Prudential Guidelines on Capital Adequacy - Implementation of Internal Models Approach for Market Risk

Prudential Guidelines on Capital Adequacy - Implementation of Internal Models Approach for Market Risk

RBI/2009-10/384
DBOD.No.BP.BC.86 /21.06.001 (A)/2009-10

April 7, 2010

The Chairmen and Managing Directors/
Chief Executive Officers of
All Commercial Banks
(Excluding  Regional Rural Banks and Local Area Banks)

Dear Sir,

Prudential Guidelines on Capital Adequacy -
Implementation of  Internal Models Approach for Market Risk

Please refer to our circular DBOD BP. BC. 23/21.06.001/2009-10 dated July 7, 2009, inter alia advising banks desirous of moving to advanced approaches under Basel II that they can apply for migrating to Internal Models Approach for market risk from April 1, 2010 onwards, provided they are adequately prepared.

2. Basel II Framework offers a choice between two broad methodologies in measuring market risks for the purpose of capital adequacy. One methodology is to measure market risks in a standardised manner as per the Standardised Measurement Method (SMM) which is being used by banks in India since March 31, 2005. The alternative methodology known as Internal Models Approach (IMA) is also available which allows banks to use risk measures derived from their own internal market risk management models. The permissible models under IMA are the ones which calculate a value-at-risk (VaR) - based measure of exposure to market risk. VaR-based models could be used to calculate measures of both general market risk and specific risk. As compared to the SMM, IMA is considered to be more risk sensitive and aligns the capital charge for market risk more closely to the actual losses likely to be faced by banks due to movements in the market risk factors.

3. The guidelines governing use of internal models for measuring the capital charge for market risk are annexed. To begin with banks in India may model general market risk and continue to use SMM for specific risk. However, banks should endeavour to develop capabilities to model specific risk including Incremental Risk.

4.  Banks interested in migrating to IMA for computing capital charge for market risk are advised to assess their preparedness with reference to these guidelines. As and when they are ready for introduction of IMA, they may first give Reserve Bank of India (RBI) (Chief General Manager-in-Charge, Reserve Bank of India, Department of Banking Operations & Development, Central Office, 12th Floor, Shahid Bhagat Singh Road, Mumbai - 400001), a notice of intention for the same. RBI will first make a preliminary assessment of the bank’s risk management system and its modelling process. If the result of this preliminary assessment is satisfactory, then RBI will allow the bank to make a formal application for migrating to IMA in a prescribed format, which would be made available to banks in due course. RBI will then perform a detailed analysis of its model with a view to approving the same.

5. It may be reiterated that banks would have the discretion to adopt IMA for market risk, while continuing with simpler approaches for computation of capital charge for credit and operational risks.

Yours faithfully,

(B. Mahapatra) 
Chief General Manager

Encls: as above