RECOGNISING A FIRM’S INTERNAL MARKET RISK MODELFOR THE PURPOSES OF CALCULATING REQUIREDREGULATORY CAPITAL: GUIDANCE TO SUPERVISORSReport by the Technical Committeeof theInternational Organization of Securities CommissionsMay 1999 SUMMARYThe purpose of this paper is to provide guidance to those supervisors which have decided inprinciple that VaR models for market risk have a part to play in their regulatory framework.It seeks to give supervisors practical guidance on how to assess their own expertise in thisfield and what the implications for the supervisory process are, as well as information that asupervisor should seek from a firm wishing to use VaR. It should be read in conjunction withthe IOSCO Technical Committee’s May 1998 report ‘Methodologies for determining capitalstandards for internationally active securities firms which permit the use of models underprescribed conditions’. The principles regarding the use of VaR models for the assessment ofmarket risk, which were established in that paper, remain applicable.The report: ‘Methodologies for determining capital standards for internationally activesecurities firms which permit the use of models under prescribed conditions’ concluded that“VaR models can have a role in setting regulatory capital for market risks”, but that “VaRmodels are more readily applicable in environments which have certain characteristics.”Supervisors should not regard VaR models as being appropriate for all firms, or for allmarkets: supervisors which decide in principle that they wish to permit the use of models willtherefore need to form a judgement on the merits of a particular firm’s model and the firm’suse of it, on a case by case basis.The May 1998 report discussed in some detail how VaR models could be fitted into aregulatory capital framework - it pointed out that VaR methodologies have limitations andthat “the market risk capital charge should be increased over and above the VaR output toaddress these limitations.” For other non-modelled risks such as operational and legal risks,“additional capital or ‘buffers’ should be introduced over and above the market risk capitalcharge.” The report concluded that “a combination of the new market risk capital charge,the existing charge for credit risk and additional buffers can provide sufficient capital.However, there is no implication in this report that the adoption of VaR models will lead to afall in the current level of regulatory capital, but will instead enable firms to manage risksmore efficiently”.Supervisors need to ensure that they have the resources and expertise to make appropriatesupervisory judgements about the quantitative and qualitative aspects of a VaR approach.The adoption of VaR models involves a shift to greater reliance on a firm’s internal controlsand therefore requires an enhancement of the supervisor’s ability to assess their effectiveness.IOSCO’s 1998 report: ‘Risk Management and Control Guidance for Securities Firms andtheir Supervisors’ established twelve benchmarks by which supervisors and securities firmscan assess the adequacy of control systems. This paper gives some guidance on how thesemight be examined in a models environment. CONTENTSSECTION I: Page IOSCO Framework for Supervisors assessing Market Risk 1Models to be Used for Regulatory Capital PurposesSECTION IIConsiderations for Supervisors 9SECTION III Specific Issues:Partial Models and Amending the Model to Capture New 13ProductsCherry picking 14Multiple Entity and Cross Border Issues 14APPENDICES1Further Guidance on Back-testing 182Further Guidance on Stress Testing 193 Guidance on Information to be Sought from Firms 21and the Model Recognition Process 1SECTION IIOSCO Framework for Supervisors Assessing Market Risk Models to be Used forRegulatory Capital PurposesIntroductionThe IOSCO Technical Committee’s May 1998 report: ’Methodologies for determiningcapital standards for internationally active securities firms which permit the use of modelsunder prescribed conditions’ developed a framework to approach the use of models forregulatory capital purposes: the recognition of models requires involvement in the followingareas:-Eight Point Framework for the Assessment of Firms Using Market Risk ModelsVerifying that VaR models are fully integrated into the day to day risk managementprocesses of the firm with an appropriate level of independent verificationThe IOSCO Technical Committee’s May 1998 report on the use of VaR techniques todetermine market risk charges agreed that a firm’s capital charges should be based on theri