Capital Adequacy Requirements (CAR) (2024) - Chapter 8 – Credit Valuation Adjustment (CVA) Risk

Information

Publication type

Guideline

Note

For institutions with a fiscal year ending October 31 or December 31, respectively.

The Capital Adequacy Requirements (CAR) for banks, banks holding companies, and trust and loan companies, collectively referred to as 'institutions', are set out in nine chapters, each of which has been issued as a separate document. This document, Chapter 8 – Credit Valuation Adjustment (CVA) Risk, should be read in conjunction with the other CAR chapters. The complete list of CAR chapters is as follows:

Chapter 1 - Overview
Chapter 2 - Definition of Capital
Chapter 3 - Operational Risk
Chapter 4 - Credit Risk - Standardized Approach
Chapter 5 - Credit Risk - Internal Ratings-Based Approach
Chapter 6 - Securitization
Chapter 7 - Settlement and Counterparty Risk
Chapter 8 - Credit Valuation Adjustment (CVA) Risk
Chapter 9 - Market Risk

Please refer to OSFI's Corporate Governance Guideline for OSFI's expectations of institution Boards of Directors in regard to the management of capital and liquidity.

Chapter 8 – Credit Valuation Adjustment (CVA) Risk

8.1 Definitions and application

Institutions that are required to determine market risk capital requirements for trading book positions (see Chapter 9) must meet the requirements of this chapter. The risk-weighted assets for credit value adjustment risk are determined by multiplying the capital requirements calculated as set out in this chapter by 12.5. [Basel Framework, MAR 50.1]
In the context of this document, CVA stands for credit valuation adjustment specified at a counterparty level. CVA reflects the adjustment of default risk-free prices of derivatives and securities financing transactions (SFTs) due to a potential default of the counterparty. [Basel Framework, MAR 50.2]
Unless explicitly specified otherwise, the term CVA in this document means regulatory CVA. Regulatory CVA may differ from CVA used for accounting purposes as follows:
1. regulatory CVA excludes the effect of the institution's own default; and
2. several constraints reflecting best practice in accounting CVA are imposed on calculations of regulatory CVA. [Basel Framework, MAR 50.3]
CVA risk is defined as the risk of losses arising from changing CVA values in response to changes in counterparty credit spreads and market risk factors that drive prices of derivative transactions and SFTs. [Basel Framework, MAR 50.4]
The capital requirements for CVA risk must be calculated by all institutions involved in covered transactions in both banking book and trading book. Covered transactions include:
1. all derivatives except those transacted directly with a qualified central counterparty and except those transactions meeting the conditions of paragraph 181 to paragraph 183 of Chapter 7; and
2. SFTs that are fair-valued by an institution for accounting purposes, if OSFI determines that the institution's CVA loss exposures arising from SFT transactions are material. In case the institution deems the exposures immaterial, the institution must justify its assessment to OSFI by providing relevant supporting documentation.
For the purpose of CVA capital requirement, SFTs that are fair-valued for accounting purposes and for which an institution records zero for CVA reserves for accounting purposes are included in the scope of covered transactions if the CVA risk of those SFTs is deemed material as described in the above sub-paragraph (2).

[Basel Framework, MAR 50.5]
The CVA risk capital requirements are calculated for an institution's "CVA portfolio" on a standalone basis. The CVA portfolio includes CVA for an institution's entire portfolio of covered transactions and eligible CVA hedges. [Basel Framework, MAR 50.6]
Two approaches are available for calculating CVA capital requirements: the standardized approach (SA-CVA) and the basic approach (BA-CVA). Institutions must use the BA-CVA unless they receive approval from OSFI to use the SA-CVA.^{Footnote 1} [Basel Framework, MAR 50.7]
Institutions that have received approval of OSFI to use the SA-CVA may carve out from the SA-CVA calculations any number of netting sets. CVA capital requirements for all carved-out netting sets must be calculated using the BA-CVA. When applying the carve-out, a legal netting set may also be split into two synthetic netting sets, one containing the carved-out transactions subject to the BA-CVA and the other subject to the SA-CVA, subject to one or both of the following conditions:
1. the split is consistent with the treatment of the legal netting set used by the institution for calculating accounting CVA (e.g. where certain transactions are not processed by the front office/accounting exposure model); or
2. OSFI approval to use the SA-CVA is limited and does not cover all transactions within a legal netting set.
[Basel Framework, MAR 50.8]
Institutions that are below the materiality threshold specified in subsection (1) may opt not to calculate its CVA capital requirements using the SA-CVA or BA-CVA and instead choose an alternative treatment.
1. Any institution whose aggregate notional amount of non-centrally cleared derivatives is less than or equal to 100 billion euro is deemed as being below the materiality threshold.
2. Any institution below the materiality threshold may choose to set its CVA capital requirement equal to 100% of the institution's capital requirement for counterparty credit risk (CCR).
3. CVA hedges are not recognized under this treatment.
4. If chosen, this treatment must be applied to the institution's entire portfolio instead of the BA-CVA or the SA-CVA.
5. OSFI, however, can remove this option if it determines that CVA risk resulting from the institution's derivative positions materially contributes to the institution's overall risk.
[Basel Framework, MAR 50.9]
Eligibility criteria for CVA hedges are specified in paragraph 17 to paragraph 19 for the BA-CVA and in paragraph 37 to paragraph 39 for the SA-CVA. [Basel Framework, MAR 50.10]
CVA hedging instruments can be external (i.e. with an external counterparty) or internal (i.e. with one of the institution's trading desks).
1. All external CVA hedges (including both eligible and ineligible external CVA hedges) that are covered transactions must be included in the CVA calculation of the counterparty providing to the hedge.
2. All eligible external CVA hedges must be excluded from an institution's market risk capital requirement calculations under Chapter 9.
3. Ineligible external CVA hedges are treated as trading book instruments and are capitalized under Chapter 9.
4. An internal CVA hedge involves two perfectly offsetting positions: one of the CVA desk and the opposite position of the trading desk:
  1. If an internal CVA hedge is ineligible, both positions belong to the trading book where they cancel each other, so there is no impact on either the CVA portfolio or the trading book.
  2. If an internal CVA hedge is eligible, the CVA desk's position is part of the CVA portfolio where it is capitalized as set out in this chapter, while the trading desk's position is part of the trading book where it is capitalized as set out in Chapter 9.
5. If an internal CVA hedge involves an instrument that is subject to curvature risk, default risk charge or the residual risk add-on under the standardized approach as set out in Chapter 9, it can be eligible only if the trading desk that is the CVA desk's internal counterparty executes a transaction with an external counterparty that exactly offsets the trading desk's position with the CVA desk.
[Basel Framework, MAR 50.11]
Institutions that use the BA-CVA or the SA-CVA for calculating CVA capital requirements may cap the maturity adjustment factor at 1 for all netting sets contributing to CVA capital requirements when they calculate CCR capital requirements under the Internal Ratings Based (IRB) approach. [Basel Framework, MAR 50.12]

8.2 Basic approach for credit valuation adjustment risk

The BA-CVA calculations may be performed either via the reduced version or the full version. An institution under the BA-CVA approach can choose whether to implement the full version or the reduced version at its discretion. However, all institutions using the BA-CVA must calculate the reduced version of BA-CVA capital requirements as the reduced BA-CVA is also part of the full BA-CVA capital calculations as a conservative means to limit hedging recognition. Institutions under the BA-CVA approach must capitalize any market risk hedges of accounting CVA according to Chapter 9, Market Risk.
1. The full version recognizes counterparty credit spread hedges and is intended for institutions that hedge CVA risk.
2. The reduced version eliminates the element of hedging recognition from the full version. The reduced version is designed to simplify BA-CVA implementation for less sophisticated institutions that do not hedge CVA.
[Basel Framework, MAR 50.13]

8.2.1 Reduced version of the BA-CVA (hedges are not recognized)

The capital requirements for CVA risk under the reduced version of the BA-CVA (DS_BA-CVA× K_reduced, where the discount scalar DS_BA-CVA = 0.65) are calculated as follows (where the summations are taken over all counterparties that are within scope of the CVA charge), where:
1. SCVA_c is the CVA capital requirement that counterparty c would receive if considered on a stand-alone basis (referred to as "stand-alone CVA capital" – see the paragraph below for its calculation);
2. The supervisory correlation parameter is ρ = 50%. Its square, ρ²=25%, represents the correlation between credit spreads of any two counterparties.^{Footnote 2} In the formula below, the effect of ρ is to recognize the fact that the CVA risk to which an institution is exposed is less than the sum of the CVA risk for each counterparty, given that the credit spreads of counterparties are typically not perfectly correlated; and
3. The first term under the square root in the formula below aggregates the systematic components of CVA risk, and the second term under the square root aggregates the idiosyncratic components of CVA risk.
  
  $K_{reduced} = \sqrt{{(ρ \cdot \sum_{c} {SCVA}_{C})}^{2} + (1 - ρ^{2}) \cdot \sum_{c} {SCVA}_{C}^{2}}$
[Basel Framework, MAR 50.14]
The stand-alone CVA capital requirements for counterparty c that are used in the formula in the paragraph above (SCVAc) are calculated as follows (where the summation is across all netting sets with the counterparty), where:
1. RW_c is the risk weight for counterparty c that reflects the volatility of its credit spread. These risk weights are based on a combination of sector and credit quality of the counterparty as prescribed in the paragraph below.
2. M_NS is the effective maturity for the netting set NS. For institutions that have OSFI's approval to use the IMM, M_NS is calculated as per paragraphs 35 and 36 of Chapter 7, with the exception that the five-year cap in paragraph 35 is not applied. For institutions that do not have OSFI approval to use the IMM, M_NS is calculated according to paragraph 132 to paragraph 140 of Chapter 5, with the exception that the five-year cap in paragraph 132 of Chapter 5 is not applied.
3. EAD_NS is the exposure at default (EAD) of the netting set NS, calculated in the same way as the institution calculates it for minimum capital requirements for CCR.
4. DF_NS is a supervisory discount factor. It is 1 for institutions using the IMM to calculate EAD, and is $\frac{1 - e^{{- 0.05 \cdot M}_{N S}}}{{0.05 \cdot M}_{N S}}$ for institutions not using the IMM.^{Footnote 3}
5. α = 1.4.^{Footnote 4}
  
  ${SCVA}_{C} = \frac{1}{α} \cdot {RW}_{C} \cdot \sum_{NS} M_{NS} \cdot {EAD}_{NS} \cdot {DF}_{NS}$
[Basel Framework, MAR 50.15]

The supervisory risk weights (RW_c) are given in Table 1. Credit quality is specified as either investment grade (IG), high yield (HY), or not rated (NR). Where there are no external ratings or where external ratings are not recognized within a jurisdiction, institutions may, subject to OSFI's approval, map the internal rating to an external rating and assign a risk weight corresponding to either IG or HY.^{Footnote 5} Otherwise, the risk weights corresponding to NR is to be applied.

Table 1 Supervisory risk weights, RW_C
Sector of counterparty	Credit quality of counterparty
Sector of counterparty	IG	HY and NR
Sovereigns including central banks and multilateral development banks	0.5%	2.0%
Local government, government-backed non-financials, education and public administration	1.0%	4.0%
Financials including government-backed financials	5.0%	12.0%
Basic materials, energy, industrials, agriculture, manufacturing, mining and quarrying	3.0%	7.0%
Consumer goods and services, transportation and storage, administrative and support service activities	3.0%	8.5%
Technology, telecommunications	2.0%	5.5%
Health care, utilities, professional and technical activities	1.5%	5.0%
Other sector	5.0%	12.0%

[Basel Framework, MAR 50.16]

8.2.2 Full version of the BA-CVA (hedges are recognized)

As set out in paragraph 13 the full version of the BA-CVA recognizes the effect of counterparty credit spread hedges. Only transactions used for the purpose of mitigating the counterparty credit spread component of CVA risk, and managed as such, can be eligible hedges. [Basel Framework, MAR 50.17]
Only single-name credit default swaps (CDS), single-name contingent CDS, risk participation agreements and index CDS can be eligible CVA hedges. [Basel Framework, MAR 50.18]
Eligible single-name credit instruments must:
1. reference the counterparty directly; or
2. reference an entity legally related to the counterparty, where legally related refers to cases where the reference name and the counterparty are either a parent and its subsidiary or two subsidiaries of a common parent; or
3. reference an entity that belongs to the same sector and region as the counterparty. [Basel Framework, MAR 50.19]
Institutions that intend to use the full version of BA-CVA must calculate the reduced version (K_reduced) as well. Under the full version, capital requirements for CVA risk DS_BA-CVA × K_full is calculated as follows, where DS_BA-CVA = 0.65, and β=0.25 is the supervisory parameter that is used to provide a floor that limits the extent to which hedging can reduce the capital requirements for CVA risk:

$K_{full} = β \cdot K_{reduced} + (1 - β) \cdot K_{hedged}$

[Basel Framework, MAR 50.20]
The part of capital requirements that recognizes eligible hedges (K_hedged) is calculated as follows (where the summations are taken over all counterparties c that are within scope of the CVA charge), where:
1. Both the stand-alone CVA capital (SCVA_C) and the correlation parameter (ρ) are defined in exactly the same way as for the reduced version calculation of the BA-CVA.
2. SNHC is a quantity that gives recognition to the reduction in CVA risk of the counterparty c arising from the institution's use of single-name hedges of credit spread risk. See paragraph 23 for its calculation.
3. IH is a quantity that gives recognition to the reduction in CVA risk across all counterparties arising from the institution's use of index hedges. See paragraph 24 for its calculation.
4. HMAC is a quantity characterizing hedging misalignment, which is designed to limit the extent to which indirect hedges can reduce capital requirements given that they will not fully offset movements in a counterparty's credit spread. That is, with indirect hedges present, K_hedged cannot reach zero. See paragraph 25 for its calculation.
  
  $K_{hedged} = \sqrt{{(ρ \cdot \sum_{C} ({SCVA}_{C} - {SNH}_{C}) - IH)}^{2} + {(1 - ρ^{2}) \cdot \sum_{C} ({SCVA}_{C} - {SNH}_{C})}^{2} + \sum_{C} {HMA}_{C}}$
[Basel Framework, MAR 50.21]
The formula for K_hedged in the paragraph above comprises three main terms as below:
1. The first term ${(ρ \cdot \sum_{C} ({SCVA}_{C} - {SNH}_{C}) - IH)}^{2}$ aggregates the systematic components of CVA risk arising from the institution's counterparties, the single-name hedges and the index hedges.
2. The second term ${(1 - ρ^{2}) \cdot \sum_{C} ({SCVA}_{C} - {SNH}_{C})}^{2}$ aggregates the idiosyncratic components of CVA risk arising from the institution's counterparties and the single-name hedges.
3. The third term $\sum_{C} {HMA}_{C}$ aggregates the components of indirect hedges that are not aligned with counterparties' credit spreads.
[Basel Framework, MAR 50.22]
The quantity SNH_c is calculated as follows (where the summation is across all single name hedges h that the institution has taken out to hedge the CVA risk of counterparty c), where:
1. r_hc is the supervisory prescribed correlation between the credit spread of counterparty c and the credit spread of a single-name hedge h of counterparty c. The value of r_hc is set out in the Table 2 of paragraph 26. It is set at 100% if the hedge directly references the counterparty c, and set at lower values if it does not.
2. $M_{h}^{S N}$ is the remaining maturity of single-name hedge h.
3. $B_{h}^{S N}$ is the notional of single-name hedge h. For single-name contingent CDS, the notional is determined by the current market value of the reference portfolio or instrument.
4. ${D F}_{h}^{S N}$ is the supervisory discount factor calculated as $\frac{1 - e^{{- 0.05 \cdot M}_{h}^{S N}}}{{0.05 \cdot M}_{h}^{S N}}$
5. RW_h is the supervisory risk weight of single-name hedge h that reflects the volatility of the credit spread of the reference name of the hedging instrument. These risk weights are based on a combination of the sector and the credit quality of the reference name of the hedging instrument as prescribed in Table 1 of paragraph 16.
  
  ${SNH}_{c} = \sum_{h \in c} r_{h c} \cdot {R W}_{h} \cdot M_{h}^{S N} \cdot B_{h}^{S N} \cdot {D F}_{h}^{S N}$
[Basel Framework, MAR 50.23]
The quantity IH is calculated as follows (where the summation is across all index hedges i that the institution has taken out to hedge CVA risk), where:
1. $M_{i}^{ind}$ is the remaining maturity of index hedge i.
2. $B_{i}^{ind}$ is the notional of the index hedge i.
3. ${DF}_{i}^{ind}$ is the supervisory discount factor calculated as $\frac{1 - e^{{- 0.05 \cdot M}_{i}^{i n d}}}{{0.05 \cdot M}_{i}^{i n d}}$
4. ${RW}_{i}$ is the supervisory risk weight of the index hedge i. ${RW}_{i}$ is taken from the Table 1 of paragraph 16 based on the sector and the credit quality of the index constituents and adjusted as follows:
  1. For an index where all index constituents belong to the same sector and are of the same credit quality, the relevant value in the Table 1 of paragraph 16 is multiplied by 0.7 to account for diversification of idiosyncratic risk within the index.
  2. For an index spanning multiple sectors or with a mixture of investment grade constituents and other grade constituents, the name-weighted average of the risk weights from the Table 1 of paragraph 16 should be calculated and then multiplied by 0.7.
    
    $IH = \sum_{i} {RW}_{i} \cdot M_{i}^{ind} \cdot B_{i}^{ind} \cdot {DF}_{i}^{ind}$
[Basel Framework, MAR 50.24]
The quantity HMA_C is calculated as follows (where the summation is across all single name hedges h that have been taken out to hedge the CVA risk of counterparty c), where $r_{h c}, M_{h}^{SN}, B_{h}^{SN}, {DF}_{h}^{SN}$ and RW_h have the same definitions as set out in [MAR50.23].

${HMA}_{c} = \sum_{h \in c} (1 - r_{h c}^{2}) \cdot {({RW}_{h} \cdot M_{h}^{SN} \cdot B_{h}^{SN} \cdot {DF}_{h}^{SN})}^{2}$

[Basel Framework, MAR 50.25]

The supervisory prescribed correlations rhc between the credit spread of counterparty c and the credit spread of its single-name hedge h are set in Table 2 as follows:

Table 2 Correlations between credit spread of counterparty and single-name hedge
Single-name hedge h of counterparty c	Value of r_hc
References counterparty c directly	100%
Has legal relation with counterparty c	80%
Shares sector and region with counterparty c	50%

[Basel Framework, MAR 50.26]

8.3 Standardized approach for credit valuation adjustment risk

The SA-CVA is an adaptation of the standardized approach for market risk set out in Chapter 9. The primary differences of the SA-CVA from the standardized approach for market risk are:
1. the SA-CVA features a reduced granularity of market risk factors; and
2. the SA-CVA does not include default risk and curvature risk.
[Basel Framework, MAR 50.27]
Under the SA-CVA, capital requirements must be calculated and reported to OSFI at a monthly frequency. In addition, institutions using the SA-CVA must have the ability to produce SA-CVA capital requirement calculations at the request of OSFI and must accordingly provide the calculations. [Basel Framework, MAR 50.28]
The SA-CVA uses as inputs the sensitivities of regulatory CVA to counterparty credit spreads and market risk factors driving the values of covered transactions. Sensitivities must be computed by institutions in accordance with the prudent valuation standards set out in Chapter 9. [Basel Framework, MAR 50.29]
For an institution to be considered eligible for the use of SA-CVA by OSFI as set out in paragraph 7, the institution must meet the following criteria at the minimum.
1. An institution must be able to model exposure and calculate, on at least a monthly basis, CVA and CVA sensitivities to the market risk factors specified in paragraph 54 to paragraph 77.
2. An institution must have a CVA desk (or a similar dedicated function) responsible for risk management and hedging of CVA.
[Basel Framework, MAR 50.30]

8.3.1 Regulatory CVA calculations

An institution must calculate regulatory CVA for each counterparty with which it has at least one covered position for the purpose of the CVA risk capital requirements. [Basel Framework, MAR 50.31]
Regulatory CVA at a counterparty level must be calculated according to the following principles. An institution must demonstrate its compliance to the principles to OSFI.
1. Regulatory CVA must be calculated as the expectation of future losses resulting from default of the counterparty under the assumption that the institution itself is free from the default risk. In expressing the regulatory CVA, non-zero losses must have a positive sign. This is reflected in paragraph 52 where ${W S}_{k}^{h d g}$ must be subtracted from ${WS}_{k}^{CVA}$ .
2. The calculation must be based on at least the following three sets of inputs:
  1. term structure of market-implied probability of default (PD);
  2. market-consensus expected loss-given-default (ELGD);
  3. simulated paths of discounted future exposure.
3. The term structure of market-implied PD must be estimated from credit spreads observed in the markets. For counterparties whose credit is not actively traded (ie illiquid counterparties), the market-implied PD must be estimated from proxy credit spreads estimated for these counterparties according to the following requirements:
  1. An institution must estimate the credit spread curves of illiquid counterparties from credit spreads observed in the markets of the counterparty's liquid peers via an algorithm that discriminates on at least the following three variables: a measure of credit quality (e.g. rating), industry, and region.
  2. In certain cases, mapping an illiquid counterparty to a single liquid reference name can be allowed. A typical example would be mapping a municipality to its home country (i.e. setting the municipality credit spread equal to the sovereign credit spread plus a premium). An institution must justify to OSFI each case of mapping an illiquid counterparty to a single liquid reference name.
  3. When no credit spreads of any of the counterparty's peers is available due to the counterparty's specific type (e.g. project finance, funds), an institution is allowed to use a more fundamental analysis of credit risk to proxy the spread of an illiquid counterparty. However, where historical PDs are used as part of this assessment, the resulting spread cannot be based on historical PD only – it must relate to credit markets.
4. The market-consensus ELGD value must be the same as the one used to calculate the risk-neutral PD from credit spreads unless the institution can demonstrate that the seniority of the exposure resulting from covered positions differs from the seniority of senior unsecured bonds.^{Footnote 6} Collateral provided by the counterparty does not change the seniority of the exposure.
5. The simulated paths of discounted future exposure are produced by pricing all derivative transactions with the counterparty along simulated paths of relevant market risk factors and discounting the prices to today using risk-free interest rates along the path.
6. All market risk factors material for the transactions with a counterparty must be simulated as stochastic processes for an appropriate number of paths defined on an appropriate set of future time points extending to the maturity of the longest transaction.
7. For transactions with a significant level of dependence between exposure and the counterparty's credit quality, this dependence should be taken into account.
8. For margined counterparties, collateral is permitted to be recognized as a risk mitigant under the following conditions:
  1. Collateral management requirements outlined in paragraph 56 and 57 of Chapter 7 are satisfied.
  2. All documentation used in collateralized transactions must be binding on all parties and legally enforceable in all relevant jurisdictions. Institutions must have conducted sufficient legal review to verify this and have a well founded legal basis to reach this conclusion, and undertake such further review as necessary to ensure continuing enforceability.
9. For margined counterparties, the simulated paths of discounted future exposure must capture the effects of margining collateral that is recognized as a risk mitigant along each exposure path. All the relevant contractual features such as the nature of the margin agreement (unilateral vs bilateral), the frequency of margin calls, the type of collateral, thresholds, independent amounts, initial margins and minimum transfer amounts must be appropriately captured by the exposure model. To determine collateral available to an institution at a given exposure measurement time point, the exposure model must assume that the counterparty will not post or return any collateral within a certain time period immediately prior to that time point. The assumed value of this time period, known as the margin period of risk (MPoR), cannot be less than a supervisory floor. For SFTs and client cleared transactions as specified in paragraph 179 of Chapter 7 the supervisory floor for the MPoR is equal to 4+N business days, where N is the re-margining period specified in the margin agreement (in particular, for margin agreements with daily or intra-daily exchange of margin, the minimum MPoR is 5 business days). For all other transactions, the supervisory floor for the MPoR is equal to 9+N business days.
[Basel Framework, MAR 50.32]
The simulated paths of discounted future exposure are obtained via the exposure models used by an institution for calculating front office/accounting CVA, adjusted (if needed) to meet the requirements imposed for regulatory CVA calculation. Model calibration process (with the exception of the MPoR), market and transaction data used for regulatory CVA calculation must be the same as the ones used for accounting CVA calculation. [Basel Framework, MAR 50.33]
The generation of market risk factor paths underlying the exposure models must satisfy and an institution must demonstrate to OSFI its compliance to the following requirements:
1. Drifts of risk factors must be consistent with a risk-neutral probability measure. Historical calibration of drifts is not allowed.
2. The volatilities and correlations of market risk factors must be calibrated to market data whenever sufficient data exist in a given market. Otherwise, historical calibration is permissible.
3. The distribution of modelled risk factors must account for the possible non-normality of the distribution of exposures, including the existence of leptokurtosis ("fat tails"), where appropriate.
[Basel Framework, MAR 50.34]
Netting recognition is the same as in the accounting CVA calculations used by the institution. In particular, netting uncertainty can be modelled. [Basel Framework, MAR 50.35]
An institution must satisfy and demonstrate to OSFI its compliance to the following requirements:
1. Exposure models used for calculating regulatory CVA must be part of a CVA risk management framework that includes the identification, measurement, management, approval and internal reporting of CVA risk. An institution must have a credible track record in using these exposure models for calculating CVA and CVA sensitivities to market risk factors.
2. Senior management should be actively involved in the risk control process and must regard CVA risk control as an essential aspect of the business to which significant resources need to be devoted.
3. An institution must have a process in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the exposure system used for accounting CVA calculations.
4. An institution must have an independent control unit that is responsible for the effective initial and ongoing validation of the exposure models. This unit must be independent from business credit and trading units (including the CVA desk), must be adequately staffed and must report directly to senior management of the institution.
5. An institution must document the process for initial and ongoing validation of its exposure models to a level of detail that would enable a third party to understand how the models operate, their limitations, and their key assumptions; and recreate the analysis. This documentation must set out the minimum frequency with which ongoing validation will be conducted as well as other circumstances (such as a sudden change in market behaviour) under which additional validation should be conducted. In addition, the documentation must describe how the validation is conducted with respect to data flows and portfolios, what analyses are used and how representative counterparty portfolios are constructed.
6. The pricing models used to calculate exposure for a given path of market risk factors must be tested against appropriate independent benchmarks for a wide range of market states as part of the initial and ongoing model validation process. Pricing models for options must account for the non-linearity of option value with respect to market risk factors.
7. An independent review of the overall CVA risk management process should be carried out regularly in the institution's own internal auditing process. This review should include both the activities of the CVA desk and of the independent risk control unit.
8. An institution must define criteria on which to assess the exposure models and their inputs and have a written policy in place to describe the process to assess the performance of exposure models and remedy unacceptable performance.
9. Exposure models must capture transaction-specific information in order to aggregate exposures at the level of the netting set. An institution must verify that transactions are assigned to the appropriate netting set within the model.
10. Exposure models must reflect transaction terms and specifications in a timely, complete, and conservative fashion. The terms and specifications must reside in a secure database that is subject to formal and periodic audit. The transmission of transaction terms and specifications data to the exposure model must also be subject to internal audit, and formal reconciliation processes must be in place between the internal model and source data systems to verify on an ongoing basis that transaction terms and specifications are being reflected in the exposure system correctly or at least conservatively.
11. The current and historical market data must be acquired independently of the lines of business and be compliant with accounting. They must be fed into the exposure models in a timely and complete fashion, and maintained in a secure database subject to formal and periodic audit. An institution must also have a well-developed data integrity process to handle the data of erroneous and/or anomalous observations. In the case where an exposure model relies on proxy market data, an institution must set internal policies to identify suitable proxies and the institution must demonstrate empirically on an ongoing basis that the proxy provides a conservative representation of the underlying risk under adverse market conditions.
[Basel Framework, MAR 50.36]

8.3.2 Eligible hedges

Only whole transactions that are used for the purpose of mitigating CVA risk, and managed as such, can be eligible hedges. Transactions cannot be split into several effective transactions. [Basel Framework, MAR 50.37]
Eligible hedges can include:
1. instruments that hedge variability of the counterparty credit spread; and
2. instruments that hedge variability of the exposure component of CVA risk.
[Basel Framework, MAR 50.38]
Instruments that are not eligible for the internal models approach for market risk under Chapter 9 (e.g. tranched credit derivatives) cannot be eligible CVA hedges.

[Basel Framework, MAR 50.39]

8.3.3 Multiplier

Aggregated capital requirements can be scaled up by the multiplier m_cva [Basel Framework, MAR 50.40]
The multiplier m_cva is set at 1. OSFI may require an institution to use a higher value of m_cva if the supervisor determines that the institution's CVA model risk warrants it (e.g. if the level of model risk for the calculation of CVA sensitivities is too high or the dependence between the institution's exposure to a counterparty and the counterparty's credit quality is not appropriately taken into account in its CVA calculations). [Basel Framework, MAR 50.41]

8.3.4 Calculations

The SA-CVA capital requirements are calculated as the sum of the capital requirements for delta and vega risks calculated for the entire CVA portfolio (including eligible hedges).

[Basel Framework, MAR 50.42]
The capital requirements for delta risk are calculated as the simple sum of delta capital requirements calculated independently for the following six risk classes:
1. interest rate risk;
2. foreign exchange (FX) risk;
3. counterparty credit spread risk;
4. reference credit spread risk (i.e. credit spreads that drive the CVA exposure component);
5. equity risk; and
6. commodity risk.
[Basel Framework, MAR 50.43]
If an instrument is deemed as an eligible hedge for credit spread delta risk, it must be assigned in its entirety (see paragraph 37) either to the counterparty credit spread or to the reference credit spread risk class. Instruments must not be split between the two risk classes. [Basel Framework, MAR 50.44]
The capital requirements for vega risk are calculated as the simple sum of vega capital requirements calculated independently for the following five risk classes. Note there here are no vega capital requirements for counterparty credit spread risk.
1. interest rate risk;
2. FX risk;
3. reference credit spread risk;
4. equity risk; and
5. commodity risk.
[Basel Framework, MAR 50.45]
Delta and vega capital requirements are calculated in the same manner using the same procedures set out in paragraph 47 to paragraph 53. [Basel Framework, MAR 50.46]
For each risk class, (i) the sensitivity of the aggregate CVA, $s_{k}^{C V A}$ , and (ii) the sensitivity of the market value of all eligible hedging instruments in the CVA portfolio, $s_{k}^{H d g}$ , to each risk factor k in the risk class are calculated. The sensitivities are defined as the ratio of the change of the value in question (i.e. (i) aggregate CVA or (ii) market value of all CVA hedges) caused by a small change of the risk factor's current value to the size of the change. Specific definitions for each risk class are set out in paragraph 54 to paragraph 77. These definitions include specific values of changes or shifts in risk factors. However, an institution may use smaller or larger values of risk factor shifts if doing so is consistent with internal risk management calculations.

An institution may use algorithmic techniques, such as adjoint algorithmic differentiation to calculate CVA sensitivities under the SA-CVA if doing so is consistent with the institution's internal risk management calculations and the relevant validation standards described in the SA-CVA framework. [Basel Framework, MAR 50.47]
CVA sensitivities for vega risk are always material and must be calculated regardless of whether or not the portfolio includes options. When CVA sensitivities for vega risk are calculated, the volatility shift must apply to both types of volatilities that appear in exposure models:
1. volatilities used for generating risk factor paths; and
2. volatilities used for pricing options.
[Basel Framework, MAR 50.48]
If a hedging instrument is an index, its sensitivities to all risk factors upon which the value of the index depends must be calculated. The index sensitivity to risk factor k must be calculated by applying the shift of risk factor k to all index constituents that depend on this risk factor and recalculating the changed value of the index. For example, to calculate delta sensitivity of S&P500 to large financial companies, an institution must apply the relevant shift to equity prices of all large financial companies that are constituents of S&P500 and re-compute the index. [Basel Framework, MAR 50.49]
For the following risk classes, an institution may choose to introduce a set of additional risk factors that directly correspond to qualified credit and equity indices. For delta risks, a credit or equity index is qualified if it satisfies liquidity and diversification conditions specified in paragraph 143 of Chapter 9; for vega risks, any credit or equity index is qualified. Under this option, an institution must calculate sensitivities of CVA and the eligible CVA hedges to the qualified index risk factors in addition to sensitivities to the non-index risk factors. Under this option, for a covered transaction or an eligible hedging instrument whose underlying is a qualified index, its contribution to sensitivities to the index constituents is replaced with its contribution to a single sensitivity to the underlying index. For example, for a portfolio consisting only of equity derivatives referencing only qualified equity indices, no calculation of CVA sensitivities to non-index equity risk factors is necessary. If more than 75% of constituents of a qualified index (taking into account the weightings of the constituents) are mapped to the same sector, the entire index must be mapped to that sector and treated as a single-name sensitivity in that bucket. In all other cases, the sensitivity must be mapped to the applicable index bucket.
1. counterparty credit spread risk;
2. reference credit spread risk; and
3. equity risk.
[Basel Framework, MAR 50.50]
The weighted sensitivities ${W S}_{k}^{C V A}$ and ${W S}_{k}^{H d g}$ for each risk factor k are calculated by multiplying the net sensitivities $s_{k}^{C V A}$ and $s_{k}^{H d g}$ , respectively, by the corresponding risk weight RW_k (the risk weights applicable to each risk class are specified in paragraph 54 to paragraph 77). [Basel Framework, MAR 50.51]

${WS}_{k}^{CVA} = {RW}_{k} s_{k}^{CVA}$

${WS}_{k}^{Hdg} = {RW}_{k} s_{k}^{Hdg}$
The net weighted sensitivity of the CVA portfolio s_k to risk factor k is obtained by:

${WS}_{k} = {WS}_{K}^{CVA} - {WS}_{k}^{Hdg}$

Note that the formula in paragraph 52 is set out under the convention that the CVA is positive as specified in paragraph 32. It intends to recognize the risk reducing effect of hedging. For example, when hedging the counterparty credit spread component of CVA risk for a specific counterparty by buying credit protection on the counterparty: if the counterparty's credit spread widens, the CVA (expressed as a positive value) increases resulting in the positive CVA sensitivity to the counterparty credit spread. At the same time, as the value of the hedge from the institution's perspective increases as well (as credit protection becomes more valuable), the sensitivity of the hedge is also positive. The positive weighted sensitivities of the CVA and its hedge offset each other using the formula with the minus sign. If CVA loss had been expressed as a negative value, the minus sign in paragraph 52 would have been replaced by a plus sign. [Basel Framework, MAR 50.52]
For each risk class, the net sensitivities are aggregated as follows:
1. The weighted sensitivities must be aggregated into a capital requirement K_b within each bucket b (the buckets and correlation parameters ρ_kl applicable to each risk class are specified in paragraph 54 to paragraph 77), where R is the hedging disallowance parameter, set at 0.01, that prevents the possibility of recognizing perfect hedging of CVA risk.
  
  $K_{b} = \sqrt{(\sum_{k \in b} {WS}_{k}^{2} + \sum_{k \in b} \sum_{l \in b, l \neq k} ρ_{kl} {WS}_{k} {WS}_{l}) + R \times \sum_{k \in b} ({({WS}_{k}^{Hdg})}^{2})}$
2. Bucket-level capital requirements must then be aggregated across buckets within each risk class (the correlation parameters γ_bc applicable to each risk class are specified in paragraph 54 to paragraph 77). Note that this equation differs from the corresponding aggregation equation for market risk capital requirements in paragraph 116 of Chapter 9, including the multiplier m_CVA.
  
  $K = m_{CVA} \sqrt{\sum_{b} K_{b}^{2} + \sum_{b} \sum_{b≠c} γ_{bc} S_{b} S_{c}}$
3. In calculating K in above (2), S_b is defined as the sum of the weighted sensitivities WS_k for all risk factors k within bucket b, floored by -K_b and capped by K_b, and the S_c is defined in the same way for all risk factors k in bucket c:
  
  $S_{b} = max \{- K_{b}; min (\sum_{k ϵ b} {WS}_{k}; K_{b})\}$
  
  $S_{c} = max \{- K_{c}; min (\sum_{k ϵ c} {WS}_{k}; K_{c})\}$
[Basel Framework, MAR 50.53]

8.3.5 Interest rate buckets, risk factors, sensitivities, risk weights and correlations

For interest rate delta and vega risks, buckets must be set per individual currencies. [Basel Framework, MAR 50.54]
For interest rate delta and vega risks, cross-bucket correlation γ_bc is set at 0.5 for all currency pairs. [Basel Framework, MAR 50.55]

The interest rate delta risk factors for an institution's reporting currency and for the following currencies USD, EUR, GBP, AUD, CAD, SEK or JPY:

The interest rate delta risk factors are the absolute changes of the inflation rate and of the risk-free yields for the following five tenors: 1 year, 2 years, 5 years, 10 years and 30 years.
The sensitivities to the abovementioned risk-free yields are measured by changing the risk-free yield for a given tenor for all curves in a given currency by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001. The sensitivity to the inflation rate is obtained by changing the inflation rate by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001.

The risk weights RW_k are set as follows:

Table 3 Risk weight for interest rate risk factors (specified currencies)
blank	1 year	2 years	5 years	10 years	30 years	Inflation
Risk weight	1.11%	0.93%	0.74%	0.74%	0.74%	1.11%

The correlations between pairs of risk factors ρ_kl are set as follows:

Table 4 Correlations for interest rate risk factors (specified currencies)
Tenor	Tenor
Tenor	1 year	2 years	5 years	10 years	30 years	Inflation
1 year	100%	91%	72%	55%	31%	40%
2 years	n/a	100%	87%	72%	45%	40%
5 years	n/a	n/a	100%	91%	68%	40%
10 years	n/a	n/a	n/a	100%	83%	40%
30 years	n/a	n/a	n/a	n/a	100%	40%
Inflation	n/a	n/a	n/a	n/a	n/a	100%

[Basel Framework, MAR 50.56]

The interest rate delta risk factors for other currencies not specified in paragraph above:
1. The interest rate risk factors are the absolute change of the inflation rate and the parallel shift of the entire risk-free yield curve for a given currency.
2. The sensitivity to the yield curve is measured by applying a parallel shift to all risk-free yield curves in a given currency by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001. The sensitivity to the inflation rate is obtained by changing the inflation rate by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001.
3. The risk weights for both the risk-free yield curve and the inflation rate RW_k are set at 1.58%.
4. The correlations between the risk-free yield curve and the inflation rate ρ_kl are set at 40%.
[Basel Framework, MAR 50.57]
The interest rate vega risk factors for all currencies:
1. The interest rate vega risk factors are a simultaneous relative change of all volatilities for the inflation rate and a simultaneous relative change of all interest rate volatilities for a given currency.
2. The sensitivity to (i) the interest rate volatilities or (ii) inflation rate volatilities is measured by respectively applying a simultaneous shift to (i) all interest rate volatilities or (ii) inflation rate volatilities by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01.
3. The risk weights for both the interest rate volatilities and the inflation rate volatilities RW_k are set to 100%.
4. Correlations between the interest rate volatilities and the inflation rate volatilities ρ_kl are set at 40%.
[Basel Framework, MAR 50.58]

8.3.6 Foreign exchange buckets, risk factors, sensitivities, risk weights and correlations

For FX delta and vega risks, buckets must be set per individual currencies except for an institution's own reporting currency. [Basel Framework, MAR 50.59]
For FX delta and vega risks, the cross-bucket correlation γ_bc is set at 0.6 for all currency pairs. [Basel Framework, MAR 50.60]
The FX delta risk factors for all currencies:
1. The single FX delta risk factor is defined as the relative change of the FX spot rate between a given currency and an institution's reporting currency, where the FX spot rate is the current market price of one unit of another currency expressed in the units of the institution's reporting currency.
2. Sensitivities to FX spot rates are measured by shifting the exchange rate between the institution's reporting currency and another currency (i.e. the value of one unit of another currency expressed in units of the reporting currency) by 1% relative to its current value and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01. For transactions that reference an exchange rate between a pair of non-reporting currencies, the sensitivities to the FX spot rates between the institution's reporting currency and each of the referenced non-reporting currencies must be measured.^{Footnote 7}
3. The risk weights for all exchange rates between the institution's reporting currency and another currency are set at 11%.
[Basel Framework, MAR 50.61]
The FX vega risk factors for all currencies:
1. The single FX vega risk factor is a simultaneous relative change of all volatilities for an exchange rate between an institution's reporting currency and another given currency.
2. The sensitivities to the FX volatilities are measured by simultaneously shifting all volatilities for a given foreign-domestic exchange rate between the institution's reporting or base currency and another currency by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01. For transactions that reference an exchange rate between a pair of non-reporting foreign-foreign currencies, the volatilities of the FX spot rates are shifted according to the representation of the foreign-foreign exchange rate volatility via two foreign-domestic (or base) exchange rate volatilities and the relevant implied correlation (the latter is assumed to be fixed).
3. The risk weights for FX volatilities RW_k are set to 100%.
[Basel Framework, MAR 50.62]

8.3.7 Counterparty credit spread buckets, risk factors, sensitivities, risk weights and correlations

Counterparty credit spread risk is not subject to vega risk capital requirements. Buckets for delta risk are set as follows:

Buckets 1 to 7 are defined for factors that are not qualified indices as set out in paragraph 50 ;
Bucket 8 is set for the optional treatment of qualified indices. Under the optional treatment, only instruments that reference qualified indices can be assigned to bucket 8, while all single-name and all non-qualified index hedges must be assigned to buckets 1 to 7 for calculations of CVA sensitivities and sensitivities. For any instrument referencing an index assigned to buckets 1 to 7, the look-through approach must be used (i.e. sensitivity of the hedge to each index constituent must be calculated).

Table 5 Buckets for counterparty credit spread delta risk
Bucket number	Sector
1	a) Sovereigns including central banks, multilateral development banks
1	b) Local government, government-backed non-financials, education and public administration
2	Financials including government-backed financials
3	Basic materials, energy, industrials, agriculture, manufacturing, mining and quarrying
4	Consumer goods and services, transportation and storage, administrative and support service activities
5	Technology, telecommunications
6	Health care, utilities, professional and technical activities
7	Other sector
8	Qualified Indices

[Basel Framework, MAR 50.63]

For counterparty credit spread delta risk, the cross-bucket correlations γ_bc are set as follows:

Table 6 Cross-bucket correlations for counterparty credit spread delta risk
Bucket	Bucket
Bucket	1	2	3	4	5	6	7	8
1	100%	10%	20%	25%	20%	15%	0%	45%
2	n/a	100%	5%	15%	20%	5%	0%	45%
3	n/a	n/a	100%	20%	25%	5%	0%	45%
4	n/a	n/a	n/a	100%	25%	5%	0%	45%
5	n/a	n/a	n/a	n/a	100%	5%	0%	45%
6	n/a	n/a	n/a	n/a	n/a	100%	0%	45%
7	n/a	n/a	n/a	n/a	n/a	n/a	100%	0%
8	n/a	n/a	n/a	n/a	n/a	n/a	n/a	100%

[Basel Framework, MAR 50.64]

The counterparty credit spread delta risk factors for a given bucket:

The counterparty credit spread delta risk factors are absolute shifts of credit spreads of individual entities (counterparties and reference names for counterparty credit spread hedges) and qualified indices (if the optional treatment is chosen) for the following tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years.
For each entity and each tenor point, the sensitivities are measured by shifting the relevant credit spread by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001.

The risk weights RW_k are set as follows depending on the entity's bucket, where IG, HY and NR represent "investment grade", "high yield" and "not rated" as specified for the BA-CVA in paragraph 16. The same risk weight for a given bucket and given credit quality applies to all tenors.

Table 7 Risk weights for counterparty credit spread delta risk
blank	1 a)	1 b)	2	3	4	5	6	7	8
blank	Bucket
IG names	0.5%	1.0%	5.0%	3.0%	3.0%	2.0%	1.5%	5.0%	1.5%
HY and NR names	2.0%	4.0%	12.0%	7.0%	8.5%	5.5%	5.0%	12.0%	5.0%

For buckets 1 to 7, the correlation parameter ρ_kl between two weighted sensitivities WS_k and WS_l is calculated as follows, where:
1. ρ_tenor is equal to 100% if the two tenors are the same and 90% otherwise;
2. ρ_name is equal to 100% if the two names are the same, 90% if the two names are distinct, but legally related and 50% otherwise;
3. ρ_quality is equal to 100% if the credit quality of the two names is the same (ie IG and IG or HY/NR and HY/NR) and 80% otherwise.
  
  $ρ_{kl} = ρ_{tenor} \cdot ρ_{name} \cdot ρ_{quality}$
For bucket 8, the correlation parameter ρ_kl between two weighted sensitivities WS_k and WS_l is calculated as follows, where
1. ρ_tenor is equal to 100% if the two tenors are the same and 90% otherwise;
2. ρ_name is equal to 100% if the two indices are the same and of the same series, 90% if the two indices are the same, but of distinct series, and 80% otherwise;
3. ρ_quality is equal to 100% if the credit quality of the two indices is the same (ie IG and IG or HY and HY) and 80% otherwise.
  
  $ρ_{kl} = ρ_{tenor} \cdot ρ_{name} \cdot ρ_{quality}$
[Basel Framework, MAR 50.65]

8.3.8 Reference credit spread buckets, risk factors, sensitivities, risk weights and correlations

Table 8 Buckets for reference credit spread risk
Bucket number	Credit quality	Sector
1	IG	Sovereigns including central banks, multilateral development banks
2	IG	Local government, government-backed non-financials, education and public administration
3	IG	Financials including government-backed financials
4	IG	Basic materials, energy, industrials, agriculture, manufacturing, mining and quarrying
5	IG	Consumer goods and services, transportation and storage, administrative and support service activities
6	IG	Technology, telecommunications
7	IG	Health care, utilities, professional and technical activities
8	HY and NR	Sovereigns including central banks, multilateral development banks
9	HY and NR	Local government, government-backed non-financials, education and public administration
10	HY and NR	Financials including government-backed financials
11	HY and NR	Basic materials, energy, industrials, agriculture, manufacturing, mining and quarrying
12	HY and NR	Consumer goods and services, transportation and storage, administrative and support service activities
13	HY and NR	Technology, telecommunications
14	HY and NR	Health care, utilities, professional and technical activities
15	(Not applicable)	Other sector
16	IG	Qualified Indices
17	HY	Qualified Indices

[Basel Framework, MAR 50.66]

For reference credit spread delta and vega risks, the cross-bucket correlations γ_bc are set as follows:

The cross-bucket correlations γ_bc between buckets of the same credit quality (i.e. either IG or HY/NR) are set as follows:

Table 9 Cross-bucket correlations for reference credit spread risk
Bucket	Bucket
Bucket	1/8	2/9	3/10	4/11	5/12	6/13	7/14	15	16	17
1/8	100%	75%	10%	20%	25%	20%	15%	0%	45%	45%
2/9	n/a	100%	5%	15%	20%	15%	10%	0%	45%	45%
3/10	n/a	n/a	100%	5%	15%	20%	5%	0%	45%	45%
4/11	n/a	n/a	n/a	100%	20%	25%	5%	0%	45%	45%
5/12	n/a	n/a	n/a	n/a	100%	25%	5%	0%	45%	45%
6/13	n/a	n/a	n/a	n/a	n/a	100%	5%	0%	45%	45%
7/14	n/a	n/a	n/a	n/a	n/a	n/a	100%	0%	45%	45%
15	n/a	n/a	n/a	n/a	n/a	n/a	n/a	100%	0%	0%
16	n/a	n/a	n/a	n/a	n/a	n/a	n/a	n/a	100%	75%
17	n/a	n/a	n/a	n/a	n/a	n/a	n/a	n/a	n/a	100%

For cross-bucket correlations γ_bc between buckets 1 to 14 of different credit quality (ie IG and HY/NR), the correlations γ_bc specified in subsection (1) are divided by 2.

[Basel Framework, MAR 50.67]

Reference credit spread delta risk factors for a given bucket:

The single reference credit spread delta risk factor is a simultaneous absolute shift of the credit spreads of all tenors for all reference names in the bucket.
The sensitivity to reference credit spread delta risk is measured by simultaneously shifting the credit spreads of all tenors for all reference names in the bucket by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001.

The risk weights RW_k are set as follows depending on the reference name's bucket:

Table 10 Risk weights for reference credit spread delta risk
Number	Bucket	Risk weight
1	IG	0.5%
2	IG	1.0%
3	IG	5.0%
4	IG	3.0%
5	IG	3.0%
6	IG	2.0%
7	IG	1.5%
8	IG	2.0%
9	IG	4.0%
10	HY/NR	12.0%
11	HY/NR	7.0%
12	HY/NR	8.5%
13	HY/NR	5.5%
14	HY/NR	5.0%
15	HY/NR	12.0%
16	HY/NR	1.5%
17	HY/NR	5.0%

[Basel Framework, MAR 50.68]

Reference credit spread vega risk factors for a given bucket:
1. The single reference credit spread vega risk factor is a simultaneous relative shift of the volatilities of credit spreads of all tenors for all reference names in the bucket.
2. The sensitivity to the reference credit spread vega risk factor is measured by simultaneously shifting the volatilities of credit spreads of all tenors for all reference names in the bucket by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01.
3. Risk weights for reference credit spread volatilities RW_k are set to 100%.
[Basel Framework, MAR 50.69]

8.3.9 Equity buckets, risk factors, sensitivities, risk weights and correlations

For equity delta and vega risks, buckets are set as follows, where:

Market capitalization ("market cap") is defined as the sum of the market capitalizations of the same legal entity or group of legal entities across all stock markets globally. The reference to "group of legal entities" covers cases where the listed entity is a parent company of a group of legal entities. Under no circumstances should the sum of the market capitalizations of multiple related listed entities be used to determine whether a listed entity is "large market cap" or "small market cap".
"Large market cap" is defined as a market capitalization equal to or greater than CAD 2.5 billion and "small market cap" is defined as a market capitalization of less than CAD 2.5 billion.
The advanced economies are Canada, the United States, Mexico, the euro area, the non-euro area western European countries (the United Kingdom, Norway, Sweden, Denmark and Switzerland), Japan, Oceania (Australia and New Zealand), Singapore and Hong Kong SAR.
To assign a risk exposure to a sector, institutions must rely on a classification that is commonly used in the market for grouping issuers by industry sector. The institution must assign each issuer to one of the sector buckets in the table above and it must assign all issuers from the same industry to the same sector. Risk positions from any issuer that an institution cannot assign to a sector in this fashion must be assigned to the "other sector" (i.e. bucket 11). For multinational multi-sector equity issuers, the allocation to a particular bucket must be done according to the most material region and sector in which the issuer operates.

Table 11 Buckets for equity risk
Bucket number	Size	Region	Sector
1	Large	Emerging market economies	Consumer goods and services, transportation and storage, administrative and support service activities, healthcare, utilities
2	Large	Emerging market economies	Telecommunications, industrials
3	Large	Emerging market economies	Basic materials, energy, agriculture, manufacturing, mining and quarrying
4	Large	Emerging market economies	Financials including government-backed financials, real estate activities, technology
5	Large	Advanced economies	Consumer goods and services, transportation and storage, administrative and support service activities, healthcare, utilities
6	Large	Advanced economies	Telecommunications, industrials
7	Large	Advanced economies	Basic materials, energy, agriculture, manufacturing, mining and quarrying
8	Large	Advanced economies	Financials including government-backed financials, real estate activities, technology
9	Small	Emerging market economies	All sectors described under bucket numbers 1, 2, 3, and 4
10	Small	Advanced economies	All sectors described under bucket numbers 5, 6, 7, and 8
11	(Not applicable)	(Not applicable)	Other sector
12	Large cap	Advanced economies	Qualified Indices
13	Other	Other	Qualified Indices

[Basel Framework, MAR 50.70]

For equity delta and vega risks, cross-bucket correlation γ_bc is set at 15% for all cross-bucket pairs that fall within bucket numbers 1 to 10. The cross-bucket correlation between buckets 12 and 13 is set at 75% and the cross-bucket correlation between buckets 12 or 13 and any of the buckets 1-10 is 45%. γ_bc is set at 0% for all cross-bucket pairs that include bucket 11. [Basel Framework, 50.71]

Equity delta risk factors for a given bucket:

The single equity delta risk factor is a simultaneous relative shift of equity spot prices for all reference names in the bucket.
The sensitivity to the equity delta risk factor is measured by simultaneously shifting the equity spot prices for all reference names in the bucket by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01.

Risk weights RW_k are set as follows depending on the reference name's bucket:

Table 12 Risk weights for equity delta risk
Bucket number	Risk weight
1	55%
2	60%
3	45%
4	55%
5	30%
6	35%
7	40%
8	50%
9	70%
10	50%
11	70%
12	15%
13	25%

[Basel Framework, MAR 50.72]

Equity vega risk factors for a given bucket:
1. The single equity vega risk factor is a simultaneous relative shift of the volatilities for all reference names in the bucket.
2. The sensitivity to the equity vega risk factor is measured by simultaneously shifting the volatilities for all reference names in the bucket by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01.
3. The risk weights for equity volatilities RW_k are set to 78% for large market capitalization buckets and to 100% for the other buckets.
[Basel Framework, MAR 50.73]

8.3.10 Commodity buckets, risk factors, sensitivities, risk weights and correlations

For commodity delta and vega risks, buckets are set as follows:

Table 13 Buckets for commodity risk
Bucket number	Commodity group	Examples
1	Energy – Solid combustibles	coal, charcoal, wood pellets, nuclear fuel (such as uranium)
2	Energy – Liquid combustibles	crude oil (such as Light-sweet, heavy, West Texas Intermediate and Brent); biofuels (such as bioethanol and biodiesel); petrochemicals (such as propane, ethane, gasoline, methanol and butane); refined fuels (such as jet fuel, kerosene, gasoil, fuel oil, naphtha, heating oil and diesel)
3	Energy – Electricity and carbon trading	electricity (such as spot, day-ahead, peak and off-peak); carbon emissions trading (such as certified emissions reductions, in-delivery month EU allowance, Regional Greenhouse Gas Initiative CO2 allowance and renewable energy certificates)
4	Freight	dry-bulk route (such as Capesize, Panamax, Handysize and Supramax); liquid-bulk/gas shipping route (such as Suezmax, Aframax and very large crude carriers)
5	Metals – non-precious	base metal (such as aluminium, copper, lead, nickel, tin and zinc); steel raw materials (such as steel billet, steel wire, steel coil, steel scrap and steel rebar, iron ore, tungsten, vanadium, titanium and tantalum); minor metals (such as cobalt, manganese, molybdenum)
6	Gaseous combustibles	natural gas; liquefied natural gas
7	Precious metals (including gold)	gold; silver; platinum; palladium
8	Grains & oilseed	corn; wheat; soybean (such as soybean seed, soybean oil and soybean meal); oats; palm oil; canola; barley; rapeseed (such as rapeseed seed, rapeseed oil, and rapeseed meal); red bean, sorghum; coconut oil; olive oil; peanut oil; sunflower oil; rice
9	Livestock & dairy	cattle (such live and feeder); hog; poultry; lamb; fish; shrimp; dairy (such as milk, whey, eggs, butter and cheese)
10	Softs and other agricultural	cocoa; coffee (such as arabica and robusta); tea; citrus and orange juice; potatoes; sugar; cotton; wool; lumber and pulp; rubber
11	Other commodity	industrial minerals (such as potash, fertilizer and phosphate rocks), rare earths; terephthalic acid; flat glass

[Basel Framework, MAR 50.74]

For commodity delta and vega risks, cross-bucket correlation γ_bc is set at 20% for all cross-bucket pairs that fall within bucket numbers 1 to 10. γ_bc is set at 0% for all cross-bucket pairs that include bucket 11. [Basel Framework, MAR 50.75]

Commodity delta risk factors for a given bucket:

The single commodity delta risk factor is a simultaneous relative shift of the commodity spot prices for all commodities in the bucket.
The sensitivities to commodity delta risk factors are measured by simultaneously shifting the spot prices of all commodities in the bucket by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01.

The risk weights RW_k are set as follows depending on the reference name's bucket:

Table 14 Risk weights for commodity delta risk
blank	1	2	3	4	5	6	7	8	9	10	11
blank	Bucket number
RW	30%	35%	60%	80%	40%	45%	20%	35%	25%	35%	50%

[Basel Framework, MAR 50.76]

Commodity vega risk factors for a given bucket:
1. The single commodity vega risk factor is a simultaneous relative shift of the volatilities for all commodities in the bucket.
2. The sensitivity to the commodity vega risk factor is measured by simultaneously shifting the volatilities for all commodities in the bucket by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01.
3. The risk weights for commodity volatilities RW_k are set to 100%. [Basel Framework, MAR 50.77]

Footnotes

Footnote 1

Note that this is in contrast to the application of the market risk approaches set out in section 9.1.2 of Chapter 9, where institutions do not need OSFI's approval to use the standardized approach.

Return to footnote 1

Footnote 2

One of the basic assumptions underlying the BA-CVA is that systematic credit spread risk is driven by a single factor. Under this assumption, ρ can be interpreted as the correlation between the credit spread of a counterparty and the single credit spread systematic factor.

Return to footnote 2

Footnote 3

DF is the supervisory discount factor averaged over time between today and the netting set's effective maturity date. The interest rate used for discounting is set at 5%, hence 0.05 in the formula. The product of EAD and effective maturity ‎in the BA-CVA formula is a proxy for the area under the discounted expected exposure profile of the netting set. The IMM definition of effective maturity already includes this discount factor, hence DF is set to 1 for IMM institutions. Outside IMM, the netting set's effective maturity is defined as an average of actual trade maturities. This definition lacks discounting, so the supervisory discount factor is added to compensate for this.

Return to footnote 3

Footnote 4

α is the multiplier used to convert Effective expected positive exposure (EEPE) to EAD in both SA-CCR and IMM. Its role in the calculation, therefore, is to convert the EAD of the netting set (EADNS) back to EEPE.

Return to footnote 4

Footnote 5

If an institution has prior approval from OSFI to use the Advanced Internal Ratings-Based approach (AIRB) or Foundation Internal Ratings Based approach (FIRB) for credit risk and to use its internal ratings mappings for a particular reference, it does not need to seek OSFI approval in the context of BA-CVA.

Return to footnote 5

Footnote 6

This would include non-CSA securities or other physical collateral which impacts the seniority in the recovery process including real estate, oil reserves or other inventories.

Return to footnote 6

Footnote 7

For example, if a EUR-reporting bank holds an instrument that references the USD-GBP exchange rate, the bank must measure CVA sensitivity both to the EUR-GBP exchange rate and to the EUR-USD exchange rate.

Return to footnote 7

Guideline (Effective January 2024)

Cover Letter Chapter 1 - Overview of Risk-based Capital Requirements Chapter 2 - Definition of Capital Chapter 3 - Operational Risk Chapter 4 - Credit Risk – Standardized Approach Chapter 5 - Credit Risk – Internal Ratings-Based Approach Chapter 6 - Securitization Chapter 7 - Settlement and Counterparty Risk Chapter 8 - Credit Valuation Adjustment (CVA) Risk Chapter 9 - Market Risk Frequently asked questions – Basel III reforms

Basel Capital Adequacy Reporting (BCAR)

Basel Capital Adequacy Reporting Manual

Implementation Notes for IRB Institutions

Collateral Management Principles for IRB Institutions Oversight Expectations for IRB Institutions The Use of Ratings and Estimates of Default and Loss at IRB Institutions Risk Quantification at IRB Institutions Validating Risk Rating Systems at IRB Institutions Data Maintenance at IRB Institutions

Approvals Related to OSFI Guidelines

AIRB Self Assessment Instructions Foreign DTI Subsidiary IRB Self Assessment Instructions

Note

For institutions with a fiscal year ending October 31 or December 31, respectively. Subsections 485(1) and 949(1) of the Bank Act (BA), subsection 473(1) of the Trust and Loan Companies Act (TLCA) require banks (including federal credit unions), bank holding companies, federally regulated trust companies, and federally regulated loan companies to maintain adequate capital. The CAR Guideline is not made pursuant to subsections 485(2) or 949(2) of the BA, or to subsection 473(2) of the TLCA. However, the capital standards set out in this guideline together with the leverage requirements set out in the Leverage Requirements Guideline provide the framework within which the Superintendent assesses whether a bank, a bank holding company, a trust company, or a loan company maintains adequate capital pursuant to the Acts. For this purpose, the Superintendent has established two minimum standards: the leverage ratio described in the Leverage Requirements Guideline, and the risk-based capital ratio described in this guideline.^{Footnote 1} The first test provides an overall measure of the adequacy of an institution's capital. The second measure focuses on risk faced by the institution. Notwithstanding that a bank, bank holding company, trust company, or loan company may meet these standards, the Superintendent may direct a bank or bank holding company to increase its capital under subsections 485(3) or 949(3) of the BA, or a trust company or a loan company to increase its capital under subsection 473(3) of the TLCA. OSFI, as a member of the Basel Committee on Banking Supervision, participated in the development of the Basel capital framework on which this guideline is based. Where relevant, the Basel framework paragraph numbers are provided in square brackets at the end of each paragraph referencing material from the Basel framework. The Capital Adequacy Requirements (CAR) for banks (including federal credit unions), bank holding companies, federally regulated trust companies, and federally regulated loan companies are set out in nine chapters, each of which has been issued as a separate document. This document should be read in conjunction with the other CAR chapters. The complete list of CAR chapters is as follows: Chapter 1 - Overview of Risk-based Capital Requirements Chapter 2 - Definition of Capital Chapter 3 - Operational Risk Chapter 4 - Credit Risk – Standardized Approach Chapter 5 - Credit Risk – Internal Ratings-Based Approach Chapter 6 - Securitization Chapter 7 - Settlement and Counterparty Risk Chapter 8 - Credit Valuation Adjustment (CVA) Risk Chapter 9 - Market Risk

Chapter 1 – Overview of Risk-based Capital Requirements

Outlined below is an overview of the capital adequacy requirements for banks (including federal credit unions), bank holding companies, federally regulated trust companies, and federally regulated loan companies, collectively referred to as 'institutions'. This chapter is drawn from the Basel Committee on Banking Supervision (BCBS) Basel Framework published on the Bank for International Settlements (BIS) website.^{Footnote 2} For reference, the Basel paragraph numbers that are associated with the text appearing in this chapter are indicated in square brackets at the end of each paragraph.^{Footnote 3}

1.1. Scope of Application

The capital adequacy requirements outlined in this guideline apply on a consolidated basis to the following institutions: all institutions designated by OSFI as domestic systemically important banks (D-SIBs); and small and medium-sized deposit-taking institutions (SMSBs^{Footnote 4}), which fall into Categories I, II or III as defined in OSFI's SMSB Capital and Liquidity Requirements Guideline.^{Footnote 5} The consolidated entity includes all subsidiaries except insurance subsidiaries. OSFI expects institutions to hold capital within the consolidated group in a manner that is consistent with the level and location of risk.

1.2. Regulatory Capital

Total capital consists of the sum of the following elements: Tier 1 capital, consisting of: Common Equity Tier 1 (CET1) capital; and Additional Tier 1 capital Tier 2 capital The criteria for the capital elements comprising the two tiers, as well as the various limits, restrictions and regulatory adjustments to which they are subject, are described in Chapter 2.

1.3. Total Risk-weighted Assets

Risk-weighted assets (RWA) make up the denominator of the risk-based capital ratios, and is calculated as the higher of: the sum of the following three elements: RWA for credit risk; RWA for market risk; and RWA for operational risk; and the adjusted RWA determined as per the capital floor described in section 1.5. [Basel Framework, RBC 20.4]

1.3.1. Credit Risk

RWA for credit risk (including counterparty credit risk) is calculated as the sum of: Credit RWA for banking book exposures which, except the RWA listed in (b) through (e) below, is calculated using: the standardized approach (as set out in Chapter 4); or the Internal Ratings-Based (IRB) approach (as set out in Chapter 5). RWA for counterparty credit risk from banking book exposures and trading book exposures (as set out in Chapter 7), except the exposures listed in (c) and (f) below. Credit RWA for equity investments in funds that are held in the banking book calculated using one or more of the approaches set out in Chapter 4: The look-through approach The mandate-based approach The fall-back approach RWA for securitization exposures held in the banking book, calculating using one or more of the approaches set out in Chapter 6: Securitization Standardized Approach (SEC-SA) Securitization External Ratings-Based Approach (SEC-ERBA) Securitization Internal Ratings-Based Approach (SEC-IRBA) Securitization Internal Assessment Approach (SEC-IAA) A risk weight of 1250% in cases where the institution cannot use (i) to (iv) above. RWA for exposures to central counterparties in the banking book and trading book, calculated using the approach set out in Chapter 7. RWA for the risk posed by unsettled transactions and failed trades, where the transactions are in the banking book or trading book and are within the scope of the rules set out in Chapter 7. RWA for credit valuation adjustment (CVA) risk for exposures in the trading and banking book, calculated as set out in Chapter 8 using either: The standardized approach for CVA; or The advanced approach for CVA. [Basel Framework, RBC 20.6] Institutions that have total regulatory capital (net of deductions) in excess of CAD $5 billion, or that have greater than 10% of total assets or greater than 10% of total liabilities that are international,^{Footnote 6} are expected to use IRB approaches for all material portfolios and credit businesses in Canada and the United States. Under the IRB approaches, exposure at default (EAD) is determined gross of all specific allowances. The amount used in the calculation of EAD should normally be based on book value, except for the following where EAD should be based on amortized cost: loans fair valued under the fair value option or fair value hedge; and debt and loans fair valued through Other Comprehensive Income. Under the standardized approach, on-balance sheet exposures should normally be measured at book value, except the following where exposures should be measured at amortized cost: loans fair valued under the fair value option or fair value hedge; debt and loans fair valued through Other Comprehensive Income; and own-use property, plant and equipment For own-use property that is accounted for using the revaluation model, reported exposures should be based on an adjusted book value that reverses the impact of: the balance of any revaluation surplus included in Other Comprehensive Income; and accumulated net after-tax revaluation losses that are reflected in retained earnings or as a result of subsequent revaluations The approaches listed in paragraph 8 specify how institutions should measure the size of their exposures (i.e. EAD) and determine their RWA. Certain types of transactions in the banking book and trading book (such as derivatives and securities financial transactions) give rise to counterparty credit risk, for which the measurement of the size of the exposure can be complex. Therefore, the approaches listed in paragraph 8 include, or cross refer to, the following methods available to determine the size of the counterparty exposures (refer to section 7.1 of Chapter 7 for an overview of the counterparty credit risk requirements including the types of transactions to which the methods below can be applied): The standardized approach for measuring counterparty credit risk exposures (SA-CCR), set out in section 7.1.7. The comprehensive approach, set out in section 4.3.3(iii) of Chapter 4. The value at risk (VaR) models approach, set out in section 5.4.1(iii) of Chapter 5. The Internal Model Method (IMM), set out in section 7.1.5. [Basel Framework, RBC 20.7] For banks with OSFI approval to use IMM to calculate counterparty credit risk exposures, EAD for counterparty credit risk exposures must be calculated according to sections 7.1.3 through 7.1.5. [Basel Framework, RBC 20.8]

1.3.2. Market Risk

Market risk requirements, as outlined in Chapter 9, apply to internationally active institutions and all institutions designated by OSFI as D-SIBs. OSFI retains the right to apply the framework to other institutions, on a case-by-case basis, if trading activities are a large proportion of overall operations. Institutions subject to market risk requirements must identify the instruments that are in the trading book following the requirements of Chapter 9. All instruments that are not in the trading book and all other assets of the institution (termed "banking book exposures") must be treated under one of the credit risk approaches. [Basel Framework, RBC 20.5] RWA for market risk are calculated as RWA for market risk for instruments in the trading book and for foreign exchange risk and commodities risk for exposures in the banking book, calculated using: The standardized approach, as described in section 9.5; or The internal models approach set out in section 9.6. [Basel Framework, RBC 20.9]

1.3.3. Operational Risk

All institutions are subject to operational risk requirements, as described in Chapter 3. RWA for operational risk are calculated using either: The Simplified Standardized Approach, set out in section 3.3; or The Standardized Approach, set out in section 3.4. D-SIBs and SMSBs that report adjusted gross income^{Footnote 7} greater than $1.5 billion must use the standardized approach. SMSBs with annual adjusted gross income less than $1.5 billion must use the simplified standardized approach, unless they have received approval from OSFI to use the standardized approach, as set out in section 3.2.

1.4. Approval to use Internal Model Based Approaches

Institutions must receive explicit prior approval from OSFI in order to use any of the following model-based approaches for regulatory capital purposes: the Foundation and Advanced IRB Approaches to credit risk, the IMM to counterparty credit risk, and the Internal Models Approach (IMA) to market risk. The steps involved in the application for approval of these approaches are outlined in OSFI Implementation Notes. OSFI will consider approval with conditions for those institutions that have made a substantial effort and are found to satisfy most requirements of the internal model regime. The institution must also be able to provide out of sample back-testing and parallel reporting consistent with OSFI's capital models implementation note.^{Footnote 8} Institutions that do not receive approval will be required to employ a form of the Standardized Approach. An institution achieving approval with conditions for one of the model-based approaches will normally be allowed to use the approach (in some cases only after OSFI confirms closure of certain deficiencies) but may be required to adhere to a higher initial capital floor. Once it achieves full compliance with all rollout and data requirements, and OSFI has agreed, the institution may proceed to the capital floor of 72.5% described in section 1.5. In either case, OSFI will not rule out the possibility of requiring floors on individual asset classes or reviewing approval conditions based on implementation progress. Once approved, institutions are expected to meet the qualitative and quantitative requirements for the internal model approach as set out in the guideline and the supporting implementation notes on an ongoing basis.

1.4.1. Approval to use the IRB Approaches to Credit Risk

For IRB credit risk approval, besides meeting the qualitative and quantitative requirements for an IRB rating system, institutions will need, at a minimum, to satisfy the following requirements to obtain approval with conditions (with a possibly higher initial floor): The institution is meeting the IRB use test principles.^{Footnote 9} The use test prohibits institutions from using default and loss estimates from their own internal ratings that are developed for the sole purpose of calculating regulatory capital, these systems must be used in other operations of the institution. On implementation, the institution will have rolled out the Advanced IRB (AIRB) or Foundation IRB (FIRB) approach to approximately 80% of its consolidated credit exposures, as of the end of the fiscal year prior to the fiscal year in which the institution receives approval to use the IRB approach, measured in terms of gross exposure and total credit RWA. Once an institution has received an approval to use the IRB Approach, OSFI will monitor, on a quarterly basis, the institution's compliance with the 80% IRB threshold for its consolidated credit exposures for which an IRB approach is permitted. In the post-approval period, compliance will be measured in terms of gross exposure and total credit risk-weighted assets as at the applicable quarter.

1.5. Capital Floor – Internal Model Based Approaches

To reduce excessive variability of RWA and to enhance the comparability of risk-based capital ratios, institutions using internal model-based approaches for credit risk, counterparty credit risk, or market risk are subject to a floor requirement that is applied to RWA. The capital floor ensures that institutions' capital requirements do not fall below a certain percentage of capital requirements derived under standardized approaches. The calculation of the floor is set out below for institutions that have implemented the IRB approach for credit risk, IMM for counterparty credit risk, or IMA for market risk. Institutions that have only implemented the standardized approaches for credit risk, counterparty credit risk, and market risk are not subject to the capital floor. Institutions that have implemented one of the internal model-based approaches for credit risk, counterparty credit risk, or market risk must calculate the difference between: the capital floor as defined in section 1.5.1, and an adjusted capital requirement as defined in section 1.5.2. [Basel Framework, RBC 20.11] If the capital floor amount is larger than the adjusted capital requirement (i.e. the difference is positive), institutions are required to add the difference to the total RWAs otherwise calculated under this guideline. This adjusted RWA figure must be used as the denominator in the calculation of the risk-based capital ratios.

1.5.1. The Capital Floor

The base of the capital floor includes the standardized approaches to credit risk and operational risk as described in paragraphs 31 through 35. The specific approach for market risk is described in paragraph 33. The capital floor is derived by applying an adjustment factor to the net total of the following amounts: total risk-weighted assets for the capital floor, less 12.5 times the amount of any general allowance that may be recognized in Tier 2 capital following the standardized approach methodology as outlined in Chapter 2 of this guideline. The adjustment factor is normally set at 72.5%. However, OSFI may set a higher or lower adjustment factor for individual institutions. This factor will be phased-in over three years, starting at a 65% factor in 2023 and rising 2.5% per year to 72.5% in 2026. Table 1: Capital Floor Transition blank Fiscal year 2023 2024 2025 2026 + Floor adjustment factor 65% 67.5% 70% 72.5% Credit risk RWAs are calculated using the standardized approach as outlined in Chapter 4 of this guideline for all asset classes except securitization. The treatment of securitization exposures under the capital floor is outlined in section 6.11 of Chapter 6. Credit risk RWAs also include charges for central counterparty (CCP) exposures and non-Delivery-versus-Payment (DvP) trades outlined in Chapter 7, and credit valuation adjustment (CVA) outlined in Chapter 8 of this guideline. For the exposure values used in the calculation of credit risk RWAs, the treatment of credit risk mitigation should follow the standardized approach outlined in section 4.3 of Chapter 4 of this guideline, while counterparty credit risk exposures must be determined using the standardized approach to counterparty credit risk outlined in section 7.1.7 of Chapter 7 of this guideline. Additionally, in order to reduce the operational complexity of implementing the capital floor, institutions may choose to apply the IRB definition of default for IRB portfolios rather than applying the standardized approach default definition. Prior to November 2023/January 2024,^{Footnote 10} market risk RWAs are calculated using the value at risk (VaR) and standardized approaches as outlined in Chapter 9 of the 2019 CAR guideline, excluding the comprehensive risk measure (CRM, section 9.11.5.2), the incremental risk charge (IRC, Appendix 9-9), and stressed VaR (SVaR, paragraph 194i) capital charges. After November 2023/January2024, market risk RWAs are calculated using the standardized approach as outlined in Chapter 9 of this guideline. Operational risk RWAs are calculated using either the Standardized Approach or the Simplified Standardized Approach, outlined in Chapter 3 of this guideline. The following approaches are not permitted to be used, directly or indirectly, in the calculation of the capital floor: IRB approach to credit risk; SEC-IRBA; the IMA for market risk; the VaR models approach to counterparty credit risk; and the IMM for counterparty credit risk.^{Footnote 11} [Basel Framework, RBC 20.12]

1.5.2. Adjusted Capital Requirement

The adjusted capital requirement is based on application of all of the chapters of this guideline and is equal to the net total of the following amounts: total risk-weighted assets, plus 12.5 times the provisioning shortfall deduction, less 12.5 times excess provisions included in Tier 2, less 12.5 times the amount of general allowances that may be recognized in Tier 2 in respect of exposures for which the standardized approach is used. The provisioning shortfall deduction, excess provisions included in Tier 2, and general allowances in Tier 2 in respect of standardized portfolios are defined in section 2.1.3.7 of Chapter 2 of this guideline.

1.6. Calculation of OSFI Minimum Capital Requirements

1.6.1. Risk-Based Capital Ratios for D-SIBs and Category I and II SMSBs

Institutions are expected to meet minimum risk-based capital requirements for exposures to credit risk, operational risk and, where they have significant trading activity, market risk. Total risk-weighted assets are determined by multiplying the capital requirements for market risk and operational risk by 12.5 and adding the resulting figures to risk-weighted assets for credit risk. The capital ratios are calculated by dividing regulatory capital by total risk-weighted assets. The three ratios measure CET1, Tier 1 and Total capital adequacy and are calculated as follows: Risk Based Capital Ratios = Capital RWA Where: Capital = CET1, Tier 1, or Total capital as set out in Chapter 2. RWA = Risk-weighted assets, calculated as described in paragraph 7. Table 2 provides the minimum CET1, Tier 1 and Total capital ratios for institutions before application of the capital conservation buffer. Table 2: Minimum capital requirements (in RWA) CET1 4.5% Tier 1 6.0% Total 8.0%

1.6.2. Simplified Risk-Based Capital Ratio for Category III SMSBs

Category III SMSBs are subject to a Simplified Risk-Based Capital Ratio (SRBCR), calculated as follows: SRBCR = Capital Adjusted Total Assets + RWA Operational Risk Where: Capital = CET1, Tier 1, or Total capital as set out in Chapter 2. Adjusted Total Assets = Total Assets from the Balance Sheet, less the aggregate of all adjustments to regulatory capital as set out in Chapter 2. RWA Operational Risk = Risk-Weighted Assets for operational risk, calculated as detailed in Chapter 3. Table 3 provides the minimum CET1, Tier 1 and Total capital ratios for Category III SMSBs before application of the capital conservation buffer. Table 3: Minimum Capital Requirements (measured as SRBCR) CET1 4.5% Tier 1 6.0% Total 8.0%

1.7. Mandated Capital Buffers

In addition to the minimum capital ratios, institutions are required to hold a capital conservation buffer and, where applicable, a countercyclical buffer. Outside of periods of stress, institutions should hold buffers of capital above the regulatory minimum. The intent of these buffers is to increase institutions' resilience going into a downturn and provide a mechanism for rebuilding capital during the early stages of economic recovery. Retaining a greater proportion of earnings during a downturn will help to ensure that capital becomes available to support the ongoing business operations of institutions through periods of stress. [Basel Framework, RBC 30.20] When buffers have been drawn down, there is a range of actions that can be taken to rebuild buffers including reducing discretionary distributions of earnings. This could include reducing dividends or other discretionary payments on shares or other capital instruments, share buy-backs and, to the extent they are discretionary, staff bonus payments.^{Footnote 12} Institutions may also choose to raise new capital from the private sector as an alternative to conserving internally generated capital. Should buffers be drawn down, institutions should implement a capital restoration plan for rebuilding buffers within a reasonable timeframe or, where the breach is expected to be corrected promptly, a plan that provides assurance that the capital conservation buffer will be restored on a sustained basis. The capital restoration plan should be discussed with OSFI as part of the capital planning process. [Basel Framework, RBC 30.21] Greater efforts should be made to rebuild buffers the more they have been depleted. In the absence of raising capital in the private sector, the share of earnings retained by institutions for the purpose of rebuilding capital buffers should increase the nearer their actual capital levels are to the minimum capital requirements. [Basel Framework, RBC 30.22] It is not acceptable for institutions which have depleted their capital buffers to use future predictions of recovery as justification for maintaining generous distributions to shareholders, other capital providers and employees. These stakeholders, rather than depositors, must bear the risk that recovery will not be forthcoming. It is also not acceptable for institutions that have depleted their capital buffers to use the distribution of capital as a way to signal their financial strength. [Basel Framework, RBC 30.23]

1.7.1. Capital Conservation Buffer

The capital conservation buffer establishes a safeguard above the minimum capital requirements and can only be met with CET1 capital. The capital conservation buffer is 2.5% of RWA.^{Footnote 13} Table 4 provides the minimum capital ratios plus the 2.5% capital conversation buffer. [Basel Framework, RBC 30.2] Table 4: Capital conservation buffer (as % of RWA) Capital conservation buffer 2.5% Minimum capital ratios plus the 2.5% capital conservation buffer CET1 7.0% Tier 1 8.5% Total 10.5% Capital distribution constraints will be imposed on an institution when capital levels fall within the buffer conservation range. Institutions will be able to conduct business as normal when their capital levels fall within the buffer range as they experience losses. The constraints imposed relate only to distributions, not the operations of the institution. The distribution constraints increase as institutions' capital levels approach the minimum requirements. By design, the constraints imposed on institutions with capital levels at the top of the range would be minimal. This reflects an expectation that institutions' capital levels may fall into this range from time to time. [Basel Framework, RBC 30.2 and 30.3] Table 5 sets out the minimum capital conservation ratios an institution must meet at various levels of CET1 capital.^{Footnote 14} The applicable conservation ratio must be recalculated at each distribution date. Once imposed, conservation ratios will remain in place until such time as capital ratios have been restored. If an institution wants to make payments in excess of the constraints set out in Table 5, sufficient capital must be raised in the private sector to fully compensate for the excess distribution. This alternative should be discussed with OSFI as part of an institution's Internal Capital Adequacy Assessment Process (ICAAP). For the purposes of determining the minimum capital conservation ratio, the CET1 ratio includes amounts used to meet the 4.5% minimum CET1 requirement, but excludes any additional CET1 needed to meet the 6% Tier 1 and 8% Total Capital requirements, as well as any CET1 capital needed to meet D-SIBs' Total Loss Absorbing Capacity (TLAC) requirements where applicable. For example, an institution with 8% CET1 and no Additional Tier 1 or Tier 2 capital would meet all minimum capital requirements, but would have a 0% capital conservation buffer and therefore be subject to the 100% constraint on capital distributions. [Basel Framework, RBC 30.4] Table 5: Minimum capital conservation ratios for corresponding levels of CET1 CET1 Ratio Minimum Capital Conservation Ratios (expressed as percentage of earnings) 4.5% - 5.125% 100% >5.125% - 5.75% 80% >5.75% - 6.375% 60% >6.375% - 7.0% 40% >7.0% 0% If an institution's capital ratio falls below the levels set out in Table 4, capital conservation ratios will be imposed that automatically limit distributions. As outlined in Table 5, these limits increase as an institution's capital levels approach the minimum requirements. For example, an institution with a CET1 capital ratio in the range of 5.125% to 5.75% would be required to maintain the equivalent of 80% of its earnings in the subsequent payment period (i.e. pay out no more than 20% in capital distributions). For clarity, where an institution's disclosed ratio is within the ranges where restrictions apply, distributions for the following payment period will be constrained based on the most recently reported ratio irrespective of the current capital position of the institution. Restrictions will remain in place until the capital conservation buffer is restored. [Basel Framework, RBC 30.4] Items considered to be distributions include dividends and share buybacks, discretionary payments on CET1 and Additional Tier 1 capital instruments and discretionary bonus payments to staff. Payments that do not result in a depletion of CET1, which may for example include certain stock dividends, are not considered distributions. The distribution restrictions do not apply to dividends which satisfy all of the following conditions: the dividends cannot legally be cancelled by the institution; the dividends have already been removed from CET1; and the dividends were declared in accordance with the applicable capital conservation ratio set out in Table 5 at the time of the declaration. [Basel Framework, RBC 30.5] Earnings are defined as distributable profits calculated prior to the deduction of elements subject to the restriction on distributions. Earnings are calculated after the tax which would have been reported had none of the distributable items been paid. As such, any tax impacts of making such distributions are reversed out. Where an institution does not have positive earnings and has a shortfall in its CET1, Tier 1, or Total Capital ratio, it will be restricted from making positive net distributions. [Basel Framework, RBC 30.5]

1.7.2. Countercyclical Buffer

The countercyclical buffer aims to ensure that banking sector capital requirements take account of the macro-financial environment in which institutions operate. It will be deployed when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital to protect it against future potential losses. [Basel Framework, RBC 30.7] The countercyclical buffer regime consists, in Canada, of the following elements: OSFI, in consultation with its Senior Advisory Committee^{Footnote 15} (SAC) partners, will monitor credit growth and other indicators^{Footnote 16} that may signal a build-up of system-wide risks^{Footnote 17} and make an assessment of whether credit growth is excessive and is leading to the build-up of system-wide risks. Based on this assessment, a countercyclical buffer requirement, ranging from 0% to 2.5% of total risk-weighted assets,^{Footnote 18} will be put in place when circumstances warrant. This requirement will be released when OSFI, in consultation with its SAC partners, assesses that system-wide risks have dissipated or crystallized. Institutions with private sector credit exposures outside Canada will look at the geographic location of those exposures and calculate their consolidated countercyclical buffer requirement as a weighted average of the countercyclical buffers that are being applied in jurisdictions to which they have credit exposures. The countercyclical buffer to which the institution is subject will be implemented by way of an extension of the capital conservation buffer described in section 1.7.1. Institutions will be subject to restrictions on distributions of earnings if they breach the extended buffer. [Basel Framework, RBC 30.8] Institutions must meet the countercyclical buffer with CET1. Consistent with the capital conservation buffer, the CET1 ratio in this context includes amounts used to meet the 4.5% minimum CET1 requirement, but excludes any additional CET1 needed to meet the 6% Tier 1 and 8% Total Capital requirements as well as D-SIBs' minimum 21.5% TLAC requirement. [Basel Framework, RBC 30.17] Table 6 provides the minimum capital conservation ratios an institution must meet at various levels of the CET1 capital ratio.^{Footnote 19} [Basel Framework, RBC 30.17] Table 6: Individual institution minimum capital conservation standards CET1 Minimum Capital Conservation Ratios (expressed as a percentage of earnings) Within first quartile of buffer 100% Within second quartile of buffer 80% Within third quartile of buffer 60% Within fourth quartile of buffer 40% Above top of buffer 0% The consolidated countercyclical buffer will be a weighted average of the buffers deployed in Canada and across BCBS member jurisdictions and selected non-member jurisdictions^{Footnote 20} to which the institution has private sector credit exposures. [Basel Framework, RBC 30.14] Institutions will look at the geographic location of their private sector credit exposures and calculate their consolidated countercyclical buffer as a weighted average of the buffers that are being applied in each jurisdiction to which they have such exposures. The buffer that will apply to an institution will thus reflect the geographic composition of its portfolio of private sector credit exposures.^{Footnote 21} [Basel Framework, RBC 30.13] The weighting applied to the buffer in place in each jurisdiction will be the institution's credit risk RWA that relates to private sector credit exposures in that jurisdiction divided by the institution's credit risk RWA that relates to private sector credit exposures across all jurisdictions.^{Footnote 22} [Basel Framework, RBC 30.14] Institutions will be subject to a consolidated countercyclical buffer that varies between 0%, where no jurisdiction in which the institution has private sector credit exposures has activated a buffer, and 2.5% of total RWA.^{Footnote 23} The consolidated countercyclical buffer applies to consolidated total RWA (including credit, market, and operational risk) as used in the calculation of all risk-based capital ratios, consistent with it being an extension of the capital conservation buffer. [Basel Framework, RBC 30.12 FAQ1] Private sector credit exposures in this context refers to exposures to private sector counterparties, including non-bank financial sector counterparties, which attract a credit risk capital charge in the banking book and the risk-weighted equivalent trading book capital charges for specific risk, the incremental risk charge, and securitization. Interbank exposures and exposures to the public sector are excluded. [Basel Framework, RBC 30.13 FAQ1] When considering the jurisdiction to which a private sector credit exposure relates, institutions should use an ultimate risk basis. Ultimate risk refers to the jurisdiction where the final risk lies^{Footnote 24} as opposed to the jurisdiction of the immediate counterparties or where the exposure is booked. [Basel Framework, RBC 30.14] The decision to activate, increase, decrease or release the countercyclical buffer will be formally communicated. The Superintendent may exempt groups of institutions, other than D-SIBs and foreign bank subsidiaries in Canada, from the countercyclical buffer requirements if the application would not meet the stated objectives of the countercyclical buffer.^{Footnote 25}^{Footnote 26} The scope of application and the rationale would be described in the OSFI communication. To give institutions time to adjust to a buffer level, OSFI will pre-announce its decision, to activate or raise the level of the countercyclical buffer, by up to 12 months but no less than 6 months. Conversely, decisions to release the countercyclical buffer will normally take effect immediately. Institutions with foreign exposures are expected to match host jurisdictions' implementation timelines unless the announcement period is shorter than 6 months in which case compliance will only be required 6 months after the host's announcement.^{Footnote 27} [Basel Framework, RBC 30.11] The maximum countercyclical buffer relating to foreign private sector credit exposures will be 2.5% of total RWAs.^{Footnote 28} Jurisdictions may choose to implement a buffer in excess of 2.5%, if deemed appropriate in their national context; in such cases the international reciprocity provisions will not apply to the additional amounts. In addition, institutions are not expected to replicate sectoral buffers or similar measures adopted by foreign jurisdictions that depart from the internationally agreed countercyclical buffer. [Basel Framework, RBC 30.9] Institutions must ensure that their countercyclical buffer is calculated and publicly disclosed with at least the same frequency as their minimum capital requirements. In addition, when disclosing their buffers, if any, institutions must also disclose the geographic breakdown of their private sector credit exposures used in the calculation of the buffer. [Basel Framework, RBC 30.19]

1.8. Domestic Systemically Important Bank (D-SIB) Surcharge

OSFI has designated six Canadian institutions as D-SIBs: Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada, and Toronto-Dominion Bank.^{Footnote 29} D-SIBs will be subject to a CET1 surcharge equal to 1% of RWAs. The 1% capital surcharge will be periodically reviewed in light of national and international developments. This is consistent with the levels and timing set out in the BCBS D-SIB framework. [BCBS Consolidated framework RBC 40.7 to 40.23] The 1% surcharge will be implemented through an extension of the capital conservation buffer. This is in line with the treatment of the higher loss absorbency requirement for global systemically important banks (G-SIBs) prescribed by the BCBS.^{Footnote 30} Table 7 below sets out the minimum capital conservation ratios a D-SIB must meet at various CET1 capital ratios and Tier 1 leverage ratios.^{Footnote 31} D-SIBs will thus be subject to a pre-determined set of restrictions on the ability to make distributions, such as dividends and share buy-backs, if they do not meet these requirements (see relevant provisions of section 1.7.1). Table 7: Minimum capital conservation ratios for D-SIBs at various ranges of CET1 or Tier 1 Leverage Ratios CET1 Ratio Tier 1 Leverage Ratio Minimum Capital Conservation Ratio 4.5% - 5.375% 3%–3.125% 100% >5.375% - 6.250% > 3.125%–3.25% 80% >6.250% - 7.125% > 3.25%–3.375% 60% >7.125% - 8.0% > 3.375%–3.50% 40% >8.0% > 3.50% 0%

1.9. Domestic Stability Buffer

In addition to the buffers described in sections 1.7.1, 1.7.2, and 1.8, D-SIBs are subject to a Domestic Stability Buffer (DSB).^{Footnote 32} The DSB is intended to cover a range of systemic vulnerabilities that, in OSFI's supervisory judgement, are not adequately captured in the Pillar 1 capital requirements described in this guideline. In addition to the DSB, D-SIBs may be required to hold further Pillar II capital, as warranted, to address idiosyncratic or systemic risks that are not adequately captured by the Pillar I requirements and buffers. Decisions on the calibration of the DSB are based on supervisory judgement, informed by analytical work on a range of vulnerabilities, and are made in consultation with the Financial Institutions Supervisory Committee (FISC).^{Footnote 33} The level of the DSB will range between 0 and 4.0% of a D-SIB's total RWA calculated under this guideline. The level of the DSB will be the same for all D-SIBs and must be met with CET1 capital. Unlike the other buffers described in this guideline, the DSB is not a Pillar 1 buffer and breaches will not result in D-SIBs being subject to the automatic constraints on capital distributions described in section 1.7. If a D-SIB breaches the buffer (i.e. dips into the buffer when it has not been released), OSFI will require a remediation plan. Supervisory interventions pursuant to OSFI's Guide to Intervention^{Footnote 34} would occur in cases where a remediation plan is not produced or executed in a timely manner satisfactory to OSFI. D-SIBs should take into account the DSB in their internal capital planning process. Additionally, D-SIBs should report the DSB in their quarterly public disclosures, and include a brief narrative on any changes to the buffer level. Breaches of the buffer by an individual D-SIB will require public disclosure pursuant to International Financial Reporting Standards (IFRS). The specific vulnerabilities covered by the DSB are expected to evolve over time, as they are based on current market conditions in combination with forward-looking expectations around the materialization of risks to key vulnerabilities, and will be communicated as part of the semi-annual DSB level-setting announcements. The decision to include a vulnerability will be based on whether it is measurable, material, cyclical and has a system-wide impact that could materialize in the foreseeable future. OSFI will undertake a review of the buffer on a semi-annual basis, and any changes to the buffer will be made public, in June and December, along with supporting rationale. In exceptional circumstances, OSFI may make and announce adjustments to the buffer in-between scheduled review dates. Transparency in setting the DSB will support institutions' ability to use this capital in times of stress by improving the understanding of the purpose of the buffer and how it should be used. Decreases of the buffer may occur in a situation when OSFI identifies that D-SIBs' exposures to the vulnerabilities have diminished or that risks have materialized. In the latter case, a decrease would be intended to allow D-SIBs to continue to provide loans and services to credit worthy households and businesses and/or to incur losses without breaching their capital targets. Increases to the buffer may occur when OSFI is of the view that it would be prudent for D-SIBs to hold additional capital to protect against the identified vulnerabilities. Increases will be subject to a phase-in period; decreases will be effective immediately.

1.10. Capital Targets

In addition to the minimum capital requirements described in section 1.6, OSFI expects all institutions to maintain target capital ratios equal to or greater than the minimum capital ratios plus the conservation buffer.^{Footnote 35} For SMSBs, this means target ratios of at least 7% for CET1, 8.5% for Tier 1 and 10.5% for Total capital. D-SIBs are expected to maintain target capital ratios equal to or greater than the minimum capital ratios plus the sum of the conservation buffer, the D-SIB surcharge and the DSB. For D-SIBs, this equates to target ratios of least 8% for CET1, 9.5% for Tier 1, and 11.5% for Total capital plus the DSB.^{Footnote 36} The target capital ratios for SMSBs and D-SIBs are summarized below in Table 8 below and illustrated in Annex 2. Table 8: Target Capital Ratios blank SMSBs D-SIBs Target CET1 capital 7.0% 8.0% plus DSB Target Tier 1 capital 8.5% 9.5% plus DSB Target Total capital 10.5% 11.5% plus DSB These targets are applicable to all institutions and are triggers for supervisory intervention consistent with OSFI's Guide to Intervention.^{Footnote 37} If an institution is offside the relevant target ratios, supervisory action will be taken proportional to the shortfall and circumstances that caused the shortfall and may include a range of actions, including, but not limited to, restrictions on distributions. The Superintendent may set higher target capital ratios for individual institutions or groups of institutions where circumstances warrant, including in respect of idiosyncratic and/or systemic risks that are not adequately captured by institutions' Pillar I capital requirements and buffers. The need for Pillar II capital and corresponding higher target capital ratios would consider how robust existing capital ratios are in light of an institution's allowances, stress testing program, and ICAAP results.^{Footnote 38}

Annex 1 – Domestic Systemic Importance and Capital Targets

The framework^{Footnote 39} for dealing with D-SIBs set out by the BCBS indicates that domestic systemic importance should be assessed with reference to the impact that an institution's failure could have on the domestic economy. Further, it notes that this assessment should consider institution-specific characteristics of systemic importance, such as size, inter-connectedness and substitutability, which are correlated with the systemic impact of failure. Accordingly, OSFI's assessment of domestic systemic importance for Canadian institutions considers a range of indicators such as asset size, intra-financial claims and liabilities, and an institution's roles in domestic financial markets and in financial infrastructures. This section describes OSFI's inferences from various measures of systemic importance.

Size

In general, an institution's distress or failure is more likely to damage the Canadian financial system or economy if its activities comprise a large share of domestic banking activity. When Canadian institutions are compared according to their size as measured by total consolidated assets, and by place of booking of assets, that is, according to whether the assets are booked in Canada or abroad, the data show that: the largest six banks account for more than 90% total banking assets; the differences among the largest banks are smaller if only domestic assets are considered; and relative systemic importance declines rapidly after the top five banks and after the sixth bank.

Inter-connections

The more inter-connected an institution is to other financial institutions, the greater is the potential for the failure of that institution to transmit problems throughout the financial system and to the broader economy. As a result, measurements of inter-connectedness also inform institutions' systemic importance. Comparing Canadian institutions according to measures of intra-financial assets (i.e. claims on other financial institutions) and intra-financial liabilities (i.e. obligations to other financial institutions) again points to the dominance of the largest Canadian banks. The rank-ordering among these banks, however, depends on the specific inter-connectedness measure under consideration.

Substitutability

The systemic impact of an institution's distress or failure is greater the less easily it can be replaced as both a market participant and a financial service provider. As a result, OSFI's identification of D-SIBs also takes into account the types of roles that institutions play in domestic financial markets and in domestic financial infrastructures, which inform views regarding substitutability. For example, this includes underwriter rankings in Canadian financial markets, and an institution's shares of Canadian dollar payments made through Canada's Large Value Transfer System (LVTS) and the Automated Clearing and Settlement System (ACSS)^{Footnote 40}. Again, activity and volume in both LVTS and ACSS are dominated by the largest Canadian banks, and bank relative importance varies according to the measure of interest. The largest banks are also the dominant participants in CDSX, the clearing and settlement system for securities transactions in Canada. Some large Canadian banks also play key roles as members of the CLS Bank, the global institution that settles foreign exchange transactions between banks in Canadian dollars and other major currencies^{Footnote 41}. For example, the Royal Bank of Canada and the Canadian Imperial Bank of Commerce are the key Canadian-dollar liquidity providers for settling Canadian dollar foreign exchange transactions through the CLS network. A variety of additional information has been assessed and recurring themes across the range of evidence are the following: The five largest banks are by far the dominant banks in Canada, and consistently play central roles in a range of activities in the Canadian financial system; and The rank-order importance of the largest banks, as well as the relative differences between them, varies somewhat according to the measure considered. This suggests that there are strong grounds for treating these banks in the same way, rather than relying on arbitrary weights to develop a single index of systemic importance. Further, distinguishing reliably between the adverse effects on the Canadian economy from individual D-SIB failures is largely moot, given the difficulty of credibly differentiating between the large adverse impacts on the Canadian economy from the failure of any one of the largest banks. This also argues against making distinctions between identified Canadian D-SIBs to assign degrees of systemic importance. Given these various considerations, the Canadian D-SIBs are judged to be Bank of Montreal, The Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada, and The Toronto-Dominion Bank, without further distinction between them. National Bank of Canada has also been designated as a D-SIB given its importance relative to other less prominent banks and in the interest of prudence given the inherent challenges in identifying ahead of time which banks are likely to be systemic in times of stress. The designation of D-SIB status will be periodically reviewed and updated as needed.

Higher Loss Absorbency Targets

The goal of a higher loss absorbency target is to reduce further the probability of failure of a D-SIB relative to non-systemic institutions, reflecting the greater impact that a D-SIB failure may have on the domestic financial system and the economy. This surcharge takes into account the structure of the Canadian financial system, the importance of large banks to the financial architecture, and the expanded regulatory toolkit required to resolve a troubled financial institution. The BCBS D-SIB framework provides for national discretion to accommodate characteristics of the domestic financial system and other local features, including the domestic policy framework. The additional capital surcharge for banks designated as systemically important provides credible additional loss absorbency given: extreme loss events as a percentage of RWA among this peer group over the past 25 years would be less than the combination of the CET1 (2.5%) capital conservation buffer and an additional 1%; and current business models of the six largest banks are generally less exposed to the fat tailed risks associated with investment banking than some international peers, and the six largest banks have a greater reliance on retail funding models compared to wholesale funding than some international peers – features that proved beneficial in light of the experience of the 2008-2009 financial crisis. From a forward-looking perspective: Canadian D-SIBs that hold capital at current targets plus a 1% surcharge (i.e. 8%) should be able to weather a wide range of severe but plausible shocks without becoming non-viable; and the higher loss absorbency in a crisis scenario achieved by the conversion to common equity) of the 2% to 3% in Additional Tier 1 and Tier 2 NVCC capital instruments promoted by Basel III also adds to the resiliency of banks.

Relationship with Basel Committee G-SIB Framework

OSFI has adopted the Basel Committee's framework on the assessment methodology for G-SIBs. The assessment methodology for G-SIBs follows an indicator-based approach agreed by the BCBS that will determine which institutions are to be designated as G-SIBs and subject to additional loss absorbency requirements that range from 1% to 3.5% RWA, depending on an institution's global systemic importance^{Footnote 42}. For Canadian D-SIBs that are also designated as G-SIBs, the higher of the D-SIB and G-SIB surcharges will apply^{Footnote 43}.

Supervisory Implications

Canadian D-SIBs are expected to have advanced practices in terms of the design and operation of oversight functions and internal controls. OSFI expects these practices to continue to improve as supervision becomes more intensive and international best practices evolve. The institutions designated as D-SIBs have historically had, and will continue to be subject to, more intensive supervision because of their larger size, broader and more complex business models and consequently more significant risk profiles. The principles of risk based supervisory intensity are reflected in OSFI's Supervisory Framework.^{Footnote 44} The Framework is applied on a consolidated basis to all Canadian institutions and requires OSFI supervisors to determine the level, extent and intensity of the supervision of institutions based on the size, nature, complexity and risk profile of the institution. OSFI's enhanced supervision of D-SIBs includes the following: extensive use of supervisory colleges to share and coordinate supervision, including the execution of supervisory plans, with the relevant host country authorities of Canadian D-SIBs' major foreign subsidiaries and affiliates; greater frequency and intensity of on- and off-site monitoring of institutions' risk management activities and corporate governance, including more granular reporting to OSFI and more structured interactions with boards and senior management; more extensive use of specialist expertise relating to credit risk, market risk, operational risk, corporate governance, and AML/compliance; stronger control expectations for important businesses, including the use of 'advanced' approaches credit, market and operational risks; greater use of cross-institution reviews, both domestically and internationally, in order to confirm the use of good risk management, corporate governance and disclosure practices; selective use of external reviews to benchmark leading risk-control practices, especially for instances where best practices may reside outside Canada; regular use of stress tests to inform capital and liquidity assessments; setting, monitoring, and enforcing minimum and target TLAC ratios as set out in OSFI's TLAC Guideline; and assessing D-SIBs' recovery and resolution plans, as well as discussion of such plans with FISC partners and at crisis management groups.^{Footnote 45}

Information Disclosure Practices

Canadian D-SIBs are expected to have public information disclosure practices covering their financial condition and risk management activities that are among the best of their international peers.^{Footnote 46} Enhanced disclosure of institutions' risk models and risk management practices can play a helpful role in enhancing market confidence. As a result, D-SIBs are expected to adopt the recommendations of the Financial Stability Board's (FSB) Enhanced Disclosure Task Force,^{Footnote 47} future disclosure recommendations in the banking arena that are endorsed by international standard setters and the FSB, as well as evolving domestic and international bank risk disclosure best practices.

Annex 2 – Supervisory Target Capital Requirements

Figure 1: DTI capital expectations (% of RWA) DTI capital expectations (percentage of risk weight assets) – Text description This figure shows the capital requirements for big banks and small and medium sized banks in two columns. For both big banks, and small and medium sized banks, the minimum total capital requirements are 8% of risk weighted assets and the Pillar 1 buffers are from 8% to 10.5%. Big banks are also required to hold a further 1% in Pillar 1 capital from 10.5% to 11.5 % for the Domestic Systemically Important Bank surcharge. Pillar 2 buffers for big banks include an additional 1% Domestic Stability Buffer (as at May 1, 2020) as well as bank specific buffers in excess of this amount. Pillar 2 buffers for small and medium sized banks are bank specific buffers in excess of 10.5%.

Notes:

The size of DTI-specific Pillar II buffers will vary by institution as they are determined by each institution. Where applicable, the size of institutions' Countercyclical Buffer add-ons will vary. Calibration of the DSB is reviewed by OSFI semi-annually and is set between 0% to 4.0% of RWA. For Category III SMSBs, the DTI capital expectations in the chart are as a % of [Adjusted Total Assets + RWA Operational Risk]

Footnotes

Footnote 1 The capital and leverage requirements for domestic systemically-important banks are supplemented by the requirements described in OSFI's Total Loss Absorbing Capacity (TLAC) Guideline. Return to footnote 1 Footnote 2 The Basel Framework Return to footnote 2 Footnote 3 Following the format: [Basel Framework, XXX yy.zz] Return to footnote 3 Footnote 4 SMSBs are banks (including federal credit unions), bank holding companies, federally regulated trust companies, and federally regulated loan companies that have not been designated by OSFI as domestic systemically important banks (D-SIBs). This includes subsidiaries of SMSBs or D-SIBs that are banks (including federal credit unions), federally regulated trust companies or federally regulated loan companies. Return to footnote 4 Footnote 5 SMSB Capital and Liquidity Guideline Return to footnote 5 Footnote 6 This includes assets and liabilities booked outside of Canada as well as assets and liabilities of non-residents booked in Canada. Return to footnote 6 Footnote 7 Adjusted gross income is defined in section 3.3 Return to footnote 7 Footnote 8 Implementation Note – Assessment of Regulatory Capital Models for Deposit-Taking Institutions Return to footnote 8 Footnote 9 The Use of Ratings and Estimates of Default and Loss at IRB Institutions – Implementation Note Return to footnote 9 Footnote 10 For institutions with a fiscal year ending October 31 or December 31, respectively. Return to footnote 10 Footnote 11 There are two exceptions to this rule. One is that banks who have approval to use the IMM and who are currently using the Standardized CVA (S-CVA) approach are permitted to use the IMM EADs and maturities in the calculation of the S-CVA for purposes of the capital floor. The other is that banks currently using the Advanced CVA (A-CVA) approach for purposes of the capital floor may continue to do so. Both of these exceptions expire when the revised CVA framework is implemented in the first fiscal quarter of 2024. Return to footnote 11 Footnote 12 Applies only to performance bonuses issued to institutions' senior management. The term "senior management" is defined in OSFI's Corporate Governance Guideline. Return to footnote 12 Footnote 13 For Category III SMSBs, the capital conservation buffer is 2.5% of [Adjusted Total Assets + RWA Operational Risk] Return to footnote 13 Footnote 14 Similar capital conservation ratios apply where an institution breaches its Tier 1 capital or Total capital requirements. In the event that an institution simultaneously breaches more than one capital requirement (e.g. 7% CET1, 8.5% Tier 1, 10.5% Total capital) it must apply the most constraining capital conservation ratio. Return to footnote 14 Footnote 15 SAC is a non-statutory body chaired by the Deputy Minister of Finance. Its membership is the same as the Financial Institutions Supervisory Committee ("FISC"), i.e. OSFI, the Department of Finance, the Bank of Canada, the Canada Deposit Insurance Corporation, and the Financial Consumer Agency of Canada. The SAC operates as a consultative body and provides a forum for policy discussion on issues pertaining to the financial sector. Return to footnote 15 Footnote 16 The document entitled Guidance for national authorities operating the countercyclical capital buffer(PDF, 360 KB) sets out the principles that national authorities have agreed to follow in making buffer decisions. This document provides information that should help institutions to understand and anticipate the buffer decisions made by national authorities in the jurisdictions to which they have credit exposures. [BCBS Consolidated framework RBC 30.10] Return to footnote 16 Footnote 17 The Bank of Canada will be the primary source of public information on macro-financial developments and the state of vulnerabilities in Canada with regard to the countercyclical buffer, including as published in its Financial System Review (FSR). Return to footnote 17 Footnote 18 For Category III SMSBs, the countercyclical buffer requirement would be applied as a % of [Adjusted Total Assets + RWA Operational Risk] Return to footnote 18 Footnote 19 Similar constraints apply with respect to breaches of Tier 1 capital and Total capital requirements. Institutions should apply the most constraining capital conservation ratio where they breach more than one requirement. Return to footnote 19 Footnote 20 Institutions are expected to reciprocate the buffers implemented by every jurisdiction listed on the dedicated page of the BIS website. Reciprocity is mandatory, for all Basel Committee member jurisdictions, up to a maximum of 2.5% RWA, irrespective of whether host authorities require a higher add-on. [BCBS Consolidated framework RBC 30.13 FAQ3 and FAQ4] Return to footnote 20 Footnote 21 The geographic location of an institution's private sector exposures is determined by the location of the counterparties that make up the capital charge irrespective of the institution's own physical location or its country of incorporation. The location is identified according to the concept of ultimate risk (i.e. based on the country where the final risk lies, not where the exposure has been booked). The geographic location identifies the jurisdiction whose announced countercyclical buffer add-on is to be applied by the institution to the corresponding credit exposure, appropriately weighted. [BCBS Consolidated framework RBC 30.13 FAQ2 and 30.14 FAQ1] Return to footnote 21 Footnote 22 For Category III SMSBs, the weighting will be based on the institution's private sector credit exposures in a particular jurisdiction divided by its total private sector credit exposures across all jurisdictions. Return to footnote 22 Footnote 23 For Category III SMSBs, the consolidated countercyclical buffer requirement would be applied as a % of [Adjusted Total Assets + RWA Operational Risk]. Return to footnote 23 Footnote 24 For purposes of determining the country of residence of the ultimate obligor, guarantees and credit derivatives are considered but not collateral with the exception of exposures where the lender looks primarily to the revenues generated by the collateral, both as the source of repayment and as security for the exposure, such as Project Finance. The location of a securitization exposure is the location of the underlying obligor or, where the exposures are located in more than one jurisdiction, the institution can allocate the exposure to the country with the largest aggregate unpaid principal balance. Return to footnote 24 Footnote 25 The Superintendent will consider factors such as whether an institution's business model involves providing credit through intermediation of funds or whether the conditions that give rise to financial system-wide issues are explicitly addressed in a robust manner in the institution's internal capital targets. Return to footnote 25 Footnote 26 The countercyclical buffer is to be computed and applied at the consolidated FRFI parent level, i.e. OSFI regulated deposit-taking institutions who are subsidiaries of an OSFI regulated deposit-taking institution are not subject to the countercyclical buffer. Return to footnote 26 Footnote 27 The pre-announced buffer decision and actual buffer in place will be published on the BIS website. Return to footnote 27 Footnote 28 For Category III SMSBs, the countercyclical buffer would be applied as a % of [Adjusted Total Assets + RWA Operational Risk]. Return to footnote 28 Footnote 29 Annex 1 contains additional details around OSFI's process for designating Canadian institutions as D-SIBs. Return to footnote 29 Footnote 30 BCBS Consolidated framework RBC 40.1 to 40.6 Return to footnote 30 Footnote 31 Similar capital conservation ratios apply where a D-SIB breaches its Tier 1 capital or Total capital requirements. In the event that a D-SIB simultaneously breaches more than one capital requirement (e.g. 8% CET1, 9.5% Tier 1, 11.5% Total Capital) it must apply the most constraining capital conservation ratio. Return to footnote 31 Footnote 32 Details related to the OSFI's DSB are included on OSFI's website. Return to footnote 32 Footnote 33 Established under section 18 of the OSFI Act, the Financial Institutions Supervisory Committee consists of the Superintendent of Financial Institutions, the Commissioner of the Financial Consumer Agency of Canada, the Governor of the Bank of Canada, the Chief Executive Officer of the Canada Deposit Insurance Corporation, and the Deputy Minister of Finance. Return to footnote 33 Footnote 34 Guide to Intervention for Federally Regulated Deposit-Taking Institutions Return to footnote 34 Footnote 35 The conservation buffer is the sum of the 2.5% capital conservation buffer plus any countercyclical buffer add-ons, where applicable. Return to footnote 35 Footnote 36 As an example, where the DSB is set to 2% of RWA, D-SIBs' target capital ratios would be at least 10% for CET1, 11.5% for Tier 1 and 13.5% for Total capital. This reflects a conservation buffer of 2.5% and a D-SIB surcharge of 1.0%. Return to footnote 36 Footnote 37 Guide to Intervention for Federally Regulated Deposit-Taking Institutions Return to footnote 37 Footnote 38 For OSFI's expectations refer to Guideline E-18: Stress Testing and Guideline E-19: Internal Capital Adequacy Assessment Process (ICAAP). Return to footnote 38 Footnote 39 A framework for dealing with domestic systemically important banks (BCBS: October 2012) Return to footnote 39 Footnote 40 ACSS handles all Canadian dollar payments not processed by the LVTS. Return to footnote 40 Footnote 41 CLS Bank provides a real-time global network that links a number of national payments systems to settle the foreign exchange transactions of its member banks Return to footnote 41 Footnote 42 BCBS Consolidated framework RBC 40.1 to 40.6 and SCO 40.1 to 50.20 Return to footnote 42 Footnote 43 Details related to G-SIB's annual public disclosure requirements are included in OSFI's Global Systemically Important Banks – Public Disclosure Requirements Advisory Return to footnote 43 Footnote 44 OSFI's Supervisory Framework (OSFI: February 2011) Return to footnote 44 Footnote 45 Consistent with the Financial Stability Board's Key Attributes of Effective Resolution Regimes for Systemically Important Financial Institutions. OSFI is responsible for leading the assessment of recovery plans. The Canada Deposit Insurance Corporation is responsible for leading the assessment of resolution plans. Return to footnote 45 Footnote 46 OSFI's Pillar 3 Disclosure Guideline for D-SIBs: this guideline provides expectations for the domestic implementation of all three phases of the Pillar 3 Framework. Return to footnote 46 Footnote 47 Enhancing the Risk Disclosures of Banks (FSB: October 2012). Return to footnote 47

Note

For institutions with a fiscal year ending October 31 or December 31, respectively. The Capital Adequacy Requirements (CAR) for banks (including federal credit unions), bank holding companies, federally regulated trust companies, and federally regulated loan companies are set out in nine chapters, each of which has been issued as a separate document. This document should be read in conjunction with the other CAR chapters. The complete list of CAR chapters is as follows: Chapter 1 - Overview of Risk-based Capital Requirements Chapter 2 - Definition of Capital Chapter 3 - Operational Risk Chapter 4 - Credit Risk – Standardized Approach Chapter 5 - Credit Risk - Internal Ratings-Based Approach Chapter 6 - Securitization Chapter 7 - Settlement and Counterparty Risk Chapter 8 - Credit Valuation Adjustment (CVA) Risk Chapter 9 - Market Risk

Chapter 2 – Definition of Capital

This chapter is drawn from the Basel Committee on Banking Supervision's (BCBS) Basel Framework dated December 15, 2019.^{Footnote 1} For reference, the Basel paragraph numbers that are associated with the text appearing in this chapter are indicated in square brackets at the end of each paragraph.^{Footnote 2}

2.1 Requirements for Inclusion in Regulatory Capital

Regulatory capital consists of three categories, each governed by a single set of criteria that instruments are required to meet before inclusion in the relevant category. Common Equity Tier 1 (CET1) capital (going-concern capital) (section 2.1.1) Additional Tier 1 capital (going-concern capital) (section 2.1.2) Tier 2 capital (gone-concern capital) (section 2.1.3) Total regulatory capital is the sum of CET1, Additional Tier 1, and Tier 2 capital, net of regulatory adjustments described in section 2.3. Tier 1 capital is the sum of CET1 and Additional Tier 1 capital, net of the regulatory adjustments applied to those categories. [Basel Framework, CAP 10.1 & 10.2]

2.1.1 CET1 Capital

CET1 capital consists of the sum of the following elements: Common shares issued by the institution that meet the criteria for classification as common shares for regulatory purposes;^{Footnote 3} Stock surplus (share premium) resulting from the issue of instruments included in CET1;^{Footnote 4} Retained earnings; Accumulated other comprehensive income and other disclosed reserves; Contractual Service Margins (CSM) that are reported as liabilities in the financial statements of the insitutiton’s insurance subsidiaries, other than CSM in respect of segregated fund contracts with guarantee risks, net of CSM that are reported as assets in the financial statements; Common shares issued by consolidated subsidiaries of the institution and held by third parties that meet the criteria for inclusion in CET1 capital (see section 2.1.1.3); and Regulatory adjustments applied in the calculation of CET1 (see section 2.3.1). Retained earnings and other comprehensive income include interim profit or loss. Dividends are removed from CET1 in accordance with applicable accounting standards. The treatment of minority interest and the regulatory adjustments applied in the calculation of CET1 capital are addressed in sections 2.1.1.3 and 2.3.1, respectively. [Basel Framework, CAP 10.6 & 10.7]

2.1.1.1 Common shares issued by the institution directly

For an instrument to be included in CET1 capital, it must meet all of the following criteria and, in the case of instruments issued by a federal credit union, with the modifications or additional specifications set out in paragraph 5: Represents the most subordinated claim in liquidation of the institution. The investor is entitled to a claim on the residual assets that is proportional with its share of issued capital, after all senior claims have been paid in liquidation (i.e. has an unlimited and variable claim, not a fixed or capped claim). The principal is perpetual and never repaid outside of liquidation (setting aside discretionary repurchases or other means of effectively reducing capital in a discretionary manner that is allowable under relevant law and subject to the prior approval of the Superintendent). The institution does not, in the sale or marketing of the instrument, create an expectation at issuance that the instrument will be bought back, redeemed or cancelled, nor do the statutory or contractual terms provide any feature which might give rise to such expectation. Distributions are paid out of distributable items, including retained earnings. The level of distributions is not in any way tied or linked to the amount paid in at issuance and is not subject to a contractual cap (except to the extent that an institution is unable to pay distributions that exceed the level of distributable items or to the extent that distributions on senior ranking capital must be paid first). There are no circumstances under which the distributions are obligatory. Non-payment is, therefore, not an event of default. This requirement prohibits features that require the institution to make payments in kind. Distributions are paid only after all legal and contractual obligations have been met and payments on more senior capital instruments have been made. This means that there are no preferential distributions, including in respect of other elements classified as the highest quality issued capital. It is the issued capital that takes the first and proportionately greatest share of any losses as they occur. Within the highest quality of capital, each instrument absorbs losses on a going concern basis proportionately and pari passu with all the others. The paid-in amount is recognized as equity capital (i.e. not recognized as a liability) for determining balance sheet solvency. The paid-in amount is classified as equity under the relevant accounting standards. It is directly issued and paid-in^{Footnote 5} and the institution cannot directly or indirectly fund the purchase of the instrument. Where the consideration for the shares is other than cash, the issuance of the common shares is subject to the prior approval of the Superintendent. The paid-in amount is neither secured nor covered by a guarantee of the issuer or related entity^{Footnote 6} or subject to any other arrangement that legally or economically enhances the seniority of the claim. It is only issued with the approval of the owners of the issuing institution, either given directly by the owners or, if permitted by applicable law, given by the Board of Directors or by other persons duly authorized by the owners. It is clearly and separately disclosed as equity on the institution's balance sheet prepared in accordance with the relevant accounting standards.^{Footnote 7} [Basel Framework, CAP 10.8]

2.1.1.2 CET1 instruments issued by a federal credit union

For an instrument to be included in CET1 capital of a federal credit union, it must meet all of the criteria in paragraph 4 with any modifications or additional specifications set out in this paragraph: For instruments other than membership shares, the instrument need not meet CET1 eligibility criteria a, b, and h. Investors entitled to claims under such other CET1 instruments must rank pari passu with membership shares up to a predetermined amount of gross CET1 capital (i.e. CET1 capital gross of the regulatory adjustments described later in this chapter) which must be reset monthly according to the institution's last consolidated balance sheet filed with OSFI. Any assets remaining after the amount is reached would be distributed exclusively to the federal credit union's membership shareholders. Membership share and other CET1 distributions may be subject to a contractual cap. The purchase or redemption of membership shares may be granted at the sole discretion of the federal credit union, rather than that of its members or other investors. As part of this discretion, the federal credit union must have the unconditional right to refuse, limit or delay redemption of membership shares and such refusal or limitation would not constitute an event of default of the federal credit union. A federal credit union may, with the prior consent of the Superintendent, purchase or redeem membership shares provided there are no reasonable grounds to believe that the payment would cause the institution to be in contravention of capital adequacy or liquidity requirements.

2.1.1.3 Common shares issued by a consolidated subsidiary to third parties (i.e. Minority interest/Non-controlling interests)

Common shares issued by a fully consolidated subsidiary of the institution to a third party may receive limited recognition in the consolidated CET1 of the parent institution only if: the instrument, if issued by the institution directly, would meet all of the criteria described in sections 2.1.1.1 and 2.1.1.2 for classification as common shares for regulatory capital purposes; and the subsidiary that issued the instrument is itself a bank^{Footnote 8} ^{Footnote 9} The amount of capital meeting the above criteria that will be recognized in consolidated CET1 is calculated as follows (refer to Appendix 2-1 for an illustrative example): Paid-in capital that meets the criteria set out in paragraph 6 above plus retained earnings that are attributable to third-party investors, gross of deductions, less the amount of surplus CET1 capital of the subsidiary that is attributable to the third-party investors. The surplus CET1 capital of the subsidiary is calculated as the CET1 capital of the subsidiary, net of deductions, minus the lower of: (1) the minimum CET1 capital requirement of the subsidiary plus the capital conservation buffer (i.e. 7.0% of risk-weighted assets (RWA^{Footnote 10}))^{Footnote 11}; and (2) the portion of the parent's consolidated minimum CET1 capital requirements^{Footnote 12} plus the capital conservation buffer (i.e. 7.0% of RWA^{Footnote 10}) that relates to the subsidiary. The amount of surplus CET1 capital that is attributable to the third-party investors is calculated by multiplying the surplus CET1 capital of the subsidiary (calculated in b. above) by the percentage of CET1 that is attributable to third-party investors. Common shares issued to third-party investors by a consolidated subsidiary that is not a bank cannot be included in the consolidated CET1 of the parent. However, these amounts may be included in the consolidated Additional Tier 1 and Tier 2 capital of the parent, subject to the conditions in sections 2.1.2.2 and 2.1.3.2. [Basel Framework, CAP 10.20 and 10.21] For capital issued by a consolidated subsidiary of a group to third parties to be eligible for inclusion in the consolidated capital of the banking group, the minimum capital requirements and definition of capital must be calculated for the subsidiary irrespective of whether the subsidiary is regulated on a standalone basis. In addition, the contribution of the subsidiary to the consolidated capital requirement of the group (i.e. excluding the impact of intragroup exposures) must be calculated. All calculations must be undertaken in respect of the subsidiary on a sub-consolidated basis (i.e. the subsidiary must also consolidate all of its subsidiaries that are also included in the wider consolidated group). If this is considered too operationally burdensome, institutions may elect to give no recognition in consolidate capital of the group to the capital issued by the subsidiary to third parties. [Basel Framework, CAP 10.21 FAQ2]

2.1.1.4 Common shares issued to third parties out of Special Purpose Vehicles (SPVs)

Where capital has been issued to third parties out of an SPV, none of this capital can be included in CET1. However, such capital can be included in consolidated Additional Tier 1 or Tier 2 capital and treated as if the institution itself had issued the capital directly to the third parties only if: it meets all the relevant eligibility criteria; and the only asset of the SPV is its investment in the capital of the institution in a form that meets or exceeds all the relevant eligibility criteria^{Footnote 13} (as required by criterion 14 under paragraph 13 for Additional Tier 1 and criterion 9 under paragraph 27 for Tier 2 capital). In cases where the capital has been issued to third parties through an SPV via a fully consolidated subsidiary of the institution, such capital may, subject to the requirements of this paragraph, be treated as if the subsidiary itself had issued it directly to the third parties and may be included in the institution's consolidated Additional Tier 1 or Tier 2 in accordance with the treatment outlined in sections 2.1.2.2 and 2.1.3.2. [Basel Framework, CAP 10.26]

2.1.2 Additional Tier 1 Capital

Additional Tier 1 capital consists of the sum of the following elements: Instruments issued by the institution that meet the criteria for inclusion in Additional Tier 1 capital (and do not meet the criteria for inclusion in CET1); Stock surplus (i.e. share premium) resulting from the issue of instruments included in Additional Tier 1 capital. Surplus that is not eligible for inclusion in CET1 will only be permitted to be included in Additional Tier 1 capital if the shares giving rise to the surplus are permitted to be included in Additional Tier 1 capital. [Basel Framework, CAP 10.13]; Instruments issued by consolidated subsidiaries of the institution and held by third parties that meet the criteria for inclusion in Additional Tier 1 capital and are not included in CET1 (see sections 2.1.2.2 and 2.1.2.3); and Regulatory adjustments applied in the calculation of Additional Tier 1 capital (see section 2.3). [Basel Framework, CAP 10.9]

2.1.2.1 Additional Tier 1 instruments issued by the institution directly

The following is the minimum set of criteria for an instrument issued by the institution to meet or exceed in order for it to be included in Additional Tier 1 capital: Issued and paid-in in cash or, subject to the prior approval of the Superintendent, in property. Subordinated to depositors, general creditors, and subordinated debt holders of the institution. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis the institution's depositors and/or creditors.^{Footnote 14} Is perpetual, i.e. there is no maturity date and there are no step-ups^{Footnote 15} or other incentives to redeem.^{Footnote 16} May be callable at the initiative of the issuer only after a minimum of five years: To exercise a call option an institution must receive the prior approval of the Superintendent; and An institution's actions and the terms of the instrument must not create an expectation that the call will be exercised;^{Footnote 17} and An institution must not exercise the call unless: It replaces the called instrument with capital of the same or better quality, including through an increase in retained earnings, and the replacement of this capital is done at conditions which are sustainable for the income capacity of the institution;^{Footnote 18} or The institution demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.^{Footnote 19} Tax and regulatory event calls are permitted at any time subject to the prior approval of the Superintendent and provided the institution was not in a position to anticipate such an event at the time of issuance.^{Footnote 20} The investor must have no rights to accelerate the repayment of future scheduled principal or interest payments, except in bankruptcy, insolvency, wind-up, or liquidation. Any repayment of principal (e.g. through repurchase or redemption) must be subject to the prior approval of the Superintendent and institutions should not assume or create market expectations that such approval will be given. Dividend/coupon discretion: the institution must have full discretion at all times to cancel distributions/payments^{Footnote 21} cancellation of discretionary payments must not be an event of default or credit event institutions must have full access to cancelled payments to meet obligations as they fall due cancellation of distributions/payments must not impose restrictions on the institution except in relation to distributions to common shareholders. Dividends/coupons must be paid out of distributable items. The instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the institution or organization's credit standing.^{Footnote 22} The instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of national insolvency law. The instrument must be classified as equity for accounting purposes.^{Footnote 23} Neither the institution nor a related party over which the institution exercises control or significant influence can have purchased the instrument, nor can the institution directly or indirectly have funded the purchase of the instrument.^{Footnote 24} The instruments cannot have any features that hinder recapitalization, such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame. If the instrument is not issued out of an operating entity or the holding company in the consolidated group (i.e. it is issued out of a special purpose vehicle – "SPV"), proceeds must be immediately available without limitation to an operating entity^{Footnote 25} or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Additional Tier 1 capital. For greater certainty, the only assets the SPV may hold are intercompany instruments issued by the institution or a related entity with terms and conditions that meet or exceed the Additional Tier 1 criteria. Put differently, instruments issued to the SPV have to fully meet or exceed all of the eligibility criteria for Additional Tier 1 capital as if the SPV itself was an end investor – i.e. the institution cannot issue a lower quality capital or senior debt instrument to an SPV and have the SPV issue higher quality capital instruments to third-party investors so as to receive recognition as Additional Tier 1 capital.^{Footnote 26} The contractual terms and conditions of the instrument must include a clause requiring the full and permanent conversion of the instrument into common shares at the point of non-viability as described under OSFI's non-viability contingent capital (NVCC) requirements as specified under section 2.2.^{Footnote 27} Where an instrument is issued by an SPV according to criterion #14 above, the conversion of instruments issued by the SPV to end investors should mirror the conversion of the capital issued by the institution to the SPV. [Basel Framework, CAP 10.11] Purchase for cancellation of Additional Tier 1 capital instruments is permitted at any time with the prior approval of the Superintendent. For further clarity, a purchase for cancellation does not constitute a call option as described in the above Additional Tier 1 criteria. Dividend stopper arrangements that stop payments on common shares or other Additional Tier 1 instruments are permissible provided the stopper does not impede the full discretion the institution must have at all times to cancel distributions or dividends on the Additional Tier 1 instrument, nor must it act in a way that could hinder the recapitalization of the institution pursuant to criterion # 13 above. For example, it would not be permitted for a stopper on an Additional Tier 1 instrument to: attempt to stop payment on another instrument where the payments on the other instrument were not also fully discretionary; prevent distributions to shareholders for a period that extends beyond the point in time that dividends or distributions on the Additional Tier 1 instrument are resumed; impede the normal operation of the institution or any restructuring activity, including acquisitions or disposals. A dividend stopper may also act to prohibit actions that are equivalent to the payment of a dividend, such as the institution undertaking discretionary share buybacks. Where an amendment or variance of an Additional Tier 1 instrument's terms and conditions affects its recognition as regulatory capital, such amendment or variance will only be permitted with the prior approval of the Superintendent.^{Footnote 28} [Basel Framework, CAP 10.11 FAQ9] Institutions are permitted to "re-open" offerings of Additional Tier 1 capital instruments to increase the principal amount of the original issuance subject to the following: institutions cannot re-open offerings where the initial issue date was on or before December 31, 2012; federal credit unions cannot re-open offerings of instruments issued prior to the institution's continuance as a federal credit union; and, in both cases, call options will only be exercised, with the prior approval of the Superintendent, on or after the fifth anniversary of the closing date of the latest re-opened tranche of securities. Defeasance or other options that could result in a decrease of the institution's regulatory capital may only be exercised on or after the fifth anniversary of the closing date with the prior approval of the Superintendent.

2.1.2.2 Additional Tier 1 qualifying capital instruments issued by a subsidiary to third parties

Additional Tier 1 capital instruments issued by a fully consolidated subsidiary of the institution to third-party investors (including amounts under section 2.1.1.3) may receive recognition in the consolidated Tier 1 capital of the parent institution only if the instrument, if issued by the institution, would meet or exceed all of the criteria for classification as Tier 1 capital. The amount of capital that will be recognized in Tier 1 is calculated as follows (Refer to Appendix 2-1 for an illustrative example): Total Tier 1 capital of the subsidiary issued to third parties that are attributable to third-party investors, gross of deductions, less the amount of surplus Tier 1 capital of the subsidiary that is attributable to the third-party investors. The surplus Tier 1 capital of the subsidiary is calculated as the Tier 1 capital of the subsidiary, net of deductions, minus the lower of: (1) the minimum Tier 1 capital requirement of the subsidiary plus the capital conservation buffer (i.e. 8.5% of RWA^{Footnote 29})^{Footnote 30}; and (2) the portion of the parent's consolidated minimum Tier 1 capital requirements^{Footnote 31} plus the capital conservation buffer (i.e. 8.5% of RWA^{Footnote 29}) that relates to the subsidiary. The amount of surplus Tier 1 capital that is attributable to the third-party investors is calculated by multiplying the surplus Tier 1 capital of the subsidiary (calculated in (b) above) by the percentage of Tier 1 that is held by third party investors. The amount of this Tier 1 capital that will be recognized in Additional Tier 1 will exclude amounts recognized in CET1 under section 2.1.1.3. [Basel Framework, CAP 10.22 and 10.23]

2.1.2.3 Additional Tier 1 instruments issued to third parties out of SPVs

As stated under paragraph 10, where capital has been issued to third parties out of an SPV none of this capital can be included in CET1. However, such capital can be included in consolidated Additional Tier 1 or Tier 2 and treated as if the institution itself had issued the capital directly to the third parties only if: it meets all the relevant eligibility criteria; and the only asset of the SPV is its investment in the capital of the institution in a form that meets or exceeds all the relevant eligibility criteria^{Footnote 32} (as required by criterion 14 of the Additional Tier 1 criteria set out under section 2.1.2.1). In cases where the capital has been issued to third parties through an SPV via a fully consolidated subsidiary of the institution, such capital may, subject to the requirements of this paragraph, be treated as if the subsidiary itself had issued it directly to the third parties and may be included in the institution's consolidated Additional Tier 1 or Tier 2 in accordance with the treatment outlined in sections 2.1.2.2 and 2.1.3.2.

2.1.2.4 Additional Tier 1 instruments issued to a parent

In addition to the qualifying criteria and minimum requirements specified in this guideline, Additional Tier 1 capital instruments issued by an institution to a parent, either directly or indirectly, can be included in regulatory capital subject to the institution providing notification of the intercompany issuance to OSFI's Capital Division together with the following: a copy of the instrument's terms and conditions; the intended classification of the instrument for regulatory capital purposes; the rationale provided by the parent for not providing common equity in lieu of the subject capital instrument; confirmation that the rate and terms of the instrument as at the date of the transaction are at least as favourable to the institution as market terms and conditions; and confirmation that the failure to make dividend or interest payments, as applicable, on the subject instrument would not result in the parent, now or in the future, being unable to meet its own debt servicing obligations nor would it trigger cross-default clauses or credit events under the terms of any agreements or contracts of either the institution or the parent.

2.1.2.5 Capital instruments issued out of branches and subsidiaries outside Canada

In addition to any other requirements prescribed in this guideline, where an institution wishes to consolidate a capital instrument issued out of a branch or subsidiary outside Canada, it must provide OSFI's Capital Division with the following documentation: a copy of the instrument's terms and conditions; certification from a senior executive of the institution, together with the institution's supporting analysis, that confirms that the instrument meets or exceeds the Basel III qualifying criteria for the tier of regulatory capital in which the institution intends to include the instrument on a consolidated basis; and an undertaking whereby both the institution and the subsidiary confirm that the instrument will not be redeemed, purchased for cancellation, or amended without the prior approval of the Superintendent. Such undertaking will not be required where the prior approval of the Superintendent is incorporated into the terms and conditions of the instrument.

2.1.3 Tier 2 Capital

Tier 2 capital (prior to regulatory adjustments) consists of the following elements: Instruments issued by the institution that meet the criteria for inclusion in Tier 2 capital (and are not included in Tier 1 capital); Stock surplus (i.e. share premium) resulting from the issue of instruments included in Tier 2 capital. Surplus that is not eligible for inclusion in Tier 1 will only be permitted to be included in Tier 2 capital if the shares giving rise to the surplus are permitted to be included in Tier 2 capital. [Basel Framework, CAP 10.17]; Instruments issued by consolidated subsidiaries of the institution and held by third parties that meet the criteria for inclusion in Tier 2 capital and are not included in Tier 1 capital (see sections 2.1.3.1 and 2.1.3.3); and Certain loan loss allowances as specified in section 2.1.3.7. [Basel Framework, CAP 10.14]

2.1.3.1 Tier 2 instruments issued by the institution directly

The following is the minimum set of criteria for an instrument issued by the institution to meet or exceed in order for it to be included in Tier 2 capital: Issued and paid-in in cash, or with the prior approval of the Superintendent, in property. Subordinated to depositors and general creditors of the institution. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis the institution's depositors and/or general creditors. Maturity: Minimum original maturity of at least five years Recognition in regulatory capital in the remaining five years before maturity will be amortized on a straight-line basis There are no step-ups^{Footnote 33} or other incentives to redeem May be callable at the initiative of the issuer only after a minimum of five years: To exercise a call option an institution must receive the prior approval of the Superintendent; and An institution must not do anything which creates an expectation that the call be exercised;^{Footnote 34} and An institution must not exercise the call unless: It replaces the called instrument with capital of the same or better quality, including through an increase in retained earnings, and the replacement of this capital is done at conditions which are sustainable for the income capacity of the institution;^{Footnote 35} or The institution demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.^{Footnote 36} The use of tax and regulatory event calls are permitted during an instrument's life subject to the prior approval of the Superintendent and provided the institution was not in a position to anticipate such an event at the time of issuance.^{Footnote 37} The investor must have no rights to accelerate the repayment of future scheduled principal or interest payments, except in bankruptcy, insolvency, wind-up, or liquidation. The instrument cannot have a credit sensitive dividend feature; that is, a dividend or coupon that is reset periodically based in whole or in part on the institution or organizations' credit standing.^{Footnote 38} Neither the institution nor a related party over which the institution exercises control or significant influence can have purchased the instrument, nor can the institution directly or indirectly have funded the purchase of the instrument. If the instrument is not issued out of an operating entity^{Footnote 39} or the holding company in the consolidated group (i.e. it is issued out of a special purpose vehicle – "SPV"), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Tier 2 capital. For greater certainty, the only assets the SPV may hold are intercompany instruments issued by the institution or a related entity with terms and conditions that meet or exceed the above Tier 2 criteria. Put differently, instruments issued to the SPV have to fully meet or exceed all of the eligibility criteria for Tier 2 capital as if the SPV itself was an end investor – i.e. the institution cannot issue a senior debt instrument to an SPV and have the SPV issue higher quality capital instruments to third party investors so as to receive recognition as Tier 2 capital.^{Footnote 40} The contractual terms and conditions of the instrument must include a clause requiring the full and permanent conversion of the instrument into common shares at the point of non-viability as described under OSFI's non-viability contingent capital (NVCC) requirements as specified under section 2.2.^{Footnote 41} Where an instrument is issued by an SPV according to criterion #9 above, the conversion of instruments issued by the SPV to end investors should mirror the conversion of the capital issued by the institution to the SPV. [Basel Framework, CAP 10.14] Tier 2 capital instruments must not contain restrictive covenants or default clauses that would allow the holder to trigger acceleration of repayment in circumstances other than the insolvency, bankruptcy or winding-up of the issuer. Purchase for cancellation of Tier 2 instruments is permitted at any time with the prior approval of the Superintendent. For further clarity, a purchase for cancellation does not constitute a call option as described in the above Tier 2 criteria. Where an amendment or variance of a Tier 2 instrument's terms and conditions affects its recognition as regulatory capital, such amendment or variance will only be permitted with the prior approval of the Superintendent.^{Footnote 42} Defeasance or other options that could result in a decrease of the institution's regulatory capital may only be exercised on or after the fifth anniversary of the closing date with the prior approval of the Superintendent. Institutions are permitted to "re-open" offerings of capital instruments to increase the principal amount of the original issuance subject to the following: institutions cannot re-open offerings where the initial issue date was on or before December 31, 2012; federal credit unions cannot re-open offerings of instruments issued prior to the institution's continuance as a federal credit union; and, in both cases, call options will only be exercised, with the prior approval of the Superintendent, on or after the fifth anniversary of the closing date of the latest re-opened tranche of securities.

2.1.3.2 Tier 2-qualifying capital instruments issued by a subsidiary to third parties

Total capital instruments (i.e. Tier 1 and Tier 2 capital instruments) issued by a fully consolidated subsidiary of the institution to third-party investors (including amounts under sections 2.1.1.3 and 2.1.2.2) may receive recognition in the consolidated Total capital of the parent institution only if the instruments would, if issued by the institution, meet all of the criteria for classification as Tier 1 or Tier 2 capital. The amount of capital that will be recognized in consolidated Total Capital is calculated as follows (refer to Appendix 2-1 for an illustrative example): Total capital of the subsidiary issued to third parties that is attributable to third-party investors, gross of deductions, less the amount of surplus Total Capital of the subsidiary that is attributable to the third-party investors. The surplus Total capital of the subsidiary is calculated as the Total Capital of the subsidiary, net of deductions, minus the lower of: (1) the minimum Total Capital requirement of the subsidiary plus the capital conservation buffer (i.e. 10.5% of RWA;^{Footnote 43} ^{Footnote 44} and (2) the portion of the parent's consolidated minimum Total Capital requirements^{Footnote 45} plus the capital conservation buffer (i.e. 10.5% of RWA^{Footnote 43}) that relates to the subsidiary. The amount of surplus Total capital that is attributable to the third-party investors is calculated by multiplying the surplus Total capital of the subsidiary (calculated in (b)) by the percentage of Total Capital that is attributable to third-party investors. The amount of this Total capital that will be recognized in Tier 2 will exclude amounts recognized in CET1 under section 2.1.1.3 and amounts recognized in Additional Tier 1 under section 2.1.2.2. [Basel Framework, CAP 10.24 and 10.25]

2.1.3.3 Tier 2 instruments issued to third parties out of SPVs

As stated under paragraph 10, where capital has been issued to third parties out of an SPV none of this capital can be included in CET1. However, such capital can be included in consolidated Additional Tier 1 or Tier 2 and treated as if the institution itself had issued the capital directly to the third parties only if: it meets all the relevant eligibility criteria; and the only asset of the SPV is its investment in the capital of the institution in a form that meets or exceeds all the relevant eligibility criteria^{Footnote 46} (as required by criterion 9 of the Tier 2 criteria set out under section 2.1.3.1). In cases where the capital has been issued to third parties through an SPV via a fully consolidated subsidiary of the institution, such capital may, subject to the requirements of this paragraph, be treated as if the subsidiary itself had issued it directly to the third parties and may be included in the institution's consolidated Additional Tier 1 or Tier 2 in accordance with the treatment outlined in sections 2.1.2.2 and 2.1.3.2. [Basel Framework, CAP 10.26]

2.1.3.4 Tier 2 instruments issued to a parent

In addition to the qualifying criteria and minimum requirements specified in this guideline, Tier 2 capital instruments issued by an institution to a parent, either directly or indirectly, can be included in regulatory capital subject to the institution providing notification of the intercompany issuance to OSFI's Capital Division together with the following: a copy of the instrument's term and conditions; the intended classification of the instrument for regulatory capital purposes; the rationale provided by the parent for not providing common equity in lieu of the subject capital instrument; confirmation that the rate and terms of the instrument as at the date of the transaction are at least as favourable to the institution as market terms and conditions; confirmation that the failure to make dividend or interest payments, as applicable, on the subject instrument would not result in the parent, now or in the future, being unable to meet its own debt servicing obligations nor would it trigger cross-default clauses or credit events under the terms of any agreements or contracts of either the institution or the parent.

2.1.3.5 Capital instruments issued out of branches and subsidiaries outside Canada

Debt instruments issued out of branches or subsidiaries outside Canada must normally be governed by Canadian law. The Superintendent may, however, waive this requirement where the institution can demonstrate that an equivalent degree of subordination can be achieved as under Canadian law. Instruments issued prior to year-end 1994 are not subject to this requirement. In addition to any other requirements prescribed in this guideline, where an institution wishes to consolidate a capital instrument issued by a foreign subsidiary, it must provide OSFI's Capital Division with the following documentation: a copy of the instrument's term and conditions; certification from a senior executive of the institution, together with the institution's supporting analysis, that confirms that the instrument meets or exceeds the Basel III qualifying criteria for the tier of regulatory capital in which the institution intends to include the instrument on a consolidated basis; and an undertaking whereby both the institution and the subsidiary confirm that the instrument will not be redeemed, purchased for cancellation, or amended without the prior approval of the Superintendent. Such undertaking will not be required where the prior approval of the Superintendent is incorporated into the terms and conditions of the instrument.

2.1.3.6 Amortization

Tier 2 capital instruments are subject to straight-line amortization in the final five years prior to maturity. Hence, as these instruments approach maturity, redemption or retraction, such outstanding balances are to be amortized based on the following criteria: Amortization criteria for outstanding balances Years to Maturity Included in Capital 5 years or more 100% 4 years and less than 5 years 80% 3 years and less than 4 years 60% 2 years and less than 3 years 40% 1 year and less than 2 years 20% Less than 1 year 0% For instruments issued prior to January 1, 2013, where the terms of the instrument include a redemption option that is not subject to prior approval of the Superintendent and/or holders' retraction rights, amortization should begin five years prior to the effective dates governing such options. For example, a 20-year debenture that can be redeemed at the institution's option at any time on or after the first 10 years would be subject to amortization commencing in year 5. Further, where a subordinated debt was redeemable at the institution's option at any time without the prior approval of the Superintendent, the instrument would be subject to amortization from the date of issuance. For greater certainty, this would not apply when redemption requires the Superintendent's approval as is required for all instruments issued after January 1, 2013 pursuant to the above criteria in section 2.1.3.1. Amortization should be computed at the end of each fiscal quarter based on the "years to maturity" schedule in paragraph 38 above. Thus, amortization would begin during the first quarter that ends within five calendar years to maturity. For example, if an instrument matures on October 31, 2020, 20% amortization of the issue would occur November 1, 2015 and be reflected in the January 31, 2016 capital adequacy return. An additional 20% amortization would be reflected in each subsequent January 31 return.

2.1.3.7 General allowances^{Footnote 47}

Institutions using the standardized approach for credit risk Allowances that are held against future, presently unidentified losses are freely available to meet losses which subsequently materialize and therefore qualify for inclusion within Tier 2. Such allowances are termed 'general allowances' in this guideline, and are defined as Stage 1 and Stage 2 allowances under IFRS 9. Allowances held against any identified losses, whether individual or grouped, should be excluded. These allowances are termed 'specific allowances' in this guideline, and are defined as Stage 3 allowances plus partial write-offs under IFRS 9. General allowances eligible for inclusion in Tier 2 capital will be limited to a maximum of 1.25% of credit RWA^{Footnote 48} calculated under the Standardized Approach, and should exclude allowances held against underlying assets treated as a securitization for capital purposes. Deposit-taking institutions in the business of lending must meet all of the principles and criteria in OSFI's IFRS 9 Guideline^{Footnote 49} in order for general allowances to be included in Tier 2 capital. Inclusion of general allowances in capital does not require prior approval from OSFI. [Basel Framework, CAP 10.18] Institutions using an IRB approach for credit risk calculate a provisioning excess or shortfall as follows: (1) general allowances, plus (2) all other allowances for credit loss excluding allowances against securitizaton exposures or underlying assets treated as a securitizaton for capital purposes, minus (3) the expected loss amount deduct provisioning shortfalls from CET1 capital include provisioning excess in Tier 2 capital up to a limit of the lower of 0.6% of IRB credit RWA or the amount of general allowances [Basel Framework, CAP 10.19] Institutions that have partially implemented an IRB approach^{Footnote 50} split general allowances between the Standardized Approach and the IRB Approach in a manner consistent with the institution's internal and external allowance reporting include general allowances allocated to the Standardized Approach in Tier 2 capital up to a limit of 1.25% of credit RWA calculated using the Standardized Approach calculate a provisioning excess or shortfall on the IRB portion of the institution as set out above deduct provisioning shortfalls on the IRB portion of the institution from CET1 capital include excess provisions calculated for the IRB portion of the institution in Tier 2 capital up to a limit of the lower of 0.6% of IRB credit RWA or the amount of general allowances allocated to the IRB portion of the institution

2.2 Non-Viability Contingent Capital Requirements (NVCC)

All regulatory capital must be able to absorb losses in a failed financial institution. The NVCC requirements aim to ensure that investors in non-common regulatory capital instruments bear losses before taxpayers where the government determines it is in the public interest to rescue a non-viable bank.^{Footnote 51}

2.2.1 Principles Governing NVCC

Effective January 1, 2013, all non-common Tier 1 and Tier 2 capital instruments issued by institutions must comply with the following principles to satisfy the NVCC requirement: Principle # 1: Non-common Tier 1 and Tier 2 capital instruments must have, in their contractual terms and conditions, a clause requiring a full and permanent conversion^{Footnote 52} into common shares of the institution upon a trigger event.^{Footnote 53} As such, the terms of non-common capital instruments must not provide for any residual claims that are senior to common equity following a trigger event. OSFI will consider and permit the inclusion of NVCC instruments with alternative mechanisms, including conversions into shares of a parent firm or affiliate, on a case-by-case basis. Institutions that are federal credit unions will be permitted to structure NVCC instruments with contractual clauses that provide for either a full and permanent write-off of the instrument upon a trigger event or a full and permanent conversion into instruments that are eligible for recognition as CET1 capital under the criteria set out in section 2.1.1.1 of this guideline. Principle # 2: All NVCC instruments must also meet all other criteria for inclusion under their respective tiers as specified in Basel III. For certainty, the classification of an instrument as either Additional Tier 1 capital or Tier 2 capital will depend on the terms and conditions of the NVCC instrument in the absence of a trigger event. Principle # 3: The contractual terms of all Additional Tier 1 and Tier 2 capital instruments must, at a minimum, include the following trigger events: the Superintendent of Financial Institutions (the "Superintendent") publicly announces that the institution has been advised, in writing, that the Superintendent is of the opinion that the institution has ceased, or is about to cease, to be viable and that, after the conversion or write-off, as applicable, of all contingent instruments and taking into account any other factors or circumstances that are considered relevant or appropriate, it is reasonably likely that the viability of the institution will be restored or maintained; or a federal or provincial government in Canada publicly announces that the institution has accepted or agreed to accept a capital injection, or equivalent support, from the federal government or any provincial government or political subdivision or agent or agency thereof without which the institution would have been determined by the Superintendent to be non-viable.^{Footnote 54} The term "equivalent support" in the above second trigger constitutes support for a non-viable institution that enhances the institution's risk-based capital ratios or is funding that is provided on terms other than normal terms and conditions. For greater certainty, and without limitation, equivalent support does not include: Emergency Liquidity Assistance provided by the Bank of Canada at or above the Bank Rate; open bank liquidity assistance provided by CDIC at or above its cost of funds; and support, including conditional, limited guarantees, provided by CDIC to facilitate a transaction, including an acquisition or amalgamation. In addition, shares of an acquiring institution paid as non-cash consideration to CDIC in connection with a purchase of a bridge institution would not constitute equivalent support triggering the NVCC instruments of the acquirer as the acquirer would be a viable financial institution. Principle # 4: The conversion terms of new NVCC instruments must reference the market value of common equity on or before the date of the trigger event.^{Footnote 55} The conversion method must also include a limit or cap on the number of shares issued upon a trigger event. Principle # 5: The conversion method should take into account the hierarchy of claims in liquidation and result in the significant dilution of pre-existing common shareholders. More specifically, the conversion should demonstrate that former subordinated debt holders receive economic entitlements that are more favourable than those provided to former preferred shareholders, and that former preferred shareholders receive economic entitlements that are more favourable than those provided to pre-existing common shareholders. Principle # 6: The issuing institution must ensure that, to the extent that it is within the institution's control, there are no impediments to the conversion or write-off so that conversion or write-off will be automatic and immediate. Without limiting the generality of the foregoing, this includes the following: the institution's by-laws or other relevant constating documents must permit the issuance of common shares upon conversion without the prior approval of existing capital providers; the institution's by-laws or other relevant constating documents must permit the requisite number of shares to be issued upon conversion; the terms and conditions of any other agreement must not provide for the prior consent of the parties in respect of the conversion or write-off, as applicable; the terms and conditions of capital instruments must not impede conversion or write-off, as applicable; and if applicable, the institution has obtained all prior authorization, including regulatory approvals and listing requirements, to issue the common shares arising upon conversion. Principle # 7: The terms and conditions of the non-common capital instruments must specify that conversion or write-off does not constitute an event of default under that instrument. Further, the issuing institution must take all commercially reasonable efforts to ensure that conversion or write-off is not an event of default or credit event under any other agreement entered into by the institution, directly or indirectly, on or after the date of this guideline, including senior debt agreements and derivative contracts. Principle # 8: The terms of the NVCC instrument should include provisions to address NVCC investors that are prohibited, pursuant to the legislation governing the institution, from acquiring common shares in the institution upon a trigger event. Such mechanisms should allow such capital providers to comply with legal prohibitions while continuing to receive the economic results of common share ownership and should allow such persons to transfer their entitlements to a person that is permitted to own shares in the institution and allow such transferee to thereafter receive direct share ownership. Principle # 9: For institutions, including Schedule II banks, that are subsidiaries of foreign financial institutions that are subject to Basel III capital adequacy requirements, any NVCC issued by the institution must be convertible into common shares of the institution or, subject to the prior consent of OSFI, convertible into common shares of the institution's parent. In addition, the trigger events in an institution's NVCC instruments must not include triggers that are at the discretion of a foreign regulator or are based upon events applicable to an affiliate (such as an event in the home jurisdiction of an institution's parent). Principle # 10: For institutions that have subsidiaries in foreign jurisdictions that are subject to the Basel III capital adequacy requirements, the institution may, to the extent permitted by the Basel III rules,^{Footnote 56} include the NVCC issued by foreign subsidiaries in the institution's consolidated regulatory capital provided that such foreign subsidiary's NVCC complies with the NVCC requirements according to the rules of its host jurisdiction. NVCC instruments issued by foreign subsidiaries must, in their contractual terms, also include triggers that are equivalent to the triggers specified in Principle # 3 above.^{Footnote 57} OSFI will only activate such triggers in respect of a foreign subsidiary after consultation with the host authority where 1) the subsidiary is non-viable as determined by the host authority and 2) the parent institution is, or would be, non-viable, as determined by OSFI, as a result of providing, or committing to provide, a capital injection or similar support to the subsidiary. This treatment is required irrespective of whether the host jurisdiction has implemented the NVCC requirements on a contractual basis or on a statutory basis.

2.2.2 Criteria to be considered in triggering conversion or write-off of NVCC

The decision to maintain an institution as a going concern where it would otherwise become non-viable will be informed by OSFI's interaction with the Financial Institutions Supervisory Committee (FISC)^{Footnote 58} (and any other relevant agencies the Superintendent determines should be consulted in the circumstances). In particular, the Superintendent will consult with the FISC member agencies prior to making a non-viability determination. It is important to note the conversion or write-off of NVCC alone may not be sufficient to restore an institution to viability; that is, other public sector interventions, including liquidity assistance, would likely be used in tandem with NVCC to maintain an institution as a going concern. Consequently, while the Superintendent would have the authority to trigger conversion or write-off, in practice, the Superintendent's decision to activate the trigger would be conditioned by the legislative provisions and decision frameworks associated with accompanying interventions by other FISC agencies. In assessing whether an institution has ceased, or is about to cease, to be viable and that, after the conversion or write-off of all contingent capital instruments, it is reasonably likely that the viability of the institution will be restored or maintained, the Superintendent would consider, in consultation with FISC, all relevant facts and circumstances, including the criteria outlined in relevant legislation and regulatory guidance.^{Footnote 59} Without limiting the generality of the foregoing, this could include a consideration of the following criteria, which may be mutually exclusive and should not be viewed as an exhaustive list:^{Footnote 60} Whether the assets of the institution are, in the opinion of the Superintendent, sufficient to provide adequate protection to the institution's depositors and creditors. Whether the institution has lost the confidence of depositors or other creditors and the public. This may be characterized by ongoing increased difficulty in obtaining or rolling over short-term funding. Whether the institution's regulatory capital has, in the opinion of the Superintendent, reached a level, or is eroding in a manner, that may detrimentally affect its depositors and creditors. Whether the institution failed to pay any liability that has become due and payable or, in the opinion of the Superintendent, the institution will not be able to pay its liabilities as they become due and payable. Whether the institution failed to comply with an order of the Superintendent to increase its capital. Whether, in the opinion of the Superintendent, any other state of affairs exists in respect of the institution that may be materially prejudicial to the interests of the institution's depositors or creditors or the owners of any assets under the institution's administration, including where proceedings under a law relating to bankruptcy or insolvency have been commenced in Canada or elsewhere in respect of the holding body corporate of the institution. Whether the institution is unable to recapitalize on its own through the issuance of common shares or other forms of regulatory capital. For example, no suitable investor or group of investors exists that is willing or capable of investing in sufficient quantity and on terms that will restore the institution's viability, nor is there any reasonable prospect of such an investor emerging in the near-term in the absence of conversion or write-off of NVCC instruments. Further, in the case of a privately-held institution, including a Schedule II bank, the parent firm or entity is unable or unwilling to provide further support to the subsidiary. For greater certainty, Canadian authorities will retain full discretion to choose not to trigger NVCC notwithstanding a determination by the Superintendent that an institution has ceased, or is about to cease, to be viable. Under such circumstances, the institution's creditors and shareholders could be exposed to losses through the use of other resolution tools or in liquidation. For information on the capital confirmation process, with specific reference to the NVCC documentation requirements see Appendix 2-2 to this chapter.

2.3 Required Regulatory Adjustments to Capital

This section sets out the regulatory adjustments to be applied to regulatory capital. In most cases these adjustments are applied in the calculation of CET1. All items that are deducted from capital are risk-weighted at 0% in the risk-based capital adequacy framework. Balance sheet assets that are deducted from Tier 1 capital are excluded from total exposures when calculating the leverage ratio. Except in respect of the items referred to in paragraphs 63 and 68 below, institutions shall not make adjustments to remove from CET1 capital unrealized gains or losses on assets or liabilities that are measured at fair value for accounting purposes. Global systemically important banks (G-SIBs) are required to meet a minimum Total Loss Absorbing Capacity (TLAC) requirement set in accordance with the Financial Stability Board's (FSB) TLAC principles and term sheet (the FSB TLAC Term Sheet). Similarly, Canadian D-SIBs are subject to minimum TLAC ratios as set out in OSFI's TLAC Guideline. Institutions that invest in TLAC or similar instruments issued by G-SIBs and/or Canadian D-SIBs may be required to deduct such holdings in calculating their own regulatory capital.^{Footnote 61} [Basel Framework, CAP 30.2] For the purpose of section 2.3, holdings of TLAC include the following, hereafter collectively referred to as "Other TLAC Instruments": all direct, indirect, and synthetic investments in the instruments of a D-SIB that are eligible to be recognized as TLAC pursuant to OSFI's TLAC Guideline and that do not otherwise qualify as regulatory capital for the issuing D-SIB;^{Footnote 62} all direct, indirect, and synthetic investments in the instruments of a G-SIB resolution entity that are eligible to be recognized as external TLAC and that do not otherwise qualify as regulatory capital for the issuing G-SIB, with the exception of instruments excluded by paragraph 54; and all holdings of instruments issued by a G-SIB resolution entity that rank pari passu to any instruments included in (ii) with the exception of: instruments listed as liabilities excluded from TLAC in section 10 of the FSB TLAC Term Sheet (i.e. "Excluded Liabilities"); and instruments ranking pari passu with instruments eligible to be recognized as TLAC by virtue of the exemptions to the subordination requirements in section 11 of the FSB TLAC Term Sheet. [Basel Framework, CAP 30.3] In certain jurisdictions (excluding Canada), G-SIBs may be able to recognize instruments ranking pari passu to Excluded Liabilities as external TLAC, up to a limit, in accordance with the exceptions to the subordination requirements set out in the penultimate paragraph of section 11 of the FSB TLAC Term Sheet. An institution's holdings of such instruments will be subject to a proportionate deduction approach. Under this approach, only a proportion of holdings of instruments that is eligible to be recognized as external TLAC by virtue of the subordination exemptions will be considered a holding of TLAC by the investing institution. The proportion is calculated as: (1) the funding issued by the G-SIB resolution entity that ranks pari passu with Excluded Liabilities and that is recognized as external TLAC by the G-SIB resolution entity; divided by (2) the funding issued by the G-SIB resolution entity that ranks pari passu with Excluded Liabilities and that would be recognized as external TLAC if the subordination requirement was not applied.^{Footnote 63} Institutions must calculate their holdings of Other TLAC Instruments of the respective issuing G-SIB resolution entities based on the latest available public information provided by the issuing G-SIBs on the proportion to be used. [Basel Framework, CAP 30.4 & 30.5] The regulatory adjustments relating to TLAC holdings set out in section 2.3 apply from Q1 2019.^{Footnote 64}

2.3.1 Regulatory Adjustments to CET1 Capital

Prudential valuation adjustments

Valuation adjustments on less liquid positions as described in paragraphs 104 to 107 of Chapter 9 of this guideline should be made in the calculation of CET1. [Basel Framework, CAP 50.14]

Goodwill and other intangibles (except mortgage servicing rights)

Goodwill related to consolidated subsidiaries, subsidiaries deconsolidated for regulatory capital purposes, and the proportional share of goodwill in joint ventures subject to the equity method accounting should be deducted in the calculation of CET1. In addition, goodwill included in the valuation of significant investments^{Footnote 65} in the capital of banking, financial, and insurance entities that are outside the scope of regulatory consolidation should also be deducted from CET1. The full amount is to be deducted net of any associated deferred tax liability which would be extinguished if the goodwill becomes impaired or derecognized under relevant accounting standards. [Basel Framework, CAP 30.7] All other intangible assets^{Footnote 66} except mortgage servicing rights and right-of-use (ROU) assets where the underlying asset being leased is a tangible asset^{Footnote 67} should be deducted in the calculation of CET1. This includes intangible assets related to consolidated subsidiaries, subsidiaries deconsolidated for regulatory capital purposes, and the proportional share of intangible assets in joint ventures subject to the equity method accounting. The full amount is to be deducted net of any associated deferred tax liability which would be extinguished if the intangibles assets become impaired or derecognized under relevant accounting standards. Mortgage servicing rights are deducted through the "threshold deductions" set out in paragraphs 91 to 93. [Basel Framework, CAP 30.7]

Prepaid portfolio insurance assets

Premiums paid for mortgage portfolio insurance (bulk insurance) and capitalized on the balance sheet are to be deducted in the calculation of CET1 where the premiums are not amortized in accordance with the expectations set out in section 4.1.23 of Chapter 4 of this guideline. The amount deducted is net of any associated deferred tax liability that would be extinguished if the asset were to become impaired or derecognized under the relevant accounting standards.

Deferred tax assets

Deferred tax assets (DTAs), except for those referenced in paragraph 61 and DTAs associated with the de-recognition of the cash flow hedge reserve, are to be deducted in the calculation of CET1. Deferred tax assets may be netted with associated deferred tax liabilities (DTLs) only if the DTAs and DTLs relate to taxes levied by the same taxation authority and offsetting is permitted by the relevant taxation authority.^{Footnote 68} Where these DTAs relate to temporary differences (e.g. allowance for credit losses) the amount to be deducted is set out in the "threshold deductions" (paragraphs 91 to 93). All other DTAs relating to operating losses, such as the carry forward of unused tax losses or unused tax credits, are to be deducted in full net of deferred tax liabilities and net of valuation allowance as described above. The DTLs permitted to be netted against DTAs must exclude amounts that have been netted against the deduction of goodwill, intangibles, defined benefit pension assets, the de-recognition of the cash flow hedge reserve, and prepaid portfolio insurance assets and must be allocated on a pro rata basis between DTAs subject to the threshold deduction treatment, DTAs that are to be deducted in full and DTAs that are risk-weighted at 100% as per paragraph 61. [Basel Framework, CAP 30.9] DTAs arising from temporary differences that the institution could realize through loss carrybacks, that is, they do not depend on the future profitability of the institution to be realized, are not subject to deduction, and instead receive a 100% risk weight.^{Footnote 69} OSFI's Capital Division requires notification, through the institution's Lead Supervisor, of any DTAs which are assigned the applicable 100% risk weight and institutions may be subject to increased supervisory monitoring in this area.

Current tax assets

When an over installment of tax, or current year tax losses carried back to prior years result in the recognition for accounting purposes of a claim or receivable from the government or local tax authority, such a claim or receivable would be assigned the relevant sovereign risk weighting. Such amounts are classified as current tax assets for accounting purposes. Current tax assets are not required to be deducted in the calculation of CET1. [Basel Framework, CAP 30.10]

Cash flow hedge reserve

The amount of cash flow hedge reserve that relates to the hedging of items that are not fair valued on the balance sheet (including projected cash flows) should be derecognized in the calculation of CET1. This includes items that are not recognized on the balance sheet but excludes items that are fair valued on the balance sheet. Positive amounts should be deducted from CET1 and negative amounts should be added back. This treatment specifically identifies the element of the cash flow hedge reserve that is to be derecognized for prudential purposes. It removes the element that gives rise to artificial volatility in common equity, as in this case the reserve only reflects one half of the picture (the fair value of the derivative, but not the changes in fair value of the hedged future cash flow). [Basel Framework, CAP 30.11 & 30.12]

Shortfall in provisions to expected losses

Provisioning shortfalls calculated under IRB Approaches to credit risk should be deducted in the calculation of CET1. The full amount is to be deducted and should not be reduced by any tax effects that could be expected to occur if provisions were to rise to the level of expected losses. [Basel Framework, CAP 30.13]

Non-payment and non-delivery on non-Delivery versus Payment (DvP) transactions

For non-DvP (including non-PvP) transactions where five business days have elapsed since the second contractual payment/delivery date and where the second leg has not effectively taken place, institutions that have made the first payment leg should deduct from CET1 capital the full amount of the value transferred plus replacement cost, if any.^{Footnote 70}

Materiality thresholds on credit protection

Materiality thresholds on payments below which the protection provider is exempt from payment in the event of loss are equivalent to retained first-loss positions. The portion of the exposure that is below a materiality threshold for credit protection must be deducted from CET1 by the institution purchasing the credit protection.^{Footnote 71} [Basel Framework, CRE 22.79]

Gain on sale related to securitization transactions

Increases in equity capital resulting from securitization transactions (e.g. capitalized future margin income, gains on sale) should be deducted in the calculation of CET1. [Basel Framework, CAP 30.14]

Cumulative gains and losses due to changes in own credit risk on fair valued financial liabilities

All after-tax unrealized gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the institution's own credit risk should be derecognized in the calculation of CET1. In addition, with regard to derivative liabilities, all accounting valuation adjustments arising from the institution's own credit risk should also be derecognized on an after-tax basis. The offsetting between valuation adjustments arising from the institution's own credit risk and those arising from its counterparties' credit risk is not allowed. Institutions that have adopted funding valuation adjustment (funding cost adjustment plus funding benefit adjustment) are expected to derecognize their funding benefit adjustment in full (i.e. gross of any funding cost adjustment).^{Footnote 72} [Basel Framework, CAP 30.15]

Defined benefit pension fund assets and liabilities

Defined benefit pension fund liabilities, as included on the balance sheet, must be fully recognized in the calculation of CET1 (i.e. CET1 cannot be increased through derecognizing these liabilities). For each defined benefit pension fund that is an asset on the institution's balance sheet, the amounts reported as an asset on the balance sheet^{Footnote 73} should be deducted in the calculation of CET1 net of any associated deferred tax liability that would be extinguished if the asset should become impaired or derecognized under the relevant accounting standards. Assets in the fund to which the institution has unrestricted and unfettered access can, with prior OSFI approval, be used to offset the deduction. In addition, where a Canadian institution has a foreign subsidiary which is insured by a deposit insurance corporation and the regulatory authority in that jurisdiction permits the subsidiary to offset its deduction from CET1 related to defined benefit pension assets on the basis that the insurer has unrestricted and unfettered access to the excess assets of the subsidiary's pension plan in the event of receivership, OSFI will allow the offset to be reflected in the Canadian institution's consolidated regulatory capital, subject to prior OSFI approval. Such offsetting assets should be given the risk weight they would receive if they were owned directly by the institution. [Basel Framework, CAP 30.16]

Reverse mortgages

Where a reverse mortgage exposure has a current loan-to-value (LTV) greater than 80%, the exposure amount that exceeds 80% LTV is deducted from CET1 capital. The remaining amount is risk weighted at 100%.

Exposures to non-qualifying central counterparties (CCP)

Institutions must fully deduct their default fund contributions (including default fund exposures to QCCP subject to the cap in paragraph 207 of Chapter 7) to a non-qualifying CCP from CET1 capital. For the purposes of this paragraph, the default fund contributions of such institutions will include both the funded and the unfunded contributions which are liable to be paid should the CCP so require. Where there is a liability for unfunded contributions (i.e. unlimited binding commitments), OSFI will determine in its Pillar 2 assessments the amount of unfunded commitments to which a CET1 deduction should apply.

Investments in own common shares - treasury stock^{Footnote 74}

All of an institution's investments in its own common shares^{Footnote 75} ^{Footnote 76} and/or other CET1 capital instruments, whether held directly or indirectly, will be deducted in the calculation of CET1 (unless already derecognized under IFRS). In addition, any own stock which the institution could be contractually obliged to purchase should be deducted in the calculation of CET1. The treatment described will apply irrespective of the location of the exposure i.e. if the exposure is in the banking book or the trading book. In addition: Gross long positions may be deducted net of short positions in the same underlying exposure only if the short positions involve no counterparty risk. Institutions should look though holdings of index securities to deduct exposures to own shares. However, gross long positions in own shares resulting from holdings of index securities may be netted against short positions in own shares resulting from short positions in the same underlying index provided the maturity of the short position matches the maturity of the long position or has a residual maturity of at least one year. In such cases, the short positions may involve counterparty credit risk (which will be subject to the relevant counterparty credit risk charge). Subject to supervisory approval, a bank may use a conservative estimate of investments in its own shares where the exposure results from holdings of index securities and the banks finds it operationally burdensome to look through and monitor its exact exposure. [Basel Framework, CAP 30.18]

Reciprocal cross holdings in the common shares of banking, financial and insurance entities

Reciprocal cross holdings in common shares (e.g. Bank A holds shares of Bank B and Bank B in return holds shares of Bank A) that are designed to artificially inflate the capital position of institutions will be fully deducted in the calculation of CET1. [Basel Framework, CAP 30.21]

Decision tree to determine the capital treatment of equity investments in funds

When an equity investment (including an equity investment in a fund) is made, the following decision tree should be used to determine how the capital requirements for that equity investment should be calculated: The first decision point is to consider whether the entity in which the equity investment is made is a banking, financial or insurance entity. If it is, then either paragraphs 84 to 93 below (significant investments) or paragraphs 77 to 83 (non-significant investments) should be used to calculate capital requirements for the equity investment. If the entity is not a financial entity, then the next question to ask is whether the entity is a fund. If it is, then either section 4.1.22 of Chapter 4 or section 5.2.2 of Chapter 5 of the CAR Guideline should be used to calculate capital requirements for the equity investment. As noted in section 4.1.22 of Chapter 4, if an equity investment is subject to the fall-back approach, the insitution's equity investment in the fund is to be deducted from CET1 capital. [Basel Framework, CRE 60.8] Finally, if the equity investment is made in an entity that is not captured in (a) or (b) above, then either paragraph 76 of this chapter (significant investment in a commercial entity) or the de-facto treatment for equity investments (non-significant investments) of either Chapter 4 or Chapter 5 should be used to calculate capital requirements for the equity investment.

Significant investments in commercial entities

Significant investments^{Footnote 77} in commercial entities that, in aggregate, exceed 10% of CET1 capital should be fully deducted in the calculation of CET1 capital. Amounts less than this threshold are subject to a 250% risk-weight^{Footnote 78} as set out in Chapter 4.

Non-significant investments in the capital and/or Other TLAC Instruments of banking, financial^{Footnote 79} and insurance entities^{Footnote 80} ^{Footnote 81}

The regulatory adjustment described in this section applies to investments in the capital and/or Other TLAC Instruments of banking, financial and insurance entities where the investment is not considered a significant investment.^{Footnote 82} These investments are deducted from regulatory capital, subject to a threshold. For the purpose of this regulatory adjustment: Investments include direct, indirect, and synthetic holdings of capital instruments and/or Other TLAC Instruments. Institutions should look through holdings of index securities to determine their underlying holdings of capital or Other TLAC Instruments. If institutions find it operationally burdensome to look through and monitor their exact exposures to other financial institutions as a result of their holdings of index securities, OSFI will permit institutions, subject to prior supervisory approval, to use a conservative estimate. An indirect holding arises when an institution invests in an unconsolidated intermediate entity that has an exposure to the capital of an unconsolidated bank, financial or insurance entity and thus gains an exposure to the capital of that entity.^{Footnote 83} ^{Footnote 84} [Basel Framework, CAP 99.9] A synthetic holding arises when an institution invests in an instrument where the value of the instrument is directly linked to the value of the capital of an unconsolidated bank, financial or insurance entity. [Basel Framework, CAP 99.10] A written put option will not be considered a synthetic holding for purposes of this paragraph where all of the following conditions have been met: The purchase price for the subject capital or Other TLAC instrument will be based on the future market value, or fair value to be determined in the future via a third party or through an arms-length negotiation between institutions. The contractual terms of the option/agreement provide that the institution has the legal right, without consent from the counterparty/counterparties, to issue an equivalent notional amount of its own capital or, for G-SIBs and D-SIBs, its own TLAC in an equivalent (or higher quality) tier as consideration for the subject capital or TLAC. The institution publicly discloses the material terms of the put option that permit the bank to settle the option through the issuance of an equivalent notional amount of its own capital or, for G-SIBs and D-SIBs, its own TLAC in an equivalent (or higher quality) tier. The institution has obtained the prior approval of the Superintendent to exclude the written put option from its investment in financials. Holdings in both the banking book and trading book are to be included. Capital includes common stock and all other types of cash and synthetic capital instruments (e.g. subordinated debt). Other TLAC Instruments are defined in paragraphs 53 and 54. For capital instruments, it is the net long position that is to be included (i.e. the gross long position net of short positions in the same underlying exposure where the maturity of the short position either matches the maturity of the long position or has a residual maturity of at least one year).^{Footnote 85} For Other TLAC Instruments, it is the gross long position that is to be included in paragraphs 102 to 104 and the net long position that is to be included in paragraph 81. Underwriting positions in capital instruments and/or Other TLAC Instruments held for five working days or less can be excluded. Underwriting positions held for more than five working days must be included. If the capital instrument of the entity in which the institution has invested does not meet the criteria for CET1, Additional Tier 1 or Tier 2 capital of the institution, the capital is to be considered common shares for the purposes of this capital deduction.^{Footnote 86}^{Footnote 87} [Basel Framework, CAP 30.22] Guarantees or other capital enhancements provided by an institution to such entities will be treated as capital invested in other financial institutions based on the maximum amount that the institution could be required to pay out under such arrangements.^{Footnote 88} [Basel Framework, CAP 30.22 FAQ1] Exposures should be valued according to their valuation on the institution's balance sheet. Subject to prior supervisory approval, institutions may temporarily exclude certain investments where these have been made in the context of resolving or providing financial assistance to reorganize a distressed institution. [Basel Framework, CAP 30.22 FAQ4] Synthetic exposures should be valued as follows: for call options, the current carrying value; for put options, the number of shares times the strike price; for any other synthetic holdings, the nominal or notional amount. For options or forward purchase agreements with a variable price, institutions are required to estimate, on a periodic basis, the market value, strike price or nominal amount of the underlying holding (as the case may be). This estimation may be subject to periodic review by OSFI and may be required to be substantiated through an external third party valuation in the case of material uncertainty. To determine the amount to be deducted from capital: Institutions should compare the total of all holdings of capital instruments (after applicable netting) and Other TLAC Instruments to 10% of the institution's CET1 after all regulatory adjustments listed in paragraphs 56 to 74. The Other TLAC Instruments included herein should not reflect those items covered by the 5% threshold described in paragraphs 103 and 104 (for D-SIBs and G-SIBs) or paragraph 102 (for all other institutions). The amount by which the total of all holdings of capital instruments and Other TLAC Instruments listed above exceeds the 10% threshold described in (a) should be deducted from capital in aggregate and on a net long basis in the manner set out below. In the case of capital instruments, deduction should be made applying a corresponding deduction approach. This means the deduction should be applied to the same component of capital for which the capital would qualify if it was issued by the institution itself. In the case of holdings of Other TLAC Instruments, the deduction should be applied to Tier 2 capital. Deductions should be applied in the following manner: The amount to be deducted from CET1 capital is equal to the deduction amount multiplied by the total holdings in CET1 of other institutions divided by the total holdings of capital instruments and Other TLAC Instruments determined in (a). The amount to be deducted from Additional Tier 1 capital is equal to the deduction amount multiplied by the total holdings in Additional Tier 1 capital of other institutions divided by the total holdings of capital instruments and Other TLAC Instruments determined in (a). The amount to be deducted from Tier 2 capital is equal to the deduction amount multiplied by the total holdings in Tier 2 capital and Other TLAC Instruments of other institutions that are not covered by paragraphs 102 to 104 divided by the institution's total holdings of capital instruments and holdings of Other TLAC Instruments determined in (a). [Basel Framework, CAP 30.26] The amount of all holdings which falls below the 10% threshold described in paragraph 81(a) will not be deducted from capital. Instead, these investments will be subject to the applicable risk weighting^{Footnote 89} as specified in the approach to credit risk (banking book exposures) or market risk (trading book exposures) used by the institution. For the application of risk weighting, the amount of holdings must be allocated on a pro rata basis between those below and those above the threshold. [Basel Framework, CAP 30.28] If an institution is required to make a deduction from a particular tier of capital and it does not have sufficient capital to make that deduction, the shortfall will be deducted from the next highest tier of capital (e.g. if an institution does not have sufficient Additional Tier 1 capital to satisfy the deduction, the shortfall will be deducted from CET1). [Basel Framework, CAP 30.27]

Significant investments^{Footnote 90} in the capital and/or Other TLAC Instruments of banking, financial and insurance entities^{Footnote 91} that are outside the scope^{Footnote 92} of regulatory consolidation^{Footnote 93} ^{Footnote 94}

The regulatory adjustments described in this section apply to investments in the capital and/or Other TLAC Instruments of banking, financial, and insurance entities that are outside the scope of regulatory consolidation where the institution has a significant investment or where the entity is an affiliate of the bank. Investments include direct, indirect, and synthetic holdings of capital instruments or Other TLAC Instruments. Institutions should look through holdings of index securities to determine their underlying holdings in capital^{Footnote 95} and/or Other TLAC Instruments. If institutions find it operationally burdensome to look through and monitor their exact exposures to other financial institutions as a result of their holdings of index securities, OSFI will permit institutions, subject to prior supervisory approval, to use a conservative estimate. An indirect holding arises when an institution invests in an unconsolidated intermediate entity that has an exposure to the capital of an unconsolidated bank, financial or insurance entity and thus gains an exposure to the capital of that entity. [Basel Framework, CAP 99.9] A synthetic holding arises when an institution invests in an instrument where the value of the instrument is directly linked to the value of the capital of an unconsolidated bank, financial or insurance entity.^{Footnote 79} [Basel Framework, CAP 99.10] A written put option will not be considered a synthetic holding for purposes of this paragraph where all of the following conditions have been met: The purchase price for the subject capital or Other TLAC instrument will be based on the future market value, or fair value to be determined in the future via a third party or through an arm's-length negotiation between institutions. The contractual terms of the option/agreement provide that the institution has the legal right, without consent from the counterparty/counterparties, to issue an equivalent notional amount of its own capital, or in the case of G-SIBs and D-SIBs, its own TLAC in an equivalent (or higher quality) tier as consideration for the subject capital. The institution publicly discloses the material terms of the put option that permit the bank to settle the option through the issuance of an equivalent notional amount of its own capital, or in the case of a G-SIB or D-SIB, its own TLAC in an equivalent (or higher quality) tier. The institution has obtained the prior approval of the Superintendent to exclude the written put option from its investment in financials. Holdings in both the banking book and trading book are to be included. Capital includes common stock and all other types of cash and synthetic capital instruments (e.g. subordinated debt). Other TLAC Instruments are defined in paragraphs 53 and 54. The net long position is to be included (i.e. the gross long position net of short positions in the same underlying exposure where the maturity of the short position either matches the maturity of the long position or has a residual maturity of at least one year).^{Footnote 96} Underwriting positions in capital instruments or Other TLAC Instruments held for five working days or less can be excluded. Underwriting positions held for more than five working days must be included. If the capital instrument of the entity in which the institution has invested does not meet the criteria for CET1, Additional Tier 1 or Tier 2 capital of the institution, the capital is to be considered common shares for the purposes of this capital deduction.^{Footnote 97} ^{Footnote 98} [Basel Framework, CAP 30.29] Institutions are required to notify OSFI's Capital Division, through their Lead Supervisor, if the required deduction is made at the insurance operating company level, rather than the insurance holding company level, where a holding company exists directly above the insurance entity and greater than 50% of the holding company's holdings are invested in insurance subsidiaries. Initial notifications should be made beginning January 2013 and subsequent updates should be provided to OSFI upon material changes. Further, institutions may be subject to increased supervisory overview in this area. Guarantees or other capital enhancements provided by an institution to such entities will be treated as capital invested in other financial institutions based on the maximum amount that the institution could be required to pay out under such arrangements.^{Footnote 99} [Basel Framework, CAP 30.29 FAQ1] Exposures should be valued using the equity method of accounting as defined under IFRS (i.e. initial cost of the subsidiary + retained earnings net of dividends + AOCI).^{Footnote 100} Subject to prior supervisory approval, institutions may temporarily exclude certain investments where these have been made in the context of resolving or providing financial assistance to reorganize a distressed institution. [Basel Framework, CAP 30.22 FAQ4] Synthetic exposures should be valued as follows: for call options, the current carrying value; for put options, the number of shares times the strike price; for any other synthetic holdings, the nominal or notional amount. For options or forward purchase agreements with a variable price, institutions are required to estimate, on a periodic basis, the market value, strike price or nominal amount of the underlying holding (as the case may be). This estimation may be subject to periodic review by OSFI and may be required to be substantiated through an external third party valuation in the case of material uncertainty. All investments in capital instruments included above that are not common shares must be fully deducted from the corresponding tier of capital. This means the deduction should be applied to the same tier of capital for which the capital would qualify if it were issued by the institution itself (i.e. investments in the Additional Tier 1 capital of other entities must be deducted from the institution's Additional Tier 1 capital).^{Footnote 101} All holdings of Other TLAC Instruments included above (and as defined in paragraphs 53 and 54, i.e. applying the proportionate deduction approach for holdings of instruments eligible for TLAC by virtue of the penultimate paragraph of section 11 of the FSB Term Sheet) must be fully deducted from Tier 2 capital. [Basel Framework, CAP 30.30] Investments included above that are common shares will be subject to the threshold deductions as described in paragraphs 91 to 93. [Basel Framework, CAP 30.31] If an institution is required to make a deduction from a particular tier of capital and it does not have sufficient capital to make that deduction, the shortfall will be deducted from the next highest tier of capital (e.g. if an institution does not have sufficient Additional Tier 1 capital to satisfy the deduction, the shortfall will be deducted from CET1). [Basel Framework, CAP 30.30]

Threshold deductions (basket)

The following items will be subject to the capital deductions described in this section: Significant investments in the common shares of banking, financial and insurance entities that are outside the scope of regulatory consolidation (as defined in paragraphs 84 to 89); Mortgage servicing rights (MSRs), including those related to consolidated subsidiaries, subsidiaries deconsolidated for regulatory capital purposes, and the proportional share of MSRs in joint ventures subject to proportional consolidation or equity method accounting.; and Deferred tax assets arising from temporary differences (see paragraph 60). [Basel Framework, CAP 30.32] To determine the amount to be deducted from capital, Institutions should compare each of the above items to 10% of the institution's CET1 after all deductions listed in paragraphs 56 to 90 but before the threshold deductions listed in this section. The amount by which each of the above items exceeds the 10% threshold described in (a) should be deducted from CET1 capital. If the amount of the aggregate of the above items not deducted from CET1 capital after the application of all regulatory adjustments exceeds 15% of the institution's CET1 after all regulatory adjustments, then a deduction of such excess from CET1 is required, subject to (d) below. To determine the amount of the aggregate of the above items that is not required to be deducted from CET1, institutions should multiply the amount of CET1 (after all deductions including the deduction of the three items in full) by 17.65% (this number is derived from the proportion of 15% to 85%). Only the excess above this amount must be deducted from CET1. See Appendix 2-3 for an example of the final calculation. [Basel Framework CAP, 30.33 FAQ1] The amount of the above three items not deducted from CET1 capital will be risk-weighted at 250%.^{Footnote 102} [Basel Framework, CAP 30.34]

2.3.2 Regulatory Adjustments to Additional Tier 1 capital

Net Tier 1 capital is defined as gross Tier 1 capital adjusted to include all Tier 1 regulatory adjustments.

Investments in own Additional Tier 1 capital instruments

Institutions are required to make deductions from Additional Tier 1 capital for investments in their own Additional Tier 1 capital instruments (unless already derecognized under IFRS). In addition, any Additional Tier 1 capital instrument in which the institution could be contractually obliged to purchase should be deducted in the calculation of Tier 1 capital. [Basel Framework, CAP 30.20]

Reciprocal cross holdings in Additional Tier 1 capital of banking, financial and insurance entities

Reciprocal cross holdings (e.g. Bank A holds investments in Additional Tier 1 capital instruments of Bank B and Bank B in return holds investments in Additional Tier 1 capital instruments of Bank A) that are designed to artificially inflate the capital position of institutions will be fully deducted from Additional Tier 1 capital. [Basel Framework, CAP 30.21]

Non-significant investments in the capital of banking, financial and insurance entities

Institutions are required to make deductions from Additional Tier 1 capital for investments in the capital of banking, financial, and insurance entities which are not considered to be significant investments as described in paragraphs 77 to 83 above.^{Footnote 103} [Basel Framework, CAP 30.26]

Significant investments in the capital of banking, financial and insurance entities that are outside the scope of regulatory consolidation^{Footnote 104} ^{Footnote 105}

Institutions are required to make deductions from Additional Tier 1 capital for significant investments in the capital of banking, financial, and insurance entities that are outside the scope of regulatory consolidation as described in paragraphs 84 to 90 above. [Basel Framework 30.29]

Deductions related to insufficient Tier 2 capital

If an institution does not have sufficient Tier 2 capital needed to make required deductions from Tier 2 capital, the shortfall must be deducted from Additional Tier 1 capital.

