Circular to Licensed Corporations Internal Models Approach for Market Risk

The Securities and Futures Commission (SFC) intends to facilitate the adoption of an internal models approach to be used by licensed corporations (LCs) where appropriate to calculate the capital requirements for market risk for proprietary investments.

In July 2015, the SFC proposed^[1] providing for this as part of amendments to the Securities and Futures (Financial Resources) Rules (FRR) to better align the FRR with international capital standards and to respond to the industry’s need for a more risk-sensitive approach to the calculation of regulatory capital. The proposed changes were supported by the industry and the SFC concluded^[2] that the internal models approach would be introduced into the FRR in a manner which reflects the latest Basel standards^[3]. This will enhance the SFC’s prudential supervisory regime and further strengthen Hong Kong’s competitiveness as a risk management centre.

Given the volume and complexity of the proposed amendments to the FRR, the legislative process will take time to complete. Separately, the Basel Committee on Banking Supervision (BCBS) announced an extended implementation timeline for its new standards on Minimum Capital Requirements for Market Risk (commonly known as the FRTB)^[4].

The SFC is aware of the need to provide further guidance under these circumstances. In the interim, the SFC may use its existing supervisory power^[5]  in considering the need to adopt the internal models approach for market risk on a case-by-case basis. The SFC will benchmark its requirements to the Revisions to the Basel II market risk framework (Basel II.5 standards)^[6], pending an update to the FRTB. Under this framework, the SFC will assess the readiness of an LC to adopt the internal models approach for market risk by focusing on the following areas.

1.  Fulfilment of principles-based general criteria including:

• appropriateness of risk management system and models;
• adequacy and competence of staff; and
• soundness of stress testing programme.

2.  Compliance with qualitative standards in relevant areas, including:

• board and senior management oversight;
• market risk management processes such as limit setting and monitoring, risk reporting, back-testing and stress testing; and
• other controls and infrastructure related to market risk management such as new product review, product control, model validation, risk data and IT infrastructure and internal audit.

3.  Adherence to quantitative standards for the calculation of market risk capital charges based on individual components, namely value-at-risk (VaR), stressed value-at-risk and incremental risk charge, including:

• calculation and aggregation of individual components, including the determination of capital multipliers;
• risk measurement parameters, such as confidence levels, holding periods and calculation frequencies for individual components;
• specification of risk factors across risk categories, including general risk and specific risk; and
• back-testing of VaR against trading outcomes and a traffic light approach to interpret results.

The SFC will also consider each LC’s unique circumstances, for example, a history of proven use of the models by the LC’s overseas parent or group company. Approval granted by a peer regulator of the models for regulatory capital purposes, though not a mandatory requirement, will be taken into account.

In addition to the areas listed above, LCs may refer to Basel II.5 standards for further information or engage the SFC for a discussion of the detailed requirements.

The SFC will continue to monitor market and international regulatory developments and may take further measures where appropriate.

Any LC that considers it is an appropriate candidate to move to the internal models approach for market risk should contact the case officers in charge to discuss the matter.

Intermediaries Supervision Department
Intermediaries Division
Securities and Futures Commission

End

SFO/IS/044/2018