Agreement No. 1 (2020) Modifying the Technical Annex of Agreement No. 003-2018 Establishing Capital Requirements for Financial Instruments in the Trading Book

Republic of Panama
Banking Superintendence
AGREEMENT No. 001-2020
(of January 28, 2020)
"By which the Technical Annex of Agreement No. 003-2018 establishing capital requirements for financial instruments registered in the trading book is modified"

THE BOARD OF DIRECTORS in exercise of its legal powers, and CONSIDERING:

That following the issuance of Law Decree No. 2 of February 22, 2008, the Executive Branch prepared a systematic ordering in the form of a single text of Law Decree No. 9 of February 26, 1998 and all its modifications, which was approved through Executive Decree No. 52 of April 30, 2008, hereinafter the Banking Law;

That in accordance with paragraphs 1 and 2 of Article 5 of the Banking Law, the objectives of the Banking Superintendence are to ensure the maintenance of the solidity and efficiency of the banking system; as well as to strengthen and foster favorable conditions for the development of the Republic of Panama as an international financial center;

That in accordance with paragraphs 3 and 5 of Article 11 of the Banking Law, it is the technical competence of the Board of Directors to approve the general criteria for classifying risk assets and the guidelines for establishing reserves for risk coverage, and to fix within the administrative scope the interpretation and scope of legal or regulatory provisions in banking matters;

That in accordance with paragraph 10 of Article 11 of the Banking Law, it is the competence of the Board of Directors to issue technical norms necessary for the compliance of the Law;

That in accordance with what is established in Article 72 of the Banking Law, the Superintendence may take into consideration and value other risks for the determination of the capital adequacy index, among which are market risk, operational risk, and country risk, which serve as a measure to value the capital fund requirement to achieve adequate risk management;

That through Agreement No. 003-2018 of January 30, 2018, capital requirements are established for financial instruments registered in the trading book;

That through Agreement No. 006-2019 of May 28, 2019, Agreement No. 003-2018 was modified in order to include and expand aspects related to the scope of application, definitions, entry into force, and to specify certain calculations of the Technical Annex;

That in working sessions of this Board of Directors, the need and convenience of modifying the Technical Annex of Agreement No. 003-2018 has been highlighted, in order to incorporate a new financial instrument and the calculation of its capital requirement.

AGREES:
ARTICLE 1. The Technical Annex of Agreement No. 003-2018 shall read as follows:

TECHNICAL ANNEX
The following instruments are considered within this regulation:

• Bonds
• Securitization Bonds
• Shares
• Forwards
• Swaps
• Options
• Credit Default Swaps

For any other instrument different from the aforementioned, the entity must consult the Banking Superintendence regarding the methodology for calculating the capital requirement.

I. Capital requirement for bond interest rate risk
I.1. Risk-free interest rate

1. For each currency, the entity must have the risk-free zero-coupon interest rate curve, and said curve must be the same one the entity uses for valuing financial instruments.
2. For each issuer, the entity must have the credit spread curve consistent with the valuation of each financial instrument.
3. The market price of the bond or, where applicable, the fair value must be available.
4. The instrument is decomposed into zero-coupon bonds and independent cash flows as long as they are present during the residual term of the bond until maturity. The sum of the present values of the zero-coupon bonds into which the instrument has been decomposed must match the market price or, where applicable, the fair value of the bond.
5. Subsequently, for the calculation of capital requirements for interest rate risk, only fixed cash flows present in the financial instrument will be considered. This implies that for floating rate instruments, only the portion of the flow corresponding to the fixed spread defined over the reference rate will be considered.
6. Each cash flow of each zero-coupon bond will be assigned to one of the vertices detailed below. The vertices are: 0.25, 0.5, 1, 2, 3, 4, 5, 10, 15, 20, and 30 years.
7. In the event that the term of the zero-coupon bond does not match the vertex, the cash flow will be distributed inversely proportional to the distance between the date where the cash flow is located and the date of each vertex.
   Let F_t be the cash flow located at residual term t, and T_i and T_{i+1} be the preceding and succeeding vertices to t.
   The amount F_t is distributed into amounts F_i and F_{i+1} according to:
   F_i = F_t × (T_{i+1} - t) / (T_{i+1} - T_i)
   F_{i+1} = F_t × (t - T_i) / (T_{i+1} - T_i)
8. The delta sensitivity to the risk-free interest rate of the present value VA_i at vertex T_i is defined by the following expression:
   SLR_{k,i} = [VA_{k,i}(z_i + 0.0001, d_i) - VA_{k,i}(z_i, d_i)] / 0.0001 SLR_{k,i} is the delta sensitivity of instrument k at vertex i when the zero-coupon interest rate z_i corresponding to said vertex is perturbed by one basis point (0.0001=0.01%), keeping the credit spread constant. VA_{k,i}(z_i, d_i) is the present value of the cash flow of instrument k at vertex T_i as a function of the risk-free interest rate z_i and the credit spread d_i, which, as a particular case, may be null.
9. All sensitivities of the financial instruments, totaling M, in the trading book, which can be positive or negative, are aggregated at vertex T_i, resulting in the net risk-free sensitivity at vertex T_i:
   SLRN_i = Σ_{k=1}^{M} SLR_{k,i}
10. The capital requirement for the aforementioned aggregated magnitude is determined according to vertex T_i, by multiplying the magnitude SLRN_i by the weighting defined in Table 1 below:

