Prudential Standard for Market Risk Management for Licensed Financial Institutions

PRUDENTIAL STANDARD FOR MARKET RISK MANAGEMENT FOR FINANCIAL INSTITUTIONS LICENSED UNDER THE BANKING ACT, 2015

JUNE 2023
EASTERN CARIBBEAN CENTRAL BANK

TABLE OF CONTENTS
ABBREVIATIONS ........................................................................................................................... 2
1 Commencement .......................................................................................................................... 3
2 Interpretation .............................................................................................................................. 3
3 Objective ...................................................................................................................................... 5
4 Application ................................................................................................................................... 5
5 Overview of the Standard ........................................................................................................... 5
6 COMPONENTS OF MARKET RISK MANAGEMENT FRAMEWORK ................................. 6
6.1 Allocation of positions to the Trading Book ......................................................................... 7
6.2 Governance Structure ............................................................................................................. 8
6.3 MARKET RISK LIMIT SRUCTURE .................................................................................... 13
6.4 INDEPENDENT RISK REVIEW ......................................................................................... 13
6.5 MARKET RISK IDENTIFICATION AND MEASUREMENT ........................................... 14
6.6 MARKET RISK MANAGEMENT SYSTEM (MIS) ............................................................. 15
7 OUTSOURCING/USE OF EXTERNAL INVESTMENT MANAGERS ................................. 18
8 INTERNAL AND EXTERNAL AUDIT .................................................................................... 18
9 REGULATORY REPORTING .................................................................................................. 19

Abbreviations
ECCB Eastern Caribbean Central Bank
ECCU Eastern Caribbean Currency Union
ICAAP Internal Capital Adequacy Assessment Process LFI Licensed financial institution MIS Management information system ECD Eastern Caribbean Dollar USD United States Dollar

PRUDENTIAL STANDARD FOR MARKET RISK MANAGEMENT FOR FINANCIAL INSTITUTIONS LICENSED UNDER THE BANKING ACT, 2015 This Standard is issued by the Eastern Caribbean Central Bank (Central Bank), in exercise of the powers conferred on it by Section 184 of the Banking Act, 20151 (hereinafter referred to as the Act). 1 COMMENCEMENT This Standard shall come into effect on 2 August 2023. 2 INTERPRETATION This section of the Standard employs the interpretation established in the Act. However, the following terms are defined for purpose of this standard:
a. Banking Book consists of positions in financial instruments that are expected to be held to maturity. They are not included in the bank’s trading book and are subject to credit risk capital requirements. b. Financial Instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. A financial asset is any asset that is cash, the right to receive cash or another financial asset or a commodity, or an equity instrument. A financial liability is the contractual obligation to deliver cash or another financial asset or a commodity. Financial instruments include primary financial instruments (or cash instruments) and derivative financial instruments:
i. Primary (cash) instruments are financial instruments whose value is
determined directly by the markets. They can be divided into securities, which can be readily transferable, and other cash instruments such as loans and deposits, where both borrower and lender have to agree on a transfer; and
ii. Derivative instruments are financial instruments which derive their
value from the value and characteristics of one or more underlying assets.
c. Foreign Exchange Risk is the current or prospective risk that a financial
institution will suffer losses due to adverse movements in foreign exchange

Anguilla Banking Act No 6 of 2015 (183), as amended.

