Annex 8. I. Definition of terms

Transcription

1 Annex 8 Methods used to calculate the exposure amount of derivatives, long settlement transactions, repurchase transactions, the borrowing and lending of securities or commodities and margin lending transactions I. Definition of terms 1. Transactions according to this Annex shall have the following meanings: a) 'netting set' shall mean a set of transactions with a single counterparty which are subject to a legally enforceable bilateral netting agreement and for which netting is eligible for the purposes of the prudential rules; each transaction covered by a legally enforceable bilateral netting agreement shall be deemed a separate netting set; the provisions of paragraph VI.4, second sentence, shall not be thereby prejudiced, b) 'risk position' shall mean a transaction in the amount stipulated according to the Standardised Method based on a previously defined algorithm, c) 'hedging set' shall mean a group of risk positions within a single netting set, for which only their balance is relevant in calculating the exposure amount according to the Standardised Method, d) 'margin agreement' shall mean a contractual arrangement according to which one counterparty shall supply collateral to a second counterparty if the second counterparty s exposure to the first counterparty exceeds a certain level, e) 'margin threshold' shall mean the maximum amount of an outstanding exposure, the exceeding of which gives the creditor the right to demand collateral, f) 'margin period of risk' shall mean the period from the last collateral delivery covering a netting set of transactions with a defaulting counterparty until that counterparty is closed out and the resulting market risk is re-hedged, g) 'effective maturity under the Internal Model Method for a netting set with maturity longer than one year' shall mean maturity stipulated under Annex 13, III.1, b), 6 to this Decree, h) 'cross-product netting' shall mean the inclusion of transactions with various categories of instruments, in particular derivatives and repurchase transactions, in one netting set, i) 'current market value' shall mean the resulting market value of all transactions with a single counterparty within a single netting set; the calculation of the current market value includes positive and negative market values. 2. Distributions according to this Annex shall have the following meanings: a) 'distribution of market values' shall mean the forecast of the probability distribution of the resulting market values for all transactions with a single counterparty within a single netting set at a certain date in the future (the forecasting horizon) stipulated according to the market values of these transactions calculated up to the present, b) 'distribution of exposures' shall mean the forecast of the probability distribution of the market values calculated so that forecast negative net market values are assigned a zero figure,

2 c) 'risk-neutral distribution' shall mean the distribution of market values or exposures at a certain date in the future calculated by means of implied volatilities or other market implied values, d) 'actual distribution' shall mean the distribution of market values or exposures at a certain date in the future using volatilities calculated from changes in prices or rates in the past or calculated by means of other historical or realised values. 1. Measurement of exposures according to this Annex shall have the following meanings: a) 'current exposure' shall mean the higher of the following amounts: 1. zero, or 2. the market value of a transaction or portfolio of transactions within a netting set which would be lost upon the default of the counterparty, assuming no recovery on the value of this transaction or portfolio of transactions in bankruptcy proceedings, b) 'peak exposure' shall mean the high percentile of the distribution of exposures at a certain date in the future before the maturity date of the longest transaction in the netting set, c) 'expected exposure (EE) at a certain date' shall mean the average of the distribution of exposures at a certain date in the future preceding the maturity date of the longest transaction in the netting set, d) 'effective EE at a certain date' shall mean the maximum expected exposure at this date or any prior date, or alternatively the higher of the following values: 1. the expected exposure at this date, or 2. the effective expected exposure at the previous date, e) 'expected positive exposure (EPE)' shall mean the weighted average of expected exposure in the relevant time interval, where the weights are the proportions which the individual expected exposures represent in the overall time interval; the calculation of capital requirements shall employ the average for the first year or, if all transactions in the netting set have a maturity of less than one year, the average for the period which equals the longest maturity of a transaction in the netting set, f) 'effective EPE' shall mean the weighted average of effective expected exposures for the first year or, if all transactions in the netting set mature within less than one year, the average over the period which equals the longest maturity of a transaction in the netting set. The weights are the proportions which the individual expected exposures represent in the overall time interval; g) 'credit valuation adjustment' shall mean an adjustment in the evaluation of a portfolio of transactions with a counterparty which takes into account the market value of a credit risk resulting from any breach of contractual provisions agreed with the counterparty, and which may take into account either the market value of the credit risk of the counterparty or the market value of the credit risk of the liable entity and the counterparty, h) 'one-sided credit valuation adjustment' shall mean a credit valuation adjustment which takes into account the market value of the credit risk resulting from the liable entity s exposure to the counterparty, but which does not take into account the market value of the credit risk resulting from the counterparty s exposure to the liable entity. 4. Forms of risk according to this Annex shall have the following meanings:

3 a) 'rollover risk' shall mean the risk that the expected positive exposure will be understated when future transactions with the relevant counterparty are expected to be concluded on an ongoing basis; additional exposure incurred as a result of these future transactions is not included in the calculation of the expected positive exposure, b) 'general wrong-way risk' shall mean the risk that the probability of default of a counterparty positively correlates with general market risk factors, c) 'specific wrong-way risk' shall mean the risk that the exposure to a certain counterparty positively correlates with the probability of this counterparty s default due to the type of transaction with that counterparty; the liable entity is exposed to specific wrong-way risk where future exposure to the specific counterparty can be expected to be high alongside a high probability of default of the counterparty. II. Choice of the method and common policy for stipulating the exposure amount of derivatives and long settlement transactions 1. The methods used to calculate the exposure amount for derivatives and long settlement transactions include the following: a) the Mark-to-Market Method, b) the Standardised Method, or c) the Internal Model Method (hereinafter the EPE Model Method ). 2. The liable entity may permanently combine these methods but only in such a way that it employs the same method to calculate the exposure to any single counterparty and uses a consistent approach over time. If the liable entity is not able to stipulate the delta or the modified duration for transactions with a non-linear risk profile, or for payment legs and transactions with underlying debt instruments, it shall proceed according to Annex 8, V, In order to calculate the capital requirement for counterparty credit risk the credit derivative exposure amount shall be zero if the liable entity a) uses this credit derivative to protect an exposure in the investment portfolio or a counterparty credit risk exposure, and also b) takes into account the effects of unfunded credit protection for the protected exposure 1. in accordance with the methods and conditions for considering this protection stated in Annex 16 of the Decree, or 2. if it has received approval to use own estimates of the LGD value in accordance with the risk quantification requirements employed in assessing the influence of unfunded credit protection according to Annex 10 of the Decree. 4. In order to calculate the capital requirement for counterparty credit risk the credit derivative exposure amount shall also be zero, if the liable entity does not utilise the option contained in the second sentence of Art. 48, The liable entity may, however, choose to consistently include in the calculation of the capital requirement for counterparty credit risk all credit derivatives included in the investment portfolio used as protection against an investment portfolio exposure or a counterparty credit risk exposure, provided the collateral is eligible.

4 6. In order to calculate the capital requirement for counterparty credit risk the exposure amount for credit default swaps is zero if the liable entity a) is the protection provider, b) assigned the credit default swaps to the investment portfolio and c) stipulates the capital requirement for the investment portfolio credit risk resulting from the total nominal value of this derivative. 7. Regardless of the method used, the exposure to the relevant counterparty shall be equal to the amount of exposures stipulated for each netting set with the said counterparty. 8. Regardless of the method used, the exposure to a central counterparty shall equal zero if a) the central counterparty has not refused payment and b) the central counterparty s exposures to all participants are every day fully protected by collateral. 9. The method used to calculate the exposure amount arising from long settlement transactions may differ from the method used to calculate the amount of exposure arising from derivatives, repurchase transactions, borrowing and lending of securities or commodities and margin lending transactions. 10. If the liable entity is authorised to use the IRB Approach it may apply risk weights according to the Standardised Approach in calculating capital requirements for long settlement transactions. III. Netting 1. The liable entity may consider a netting agreement if a) it has concluded this with a counterparty that is authorised to conclude such an agreement (hereinafter in this Annex the netting counterparty ), b) the agreement belongs to types of netting agreements that are recognised as risk mitigation techniques, and c) the conditions have been met for recognising netting agreements stipulated in this Annex. 2. The types of netting agreement which are recognised as risk mitigation techniques include a) bilateral novation agreements under which mutual claims and commitments are automatically combined so that a single net sum is stipulated for each novation, thus creating a legally binding new agreement, which cancels the previous agreements, b) other bilateral netting agreements between the liable entity or entity in the regulated consolidated whole and its counterparty, or c) cross-product netting agreements; the categories of instruments used for cross-product netting agreements shall mean derivatives, repurchase transactions and the borrowing and lending of securities or commodities and margin lending transactions. Crossproduct netting agreements are only recognised if the liable entity is authorised to calculate the exposure amount for these transactions using the EPE model. Cross-

