Regulation on Minimum Requirements for Market Risk Management in Commercial Banks and Other Financial-Credit Organizations Licensed by the National Bank of the Kyrgyz Republic

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Creation date: 2024-03-14

Registered in the Ministry of Justice of the Kyrgyz Republic

August 4, 2006. Registration number 85-06

Approved

by the resolution of the Board of Directors

of the National Bank of the Kyrgyz Republic

of June 28, 2006 No. 19/2

REGULATION

"On Minimum Requirements for Market Risk Management in Commercial Banks and Other Financial-Credit Organizations Licensed by the National Bank of the Kyrgyz Republic"

(In the edition of the resolutions of the Board of Directors of the NBKR of November 16, 2012 No. 43/1, June 15, 2017 No. 2017-P-12/25-7, June 20, 2018 No. 2018-P-12/24-1, October 30, 2019 No. 2019-P-12/54-3, January 17, 2024 No. 2024-P-12/1-3)

1. General Provisions

1.1. This Regulation establishes mandatory requirements for compliance by commercial banks (hereinafter - banks) regarding the organization of market risk management.

(In the edition of the resolution of the Board of Directors of the NBKR of January 17, 2024 No. 2024-P-12/1-3)

1.2. The Regulation defines the main elements and principles of market risk management in accordance with standards of prudent banking practice, and serves as additional guidance for banks regarding minimum requirements for the risk management system (see Note 1), which provide, at a minimum, the following:

• objectives and tasks of market risk management;

• procedures for identifying, assessing, determining acceptable levels of market risk, and monitoring market risk levels, including on a consolidated basis;

• measures to maintain acceptable levels of market risk, including risk control and/or minimization;

• information support procedures regarding market risk (procedures for information exchange between departments and employees, procedures and frequency of reporting and other information on market risk management);

• procedures for managing market risk when changing the structure of financial instruments, their quantitative and value indicators, developing and implementing new technologies and conditions for conducting banking operations and other transactions, other financial innovations and technologies, and entering new markets;

• distribution of powers and responsibilities between the Board of Directors, executive bodies, departments, and employees regarding the implementation of the main principles of market risk management;

• procedures for controlling the effectiveness of market risk management.

(In the edition of the resolution of the Board of Directors of the NBKR of June 15, 2017 No. 2017-P-12/25-7)

2. Definition of Market Risk

2.1. Market risk is the risk of losses to which a bank is exposed in the event of adverse changes in the value of the bank's on-balance-sheet and off-balance-sheet assets and liabilities resulting from changes in market interest rates, exchange rates, stock prices, and/or commodity prices. There are several types of market risk, including interest rate risk, currency risk, and price risk.

2.2. Interest rate risk is the risk of losses to which the bank's capital and profitability are exposed due to changes in market interest rates. Several types of interest rate risk are distinguished, including:

2.2.1. Repricing risk is the result of the difference between the time of interest rate change and the time of cash flows arising from the assessment and establishment of terms for repayment of bank assets, liabilities, and off-balance-sheet items. This risk arises due to differences in the timing of payments on fixed-rate assets and liabilities and the repricing of floating-rate assets and liabilities (see Note 2).

2.2.2. Basis risk is the result of changes in the relationship between interest rates on different financial markets. This risk arises when there is weak correlation between changes in interest rates on assets and liabilities that are repriced depending on fluctuations in various indices and/or changes on different financial markets (see Note 3).

2.2.3. Option risk is the risk arising when a bank client has the right, but not the obligation, to change the volume or timing of cash flows on assets or liabilities. This forces the bank to reprice these assets and liabilities at current market interest rates, which may be unfavorable to the bank (see Note 4).

2.2.4. Yield curve risk is the risk arising from fluctuations in interest rates up to maturity. It entails changes in the ratio between interest rates of different maturities for the same index or market.

Changes in the yield curve can highlight the risk of the bank's position, thereby strengthening the effect of maturity mismatch.

(In the edition of the resolution of the Board of Directors of the NBKR of June 15, 2017 No. 2017-P-12/25-7)

2.3. Currency risk is the risk of incurring expenses (losses) associated with changes in foreign exchange rates during the bank's activities and in the presence of an open position in a specific currency. The following types of risks may arise during currency operations, including:

2.3.1. Credit risk is the risk of a borrower failing to fulfill its obligations according to the terms and conditions of the contract (see Note 5).

2.3.2. Settlement risk is the risk that arises when sold currency is remitted before the bank has received the purchased currency. The risk begins from the time when the currency sale contract can no longer be unilaterally canceled and exists until the purchased currency is received.

2.3.3. Liquidity risk is the risk arising when significant fluctuations in exchange rates or domestic events, such as tightening of currency regulation, may limit access to currency funds. Banks conducting activities in many currencies must provide measures to maintain foreign currency liquidity in their overall liquidity management strategy.

2.3.4. Country risk is the risk of losses arising from changes in economic, social, and political conditions and events in foreign countries, including in their international lending and foreign investment activities.

2.4. Price risk is the risk of losses to which a bank is exposed in the event of adverse changes in the value of financial instruments and other investments or assets owned by the bank (on or off-balance sheet) resulting from changes in market prices.

2.5. The trading portfolio includes all financial instruments intended either for trading or for hedging other elements of the trading portfolio. These financial instruments are held in the portfolio with the aim of generating income from their sale in the short term and/or generating income resulting from actual or expected short-term market fluctuations. In case of uncertainty in classifying financial instruments, the bank must follow the standards of the Basel Committee on Banking Supervision.

(In the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

2.6. The banking portfolio includes all on-balance-sheet and off-balance-sheet items that are not included in the bank's trading portfolio. These items are not intended for active trading and are classified as held-to-maturity. Banking portfolio items are usually not revalued at market value but are accounted for at amortized cost.

(In the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

2.7. The economic value of a financial instrument or portfolio of instruments represents the current (present) value of expected net cash flows of the instrument or portfolio, discounted at the market interest rate. As the discount rate within this Regulation, a risk-free rate must be applied.

As a risk-free rate, the yield on government securities is often accepted. Depending on the currency and distribution of the financial instrument to a specific time range, the yield on foreign government securities may be taken, as well as with different maturities. For example, for financial instruments denominated in som, the weighted average yield on tradable Treasury Bills of the Ministry of Finance of the Kyrgyz Republic with maturities of 2 years, 3 years, 5 years, 7 years, and 10 years may be used. For financial instruments denominated in US dollars, US Treasury bills, notes, and bonds may be used.

(In the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

2.8. A significant currency within the framework of this Regulation is a currency whose share in total on-balance-sheet and off-balance-sheet assets or total on-balance-sheet and off-balance-sheet liabilities is not less than 5%.

(In the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

3. Organization of Market Risk Management

3.1. Market risk management must correspond to the scale of activities, risk appetite, and the level of market risk assumed by the bank. The bank must take measures to reduce market risk associated with the conduct of its operations.

(In the edition of the resolution of the Board of Directors of the NBKR of June 20, 2018 No. 2018-P-12/24-1)

3.2. Banks are recommended to maintain a capital size that is sufficient to cover losses associated with market risk.

3.3. For the purpose of managing market risk, the bank must have policies and internal procedures defining control measures for risk levels and their impact on the bank's profitability and capital.

3.4. The market risk management policy approved by the bank's Board of Directors must take into account the level and complexity of risk to which the bank is exposed, and cover those types of market risk associated with the bank's activities, as well as the level of risk from the introduction of new banking products and services.

Banks must take into account general and macroeconomic conditions in which they conduct their activities when assessing, managing their risks, and their ability to lead the bank to significant losses.

Note: Sources of macroeconomic data may include the Bulletin of the National Bank or other sources.

If the bank decides to hedge risks, the market risk management policy must define methods and criteria for risk hedging, including, among other things, criteria for efficiency (optimality) and cost of hedging.

(In the edition of the resolution of the Board of Directors of the NBKR of June 20, 2018 No. 2018-P-12/24-1)

3.5. The bank's Board of Directors must annually review the market risk management policy to ensure its relevance and compliance with the scale of activities and the bank's level of market risk. The bank's Board of Directors must control the Management's activities to ensure an effective market risk management process.

3.6. The bank must organize a reliable reporting system for assessing and analyzing the volume and nature of potential losses associated with market risk. The reporting system must cover the analysis of potential losses for all bank operations. Reporting on current market risk analysis must be submitted for consideration by the bank's Board of Directors. The frequency of reporting is determined by the bank's Board of Directors.