rates2. The potential for loss arises from the process of revaluing foreign currency positions on both on- and off- balance sheet items. d. Interest Rate Risk is the current or prospective risk of loss resulting from changes in interest rates for items in the trading book. Excessive interest rate risk can pose a significant threat to an institution’s earnings and capital base. Changes in interest rates affect an institution’s earnings by changing its net interest income and the level of other interest sensitive income and operating expenses. Changes in interest rates thus can have adverse effects both on an institution’s earnings, capital and its economic value. e. Long Position of the holder or buyer of a security or other instrument, is a position that is expected to appreciate in value when market prices increase. f. Market Risk is defined as the risk of losses in on and off-balance sheet positions arising from movements in market prices of the following instruments:
i. Interest rate related instruments held in the trading book and
equities in the trading book; and
ii. Foreign exchange risk and commodities risk throughout the licensed
financial institutions (LFIs/licensees). g. Marking-to-market is at least the daily valuation of positions at readily available close out prices that are sourced independently. Examples of readily close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers. h. Short Position is a position whereby an investor incurs rights and obligations that mirror the characteristics of another counterparty's asset position, or a position that appreciates in value when the underlying market price decreases.
i. Trading Book consists of positions in financial instruments held either
with trading intent (short-term resale, profiting from short-term price movements, locking in arbitrage profits) or in order to hedge other elements of the trading book. Trading book items will be accounted for as fair value through profit and loss under the International Financial Reporting Standards (IFRS). To be eligible for the trading book, positions should be frequently and accurately valued, and the portfolio should be actively managed.

2 Given the peg between the EC dollar (ECD) and the USD, the USD currency is not currently considered to create market risk in the ECCU.

j. Trading Desk is a group of traders or trading accounts in a business line within a bank that follows defined trading strategies with the goal of generating revenues or maintaining market presence from assuming and managing risk. 3 OBJECTIVE This Standard is intended to:
a. Outline the key principles and establish minimum standards and requirements for the management of market risk by LFIs; and b. Provide guidance to enhance the effectiveness of the governance, systems and processes adopted by LFIs to manage market risk. The Central Bank expects an LFI’s market risk management framework to reflect the elements of this Standard3 and be commensurate with the size, nature and complexity of its operations, risk appetite, risk profile, capital strength and market risk exposures. 4 APPLICATION This Standard applies to all applicable LFIs. In addition, these LFIs shall conduct their affairs in conformity with other applicable legal requirements. By issuing this Standard, the Central Bank aims to strengthen the overall framework for the management of market risk. 5 OVERVIEW OF THE STANDARD Market risk is the risk of losses in on and off-balance sheet positions arising from movements in market prices. The main sub-categories of market risk to which LFIs in the Eastern Caribbean Currency Union (ECCU) are exposed are non- United States Dollar (USD) denominated foreign exchange4 and equity price risk. This standard provides LFIs with guidance on key principles of, and sound practices for market risk management. The development and implementation of a framework for market risk management is extremely important for ensuring the safety and soundness of an LFI. Therefore, the LFI’s board of directors5 (Board)

3 LFIs should also refer to relevant publications such as those issued by the Basel Committee on Banking Supervision (BCBS) for further guidance, where appropriate, on supervisory expectations relating to market risk management. These include BCBS’ “Principles for the Management and Supervision of Interest Rate Risk” (July 2004) and subsequent or other relevant publications that may be issued from time to time. 4 The market risk section of the Basel II/III Capital Standard deals with the Central Bank’s treatment of exposures in United States dollar. 5 Any reference to the Board also includes the Board’s designated committee with responsibility for market risk management, where applicable.

and management are responsible for taking the initiative to develop and implement such a framework. The LFI’s consideration of market risk should capture all risk factors that it is exposed to, and it must manage these risks soundly. The LFI should also take into account the general market and macroeconomic conditions in which it operates in its assessment and management of risks and its loss absorbing capacity. It should ensure that its risk processes and capital levels are adequate for countering the impact of potential stress developments, including significant deterioration of market liquidity conditions, which may emanate from its operating environment. All LFIs are required to comply with the Central Bank’s Prudential Standard for the Internal Capital Adequacy Assessment Process (ICAAP) and Prudential Standard for Capital Measurement for LFIs Licensed under the Banking Act, 2015 /Basel II/III Capital Definition and Pillar I Framework (Capital Standard)6 and any other applicable prudential standard(s). 6 COMPONENTS OF MARKET RISK MANAGEMENT FRAMEWORK LFIs should establish a sound and comprehensive market risk management framework. This should, inter alia comprise the following:
a. Processes for allocation of positions to the trading book; b. An effective governance structure including guidelines and other parameters used to govern risk-taking;
c. A market risk limit structure that is appropriate and consistent with the
LFI’s risk appetite, risk profile and capital strength, and which is communicated regularly to, and understood by relevant staff and external third parties; d. An independent market risk review function; e. Adequate systems and procedures and effective controls related to the use of methods including models to identify, measure and monitor market risk; f. Appropriate MIS for accurate and timely identification, aggregation, monitoring, controlling and reporting of market risk, to the Board and senior management; g. Market risk stress testing including assessment of sensitivity to key assumptions and parameters should form an essential component of an LFI’s market risk management process; and