5 product netting agreements are not eligible for transactions concluded between various entities. 3. The conditions for recognising netting agreements are deemed to have been met if a) the netting agreement meets the following criteria: 1. the agreement is legally effective and enforceable in all relevant jurisdictions, including in the event that reorganisation or discharge is permitted or bankruptcy is declared on the counterparty s assets, 2. in the event of a counterparty default it gives the liable entity or the entity in the regulated consolidated whole that is not in default the right in a timely fashion to terminate and settle all transactions to which this agreement relates, including in the event that reorganisation or discharge is permitted or bankruptcy is declared on the counterparty s assets, 3. it allows for as yet unpaid, or where relevant, also paid mutual claims to be netted in such a way that the result will be the only claim in the amount of the difference between the aggregate amount of the current values of the mutual claims, 4. it is not part of another agreement which authorises both parties in the event of a counterparty default not to pay or to pay only a part of the net sum, 5. the netting agreement may be considered recognised if the liable entity announces, pursuant to Art. 221b, and discusses with the Czech National Bank its plan to reflect this agreement; it shall present a satisfactory legal analysis with its notice confirming that netting will take place in the event of a counterparty default, b) a cross-product netting agreement shall also meet these criteria: 1. the result of netting shall be the only claim in the difference between the current values of mutual claims from partial agreements and individual transactions, 2. the legal analysis by the person that provides legal services in this field over a long period shall also focus on the legal effectiveness and enforceability of the whole cross-product netting agreement and on this agreement s impact on the provisions of any partial agreement which is included in the cross-product netting agreement. The legal analysis must be generally recognised by other persons that provide legal services in this field in the long-term or by means of a memorandum of law, which shall focus on the justification for all relevant questions; 3. the liable entity shall have procedures to verify that a legal analysis has been performed for each transaction that is to be assigned to the category of transactions with protection; 4. partial bilateral netting agreements included in a cross-product netting agreement for different instruments shall meet the conditions for the recognition of these agreements and comply with credit risk mitigation techniques, c) the netting agreement is considered in the amount of the aggregated exposure to every counterparty. The liable entity manages counterparty risk on the basis of this aggregated exposure. It uses it as a marker for calculating credit limits and allocating internal capital. IV. Mark-to-Market Method 1. The exposure amount of a derivative or long settlement transaction is calculated as the sum of

6 a) the fair value of the derivative or long settlement transaction and b) the amount of a future exposure from a derivative or long settlement transaction. 2. The amount of the future exposure from a derivative or long settlement transaction is calculated as the product of a) the nominal value of the derivative or long settlement transaction and b) the conversion factor according to Table 1 in this Annex and in the case of credit derivatives according to paragraphs 5 and If the fair value of the derivative or long settlement transaction is negative it shall be considered a zero value for purposes of calculating the exposure amount. 4. The exposure amount from sold options shall be zero starting from the final payment of the option premium. 5. If the reference instrument for a total return swap or credit default swap is a qualifying instrument according to Annex 20 of the Decree the conversion factor shall be In other cases it shall be 0.1. If the reference instrument of the nth lowest loan quality is a qualifying instrument, the conversion factor for an nth-to-default credit derivative shall be In other cases it shall be If a credit default swap is concluded in the event of the bankruptcy, reorganisation or discharge of the counterparty, even though default does not take place for the reference instrument, the protection seller shall use the conversion factor according to the previous paragraph. However, the future exposure amount shall be limited to the size of the unpaid premium. In other cases the protection seller shall use a zero conversion factor for a credit default swap. residual maturity 1) 1. up to 1 year incl. 2. from 1 to 5 years 3. over 5 years interest 2) Conversion factors derivatives and long settlement transactions currency, incl. equity for precious derivatives for metals apart monetary gold from derivatives for monetary gold Table 1 for other commoditie s 3 1) For derivatives where settlement takes place on certain precisely defined dates and the settlement conditions are such that the fair value of the derivatives on these dates is zero, the residual maturity is deemed to be the period up to the next such date. The conversion factor may not be lower than for derivatives in the case of interest rate instruments with residual maturity over one year. The reason for the lower limit is that even though the aforementioned characteristics of derivatives limit the potential price fluctuations of long-term derivatives until the nearest settlement date the derivative still represents a long-term commitment and thus a greater risk than a derivative with a short residual maturity. The lower limit ensures that the capital requirement for such a derivative is never zero. 2) For interest rate swaps using a variable interest rate/variable interest rate in one currency the exposure value is calculated only according to the instrument s fair value; this means that the conversion factors are deemed to be zero. 3) Derivatives for commodities, apart from monetary gold and precious metal, are assigned to this category of derivatives

7 Consideration of netting agreements 7. In the case of a novation agreement one exposure is calculated for all derivatives concluded with the relevant counterparty which are assigned to the trading and the investment portfolio and which are covered by a bilateral novation agreement. This exposure shall equal the sum of the net fair value and the net potential future exposure, provided that a) the net fair value is equal to the sum of the fair values of the derivatives concluded with the relevant counterparty. If the net fair value is negative it shall be considered a zero value in order to calculate the exposure, b) the net potential future exposure is calculated as the sum of the products of the nominal values of the derivatives and the conversion factors according to Table 1 in this Annex. 8. In the case of other netting agreements one exposure is calculated for all derivatives concluded with the relevant counterparty which are assigned to the trading and the investment portfolio and which are covered by a master netting agreement. This exposure shall equal the sum of the net fair value and the potential future exposure, provided that a) the net fair value is equal to the sum of the fair values of derivatives concluded with the relevant counterparty. If the net fair value is negative it shall be considered a zero value in order to calculate the exposure b) the potential future exposure is calculated according to the relation: PCE red = 0.4 PCE gross NGR PCE gross, where: PCE gross NGR designates the sum of the products of nominal values of the derivatives and the conversion factors pursuant to Table 1 hereof, designates the share, 1. whose numerator includes the net fair value of the derivatives covered by a master netting agreement with the relevant counterparty (if this value is negative it shall be considered a zero figure) and the denominator includes the gross fair value of such derivatives, which shall be equal to the sum of positive fair values of the derivatives, or 2. whose numerator includes the sum of the net fair values of the derivatives covered by master netting agreements with all counterparties, and the denominator includes the gross fair value of such derivatives with all counterparties, which shall be equal to the sum of positive fair values of the derivatives with all counterparties. The resulting exposure is divided into the part belonging to the investment portfolio and the part belonging to the trading portfolio in the same ratio as that of the sum of the exposures for the investment portfolio derivatives (covered by netting agreements with the relevant counterparty without considering bilateral agreements on netting) and the sum of the exposures for the trading portfolio derivatives (covered by netting agreements with the relevant counterparty without considering bilateral netting agreements). V. Standardised Method

8 1. The exposure amount for a derivative or long settlement transaction (hereinafter the transaction ) is stipulated a) separately for each netting set and after taking into account eligible collateral. Collateral can be considered if it uses the Financial Collateral Comprehensive Method, which meets the eligibility conditions for financial collateral under Annex 15 of the Decree. When calculating the exposure amount for transactions in the trading portfolio it is also possible to consider financial instruments and commodities if these meet the requirements for assignment to the trading portfolio; and b) according to the relation: where: CMV designates the current market value of the portfolio of transactions in the netting set with the counterparty without taking into account collateral, CMC designates the current market value of collateral assigned to the relevant netting set, or, alternatively where: CMV i designates the current market value of the transaction i, kde: CMC l designates the current market value of collateral 1, i designates the transaction, l designates the collateral, j designates the hedging set category. These hedging sets reflect the risk factors for which it is possible to offset long and short risk positions and thus obtain a net position which defines the exposure amount; RPT ij designates the risk position from the transaction i, which relates to hedging set j, RPC lj designates the risk position from collateral l, which relates to hedging set j, CCRM j designates the conversion factor according to Table 2 hereof, which relates to hedging set j, β designates parameter beta, which equals 1.4. Collateral received from the counterparty shall have a plus sign (+) and collateral provided to the counterparty shall have a minus sign (-).

9 Table 2 Conversion factors for hedging set categories Category Conversion factor (CCRM) Interest rates 0.2 % Interest rates for risk positions from the reference instrument that 0.3 % underlies a credit default swap and for which a capital requirement of 1.60% or less would be stipulated for specific interest rate risk Interest rates for risk positions from a debt instrument or reference debt 0.6 % instrument for which a capital requirement of more than 1.60% would be stipulated for specific interest rate risk Exchange rates 2.5 % Electricity 4.0 % Monetary gold 5.0 % Equities 7.0 % Precious metals apart from monetary gold 8.5 % Other commodities apart from precious metals and electricity 10.0 % Underlying instruments of derivatives and long settlement transactions 10.0 % not included in another category 1) 1) Underlying instruments from these derivatives and long settlement transactions are assigned to separate hedging sets for each category of underlying instruments. 2. If a transaction with a linear risk profile is to be exchanged for cash, the part which involves cash is designated as the payment leg. A transaction where cash is to be exchanged for cash comprises two payment legs. Payment legs consist of contractually agreed amounts, including the transaction s nominal value. Subsequent calculations do not have to take into account the interest rate risk from a payment leg with a residual maturity of less than one year. Transactions which comprise two payment legs in the same currency, e.g. interest swaps, can be treated as a single aggregated transaction. The payment legs are then treated in relation to the aggregated transaction. 3. Transactions with a linear risk profile with equities, including equity indices, gold, other precious metals or other commodities as the underlying instruments are assigned to the risk position in the relevant equity or equity index or commodity, including gold and other precious metals, and to the interest rate risk position in the case of the payment leg. If the payment leg is denominated in a foreign currency it is also assigned to the risk position in the relevant currency. 4. Transactions with a linear risk profile with a debt instrument as the underlying instrument are assigned to one interest rate position in the case of the debt instrument and to another interest rate position in the case of the payment leg. Transactions with a linear risk profile according to which cash should be exchanged for cash, including currency forwards, are assigned to one interest position in the case of each payment leg. If the underlying debt instrument is denominated in a foreign currency this debt instrument shall be assigned to the risk position in this currency. If the payment leg is denominated in a foreign currency