Table 1. Weightings according to vertex
Vertex: 0.25 | 0.50 | 1 | 2 | 3 | 4
Weighting: 2.40% | 2.40% | 2.25% | 1.88% | 1.73% | 1.62% Vertex: 5 | 10 | 15 | 20 | 30 Weighting: 1.50% | 1.50% | 1.50% | 1.50% | 1.50%

The capital requirement for the net exposure at vertex T_i is KLR_i = SLRN_i × p_i Where p_i is given in Table 1 above.
11. Correlations. The existence of correlations between the magnitudes KLR_i and KLR_j assigned to vertices T_i and T_j is assumed. The correlation coefficient is defined by:
ρ_{ij} = Max[exp(-θ × |T_i - T_j| / Min(T_i, T_j)); 0.4] where θ = 3% is a parameter that the Superintendence may change according to market conditions.
12. The capital requirement for risk-free interest rates for financial instruments denominated in currency b is obtained through the following expression:
K_b = Σ_{i=1}^{V} Σ_{j<i} (KLR_i^2 + 2ρ_{ij} × KLR_i × KLR_j) where V is the number of vertices.
13. In the event that bonds are denominated in multiple currencies, the same calculation process is performed using the risk-free zero-coupon interest rate curve of the currency. All obtained magnitudes are expressed in USD, using the spot exchange rate of each currency.
14. Let K_a, K_b, K_c, ..., K_n be the regulatory capital amounts obtained for each currency, expressed all in the functional currency, that is, in Balboas. The capital requirement is defined by the expression:
K = Σ_{b=1}^{n} Σ_{c<b} (K_b^2 + 2γ_{bc} × S_b × S_c) With S_b = Σ KLR for currency b and S_c = Σ KLR for currency c.
In the particular case that the expression Σ_{b=1}^{n} (K_b^2 + Σ_{b≠c} γ_{bc} × S_b × S_c) were a negative number, the expression:
K = Σ_{b=1}^{n} Σ_{c<b} (K_b^2 + 2γ_{bc} × R_b × R_c) Where R_b = Max(Min(S_b, K_b), K_b) and R_c = Max(Min(S_c, K_c), K_c) will be used. In all cases γ_{bc} = 0.5.
15. Correlation scenarios. For the calculation of capital requirements, three values must be calculated depending on three correlation scenarios. The scenarios are defined as follows:
Scenario 1. The correlation coefficients ρ_{ij} and γ_{bc} are multiplied by 1.25 with a limit of 100%.
Scenario 2. The correlation coefficients ρ_{ij} and γ_{bc} are kept at their original values.
Scenario 3. The correlation coefficients ρ_{ij} and γ_{bc} are multiplied by 0.75.
16. Capital requirement for risk-free interest rate risk. It is determined by the highest amount obtained using each of the scenarios.

I.2. Yield spread for credit risk
17. Three modalities are distinguished:
a) Non-securitizations b) Trading book securitizations with correlation c) Other securitizations

a) Non-securitizations
18. The vertices are 0.25, 0.5, 1, 2, 3, 4, 5, 10, 15, 20, and 30 years.
19. The delta sensitivity to the increase in the yield spread of each present value VA_i assigned to vertex T_i is calculated through the expression:
SDR_{k,i} = [VA_{k,i}(z_i, d_i + 0.0001) - VA_{k,i}(z_i, d_i)] / 0.0001 SDR_{k,i} is the sensitivity of instrument k at vertex i when the yield spread d_i corresponding to said vertex is perturbed by one basis point (0.0001=0.01%), keeping the risk-free zero-coupon interest rate constant. VA_{k,i}(z_i, d_i) is the present value of the cash flow of instrument k at vertex T_i, as a function of the risk-free interest rate z_i and the credit spread d_i.
20. The risk factors considered for calculating capital requirements are: i) issuer, ii) rating, iii) sector, and iv) vertex.
21. The delta sensitivities calculated in 19 must be assigned to a category, from 1 to 16, as defined in Table 2 below:

Table 2. Yield spread categories
Investment Grade (IG)
No. Sector
1 Sovereign issuers, central banks, and multilateral development banks 2 Public administration, local governments, non-financial public sector enterprises 3 Financial, including public sector financial entities 4 Basic materials, energy, industrial goods, agriculture, manufacturing, mining, and extraction 5 Consumer goods and services, transport and storage, support activities for the services sector 6 Technology, Communications 7 Health, public utilities, professional and technical activities 8 Covered bonds High Yield (HY) and No Rating (NR) No. Sector 9 Sovereign issuers, central banks, and multilateral development banks 10 Public administration, local governments, non-financial public sector enterprises 11 Financial, including public sector financial entities 12 Basic materials, energy, industrial goods, agriculture, manufacturing, mining, and extraction 13 Consumer goods and services, transport and storage, support activities for the services sector 14 Technology, Communications 15 Health, public utilities, professional and technical activities 16 Other sectors

22. The risk-weighted sensitivity, KDR_{ij} = SDR_i × p_j, is defined by the product of each delta sensitivity i that belongs to a certain category j, by the weighting p_j established in Table 3 for category j, j = 1,2,...,16.
23. The risk weightings for categories 1 to 16 are:

Table 3. Yield spread weightings
Category No. | Weighting
1 | 0.5%
2 | 1.0%
3 | 5.0%
4 | 3.0%
5 | 3.0%
6 | 2.0%
7 | 1.5%
8 | 4.0%
9 | 3.0%
10 | 4.0%
11 | 12.0%
12 | 7.0%
13 | 8.5%
14 | 5.5%
15 | 5.0%
16 | 12.0%

24. Correlations. The correlation coefficient between two risk-weighted sensitivities, k and l, considering the issuer and vertex factors, of the same category j, is defined as follows:
    ρ_{kl} = ρ_{issuer} × ρ_{vertex} where ρ_{issuer} = 1 if issuers k and l coincide, 0.35 otherwise.
    ρ_{vertex} = 1 if vertices k and l coincide, 0.65 otherwise.
25. There is an exception to the above criterion for the "Other sector" category. The capital requirement within the "Other sector" category is the simple sum of the absolute values of the net risk-weighted delta sensitivities assigned to this category:
    K_{b(other sector)} = Σ_i |KDR_i|
    The resulting capital requirement from the "other sectors" category will be added to the general capital level for all risk classes.
26. The capital requirement K_h within each category h is established through the expression:
    K_h = Σ_{i=1}^{n_h} Σ_{j<i} (KDR_{ih}^2 + 2ρ_{ij} × KDR_{ih} × KDR_{jh}) Given category h, which contains n_h risk-weighted sensitivities, Σ_{i=1}^{n_h} KDR_{ih}^2 is the sum of the squares of the risk-weighted delta sensitivities assigned to category h. Σ_{i<j} ρ_{ij} × KDR_{ih} × KDR_{jh} is the sum of the products of the correlation coefficient by the risk-weighted sensitivities different from category h.
27. The correlation coefficient between the capital requirements of two different categories is defined, using the rating and sector factors. The correlation coefficient γ_{bc} is established as follows:
    γ_{bc} = γ_{rating} × γ_{sector} where γ_{rating} = 1 if categories b and c have the same rating (IG or HY/NR), 0.50 otherwise.
    γ_{sector} = 1 if categories b and c are from the same sector, determined in Table 4 otherwise.

