Risk monitoring and control

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(c) The accuracy and reliability of a model should be subject to regular validation (e.g. back-testing and review of related fundamental analyses) performed by independent parties, including independent audits conducted by capable internal or external auditors. The model should also be subject to periodic updates to reflect changing market conditions. AIs should regularly compare model-based valuations with available market proxies and/or valuations of similar instruments produced by other institutions.

(d) Locally incorporated AIs using internal models for capital adequacy purposes must meet the applicable requirements set out in the BCR (including Schedules 2 and 3 to the BCR), the requirements set out in CA-G-3

“Use of Internal Models Approach to Calculate Market Risk”, CA-G-4 “Validating Risk Rating Systems under the IRB Approaches” or Schedule 2A to the BCR, as the case may be. In the case of AIs incorporated outside Hong Kong, all or part of their models may be centrally developed and monitored on a group basis. The HKMA will generally rely on the home supervisors of the AIs to ensure that models used by the AIs are robust and subject to proper validation procedures unless the HKMA has concern over the scope and approach of the home supervisors’ supervision in this regard.

2.6 Risk monitoring and control

2.6.1 CRT activities should be subject to ongoing monitoring and control performed by a control function which is independent of the business or risk-taking units and resourced in a manner commensurate with the complexity and volume of the CRT activities of the AIs. As mentioned in paragraph 2.1.2, the control function should be able to monitor CRT exposures on a firm-wide basis as well as on aggregate bases (i.e.

aggregated, say based on risk categories, with other non-CRT exposures).

2.6.2 The control function typically performs the following functions –

(a) Independent risk assessment, approval (within delegated authorities) and regular review of CRT

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activities. In the case of securitization exposures, the review should cover performance of underlying exposures, compliance with covenants and the status of various trigger measurements/ratios (e.g. early amortization trigger, excess spread level and asset quality test);

(b) Design and implementation of risk management systems for CRT activities, including initial and ongoing valuation, design of scenarios for stress-testing and sensitivity analysis, regular review/validation of valuation methodologies and models (where applicable). In the case of AIs incorporated outside Hong Kong, these could be done at head office level where appropriate;

(c) Daily monitoring of CRT activities and exposures, usage of and compliance with established limits, and identification and resolution of exceptions;

(d) Measurement and valuation of CRT exposures;

(e) Design and preparation of management reports for monitoring such aspects as composition of CRT portfolios, trend of aggregate CRT exposures relative to defined risk appetite, risk/return information and performance of underlying exposures;

(f) Conducting of stress tests and sensitivity analyses;

(g) Regular review of effectiveness of hedges (e.g. changes in the correlation of default risk between the protection seller and the exposure hedged, basis risk); and

(h) Collateral management (e.g. monitoring of margin level of derivative position).

2.6.3 In particular, AIs should review regularly (and not, in any event, less than once a year) all material potential exposures to securitization transactions (including off-balance-sheet SPEs), broken down by

(a) product;

(b) underlying exposures;

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(c) role played by the AIs (e.g. originator, servicer, distributor, trustee); and

(d) exposures held by the AIs as investors.

The nature of the exposures should be reflected in the review accurately.

Monitoring specific to originating AIs

2.6.4 An originating AI of a securitization transaction should monitor, on an ongoing basis over the life of the transaction, the quality and performance of the underlying exposures of the transaction, taking into consideration any possible impacts on the risk profile of the AI. The monitoring process should impose duties on relevant business units and the risk management function to identify early-warning signals and ensure prompt management attention to such warnings.

Although the ownership rights and control of the underlying exposures may have been sold or the credit risk of the underlying exposures may have been significantly transferred, such monitoring is necessary because the reputation of the AI as an originator or servicer remains exposed. Moreover, if the AI has securitized its highest quality assets or provided support (e.g. liquidity facilities and reserve funds) to the transaction, it may have put itself and its unsecured creditors in a weaker position in relation to the investors in the transaction, and should be alert to any potential impacts on its financial position such as funding costs, credit standing and capital position.

2.6.5 The following are examples of items which would be expected to be included in the monitoring reports of originating AIs—

(a) Reports on securities backed by revolving credit facilities (e.g. credit cards) would typically monitor—

(i) portfolio’s gross yield;

(ii) delinquencies;

(iii) charge-off rate;

(iv) base rate (i.e. coupon rate paid on investor certificates plus servicing fee);

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(v) monthly excess spread;

(vi) rolling three-month average excess spread; and (vii) monthly payment rate.

(b) Reports on securities backed by instalment loans (automobiles, mortgages, etc.) would typically monitor—

(i) charge-off rate;

(ii) net portfolio yield (portfolio yield minus charge-offs);

(iii) number and status of restructured accounts;

(iv) delinquencies (aged);

(v) loan-to-value ratio (if applicable);

(vi) principal prepayment speeds; and

(vii) outstanding principal compared to original security size.