10 it shall also be assigned to the risk position in this currency. The amount of the exposure assigned to a basis currency swap is zero. 5. The risk position amount from a transaction with a linear profile shall equal the market value of the underlying instruments. This provision shall not apply if the underlying instrument is a debt instrument. 6. In the case of debt instruments and payment legs the risk position amount shall equal the market value of the underlying instruments multiplied by the modified duration of the debt instrument or the payment leg. 7. In the case of a credit default swap the risk position amount shall equal the nominal value of the reference instrument multiplied by the residual maturity of the credit default swap. 8. In the case of derivatives with a non-linear risk profile, including options and swaps, the risk position amount shall equal the delta equivalent of the underlying instrument s market value. This provision shall not apply if the underlying instrument is a debt instrument. 9. In the case of derivatives with a non-linear risk profile, including options and swaps, whose underlying is a debt instrument or a payment leg, the risk position amount shall equal the delta equivalent of the market value of the debt instrument or the payment leg, multiplied by the modified duration of the debt instrument or the payment leg. 10. When defining risk positions the collateral received from a counterparty shall be treated as a claim on the relevant counterparty (long position) payable today, and the collateral provided to the counterparty shall be treated as a commitment to the relevant counterparty (short position) payable today. 11. The amount and the sign of the risk position are defined as follows: a) for all instruments apart from debt instruments according to the relation: the market value of the underlying instruments or the delta equivalent of the market value of the underlying instruments are equal to where: p ref designates the price of the underlying instrument in the reference currency, V designates the amount of the financial instrument; in the case of an option the price of the option, in the case of a transaction with a linear risk profile the price of the underlying instrument, p designates the price of the underlying instrument expressed in the same currency as V; b) in the case of debt instruments and payment legs of all transactions according to the relation: the market value of the underlying instruments multiplied by the modified duration or the delta equivalent of the market value of the underlying instruments multiplied by the modified duration are equal to where: V designates the amount of the financial instrument; in the case of an option the price of the option, in the case of a transaction with linear risk profile the value of the underlying instrument, or the payment leg,

11 r designates the interest rate. 12. Risk positions shall be assigned to hedging sets. The individual positions in a hedging set are summed. The absolute value of this sum shall be termed as the net risk position, or in the relation under paragraph For interest rate positions from debt instruments and from cash received as collateral from a counterparty, for which a capital requirement of 1.60% or less would be stipulated for specific interest rate risk, and for interest rate positions from payment legs, for each currency there exist six hedging sets stated in Table 3 hereof. Reference interest rates Table 3 State bonds Other than state bonds Maturity up to 1 year inclusive up to 1 year inclusive 1 to 5 years inclusive 1 to 5 years inclusive over 5 years over 5 years 14. In the case of interest rate positions from debt instruments or payment legs for which the interest rate is linked to a reference interest rate representing the general level of interest rates in the market, the residual maturity shall equal the length of time until the next revaluation. In other cases it shall equal the residual maturity of the underlying debt instrument or, in the case of the payment leg, the residual maturity of the transaction. 15. There is one hedging set for every issuer of a reference instrument that underlies a credit default swap. An nth-to-default credit default swap shall be treated as follows: a) the size of a risk position in a reference debt instrument in the basket underlying the given credit derivative is equal to its market value multiplied by the modified duration of the given credit derivative with respect to a change in the credit spread of the given reference debt instrument; b) there is one hedging set for each reference debt instrument in the basket of instruments underlying the given credit derivative; risk positions that arise from other nth-to-default credit default swaps are not included in this hedging set; c) the conversion factor related to each individual hedging set corresponding to one reference debt instrument in the basket of instruments underlying the given credit derivative equals 0.3% in the event that the reference debt instrument has a credit rating by an eligible rating agency corresponding to credit quality steps 1 to 3, and 0.6% in other cases. 16. For interest rate positions from debt instruments and cash received as collateral from a counterparty where the debt instruments would attract a specific interest rate risk capital requirement of more than 1.60% there is one hedging set for each issuer and each cash provider. If the payment leg emulates a debt instrument of high specific interest rate risk there shall also exist one hedging set for each issuer of the reference bond. Risk positions

