the option on the bank's books. NSI The market value of the underlying position multiplied by P%. NSO The market value of the underlying position multiplied by P% minus 0.5 multiplied by the amount by which the option is Out of Money (subject to a maximum reduction to zero) LPI The market value of the underlying position minus 76

77 (1-P%) multiplied by the underlying position valued at the exercise price HO The market value of the underlying position multiplied by P% SHI The market value of the underlying position multiplied by P% minus the mark to market value of the option (subject to a maximum reduction to zero) LCI (1+P%) multiplied by the underlying position valued at the exercise price minus the market value of the underlying position 77

78 Annex II Alternative Method 1 Where a bank chooses to use this method in preference to the standard method, it must calculate the equity position risk capital requirement as being the higher of: a) Calculation 1; and b) Calculation 2 Calculation 1 refers to the following table of factors: Category A B C D UK & Ireland Constituents of FTSE100 Index Other Constituents of the FT All Share Index Other Equities with a normal market size Other UK & Irish equities Japan Constituents of Nikkei225 Index Other constituents of the First Section of the Tokyo Stock Exchange Other Japanese Equities USA Constituents of the S&P500 Index Other constituents of the NYSE, AMEX and NASDAQ NMS Other US equities Constituents of the FT-Actuaries World Indices % N/A N/A N/A Australia Belgium Canada Denmark France Germany Hong Kong Italy Netherlands Norway Singapore Spain Sweden Switzerland E Other Equities 30.0 N/A N/A Calculation 1 2 Having allocated equity positions according to the categories in the table, calculate the capital requirement for each country portfolio separately, and aggregate the results. The equity capital requirement for a country portfolio is: a) {Aggregate Long Positions + Aggregate Short Positions}* Column 1 in the table unless the portfolio is a qualifying country portfolio, as set out below, in which case calculate the capital requirement for that country portfolio as: - 78

79 b) 1/100*{Basic Risk * Liquidity Adjustment Factor} Notwithstanding a) & b) above, if a bank has a qualifying country portfolio in at least two out of three of the UK, US and Japan, it may calculate the equity position risk capital requirement for these portfolios as : - c) 1/100*{Modified Basic Risk * Modified Liquidity Adjustment Factor} The terms used in calculations a), b) and c) are defined below. 3 A qualifying country portfolio is either: i) a UK, US or Japan country portfolio containing positions only in those categories against which figures appear in columns 2 and 3 of the table, and which contains at least 10 long or 10 short individual net positions; or ii) a portfolio of any other country listed in Part D of the table which comprises constituents of the FT-Actuaries World indices and contains at least 5 long or 5 short individual net positions 4 The Basic Risk Calculation i) Calculate the square of the net overall position of the qualifying country portfolio; ii) Multiply the figure generated in i) by the appropriate figure in column 3 of the table; iii) Calculate the square of the value of each individual net position, excluding positions arising from broad based equity index contracts, and total the squared amounts for each country; and iv) Multiply the total calculated in iii) by the appropriate figure shown in column 2 of the table. The basic risk of a qualifying country portfolio is the sum of ii) and iv). 5 Liquidity Adjustment Factors - Calculate liquidity adjustment factors for the UK, US and Japan country portfolios as follows:- i) calculate the overall gross position (ie long plus short positions) in each category and aggregate these to form the overall gross position for each country portfolio; ii) calculate the following proportions: I) the constituents of the FTSE100 Index category portfolio as a proportion of the UK country portfolio; II) the FT-All Share Index category, excluding FTSE100 stocks, as a proportion of the UK country portfolio; III) the constituents of the Nikkei 225 Index category portfolio as a proportion of the Japan country portfolio, and; IV) the constituents of the Standard & Poor s 500 Index category portfolio as a proportion of the US country portfolio; Liquidity adjustment factors for the Japan and US country portfolios are, respectively: 6 / (proportion III * 4) + 2 and 6 / (proportion IV * 4) + 2 Liquidity adjustment factor for the UK country portfolio is: 79

80 6 / (proportion I * 4) proportion II The liquidity adjustment factor for other qualifying country portfolios is 1. 6 Modified Basic Risk Calculation i) Calculate the basic risk for each qualifying country portfolio as in paragraph 4 and take the sum of these ii) Calculate the overall net position for each qualifying country portfolio; multiply together the overall net positions for pairs of countries; and then multiply by the factors shown below - Overall Net Position Factor UK & US 17 UK & Japan 11 US & Japan 11 The modified basic risk figure is the sum of i) and ii). 7 Modified Liquidity Adjustment Factor: Calculate the modified liquidity adjustment factors for UK, US and Japan country portfolios as follows - i) calculate the overall gross position of all qualifying country portfolios and sum these to obtain the aggregate overall gross position; ii) calculate the following proportions:- I) the overall gross position of the portfolio comprising the FTSE100 Index category portfolio plus the Nikkei225 portfolio plus the Standard & Poor s 500 Index category portfolio, all as a proportion of i); and II) the overall gross position of the FT All Share Index category portfolio, excluding the FTSE100 stocks, as a proportion of i). The modified liquidity adjustment factor is - 6 (proportion I * 4) proportion II Calculation 2 8 Calculate the equity position risk capital requirement on a country by country basis as the aggregate of the specific and general market risk requirements, and sum the results across all countries. Specific Risk 9 For each country, the specific risk capital requirement is the overall gross position for that country portfolio multiplied by: i) For single stocks 4%; or ii) For diversified portfolios of highly liquid stocks 2%; or iii) For broad-based equity indices which are not broken down into their constituent stocks 0%. General Market Risk 10 For each country, the general market risk capital requirement is the overall net position for that country portfolio multiplied by 8%. 80

81 Chapter 7 Commodity Position risk Explanation 1 This chapter outlines the capital standards for commodity position risk. a) For the purposes of this chapter, a commodity includes any physical product which is or can be traded on a secondary market and positions in respect of contracts, whether in tangibles or intangibles, not covered in the chapters on equity, foreign exchange and interest rate position risk. i) Commodities therefore include agricultural products, base metals, other minerals and various precious metals other than gold; positions in gold are treated under the methodology for calculating foreign exchange position risk. A position in a commodity arising from a derivative contract will also generally fall within the methodology outlined below. 2 This chapter covers the following parts of the Capital Adequacy Directive ( ): Article 2 paragraphs 6 and Annex VII Scope 3 The capital requirements for commodity position risk were introduced by Directive 98/31/EC which amends the Capital Adequacy Directive (93/6/EEC). Its provisions are to be implemented for banks in Gibraltar with effect from 1 July The requirements set out in this chapter apply to all banks incorporated in Gibraltar on a solo or solo-consolidated) and consolidated basis. a) Note that the requirements apply to all Gibraltar incorporated banks: as with FX risk, banks are charged capital for positions in commodities, whether or not they have a trading book as defined by the. Calculation of the Capital Requirement 5 The price risks attached to commodity positions are often more complex and volatile than hose associated with currencies and interest rates. It is often the case that commodity markets are less liquid than those for interest rates and currencies; consequently shifts in supply and demand may have a more significant effect on price and volatility than for other types of product. Such characteristics make the hedging of commodities risk more difficult. 6 For a bank engaged in spot or physical trading, the risk arising from a change in the spot price on open positions is of particular importance. A bank using derivative contracts as part of its portfolio strategy is exposed to additional risks, which may be larger than the change in spot prices. Other forms of risk include: (a) basis risk, which is the risk that the relationship between prices in similar commodities changes through time; (b) interest rate risk, which is the risk of a change in the cost of financing for forward positions and options; and 81

