Market Risk Management

Bank of Israel Bank Supervision Policy and Regulation Department

Jerusalem, 21 Sivan, 5773 May 30, 2013 Circular No. 06-2378

To: Banking Corporations and Credit Card Companies

Subject: Market Risk Management (Prudent Banking Instruction No. 339)

Introduction

1. Following the enactment of Prudent Banking Instruction No. 333 (Interest Rate Risk Management), adjustments were made to this Instruction.
2. After consulting with the Advisory Committee on Banking Matters and with the Governor's approval, I have amended Prudent Banking Instruction No. 339, regarding Market Risk Management.

Amendments to the Instruction 3. The name of the Instruction shall be changed from "Market and Interest Rate Risk Management" to "Market Risk Management".

Explanatory Notes The change was made in light of the fact that the topic of interest rate risk management has been assigned to a new Instruction.

4. In subsection (c) of the Introduction, a clarification shall be added stating that "Additional guidelines regarding market risk are included in the Supervisor's Instructions regarding measurement and capital adequacy - market risk (Instruction No. 208), treatment of illiquid positions (Instruction No. 209), and hedging (Instruction No. 205). Furthermore, the topic of interest rate risk management in general and in the banking book in particular is treated specifically in Prudent Banking Instruction No. 333 regarding 'Interest Rate Risk Management'."

5. An applicability section shall be added to anchor the applicability of the Instruction to banking corporations, excluding a joint service company, and to credit card companies.

6. Section 8 shall be repealed.

Explanatory Notes The change was made in light of the fact that interest rate risk is treated in a new Instruction.

7. Section 9(b)(3) shall be repealed.

Explanatory Notes The change was made in light of the fact that interest rate risk is treated in a new Instruction.

8. In Section 9(c)(2), a clarification shall be added that the calculation frequency regarding the trading book shall be at least daily, and the words "at least monthly" regarding the valuation frequency of positions shall be deleted.

Explanatory Notes The clarification is consistent with the requirements in Prudent Banking Instruction No. 208. The valuation of positions shall be in accordance with the frequency of ongoing measurement.

9. In Section 10(b), a reference to Prudent Banking Instruction No. 310 regarding "Risk Management" shall be added.

Explanatory Notes Addition of a reference to the Instruction regarding risk management also in the context of the functions of the market and interest rate risk management unit.

Effective Date 10. The applicability of the provisions of this Circular is from July 1, 2014.

File Update 11. Attached are update pages for the Prudent Banking Instruction file. The following update instructions apply:

Removed Page	Inserted Page
339-1-3 [4] (12/12)	339-1-3 [5] (5/13)

With respect,

David Zaken Inspector of Banks

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Market Risk Management

Introduction (2/97) (a) Developments in Israel's financial and capital markets, the shift from financial intermediary to market maker status, globalization, and financial innovation have an increasing impact on the potential exposure to risks inherent in the various operations of banking corporations. (b) Repealed. (c) This Instruction sets rules for the management and measurement of market risk, applying the basic principles established in Instruction 310 regarding "Risk Management". Additional guidelines regarding market risk are included in the Supervisor's Instructions regarding measurement and capital adequacy - market risk (Instruction No. 208), treatment of illiquid positions (Instruction No. 209), and hedging (Instruction No. 205). Furthermore, the topic of interest rate risk management in general and in the banking book in particular is treated specifically in Prudent Banking Instruction No. 333 regarding "Interest Rate Risk Management".

Applicability 2. This Instruction applies to a banking corporation, as defined in the Banking (Regulation) Law, 5741-1981, excluding a joint service company, and also to an auxiliary corporation that is a credit card company (both groups are referred to hereinafter as "banking corporation"). Notwithstanding the above, the Supervisor may determine that certain requirements specified below shall not apply to specific banking corporations.