12 from the debt instruments of a certain issuer or from the reference debt instruments of the same issuer, which are emulated by payment legs or which underlie a credit default swap, can be assigned to the same hedging set. 17. Underlying financial instruments other than debt instruments shall be assigned to the same hedging set if they are identical or similar. In other cases, they shall be assigned to a separate hedging set. The similarity of instruments is determined according to the following criteria: a) for equities similar instruments are equities of the same issuer; an equity index is treated as an independent issuer, b) for precious metals similar instruments are instruments with the same metal; an index of precious metals is treated in the same way as an independent precious metal, c) for electricity similar instruments are the rights and obligations connected with supplies during the same peak or off-peak interval over a 24-hour period, d) for commodities similar instruments are instruments with the same commodity; a commodity index is treated as an independent commodity. 18. The conversion factors for individual hedging set categories are given in Table 2 in this Annex. 19. If the liable entity is not able to calculate the delta or the modified duration for transactions using the approved models, a) it shall use the Mark-to-Market Method, or b) it shall itself produce a conservative calculation of the amount of the risk positions and the conversion factor which applies to the hedging set, unless the Czech National Bank rejects this calculation. In these cases netting is not taken into consideration and the exposure amount shall be calculated as if a netting set existed which contains only this one transaction. VI. EPE Model Method 1. The EPE Model Method can be used with the approval of the competent authority to calculate the exposure amount of a) derivatives, b) repurchase transactions, c) borrowing and lending of securities or commodities, d) margin lending transactions, or e) long settlement transactions. The EPE model does not have to be used for exposures which are immaterial with regard to their amount and risk. 2. The EPE model may be implemented gradually for different types of transactions. While the EPE model is being implemented other methods can be used in parallel. A liable entity that already uses the EPE model shall not return to the other methods unless it is able to demonstrate a sound reason to do so and the competent authority grants its approval.

13 3. If a liable entity that already uses the EPE model ceases to meet the requirements for its use it shall notify the Czech National Bank of this fact and submit to it a plan for a prompt renewal of compliance. In this it shall state how it intends to meet these requirements again. It does not have to submit this plan if can demonstrate that the impact of not meeting the requirements for using the EPE model is immaterial. Exposure amount 4. The exposure amount is calculated at the level of the netting set. The EPE models must specify the estimated distribution for changes in the market value of the netting set as a result of changes in market risk factors, such as interest rates or exchange rates. The liable entity may choose that it will treat all netting sets with the same counterparty as one netting set, provided that negative simulated market values of the individual netting sets are set to zero in the estimation of the expected exposure as at a certain date. The EPE model is used to calculate the exposure amount for a netting set at any date in the future depending on changes in market risk factors. In the case of counterparties with whom transactions protected by collateral are conducted, the model can capture future collateral fluctuations. 5. The estimated distributions for changes in the netting set s market value can include collateral in the form of a) financial collateral under the Financial Collateral Comprehensive Method, which meets the conditions for eligibility of financial collateral pursuant to Annex 15 of the Decree, b) a financial instrument and commodity that meet the requirements for inclusion in the trading portfolio. 6. The exposure amount is calculated according to the relation E = α effective EPE, where: E designates the exposure amount, α designates the alpha parameter, which equals 1.4, or the amount stipulated when approval to use the EPE model was granted, effective EPE designates the effective expected positive exposure (EPE), which is calculated by estimating the expected exposure (EE t ) as the average exposure at future date t, where the average is taken across possible future values of relevant market risk factors. The model estimates the expected exposure (EE) at a series of future dates t 1, t 2, t The effective expected exposure is calculated recursively according to the relation: Effective EE tk = max {effective EE tk-1 ; EE tk }, where: t 0 designates the current date, effective EE t0 designates the effective expected exposure at t The effective EPE is the average of the effective expected exposure (EEE) during the first year of the future exposure. If all transactions in the netting set have maturity of up to one year the expected positive exposure (EPE) shall be equal to the average of the expected exposure until the maturity of all transactions in the netting set. The effective EPE is calculated as a weighted average of the effective EE according to the relation:

14 EffectiveEPE = min ( 1year, maturity) k = 1 EffectiveEE t t k k where: weights t k = t k t k-1 exist for cases where the future exposure is calculated on dates which are not equally spaced over time. 9. The expected exposure or peak exposure is calculated on the basis of a distribution of exposures which takes into account the possible non-normality of the distribution of exposures. 10. The liable entity may use a more conservative approach than the multiplication of the effective EPE by parameter alpha. 11. Conditional upon the approval of the competent authority, the liable entity may use its own estimate of parameter alpha provided that alpha does not fall below 1.2. Parameter α is then equal to the ratio of internally stipulated capital from a full simulation of the exposure to the counterparty for all counterparties (numerator) and internally stipulated capital based on the EPE (denominator). In the denominator the EPE is used as if it involved a fixed owed amount. The liable entity shall demonstrate that in the own estimate of parameter α the numerator captures material sources of dependency of the distribution of market values of the transactions or portfolios of transactions across counterparties. 12. The liable entity shall ensure that the numerator and denominator of parameter alpha are calculated with regard to the used modelling approaches, parameters and the composition of the portfolio according to a consistent approach. The approach used shall be based on the liable entity s own procedure for defining internal capital and shall be duly documented and independently evaluated. The liable entity shall review its estimates at least once every quarter, or more often if the portfolio s composition changes in the meantime. The liable entity shall also assess risk associated with the model used. 13. The volatility and correlation of market risk factors used in a common simulation of market and credit risk should be conditional on the credit risk factor reflecting possible increases in volatility or correlations in the event of an economic downturn. 14. If the netting set forms part of a margin agreement one of the following EPE amounts shall be used: a) effective EPE without taking into account the margin agreement, b) the margin threshold stipulated in the margin agreement, if this is positive, increased by an additional sum reflecting a possible rise in the exposure over the margin period of risk. This additional sum shall be calculated as the expected increase in the netting set exposure beginning from a current exposure of zero over the margin period of risk. The minimum period for the margin period of risk shall for these purposes mean: 1. 5 business days for netting sets which only consist of repurchase transactions revalued daily and with daily collateral supplements, or business days for other netting sets if the EPE model in the EE estimates captures the impacts of supplementary collateral; with the approval of the competent authority the expected exposure amounts measured by the model may be used directly in the relation described in paragraph 8.