82 (c) forward gap risk, which is the risk that the forward price may change for reasons other than a change in interest rates. 7 A bank is, in addition, required to calculate explicit capital charges in respect of its commodity contracts held in either the banking or the trading book to take account of counterparty credit risk. Framework for calculating commodity risk capital charges 8 There are three arrangements for measuring and calculating the capital charges for commodity position risk: (a) the internal models approach; (b) the maturity ladder approach; and (c) the simplified approach. Internal models approach 9 A bank may use its internal model as the basis for calculating its capital requirements on its commodity positions. The use of such models is permitted only where a number of qualitative and quantitative standards are met. These are outlined in Chapter 9 Eligible Models. 10 Any bank wishing to utilise the models approach should contact the Banking Supervisor well ahead of starting to use its model to determine capital charges in respect of its commodities business. Common issues for maturity ladder and simplified approaches Definition of a single commodity 11 Capital charges for each commodity are to be calculated separately, except under either of the following provisions, where positions may be treated as if they are in the same commodity: (a) positions in different sub-categories of commodities in cases where the sub-categories are deliverable against each other; or (b) positions in commodities which are close substitutes for each other and whose price movements over a minimum period of one year can be shown to exhibit a stable and reliable correlation of at least Any offsetting of positions under 11(b) may only be exercised with the prior written approval of the Banking Supervisor. It is the responsibility of a bank wishing to use this provision to demonstrate that the correlation is valid and to monitor its continued existence. Treatment of derivative positions 13 All commodity derivatives and off-balance sheet positions which are affected by changes in commodity prices should be included in the measurement framework, as set out below. These include commodity futures, commodity swaps and options. 14 When applying the maturity ladder and simplified approaches, commodity derivative positions should be converted into notional commodity positions and assigned a maturity as follows: (a) futures and forward positions relating to individual commodities should be included as notional amounts of barrels, kilos etc. and should be assigned a maturity based on their expiry date; 82

83 (b) commodity swaps where one leg is fixed price and the other is the current market price should be incorporated as a series of positions equal to the notional amount of the contract, with one position corresponding with each payment on the swap and slotted into the maturity ladder accordingly. The positions are long positions if the bank is paying fixed and receiving floating and short positions if the bank is receiving fixed and paying floating; and (c) for commodity swaps where the legs are in different commodities, each leg should be included in the relevant maturity ladder. No matching or off-setting should be allowed unless the commodities belong to the same sub-category as defined in 11(b) above. 15 Options and warrants on commodities may be treated under one of two methods. A simple method, called the carve-out, may be used for portfolios which contain (at most) only a small number of written options or warrants, and providing also they contain only plain vanilla and shorter-dated instruments. These conditions, and the carve-out calculations themselves are shown in Annex II of this chapter. Banks with larger and/or more complex options portfolios will need to seek recognition from the Banking Supervisor for use of an options risk management model. The maturity ladder approach 16 When using the maturity ladder approach, a bank must first express each commodity position (spot plus forward) in terms of a standard unit of measurement (barrels, tonnes, kilos). For each commodity, contracts or holdings expressed in a standard unit of measurement should be assigned to one of seven maturity or time bands (see table below). a) The calibration of derivative items into notional commodity amounts is dealt with in paragraphs above. b) Physical stocks should be entered into the first time band. 17 Before matching positions within the time bands included in the maturity ladder, a bank may also engage in pre-processing (also known as off-setting or optimisation) in respect of commodities traded in markets which have daily delivery dates. Under this procedure, a bank can off-set long and short positions in a given commodity which mature on the same day or which mature within ten days of each other, and is not required to include these off-set positions in the maturity ladder calculation. 18 Time bands and spread rates for the maturity ladder are as follows: Time band Spread rate 0 1 month 1.5% 1-3 months 1.5% 3-6 months 1.5% 6-12 months 1.5% 1-2 years 1.5% 2-3 years 1.5% over 3 years 1.5% 19 Matched long and short positions in each time band incur a capital charge. This charge is calculated as the sum of matched positions (i.e. both long and short positions), multiplied first by the spot price for that commodity (expressed in 83

84 the bank s reporting currency) and second by the spread rate for that band (1.5%). 20 Any remaining unmatched position in a time band must be carried forward to the next time band. This amount can then be used to match positions in time bands that are further out. As the matching of positions maturing in different time bands provides an imperfect hedge, a capital surcharge is incurred, equal to the remaining unmatched position multiplied first by 0.6% and second by the number of time bands this position is carried forward. The capital charge for each matched amount created by carrying unmatched positions forward is then calculated in the same manner outlined in paragraph 19 above. 21 Once a bank has completed the functions of pre-processing and matching above (including the effect of carrying net sums to further time bands), it should have either a net long or short position in the relevant commodity. A capital charge of 15% applies to this net open position. 22 The same level of percentage charges applies to each commodity. A bank which wishes to have a more commodity specific assessment of its market risk should adopt the models approach. 23 A worked example of the maturity ladder approach is shown in Annex I of this chapter. The simplified approach 24 In calculating the capital requirement under the simplified approach, a charge equal to 15% of the overall net open position, long or short, is incurred in respect of each commodity. To further guard against basis risk, interest rate risk and forward gap risk, the total capital charge for each commodity is subject to an additional capital charge equal to 3% of a bank s gross positions, long plus short, in the relevant commodity. a) In valuing commodity positions for these purposes, a bank should use the current spot price, expressed in the bank s reporting currency at the prevailing spot rate. 25 A worked example of the simplified approach is shown in Annex I of this chapter. 84

85 Annex I: Illustrative Calculations Using Maturity Ladder and Simplified Approaches 1 An illustrative calculation of the maturity ladder approach once pre-processing is complete, and with positions multiplied by their spot price (expressed in sterling, the reporting currency in this example): Time Band Position 0-1 month 1.5% 1-3 months 1.5% 3-6 months Long 800 Short 1000 Spread Rate Capital Calculation 1.5% 800 long short (matched) multiply by 1.5% = 200 short carried forward to 1-2 years; capital surcharge = 200 x 2* x 0.6% = 6-12 months 1.5% 1-2 years Long % 200 long short (matched) x 1.5% = 400 long c/f to over 3 years ; capital charge; 400 x 2* x 0.6% = 2-3 years 1.5% over 3 years Short % 400 long short (matched) x 1.5% = net position; 200 capital charge; 200 x 15% = Capital Charge The total capital charge will be a) The calculations multiplied by 2 above (shown*) are because they are unmatched positions carried forward two time bands. b) This total capital charge is then fed into the overall calculation of the capital requirement for the bank. 2 An illustrative calculation of the simplified approach: Positions (volume * spot price) Capital charges Positions (volume * spot Capital charges price) Long Short Overall NOP = ( 200) Gross positions = 3000 Total capital charge = x 15% = x 3% = 90 85

86 Annex II: Carve Out Method for Options 1 Subject to the prescriptions below, the simple carve-out method can be applied to any purchased commodity option. However, the method is not appropriate for large portfolios of sold/written options and consequently should only be used for sold/written option positions up to a de minimis level, a) As a guide, the advice of the Banking Supervisor should be sought before applying the carve-out to more than five written commodities options. The Banking Supervisor would expect banks with larger portfolios to be actively seeking recognition of an option risk management model. 2 Different treatments apply to plain vanilla options and to exotic options: (a) plain vanilla options: Where a bank uses the simple carve-out approach (i.e., for any purchased options positions, and for sold/written options positions up to the de minimis level or with specific agreement from the Banking Supervisor), the table below is used to calculate the market risk capital requirements for the options plus any related hedges. a) These figures may only be used for plain vanilla options with a residual maturity of less than six months. b) For longer-maturity plain vanilla options the advice of the Banking Supervisor must be sought. Where a bank values its option with reference to the forward price of the underlying commodity rather than the spot price, and also calculates whether (and by how much) the option is in/out of the money with reference to the forward price, then the supervisor may agree that the approach can be used for options with a residual maturity greater than six months also. The Banking Supervisor has discretion, however, to insist that model recognition is sought for options with longer-term residual maturities. (b) exotic options: a) The simple carve-out approach is not suitable for exotic options (including barrier options, digital options, quanto options and other path-dependent options), and consequently the Banking Supervisor expects banks trading exotic options to seek model recognition. b) However, the simple carve-out approach may be used to calculate an interim capital requirement for exotic options pending model recognition. i) The advice of the Banking Supervisor should be sought by any bank wishing to include exotic options in the simple carve-out for an interim period. c) A number of alternatives are available for the interim capital treatment of exotic options pending model recognition, including the use of the simple carve-out method and existing option model recognition (possibly subject to capital buffers and/or to nominal or volume caps). 86

