REGULATION ON THE CALCULATION OF CAPITAL REQUIREMENTS FOR MARKET RISKS FOR BANKS AND SAVINGS BANKS *

Transcription

1 THIS TEKST IS UNOFFICIAL TRANSLATION AND MAY NOT BE USED AS A BASIS FOR SOLVING ANY DISPUTE (unofficial consolidated text) Official Gazette of the Republic of Slovenia, No. 135/06 of 21 December 2006 basic text (in force since 1 January 2007). Official Gazette of the Republic of Slovenia, No. 104/07 of 16 November 2007 Amendments and Additions (in force since 24 November 2007). Pursuant to point 5 of Article 129 and Article 405 of the Banking Act (Official Gazette of the Republic of Slovenia, No 131/06) and paragraph 1 of Article 31 of the Bank of Slovenia Act (Official Gazette of the Republic of Slovenia No 72/06 - official consolidated text), the Governing Board of the Bank of Slovenia issues the following REGULATION ON THE CALCULATION OF CAPITAL REQUIREMENTS FOR MARKET RISKS FOR BANKS AND SAVINGS BANKS * 1. GENERAL PROVISIONS Article 1 (content of the regulation) (1) This regulation defines in detail the rules relating to calculating the capital requirements for market risks for banks and saving banks (hereinafter: banks). (2) Market risk for the purposes of this regulation comprises: (a) position risk (specific and general risk of price changes in financial instruments) associated with debt instruments associated with equity instruments (b) settlement and counterparty credit risk (c) foreign exchange risk (d) commodity risk (e) risk of exceeding the maximum allowable exposure from trading. (3) When this regulation refers to provisions of other regulations, these provisions shall be applied according to the text in force. Article 2 (general terms) (1) The terms used in this regulation are the same as those defined in Banking Act (Official Gazette of the Republic of Slovenia, No. 131/06; hereinafter: ZBan-1), such as: (b) local firm in the second paragraph of Article 14, (d) probability of default (hereinafter: PD) in the first paragraph of Article 115, (e) default in the second paragraph of Article 115, (f) loss given default (hereinafter: LGD) in the fourth paragraph of Article 115, (g) conversion figure (hereinafter: CF) in the fifth paragraph of Article 115, (h) expected loss (hereinafter: EL) in the sixth paragraph of Article 115, (i) a repurchase transaction in Article 117, The official language of the document translated herein is Slovene. In case of any doubt or misuderstanding the Slovene version should therefore be considered final... * Sklep o izračunu kapitalske zahteve za tržna tveganja za banke in hranilnice (Uradni list 135/06 in 104/07).

2 (j) a securities or commodities lending or borrowing transaction in Article 118, (k) cash assimilated instrument in Article 119, (l) originator in the sixth paragraph of Article 120, (m) sponsor in the seventh paragraph of Article 120, (n) a financial instrument in the first paragraph of Article 121, (o) a derivative instrument in the fifth paragraph of Article 121, (p) a convertible security in the third paragraph of Article 121, (q) a warrant in the fourth paragraph of Article 121, (r) a regulated market referred to in Article 122. (2) For the purpose of this regulation the following definitions shall apply: (a) "over-the-counter (OTC) derivate instruments are financial instruments defined in Annex I to this regulation, other than those instruments to which an exposure value of zero is attributed in accordance with Table 7 of Article 48 of this regulation; (b) "stock financing" means positions where physical stock has been sold forward and the cost of funding has been locked in until the date of the forward sale; (c) "clearing member" means a member of the exchange or the clearing house which has a direct contractual relationship with the central counterparty (market guarantor); (d) "delta" means the expected change in an option price as a proportion of a small change in the price of the instrument underlying the option; (e) a "central counterparty" is an entity that legally interposes itself between counterparties to transactions (contracts) traded on one or more financial markets, becoming the buyer to every seller and the seller to every buyer; (f) "counterparty credit risk" (hereinafter: CCR) is the risk that the counterparty to a transaction could default before the final settlement of the transaction s cash flows; (g) "long settlement transactions" are transactions where a counterparty undertakes to deliver a security, a commodity or a foreign currency against cash, other financial instruments, or commodities, or vice versa, at a settlement or delivery date that is contractually specified as more than the market standard for this particular transaction, or at least five business days after the date on which the credit institution enters into the transaction; (h) "margin lending transactions" mean transactions in which a credit institution extends credit in connection with the purchase, sale, carrying or trading of securities. Margin lending transactions do not include other loans that happen to be secured by securities collateral; (i) an "eligible external credit assessment institution" (hereinafter: eligible ECAI) is an ECAI that the Bank of Slovenia has placed on the list of eligible ECAIs for a particular category of exposure pursuant to the Regulation on the Recognition of External Credit Assessment Institutions (Official Gazette of the Republic of Slovenia, No. 135/06; hereinafter: the ECAI regulation); (j) "credit quality step" is the step to which the Bank of Slovenia maps the individual credit assessment of an eligible ECAI; (k) "management body" is the management board in a two-tiered bank management system or the executive directors of the management board in a one-tiered bank management system; (l) "investment firm" is investment firm in the first paragraph of Article 14 in ZBan-1 for which Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC; (m) "institutions" are credit institutions and investment firms; (n) a "recognised exchange" is an exchange from Annex II of this regulation and which meets the following conditions: 1. it functions regularly, 2. it has rules: issued or approved by the appropriate authorities of the home country of the exchange, and defining the conditions for the operation of the exchange, the conditions of access to the exchange as well as the conditions that shall be satisfied by a contract before it can effectively be dealt on the exchange; and 2