3.7. The Board of Directors and Management of the bank must ensure adequate internal control, which at a minimum involves control:

• over compliance with requirements and procedures established by the bank's market risk management policy and internal documents regulating the market risk assessment process;

• over compliance with established limits;

• over compliance with the principle of separation of powers, approval procedures, and accountability for conducted operations and provided services;

3.8. The bank's Management is responsible for identifying, measuring, monitoring, and controlling the market risk to which the bank is exposed.

3.9. The bank's Management must ensure training and professional development of personnel necessary for monitoring the actual level of complexity of the bank's market activities.

3.10. The inability to create adequate market risk management systems may constitute unhealthy and unsafe banking practice and lead to the National Bank of the Kyrgyz Republic requiring the bank to cease such types of activities.

(In the edition of the resolution of the Board of Directors of the NBKR of June 15, 2017 No. 2017-P-12/25-7)

3.11. The bank's internal audit must regularly check the integrity, accuracy, and effectiveness of the bank's management of its market risk. Information on the follow-up execution of corrective measures for deficiencies identified during internal audit must be reported periodically, but no less than once every six months, to the bank's Board of Directors and, at a minimum, no less than once a quarter to the Audit Committee.

The market risk assessment conducted by the bank's internal audit must include at least the following factors:

• adequacy of the scale of market risk management processes (taking into account the type, content, and level of complexity of positions causing market risk, it must also be checked whether they were adequately considered in the bank's market risk management process);
• adequacy of the bank's market risk management system used;
• reliability, completeness, integrity, and consistency of all data and sources of such data, as well as assessment methods used in market risk assessment;
• adequacy of the bank's market risk management system used;
• reliability, completeness, integrity, and consistency of all data and sources of such data, as well as assessment methods used in market risk assessment.

(In the edition of the resolution of the Board of Directors of the NBKR of June 20, 2018 No. 2018-P-12/24-1)

Note of the Center for Information "Toktom": The number of paragraphs in point 3.11 of this Regulation does not correspond to the number of paragraphs in point 3.11 of the text in the state language.

4. Requirements for Interest Rate Risk Management

(Chapter in the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

4.1. In managing interest rate risk, the bank must take into account risks arising from banking operations with both the trading and banking portfolios.

Interest rate risk management must cover repricing risk, basis risk, option risk, and yield curve risk.

The bank must have a policy for managing interest rate risk, which may be a component of the market risk management policy. The interest rate risk management policy must at a minimum contain:

• a description of the interest rate risk assessment process, which also includes determining limits for interest rate risk in banking and trading operations. These limits are taken into account in managing the bank's assets and liabilities and correspond to the bank's risk appetite and capital;

• clear definition of powers and responsibilities of the bank's Management and/or the corresponding body appointed by the Board of Directors for decision-making on interest rate risk management, including approval of relevant limits;

• separation of powers and responsibilities of structural departments/employees of the bank for implementing policies and procedures for interest rate risk management. Persons responsible for monitoring and controlling risk must be independent of persons performing operations carrying interest rate risk;

• requirements for the Management Information System (MIS) collecting data on interest rate risks across all areas of the bank's activities. The MIS must ensure timely provision of information to the Management and Board of Directors of the bank regarding the level of interest rate risk;

• requirements for bank reporting, which must include information sufficient for timely management decision-making and control by the Board of Directors;

• definition of processes and principles related to new products.

(In the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

4.2. Methods for measuring interest rate risk may vary depending on the origin and complexity of the risk arising in the bank's activities. Banks may apply different methods, but must at least conduct gap analysis and stress testing, and must determine the degree of exposure of the banking portfolio to interest rate risk (Appendix 1).

(In the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

4.2.1. Gap analysis involves determining the gap between assets and liabilities sensitive to interest rate changes.

(In the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

4.2.2. The main task of stress testing is to assess the sensitivity of the bank's balance sheet to the impact of banking risks, as well as the ability of the bank's capital to compensate for possible large losses under various scenarios of further development.

(In the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

4.2.3. Determining the degree of exposure of the banking portfolio to interest rate risk is carried out based on gap analysis by applying a assumed change in interest rates (standardized interest rate shock).

(In the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

4.2.4. Additionally, the bank must:

• calculate and monitor net interest margin;
• assess risks associated with early repayment and withdrawal of loans/deposits;
• assess risks associated with attracting/placing funds at floating interest rates.

