Prudential Regulation Authority Rulebook

1.

By way of derogation from point (b) of Article 92(3), institutions may calculate the own funds requirement for their trading book business in accordance with paragraph 2 of this Article, provided that the size of the institutions' on- and off-balance-sheet trading book business is equal to or less than both of the following thresholds on the basis of an assessment carried out on a monthly basis using the data as of the last day of the month:

1. (a) 5% of the institution's total assets;
2. (b) GBP 44 million.

2.

Where both conditions set out in points (a) and (b) of paragraph 1 are met, institutions may calculate the own funds requirement for their trading book business as follows:

1. (a) for the contracts listed in point 1 of Annex II of the CRR, contracts relating to equities which are referred to in point 3 of that Annex and credit derivatives, institutions may exempt those positions from the own funds requirement referred to in point (b) of Article 92(3);
2. (b) for trading book positions other than those referred to in point (a) of this paragraph, institutions may replace the own funds requirement referred to in point (b) of Article 92(3) with the requirement calculated in accordance with point (a) of Article 92(3).

3.

Institutions shall calculate the size of their on- and off-balance-sheet trading book business on the basis of data as of the last day of each month for the purposes of paragraph 1 in accordance with the following requirements:

1. (a) all the positions assigned to the trading book in accordance with Article 104 shall be included in the calculation except for the following:
1. (i) positions concerning foreign exchange and commodities;
2. (ii) positions in credit derivatives that are recognised as internal hedges against non- trading book credit risk exposures or counterparty risk exposures and the credit derivative transactions that perfectly offset the market risk of those internal hedges as referred to in Article 106(3);
2. (b) all positions included in the calculation in accordance with point (a) shall be valued at their market value on that given date; where the market value of a position is not available on a given date, institutions shall take a fair value for the position on that date; where the market value and fair value of a position are not available on a given date, institutions shall take the most recent of the market value or fair value for that position;
3. (c) the absolute value of long positions shall be summed with the absolute value of short positions.

4.

Where both conditions set out in points (a) and (b) of paragraph 1 of this Article are met, irrespective of the obligations set out in provisions implementing Articles 74 and 83 of Directive 2013/36/EU, Article 102(3) and Articles 103 of this Chapter 3 of the Trading Book (CRR) Part of the PRA Rulebook shall not apply to an institution.

5.

Institutions shall notify the competent authorities when they calculate, or cease to calculate, the own funds requirements of their trading-book business in accordance with paragraph 2.

6.

An institution that no longer meets one or more of the conditions set out in paragraph 1 shall immediately notify the competent authority thereof.

7.

An institution shall cease to calculate the own funds requirements of its trading book business in accordance with paragraph 2 within three months of one of the following occurring:

1. (a) the institution does not meet the conditions set out in point (a) or (b) of paragraph 1 for three consecutive months;
2. (b) the institution does not meet the conditions set out in point (a) or (b) of paragraph 1 during more than 6 out of the last 12 months.

8.

Where an institution has ceased to calculate the own funds requirements of its trading book business in accordance with this Article, it shall only be permitted to calculate the own funds requirements of its trading book business in accordance with this Article where it demonstrates to the competent authority that all the conditions set out in paragraph 1 have been met for an uninterrupted full-year period.

[Note: This is a permission under section 144G and 192XC of FSMA to which Part 8 of the Capital Requirements Regulations applies]

9.

Institutions shall not enter into, buy or sell a trading book position for the sole purpose of complying with any of the conditions set out in paragraph 1 during the monthly assessment.

[Note: This rule corresponds to Article 94 of the CRR as it applied immediately before revocation by the Treasury.]

1.

Institutions shall ensure that positions in the trading book shall be either free of restrictions on their tradability or able to be hedged.

2.

Institutions shall ensure that trading intent shall be evidenced on the basis of the strategies, policies and procedures set up by the institution to manage the position or portfolio in accordance with Articles 103, and 104.

3.

Institutions shall establish and maintain systems and controls to manage their trading book in accordance with Article 103.

4.

[Note: Provision left blank]

5.

Institutions shall ensure that positions in the trading book shall be subject to the requirements for prudent valuation specified in Article 105.

6.

Institutions shall treat internal hedges in accordance with Article 106.

[Note: This rule corresponds to Article 102 of the CRR as it applied immediately before revocation by the Treasury.]

1.