3 3. it has a clearing mechanism whereby contracts listed are subject to daily margin requirements which, in the opinion of the Bank of Slovenia, provide appropriate protection. Article 3 (terms relating to netting sets, hedging sets and related expressions) For the purposes of this regulation the following definitions of netting sets, hedging sets, and related expressions shall apply: (a) "netting set" means a group of transactions with a single counterparty that are subject to a legally enforceable bilateral netting arrangement and for which netting is recognised under Article 70 of this regulation and the Regulation on Credit Protection (Official Gazette of the Republic of Slovenia, No 135/06; hereinafter: Regulation on Credit Protection). Each transaction that is not subject to a legally enforceable bilateral netting arrangement, which is recognised under Article 70 of this regulation, should be interpreted as its own netting set for the purpose of this regulation; (b) "risk position" means a risk number that is assigned to a transaction under the Standardised Method set out in Articles 50 to 52 of this regulation following a predetermined algorithm; (c) "hedging set" means a group of risk positions from the transactions within a single netting set for which only their balance is relevant for determining the exposure value under the Standardised Method set out in Articles 50 to 52 of this regulation; (d) "margin agreement" means a contractual agreement or provisions of an agreement under which one counterparty must supply collateral to a second counterparty when an exposure of that second counterparty to the first counterparty exceeds a specified level. Collateral means financial collateral, real estate collateral, other physical collateral, and monetary receivables; (e) "margin threshold" means the largest amount of an exposure for a counterparty that remains outstanding until one party has the right to call for collateral; (f) "margin period of risk" means the time period from the last exchange of collateral 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 greater than one year" (effective maturity) means the ratio of the sum of expected exposure over the life of the transactions in the netting set discounted at the risk-free rate of return divided by the sum of expected exposure over one year in a netting set discounted at the risk-free rate. This effective maturity may be adjusted to reflect rollover risk by replacing expected exposure with effective expected exposure for forecasting horizons under one year; (h) "cross-product netting" means the inclusion of transactions of different product categories within the same netting set pursuant to the Cross-Product Netting rules set out in Article 70 of this regulation; (i) "current market value" means the net market value of the portfolio of transactions within the netting set with the counterparty. Both positive and negative market values are used to calculate the current market value. Article 4 (terms relating to distributions) For the purposes of this regulation, the following definitions of distribution shall apply: (a) "distribution of market values" means the forecast of the probability distribution of net market values of transactions within a netting set for some future date (the forecasting horizon), given the realised market value of those transactions up to the present time; (b) "distribution of exposures" means the forecast of the probability distribution of market values that is generated by setting forecast instances of negative net market values equal to zero; (c) "risk-neutral distribution" means a distribution of market values or exposures at a future time period where the distribution is calculated using market-implied values that express risks such as market volatility; 3

