Explanations :

(1) All the on-balance sheet items are assigned percentage weights as per degree of credit risk. The value of each asset/item is to be multiplied by the relevant risk weight to arrive at risk adjusted value of the asset, as detailed below. The aggregate of the Risk Weighted Assets will be taken into account for reckoning the minimum capital ratio.

(bi) Interest Rate Contracts

For the Interest Rate related contracts, which generally are - interest rate swaps, forward rate agreements, basis swaps, interest rate futures, interest rate options and other contracts of similar nature, the methodology for capital charge calculation will be as under :

Market risk is defined as the risk of losses in on and off – balance sheet positions arising from movements in market prices. The objective in introducing the capital adequacy for market risk is to provide an explicit capital cushion for the price risk to which the PDs are predominantly exposed in their portfolio.

Internationally there are two methods for working out the capital charge for market risks viz : (i) the standardised model and (ii) the internal risk management based model – subject to fulfillment of certain conditions.

As the risk management systems at the PDs are still evolving, it is considered appropriate that PDs calculate capital charges based on the standardised method as also under the internal risk management framework based (VaR) model, the minimum parameters for which are indicated elsewhere in this Note, and maintain the higher of the two requirements.

In case the capital charges are already being maintained as per the risk based model and work out to be higher than as per the standardised method, such PDs should not scale down or modify the model. Permitting maintenance of capital charges based exclusively on the risk based model will be considered after the PDs gain sufficient experience in this regard.

The methodology for working out the capital charges for market risk on the portfolio are detailed in Annexure – 1(a) (Fixed Income instruments - as per the Standardised method), Annexure – 1(b) (Fixed Income instruments - as per the internal risk model [VaR] based method, Annexure – 2 (on Equity Positions) and Annexure – 3 (on Interest Rate Contracts).

The capital adequacy requirements for the PDs will comprise

@ the credit risk requirements as indicated in Section : A, plus

@ the capital charge for market risk requirements as arrived at under Section:B Annexure-1(a) or (b), Annexures-2 and 3.

• Every Primary Dealer shall maintain a minimum capital ratio consisting of Tier I and Tier II Capital which shall not be less than fifteen per cent of its aggregate risk weighted assets and of risk adjusted value of off-balance sheet items.
• The total of Tier II Capital, if any, shall not exceed one hundred per cent of Tier I Capital, at any point of time.
• The total of Tier III Capital, if any, shall not exceed two hundred and fifty per cent of the Tier I and Tier II Capital available for meeting market risk capital charge i.e. excess over the credit and counter party risk capital requirements.
• In working out the eligible capital, the PDs are required to first calculate their minimum capital requirements for credit risk and only afterwards the capital charge towards market risk requirements. The total capital funds will represent the capital available to meet both the credit as also the market risks.
• The overall capital adequacy ratio will be calculated by establishing an explicit numerical link between the credit risk and the market risk factors, by multiplying the market risk capital charge with 6.67 i.e. the reciprocal of the minimum credit risk capital charge of 15 %. The resultant figure is added to the sum of risk weighted assets worked out for credit risk purpose. The numerator for calculating the overall ratio will be the PD’s Tier I , Tier II and the Tier III Capital after head room deductions, if any. Illustratively, the calculation of capital charge would be as under :

Though generally choice between two principal methods of measuring the risk is permitted under the standardised method, the " duration’’ method is considered more appropriate for the PDs as compared to the method based on residual maturity. The capital charge under this method is the sum of four components :

1. the net short or long position in the whole trading book;
2. a small proportion of the matched positions in each time-band (the "vertical disallowance’’);
3. a larger proportion of the matched positions across different time-bands (the "horizontal disallowance’’) ;
4. a net charge for positions in options, where appropriate

Note : Since blank short selling in the cash position is not allowed, netting as indicated at (a) and the system of `disallowances’ as at (b) and (c) above are applicable currently only to the PDs entering into FRAs/IRSs.