Institutions shall have in place clearly defined policies and procedures for the overall management of the trading book. Those policies and procedures shall at least address:

1. (a) the activities which the institution considers to be trading business and as constituting part of the trading book for own funds requirement purposes;
2. (b) the extent to which a position can be marked-to-market daily by reference to an active, liquid two-way market;
3. (c) for positions that are marked-to-model, the extent to which the institution can:
1. (i) identify all material risks of the position;
2. (ii) hedge all material risks of the position with instruments for which an active, liquid two-way market exists;
3. (iii) derive reliable estimates for the key assumptions and parameters used in the model;
4. (d) the extent to which the institution can, and is required to, generate valuations for the position that can be validated externally in a consistent manner;
5. (e) the extent to which legal restrictions or other operational requirements would impede the institution's ability to effect a liquidation or hedge of the position in the short term;
6. (f) the extent to which the institution can, and is required to, actively manage the risks of positions within its trading operation.
7. (g) [Note: Provision left blank]

2.

In managing its positions or portfolios of positions in the trading book, the institution shall comply with all the following requirements:

1. (a) the institution shall have in place a clearly documented trading strategy for the position or portfolios in the trading book, which shall be approved by senior management and include the expected holding period;
2. (b) the institution shall have in place clearly defined policies and procedures for the active management of positions or portfolios in the trading book; those policies and procedures shall include the following:
1. (i) which positions or portfolios of positions may be entered into by each trading desk or, as the case may be, by designated dealers;
2. (ii) the setting of position limits and monitoring them for appropriateness;
3. (iii) ensuring that dealers have the autonomy to enter into and manage the position within agreed limits and according to the approved strategy;
4. (iv) ensuring that positions are reported to senior management as an integral part of the institution's risk management process;
5. (v) ensuring that positions are actively monitored with reference to market information sources and an assessment is made of the marketability or hedgeability of the position or its component risks, including the assessment, the quality and availability of market inputs to the valuation process, level of market turnover, sizes of positions traded in the market;
6. (vi) active anti-fraud procedures and controls;
3. (c) the institution shall have in place clearly defined policies and procedures to monitor the positions against the institution's trading strategy, including the monitoring of turnover and positions for which the originally intended holding period has been exceeded.

[Note: This rule corresponds to Article 103 of the CRR as it applied immediately before revocation by the Treasury.]

1.

Institutions shall have in place clearly defined policies and procedures for determining which position to include in the trading book for the purposes of calculating their capital requirements, in accordance with the requirements set out in Article 102 and the definition of trading book in accordance with point (86) of Article 4(1), taking into account the institution's risk management capabilities and practices. The institution shall fully document its compliance with these policies and procedures and shall subject them to periodic internal audit.

2.

[Note: Provision left blank]

[Note: This rule corresponds to Article 104 of the CRR as it applied immediately before revocation by the Treasury.]

1.

Institutions shall ensure that all trading book positions and non-trading book positions measured at fair value shall be subject to the standards for prudent valuation specified in this Article and in Chapter 4 of the Trading Book (CRR) Part of the PRA Rulebook. Institutions shall in particular ensure that the prudent valuation of their trading book positions achieves an appropriate degree of certainty having regard to the dynamic nature of trading book positions and non-trading book positions measured at fair value, the demands of prudential soundness and the mode of operation and purpose of capital requirements in respect of trading book positions and non-trading book positions measured at fair value.

2.

Institutions shall establish and maintain systems and controls sufficient to provide prudent and reliable valuation estimates. Institutions shall ensure that those systems and controls shall include at least the following elements:

1. (a) documented policies and procedures for the process of valuation, including clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of market information and review of their appropriateness, guidelines for the use of unobservable inputs reflecting the institution's assumptions of what market participants would use in pricing the position, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, month end and ad-hoc verification procedures;
2. (b) reporting lines for the department accountable for the valuation process that are clear and independent of the front office, which shall ultimately be to the management body.

3.

Institutions shall revalue trading book positions at fair value at least on a daily basis. Institutions shall report changes in the value of those positions in the profit and loss account of the institution.

4.

Institutions shall mark their trading book positions and non-trading book positions measured at fair value to market whenever possible, including when applying the relevant capital treatment to those positions.

5.

When marking to market, an institution shall use the more prudent side of bid and offer unless the institution can close out at mid-market. Where institutions make use of this derogation, they shall every six months inform their competent authorities of the positions concerned and furnish evidence that they can close out at mid-market.

6.

Where marking to market is not possible, institutions shall conservatively mark to model their positions and portfolios, including when calculating own funds requirements for positions in the trading book and positions measured at fair value in the non-trading book.

7.