Table 4. Correlations between sectors
1/9 | 2/10 | 3/11 | 4/12 | 5/13 | 6/14 | 7/15 | 8 1/9 | 0.75 | 0.10 | 0.20 | 0.25 | 0.20 | 0.15 | 0.10 2/10 | 0.05 | 0.15 | 0.20 | 0.15 | 0.10 | 0.10 3/11 | 0.05 | 0.15 | 0.20 | 0.05 | 0.20 4/12 | 0.20 | 0.25 | 0.05 | 0.05 5/13 | 0.25 | 0.05 | 0.15 6/14 | 0.05 | 0.20 7/15 | 0.05 8 |

28. The capital requirement, taking into account the rating and sector factors, is defined by the expression:
    K = Σ_{b=1}^{15} Σ_{c<b} (K_b^2 + 2γ_{bc} × S_b × S_c) + K_{b(other sector)} With S_b = Σ_i KDR_{ib} for category b and S_c = Σ_i KDR_{ic} for category c. In the particular case that the expression Σ_{b=1}^{15} Σ_{c<b} (K_b^2 + 2γ_{bc} × S_b × S_c) were a negative number, the expression:
    K = Σ_{b=1}^{15} Σ_{c<b} (K_b^2 + 2γ_{bc} × R_b × R_c) + K_{b(other sector)} Where R_b = Max(Min(S_b, K_b), K_b) and R_c = Max(Min(S_c, K_c), K_c) will be used.
29. Correlation scenarios. For the calculation of capital requirements, three values must be calculated depending on three correlation scenarios. The scenarios are defined as follows:
    Scenario 1. The correlation coefficients ρ_{ij} and γ_{bc} are multiplied by 1.25 with a limit of 100%.
    Scenario 2. The correlation coefficients ρ_{ij} and γ_{bc} are kept at their original values.
    Scenario 3. The correlation coefficients ρ_{ij} and γ_{bc} are multiplied by 0.75.
30. Capital requirement for yield spread risk. It is determined by the highest amount obtained using each of the scenarios.

b) Trading book securitizations with correlation
31. The sensitivities of each instrument (to the risk-free interest rate and to the yield spread) must be calculated according to the underlying interest rate that determines its value, or where applicable, considering the instrument's valuation model.
32. The vertices are 0.25, 0.5, 1, 2, 3, 4, 5, 10, 15, 20, and 30 years.
33. An instrument is defined as belonging to the "Trading book securitizations with correlation" portfolio if it meets the following criteria:
a) The instrument is not a re-securitization position. b) The instrument is traded in a market where independent buy and sell offers exist so that the price can be determined daily. c) The instrument is not referenced to an underlying with retail exposure, residential mortgage exposure, or commercial mortgage exposure.
34. The risk categories for Trading book securitizations with correlation are the same as those defined in Table 2.
35. The risk weightings are defined in Table 5.

Table 5. Weightings for the Trading book securitizations with correlation portfolio
Category No. | Weighting
1 | 4.0%
2 | 4.0%
3 | 8.0%
4 | 5.0%
5 | 4.0%
6 | 3.0%
7 | 2.0%
8 | 6.0%
9 | 13.0%
10 | 13.0%
11 | 16.0%
12 | 10.0%
13 | 12.0%
14 | 12.0%
15 | 12.0%
16 | 13.0%

36. The correlations ρ_{kl} and γ_{bc} are the same as those defined in 24 and 27. The capital requirement within each risk category will be calculated with the same procedure defined in paragraph 26; with the exception of the other sectors category (category 16 of Table 5) for which the exception in paragraph 25 will apply. The total capital requirement for the trading book with correlation (excluding the other sectors category) will be estimated according to the procedure established in paragraphs 28, 29, and 30.

c) Other Securitizations
37. Securitization instruments that do not fall into the aforementioned portfolio will be assigned to one of the following 25 categories:

Table 6. Securitizations
Investment Grade Preferred (IG)
No. Sector
1 RMBS - Prime
2 RMBS - Mid Prime
3 RMBS – Sub-Prime
4 CMBS
5 ABS – Student Loans
6 ABS – Credit Cards
7 ABS - Automobiles
8 CLO not in trading book with correlation
Investment Grade Non-Preferred (IG)
No. Sector
9 RMBS - Prime
10 RMBS - Mid Prime
11 RMBS – Sub-Prime
12 CMBS
13 ABS – Student Loans
14 ABS – Credit Cards
15 ABS - Automobiles
16 CLO not in trading book with correlation
High Yield (HY) and No Rating (NR)
No. Sector
17 RMBS - Prime
18 RMBS - Mid Prime
19 RMBS – Sub-Prime
20 CMBS
21 ABS – Student Loans
22 ABS – Credit Cards
23 ABS - Automobiles
24 CLO not in trading book with correlation
25 Other sector