6 For the time being, the ICAAP Prudential Standard and the Capital Standard do not apply to non-bank financial institutions. The Central Bank will advise accordingly.

h. Prudent valuation practices and valuation policies, including policies and processes for determining the fair value of assets and liabilities. An LFI should incorporate, to the fullest extent possible, its market risk management process into its overall risk management system. This would enable the LFI to understand and manage its risks more effectively on an enterprise wide basis. Where the LFI is part of a financial group, the risk management process should also be integrated with the group’s overall risk management system, where practicable. The risk management system should be commensurate with the scope, size and complexity of an LFI’s trading and other financial activities and the level of market risk assumed. It should also enable the various market risk exposures to be accurately and adequately identified, measured, monitored and controlled. All significant risks should be measured and aggregated on an institution-wide basis. Limits for market risk that are consistent with the maximum exposures should be authorised by the Board and monitored by senior management.
6.1 ALLOCATION OF POSITIONS TO THE TRADING BOOK
All LFIs on-boarding market risk are required to allocate their trading positions to the trading book7. A trading book consists of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book. Positions held with trading intent are those held intentionally for short-term resale and/or with the intent of benefiting from actual or expected short-term price movements or to lock in arbitrage profits. Positions that are in the trading book should be actively managed by the trading desks and all trading book instruments must be fair valued daily and their valuation change recognised in the profit and loss account LFIs are required to have clearly defined policies and procedures for determining which exposures to include in, and to exclude from the trading book for purposes of: calculating their regulatory capital, to ensure compliance with the criteria for trading book and taking into account the bank’s risk management capabilities and practices. The policies and procedures for determining inclusion and exclusion from the trading book, should, at a minimum, address the following considerations:
a. The activities the bank considers to be trading and as constituting part of the trading book for regulatory capital purposes; b. The extent to which an exposure can be marked-to-market daily by reference to an active liquid two-way market;
c. The extent to which valuations for the exposure can be validated externally
in a consistent manner;

7 Market risk includes commodities and foreign exchange in both the trading and banking books.

d. The extent to which legal restrictions or other operational requirements would impede the bank’s ability to effect an immediate liquidation of the exposure; e. The extent to which the bank can actively risk manage the exposure within its trading operations; and f. The extent to which the bank may transfer risk or exposures between the banking and trading books and criteria for such transfers. LFIs require the Central Bank’s approval to make such transfers after initial classification. The following are the basic requirements for positions eligible to receive trading book capital treatment. a. Clearly documented trading strategy for the position/instrument or portfolios, approved by senior management (which would include expected holding horizon). b. Clearly defined policies and procedures for the active management of the position, which must include:
i. Positions are managed on a trading desk;
ii. Position limits are set and monitored for appropriateness;
iii. Dealers have the autonomy to enter into/manage the position within
agreed limits and according to the agreed strategy;
iv. Positions are marked to market at least daily and when marking to
model the parameters must be assessed on a daily basis;
v. Positions are reported to senior management as an integral part of
the institution’s risk management process; and
vi. Positions are actively monitored with reference to market
information sources (assessment should be made of the market liquidity or the ability to hedge positions or the portfolio risk profiles). This would include assessing the quality and availability of market inputs to the valuation process, level of market turnover, sizes of positions traded in the market, etc.
c. Clearly defined policy and procedures to monitor the positions against the
bank’s trading strategy including the monitoring of turnover and stale positions in the bank’s trading book. 6.2GOVERNANCE STRUCTURE An effective governance framework for market risk management should include the following, at a minimum:
6.2.1 Board of Director’s Oversight
The Board generally provides oversight of market risk management. The Board may establish a committee, consisting of a cross section of members of the Board and senior management to review market risk related matters in greater depth.