87 i) This decision will rest on a number of factors, including the risk profile of the portfolio, and the scope and nature of any existing model recognition granted. ii) A bank which has models which have been recognised by the Banking Supervisor should not use the carve-out method for those instruments which are covered by the recognised model. d) The Banking Supervisor recognises that the carve-out calculation method is only approximate, and tends to overstate the market risk of options. Institutions whose option positions are large, so that this overstatement puts them at a significant disadvantage, are encouraged to apply for model recognition as described in the relevant chapter. e) This section covers the application of the carve-out method to commodity options only The method covers all of the options risks. Details of the carve-out method in general, and its application to options on other risk categories are given in the chapters on interest rate risk, equity risk and FX risk. 3 The carve-out method distinguishes between: naked, or open positions. i.e. where a bank does not have an opposite, offsetting position; and hedged positions, i.e. those where a bank has an offsetting position. a) An option will be deemed to be hedged for the purposes of the carve-out when the size of the offsetting underlying position matches the amounts into which the option or warrant is exercisable. b) Where the amounts underlying the option are larger than the offsetting positions, the residual option will be treated as a separate naked option. c) Where the position hedging an option is larger than the amount underlying the option, the residual position should be included in the net open position calculation. d) Where options are back to back (i.e. opposite positions are exactly equal in terms of strike price, maturity date, underlying, and any other relevant factors) there are no market risk capital requirements. However, counterparty risk charges still apply. 4 The relevant capital requirements are calculated using the following table: Option Position In the money By > 15% In the money by < 15% Out of the Money Naked Long Call/Put NL NL NL Short Call/Put NSI NSI NSO Hedged: Long in Underlying Long Put Short call 0% SHI LPI SHI HO HO Hedged: Short in Underlying Long Call Short Put 0% SHI LCI SHI HO 87

88 HO a) The key to the abbreviations used in this table are given in the paragraphs below. b) As with all carve-outs, a long option position is one where an option has been purchased while a short option position is one where an option has been written/sold. c) At the money options should be treated as if they were in the money by less than 15%. For these purposes, at the money means those options and warrants whose strike price is equal to the current market price of the underlying commodity. d) In the money means that the exercise level of a call option or warrant is less than the current market price of the underlying commodity and, for put options or warrants, that the current market price of the underlying commodity is less than the exercise level of the put option or warrant. e) Out of the money means, for these purposes, those options and warrants that are not in the money or at the money. 5 The capital requirements are: NL: The lesser of the market value of the underlying instrument multiplied by 15% the current value of the option on the bank s books. NSI*: The market value of the underlying position multiplied by 15% NSO*: The market value of the underlying position multiplied by 15% minus the amount by which the option is out of the money (subject to a maximum reduction to zero). 0% Options which are heavily in the money (defined for these purposes as where a shift in the market exchange rate by greater than 15% would be required to place it out of the money) have similar price characteristics to the underlying. If hedged by the underlying, there is little or no risk to the holding bank, and hence the 0% capital charge marked in the table above. LPI: The market value of the underlying position minus ((1-15%) multiplied by the underlying position valued at the exercise price). LCI: (1.15 [i.e. I + 15%) multiplied by the underlying position valued at the exercise price) minus the market value of the underlying position (subject to a maximum reduction to zero). SI-LI: (The market value of the underlying position multiplied by 15%) minus the mark to market value of the option (subject to a maximum reduction to zero). HO: The market value of the underlying position multiplied by 15%. 88

89 Chapter 8- Underwriting Explanation 1 A bank which is involved in the underwriting of debt, and/or equity, and/or other securities issues may take significant direct exposures, to the issuer and to the market place, which in the normal course of events can be expected to reduce quickly through sales, or by obtaining underwriting commitments from other firms. Underwriting is therefore to be included within the trading book. 2 The underwriting process, whether of bonds, equities or other securities, has a common set of events: Announcement Date Launch Date Commitment Date Allotment Date Subscription Date Closing Date Payment Date These events may occur with different time gaps between them depending upon particular aspects of the underwriting mechanism. For example the gap between the Announcement Date and the Launch Date may be negligible for a bond underwriting, but may be several days for an equity underwriting. 3 Reductions in Large Exposures and Position Risk capital requirements are not available to banks which make purchases on the grey market, and are neither underwriters, nor members of the syndicate for underwriting or distributing the particular securities. The treatments described below only apply to new instruments and new tranches of existing instruments. Large size secondary market trades of equities or bonds will not benefit from any reductions in Large Exposures or position risk capital requirements. 4 Where an underwriting commitment is for a new tranche of existing securities then it may be netted against offsetting positions according to the rules set out in the Interest Rate Position Risk and Equity Position Risk chapters in the sections on Netting. Such netting will lead to reductions in position risk capital requirements and Large Exposures. 5 This chapter describes the way in which the capital required to support the underwriting commitments should be calculated from the perspective of position risk. Large Exposures treatment is covered in Chapter 3 - Large Exposures. Where a bank is underwriting a capital raising issue for another financial institution, it will not be able to reduce the deduction from its own capital base from 100% of the net underwriting commitment unless it has express written agreement of the Banking Supervisor for these types of transactions, see Chapter 11 - Own Funds. 6 The following section of the is covered by this chapter: Annex 1 paragraph 39 Scope 7 Banks may apply the underwriting treatments below to new securities or securities which are new to the market where the bank has given: 89

90 a) A commitment to an issuer to purchase, underwrite or distribute those securities; or b) It is a member of the syndicate for the underwriting or distribution of those securities. Where a bank is permitted, but chooses not, to apply the treatments below then the capital requirements must be applied to the net commitment using techniques detailed in the other chapters. 8 Banks which apply the underwriting method may only apply it to: a) Any commitment to an issuer of securities to purchase or distribute new securities and securities that are new to the market; b) Any sub-underwriting commitment obtained by the bank from others; and c) Any allotment, purchase or sale of the securities in respect of which the bank has given a commitment under a) or b). 9 A bank may apply the underwriting treatment to a commitment to purchase existing securities that are exchange traded only with the prior written approval of the Banking Supervisor. Note: The Banking Supervisor will only grant approval to apply the underwriting treatment where it determines that the purchase of existing securities has the characteristics of an offering of new securities which are new to the market, by reference to: a) the extent of the publicity; b) the method of distribution; c) how widely the offering is to be made; and d) the type of documentation to be used. For example, the sale to the public of further shares of a partially privatised company would generally qualify for underwriting treatment, but the private placement of shares in a subsidiary company sold off by its parent holding company would not. Commitment 10 A bank must treat its commitment to the issuer, for Large Exposure monitoring and notification purposes, as commencing on the date that the initial commitment is given, except: a) For a bond issue with the pricing terms fixed, the commitment shall be deemed to commence on the opening of business on the third UK business day after the launch date; or b) For a bond issue with the pricing terms not fixed, the commitment shall be deemed to commence on the day that the pricing terms are fixed (unless the bank has the right to withdraw the commitment in which case the commitment commences when that right has expired), even if it is subject to formal, legal or other conditions which would reasonably be expected to be satisfied. c) Where an agreement constituting a commitment is placed in escrow or held in deposit subject to the fulfilment of conditions, the commitment commences on the day on which the agreement is released from escrow or deposit. 90