15 EPE model requirements 15. The EPE model must meet requirements concerning: a) counterparty risk management, b) use test, c) stress tests, d) wrong-way risk, e) the integrity of the modelling process. 16. The EPE model shall meet requirements concerning counterparty risk management if a) the liable entity has a department that is responsible for devising and implementing a counterparty risk management system, including initial and continual validation of the EPE model. This department shall control the correctness of input data and prepare and analyse reports on outputs from the model, including an evaluation of the relation between the risk exposure amount and credit limits and trading limits. The department must be independent of the trading departments and must not be subject to unwanted influences, it must have qualified employees and be directly subject to the liable entity s senior management. The activity of this department shall be an integrated part of the everyday risk management process; b) the liable entity has strategies and procedures for counterparty risk management which also take into account the market risk, liquidity risk and operational risk which may be connected with counterparty credit risk. The liable entity shall not begin to trade with the counterparty without first evaluating its economic and financial situation and taking into account credit risk during and before settlement. The liable entity shall manage these risks comprehensively at the counterparty level by aggregating all exposures to the counterparty; c) the liable entity s senior management actively participates in the counterparty credit risk management process. It shall be cognisant of the criteria on which the relevant model is based and any shortcomings and limitations therein; d) daily reports prepared by the department responsible for counterparty credit risk management are reviewed by managerial employees with the authority to reduce both the exposures held by the relevant employees and the overall exposure to counterparty credit risk, e) the counterparty credit risk management system is thoroughly linked to the internal credit and trading limits. Senior management and relevant employees (credit managers, traders) shall understand these relations; f) in the measurement of counterparty credit risk the liable entity shall include the use of credit lines both at the end of and during the day. The liable entity shall measure current exposure both without taking into account collateral received and after taking this into account. In relation to the portfolio and the counterparty the liable entity shall calculate and monitor the peak exposure or potential future exposure at a confidence interval, which it shall choose itself. The liable entity shall take into account large or concentrated positions, in particular on the basis of economically connected groups of persons, sectors, markets;

16 g) the liable entity shall regularly perform adequate stress tests, the results of which will be reviewed by senior management and subsequently reflected in internal approaches and limits, h) the liable entity shall have procedures for monitoring internal procedures and control mechanisms to ensure compliance with the counterparty credit risk management system, i) the liable entity shall ensure that the regular independent verification of the counterparty credit risk management system forms part of the internal audit. This verification shall relate not only to the department responsible for counterparty credit risk management but also to the credit and other trading departments, and shall include 1. verification that there is adequate documentation for the counterparty credit risk management procedure and the organisation of the counterparty credit risk management department and its activities, 2. the method for incorporating outputs from the measurement of counterparty credit risk in daily risk management and in the information system, 3. verification of the approach used to approve the systems for evaluating and assessing counterparty credit risk used by the trading departments and transaction settlement departments, 4. verification of any material change to the process for measuring counterparty credit risk, 5. an assessment of the extent to which counterparty credit risk is identified by the model, 6. an assessment of the accuracy and completeness of data used by the model, the accuracy and suitability of used volatilities and correlations, the accuracy and sensitivity of algorithms for calculating risks undertaken, 7. an assessment of the approach used to evaluate the consistency, integrity, timeliness and reliability of source data used by the model, including the independence of such data, 8. an assessment of the approach used to evaluate back-testing. 17. EPE model requirements involving the use test are as follows: a) the distribution of exposures, which is the output from the model according to which the effective expected positive exposure (effective EPE) is calculated, shall be incorporated in the daily counterparty credit risk management procedure. The output from the model plays an important role in the approval of credits, counterparty credit risk management, the allocation of internal capital and in the management of the liable entity; b) the liable entity shall keep records of the model s use. The liable entity shall demonstrate that the model used to calculate the distribution of exposures on which the calculation of the expected positive exposure (EPE) is based meets the criteria for the EPE model at least for a period of one year before approval is granted by the competent authority; c) the model used to calculate the distribution of exposure shall form part of the counterparty credit risk management, which also includes the measurement of the use of credit lines (accumulation of exposures to the counterparty) and the allocation of internal capital. Apart from the expected positive exposure (EPE) the liable entity shall also monitor and measure current exposures. If appropriate, the liable entity shall