Definitions (2/97) 2a. "Economic Capital" - the difference between the fair value of assets and liabilities, on and off-balance sheet, in a specific sector (hedged, unhedged, foreign exchange); "Fair Value of a Financial Derivative Instrument" - as defined in the regulations regarding the preparation of annual financial reports of a banking corporation (Public Reporting Regulations); "Market Risk" - the risk of loss in on-balance sheet and off-balance sheet positions resulting from a change in the fair value of a financial instrument due to a change in market conditions (change in price levels in various markets, interest rates, exchange rates, inflation, stock and commodity prices); "Market Maker" - a banking corporation engaged in financial instruments and financial derivative instruments with clients and other market makers, and holding a portfolio of these instruments, selling and buying them by quoting bid and ask prices while earning income from the spread between purchases and sales.

Management Infrastructure (2/97) 3. Repealed.

Exposure Document (2/97) 4. Repealed.

Board of Directors and Policy (2/97) 5. Repealed.

Risk Manager (2/97) 6. Repealed.

Internal Audit (2/97) 7. Repealed.

Interest Rate Risk (2/97) 8. Repealed.

Market Risk (2/97) (7/99) (6/04) (a) A banking corporation taking positions in foreign currency, investing in securities for its own account (proprietary trading), or acting as a market maker in financial derivative instruments on a broad scale (as defined in subsection (b) below), shall manage the market risks arising from its overall activity through a sophisticated system as detailed in subsection (c) below. Notwithstanding the above, a banking corporation whose main market risks are focused in only a few areas shall be permitted to manage market risks as required in this Section only for those areas. (b) The provisions of this Section shall apply only to banking corporations meeting at least one of the following criteria: (1) The investment portfolio in securities for sale and trading exceeds 3 billion NIS, or 50% of the banking corporation's capital; (2) The total limits and authorizations for holding positions in the foreign exchange sector, including existing exposure ceilings in the banking corporation's sections outside Israel, exceed half a billion NIS, or 33% of the banking corporation's equity net of non-monetary items; (3) Repealed; (4) The banking corporation acts as a market maker in derivative instruments (excluding market making in one-way trading in the foreign currency/Shekel market) and has not received a waiver from the Bank Supervision Department from this Section due to low activity levels.

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(c) The market risk management system of banking corporations must include all the following components: (1) An internal model for measuring market risk based on statistical techniques such as: variance - covariance, historical simulations, and "Monte Carlo" simulations; (2) Ongoing measurement (at least daily, and in the trading book, daily) of the banking corporation's exposure to market risks using Value at Risk (hereinafter - VAR) estimates, based on the corporation's internal model. The VAR estimates the maximum expected loss for the corporation due to the realization of market risks over a given time period and a pre-determined statistical confidence level; the use of this method requires ongoing revaluation of all the corporation's positions based on the fair value of assets and liabilities; (3) Analysis of market risks in extreme scenarios (Stress-Scenario Analysis); (4) A model, or method for assessing the viability of taking positions in the various areas, taking risks into consideration; (5) A market and interest rate risk management unit (as detailed in Section 10).

Market and Interest Rate Risk Management Unit (2/97) 10. (a) A banking corporation required to manage market risks according to a model, within the VAR methodology, shall establish an independent function for market and interest rate risk management that shall be independent of the parties responsible for the management and execution of trading in the various instruments. (2) The risk management unit shall be subordinate to the Chief Risk Officer of the banking corporation, as defined in Prudent Banking Instruction No. 310 regarding "Risk Management".

(b) The risk management unit shall operate in accordance with the provisions of Prudent Banking Instruction No. 310 regarding "Risk Management", including, inter alia, the risk management unit shall evaluate the adequacy of the models applied in the banking corporation for measuring risk, examine the degree of fit of actual activity and exposures to approved principles and exposure limits, periodically check actual results against model forecasts, develop and conduct extreme scenario tests, prepare reports for risk quantification, and report on the results of the checks on an ongoing basis. (c) Repealed.

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Updates

Circular No.	Version	Details	Date
1852	1	Original Instruction	23/2/97
1980	2	Update	14/7/99
2134	3	Update	13/6/04
2358	4	Update	27/12/12
2378	5	Update	30/5/13