The Committee should be issued with documented terms of reference and report to the Board. The Board’s responsibilities include, at a minimum, the following:
a. Approving an appropriate market risk strategy. The market risk strategy is a forward-looking, written definition of risk parameters to be achieved by the LFI. In formulating the strategy, the Board should consider inter alia, the economic /operating environment, the target market, desired portfolio mix, staff capacity8 and technological and organisational infrastructure; b. Reviewing the risk strategy periodically (at least annually) to ensure its adequacy with the level of capital available, market risk management expertise, relevance with changing economic conditions and the LFI’s capability;
c. Ensuring that qualified and competent management is appointed to
administer the market risk management function; d. Approving documented policies and procedures to prudently measure, monitor and control market risk; e. Reviewing at least annually, market risk policies, procedures, controls and reports to ensure continued adequacy, relevance and effectiveness. The reviews should, inter alia, ensure consistency with the Board’s market risk goals, objectives, risk appetite and tolerances, ensure continued relevance and help to identify where updates may be needed based on, for example, deficiencies in the market risk management framework, changes to the business model or risk profile, changes in regulations or accounting standards, changes in technology etc. Reviews should be conducted more frequently where there are proposed changes in business strategy and operations or where there are changes in market conditions that could impact the LFI’s market risk profile; f. Deciding delegation of approval powers for market risk; g. Ensuring through an internal audit/independent review function, adherence to policies, controls and procedures; h. Reviewing periodic reports that are timely and contain detailed information to allow for a clear understanding of the nature and level of the LFI’s overall market risk exposure and performance of the investment portfolio, including:
i. The extent to which these exposures affect enterprise-wide
operations and strategic plans;
ii. How market risk is managed and may affect the LFI’s soundness;

8 Staff should have the requisite technical knowledge and experience, consistent with the nature and scope of the LFI’s activities.

iii. Information on concentration;
iv. Classification of investments;
v. The level of provisioning, delinquent and impaired assets; and
vi. Management action taken or contemplated;
i. Approving proposals for new types of business transactions, whether this
be new products, new types of transactions or entry into new markets prior to implementation; and j. Ensuring that weaknesses and concerns identified via the audit process (internal and external) as well as from the review of the supervisory authority are adequately implemented in a timely manner.
6.2.2 Senior Management
The senior management is responsible for implementing the Board-approved market risk strategy. Senior management responsibilities include the following:
a. Developing and recommending market risk policies and procedures as part of the overall market risk management system for the Board’s approval; b. Disseminating the strategy, policies and procedures to all relevant staff and external third parties employed in functions involving market risk and personnel accountable for compliance with established policies and procedures;
c. Establishing and implementing adequate control functions such as limit
setting, exposure and exception monitoring, reporting, custody and documentation over the market risk function; d. Monitoring the quality of the investment portfolio and ensuring that the portfolio is soundly and conservatively valued, uncollectible investments written off and anticipated losses adequately provided for; a. Ensuring the implementation of an effective and independent review function/internal audit to review and assess market risk management activities; b. Developing and implementing management information systems (MIS) that allow the LFI to adequately manage its market risk;
c. Developing a written analysis of any new types of business transaction,
including new products, types of transactions or entry into new markets for the Board’s approval. This analysis shall include:

