MORNBFI Vol. 1 - Planters Development Bank

APP. Q-4308.12.315. Procedures to be used to measure,monitor, and control the risks of theproposed product or activity.C. Appropriate risk measurementmethodologies, limits structure,monitoring, and management informationsystemMarket risk measurement models/methodologiesIt is essential that FIs have market riskmeasurement systems that capture allmaterial sources of market risk and thatassess the effect of changes in market riskfactors in ways that are consistent with thescope of their activities. Depending uponthe size, complexity, and nature ofactivities that give rise to market risk, theability to capture all material sources ofmarket risk in a timely manner mayrequire an FI’s market risk measurementsystem to be interfaced with other systems,such as the treasury system or loan system.The assumptions underlying themeasurement system should be clearlyunderstood by risk managers and seniormanagement.Market risk measurement systemsshould:1. Assess all material market riskassociated with an FI’s assets, liabilities,and off-balance sheet positions;2. Utilize generally acceptedfinancial concepts and risk measurementtechniques; and3. Have well-documented assumptionsand parameters.There are a number of methods/techniques for measuring market risks.Complexity ranges from simple marking-tomarketor valuation techniques to moreadvanced static simulations using currentholdings to highly sophisticated dynamicmodeling techniques that reflect potentialfuture business activities. In designingmarket risk measurement systems, FIsshould ensure that the degree of detailregarding the nature of their positions iscommensurate with the complexity andrisk inherent in those positions.At a minimum, smaller non-complex FIsshould have the ability to mark-to-market orrevalue their investment portfolio andconstruct a simple re-pricing gap. Whenusing gap analysis, the precision of interestrate risk measurement depends in part onthe number of time bands into whichpositions are aggregated. Clearly,aggregation of positions/cash flows into broadtime bands implies some loss of precision.In addition, the use of reasonable and validassumptions is important for a measurementsystem to be precise. In practice, the FI mustassess the significance of the potential lossof precision in determining the extent ofaggregation and simplification to be built intothe measurement approach. Assumptionsand limitations of the measurementapproach, such as the loss of precision,should be documented.On the other hand, banks holding anexpanded derivatives license and FIsengaging in options or structured productswith embedded options cannot capture allmaterial sources of market risk by usingstatic models such as the re-pricing gap.These FIs should have interest rate riskmeasurement systems that assess theeffects of rate changes on both earningsand economic value. These systemsshould provide meaningful measures of anFI’s current levels of interest rate riskexposure, and should be capable ofidentifying any excessive exposures thatmight arise. Pricing models and simulationtechniques will probably be required.There is also a question on the extentto which market risk should be viewed ona whole institution basis or whether thetrading book, which is marked to market,and the accrual book, which is often not,should be treated separately. As a generalrule, it is desirable for any measurementManual of Regulations for Non-Bank Financial InstitutionsQ RegulationsAppendix Q-43 - Page 9