4 (d) "actual distribution" means a distribution of market values or exposures at a future time period where the distribution is calculated using historic or realised values such as volatilities calculated using past price or rate changes. Article 5 (terms relating to exposure measures and adjustments) For the purposes of this regulation, the following definitions of exposure measures and adjustments shall apply: (a) "current exposure" means the market value of a transaction or portfolio of transactions within a netting set with a counterparty that would be lost upon the default of the counterparty, assuming no recovery on the value of those transactions in bankruptcy. If the market value is negative, the value is given as zero; (b) "peak exposure" means a high percentile of the distribution of exposures at any particular future date before the maturity date of the longest transaction in the netting set; (c) "expected exposure" means the average of the distribution of exposures at any particular future date before the longest maturity transaction in the netting set matures; (d) "effective expected exposure (Effective EE) at a specific date means the maximum expected exposure that occurs at that date or any prior date. Alternatively, it may be defined for a specific date as the greater of the expected exposure at that date, or the effective exposure at the previous date; (e) "expected positive exposure (EPE)" means the weighted average over time of expected exposures where the weights are the proportion that an individual expected exposure represents of the entire time interval. When calculating the minimum capital requirement, the average is taken over the first year or, if all the contracts within the netting set mature within less than one year, over the time period of the longest maturity contract in the netting set; (f) "effective expected positive exposure (Effective EPE)" means the weighted average over time of effective expected exposure over the first year, or, if all the contracts within the netting set mature within less than one year, over the time period of the longest maturity contract in the netting set, where the weights are the proportion that an individual expected exposure represents of the entire time interval; (g) "credit valuation adjustment" means an adjustment to the mid-market valuation of the portfolio of transactions with a counterparty; this adjustment reflects the market value of the credit risk due to any failure to perform on contractual agreements with a counterparty; this adjustment may reflect the market value of the credit risk of the counterparty or the market value of the credit risk of both the counterparty and the bank; (h) "one-sided credit valuation adjustment" means a credit valuation adjustment that reflects the market value of the credit risk of the counterparty to the bank, but does not reflect the market value of the credit risk of the bank to the counterparty. Article 6 (terms relating to CCR-related risk) For the purposes of this regulation, the following definitions of CCR-related risks shall apply: (a) "rollover risk" means the amount by which expected positive exposure is understated when future transactions with a counterpart are expected to be conducted on an ongoing basis; the additional exposure generated by those future transactions is not included in calculation of EPE; (b) "general wrong-way risk" arises when the PD of counterparties is positively correlated with general market risk factors; (c) "specific wrong-way risk" arises when the exposure to a particular counterparty is positively correlated with the PD of the counterparty due to the nature of the transactions with the counterparty. A credit institution shall be considered to be exposed to Specific Wrong-Way Risk if the future exposure to a specific counterparty is expected to be high when the counterparty's PD is also high. 4

5 2. CAPITAL REQUIREMENT FOR MARKET RISK Article 7 (calculation of capital requirement) (1) The capital requirement for market risk is equal to the amount of: (a) the capital requirements calculated for trading book business, i.e. for: position risk (in accordance with Articles 15 to 42 of this regulation); settlement and counterparty credit risk (in accordance with Articles 43 to 74 of this regulation); risk of exceeding the maximum allowable exposure from trading (in accordance with Article 93 of this regulation); (b) the capital requirements calculated for all business (non-trading and trading book items), i.e. for: foreign exchange risk (in accordance with Articles 75 and 76 of this regulation); commodities risk (in accordance with Articles 77 to 80 of this regulation). (2) Banks may also use internal models to calculate capital requirements for position risk, exchange rate risk and/or commodities risk (in accordance with Articles 81 to 92 of this regulation), or use a combination of internal models and the methods defined in Articles 15 to 42, 75, 76 and 77 to 80 of this regulation, but only if authorised by the Bank of Slovenia or the competent authority of another Member State to use internal models to calculate capital requirements for position risk, exchange rate risk and/or commodities risk. (3) Instead of calculating the capital requirements for their trading book items in accordance with Articles 15 to 42 of this regulation, banks may calculate them in accordance with the Regulation on the Calculation of Capital Requirements for Credit Risk using the Standardised Approach for Banks and Savings Banks (Official Gazette of the Republic of Slovenia, No 135/06; hereinafter: Standardised Approach Regulation) or the Regulation on the Calculation of Capital Requirements for Credit Risk Using an Internal Ratings-Based Approach for Banks and Savings Banks (Official Gazette of the Republic of Slovenia, No 135/06; hereinafter: the IRB Approach Regulation), if at the same time the following conditions have been fulfilled: (a) the trading book business of such institutions does not normally exceed 5% of their total business; (b) their total trading book positions do not normally exceed EUR 15 million; and (c) the trading book business of such institutions never exceeds 6% of their total business and their total trading book positions never exceed EUR 20 million. (4) For the purpose of points (a) and (c) of the preceding paragraph, total business shall refer to onand off-balance-sheet business (from B.-1 to B.-4 on the balance sheet). When the size of on- and offbalance-sheet business is assessed, debt instruments shall be valued at their market prices or their nominal value or amortised cost, equities at their market prices, and derivatives according to the nominal or market values of the instruments underlying them. Long positions and short positions shall be summed regardless of their signs. (5) The spot rate shall be used to convert the value of trading business or the total position referred to in the third paragraph of this article into euros. (6) Irrespective of the third paragraph of this article, the Bank of Slovenia may issue a decision requiring banks that meet the conditions set out in that paragraph to calculate the capital requirements for trading book business in accordance with Articles 15 to 42, 43 to 74 and 93 of this regulation, if the trading book business is significant in terms of overall bank business. 5