17 measure current exposure both without taking into account collateral received and after taking it into account. The use test is also met in the event that the liable entity uses other quantities to calculate the expected positive exposure, for example the peak exposure or potential future exposure according to a distribution of exposures produced by the same model; d) the liable entity shall be able, where necessary, to calculate the expected exposure (EE) daily unless it can demonstrate that the level of counterparty credit risk undertaken allows it to perform less frequent calculations. When calculating expected exposures the liable entity shall in the appropriate manner take into account the time structure of future cash flows, the maturity of transactions, the materiality and composition of exposures; e) the liable entity shall monitor and measure exposures for the entire duration of all transactions with a netting set, and not only for a period of one year. The liable entity shall also have approaches to manage counterparty credit risk in cases where the exposure exceeds a period of one year. The predicted increase in the exposure amount is entered into the model used by the liable entity to estimate internal capital. 18. EPE model requirements involving stress tests are as follows: a) the liable entity shall perform stress tests and use their outputs to evaluate its capital adequacy. It shall compare the outputs from stress tests with measured expected positive exposures and consider them as part of the internal capital adequacy evaluation procedure. Stress tests shall include the identification of possible events or future changes in economic conditions which could adversely affect the level of risk undertaken, as well as an evaluation of the liable entity s ability to deal with these changes; b) in performing stress tests of its exposures to counterparties the liable entity shall take into account the level of market and credit risk factors. Stress tests for counterparty credit risk shall take into account 1. the risk of concentration to one counterparty or groups of counterparties, 2. the risk of correlation between market and credit risk, 3. the risk that the liquidation of counterparty positions may move the market. Stress tests shall also take into account the impact of market movements on the liable entity s own positions and shall include this impact in an evaluation of counterparty credit risk. 19. EPE model requirements involving wrong-way risk are as follows: a) the liable entity shall pay due attention to exposures with a material general wrongway risk, b) the liable entity shall identify, evaluate and monitor individual cases of specific wrong-way risk from the beginning of a specific transaction until its end. 20. EPE model requirements involving the integrity of the modelling process are as follows: a) Transactions, including their specific characteristics, shall be included in the model on a timely, complete and conservative basis. Specific characteristics shall include, for example, the nominal value of the transaction, maturity, the reference instrument, margin agreements and netting agreements. This information is stored in a secure database which is subject to a regular internal audit. The procedure by which

18 agreements are recognised requires approval by the person that performed a legal analysis of the agreement and verified the legal enforceability of the netting. The transfer of data on transactions from the database to the model shall be the subject of regular reconciliation and shall also be verified by the internal audit in order to ensure that the model give a correct, or at least conservative, record of the transactions; b) in order to calculate current exposures the model shall use current market data. Where past data are used to estimate volatility and correlations these data shall have been used for at least three years and updated quarterly or more frequently, according to market conditions. The data files shall cover the full range of economic conditions, for example the full economic cycle. Prices supplied by the trading department shall be validated by a different department, which shall be independent of the trading department. Data shall be obtained independently of trading lines, assigned to the model on a timely and complete basis and stored in a secure database, which is regularly validated by the internal audit. Procedures to ensure the integrity of data shall ensure that erroneous or anomalous data are eliminated. In cases where proxy data are used, for example for new products for which past data have not been available for three years, procedures must exist to select these proxy data. The liable entity shall be able empirically to demonstrate that these proxy data prudently reflect the underlying risk even in adverse market conditions. If the model includes the influence of collateral on changes in the market value of the netting set, the liable entity shall have available the relevant past data to model the volatility of the collateral; c) the liable entity shall validate the model according to the stipulated approaches, which shall clearly define the type of test that is needed to ensure the model s integrity and which identify the conditions under which the criteria applied to develop the model are found to be incorrect, with the possibility that they might lead to the expected positive exposure (EPE) being undervalued. The validation shall also verify the comprehensiveness of the model; d) the liable entity shall monitor associated risks and have procedures for modifying its expected positive exposure (EPE) estimates, if these risks become material. The liable entity shall 1. manage specific wrong-way risk, 2. for exposures whose risk profile rises after one year regularly compare the estimate of expected positive exposure for one year with the expected positive exposure for the whole period of its duration, 3. for exposures with residual maturity of up to one year regularly compare the fair value of the exposure (current exposure) and the realised exposure profile, or have available data which allow such a comparison, e) before assigning a transaction to the netting set the liable entity shall verify that a netting agreement applies to the transaction which is legally enforceable and which meets the requirements for netting agreements set forth in this Annex, f) before taking into account collateral the liable entity shall verify that the conditions have been met for the recognition of an agreement on balance sheet netting pursuant to Annex 15 of the Decree. Requirements for the validation of the EPE model 21. The liable entity shall meet the requirements for validation of the EPE model if