Market risk positions
With respect to the capital charge for market price risk, a distinction is made between the individual market price risk categories (foreign currency, commodity price, interest rate and equity price risk, and other types of market risk). Institutions with a small volume of trades (non-trading book institutions) have a de minimis exemption from applying the complex calculation procedure for trading book positions with interest rate and equity price risks (pursuant to section 2 (11) of the Banking Act).
The procedures for quantifying market price risks are regulated by Part 4 of the Solvency Regulation. Non-trading book and trading book institutions alike are required to back market price risks from foreign currency and commodities with own funds. Moreover, trading book institutions are required to back the market price risks of their interest rate and equity risk positions. For this purpose, the risks from equity and interest rate instruments are broken down into a general risk component and a specific risk component. The capital charge for the general price risk is intended to cover potential losses caused by general market fluctuations, while the capital charge for specific price risk is intended to cover issuer-specific risks.
Institutions can either use standardised approaches prescribed by supervisors to calculate the capital charges for their market risk positions or – following a suitability examination and supervisory approval – apply internal market risk models.
Internal risk models
Internal risk management models are time-related stochastic representations of changes in market prices and their impact on the market value of individual financial instruments. They comprise mathematical-statistical structures and distributions that are used for calculating key ratios which are determined by means of appropriate computer-assisted procedures, notably time series analyses. Here, the value at risk of market risks is quantified.
Since the internal risk management models are integrated into institutions' general risk management frameworks, the institutions are freed from duplication of work regarding the calculation of the prudential capital charges.
Section 313 (3) sentence 1 of the Solvency Regulation stipulates that an internal risk management model is deemed to be suitable only if it demonstrates a satisfactory predictive quality. Pursuant to section 318 (1) of the Solvency Regulation, the forecast quality has to be determined by daily backtesting (ie by the backward comparison of the risk forecast with the hypothetical portfolio value changes). BaFin and the Deutsche Bundesbank are to be promptly notified of any backtesting exception pursuant to section 318 (1) of the Solvency Regulation. The Notice below defines how backtesting exceptions are to be reported and analysed.
Material changes to and extensions of the risk model are subject to renewed approval by supervisors. Significant and insignificant changes do not need to be subjected to another suitability examination; however, supervisors must be notified of them in writing. Significant changes to the risk model must be agreed on with BaFin before the changed risk model is applied. The purpose of the Notice of 19 February 2010, below, is to interpret the provisions concerning model changes from the supervisors' viewpoint and to specify the supervisory requirements in dealing with model changes.