6 Article 8 (calculating capital requirements when limits are exceeded) (1) If a bank should, for a lengthier period, exceed either or both of the limits imposed in points (a) and (b) of the third paragraph of Article 7 of this regulation, or if it exceeds either or both of the limits imposed by point (c) of the third paragraph of Article 7 of this regulation, it must calculate capital requirements in accordance with Articles 15 to 42, 43 to 74 and 93 of this regulation for trading book business, and not in accordance with the Standardised Approach Regulation or the IRB Approach Regulation. The bank must immediately notify the Bank of Slovenia of exceeding the stated limits. (2) A bank shall be deemed to have exceeded either or both of this limits imposed in points (a) and (b) of the third paragraph of Article 7 of this regulation, if it exceeds either or both of the stated limits three times per month, within the period for which it is required to report to the Bank of Slovenia on calculation of and compliance with capital requirements for market risk. 3. DEFINITION OF TRADING BOOK Article 9 (general) (1) The trading book of an institution shall consist of all positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book and which are either free of any restrictive covenants on their tradability or able to be hedged. (2) Positions held with trading intent are those held intentionally for short-term resale and/or with the intention of benefiting from actual or expected short-term price differences between buying and selling prices or from other price or interest rate variations. These positions include proprietary positions and positions arising from client servicing and market making. (3) Trading intent shall be evidenced on the basis of strategies, polices, and procedures set up by the bank in accordance with Article 10 of this regulation. The distinction between trading book and nontrading business is based on objective criteria that are used consistently and defined in advance in internal documents. (4) Banks must establish and maintain systems and controls for the management and valuation of their trading book in accordance with Articles 12 and 13. (5) In accordance with Article 14 of this regulation, banks may include internal hedges against risk for non-trading items in the trading book. Article 10 (evidence of trading intent) For the purposes of managing positions/portfolios intended for trading, banks must produce and take into consideration: (a) a clearly documented trading strategy for positions/portfolios, approved by senior management and including the expected holding horizon; the intent of acquiring a financial instrument or commodity, or concluding a contract in relation to a financial instrument or commodity must be known before the actual acquisition or conclusion of contract; evidence of trading intent is given on the basis of the bank s expectations or wishes in relation to trading and/or generating earnings from changes in prices, interest rates, or historical patterns of bank operations and methodologies used to evaluate risk; 6

7 (b) clearly defined policies and procedures for the active management of the position, which shall include the following: there must be a trading desk in which all trading positions are entered; the position limits are set and monitored for appropriateness; dealers have the autonomy to enter into/manage the position within agreed limits and according to the approved strategy; senior management are notified of positions as part of the risk management process; positions are actively monitored with reference to market information sources and an assessment made of the marketability or hedge-ability of the position or its component risks, including the assessment of, the quality and availability of market inputs to the valuation process, level of market turnover, sizes of positions traded in the market; and (c) clearly defined policy and procedures to monitor positions against the institution's trading strategy, including the monitoring of turnover and sale positions in the institution's trading book. Article 11 (trading policies and procedures) (1) Banks shall have clearly defined policies and procedures for determining which exposures to include in the trading book for the purposes of calculating their capital requirements, consistent with the criteria set out in Article 9 of this regulation, and taking into account the bank's risk management capabilities and practices. Compliance with these policies and procedures shall be fully documented and subject to periodic internal audit. (2) Banks must have clearly defined policies and procedures for overall management of the trading book. These policies and procedures shall address at least: (a) the activities the institution considers to be trading and as constituting part of the trading book for capital requirement purposes; (b) the extent to which an item can be marked-to-market daily by reference to an active, liquid two-way market; (c) for positions that are marked-to-model, the extent to which the bank can: identify all material risks relating to these positions; hedge all material risks of these items with instruments for which an active, liquid two-way market exists; derive reliable estimates for the key assumptions and parameters used in the internal model; (d) the extent to which the bank can and to which it is required to generate valuations for the exposures that may be subject to consistent external validation; (e) the extent to which legal restrictions or other operational requirements would impede the bank's ability to effect a liquidation or hedge of the position in the short term; (f) the extent to which the bank can and to which it is required to actively manage risk; (g) the extent to which the bank may transfer risk or positions between the non-trading and trading books and the criteria for such transfers. (3) Banks may only include positions that represent items set out in points (a), (b) and (c) of the second paragraph of Article 22 of the Regulation on the Calculation of the Capital of Banks and Savings Banks (Official Gazette of the Republic of Slovenia, No 135/06; hereinafter: the Capital Regulation) as equity or debt instruments, as appropriate, in their trading book, if they demonstrate they are an active market maker for these positions. In this case, the bank must have adequate systems and controls to monitor trading of eligible own funds instruments. For the purposes of this paragraph, a bank shall be deemed an active market maker, if it can demonstrate that it maintains stable security buying and selling prices, and that it is, at any time, prepared and capable of immediately purchasing and selling securities at publicly accessible listings. 7