38. The risk weightings for categories 1 to 8 (Investment Grade Preferred) are established in Table 7.

Table 7. Risk weightings for categories 1 to 8
Category No. | Risk Weighting
1 | 0.9%
2 | 1.5%
3 | 2.0%
4 | 2.0%
5 | 0.8%
6 | 1.2%
7 | 1.2%
8 | 1.4%

39. The risk weightings for categories 9 to 16 (Investment Grade Non-Preferred) are the result of multiplying the weightings of Table 7 by 1.25.
40. The risk weightings for categories 17 to 24 (High Yield and No Rating) are the result of multiplying the weightings of Table 7 by 1.75.
41. The risk weighting for category 25 is set at 3.5%.
42. The correlations between sensitivities within the same category are established as follows:
    ρ_{kl} = ρ_{tranche} × ρ_{vertex} where ρ_{tranche} = 1 if tranches k and l coincide, 0.40 otherwise.
    ρ_{vertex} = 1 if vertices k and l coincide, 0.80 otherwise.
43. There is an exception to the above criterion for the "Other sector" category. The capital requirement within the "Other sector" category is the simple sum of the absolute values of the net risk-weighted delta sensitivities assigned to this category:
    K_{b(other sector)} = Σ_i |KDR_i|
    This capital will be added to the capital level for all risk classes.
44. The correlation parameter γ_{bc} for capital aggregation between categories is set at 0%.
45. The capital requirement for the Other Securitizations portfolio is obtained by first calculating the capital requirement for each category, except the "Other sector" category, according to an expression similar to that in paragraph 26. Subsequently, the capital for all categories is aggregated through the square root of the sum of the squares of the capital requirement of each category plus, where applicable, the capital requirement of the "other sector" category, that is:
    K = √[ Σ_{j=1}^{24} K_j^2 + K_{b(other sector)} ]

II. Equity Risk
46. The exposure of an equity position is equal to its market value.
47. Each position must be assigned to one of the following categories in Table 8.

Table 8. Equity categories
Category | Risk Indicator | Weighting
1 | I < 1.25% | 2%
2 | 1.25% ≤ I < 2.00% | 3.6%
3 | 2.00% ≤ I < 2.75% | 5.2%
4 | 2.75% ≤ I < 3.50% | 6.9%
5 | I ≥ 3.50% | 8.0%

The risk indicator is defined by the standard deviation of the stock's return calculated with the series of market prices from the last 30 days. I = √[ Σ_{t=1}^{30} (R_t - R̄)^2 / 30 ] where R_t = (P_t - P_{t-1}) / P_{t-1} = (P_t / P_{t-1}) - 1 P_t is the market price of the stock on day t.
48. The capital requirement for each position is calculated by multiplying the exposure by the weighting, according to the assigned category.
K_i = E_i × p_i
Where E_i is the absolute value of the net exposure in stock i.
49. The capital requirement for the equity portfolio is calculated using the formula:
K = Σ_{i=1}^{n} Σ_{j<i} (K_i^2 + 2ρ_{ij} × K_i × K_j) The correlation coefficient takes the value 0.40 for the correlation between long positions, 0.4 between short positions, and -0.40 for the correlation between long and short positions.
50. Liquidity adjustment. If during the calculation of the indicator over the last 30 days there are more than six days without a market price, the next category indicated by the indicator will be assigned, with a weighting limit of 80%.

III. Exchange Rate Risk
51. The sensitivity of a financial instrument whose value depends on a given exchange rate is calculated through the following expression:
SFX_i = [V_i(1.01 × FX) - V_i(FX)] / 0.01
V_i(FX) is the market value of the financial instrument expressed as a function of the spot value of the exchange rate FX.
V_i(1.01 × FX) is the value of the financial instrument when the exchange rate increases by 1%.
52. The capital requirement for exchange rate risk for instrument i is obtained by multiplying the sensitivity by 30%. The capital requirement for all positions in a given currency d is the absolute value of the sum of the capital requirements for long positions minus the sum of the capital requirements for short positions. That is:
K_d = | Σ_{i=1}^{n} K_il - Σ_{i=1}^{m} K_ic |
Where K_il is the capital requirement for each long position i, and K_ic is the capital requirement for each short position i.
The correlation coefficient between currencies is assumed to be equal to 0%. Therefore, the aggregated capital requirement for all currencies is obtained through the square root of the sum of the squares of the capital requirement of each currency. K = √[ Σ_{d=1}^{n} K_d^2 ]

IV. Forward Contracts on Bonds, Interest Rates, Stocks, and Currencies.
53. The delta sensitivity of forward contracts on bonds is established as follows: