B6.1 General
Risk increasing factors are specific factors that negatively affect the risk profile of an AI and which may hence be indicative of a need for an increase in the AI’s Pillar 2 capital requirement. Such factors may relate to:
- Material risks specific to the AI’s business and operations or material risk concentrations identified within the AI’s business activities. For example, an AI may be exposed to business concentration risk by relying heavily on a particular business activity, or the risk posed by its non-banking activities (such as securities dealing or insurance-related activities) is becoming increasingly high, as a result of rapid expansion in the absence of adequate expertise and management systems;
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V.54 – 08.04.2016 Consultation- Significant “outliers” identified in the review of common assessment factors. These may relate to extremely high levels of inherent risk, substantial management problems or control weaknesses, or significant vulnerability to adverse economic events which warrant a full assessment of the additional capital required to cover the risks involved; and
- Specific issues arising from the application of the capital adequacy framework. In particular, these issues relate to an AI’s ongoing compliance with various minimum standards and requirements applicable to it for the purpose of calculating regulatory capital for credit, market or operational risk. The MA will consider such issues under the SRP if they are not adequately catered for under Pillar 1. Such issues may result in an AI being required to rectify deficiencies by improving its systems and controls or reducing its risk exposures, or to hold additional capital pending rectification of the deficiencies. See subsections B6.2 and B6.3 for a consideration of such issues in relation to credit risk (including counterparty credit risk) and market risk.
Those relating to operational risk are mentioned under subsection B2.2.
The MA should determine the extent to which the Pillar 2 capital requirement of an AI should be increased due to a risk increasing factor based on his assessment of the extent to which such a factor has the potential to increase the risk of the AI.
B6.2 Specific issues in relation to credit risk Credit risk mitigation
An AI may be exposed to residual credit risk associated with credit risk mitigation if the techniques used give rise to risks that could render the overall risk reduction less effective.
Examples of these risks include:
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V.54 – 08.04.2016 Consultation- inability to seize, or realise in a timely manner, collateral pledged (on default of the obligor);
- refusal or delay by a guarantor to pay;
- ineffectiveness of untested documentation; and
- high cost credit protection transactions where there is an immediate regulatory capital benefit but a delayed recognition of losses or costs of protection in earnings by an AI. The relevant supervisory requirements and guidance relating to high cost credit protection transactions are set out in Annex G.
There may also be specific wrong-way risk if there is a high correlation in the creditworthiness of a credit protection provider and the obligor due to their performance being dependent on common economic factors.
The MA will determine if there are instances suggesting the lack of appropriate policies and procedures on the part of the AI to control these residual risks, and assess the need for taking appropriate action (e.g. increasing the AI’s Pillar 2 capital requirement).
IRB approach
An AI’s adoption of the IRB approach may give rise to some issues which will be subject to the MA’s review in determining the appropriate supervisory actions to be taken (including whether the AI’s regulatory capital requirement should be increased pending rectification of deficiencies).
Examples include:
- deficiencies or flaws identified in the risk quantification or back-testing methodologies or processes associated with IRB models;
- deviations from the reference definition of default used for risk estimation (e.g. use of external data or historical
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V.54 – 08.04.2016 Consultationinternal data not fully consistent with the reference definition of default prescribed by the MA);
- weaknesses arising from the application of credit risk stress tests under the IRB approach, such stress-testing being a requirement for using this approach. For example, the stress-testing processes or methodologies employed may not be appropriate to an AI’s circumstances or a capital shortfall (i.e. capital insufficient to cover the minimum capital requirements under the IRB approach according to the credit risk stress tests performed) is identified but not adequately addressed; and
- inadequate systems and controls (applicable to AIs adopting double default treatment) in monitoring the deterioration in the credit quality of protection providers and in assessing the impact of protection providers falling outside the eligibility criteria (due to rating changes) on their capital requirements at the time of default.
Basic approach
AIs using the basic approach are not subject to a higher capital charge for their past due exposures. If such exposures have reached a significant level compared with an AI’s peers, the MA may consider whether a capital adjustment under the SRP is necessary to reflect the higher risk associated with the problem exposures.
Standardized approach
AIs should have methodologies that enable them to assess the credit risk involved in exposures to individual borrowers or counterparties as well as at the portfolio level. AIs should assess exposures, regardless of whether they are rated or unrated, and determine whether the risk weights applied to such exposures are appropriate for their inherent risk.