91 For monitoring and notification purposes, this applies to the gross amount to which a bank is potentially committed. Banks will be required to pre-notify all exposures in excess of 25% of their capital base. Banks which have been given expert underwriting status must comply with the requirements imposed by the Banking Supervisor. 11 Working Day 0 is defined as the working day on which the bank becomes unconditionally committed to accepting a known quantity of securities at a known price. a) For bond issues, and other securities that utilise the same underwriting process, such as international equity and warrant issues Working Day 0 is the later of the Allotment Date or the Payment Date. b) For domestic equity issues, and other securities that use the same underwriting process, Working Day 0 is the later of the Subscription Date or the announcement of allocations. c) The unconditional commitment only falls to the underwriters of rights issues after the subscription period has ended and as a result is in the form of the securities into which the rights are exercisable. 12 A bank's net commitment will be the amount of the gross commitment adjusted for: a) Underwriting, or sub-underwriting, commitments obtained from others; b) Purchases and Sales of the securities; c) Allocations granted, or received, with regard to the underwriting commitments. To form the net underwriting position. It is only after Working Day 0 that the net commitment must be taken into account for the Large Exposures calculation. A scaling factor is applicable (see Chapter 3 - Large Exposures paragraphs 21ff). Capital Requirements - Commitment To Working Day 0 13 Capital is required to support the net underwriting commitment from the time of initial commitment. The capital requirement differs between the bond type underwriting techniques in paragraph 11a) and those equity type underwriting techniques in paragraph 11b) and 11c). For the purposes of generating the capital requirements pre-working Day 5 rights issues and warrant issues will be converted into the underlying instrument using the current market price of the underlying instrument. 14 For bond type underwriting (including warrants on currencies, bullion and debt instruments) the capital requirement, from the close of business on the date of initial commitment until Working Day 0 will be the general market risk requirement only for that instrument. The general market risk requirements which are to be applied to the entire net commitment in that instrument, are determined by the Interest Rate Position Risk, and (if appropriate) Foreign Exchange Exposure chapters. The net commitment may be incorporated into portfolios of other like instruments so as to benefit from any hedging. 15 For equity type underwriting, and rights and warrant issues on equity instruments, the capital requirement, from the close of business on the date of initial commitment until Working Day 0, will be the specific and general market risk requirement for that instrument applied to the entire net commitment in that instrument reduced by 90%. The specific and general market risk requirements are to be generated as for a portfolio containing only the 91

92 instrument being underwritten. The net commitments, reduced by 90%, may not be incorporated into portfolios of other like instruments. Capital Requirements - From Working Day 0 16 From Working Day 0 various scaling factors are applied to the specific and general market risk capital requirements for bond and equity positions. a) For bond type underwritings the specific risk is applied to the net commitment from Working Day 0. The specific risk capital requirements are reduced according to the table. For example on Working Day 2 there is no reduction in the general market risk requirement on the net commitment, but for specific risk the capital requirement is reduced by 75%. For general market risk purposes the net commitment may be incorporated into portfolios of similar positions. b) For equity type underwritings the specific and general market risk requirements are reduced from Working Day 0 according to the table below. For example on Working Day 2 the capital requirement of the net commitment will be reduced by 75% of the specific and general market risk requirements of the net commitment. For general market risk purposes the net commitment may only be incorporated into portfolios of similar positions on Working Day 5 and after. If a bank wishes to incorporate the position in a portfolio of similar positions prior to Working Day 5, it may do so, but in such circumstances it will not be able to benefit from the reduced capital requirements set out in the table below. Reduction in capital requirements for underwriting Time Band Bond Type Issues Equity Type Issues Specific risk General market Specific risk General market risk risk Up to and including 100% 0% 90% 90% Working Day 0 Working Day 1 90% 0% 90% 90% Working Day 2 75% 0% 75% 75% Working Day 3 75% 0% 75% 75% Working Day 4 50% 0% 50% 50% Working Day 5 25% 0% 25% 25% After Working Day 5 0% 0% 0% 0% 92

93 Chapter 9 - Eligible Models 1 This chapter implements the requirements of Annex VIII of the (Directive 93/6/EEC), as amended by Directive 98/31/EC. 2 Eligible models can cover: options risk and interest rate risk in derivatives in the trading book; and foreign exchange risk and commodity position risk in the banking and trading books. For these risks, sets two methods for determining capital requirements. There is a standard approach for banks without recognised models and a more complex approach for institutions with recognised models - which will normally result in lower capital requirements for a given quantity of position or foreign exchange risk. The methods for determining capital requirements for banks without recognised models are covered in Chapters 4 to 7. It should be noted that positions in the trading book may also generate counterparty risk requirements independent of the capital requirement by a model; this will be calculated in accordance with Chapter 2 - Counterparty risk. 3 The systems requirements for producing adequate Eligible Models are complex. provides for competent authorities to recognise models used by banks for the purposes of calculating capital adequacy requirements. The detailed conditions under which such models may be recognised are outlined in Annex VIII of the (as amended by Directive 98/31/EC). The Banking Supervisor does not consider that banks in Gibraltar are as yet likely to wish to take advantage of the Eligible Model process for the purposes of calculating their Capital Requirements. 4 However, provision will be made for the approval of Eligible Models or for such models to be approved should a bank so wish to. The conditions that must be satisfied for a model to be used instead of the standard calculations are as follows : the model has already been approved by a competent authority in a EEA member State or a member of the Basle Committee and is identical, not only in application but also in the peripheral controls and inputs to the proposed model that will be used by the local bank; and the bank can satisfy the Banking Supervisor about the adequacy of the systems and controls surrounding the model in Gibraltar; or the bank requests the Banking Supervisor to consider whether it would be possible to review its model and surrounding systems and controls at its own expense. 5 The process to have a model approved is both lengthy and expensive. Banks wishing to undergo this review should cost and budget accordingly. Banks should contact the Banking Supervisor at the earliest opportunity if considering following this route. In these cases the model review is likely to follow the UK s Model Review Process as detailed in the Bank of England s Notice on implementation. 6 The Banking Supervisor may approve a VAR model in place of the standard calculation where it is deemed appropriate. There will be a number of strict conditions to be met before agreement can be given. The underlying principle will be that a bank should compare at a date chosen at random by the Banking Supervisor a scaled up version of its own VAR model calculation with the requirement. A bank may use this system for all or part of its trading risks. If it contemplating doing so it should consult the Banking Supervisor urgently in order that the arrangements for the comparative measure between the requirement and its VAR model output can be put into place as soon as possible. 93

94 Chapter 10 - Own Funds Explanation 1 Licensed institutions such as banks are required to allocate positions, securities, derivatives, assets and liabilities to either the trading book, or the banking book. For items allocated to the trading book, the level of capital (sometimes referred to as a "haircut") required to support associated risks is expressed as an absolute figure. For items in the banking book, capital requirements are expressed as a percentage of risk weighted assets. An licensed institution will need - at all times - to have sufficient capital to satisfy both capital requirements. This chapter defines the own funds of a bank, sets out the limits on use of particular forms of capital, and explains how the Banking Supervisor will measure an licensed institution s capital adequacy. 2 The current Administrative Notices governing Own Funds are: Admin Notice 2 Implementation in Gibraltar of the Directive on Own Funds of Credit Institutions; Admin Notice 2a Subordinated loan capital. 3 This chapter covers the following sections of the Capital Adequacy Directive: Article 3 Annex V Application Of Capital 4 Banks may use three types of own funds to meet their capital requirements as set out below: Tiers 1 & 2 May be used to support any activities. Tier 3 May only be used to support trading book activities and foreign currency risk, and may not be applied to those trading book capital requirements arising out of counterparty and settlement risk. (The latter restriction may, with the Banking Supervisor s prior consent, be waived, but only at a consolidated level. This concession is designed to accommodate the Own Funds regimes of other supervisors.) Definition Of Capital 5 The capital held/issued by Gibraltar banks directly, or by their domestic and overseas subsidiaries for inclusion in the institution s consolidated capital base, may be of the following forms: Tier 1: Core Capital 6 a) Permanent Shareholders' equity: i) Allotted, called up and fully paid share capital/common stock (net of any own shares held, at book value); ii) Perpetual non-cumulative preferred shares (sometimes referred to as preferred stock), including such shares redeemable at the option of the issuer and with the Bank's prior consent, and such shares convertible into ordinary shares. b) Disclosed reserves in the form of general and other reserves created by appropriations of retained earnings, share premiums, capital gifts, capital redemption reserves, and other surplus. 94