8 Furthermore, the bank must have performed these transactions regularly and frequently with unrelated counterparties at market prices for at least one year. (4) Banks may include trading-related repo-style transactions accounted for in its non-trading books in the trading book for capital requirement purposes, but only if all such transactions are included. For this purpose, trading-related repo-style transactions are defined as transactions that meet the requirements in the second paragraph of Article 9 and Article 10 of this regulation, where both legs are in the form of either cash or securities that can be included in the trading book. Regardless of where they are booked, all repo-style transactions are subject to a non-trading book counterparty credit risk (CCR) capital requirement calculation. Article 12 (systems and controls for management and valuation of the trading book) (1) Banks must establish and maintain systems and controls sufficient to provide prudent and reliable valuation estimates for trading book positions. These rules require banks to ensure that the value applied to each of its trading book positions appropriately reflects the current market value. This value shall contain an appropriate degree of certainty with regard to the dynamic nature of trading book positions, the demands of prudential soundness and the mode of operation and purpose of capital requirements with regard to trading book positions. (2) The systems and controls referred to in the first paragraph of this article must include the following elements: (a) documented policies and procedures for the process of valuation of trading book positions; this includes clearly defined responsibilities of the various areas involved in the determination of the valuation, market information and the review of its appropriateness, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, and month-end and ad-hoc verification procedures; and (b) reporting lines for the department accountable for the valuation process that are clear and independent of the front office; the reporting line shall ultimately be to the management board. (3) Banks must revalue trading book positions according to current market prices (marking-to-market). If that is not possible, they must mark-to-model their positions. Positions must be revalued at least daily. (4) Marking-to-market means revaluing positions at least on a daily basis at readily available close out prices that are independently sourced, such as exchange prices, screen prices, or quotes from several independent reputable brokers. (5) When marking-to-market, the more prudent side of bid/offer shall be used, unless the bank is a significant market maker in the particular type of financial instrument or commodity in question and can close out at mid market (between the sale and purchase price). (6) Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input. (7) The following requirements must be complied with, if banks use marking-to-model to value trading book positions: (a) senior management must be aware of the trading book positions that are subject to marking-tomodel and must understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business; (b) market inputs must, where possible, be in line with market prices, and the appropriateness of the market inputs for a particular position being valued and the parameters of the model must be assessed on a frequent basis; 8

9 (c) where available, valuation methodologies which are accepted market practice for particular financial instruments or commodities shall be used; (d) where the model is developed by the bank itself, it must be based on appropriate assumptions, which have been assessed and tested by suitably qualified parties that did not participate in the development process; the model must be developed and approved independently of the front office and must be independently tested, including validation of the mathematical calculations, assumptions and software; (e) there shall be formal change control procedures in place and a secure copy of the model shall be held and periodically used to check valuations; (f) those responsible for risk management must be aware of the weaknesses of the model used and how best to reflect them in the valuation output; (g) the model shall be subject to periodic review to determine the accuracy of its performance (e.g. assessing the continued appropriateness of assumptions, analysis of profit and loss versus risk factors, comparison of actual close out values to model outputs). (8) Independent price verification should be performed in addition to daily marking-to-market or marking-to-model. This is the process by which market prices or model inputs are regularly verified for accuracy and independence. While daily marking-to-market may be performed by dealers, verification of market prices and model inputs should be performed by a unit independent of the dealing room/front office, at least monthly (or, depending on the nature of the market/trading activity, more frequently). Where independent pricing sources are not available or pricing sources are more subjective, prudent measures such as valuation adjustments may be appropriate. Article 13 (valuation adjustments to trading book positions) (1) Notwithstanding the fact that banks must value trading book positions in accordance with international accounting reporting standards, they must also have appropriate procedures for valuation adjustments to trading book positions. These adjustments are only considered for the purposes of calculating bank capital in accordance with the sixth paragraph of this article. Banks must review valuation adjustments on an ongoing basis. (2) Banks must produce valuation adjustments to trading book positions due to: unearned credit spreads, close-out costs, operational risks, early termination, investing and funding costs, future administrative costs and model risk. (3) If possible, banks must also produce a valuation adjustment for less liquid trading book positions. Less liquid positions could arise from both market events and situations in the banks (e.g. concentrated positions and/or stale positions). (4) Banks must consider the following factors when determining whether to make a valuation adjustment: the amount of time it would take to hedge out the position/risks within the position, the volatility and average of bid/offer spreads, the availability of market quotes (number and identity of market makers), and the volatility and average of trading volumes, market concentrations, the aging of positions, the extent to which valuation relies on marking-to-model, and the impact of other model risks. (5) If banks use third party valuations or marking-to-model for valuations of trading book positions, they shall consider whether to apply a valuation adjustment for this reason. (6) If the valuation adjustment from the first paragraph of this Article is material, in accordance with point (c) of Article 12 of the Capital Regulation, the bank must deduct them from the bank s original own funds. If the valuation adjustment from the first paragraph of this Article is not material, in accordance with Article 25 of the Capital Regulation, the bank must deduct them from the additional own funds eligible to cover market risk. 9