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V.54 – 08.04.2016 Consultation In those instances where an AI determines that the inherent risk of a credit exposure, particularly if it is unrated, is significantly higher than that implied by the risk-weight to which it is assigned, the MA expects the AI to consider the higher degree of credit risk in the evaluation of its overall capital adequacy.
For more sophisticated AIs, the MA expects the credit review assessment of capital adequacy conducted as part of their CAAP, at a minimum, to cover four areas: risk rating systems, portfolio analysis / aggregation, securitization / complex credit derivatives, and large exposures and risk concentrations.
Securitization
The MA will be alert for any indication that may call into question an AI’s compliance with the relevant requirements on the recognition of risk transference for its securitization transactions. If the MA determines that the level of risk transfer for a particular transaction has been overstated and does not justify the capital relief granted, it may lead to an increase in capital requirements for the transaction concerned or, where necessary, an increase in the overall level of capital the AI is required to hold.
Similarly, if there is indication that an AI has provided implicit support to transactions that it has securitized, the MA will consider the appropriateness of taking one or more supervisory actions (including an increase in the AI’s §97F minimum CAR) as specified in Part 7 of the Banking (Capital) Rules.
In the event that an AI is engaged in complex securitization transactions the risks of which are not adequately accounted for under Pillar 1 (e.g. as a result of market innovations introducing new features to a securitization), the MA may consider imposing a specific capital treatment for such transactions or adjust the AI’s §97F minimum CAR to account for the additional risk incurred.
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V.54 – 08.04.2016 Consultation The MA will also review any other issues arising from an AI’s compliance with the securitization requirements (e.g. in relation to call options and early amortization provisions) to determine the need for a capital adjustment or other supervisory actions.
Annex E provides further discussion on the various risks associated with securitization and other off-balance sheet activities and the MA’s expectations of how such risks should be addressed by AIs in their CAAP and managed, as well as the MA’s approach to assessing such risks under the SRP. The MA will consider the need for additional capital or supervisory measures if there are major concerns in the way an AI addresses these risks.
Counterparty credit risk
The MA will focus substantially on an AI’s systems of control to manage the AI’s counterparty credit risk in assessing its capital adequacy in relation to such risk under the SRP.
For an AI that uses the IMM(CCR) approach to calculate counterparty credit risk, where it is apparent to the MA that the estimates from the calculation do not adequately reflect the AI’s exposure to such risk, the MA will determine the appropriate action to be taken, which may include directing the AI to (i) revise its estimates; (ii) apply higher estimates of exposure or exposure at default (“EAD”) under the IMM(CCR) approach; or (iii) not recognise internal estimates of EAD for regulatory capital purposes.
The MA will also assess AIs’ exposures to central counterparties under the SRP. In particular, an AI should review, and the MA will assess, whether there is a need for the AI to hold additional capital against such exposures, including any unlimited funding commitments arising from an AI’s default fund contributions (which are not entirely prefunded) to a central counterparty.
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V.54 – 08.04.2016 Consultation Detailed supervisory requirements and guidance in relation to counterparty credit risk are set out in Annex H.
B6.3 Specific issues in relation to market risk IMM approach
A variety of issues may arise from an AI’s adoption of the IMM approach for the calculation of market risk. These include:
- deficiencies or flaws identified in the risk quantification or back-testing methodologies or processes associated with market risk internal models;
- deficiencies arising from valuation issues, such as inappropriate valuation adjustments to less well diversified portfolios or portfolios consisting of less liquid cash instruments;
- weaknesses arising from the application of market risk stress tests under the IMM approach, such stress-testing being a requirement for using this approach. For example, the stress-testing assumptions or methodologies may not be appropriate or commensurate with an AI’s trading activities or a capital shortfall (i.e.
capital insufficient to cover the minimum capital requirements under the IMM approach according to the market risk stress tests performed) is identified but not adequately addressed; and
- weaknesses arising from capturing specific risk under the IMM approach. For example, model effectiveness is undermined by positions with limited price transparency or by illiquid positions, or the approach to capturing incremental risks28 is inadequate.
28 These include default risk and credit migration risk that are incremental to the risks captured in the VaR-based capital charge calculations.
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V.54 – 08.04.2016 Consultation The MA will determine the appropriate supervisory actions to be taken in respect of these issues (including whether the AI’s §97F minimum CAR should be increased pending rectification of weaknesses).