95 c) Interim retained profits which have been verified by external auditors. d) Minority interests arising on consolidation from interests in permanent shareholders equity. Less e) Goodwill and other intangible assets (including mortgage servicing rights, unless it can be demonstrated, to the Bank's satisfaction, that there is an active and liquid market in which they can be traded). f) Current year's cumulative unpublished net losses on the banking and trading books when taken together. g) Fully paid shareholders equity issued after 1 January 1992 by the capitalisation of property revaluation reserves. Tier 2: Supplementary Capital 7 a) Reserves arising from the revaluation of tangible fixed assets and fixed asset investments. b) General Provisions: i) Provisions held against possible or latent loss, but where these losses have not as yet been identified will be included to the extent that they do not exceed 1.25% of the sum of risk weighted assets in the banking book and notional risk weighted assets in the trading book; ii) Provisions earmarked, or held specifically, against lower valuations of particular claims or classes of claims will not be included in capital. c) Hybrid capital instruments: i) Perpetual cumulative preferred shares, including shares redeemable at the option of the issuer and with the prior consent of the Bank, and such shares convertible into ordinary shares; ii) Perpetual subordinated debt, including such debt which is convertible into equity. Where such debt was issued prior to May 1994, it should meet the conditions for primary perpetual subordinated debt set out in BSD/1986/2. Where it was issued after May 1994, it should meet the conditions for hybrid capital instruments set out in BSD/1994/3. d) Subordinated term debt: i) Dated preferred shares (irrespective of original maturity); ii) Subordinated term loan capital with a minimum original maturity of at least five years plus one day. Where such debt was issued prior to 1 July 1994, it should meet the conditions set out in Admin Notice 2a, subject to a straight-line amortisation during the last five years leaving no more than 20% of the original amount issued outstanding in the final year before redemption. Where such debt was issued after 1 July1994, it should meet the conditions for term subordinated debt set out in Admin Notice 2a. 95

96 e) Minority interests arising upon consolidation from interests in Tier 2 capital items. f) Fully paid shareholders equity issued after 1 January 1992 by the capitalisation of property revaluation reserves. Deductions from Tiers 1 & 2 Capital. 8 a) Investments in unconsolidated subsidiaries and associates; b) Connected lending of a capital nature; c) All holdings of capital instruments issued by other banks, building societies and those investment firms that are subject to the or an analogous regime (see Chapter 12). As currently, concessions to this deduction may be granted to banks making markets in such instruments under limits agreed with the Banking Supervisor. d) Qualifying holdings in financial and non-financial companies (see Consolidated Supervision of Credit Institutions Admin Notice No.4). e) Others to be agreed on a case-by-case basis. Tier 3: Trading Book Ancillary Capital 9 a) Short term subordinated debt subject to the following restrictions (and otherwise meeting the conditions for term subordinated debt. i) Minimum original maturity of two years. ii) The terms of the debt must provide that if the bank s allowable capital falls below its target capital requirement then the Banking Supervisor must be notified and the Banking Supervisor may require that interest and principal payments be deferred on Tier 3 debt. (Where Tier 3 capital is issued by a company within the consolidated group but it is not subject to a lock-in clause that refers to target capital, the Banking Supervisor should be consulted prior to its inclusion in the consolidated capital base.) iii) The Banking Supervisor would not normally expect to give consent to any repayment within two years from the date of issuance or drawdown. Repayment will only be granted when the Banking Supervisor is satisfied that the institution s capital will be adequate after repayment and is likely to remain so; iv) The contribution that this subordinated debt can make to the capital base does not have to be amortised over its life. b) Cumulative daily net trading book profits net of any foreseeable charges or dividends, where these have not yet been verified by external auditors but the Banking Supervisor is satisfied that they have been calculated using appropriate techniques. (Profits should be calculated on a basis consistent with that used by the external auditors, and should take account of all costs (funding, staff, tax, overheads, etc.) that should properly be attributed to trading book activity.) 96

97 Limits On The Use Of Different Forms Of Capital 10 At both a solo (solo-consolidated) and a consolidated level, an institution must satisfy the following limits: i) Limit regarding Tier 2 Subordinated Term Debt: Total Tier 2 subordinated term debt cannot exceed 50% of total Tier 1; ii) Limits on capital used to meet Banking Book capital requirements: Tier 2 capital used to meet the banking book capital requirements cannot exceed 100% of the Tier 1 capital used to meet those requirements; iii) Limits on capital used to meet the Trading Book capital requirements: Tier 2 capital and Tier 3 subordinated debt used to meet the trading book capital requirements must not - in total - exceed 200% of the Tier 1 capital used to meet those requirements; 11 In addition, at the consolidated level (or the solo level when a bank is not part of a consolidated group), the following overall limit applies: Tier 2 and Tier 3 capital cannot - in total - normally exceed 100% of the bank s Tier 1. This limit cannot be exceeded without the Banking Supervisor s express permission, which will only normally be granted where a bank s trading book accounts for most of its business; 12 Where a bank has any subordinated debt surplus to the ratios described above, this debt will be disregarded in the calculation of a bank's own funds and treated as part of the long term funding of the bank. Calculation Of Capital Adequacy 13 For comparative purposes, published risk asset ratios need to be calculated on a common basis, as set out in paragraph 16. However, banks will also be required to calculate their capital position for supervisory purposes in a way which incorporates the existing concepts of trigger and target ratios. This is set out in paragraphs In each case, the calculation is complicated by the existence of tier 3 capital which, subject to the conditions set out in paragraphs above, may contribute to meeting some of the capital requirements of the trading book. 14 In each case, the bank should start by determining its capital haircuts for: i) FX Position risk (including options); Ii) Equity Position risk (including options); iii) Interest Rate Position risk (including options); iv) Large Exposures; and v) Trading Book Counterparty and settlement risk (using an 8% ratio). vi) Commodity Position Risk 15 The bank should next calculate its banking book risk-weighted assets. 16 A bank s risk asset ratio (for published or comparative purposes) is then eligible capital as a percentage of the sum of banking book risk weighted assets and trading book notional risk weighted assets, where the latter is obtained by multiplying the total capital haircut (as in paragraph 14) by For supervisory purposes, however, banks will be subject to separate triggers on their banking and trading books rather than the common 8% implied by the preceding paragraph. The minimum capital requirement on the banking book 97

98 will be equal to risk weighted assets multiplied by the banking book trigger. The minimum capital requirement on the trading book will be notional risk weighted assets (as defined in paragraph 16 above) multiplied by the trading book trigger. Eligible capital will then be expressed as a percentage of the sum of the minimum banking and trading book capital requirements. A bank having capital adequacy of 100% will be deemed to be meeting its minimum capital requirements for supervisory purposes: in other words, it will be at its trigger. 18 Triggers on banking books will vary according to an institution s characteristics. In view of the comprehensive coverage of the for trading book risks, however, banks with diversified trading books and good internal risk management systems are likely to have trading book triggers close to 8%. Others will have trading book triggers at higher levels; although in most cases these will not be above 12%, this will depend on the nature of the risks faced by the institution. 19 The Banking Supervisor will set a target as well as a trigger for each book. The target capital requirement for the banking book will be equal to risk weighted assets multiplied by the banking book target. The target capital requirement for the trading book will be equal to notional risk weighted assets (as defined in paragraph 16 above) multiplied by the trading book target. A bank will be deemed to meet its target capital requirement if it satisfies the target capital requirement for both books taken together. 20 Where either the trading book business or the banking book business of a bank on a solo or consolidated basis does not normally exceed 10% of its combined on and off balance sheet business (as defined in Chapter 1, paragraph 23), only one trigger will be set. Reporting Requirements 21 Licensed institutions will be required to report their capital adequacy to the Banking Supervisor on a regular basis to be agreed. However, if capital falls below the target level, the Banking Supervisor must be notified immediately. 98

99 Annex: Calculation Of Capital Adequacy For Supervisory Purposes 1 Calculate trading book capital requirements. Trading book trigger = x% Haircut Notional Capital risk weighted required assets FX Position Risk A 12.5 x A x% of (12.5 x A) Equity Position Risk B 12.5 x B x% of (12.5 x B) Interest Rate Position Risk C 12.5 x C x% of (12.5 x C) Large Exposures D 12.5 x D x% of (12.5 x D) Trading Book Counterparty and Settlement Risk E 12.5 x E x% of (12.5 x E) Commodity Position Risk F 12.5 x F x% of (12.5 x F) 2 Calculate banking book capital requirement Banking book trigger = y% Risk weighted Capital assets required Credit risk G y% of G 3 Allocate capital to banking book Maximise use of Tier 2 subject to limitations listed in paragraphs Determine quantity of Tier 1 needed for banking book. 4 Allocate capital to trading book Maximise use of Tiers 2 and 3 subject to limitations in paragraphs 4 and Allocate necessary Tier 1 to trading book. 5 Identify any unused but eligible capital The bank may find that it has unused (but eligible) Tier 1 or 2 capital. 6 Calculate capital adequacy Tier I + eligible Tier 2 + eligible Tier 3 (from (4) above) - deductions x% of 12.5 x (A + B + C + D + E + F) + y% of G Note: Banks must allocate capital to the banking book before allocating it to the trading book. 99

