Circular No. 3646: Minimum Requirements and Procedures for Calculating Daily RWAmint Value Using Internal Market Risk Models

CIRCULAR NO. 3,646, OF MARCH 4, 2013
Establishes the minimum requirements and procedures for the calculation, through internal market risk models, of the daily value regarding the RWAMINT portion of risk-weighted assets (RWA), as provided for in Resolution No. 4,193, of March 1, 2013, and provides for the authorization for the use of said models. The Board of Directors of the Central Bank of Brazil, in an extraordinary session held on March 1, 2013, based on arts. 9, 10, item IX, and 11, item VII, of Law No. 4,595, of December 31, 1964, and on arts. 3, § 2, and 15 of Resolution No. 4,193, of March 1, 2013, R E S O L V E:
Art. 1. The use of internal market risk models for the calculation of the daily value regarding the RWAMINT portion, as provided for in Resolution No. 4,193, of March 1, 2013, in substitution for the RWAMPAD portion, is permitted for the following institutions:
I - multiple banks, savings banks, and commercial banks, except for cooperative banks that are not part of a financial conglomerate and a prudential conglomerate, and the National Bank for Economic and Social Development (BNDES); and II - institutions that are part of a financial conglomerate and a prudential conglomerate, in accordance with the Accounting Plan of the Institutions of the National Financial System (Cosif), and the economic-financial consolidated statements, composed of at least one of the institutions mentioned in item I. § 1. The use of internal market risk models depends on prior authorization by the Central Bank of Brazil. § 2. The authorization may be canceled, at the discretion of the Central Bank of Brazil, if the requirements established in this Circular are no longer met or if the calculated values no longer adequately reflect the market risk of their exposures. § 3. Institutions must prove that they meet the minimum requirements established in this Circular, and must promptly inform the Central Bank of Brazil if they cease to meet them. § 4. Once the authorization is granted, institutions must obligatorily use internal market risk models for the calculation of the daily value regarding the RWAMINT portion of risk-weighted assets (RWA). § 5. Institutions require prior authorization from the Central Bank of Brazil to cease using internal models. Qualitative Requirements Circular No. 3,646, of March 4, 2013 Page 2 of 14 Art. 2. Internal market risk models must:
I - be integrated into the market risk management structure and be used together with the limits defined by the institution to measure, monitor, and control exposure to market risk; II - possess sophistication, controls, and technological infrastructure compatible with the nature of operations, the complexity of products, and the dimension of exposure to market risk of the institution; III - measure all relevant market risks; IV - adequately measure the risk arising from the non-linear characteristics of options and other financial instruments, when relevant; V - evaluate new products and financial instruments with low liquidity in a conservative manner; VI - allow the measurement of market risk, through the use of hypothetical portfolios; and VII - adequately treat portfolios concentrated in certain risk factors. Art. 3. Institutions must maintain a sufficient quantity of technically qualified professionals in their business, operational, risk management, internal audit, information technology areas, as well as in any others involved in the development, validation, evaluation, and use of internal models. Art. 4. Institutions must maintain adequate and updated documentation on all relevant aspects of the internal market risk model, covering, at minimum:
I - policies and strategies adopted;
II - internal controls;
III - theoretical basis;
IV - description of evaluation, measurement, and monitoring methodologies; V - operational routines; VI - evaluation reports, including those from internal audit, validation processes, and backtests; VII - risk reports, including Value at Risk (VaR) reports and stress tests; VIII - management reports that provide support for the decision-making process of the institution's board of directors and board of directors, if any; and Circular No. 3,646, of March 4, 2013 Page 3 of 14 IX - history of changes made to the internal model, including in the validation process. Art. 5. The institution's board of directors and board of directors, if any, must define the guidelines for the operation of internal control activities, the levels of authorization necessary to assume different levels of risk, as well as the information and periodic reports to be submitted for their consideration. Sole paragraph. The institution's board of directors must define the risk limit structure assumed by the institution and verify the adequacy of the internal market risk model results to the institution's risk profile. Quantitative Requirements Art. 6. The daily value regarding the RWAMINT portion must correspond to the following formula:
RWA_t = F * [ max( max_{i=1 to 60} (VaR_{t-i}) + max_{i=1 to 60} (sVaR_{t-i}) ) * M + VPad_t ] * SM_t where:
I - F = factor established in art. 4 of Resolution No. 4,193, of 2013; II - RWAMINT_t = daily value regarding the RWAMINT portion, for business day t; III - VaR = Value at Risk (VaR) of business day t; IV - sVaR = stressed VaR of business day t; V - M = multiplier defined in art. 13; VI - VPad = daily value regarding the sum of the RWAMPAD portions, for business day t, calculated in accordance with Circulars Nos. 3,634, 3,635, 3,636, 3,637, 3,638, 3,639, and 3,641, all of March 4, 2013; VII - SM = transition factor for internal market risk models; and § 1. The SM factor corresponds, for the periods mentioned below, counted from the start of the use of the internal market risk model for the calculation of the daily value regarding the RWAMINT portion, to the following values:
I - from the 1st to the 365th day: 0.90 (ninety hundredths); II - from the 366th to the 730th day: 0.80 (eighty hundredths); III - from the 731st to the 1,095th day: 0.70 (seventy hundredths); and IV - from the 1,096th day onwards: zero. Circular No. 3,646, of March 4, 2013 Page 4 of 14 § 2. For exposures not considered relevant in certain market risk factors, the daily value regarding the RWA portions dealing with these factors may be calculated, provided that previously authorized by the Central Bank of Brazil, in accordance with Circulars Nos. 3,634, 3,635, 3,636, 3,637, 3,638, 3,639, and 3,641, all of 2013. § 3. For institutions that are part of a financial conglomerate and a prudential conglomerate whose exposures are not considered relevant, and for non-financial institutions that are part of an economic-financial consolidated statement, the daily value regarding the RWAMINT portion may be calculated, provided that previously authorized by the Central Bank of Brazil, in accordance with Circulars Nos. 3,634, 3,635, 3,636, 3,637, 3,638, 3,639, and 3,641, all of 2013. § 4. Values calculated in accordance with the provisions of §§ 2 and 3 of this article must be added to the RWAMINT_t portion value, and the respective exposures excluded from VPad. § 5. In the case of relevant corporate changes, an implementation plan must be submitted, subject to authorization by the Central Bank of Brazil, for the calculation of the daily value regarding the RWAMINT portion. Art. 7. The risk factors used to measure the market risk of exposures must be classified into the following categories:
I - interest rates;
II - exchange rates;
III - stock prices; and
IV - commodity prices (commodities).
§ 1. Risk factors must be specified for each of the currencies and markets in which the institution has relevant exposure.
§ 2. For exposures to interest rates in a given currency and market, the internal market risk model must use term structures and a sufficient number of vertices to adequately assess the risks of all financial instruments with which the institution operates. § 3. Correlations between risk factors may be incorporated into the internal market risk model, provided that the calculation process is consistent and verifiable. Art. 8. The VaR mentioned in art. 6, item III, must be calculated daily, representing the maximum loss, based on a one-tailed confidence interval of 99% (ninety-nine percent) and a holding period of at least ten business days, appropriate to the size of the exposure and the liquidity conditions of the instrument. § 1. VaR values calculated for shorter holding periods may be used, if converted to ten business days or more. Circular No. 3,646, of March 4, 2013 Page 5 of 14 § 2. The methodologies for estimating the VaR referred to in the caput must consider an adequate degree of conservatism to mitigate potential model risks. Art. 9. The historical observation periods used for calculating VaR must be at least one year. § 1. The use of historical observation periods shorter than one year is admitted, subject to the evaluation of the Central Bank of Brazil:
I - of historical observation periods shorter than one year, provided they are adequate to the characteristics of the volatilities and the model used; and II - of decay factors adequate to the characteristics of the volatilities and the model used. § 2. The Central Bank of Brazil may determine the use of historical observation periods shorter than one year, as well as changes in the decay factors eventually used. § 3. The use of the prerogatives referred to in § 1 of this article must be based on consistent and verifiable criteria, with documented information available to the Central Bank of Brazil. Art. 10. The stressed VaR (sVaR) mentioned in art. 6, item IV, must be calculated in a way that replicates the VaR calculation that would be made in a given historical stress period, but using the institution's current portfolio. § 1. The sVaR calculation must observe the provisions of arts. 8 and 9, with weekly calculation being permitted. § 2. All model parameters must be calibrated with data from a twelve-month historical period that represents relevant stress for the institution's current portfolio profile. § 3. The historical stress period to be used must be selected by the institution itself, considering data from January 1, 2004, and reviewed regularly. § 4. The use of the decay factor for sVaR is optional. Art. 11. The information used to calculate VaR must be updated at least monthly, considering adequacy to the methodology used. Backtests Art. 12. Backtests must be performed that allow the comparison of effective and hypothetical results with the VaR calculated by the internal market risk model, in order to ensure consistent evaluations of the model's fit. § 1. Backtests must meet, at minimum, the following requirements:
I - holding period of one day;
Circular No. 3,646, of March 4, 2013 Page 6 of 14 II - minimum monthly frequency; III - use of various observation periods; IV - use of various confidence intervals; and V - coverage of all operations jointly and segmented. § 2. The effective result corresponds to the variation in portfolio value until the end of the day, including intraday operations and excluding values not related to market price variations, such as fees, brokerage, and commissions. § 3. The hypothetical result corresponds to the application of one-day market price variations to the portfolio at the end of the previous business day. § 4. Backtests must be used to improve the model. Multiplier M Art. 13. The value of the multiplier M mentioned in art. 6, item V, must be calculated based on the following formula:
M = 3 + A + A_q where:
I - A = addition related to backtests; and
II - A_q = addition related to qualitative evaluation, whose value is between 0 and 1.
Art. 14. The value of the addition A must be calculated on the base dates of March 31, June 30, September 30, and December 31, as follows:
I - identification, among the last 250 business days, of the number of days in which effective losses exceeded the respective VaR, considering the total portfolio, based on a one-tailed confidence interval of 99% (ninety-nine percent) and a holding period of one day; II - identification, among the last 250 business days, of the number of days in which hypothetical losses exceeded the respective VaR, considering the total portfolio, based on a one-tailed confidence interval of 99% (ninety-nine percent) and a holding period of one day; and III - consider the maximum between the values identified in items I and II, in the table below:
Maximum of losses that exceeded VaR | A
4 or less | 0.00
5 | 0.40
Circular No. 3,646, of March 4, 2013 Page 7 of 14 6 | 0.50 7 | 0.65 8 | 0.75 9 | 0.85 10 or more | 1.00 § 1. The losses mentioned in items I and II must be analyzed and documented. § 2. The information referred to in § 1 must be sent to the Central Bank of Brazil by the 15th business day following the respective base dates mentioned in the caput. § 3. The new value of A must be used from the 1st business day of the second month following the respective base dates mentioned in the caput. § 4. Based on the analysis of the information referred to in § 2, the Central Bank of Brazil may require adjustments to the institution's internal model, without prejudice to the provisions of art. 1, § 1. Art. 15. The value of the addition A_q is determined by the Central Bank of Brazil, for each institution, based on the evaluation of the qualitative aspects of the internal market risk model and the market risk management structure. Stress Tests Art. 16. Simulations of extreme market conditions (stress tests) must be performed, with a minimum weekly frequency, that compose a rigorous and comprehensive program, in order to consider situations that may produce extraordinary losses or gains. § 1. The stress tests mentioned in the caput must meet, at minimum, the following requirements:
I - be integrated into the risk management structure; II - associate potential losses with plausible events; III - be considered in the development of risk mitigation strategies and the institution's contingency plans; IV - be performed individually by risk factor and jointly; and V - consider concentration in certain risk factors, non-linear instruments, and the breaking of VaR model assumptions. § 2. The institution must seek continuous improvement of its stress test program. Circular No. 3,646, of March 4, 2013 Page 8 of 14 § 3. The results of stress tests must be used to assess the capacity to absorb large losses and identify potential measures to reduce risks. Art. 17. Scenarios must be developed that:
I - reproduce historical periods of market stress; II - reproduce periods of the institution's largest losses; and III - prospectively simulate adversities based on the characteristics of the institution's portfolio and the macroeconomic environment that represent severe, but plausible, conditions. Sole paragraph. The scenarios mentioned in the caput must include price shocks, including their effects on margins in clearinghouses, lack of liquidity of financial instruments, event risk, and significant changes in correlations. Art. 18. The stress test program, including the definition of scenarios, must be approved and periodically reviewed by the institution's board of directors. Sole paragraph. The board of directors must consider the results of stress tests in defining the institution's policies and strategies, without prejudice to the provisions of art. 3, item V, of Resolution No. 3,464, of June 26, 2007. Validation Art. 19. Institutions must have a validation process that critically analyzes their internal market risk models. § 1. In the validation process mentioned in the caput, the following must be evaluated, at minimum:
I - the methodologies, assumptions, and theoretical foundations of the model, including the mapping of positions and pricing methods; II - the accuracy and adequacy of volatility and correlation assumptions; III - the inclusion of all relevant risks; IV - the comprehensiveness, consistency, integrity, and reliability of the model's input data, as well as the independence of its sources; V - the ability to adequately consider the characteristics of new products that may impact the institution's market risk; VI - the adequacy of backtests and stress tests, including the adequacy of the respective reports and their planned use in the measurement, monitoring, and market risk management process; Circular No. 3,646, of March 4, 2013 Page 9 of 14 VII - the adequacy of internal controls related to the model; VIII - the adequacy of the technological infrastructure and the functioning of the systems used in the model, including tests, homologations, and certifications; IX - the compatibility of the calculations performed by the systems and the operational logic with the assumptions and methodologies adopted; X - the integrity, comprehensiveness, and adequacy of the model documentation; and XI - the content and comprehensiveness of the risk measurement reports. § 2. The validation process is the exclusive responsibility of the institution, which must demonstrate the adequacy and fit of the model used to its risk profile. § 3. The validation process referred to in the caput must be performed, at minimum, every three years and, in particular, whenever any relevant change occurs in the model or the institution's risk profile. § 4. The validation process must include tests with hypothetical portfolios to ensure the robustness of the model regarding specific structural aspects, such as concentration in certain risk factors, basis risk, and other potential risks not present in the institution's usual portfolio. § 5. The validation process must be independent of the model development and use processes and must be conducted by technically qualified personnel. § 6. The validation process must be conducted within an appropriate incentive structure, must be isolated from pressures from persons who may benefit from it, and, in particular, persons involved in the said process cannot obtain gains arising from the result of the model validation. § 7. models and information technology systems acquired from third parties must be submitted to the same procedures established in this article. § 8. The validation process must be adequately documented, and its results submitted to the institution's board of directors and board of directors, if any. Internal Audit Evaluation Art. 20. The institution's market risk management process must be subject to evaluation, with a minimum annual frequency, covering, at minimum:
I - verification of the effectiveness of the validation process referred to in art. 19; II - verification of the performance of validation processes in cases of relevant changes in the model or the institution's risk profile, in accordance with art. 19, § 3; III - organization of the market risk management structure; Circular No. 3,646, of March 4, 2013 Page 10 of 14 IV - integration of the internal market risk model into daily management activities, including stress tests; V - integrity of backtests and their effective use in verifying performance and improving the model; VI - compliance with risk management policies, including limit structures and related policies; VII - sufficiency and technical qualification of professionals in business, operational, risk management, information technology areas, as well as any others involved in the development, validation, and use of the internal model; VIII - integrity and adequacy of management information systems; IX - involvement of the institution's board of directors in the market risk management process; and X - timeliness and quality of information provided to the board of directors. § 1. The evaluation process referred to in this article, which is the responsibility of the institution's internal audit, must be independent of the model development and use processes and be conducted by technically qualified personnel. § 2. The provisions of items I, II, and VII of the caput must be performed independently of the validation process referred to in art. 19. Information Disclosure Art. 21. From the granting of the authorization referred to in art. 1, the institution must highlight the following information in a public access report:
I - for the base dates of March 31, June 30, September 30, and December 31:
a) maximum, minimum, average, and end-of-quarter VaR, calculated using the parameters mentioned in art. 8, for the total portfolio and for the risk factor categories established in art. 7; b) maximum, minimum, average, and end-of-quarter sVaR, calculated in accordance with the provisions of art. 10, for the total portfolio and for the risk factor categories established in art. 7; c) results of the comparisons referred to in art. 14, items I and II, accompanied by analysis of the identified exceptions; and d) value regarding the RWAMINT portion; and II - with a minimum annual frequency:

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a) pricing policies, procedures, and methodologies; b) characteristics of the internal model; c) indication of risk factors and institutions to which the option provided in §§ 2 and 3 of art. 6 is exercised; d) description of the stress tests referred to in arts. 16 and 17; e) description of the goodness-of-fit tests referred to in art. 12; and f) description of the validation process referred to in art. 19.

§ 1st The update of the information:
I - provided for in item I of the main text must be carried out within a maximum period of sixty days for the base dates of March 31, June 30, and September 30, and ninety days for the base date of December 31; and II - provided for in item II of the main text must be carried out within a maximum period of ninety days after the period to which the information refers.

§ 2nd The information provided for in item I of the main text regarding the last five years must be available for public consultation in the same location, accompanied by a comparative assessment and an explanation for relevant variations.

Art. 22. The institution must disclose additional information it deems relevant, in order to ensure appropriate transparency of its internal market risk model.

Sole paragraph. The Central Bank of Brazil may determine the disclosure of additional information beyond that provided for in this Circular.

Art. 23. The information referred to in arts. 21 and 22 must be available together with that provided for in Circular No. 3.477, of December 24, 2009.

Art. 24. The director indicated under the terms of art. 10 of Resolution No. 3.464, of 2007, is responsible for the information to be disclosed in accordance with arts. 21 and 22.

Other requirements

Art. 25. The institution must have been using internal VaR models for market risk management, observing art. 2, item I, for a minimum period of two years before requesting the authorization referred to in art. 1.

Art. 26. Relevant changes in the institution's risk profile and, prior to implementation, relevant changes in the methodology used in internal market risk models, including the validation process, as well as those that cause a significant impact on the calculation of the daily value regarding the RWAMINT portion, must be communicated to the Central Bank of Brazil.

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Sole paragraph. The provision in the main text also applies to changes that are not relevant in isolation but are relevant collectively.

Art. 27. The relevance of changes, exposures, and risk factors must be defined according to consistent and verifiable criteria, adequately documented, and subject to evaluation by the Central Bank of Brazil.

Art. 28. The Central Bank of Brazil may authorize a compliance plan for any requirements not fully met, provided that they do not compromise the internal model or the institution's market risk management.

Art. 29. From the granting of the authorization referred to in art. 1, the institution must keep available to the Central Bank of Brazil, for a period of five years, the information referred to in this Circular.

Authorization Request

Art. 30. The institutions referred to in art. 1 interested in using internal market risk models must request authorization from the Central Bank of Brazil, through a petition filed in one of the Regional Administrative Manageries, addressed to the Department of Bank and Banking Conglomerate Supervision (Desup), signed by the institution's president-director and by the directors indicated in accordance with art. 10 of Resolution No. 3.464, of 2007, and art. 14 of Resolution No. 4.193, of March 1, 2013.

Sole paragraph. The request referred to in the main text must be accompanied by the following documentation:
I - declarations attesting that the institution:
a) is aware that, once the authorization to use the internal model is granted, it will no longer be able to use the methodologies established in Circulas Nos. 3.634, 3.635, 3.636, 3.637, 3.638, 3.639, and 3.641, all of 2013, except in special situations and with prior authorization from Desup; b) meets the minimum requirements established in this Circular, and that the eventual non-full compliance with specific aspects does not compromise the internal model and market risk management; and c) has used internal Value at Risk (VaR) models for at least two years for market risk management, complying with the provisions of art. 2; II - declaration attesting to the truthfulness and integrity of the information sent; III - report prepared by the institution, based on the document "Information on the Internal Market Risk Model", to be published by the Central Bank of Brazil; IV - compliance plan, containing schedule, measures, and responsibilities for full compliance with the specific aspects mentioned in item I, letter "b"; and

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V - internal audit opinion, containing conclusions on the evaluation referred to in art. 20.

Art. 31. Institutions that request authorization will be subject to a selection and prioritization process, which will define those whose internal models will be analyzed.

Sole paragraph. In the selection and prioritization process referred to in the main text, the following criteria will be taken into consideration:
I - completeness and adequacy of the documents mentioned in art. 31; II - the institution's history with the Central Bank of Brazil regarding risk and control assessments, economic-financial solidity, transparency in relationships, compliance with regulations, and timely compliance with determinations; III - stage of development of the internal model and market risk management structure; IV - proportion of the daily value regarding the RWAMINT portion of the institution, referred to in Resolution No. 4.193, of 2013, in relation to the aggregate RWA of the financial system; V - proportion of the daily value regarding the RWAMINT portion in relation to the institution's RWA; VI - treasury activities and level of specialization; VII - asset volume; and VIII - date of the authorization request.

Art. 32. During the analysis process of internal market risk models, the institution must:
I - promptly provide any additional information; II - inform, in the manner to be established, the daily value regarding the components of the RWAMINT portion; and III - facilitate access to people, documents, and systems.

Art. 33. The use of internal market risk models under the terms of this Circular shall occur only after the date stipulated in the respective authorization.

Art. 34. This Circular enters into force on October 1, 2013.

Art. 35. Circular No. 3.478, of December 24, 2009, is hereby revoked, effective October 1, 2013.

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Sole paragraph. Citations to Circular No. 3.478, of 2009, shall henceforth refer to this Circular.

Luiz Awazu Pereira da Silva
Director of Financial System Regulation

This text does not replace the published in the DOU of 3/7/2013, Section 1, p. 21-23, and in Sisbacen.