Institutions shall comply with the following requirements when marking to model:

1. (a) senior management shall be aware of the elements of the trading book or of other fair-valued positions which are subject to mark to model and shall understand the materiality of the uncertainty thereby created in the reporting of the risk/performance of the business;
2. (b) institutions shall source market inputs, where possible, in line with market prices, and shall assess the appropriateness of the market inputs of the particular position being valued and the parameters of the model on a frequent basis;
3. (c) where available, institutions shall use valuation methodologies which are accepted market practice for particular financial instruments or commodities;
4. (d) where the model is developed by the institution itself, the institution shall ensure that it is based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process;
5. (e) institutions shall have in place formal change control procedures and shall hold a secure copy of the model and use it periodically to check valuations;
6. (f) risk management shall be aware of the weaknesses of the models used and how best to reflect those in the valuation output; and
7. (g) institutions shall subject their models to periodic review to determine the accuracy of their performance, which shall include assessing the continued appropriateness of assumptions, analysis of profit and loss versus risk factors, and comparison of actual close out values to model outputs.

For the purposes of point (d) of the first subparagraph, institutions shall ensure that the model is developed or approved independently of the trading desks and is independently tested, including validation of the mathematics, assumptions and software implementation.

8.

Institutions shall perform independent price verification in addition to daily marking to market or marking to model. Institutions shall ensure that verification of market prices and model inputs shall be performed by a person or unit independent from persons or units that benefit from the trading book, at least monthly, or more frequently depending on the nature of the market or trading activity. Where independent pricing sources are not available or pricing sources are more subjective, institutions shall take into account that prudent measures such as valuation adjustments may be appropriate.

9.

Institutions shall establish and maintain procedures for considering valuation adjustments.

10.

Institutions shall formally consider the following valuation adjustments: unearned credit spreads, close-out costs, operational risks, market price uncertainty, early termination, investing and funding costs, future administrative costs and, where relevant, model risk.

11.

Institutions shall establish and maintain procedures for calculating an adjustment to the current valuation of any less liquid positions, which can in particular arise from market events or institution-related situations such as concentrated positions and/or positions for which the originally intended holding period has been exceeded. Institutions shall, where necessary, make such adjustments in addition to any changes to the value of the position required for financial reporting purposes and shall design such adjustments to reflect the illiquidity of the position. Under those procedures, institutions shall consider several factors when determining whether a valuation adjustment is necessary for less liquid positions. Those factors include the following:

1. (a) the amount of time it would take to hedge out the position or the risks within the position beyond the liquidity horizons;
2. (b) the volatility and average of bid/offer spreads;
3. (c) the availability of market quotes (number and identity of market makers) and the volatility and average of trading volumes including trading volumes during periods of market stress;
4. (d) market concentrations;
5. (e) the ageing of positions;
6. (f) the extent to which valuation relies on marking-to-model;
7. (g) the impact of other model risks.

12.

When using third party valuations or marking to model, institutions shall consider whether to apply a valuation adjustment. In addition, institutions shall consider the need to establish adjustments for less liquid positions and on an ongoing basis review their continued suitability. Institutions shall also explicitly assess the need for valuation adjustments relating to the uncertainty of parameter inputs used by models.

13.

With regard to complex products, including securitisation exposures and n-th-to-default credit derivatives, institutions shall explicitly assess the need for valuation adjustments to reflect the model risk associated with using a possibly incorrect valuation methodology and the model risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model.

14.

[Note: Provision left blank]

[Note: This rule corresponds to Article 105 of the CRR as it applied immediately before revocation by the Treasury.]

1.

Institutions shall ensure that an internal hedge shall in particular meet the following requirements:

1. (a) it shall not be primarily intended to avoid or reduce own funds requirements;
2. (b) it shall be properly documented and subject to particular internal approval and audit procedures;
3. (c) it shall be dealt with at market conditions;
4. (d) the market risk that is generated by the internal hedge shall be dynamically managed in the trading book within the authorised limits;
5. (e) it shall be carefully monitored in accordance with adequate procedures.

2.

The requirements of paragraph 1 apply without prejudice to the requirements applicable to the hedged position in the non-trading book.

3.

By way of derogation from paragraphs 1 and 2, when an institution hedges a non-trading book credit risk exposure or counterparty risk exposure using a credit derivative booked in its trading book using an internal hedge, institutions shall ensure that the non-trading book exposure or counterparty risk exposure shall not be deemed to be hedged for the purposes of calculating risk-weighted exposure amounts unless the institution purchases from an eligible third party protection provider a corresponding credit derivative meeting the requirements for unfunded credit protection in the non-trading book. Without prejudice to point (h) of Article 299(2), where such third party protection is purchased and recognised as a hedge of a non-trading book exposure for the purposes of calculating capital requirements, institutions shall ensure that neither the internal nor external credit derivative hedge shall be included in the trading book for the purposes of calculating capital requirements.

[Note: This rule corresponds to Article 106 of the CRR as it applied immediately before revocation by the Treasury.]