(In the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

4.3. The Board of Directors and Management of the bank must regularly, but no less than once every six months, analyze the results of stress testing, including the main assumptions underlying them. The results of such work should be taken into account in creating and reviewing the market risk management policy. Taking into account potential losses forecasted by stress tests and the probability of such losses occurring, the Board of Directors and Management of the bank may take additional measures to strengthen risk management.

Establishing limits on the absolute size of a specific gap or the ratio of the gap to income-generating assets (or capital) is a generally accepted means of limiting overall exposure to interest rate risk.

The bank may provide limits limiting the vulnerability of net interest income resulting from changes in interest rates. The bank's Management, in agreement with the Board of Directors, may establish risk limits for internal purposes that the bank is willing to accept (for example, 15% of the size of capital or 10-30% of the size of net interest income).

Also, the bank must establish internal limits on the coefficient of exposure of the economic value of the banking portfolio to interest rate risk in accordance with part 3 of Appendix 1 to this Regulation.

(In the edition of the resolution of the Board of Directors of the NBKR of October 30, 2019 No. 2019-P-12/54-3)

5. Requirements for Currency Risk Management

5.1. The currency risk management policy, which may be a component of the market risk management policy, must at a minimum contain:

• a description of the currency risk assessment process, which also includes determining limits for currency risk in banking and trading operations, including currency risk limits established by the NBKR;

• types of foreign currency operations that the bank intends to conduct, as well as foreign currency operations prohibited by the bank's Board of Directors;

• clear definition of powers and responsibilities of the bank's Management for decision-making on currency risk management, including approval of individual limits for dealers and limits on open currency positions, limits on amounts of individual contracts, and limits on individual counterparties;

• requirements for the Management Information System (MIS) allowing immediate recording of currency operations in accounting and determining both the total currency position of the bank and positions for each currency on a constant basis in real-time mode;

• clear separation of responsibilities between structural departments conducting client work (front office) and operation accounting (back office);

• requirements for bank reporting, which must include information sufficient for timely management decision-making and control by the Board of Directors.

5.2. Methods for managing currency risk may vary depending on the nature and complexity of the risk arising in the bank's activities. Risk assessment must include, at a minimum:

5.2.1. Measurement of the bank's currency risk, including calculation of the open currency position (see Note 6).

5.2.2. Accounting for currency risk in the bank's liquidity management. In particular, when the bank uses national or another currency to purchase a third currency, currency liquidity must be measured and tested using stress testing and in conjunction with the bank's national currency liquidity.

5.2.3. Assessment of the impact of currency exchange rate fluctuations on the bank. Banks must use stress testing to determine potential currency losses in emergency situations. In this regard, it is recommended to consider the impact on the bank's capital from historical extreme currency fluctuations, as well as to model realistic but extreme scenarios allowing determination of the bank's resilience under various levels of risk.

6. Requirements for Managing Price Change Risk on Stocks and Commodities

6.1. Price change risk on stocks and commodities arises from adverse changes in prices of stocks or precious metals owned by the bank.

6.2. Trading in stocks and financial participation in share capital expose the bank to price risk, as changes in stock prices can adversely affect the bank's profitability and capital.

6.3. The bank may conduct operations with precious metals only on the basis of an additional license issued in accordance with requirements established by the NBKR.

6.4. Management of price change risk on precious metals may be similar to currency risk management, given the similarity of the currency market and the precious metals market.

6.5. Banks conducting these types of activities must create appropriate risk control systems that must comply with requirements established in this Regulation.

6.6. The Board of Directors and Management of the bank are responsible for timely identification, assessment, monitoring, and control of risks in trading activities. The bank's Management must conduct thorough monitoring of all investments in equity securities, regularly assess the bank's exposure to market risk, including price risk, and timely report to the Board of Directors.

7. Disclosure of Information on Market Risk Management

7.1. The bank must disclose information on measures to reduce market risk within the framework of the bank's annual report. The volume of information disclosure must correspond to the degree and level of the bank's exposure to market risk.

Notes:

(1) - In accordance with the Regulation "On Minimum Requirements for Risk Management in Banks of the Kyrgyz Republic", approved by the resolution of the Board of Directors of the National Bank of the Kyrgyz Republic.

(2) - For example, a bank that has issued a long-term loan with a fixed interest rate and has a short-term deposit may face a decrease in future income resulting from an increase in market interest rates. Funds received from the loan are fixed for the entire term, while interest paid on short-term borrowings increases, which negatively affects the bank's income.

(3) - For