100 Chapter 11 - Consolidation Explanation 1 The Banking Supervisor is committed to the principle that the supervision of licensed institutions should be conducted on a consolidated basis, whenever such institutions are members of a wider group. The term consolidation is used to mean the preparation of consolidated returns covering a group, or part of a group. The term consolidated supervision is used to mean a qualitative assessment of the overall strength of a group to which an licensed institution belongs, to evaluate the potential impact of other group companies on the licensed institution. Consolidated supervision also takes into account the activities of group companies which are not included in the consolidated returns because the nature of their assets is such that their inclusion would not be meaningful, for example industrial or insurance companies. In general, the Banking Supervisor takes account of the activities of group companies to the extent that they may have a material bearing on the reputation and financial soundness of the licensed institution in the group. The purpose of supervision on a consolidated basis is not to supervise all the companies in the group to which the bank belongs, but to supervise the bank as part of the group. 2 The Banking Supervisor regards consolidated supervision as a complement to, rather than a substitute for, the solo supervision of the licensed institution. Events elsewhere in the group and the activities of other group companies can pose a threat to the licensed institution in ways which consolidated supervision cannot detect. For example, intra group linkages arising from transactions between the bank and other group companies will only be revealed by the solo supervision of the bank. As a consequence the Banking Supervisor sets solo capital adequacy ratios and large exposures limits for licensed institutions in addition to those which apply at the consolidated level. 3 The current Admin Notice governing consolidated supervision and the Consolidated Supervision Directive is No.4. 4 This chapter covers the following sections of the Capital Adequacy Directive: Article 7 Scope Of Consolidation 5 The scope of consolidation (including the definition of subsidiary and participation) is as set out in Admin Notice No.4, paragraphs Exceptions To Consolidation 6 Exceptions to consolidation are as set out in Admin Notice No.4, paragraph 19. Distribution Of Capital Resources Within The Group 7 Rules governing the distribution of capital resources within the group (including those for concessionary weighting for intra-group exposures and details of the circumstances in which subsidiaries can be solo-consolidated) are as given in Admin Notice No.4, paragraphs Groups Not Subject To Consolidation 8 Requirements for those groups not subject to consolidation are as given in Admin Notice No.4, paragraphs Techniques Of Consolidation 100

101 9 As at present, the technique of consolidation usually required will be the full consolidation for all majority shareholdings, and participations. The Banking Supervisor will apply proportionate ("pro rata") consolidation to participations in only exceptional circumstances, where it is satisfied that there are other significant shareholders who have the means and the will to provide as much parental support to the entity as the shareholder subject to consolidated supervision. This criterion is usually most likely to be met by another bank. 10 The manner in which full consolidation will be achieved varies depending on the type of subsidiary to be consolidated. The various cases are set out below. a) Banks: Banking Books 11 Consolidation for banking books will be carried out on a line-by-line (or accounting) basis across the group members being consolidated, effectively continuing the present regime. b) Banks: Trading Books (including foreign exchange exposure) 12 Trading book exposures (including counterparty exposures) and foreign exchange exposure will usually be consolidated using aggregation plus. The trading book s notional risk weighted assets are separately calculated. These are included in the consolidated risk-asset-ratio, and are converted into a capital charge to be included in the supervisor s measure of capital adequacy. (See Chapter 10 and Annex II.) 13 When using aggregation-plus, the trading book s notional risk weighted assets, should be determined using: a) the as implemented by the relevant EU/EEA banking supervisor; or b) the host banking supervisor s rules, where these are deemed to be broadly equivalent to the ; or c) the as set out in this policy notice. 14 The trading book capital requirement is then generated by multiplying notional risk weighted assets by the bank s trading book trigger, except in cases where other supervisors rules are used (when multiplication is by the trigger applied to the subsidiary, typically 8%). 15 At present, no non-eu/eea banking supervisor has adopted a market risk regime of a kind that generates a measure of notional risk weighted assets for trading activity. However, although it is not possible yet to make use of host supervisory rules when consolidating banking subsidiaries based in countries outside the EU/EEA, once a supervisor has implemented the Basle market risk proposals, it will be deemed to have a regime `broadly equivalent to the for the purpose of calculating consolidated capital requirements. 16 When using aggregation plus, an institution may satisfy itself on a daily basis that it meets the Banking Supervisor s minimum capital requirement (ie its target) with reference to position limits as opposed to actual positions. It may adopt such a procedure only after first satisfying the Bank that its control systems are such that actual positions may reliably be taken as being no higher than the adopted position limits. 17 As an alternative to aggregation-plus, consolidation of a banking subsidiary s trading book may be carried out on a line-by-line (or accounting) basis, if the Institution can satisfy the Banking Supervisor that: 101

102 a) the parent bank calculates or monitors trading book positions in an integrated fashion across the entities using this basis of consolidation; and b) the banking subsidiary satisfies its local supervisory requirements on a solo basis; and c) the parent bank is able to carry out adequate line by line consolidation on a daily basis; and d) capital resources are freely transferable between the banking subsidiary and the rest of the group. 18 When consolidating using line-by-line, banks - if they wish - can construct their consolidated capital requirement for general market risk without first calculating the net position in each security on a consolidated basis. However, the method used to measure general market risk must be the same for all entities subject to the line-by-line consolidation. c) Investment firms 19 Investment firms will usually be consolidated using aggregation plus. The firm s notional risk weighted assets are separately calculated. These are included in the consolidated risk-asset-ratio, and are converted into a capital requirement to be included in the Banking Supervisor s measure of capital adequacy. (See Chapter 10 and Annex II.) 20 When using aggregation-plus, the investment firm s notional risk weighted assets, should be determined using: a) the as implemented by the relevant EU/EEA securities regulator; or b) the host securities regulator s rules, where these are deemed to be broadly equivalent to the ; or c) the as set out in this policy notice. 21 The investment firm s capital requirement is then generated by multiplying its notional risk weighted assets by the bank s trading book trigger, except in cases where other supervisors rules are used (when multiplication is by the trigger applied to the subsidiary, typically 8%). 22 For the list of non-eu/eea securities regulators with regimes deemed to be broadly equivalent to the see Chapter When using aggregation plus, an institution may satisfy itself on a daily basis that it meets the Banking Supervisor s minimum capital requirement (ie its target) with reference to position limits as opposed to actual positions. It may adopt such a procedure only after first satisfying the Banking Supervisor that its control systems are such that actual positions may reliably be taken as being no higher than the adopted position limits. (The Banking Supervisor reserves the right to require consolidation of an investment subsidiary on the basis of the parent s total investment in that company, depending on the quality of the bank s control systems and the ease with which surplus capital can be transferred out of the subsidiary.) 24 The use of aggregation-plus for investment subsidiaries may be constrained by the size of non-trading activity. If this is large, the Banking Supervisor reserves the right to use line-by-line (or accounting) consolidation for these assets. 102