Separate duration ladders should be used and capital charges summed up with no offsetting between positions of opposite sign, in case such a situation exists.

After mapping all the positions, individual net positions are to be summed within each time band irrespective of whether they are long or short positions, to produce a gross position figure.

Under the duration method, PDs with the necessary capability may, with RBI’s permission use a more accurate method of measuring all of their general market risks by calculating the price sensitivity of each position separately. PDs must elect and use the method on a continuous basis and the system adopted will be subjected to monitoring by RBI. The mechanics of this method are as follows:

The gross positions in each time-band will be subject to risk weighting as per the assumed change in yield set out in Table 2, with no further offsets.

The PDs should calculate the capital requirement based on their internal Value at Risk model for market risk, as per the following minimum parameters :

1. "Value-at-risk" must be computed on a daily basis.
2. In calculating the value-at-risk, a 99^th percentile, one-tailed confidence interval is to be used.
3. An instantaneous price shock equivalent to a 30-day movement in prices is to be used, i.e. the minimum "holding period" will be thirty trading days.
4. The choice of historical observation period (sample period) for calculating value-at-risk will be constrained to a minimum length of one year and not less than 250 trading days. For PDs who use a weighting scheme or other methods for the historical observation period, the "effective" observation period must be at least one year (that is, the weighted average time lag of the individual observations cannot be less than 6 months).
5. The capital requirement will be the higher of (i) the previous day's value-at-risk number measured according to the above parameters specified in this section and (ii) the average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by a multiplication factor prescribed by RBI (3.30 presently).
6. No particular type of model is prescribed. So long as the model used captures all the material risks run by the PDs, they will be free to use models, based for example, on variance-covariance matrices, historical simulations, or Monte Carlo simulations etc.

Annexure - 2

(b) Equity positions

This section sets out a minimum capital standard to cover the risk of holding or taking positions in equities by the PDs. It applies to long and short positions in all instruments that exhibit market behavior similar to equities, but not to non-convertible preference shares (which will be covered by the interest rate risk requirements described in Section B). Long and short positions in the same issue may be reported on a net basis. The instruments covered include equity shares, convertible securities that behave like equities, and commitments to buy or sell equity securities.

As with debt securities, the minimum capital standard for equities is expressed in terms of two separately calculated charges for the "credit risk’’ and for the "general market risk’’ of holding a position in equity as indicated in Sections A and B. For the purposes of market risk, the equity holdings should be included in the duration ladder with the maximum sensitivity i.e. below 1 month.

The measurement system should include all interest rate derivatives and off-balance-sheet instruments in the portfolio, which react to changes in interest rates, [viz. forward rate agreements (FRAs), interest rate swaps (IRS)]. A summary of the rules for dealing with interest rate derivatives is set out below.

The derivatives should be converted into positions in the relevant underlying and become subject to market risk charges as described above. The amounts reported should be the market value of the principal amount of the underlying or of the notional underlying.

These instruments are treated as a combination of a long and a short position in a notional Government security. The maturity of a future or a FRA will be the period until delivery or exercise of the contract, plus – where applicable – the life of the underlying instrument. For example, a long position in a June three-month interest rate future (taken in April) is to be reported as a long position in a Government security with a maturity of five months and a short position in a Government security with a maturity of two months. Where a range of deliverable instruments may be delivered to fulfil the contract, the PD has flexibility to elect which deliverable security goes into the duration ladder.

Swaps will be treated as two notional positions in Government securities with relevant maturities. For example, an interest rate swap under which a PD is receiving floating rate interest and paying fixed will be treated as a long position in a floating rate instrument of maturity equivalent to the period until the next interest fixing and a short position in a fixed-rate instrument of maturity equivalent to the residual life of the swap. For swaps that pay or receive a fixed or floating interest rate against some other reference price, the interest rate and the reference rate components should be slotted into the appropriate repricing duration category, relevant for that component.