10 For the purpose of this paragraph of this article, an adjustment shall be considered material, if the bank makes an adjustment in position value that exceeds 2% of the value of the portfolio to which the position in question refers. Article 14 (internal hedging against risk arising from non-trading items) (1) An internal hedge is a position that materially or completely offsets the component risk element of a non-trading book position or a set of positions. Positions arising from internal hedges are eligible for trading book capital treatment, provided that they are held with trading intent and that the general criteria on trading intent and prudent valuation specified in Articles 10 to 13 of this regulation are met. Banks must respect the following requirements, in particular: (a) internal hedges shall not be primarily intended to avoid or reduce capital requirements; (b) internal hedges shall be properly documented and subject to specific internal approval and audit procedures; (c) internal hedge transactions must be dealt with according to market conditions; (d) the bulk of the market risk that is generated by the internal hedge shall be dynamically managed in the trading book within the authorised limits; and (e) internal hedging transactions must be carefully monitored, and that monitoring guaranteed by appropriate procedures. (2) The treatment referred to in the first paragraph of this Article applies to the capital requirements applicable to the non-trading book leg of the internal hedge. (3) Notwithstanding the second paragraph of this Article, when a bank hedges a non-trading book credit risk exposure using a credit derivative in its trading book, the non-trading book exposure is not deemed to be hedged for the purposes of calculating capital requirements, unless the bank purchases a credit derivative meeting the requirements set out in Article 40 of the Credit Protection Regulation from an eligible third party protection provider for non-trading exposure. When a bank purchases such third party protection, which is recognised as a hedge for a non-trading book exposure for the purposes of calculating capital requirements, neither the internal nor external credit derivative hedge shall be included in the trading book for the purposes of calculating capital requirements. 4. CALCULATING CAPITAL REQUIREMENTS FOR POSITION RISK 4.1. General Provisions Article 15 (netting) (1) The excess of an institution's long (short) positions over its short (long) positions in the same equity, debt and convertible issues and identical financial futures (options, warrants and covered warrants) shall be its net position in each of those different instruments. In calculating the net position, positions in derivative instruments may be treated as positions in the underlying (or notional) security or securities, in accordance with Articles 17 to 20 of this regulation. Banks holdings of their own debt instruments shall be disregarded in calculating specific risk. (2) No netting shall be possible between the position of a convertible security and the position of the financial instrument underlying it. (3) All net positions in financial instruments in foreign currency must be converted, irrespective of their signs, into the reporting currency according to the valid spot exchange rate, before their aggregation. 10

11 Article 16 (general rules for breaking down the positions of particular instruments) The positions of the particular instruments set out in Articles 17 to 20 of this regulation are broken down into hypothetical positions in the following manner: (a) if the underlying instrument is a debt instrument: into a debt instrument, where the particular instrument depends on the price (interest rate) of the specifically defined underlying debt instrument it refers to; and/or into a hypothetical debt instrument that covers the interest rate risk arising from future payments and received cash flows (including hypothetical payments and receipts); as they generated to reflect a general position risk (and not a specific position risk), they are called hypothetical risk-free debt instruments; into debt instruments and hypothetical debt instruments together; (b) if the underlying instrument is an equity: into hypothetical positions in individual equities, baskets of equities, or equity indices; (c) if the underlying instrument is a commodity: into hypothetical positions in the commodities to which they refer. Article 17 (interest rate futures, forward rate agreements, and forward commitments to buy or sell debt instruments) (1) Interest rate futures, forward rate agreements (FRAs) and forward commitments to buy or sell debt instruments shall be treated as combinations of hypothetical long and short positions in underlying financial instruments, as defined in the second to fifth paragraphs of this article. (2) For the purposes of this article, long position means a position in which a bank has set the interest rate it will receive at some time in the future, and short position means a position in which it has set the interest rate it will pay at some time in the future. (3) A long interest rate futures position shall be treated as a combination of a short position in a riskfree zero coupon debt security maturing on the delivery date of the futures contract and a long position in a risk-free zero-coupon debt security maturing on the delivery date of the futures contract, plus the agreed contract period. (4) A sold FRA shall be treated as a long position in a risk-free zero coupon debt security maturing on the settlement date, plus the agreed or contracted period, and a short position in a risk-free zero coupon debt security maturing on the settlement date. (5) A forward commitment to buy a debt instrument shall be treated as a combination of a short position in a risk-free zero coupon debt security maturing on the delivery date and a long (spot) position in the bond to which the forward contract refers, with maturity the same as the bond s remaining maturity. (6) Calculations of the capital requirements for a specific risk, positions in risk-free zero coupon debt securities shall be included in the first category (weighting 0%) in Table 1 of Article 28 of this regulation, and the position in the bond shall be included in the appropriate category in the same table. (7) Banks may use, as the capital requirement for the contracts set out in the first paragraph of this article, if they are traded on recognised exchanges listed in Annex II of this regulation, a sum that is equal to the margin required for such contracts by the exchange in question. (8) Banks may use, as the capital requirement for the contracts set out in the first paragraph of this article, which are traded OTC, that are cleared by a recognised clearing house listed in Annex II of this 11