103 25 As an alternative to aggregation-plus, consolidation of an investment firm may be carried out on a line-by-line basis, if the institution can satisfy the line supervisor that: a) the parent bank calculates or monitors trading book positions in an integrated fashion across the entities using this basis of consolidation; and b) the investment subsidiary satisfies its local supervisory requirements (where these apply) on a solo basis; and c) the parent bank is able to carry out adequate line by line consolidation on a daily basis; and d) capital resources are freely transferable between the investment subsidiary and the rest of the group. Where an investment firm is deemed only to be exposed to counterparty risks (i.e. no market risk charges apply), condition (a) need not be met in order to carry out line-by-line consolidation. However, in such cases, the Banking Supervisor will pay particular regard to the appropriateness of the Banking Supervisor s capital adequacy regime for the business conducted by the investment firm. If, as is likely, the relevant securities regulator s regime provides a more accurate measure of the capital required by the subsidiary, the Banking Supervisor reserves the right to insist on use of aggregation plus based on the local regulator s rules. 26 When consolidating using line-by-line, banks - if they wish - can construct their consolidated capital requirement for general market risk without first calculating the net position in each security on a consolidated basis. However, the method used to measure general market risk must be the same for all entities subject to the line-by-line consolidation. d) Other firms 27 Other financial companies (as defined in the Annex to Admin Notice No.4) will usually be consolidated on a line-by-line basis. Other Issues Recognition for offsetting exposures amongst companies being consolidated 28 In determining consolidated group capital requirements, recognition for offsetting exposures can only be given where consolidation is done on a lineby-line basis. Banks wishing to offset exposures should consult their supervisor first. Large Exposures 29 The application of large exposure limits (see Chapter 3 - Large Exposures) to counterparty exposures will be based upon either: the sum of all the counterparty exposures to an individual entity or group; or, where the Bank s prior approval has been granted, a group may aggregate the sum of its counterparty exposure limits to determine its compliance with the Large Exposure requirements for counterparty exposure. When using the aggregation plus approach to consolidation, any incremental capital requirements generated by large exposures at the solo level need not be included in the capital requirement at the consolidated level. 103

104 Annex I: - A Consolidation Techniques Schematic Large Exposures Consolidated on a line-by-line basis irrespective of whether the exposure is in the banking or trading books. Gibraltar Subsidiary Bank Subsidiary Banking book Line-by-line Trading book Aggregation plus, or Investment Subsidiary 1 Aggregation plus using local supervisor s rules, or Line-by-line EU/EEA Non-Gibraltar Subsidiary Non-EU/EEA Subsidiary Line-by-line Banking book Line-by-line Trading book Aggregation plus using as implemented by local supervisor, or - if preferred - as implemented by the Banking Supervisor or Line-by-line Banking book Line-by-line Trading book Aggregation plus using Banking Supervisor rules (until a host supervisor implements the Basle market risk proposals), or Line-by-line Aggregation plus using as implemented by host supervisor, or - if preferred - as implemented by the Banking Supervisor (and set out in this notice) or Line-by-line Aggregation plus using host supervisor s rules (if deemed broadly equivalent to ) or as implemented by the Banking Supervisor (and set out in this notice) or Line-by-line Annex ii: Calculation Of Consolidated Capital Adequacy Suppose a consolidated group contains three companies: - a parent bank - a banking subsidiary outside Gibraltar - an investment subsidiary Suppose also that the following applies: Consolidated banking book risk weighted assets 1 Use of aggregation plus for non-trading book exposures only permitted if these are not substantial. 104

105 B(t) Trading book notional risk weighted assets - consolidated using line-by-line T(t) - parent bank T(p) - banking subsidiary T(b1) according to Bank rules T(b2) according to host supervisor - investment subsidiary T(i1) according to Bank rules T(i2) according to local supervisor Banking book trigger y% Trading book trigger x% Case 1: All trading activity consolidated using line-by-line Risk Asset Ratio: Total capital B(t) + T(t) Supervisory capital adequacy Total capital y% of B(t) + x% of T(t) Case 2: Trading activity consolidated using aggregation-plus but Banking Supervisor rules Risk Asset Ratio: Total capital B(t) + T(p) + T(b1) + T(i1) Supervisory capital adequacy Total capital y% of B(t) + x% of [T(p) + T(b1) + T(i1)] Case 3: Trading activity consolidated using aggregation-plus and host supervisors rules Risk Asset Ratio: Total capital 105

106 B(t) + T(p) + T(b2) + T(i2) Supervisory capital adequacy Total capital y% of B(t) + x% of T(p) + 8% of [T(b2) + T(i2)] 106

107 Chapter 12 - Lists Explanation 1 This Administrative Notice makes reference to various lists, the contents of which are expected to change over time. Such updates might occur, for example, as a result of changes agreed with the European Commission, or as a result of changes in the Commissioner of Banking s implementation policy. Changes might be made in the light of policies adopted by other European supervisors in implementing the Capital Adequacy Directive. 2 The lists have been brought together in a single Chapter to facilitate circulation of periodic updates. It is not the intention to reissue this entire policy notice on a regular basis, but this Chapter will be reissued as necessary. 3 Chapter references are given for each list, and detailed information on how the lists are to be used in calculating capital requirements is given in the relevant policy Chapters. Lists Applicable To Market Risk Currency Pairs Subject To Binding Inter-Governmental Agreements 4 When measuring foreign exchange risk (see Chapter 4 - Foreign Exchange Risk), banks may apply a separate treatment to those currencies that are subject to binding inter-governmental agreements. The following binding intergovernmental agreement is recognised for this purpose: Belgian and Luxembourg francs. Multilateral Development Banks 5 In measuring interest rate risk (see Chapter 5 - Interest Rate Position Risk), debt instruments issued by the following multilateral development banks are deemed to be qualifying : African Development Bank (AfDB) Asian Development Bank (AsDB) Caribbean Development Bank (CDB) Council of Europe Resettlement Fund Council of Europe Social Development Fund European Bank for Reconstruction and Development (EBRD) European Investment Bank (EIB) Inter-American Development Bank (IADB) Inter-American Investment Corporation (IAIC) International Bank for Reconstruction and Development (IBRD) International Finance Corporation (IFC) Nordic Investment Bank (NIB) this list may be amended periodically as a result of any amendment of the Solvency Ratio Directive. Relevant Credit Rating Agencies And Investment Grade Ratings 107

108 6 The determination of qualifying debt instruments for the calculation of specific interest rate risk (see Chapter 5 - Interest Rate Position Risk) can be based upon credit ratings. The ratings agencies used for this purpose and the rating deemed to be investment grade are listed below: For all issuers Moody's Investors Service Standard & Poor s Corporation Fitch IBCA Minimum Ratings Securities Money Market Obligations Baa3 BBB- BBB- For all banks, Building Societies and parent companies and subsidiaries of banks Thomson Bankwatch BBB- TBW-3 For Canadian issuers Canadian Bond Rating Service Dominion Bond Rating Service For Japanese issuers Japan Credit Rating Agency, Ltd Japan Rating and Investment Information Inc Mikuni & Co B++low BBB low BBB- BBB- BBB For United States issuers Duff & Phelps, Inc BBB- 3 This list may be amended periodically. Qualifying Countries For Equity Position Risk 7 Equities listed in the following countries qualify for a 4% specific risk charge (see Chapter 6 - Equity Position Risk). Australia France Japan Spain Austria Germany Luxembourg Sweden Belgium Greece Netherlands Switzerland Canada Ireland Norway UK Denmark Italy Portugal USA Finland Highly Liquid Equity Indices 8 Individual equities included in the following indices are automatically considered to be liquid (see Chapter 6 - Equity Position Risk) P3 A3 F3 A-3 R-2 J-2 a-2 M-3 Australia All Ords Japan Nikkei225 Austria ATX Netherlands EOE25 Belgium BEL 20 Spain IBEX35 Canada TSE35 Sweden OMX France CAC40 Switzerland SMI Germany DAX UK FTSE 100 Hong Kong Hang Seng UK FTSE mid-250 Italy MIB-30 USA S&P

109 Note on lists for equity position risk 9 Lists for equity position risk may be amended periodically. Information likely to be used in revising equity lists is set out below. The precise data required will be dependent on the particular market and/or index being considered. As a guide, the data set would be likely to include:- a) The existence of a published national broad-based index; b) Details of the market structure; c) 3 years of daily price data of the major broad-based index of that country; d) 3 years of daily price data of a number representative single stocks contained in that index, spread by sector and market capitalisation, and numbering at least 50% of the total number of stocks which make up the index; and e) Details of traded futures and options markets together with data on the daily volumes. The price data should be accompanied by the prevailing spot exchange rates to sterling for the same period. Lists Applicable To Counterparty Risk And Consolidation Third Country Equivalent Regimes For Investment Firms 10 The list of third countries with equivalent regimes for the supervision of investment firms is used in three cases: a) Investment firms regulated by these third-country securities regulators qualify for a 20% counterparty risk weight (see Chapter 2 - Counterparty Risk); b) Exposures to investment firms regulated by these third country securities regulators should be treated as exposures to banks for large exposure purposes (see Chapter 3 - Large Exposures) c) When using aggregation-plus to consolidate investment firms regulated by these third country securities regulators, banks may use host country rules (see Chapter 11 - Consolidation); 11 The following regulators of investment firms are deemed to have equivalent regimes: Australia Sydney Futures Exchange Australian Stock Exchange Canada Hong Kong Alberta Stock Exchange Montreal Exchange Toronto Stock Exchange Vancouver Stock Exchange Investment Dealers Association of Canada Hong Kong Monetary Authority Hong Kong Securities and Futures Commission 109

