1. This Section sets out the conditions under which an Authorised Person is permitted to use an internal model to calculate its Market Risk Capital Requirement or any component of its Market Risk Capital Requirement. An Authorised Person that wishes to use an internal model to calculate any part of this requirement is required to apply to the Regulator. Internal models will commonly permit more extensive Netting of long and short positions and have greater risk sensitivity.
2. In assessing whether to give approval, the Regulator will consider an Authorised Person's risk management standards; the quantitative model standards; the stress-testing and back-testing standards and the process surrounding the calculation of the appropriate regulatory Capital Requirement.
3. The Regulator will usually only give its approval for the use of an internal risk model if:
a. the use of the model to calculate the Market Risk Capital Requirement has been approved by another appropriate regulator or the Regulator is satisfied having been provided by the Authorised Person with such opinions from independent experts as it may require, that the model adequately addresses Market Risk requirements;
b. use of the methodology is integrated into the governance and control framework of the Authorised Person. Specifically, the Governing Body and senior management of the Authorised Person receives and reviews appropriate reports in respect of the entity;
c. it is satisfied that the Authorised Person's risk management system is conceptually sound and is implemented with integrity;
d. the Authorised Person has sufficient numbers of staff skilled in the use of sophisticated models not only in the trading area but also in the risk control, audit, and if necessary, back office areas;
e. the Authorised Person's models have a proven track record of reasonable accuracy in measuring risk; and
f. the Authorised Person regularly conducts stress tests.
4. In determining whether an internal value at risk (VaR) model meets the standard for approval, the Regulator will apply the criteria set out in Section A5.9, which are based on the Basel Market Risk Capital Amendment 1996 and Basel Revisions to the Basel II Market Risk framework 2009 and which can be grouped under the following headings:
a. qualitative standards;
b. specification of Market Risk factors;
c. quantitative standards;
d. adjustments to Market Risk Capital Requirements;
e. stress testing; and
f. combination of internally developed models and the Standardised Methodology.
5. In addition to value-at-risk models, the Regulator recognises Option risk aggregation models and interest rate 'pre-processing' or sensitivity models, as set out under the EU's Capital Adequacy Directive (these are the so-called 'CAD1 models').
6. Option risk aggregation models analyse and aggregate Options risks for interest rate, equity, foreign exchange and commodity Options.
7. Interest rate pre-processing models are used to calculate weighted positions for inclusion in an Authorised Person's interest rate Market Risk Capital Requirement calculation under the Duration Method.