d. An assessment of the risk level of the new type of business transactions; e. An assessment of the implications of the processing/execution of this investment for risk management and risk control as well as the risk strategy; and f. Reporting to the Board comprehensively on market risk and the composition and quality of the investment portfolio, at least once per quarter.
6.2.3 Trading Desk
A trading desk is a group of traders or trading accounts that implements a well-defined business strategy operating within a clear risk management structure. The trading desk actively manages the trading book, consistent with the goal of generating revenues or maintaining market presence from assuming and managing market risk. All LFIs active in trading activities are required to establish trading desks9. This requirement only applies to LFIs with trading book exposures that exceed a threshold of 3.0 per cent of total on-balance and off-balance sheet assets10. The LFI must identify key groups and personnel responsible for overseeing the risk-taking activities at the trading desk. The key attributes of a trading desk are as follows:
a. Is a defined group of traders or trading accounts; b. Must have a well-defined and documented business strategy, including an annual budget and regular management information reports;
c. Must have a clear management structure; and
d. Must have clearly define trading limits based on the business strategy of the trading desk and these limits must be reviewed at least annually by senior management.
6.2.4 Market Risk Management Strategy
An LFI should develop a sound and well informed strategy to manage market risk. The strategy should be approved by the Board. Based on the recommendation of senior management, the Board should first determine the level of market risk the LFI is prepared to assume and the possible losses it is willing to bear. This level should be determined, taking into consideration the amount of market risk capital, which has been allocated by the LFI against unexpected losses, among other factors. In setting its market risk strategy, an LFI should consider the following factors:
a. Economic, market and liquidity conditions and their impact on market risk;

9 Currently, eligible LFIs do not require supervisory approval to establish trading desks. Notwithstanding, the Central Bank reserves the right to require an LFI to seek approval to establish a trading desk /to restructure its trading desk, as the case may be. 10 Please refer to the Capital Standard for more information regarding the reporting threshold for market risk.

b. Whether the LFI has the expertise to take positions in specific markets and is able to identify, measure, evaluate, monitor, report and control or mitigate the market risk on a timely basis in those markets; and
c. The LFI’s portfolio mix and the anticipated effects of assuming more
market risk.
NB: LFIs will need authorisation from the Central Bank:
i. To engage in any kind of derivatives including those traded through
institutional exchanges (like futures and options), other than simple forwards on FX and interest rates, FX swaps, currency swaps on interest rates swaps;
ii. Transfer instruments from the trading book to the banking book or vice
versa; and
iii. To take short positions.
LFIs should develop and establish a process whereby any significant changes in the size or scope of its activities would trigger an analysis of the adequacy of capital supporting those activities. LFIs are encouraged to have an internal capital allocation system which meaningfully links identification, monitoring and evaluation of market risks to economic capital. The Board and senior management should periodically review the LFI’s market risk strategy. The review should take into consideration the LFI’s financial performance, market risk capital and recent market developments. The market risk strategy should be effectively communicated to the relevant staff. LFIs should report to the Board deviations from the approved market risk strategy, operating bands and target markets.
6.2.5 Market Risk Management Policy
The market risk management policy reflects the strategy and processes of the LFI, including its approach to control and manage market risk. The market risk policy should be written clearly and comprehensively, communicated to those involved with the management of market risk and reviewed periodically (at least annually) to ensure that it remains effective and relevant, and continues to meet the LFI’s objectives. Taking into account the nature, complexity and level of market risk related businesses, the market risk policy should at a minimum:
a. Include a description of the LFI’s market risk strategy and philosophy; b. Spell out the process by which the Board decides on the maximum market risk the LFI is able to take, as well as the frequency of review of risk limits;

c. Delineate the lines of authority and responsibilities of the Board, senior
management and other personnel/units responsible for managing market risk; d. Establish the processes by which the LFI determines the appropriate levels of capital against unexpected losses in relation to market risk; e. Identify and set guidelines on the market risk control limit structure, delegation of approving authority for market risk control limit setting and limit excesses, capital requirements, and investigation and resolution of irregular or disputed transactions; f. Address the frequency, form and content of Board reporting; g. Address appropriate segregation of duties within the market risk management environment; h. Outline the objectives and elements of the market risk review management function; and
i. Provide for the establishment and implementation of information systems
to record, retain and report accurate market risk related data/information.
6.3 MARKET RISK LIMIT SRUCTURE
Market risk limits for business units should be established in alignment with the established risk appetite approved by the Board. These limits should be approved by the Board and periodically reviewed by senior management. Changes in market conditions or resources of the LFI should prompt a reassessment of limits. The limits should be set with sufficient granularity for effective risk control. For instance, limits for trading desks, portfolios, and dealers by markets, products, instruments and tenors, should be set, where appropriate. Limits should be clearly understood by, and any changes clearly communicated to all relevant parties (both internal and external). Compliance with limits should be monitored by a unit independent of risk-taking activities. An LFI should have procedures prescribing the course of action for limit excesses /breaches. These actions should include investigating the reasons for the excesses /breaches, reporting the incidents to management and seeking approval from the Board or senior management, as appropriate. These procedures should also prescribe the actions required for the approval of temporary excesses and limit increases.
6.4 INDEPENDENT RISK REVIEW
An independent risk management function should be established, with the responsibility for defining risk management policies, setting procedures for market risk identification, measurement and assessment and monitoring the LFI’s