12 regulation, a sum that is equal to the margin required for such contracts by the clearing house in question. Article 18 (options) (1) Options on interest rates, debt instruments, equities, equity indices, financial futures, swaps and foreign currencies shall be treated as if they were positions equal in value to the amount of the underlying instrument to which the option refers, multiplied by its delta for the purposes of this chapter. The latter positions may be netted off against any offsetting positions in the identical instruments underlying the options. In calculating capital requirements in respect of position risk, the positions in options shall be treated as a combination of hypothetical long and short positions; i.e. they are broken down into the positions in the underlying instruments to which the options refer. The capital requirement for a written OTC option must be calculated in relation to the underlying instrument to which the options refer. (2) The delta used shall be that of a recognised exchange listed in Annex II of this regulation where the options are traded. For options for which there is no available delta from a recognised exchange, or for OTC options, banks may calculate the delta themselves, if they demonstrate that their delta calculation model is appropriate. The Bank of Slovenia may prescribe a delta calculation methodology. (3) The delta-weighted positions for underlying instruments shall be taken into account for the calculation of capital requirements in respect of position risks as follows: (a) a purchased call option as a long position (b) a written call option as a short position (c) a purchased put option as a short position, and (d) a written put option as a long position. (4) It is essential that banks safeguard against other risks associated with options, apart from delta. Banks therefore must calculate the additional capital requirement for other risks associated with options, e.g. risks of changes to the delta (gamma risk), or volatility of the underlying instrument (vega risk). Gamma and vega used shall be that of a recognised exchange listed in Annex II of this regulation where the options are traded. For options for which there is no available gamma and vega from a recognised exchange, or for OTC options, banks may calculate the gamma and vega themselves, if they demonstrate that their models for calculation are appropriate. The Bank of Slovenia may prescribe a calculation methodology for gamma and vega. (5) Banks may use, as the capital requirement for the options set out in the first paragraph of this article, if they are traded on recognised exchanges listed in Annex II of this regulation, a sum that is equal to the margin required for such options by the exchange in question. (6) Banks may use, as the capital requirement for the contracts set out in the first paragraph of this article, which are traded OTC and are cleared by a recognised clearing house listed in Annex II of this regulation, a sum that is equal to the margin required for such contracts by the clearing in question. (7) Banks may use, as the capital requirement for the purchase options set out in the first paragraph of this article, if they are traded on recognised exchanges or as OTC options, a sum that is equal to the requirement required for the financial instruments to which the options refer. The capital requirement defined in the manner shall not exceed the market value of the options referred to in the first paragraph of this article. Article 19 (warrants) Warrants relating to debt instruments and equities shall be treated in the same way as options. 12