PDs may exclude from the interest rate maturity framework, long and short positions (both actual and notional) in identical instruments with exactly the same issuer, coupon, currency and maturity. In addition, opposite positions in the same category of instruments can in certain circumstances be regarded as matched and allowed to offset fully. To qualify for this treatment the positions must relate to the same underlying instruments, and be of the same nominal value. In addition, for Swaps and FRAs: the reference rate (for floating rate positions) must be identical and the coupon closely matched (i.e. within 15 basis points); and the next interest fixing date or, for fixed coupon positions, the residual maturity must correspond within the following limits:

. less than one month hence: same day;

. between one month and one year hence: within seven days;

. over one year hence: within thirty days.

PDs with large swap books may use alternative formulae for these swaps to calculate the positions to be included in the duration ladder. One method would be to first convert the payments required by the swap into their present values. For that purpose, each payment should be discounted using/building zero coupon yields, and a single net figure for the present value of the cash flows entered into the appropriate time-band using procedures that apply to zero (or low) coupon bonds; these figures should be slotted into the general market risk framework as set out earlier. Another method would be to calculate the sensitivity of the net present value implied by the change in yield used in the duration method and allocate these sensitivities into the time-bands set out in Table 1 to Annexure – 1(a).

Attachment I

Criteria for Tier – III Capital

The principal form of eligible capital to cover market risk consists of shareholders’ and retained earnings (Tier I Capital) and supplementary capital (Tier II Capital) as defined in the Note. But PDs may also employ a third tier of capital ("Tier III"), consisting of short-term subordinated debt as defined in paragraph 2 below for the sole purpose of meeting a portion of the capital requirements for market risks, subject to the following conditions:

• PDs will be entitled to use Tier III Capital solely to support market risks as defined in Section B. This means that any capital requirement arising in respect of credit and counter party risk, including the credit counter party risk in respect of derivatives etc. in terms of Section A (b) of the Note, need to be met by the Tier I and II Capital only;
• Tier III Capital will be limited to 250% of a PD’s Tier I Capital that is required to support market risks i.e. surplus after meeting the credit and counter party risk capital requirements;
• in case a PD is having surplus Tier II Capital elements, they may be substituted for Tier III up to the same limit of 250% subject to the limitations that - eligible Tier II Capital may not exceed total Tier I Capital, and long-term subordinated debt may not exceed 50% of Tier I Capital (long-term subordinated debt with a minimum original term to maturity of over five years will continue to be part of Tier II Capital);
• the sum total of Tier II plus Tier III Capital should not exceed total Tier I Capital.

2. For short-term subordinated debt to be eligible as Tier III Capital, it needs, if circumstances demand, to be capable of becoming part of PD’s permanent capital and that be available to absorb losses in the event of insolvency. It must, therefore, at a minimum;

• be unsecured, subordinated and fully paid up;
• have an original maturity of at least two years;
• not be repayable before the agreed repayment date unless the RBI agrees;
• be subject to a lock-in clause that neither interest nor principal may be paid (even at maturity) if such payment means that the PD falls below or remains below its minimum capital requirement.

3. In calculating eligible capital, it will be necessary first to calculate the PD’s minimum capital requirement for credit risk, and only afterwards its market risk requirement, to establish how much Tier I and Tier II Capital is available to support market risk. Tier III Capital will be regarded as eligible only if it can be used to support market risks under the conditions set out in paragraphs 1 and 2 above. Excess, as unused but eligible Tier III Capital, which is not at present supporting market risks, may be reported separately.

• the PD's risk management system is conceptually sound and its implementation is certified by external auditors;
• the PD has, in the RBI’s view, sufficient numbers of staff skilled in the use of sophisticated models not only in the trading area but also in the risk control, audit, and back office areas;
• the PD has, in the RBI’s judgement, a proven track record of reasonable accuracy in measuring risk (back testing);
• the PD regularly conducted stress tests along the lines discussed in Para B.4 below