compliance with established policies and market risk limits. It should also ensure that market risk exposures are reported in a timely manner to the Board and senior management. Risk management staff should be separate from and independent of risk-taking staff. 6.5MARKET RISK IDENTIFICATION AND MEASUREMENT Measurement systems may range from simple methods to sophisticated programs and can be internally developed by the LFI or developed by a third party external to the LFI. However, methodologies adopted by the LFI to calculate market risk should be commensurate with the size, complexity, risk profile and available resources of the LFI. LFIs should implement suitable and appropriate measures for all sub-categories of market risk assumed. The broad risk sub-categories are outlined below:
6.5.1 Interest Rate Risk
Interest rate risk in each currency should be calculated separately. An LFI should establish an appropriate interest rate risk measurement system and adequate MIS to identify, measure, monitor and report on a comprehensive basis its exposure to interest rate risks in the trading book.
6.5.2 Equity Risk
The measurement of equity risk should capture the risk exposure to price movements in the overall equity market (e.g. a market index), specific sectors of the equity market (e.g. industry sectors or cyclical and non-cyclical sectors), and individual equity issues where appropriate.
6.5.3 Foreign Exchange Risk
There should be measurement corresponding to individual foreign currencies. The risk arising from changes in value or asset-liability mismatch of these foreign currencies to the domestic currency (excluding the USD) should be captured.
6.5.4 Commodity risk
LFI´s should evaluate their direct or indirect exposure to commodity risk. LFIs should regularly evaluate market risk measurement systems (techniques, methods, models and assumptions) to ensure that they provide reasonable estimates of market risk. Risk measurement systems should be independently validated, back tested and recalibrated when necessary. Validation should include verifying the consistency, timeliness, reliability, independence and completeness of data sources; and the accuracy of valuation and risk factors correlations. A back￾testing programme should also be conducted regularly to verify that the measurement techniques, methods and models are reliable in measuring potential losses over time. The verification should be done at both individual and consolidated levels to ensure that exceptional losses are not concealed in aggregation.

6.6 MARKET RISK MANAGEMENT SYSTEM (MIS)
In measuring and monitoring its market risk, an LFI should use a risk management system that is commensurate with the scale and complexity of its market risk exposure. The system should be capable of measuring current exposures (through mark-to-market or mark-to-model) as well as potential market risks. It should be able to accommodate volume increases, new valuation methodologies and new products. The risk management system should provide information on the outstanding positions and unrealised profit or loss, as well as, to the extent applicable, the accrued profit or loss on a daily basis. This information should be available for audit and investigation purposes. An LFI that is active in trading should have a system that is able to monitor trading positions and market movements on a daily basis. The market risk management system should be capable of conducting exception tracking and reporting in order to ensure that prompt corrective action is taken at the Board or the appropriate level of the LFI’s Senior Management, where appropriate. A screening process should be in place to ensure the integrity of data fed into the risk management system. Data should be appropriate (e.g. marked-to-market for trading activities), accurate, complete (e.g. both on and off-balance sheet positions), timely, frequently updated and sourced independently of the risk￾taking units. There should be sufficient documentation of data sources used. The market risk management system should be capable of producing, typical reports such as market risk exposures by product, market, currency and duration; and exception tracking and compliance with policies, procedures, controls (e.g. limits) and regulatory requirements.
6.7 SCENARIO ANALYSIS AND STRESS TESTING
Stress testing should form an essential component of an LFI’s overall market risk management process. Scenarios for stress testing can be obtained by analysing historical data of changes in market risk factors or by simulating forward-looking scenarios. The objective should be to allow the LFI to assess the effect of changes in market risk factors on its balance sheet position and financial performance. Thus, scenarios should include low probability but high impact events that could produce extraordinary losses. Scenario analysis and stress testing should be both quantitative and qualitative. Scenario analysis and stress testing should, as far as possible, be conducted on an institution-wide basis, taking into account the effects of unusual changes in market and non-market risk factors. Such market risk factors include: prices, interest rates, volatilities, market liquidity, historical correlations and assumptions in stressed market conditions.