13 Article 20 (swaps) Banks must treat swaps (e.g. cross-currency swaps, interest rate swaps, equity swaps) for interest rate risk on the same basis as on-balance sheet instruments. Thus, an interest rate swap for which banks receive a floating rate interest and pay fixed rate interest shall be treated as equivalent to a combination of a long position in a floating rate instrument of maturity equivalent to the period until the next time the interest rate is set and a short position in a fixed rate instrument with the same maturity as the swap itself. Article 21 (treatment of the protection seller) Unless otherwise stated, the nominal value of a credit derivative shall be used for the calculation of the capital requirement against the position risk of the party assuming the credit risk ("protection seller"). When calculating the capital requirement for the specific risk of the party, except for total return swaps, the maturity of the credit derivative contract is used instead of the maturity of the obligation. The positions are therefore set as follows: (a) a total return swap creates a long position in the general market risk of the reference obligation and a short position in the general market risk of a government bond, which is assigned a 0% risk weight using the standard approach for calculating the capital requirement for credit risk and has a maturity equivalent to the period until the next interest rate fixing; It also creates a long position in the specific risk of the reference obligation; (b) a credit default swap does not create a position for the general market risk; for the purposes of specific risk, banks must record a synthetic long position in an obligation of the reference entity, unless the derivative has an external rating and meets the conditions for a qualifying debt item (debt from a qualified issuer); in that case a long position in the derivative is recorded. If premium or interest payments are due under the credit default swap, these cash flows must be represented as notional positions in government bonds; (c) a single name credit linked note (CLN) creates a long position in the general market risk of the note itself, as an interest rate product. For the purpose of specific risk, a synthetic long position is created in an obligation of the reference entity; an additional long position is created in the obligation of the note issuer; where the credit linked note has an external rating and meets the conditions for a qualifying debt item, a single long position with the specific risk of the note need only be recorded; (d) in addition to a long position in the specific risk of the issuer of the note, a multiple name credit linked note providing proportional protection creates a position in the obligations of each reference entity, with the total nominal amount of the credit linked note assigned across the positions according to the proportion of the total nominal amount that each exposure to a reference entity represents. Where more than one obligation of a reference entity can be selected, the obligation with the highest risk weight determines the specific risk. Where a multiple name credit linked note has an external rating and meets the conditions for a qualifying debt item, only a single long position for the specific risk of the note need to be taken into account; (e) a first-asset-to-default credit derivative creates a position for the nominal amount in an obligation of each reference entity; if the size of the maximum credit event payment is lower than the capital requirement calculated using the method in the preceding sentence, the maximum credit event payment amount may be taken as the specific risk capital requirement (capital charge); a second-asset-to-default credit derivative creates a position for the nominal amount in an obligation of each reference entity less one (the one with the lowest specific risk capital charge); if the size of the maximum credit event payment is lower than the capital requirement calculated using the method in the preceding sentence, the maximum credit event payment amount may be taken as the specific risk capital charge; 13

14 if a first- or second-asset-to-default derivative has as external rating and meets the conditions for a qualifying debt item, then the protection seller only has to calculate one capital requirement for the specific risk reflecting the rating of the credit derivative. Article 22 (treatment of the protection buyer) (1) For the party transferring credit risk (the "protection buyer"), the positions are determined as the mirror image of the protection seller s positions, with the exception of a credit-linked note (which does not create any short position in the issuer). If at a given moment there is a call option in combination with a step-up, this moment is treated as the maturity of the protection. In the case of nth to default credit derivatives, protection buyers are allowed to offset specific risk for n-1 of the underlying obligations (i.e., the n-1 assets with the lowest capital requirement for specific risk). (2) Banks that mark-to-market and manage the interest rate risk on the derivative instruments referred to in Articles 17 to 20 of this regulation on the basis of a discounted cash flow, may use sensitivity models to calculate the positions in the derivative instruments. These models may also be used to calculate positions in bonds that are amortised over their residual life, rather than via one final repayment of principal. The positions determined in this manner shall be included in the calculation of the capital requirement for general market risk of the debt instruments. (3) Banks may only use the sensitivity models referred to in the second paragraph of this regulation, if authorised by the Bank of Slovenia. The Bank of Slovenia shall issue this permission if the following two conditions are met: (a) the models generate positions that have the same sensitivity to interest rate changes as the underlying instruments; (b) this sensitivity must be assessed with reference to independent movements in sample rates across the yield curve, with at least one sensitivity point in each of the maturity bands set out in Table 2 of the fourth paragraph of Article 32. (4) Banks shall prove that they meet the conditions specified in the third paragraph of this article by submitting the following documentation as part of the request for the permission: (a) documentation on the type of financial instruments for which they intend to use the sensitivity model, and on the basic information on the models; (b) documentation proving that the models generate positions that have the same sensitivity to interest rate changes as the underlying instruments; (c) documentation that demonstrates that the sensitivity is assessed with reference to independent movements in sample rates across the yield curve, with at least one sensitivity point in each of the maturity bands set out in Table 2 of the fourth paragraph of Article 32. (5) Banks must meet the conditions referred to in the third paragraph of this article on an ongoing basis from the moment the Bank of Slovenia issues its permissions onwards. (6) More detailed instructions on the form for requesting a Bank of Slovenia permission to use sensitivity models to calculate positions in derivatives or the form for requesting an amendment to this permission are set out in Annex III of this regulation. (7) The Bank of Slovenia shall withdraw the permission for use of sensitivity models, if: (a) a bank acts in contradiction with the Bank of Slovenia order, or a Bank of Slovenia order with additional measures for the correction of a violation in fulfilment of the conditions from the third paragraph of this article; (b) a bank seriously violates the fulfilment of the conditions from the third paragraph of this article. 14