110 Note: Japan Singapore South Africa Switzerland USA Japanese Financial Supervisory Agency Monetary Authority of Singapore Stock Exchange of Singapore Johannesburg Stock Exchange South African Futures Exchange Bond Exchange of South Africa Federal Banking Commission Securities and Exchange Commission Commodity and Futures Trading Commission To the extend that subsidiaries have market or counterparty risk which is not captured by these exchanges rules, The Commissioner of Banking s rules will need to be applied. This list is provisional. Banks may apply to have countries added to this list, and the Banking Supervisor will consider any additions suggested by the UK s Financial Supervisory Authority (FSA). Recognised Clearing Houses & Exchanges 12 The list of recognised clearing houses and exchanges is used in two cases: a) Claims on recognised clearing houses and exchanges are weighted at 20% (see Chapter 2 - Counterparty Risk). b) Exposures to recognised clearing houses and exchanges should be treated in the same way as exposures to banks for large exposures purposes (see Chapter 3 - Large Exposures). Third Country Banking Supervisors with Equivalent Regimes 13 When using aggregation-plus to consolidate the trading book of third country banking subsidiaries, banks may use host country rules where the Banking Supervisor has deemed these rules to be broadly equivalent to the (see Chapter 11 - Consolidation). 14 Non-EU/EEA banking supervisors that the Banking Supervisor currently accepts have market risk regimes broadly equivalent to the include those of Australia, Canada, Hong Kong, Japan, Singapore, Switzerland and the USA. Banks should refer to the Banking Supervisor should they wish to check the status of third country regimes. Recognised Clearing Houses And Exchanges (Amendment) The following lists apply. The Banking Supervisor has adopted the lists published by the UK s Financial Services Authority. Banks may apply to add clearing houses and exchanges to these lists. (Counterparty exposures to CEDEL and Euroclear continue to attract a 20% weighting.) Recognised Exchanges Alberta Stock Exchange American Stock Exchange Amsterdam Pork and Potato Terminal Market (Termijnmarkt Amsterdam BV) 110

111 Amsterdam Stock Exchange (Amsterdamse Effectenbeurs) Antwerp (Effectenbeursvennootschap van Antwerpen) Athens Stock Exchange (ASE) Australian Stock Exchange Basle Stock Exchange (Basler Effektenborse) Barcelona Stock Exchange (Bolsa de Valores de Barcelona) Belgian Futures & Options Exchange (BELFOX) Berlin Stock Exchange (Berline Borse) Bilbao Stock Exchange (Bolsa de Valores de Bilbao) Bologna Stock Exchange (Borsa Valori de Bologna) Bordeaux (Bourse de Bordeaux) Bremen Stock Exchange (Bremer Wertapierborse) Brussels Stock Exchange (Societe de la Bourse des Valeurs Mobilieres)/(Effecten Beursvennootschap van Brussel) Chicago Board of Trade Chicago Board Options Exchange Chicago Mercantile Exchange Coffee, Sugar and Cocoa Exchange Inc. Copenhagen Stock Exchange (Kobenhavns Fondsbors) DTB Deutsche Terminborse The Dublin Stock Exchange Dusseldorf Stock Exchange (Rheinisch-Westfalische Borse zu Dusseldorf) European Options Exchange Fiannciele Termijnmarkt, Amsterdam Finnish Options Exchange Finnish Options Market Florence Stock Exchange (Borsa Valori di Firenze) Frankfurt Stock Exchange (Frankfurter Wertpaperborse) Genoa Stock Exchange (Borsa Valori di Genova) Geneva Stock Exchange (Bourse de Geneve Hamburg Stock Exchange (Hanseatische Vertpapier Borse Hamburg) Hannover (Niedersachisische Borse zu Hannover) Helsinki Stock Exchange (Helsingin Arvopaperiporssi Osuuskunta) Hong Kong Futures Exchange International Petroluem Exchange of London Ltd International Stock Exchange of the United Kingdom and the Republic of Ireland Ltd Irish Futures & Options Exchange (IFOX) 111

112 Kansas City Board of Trade Lille (Bourse de Lille) Lisbon Stock Exchange (Bolsa de Valores de Lisbao) London Commodity Exchange 1986 Ltd London International Financial Futures & Options Exchange London Metal Exchange Ltd London Stock Exchange Luxembourg Stock Exchange (Societe de la Bourse de Luxembourg SA) Lyon (Bourse de Lyon) Madrid Stock Exchange (Bolsa de Valores de Madrid) Marche a Terme International de France (MATIF) Marche des Options Negociables de Paris (MONEP) Marseille (Bourse de Marseille) MEFF Renta Fija MEFF Renta Variable Mercato Italiano Derivati (IDEM) Mercato Italiano Futures (MIF) Mid American Commodity Exchange Milan Stock Exchange (Borsa Valori de Milano) Montreal Exhange Munich Stock Exchange (Bayerische Borse in Munchen) Nagoya Stock Exchange Nancy (Bourse de Nancy) Nantes (Bourse de Nantes) Naples Stock Exchange (Borsa Valori di Napoli) National Association of Securities Dealers Incorporated (NASDAQ) New York Cotton Exchange New York Futures Exchange New York Mercantile Exchange New York Stock Exchange OM Stockholm AB OMLX, The London Securities and Derivatives Exchange Ltd Oporto Stock Exchange (Bolsa de Valores do Porto) Osaka Securities Exchange Oslo Stock Exchange (Oslo Bourse) Pacific Stock Exchange Palermo Stock Exchange (Borsa Valori di Palermo) Paris Stock Exchange 112

113 Philadelphia Board of Trade Philadelphia Stock Exchange Rome Stock Exchange (Borda Valori di Roma) Singapore International Monetary Exchange Limited (SIMEX) Stockholm Stock Exchange (Stokholm Fondbors) Stock Exchange of Hong Kong Ltd Stock Exchange of Sinagpore Stuttgart Stock Exchange (Baden-Wurtembergische Wertpapierborse zu Stuttgart) Swiss Futures and Options Exchange (SOFFEX) Sydney Futures Exchange Tokyo Stock Exchange Tokyo International Financial Futures Exchange Toronto Stock Exchange Trieste Stock Exchange (Borsa Valori di Trieste) Turin Stock Exchange (Borsa Valori de Torino) Valencia Stock Exchange (Bolsa de Valores de Valencia) Vancouver Stock Exchange Venice Stock Exchange (Borsa Valori de Venezia) Vienna Stock Exchange Zurich Stock Exchange (Zurcher Borse) Recognised Clearing Houses Austrian Kontroll Bank (OKB) Board of Trade Clearing Corporation Cassa di Compensazione e Garanzia S.p.A (CCG) Commodity Clearing Corporation The Emerging Markets Clearing Corporation European Options Clearing Corporation Holding BV (EOCC) Guarantee Fund for Danish Options and Futures (Garantifonden for Danske Optioner OG Futures) (FUTOP) Kansas City Board of Trade Clearing Corporation Hong Kong Futures Exchange Clearing Corporation Ltd Hong Kong Securities Clearing Company Ltd London Clearing House (LCH) Norwegian Futures & Options Clearing House (Norsk Opsjonssentral A.S.) N.V. Nederlandse Liquidatiekas (NLKKAS) OM Stockholm AB (OM) 113

114 Options Clearing Corporation OTOB Clearing Bank AG (OTOB) Societe de Compensation des Marches Conditionnels (SCMC) Sydney Futures Exchange Clearing House (SFECH Ltd) 114