One of the main reasons for scenario analysis and stress testing is to enable the Board and senior management to better assess the potential impact of various market related changes on the LFI’s capital position, earnings performance and business strategies. The results of scenario analyses and stress testing, including the major assumptions that underpin them should be regularly reviewed by the Board and senior management. Such results should be considered during the establishment and review of policies, limits and risk management approaches.
6.8 PRUDENT VALUATION PRACTICE

LFIs should have prudent valuations for positions in their trading book. A framework for prudent valuation practices should at a minimum, include the following:
6.8.1 Governance Structures and Control Processes for Fair Valuing
Exposures
LFIs must establish adequate governance structures and control processes for fair valuing exposures for risk management and financial reporting purposes to give management and the Central Bank the confidence that their valuation estimates are prudent and reliable. The valuation governance structures and related processes should be embedded in the overall governance structure of the LFI, and consistent for both risk management and reporting purposes. This must include:
a. Documented policies and procedures for the process of valuation. This includes clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of the market information and review of their appropriateness, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, end of month and ad-hoc verification procedures; b. In addition, policies and procedures should set forth the range of acceptable practices for the initial pricing, marking-to-market/model, valuation adjustments and periodic independent revaluation; and
c. Clear and independent (i.e. independent of front office) reporting lines for
the function/unit/department accountable for the valuation process. In assessing whether sources of valuation are reliable and relevant, LFIs should consider, among other things:
a. The frequency and availability of the prices/quotes; b. Whether those prices represent actual regularly occurring transactions on an arm's length basis;
c. The breadth of the distribution of the data and whether it is generally
available to the relevant participants in the market; d. The timeliness of the information relative to the frequency of valuations;

e. The number of independent sources that produce the quotes/prices; f. Whether the quotes/prices are supported by actual transactions; g. The maturity of the market; and h. The similarity between the financial instrument sold in a transaction and the instrument held by the LFI.
6.8.2 Valuation Methodologies
6.8.2.1 Marking to Market
LFIs must mark-to-market as much as possible, using the more prudent side of bid/offer. Where values are determined to be in an active market, an LFI should maximise the use of relevant observable inputs and minimise the use of unobservable inputs when estimating fair value using a valuation technique.
6.8.2.2 Marking to Model
When marking to market is not possible, as is the case of the absence of a transparent price from a liquid market, the valuation must rely on models or proxy-pricing methodologies, as well as on expert judgment. The outputs of such models and processes are highly sensitive to the inputs and parameter assumptions adopted, which may themselves be subject to estimation error and uncertainty. Moreover, calibration of the valuation methodologies is often complicated by the lack of readily available benchmarks. LFIs relying on modelling for the purposes of valuation should ensure that the model is validated by a function independent of the relevant risk-taking businesses units. Also, LFIs should establish and maintain policies and processes for considering valuation adjustments for positions that otherwise cannot be prudently valued, including concentrated, less liquid, and stale positions.
6.8.2.3 Independent Price Verification
Independent price verification is the process by which market prices are regularly verified for accuracy. While daily marking-to-market may be performed by dealers, verification of market prices should be performed by a unit independent of the dealing room, at least monthly. Independent price verification need not be performed as frequently as daily mark-to-market. 6.8.3Valuation Adjustments or Reserves LFIs must establish and maintain procedures for considering valuation adjustments/reserves. LFIs using third-party valuations are to consider whether valuation adjustments are necessary. The following valuation adjustments/reserves are to be formally considered at a minimum:
a. Unearned credit spreads; b. Close-out costs;

c. Operational risks;
d. Early termination; e. Investing and funding costs; and f. Future administrative costs. 7 OUTSOURCING/USE OF EXTERNAL INVESTMENT MANAGERS Where investment management is outsourced, in whole or in part to a third party11, the Board and senior management must be satisfied that there are appropriate and effective controls in place. The Board and senior management should ensure that the effects of in-house activities are considered in conjunction with outsourced activities when monitoring exposures to investment areas and counterparties. The LFI should execute a formal written agreement with the investment manager inclusive of a clear investment mandate outlining the parameters within which the investment manager may operate. It should be tailored to take into consideration:
a. Legislative constraints; b. Investment limits set by the LFI;
c. Priorities and strategic goals;
d. Benchmarks; e. Acceptable levels of risk and, more generally; and f. The LFI’s specific circumstances. Apart from any specific limits, the parameters need to strike an appropriate balance between risk and reward, taking into account the nature of the LFI’s liabilities and where appropriate the interests and reasonable expectations of its stakeholders. The LFI should monitor the activities of the investment manager to ensure that its investment strategy and other areas of the agreement are strictly adhered to. The reporting by investment managers should be sufficient to enable an LFI to assess whether their operations are in line with the LFI’s strategy and in particular, whether it meets the LFI’s risk-reward criteria. The reporting should also allow the LFI to ascertain if it is in compliance with relevant regulatory requirements. 8 INTERNAL AND EXTERNAL AUDIT There is a need for both internal and external audit functions to assume a more relevant and active role in the assessment of market risk; given the necessity of accurately measuring the capital impact of market risk activities on the financial viability of LFIs. The following are some of the basic supervisory expectations regarding the roles of internal and external audit as it relates to market risk:
a. At a minimum, there should be annual independent review of the market risk management framework. However, the frequency of review should

11 This includes other entities within the financial group.

depend on factors such as: the internal risk rating, the volatility of the operating environment and market conditions. b. The scope of the review should be clearly documented, defined by the audit staff and approved by the Board or the audit committee of the Board, as appropriate;
c. The breadth and depth of the reviews should be proportionate to the LFI’s
market risk profile and activities; d. LFIs should ensure that persons conducting the audit possess the requisite knowledge, skills, experience and are adequately resourced to competently assess the market risk management framework; e. LFIs should ensure independence of audit personnel from those involved in the development and operation of the market risk framework; f. Where the review of the market risk management framework is outsourced, the Board and senior management should ensure that the reviews meets the expectations of the supervisory authority and are sufficiently robust; g. Findings should be reviewed with appropriate investment officers, department managers and senior management. Management’s responses to all noted deficiencies and identified weaknesses should include existing or planned corrective actions and timeframes for correction. In subsequent review, the audit function should follow up on whether the proposed corrective measures were implemented by management; and h. Working papers for the audit should be maintained and filed for future use whether by the LFI or external agents such as Regulators. The audit function should report directly to the Board or its designated committee 9 REGULATORY REPORTING On a quarterly basis, LFIs to which the Central Bank’s Basel II/III capital framework applies, will report a capital charge for market risk in accordance with the Capital Standard, using the relevant prudential return. All other LFIs are expected to prudently establish capital buffers commensurate with their level of exposure to market risk. All LFIs should have critical information available for review by the Central Bank, upon request. This includes but is not limited to the following:
a. Market risk reports (including internal audit and compliance reports) submitted to the Board and senior management; b. Evidence of systems in place to ensure:
i. The ongoing management of market risk;

ii. Compliance with the regulatory capital requirements for market risk on
a daily basis including the monitoring of daily losses/gains on trading positions compared against the previous day’s capital requirements;
iii. The investments in the trading book are accounted as fair value through
profit and loss; and
iv. The tracking of the liquidity of each investment including the
availability of prices, the negotiation volume, the quantity of new prices at various frequencies (e.g. per month) and theoretical models used (if any), to generate prices in the event that prices are unavailable.
c. A qualitative description of the trading desk including: who is in charge of
the trading desk and/or management of market risk within the institution, internal controls, limits, existing policies and processes, internal audit of these, et cetera.