2.3.3 Regulatory Adjustments to Tier 2 capital

Net Tier 2 capital is defined to be Tier 2 capital including all Tier 2 regulatory adjustments, but may not be lower than zero. If the total of all Tier 2 deductions exceeds Tier 2 capital available, the excess must be deducted from Tier 1.

Investments in own Tier 2 capital instruments and/or own Other TLAC Instruments

Institutions are required to make deductions from Tier 2 capital for investments in their own Tier 2 capital instruments (unless already derecognized under IFRS). In addition, any Tier 2 capital instrument in which the institution could be contractually obliged to purchase should be deducted in the calculation of Total capital. G-SIBs and D-SIBs must also deduct holdings of their own Other TLAC Instruments in the calculation of their TLAC ratios.^{Footnote 106} [Basel Framework, CAP 30.20)]

Reciprocal cross holdings in Tier 2 capital and/or Other TLAC Instruments of banking, financial and insurance entities

Reciprocal cross holdings (e.g. Bank A holds investments in Tier 2 capital instruments of Bank B and Bank B in return holds investments in Tier 2 capital instruments of Bank A) that are designed to artificially inflate the capital position of institutions will be fully deducted from Tier 2 capital. Reciprocal cross holdings of Other TLAC Instruments that are designed to artificially inflate the TLAC position of G-SIBs and/or D-SIBs must also be deducted in full from Tier 2 capital. [Basel Framework, CAP 30.21]

Non-significant investments in the capital of banking, financial and insurance entities and/or Other TLAC Instruments issued by G-SIBs and D-SIBs (which are not considered significant investments)^{Footnote 107}

Institutions are required to make deductions from Tier 2 capital for investments in the capital of banking, financial, and insurance entities and/or investments in Other TLAC Instruments issued by D-SIBs and/or G-SIBs which are not considered significant investments as described in paragraphs 77 to 83 above. [Basel Framework, CAP 30.26] If an institution is not a D-SIB or a G-SIB, its holdings of Other TLAC Instruments must be deducted from Tier 2 capital per subparagraph 81(b)(iii) unless: (1) such holdings are, in aggregate and on a gross long basis, less than 5% of the institution's CET1 (after applying the regulatory adjustments listed in paragraphs 56 to 74); or (2) the holding falls within the 10% threshold provided for in paragraph 81. [Basel Framework, CAP 30.25] A D-SIB or G-SIB's holdings of Other TLAC Instruments must be deducted from Tier 2 capital per subparagraph 81(b)(iii) unless (1) the following market-making exemption conditions are met; or (2) the holding falls within the 10% threshold provided for in paragraph 81: the holding has been designated by the D-SIB or G-SIB to be treated as market-making activities in accordance with this paragraph; the holding is in the bank's trading book; and the holding has not been held for more than 30 business days from the date of its acquisition. This market-making exemption is available for holdings that are, in aggregate and on a gross long basis, up to 5% of the D-SIB or G-SIB's CET1 (after applying the regulatory adjustments listed in paragraphs 56 to 74). Holdings in excess of 5% of the D-SIB or G-SIB's CET1 must be deducted from Tier 2 capital. [Basel Framework, CAP 30.23] If a holding designated under paragraph 103 no longer meets any of the market-making exemption conditions set out in that paragraph, it must be deducted in full from Tier 2 capital. Once a holding has been designated under paragraph 103, it may not subsequently be included within the 10% threshold referred to in paragraph 81. This approach is designed to limit the use of the 5% allowance in paragraph 103 to holdings of Other TLAC Instruments needed to be held within the banking system to ensure deep and liquid markets. [Basel Framework, CAP 30.24] The amount of all holdings which falls below the 5% thresholds described in paragraphs 102 and 103 will not be deducted from capital. Instead, these investments will be subject to the applicable risk weighting as specified in the approach to credit risk (banking book exposures) or market risk (trading book exposures) used by the institution. For the application of risk weighting, the amount of holdings must be allocated on a pro rata basis between those below and those above the threshold. [Basel Framework, CAP 30.28]

Significant investments in the capital of banking, financial and insurance entities and/or Other TLAC Instruments issued by G-SIBs and D-SIBs that are outside the scope of regulatory consolidation^{Footnote 108} ^{Footnote 109}

Institutions are required to make deductions from Tier 2 capital for significant investments in the capital of banking, financial, and insurance entities and/or investments in Other TLAC Instruments issued by D-SIBs and/or G-SIBs that are outside the scope of regulatory consolidation as described in paragraphs 84 to 90 above. [Basel Framework, CAP 30.29]

2.4 Transitional arrangements for Federal Credit Unions

The following transition will apply to non-qualifying capital instruments issued by a federal credit union or a subsidiary of a federal credit union. Beginning in the year that an institution continues as a federal credit union, outstanding capital instruments that do not qualify as CET1, Additional Tier 1 or Tier 2 capital according to the criteria for inclusion outlined in section 2.1 will be subject to a phase-out. To be eligible for a phase-out, the instrument must have been recognized under provincial capital requirements as regulatory capital prior to the institution's continuance as a federal credit union. Non-qualifying instruments that were not recognized as regulatory capital under provincial capital requirements prior to continuance will not be eligible for transitioning. The phase-out period will begin upon the institution's continuance as a federal credit union.^{Footnote 110} Fixing the base at the nominal amount of the capital instruments outstanding on the continuance date, recognition of non-qualifying instruments will be capped at 90% in Year 1, with the cap reducing by 10 percentage points in each subsequent year.^{Footnote 111} Transitional phase-out of outstanding non-qualifying federal credit union instruments Reporting period Applicable cap Year 1 90% Year 2 80% Year 3 70% Year 4 60% Year 5 50% Year 6 40% Year 7 30% Year 8 20% Year 9 10% Year 10 0% This cap will be applied to non-qualifying CET1, Additional Tier 1 and Tier 2 capital separately.^{Footnote 112} As the cap refers to the total amount of instruments outstanding within each tier of capital, some instruments in a tier may continue to fully qualify as capital while others may need to be excluded to comply with the cap. To the extent an instrument is redeemed, or its recognition in capital is amortized during the transitioning period, the nominal amount serving as the base is not reduced. Where an instrument is fully derecognized upon the institution's continuance as a federal credit union or otherwise ineligible for these transitioning arrangements, the instrument must not be included in the fixed base. Where an instrument's recognition in capital is subject to amortization on or before the institution's continuance, only the amortized amount recognized in capital as at that date should be taken into account in the amount fixed for transitioning rather than the full nominal amount. In addition, limited life instruments subject to transition will be subject to amortization on a straight-line basis at a rate of 20% per annum in their final five years to maturity, while the aggregate cap will be reduced at a rate of 10% per year. Where a non-qualifying instrument includes a step-up or other incentive to redeem, it must be fully excluded from regulatory capital on the effective date of that incentive to redeem. Surplus (i.e. share premium) may be included in the base provided that it relates to an instrument that is eligible to be included in the base for the transitional arrangements. Non-qualifying instruments that are denominated in a foreign currency should be included in the base using their value in the reporting currency of the institution as at the date of continuance. The base will therefore be fixed in the reporting currency of the institution throughout the transition period. During the transition period, instruments denominated in a foreign currency should be valued as they are reported on the balance sheet of the institution at the relevant reporting date (adjusting for any amortization in the case of Tier 2 instruments).

Appendix 2-1 – Illustrative example of the inclusion of capital issued by a subsidiary to third parties in consolidated regulatory capital

The following is an illustrative example of the calculation for determining the amount of capital issued out of subsidiaries to third parties that can be included in the parent's consolidated capital, as described in sections 2.1.1.3, 2.1.2.2, and 2.1.3.2. Assume the subsidiary has issued qualifying common shares to third parties which, together with retained earnings attributable to third parties, equal $400. The amount of common shares issued to and retained earnings attributable to the parent equal $1600. The required regulatory adjustments to CET1 are $500. There are no regulatory adjustments to Additional Tier 1 or Tier 2 capital. The subsidiary has also issued $200 in qualifying Additional Tier 1 instruments and $300 in qualifying Tier 2 instruments to third parties. (No Additional Tier 1 or Tier 2 instruments have been issued by the subsidiary to the parent). Paid in capital of the subsidiary blank Value Paid in common shares plus retained earnings owned by third parties, gross of all deductions 400 Paid in common shares plus retained earnings owned by the group, gross of all deductions 1,600 Total CET1 of the subsidiary, net of deductions 1,500 Paid in Tier 1 capital plus retained earnings owned by third parties, gross of all deductions 600 Paid in Tier 1 capital plus retained earnings owned by the group, gross of all deductions 1,600 Total Tier 1 capital (CET1 + Additional Tier 1) of the subsidiary, net of deductions 1,700 Paid in Total capital plus retained earnings owned by third parties, gross of all deductions 900 Paid in Total capital plus retained earnings owned by the group, gross of all deductions 1,600 Total capital (CET1 + Additional Tier 1 + Tier 2) of the subsidiary, net of deductions 2,000 To determine how much of the above capital issued to third parties can be included in the consolidated capital of the parent, the surplus capital of the subsidiary needs to be calculated using the minimum capital requirements plus capital conservation buffer are 7% CET1, 8.5% Tier 1 and 10.5% Total capital. Step 1: Calculate the minimum capital requirements (plus capital conservation buffer) of the subsidiary. This is based on the lower of (i) the RWA of the subsidiary and (ii) the portion of the consolidated RWA that relates to the subsidiary multiplied by 7%, 8.5%, and 10.5% for CET1, Tier 1 and Total capital, respectively. Minimum plus capital conservation buffer (CCB) requirements of the subsidiary blank Value Calculation Total RWA of the subsidiary 10,000 blank RWA of the consolidated group that relate to the subsidiary 11,000 blank Minimum CET1 requirement of the subsidiary plus CCB 700 = 10,000 × 7% Portion of the consolidated minimum CET1 requirement plus CCB that relates to the subsidiary 770 = 11,000 × 7% Minimum Tier 1 requirement of the subsidiary plus the CCB 850 = 10,000 × 8.5% Portion of the consolidated minimum Tier 1 requirement plus CCB that relates to the subsidiary 935 = 11,000 × 8.5% Minimum Total capital requirements of the subsidiary plus CCB 1,050 = 10,000 × 10.5% Portion of the consolidated minimum Total capital requirement plus CCB that relates to the subsidiary 1,155 = 11,000 × 10.5% Step 2: Calculate the surplus capital of the subsidiary. This is the difference between the eligible capital of the subsidiary held (net of deductions) less the minimum capital (plus capital conservation buffer) required. Capital of the subsidiary, net of deductions blank Value Calculation Total CET1 of the subsidiary, net of deductions 1,500 blank Total Tier 1 (CET1 + Additional Tier 1) of the subsidiary, net of deductions 1,700 blank Total Capital (CET1 + Additional Tier 1 + Tier 2) of the subsidiary, net of deductions 2,000 blank Surplus capital of the subsidiary Surplus CET1 of the subsidiary 800 = 1,500 − 700 Surplus Tier 1 of the subsidiary 850 = 1,700 − 850 Surplus Total Capital of the subsidiary 950 = 2,000 − 1,050 Step 3: Calculate the amount of surplus capital that is attributable to third party investors. This is equal to the amount of surplus capital of the subsidiary multiplied by the percentage of the subsidiary owned by third parties (based on the paid in capital plus related retained earnings owned by third parties). Surplus capital of the subsidiary attributable to third party investors blank Value Calculation Surplus CET1 of the subsidiary that is attributable to third party investors 160 = 800 × (400/2,000) Surplus Tier 1 of the subsidiary that is attributable to third party investors 232 = 850 × (600/2,200) Surplus Total capital of the subsidiary that is attributable to third party investors 342 = 950 × (900/2,500) Step 4: Calculate the amount of capital issued to third parties that can be included in the consolidated capital of the parent. This is equal to the amount of capital issued to third parties (plus attributable retained earnings) less the surplus capital attributable to third parties. Amount recognized in consolidated capital blank Value Calculation Amount of capital issued to third parties recognized in CET1 240 = 400 − 160 Amount of capital issued to third parties recognized in Tier 1 368 = 600 − 232 Amount of capital issued to third parties recognized in Total capital 558 = 900 − 342 Amount of capital issued to third parties recognized in Additional Tier 1 128 = 368 − 240 Amount of capital issued to third parties recognized in Tier 2 190 = 558 − 240 − 128

Appendix 2-2 - Information Requirements to Confirm Quality of NVCC Instruments

While not mandatory, institutions are strongly encouraged to seek confirmations of capital quality prior to issuing NVCC instruments.^{Footnote 113} Confirmations request should be sent electronically by email to OSFI's Capital Division at confirmations@osfi-bsif.gc.ca. In conjunction with such requests, the institution is expected to provide, at minimum, the following information. An indicative term sheet specifying indicative dates, rates and amounts and summarizing key provisions should be provided in respect of all proposed instruments. The draft and final terms and conditions of the proposed NVCC instrument supported by relevant documents (e.g. Prospectus, Offering Memorandum, Debt Agreement, etc.). A copy of the institution's current by-laws or other constating documents relevant to the capital to be issued. Where applicable, for all debt instruments only: the draft and final Trust Indenture; and the terms of any guarantee relating to the instrument. An external legal opinion addressed to OSFI confirming that the contingent conversion feature or write-off, as applicable is enforceable, that the issuance has been duly authorized and is in compliance with applicable law^{Footnote 114} and that there are no impediments to the automatic conversion of the NVCC instrument into common shares of the institution or to the write-off, as applicable upon a trigger event. For precedent-setting confirmations of quality of capital where the terms of the instrument include a redemption, or similar feature upon a tax event, an external tax opinion confirming the availability of such deduction in respect of interest or distributions payable on the instrument for income tax purposes.^{Footnote 115} For all confirmations of quality of capital where the terms of the instrument include a tax event redemption or similar feature, an attestation from a senior officer of the institution confirming that the institution is not aware of any circumstances that would constitute grounds for a tax event at the date of issuance, including, but not limited to, any recent or proposed changes to the income tax legislation. For Additional Tier 1 instruments other than preferred shares, institutions should submit an analysis which confirms that the instrument will be treated as equity under IFRS until the point of non-viability. Institutions should consult and obtain the concurrence of their external auditors in respect of their conclusions regarding the proposed treatment and disclosure of the NVCC instrument.^{Footnote 116} Where the initial interest or coupon rate payable on the instrument resets periodically or the basis of the interest rate changes from fixed to floating (or vice versa) at a pre-determined future date, calculations demonstrating that no incentive to redeem, or step-up, will arise upon the change in the initial rate. Where applicable, a step-up^{Footnote 117} calculation should be provided, which confirms there is no step-up upon the change in interest rate. The step-up calculation should be supported by the following: Screenshots of the relevant benchmarks used for the step-up calculation should be provided. The interpolated benchmark yield should be calculated with the two closest maturities to the reset date, unless a written explanation is provided to OSFI explaining the deviation. The interpolated benchmark yield should be rounded up to the nearest hundredth for the purpose of calculating the reset spread. Where the terms of the instrument provide for triggers in addition to the baseline triggers specified in Principle # 2, the rationale for such additional triggers and a detailed analysis of the possible market implications that might arise from the inclusion of such additional triggers or upon a breach of such triggers. An assessment of the features of the proposed capital instrument against the minimum criteria for inclusion in Additional Tier 1 capital or Tier 2 capital, as applicable, as set out in Basel III as well as the principles for NVCC instruments set out in section 2.2 of this guideline. For certainty, this assessment would only be required for an initial issuance or precedent and is not required for subsequent issuances provided the terms of the NVCC instrument are not materially altered. A written attestation from a senior officer of the institution confirming that the institution has not provided financing to any person for the express purpose of investing in the proposed capital instrument. A written attestation from a senior officer of the institution confirming that the institution has taken all commercially reasonable efforts to ensure that conversion or write-off is not an event of default or credit event under any other agreement entered into by the institution, directly or indirectly, on or after January 1, 2013, including senior debt agreements and derivative contracts.

Additional information requirements for NVCC instruments issued to a parent

Requirement 12 is not required for issuing NVCC instruments to a parent. The rationale provided by the parent for not providing common equity in lieu of the subject capital instrument. A written attestation from a senior officer confirming that the rate and terms of the instrument as at the date of transaction are at least as favourable to the institution as market terms and conditions. A written attestation confirming that the failure to make dividend or interest payments, as applicable, on the subject instrument would not result in the parent, now or in the future, being unable to meet its own debt servicing obligations nor would it trigger cross-default clauses or credit events under the terms of any agreements or contracts of either the institution or the parent.

Appendix 2-3 - Example of the 15% of common equity limit on specified items (threshold deductions)

This Appendix is meant to clarify the calculation of the 15% limit on significant investments in the common shares of unconsolidated financial institutions (banks, insurance and other financial entities); mortgage servicing rights, and deferred tax assets arising from temporary differences (collectively referred to as specified items). The recognition of these specified items will be limited to 15% of CET1 capital, after the application of all deductions. To determine the maximum amount of the specified items that can be recognized,^{Footnote *} banks and supervisors should multiply the amount of CET1^{Footnote **} (after all deductions, including after the deduction of the specified items in full) by 17.65%. This number is derived from the proportion of 15% to 85% (i.e. 15%/85% = 17.65%). As an example, take a bank with $85 of common equity (calculated net of all deductions, including after the deduction of the specified items in full). The maximum amount of specified items that can be recognized by this bank in its calculation of CET1 capital is $85 x 17.65% = $15. Any excess above $15 must be deducted from CET1. If the bank has specified items (excluding amounts deducted after applying the individual 10% limits) that in aggregate sum up to the 15% limit, CET1 after inclusion of the specified itemswill amount to $85 + $15 = $100. The percentage of specified items to total CET1 would equal 15%. [Basel Framework, CAP 30.33 FAQ1]

Footnotes

Footnote 1 The Basel Framework Return to footnote 1 Footnote 2 Following the format: [Basel Framework, XXX yy.xx] Return to footnote 2 Footnote 3 For an institution that is a federal credit union, references to "common shares" in this guideline encompass "membership shares", as defined in subsection 79.1(1) of the Bank Act, and other instruments recognized as CET1 capital under this guideline. Return to footnote 3 Footnote 4 Where repayment is subject to Superintendent approval. Return to footnote 4 Footnote 5 Paid-in capital generally refers to capital that has been received with finality by the institution, is reliably valued, fully under the institution's control and does not directly or indirectly expose the institution to the credit risk of the investor. [Basel Framework, CAP 10.8 FAQ2] Return to footnote 5 Footnote 6 A related entity can include a parent company, a sister company, a subsidiary or any other affiliate. A holding company is a related entity irrespective of whether it forms part of the consolidated banking group. Return to footnote 6 Footnote 7 The item should be clearly and separately disclosed on the balance sheet published in the institution's annual report. Where an institution publishes results on a semi-annual or quarterly basis, disclosure should also be made at those times. Return to footnote 7 Footnote 8 Any institution that is subject to the same minimum prudential standards and level of supervision as a bank may be considered to be a bank. Return to footnote 8 Footnote 9 Minority interest in a subsidiary that is a bank is strictly excluded from the parent bank's common equity if the parent bank or affiliate has entered into any arrangements to fund directly or indirectly minority investment in the subsidiary whether through an SPV or through another vehicle or arrangement. The treatment outlined above, thus, is strictly available where all minority interests in the bank subsidiary solely represent genuine third party common equity contributions to the subsidiary. Return to footnote 9 Footnote 10 Category III SMSBs should use [Adjusted Total Assets + RWA Operational Risk] instead of RWA in the calculation of the surplus CET1 capital of the subsidiary. Return to footnote 10 Footnote 11 Calculated using the local regulator's RWA calculation methodology, e.g. if the local regulator's requirements are based on Basel I rules, this calculation method can be used. The calculation must still be based on the minimum plus the capital conservation buffer (i.e. 7.0% of RWA). Return to footnote 11 Footnote 12 This amount should exclude any intercompany exposures (e.g. loans or debentures) from the subsidiary to the parent that would boost the subsidiary's RWA. Return to footnote 12 Footnote 13 Assets that relate to the operation of the SPV may be excluded from this assessment if they are de minimus. Return to footnote 13 Footnote 14 Further, where an institution uses an SPV to issue capital to investors and provides support, including overcollateralization, to the vehicle, such support would constitute enhancement in breach of Criterion # 3 above. [Basel Framework, CAP 10.11 FAQ2] Return to footnote 14 Footnote 15 A step-up is defined as a call option combined with a pre-set increase in the initial credit spread of the instrument at a future date over the initial dividend (or distribution) rate after taking into account any swap spread between the original reference index and the new reference index. Conversion from a fixed rate to a floating rate (or vice versa) in combination with a call option without any increase in credit spread would not constitute a step-up. [Basel Framework, CAP 10.11 FAQ4] Return to footnote 15 Footnote 16 Other incentives to redeem include a call option combined with a requirement or an investor option to convert the instrument into common shares if the call is not exercised. [Basel Framework, CAP 10.11 FAQ4] Return to footnote 16 Footnote 17 An example of an action that would be considered to create an expectation that a call will be exercised is where an institution calls a capital instrument and replaces it with an instrument that is more costly (e.g. a higher credit spread). [Basel Framework, CAP 10.11 FAQ8] Return to footnote 17 Footnote 18 Replacement issuances can be concurrent with but not after the instrument is called. Return to footnote 18 Footnote 19 The term "minimum" refers to OSFI's target capital requirements described in section 1.10 of Chapter 1 of this guideline which may be higher than the Basel III Pillar 1 minimum requirements. Return to footnote 19 Footnote 20 Where an institution elects to include a regulatory event call in an instrument, the regulatory event call date should be defined as "the date specified in a letter from the Superintendent to the institution on which the instrument will no longer be recognized in full as eligible Additional Tier 1 capital of the institution or included in Total regulatory capital". Return to footnote 20 Footnote 21 A consequence of full discretion at all times to cancel distributions/payments is that "dividend pushers" are prohibited. An instrument with a dividend pusher obliges the issuing institution to make a dividend/coupon payment on the instrument if it has made a payment on another (typically more junior) capital instrument or share. This obligation is inconsistent with the requirement for full discretion at all times. Furthermore, the term "cancel distributions/payments" means to forever extinguish these payments. It does not permit features that require the institution to make distributions or payments in kind at any time. Institutions may not allow investors to convert an Additional Tier 1 instrument to common equity upon non-payment of dividends as this would also impeded the practical ability of the bank to exercise its discretion to cancel payments. Return to footnote 21 Footnote 22 Institutions may use a broad index as a reference rate in which the issuing institution is a reference entity, however, the reference rate should not exhibit significant correlation with the institution's credit standing. If an institution plans to issue capital instruments where the margin is linked to a broad index in which the institution is a reference entity, the institution should ensure that the dividend/coupon is not credit-sensitive. [Basel Framework, CAP 10.11 FAQ12] Return to footnote 22 Footnote 23 OSFI expects Additional Tier 1 instruments to be fully classified as equity at all times where the Superintendent has not declared the institution non-viable. Return to footnote 23 Footnote 24 The intention of this criterion is to prohibit the inclusion of instruments in capital in cases where the institution retains any of the risk of the instruments. The criterion is not contravened if third-party investors bear all of the risks and rewards associated with the instrument. [Basel Framework, CAP 10.11 FAQ14] Return to footnote 24 Footnote 25 An operating entity is an entity set up to conduct business with clients with the intention of earning a profit in its own right. Return to footnote 25 Footnote 26 [Basel Framework, CAP 10.11 FAQ16 and FAQ17] Return to footnote 26 Footnote 27 The amount recognized as regulatory capital should be adjusted to account for any actual or foreseeable deferred tax liabilities or tax payments resulting from the conversion or writedown of the instrument. This adjustment should be made from the date of issuance. [Basel Framework, CAP 10.11 FAQ23] Return to footnote 27 Footnote 28 Any modification of, addition to, or renewal or extension of an instrument issued to a related party is subject to the legislative requirement that transactions with a related party be at terms and conditions that are at least as favourable to the institution as market terms and conditions. Return to footnote 28 Footnote 29 Category III SMSBs should use [Adjusted Total Assets + RWAOperational Risk], instead of RWA, in the calculation of the surplus Tier 1 capital of the subsidiary. Return to footnote 29 Footnote 30 Calculated using the local regulator's RWA calculation methodology, e.g. if the local regulator's requirements are based on Basel I rules, this calculation method can be used. The calculation must still be based on the minimum plus the capital conservation buffer (i.e. 8.5% of RWA). Return to footnote 30 Footnote 31 This amount should exclude any intercompany exposures (e.g. loans or debentures) from the subsidiary to the parent that would boost the subsidiary's RWA. Return to footnote 31 Footnote 32 Assets that relate to the operation of the SPV may be excluded from this assessment if they are de minimus. Return to footnote 32 Footnote 33 A step-up is defined as a call option combined with a pre-set increase in the initial credit spread of the instrument at a future date over the initial dividend (or distribution) rate after taking into account any swap spread between the original reference index and the new reference index. Conversion from a fixed rate to a floating rate (or vice versa) in combination with a call option without any increase in credit spread would not constitute a step-up. Return to footnote 33 Footnote 34 An option to call the instrument after five years but prior to the start of the amortization period will not be viewed as an incentive to redeem as long as the institution does not do anything that creates an expectation that the call will be exercised at this point. Return to footnote 34 Footnote 35 Replacement issuances can be concurrent with but not after the instrument is called. Return to footnote 35 Footnote 36 The term "minimum" refers to OSFI's target capital requirements as described in section 1.10 of Chapter 1 of this guideline which may be higher than the Basel III Pillar 1 minimum requirements. Return to footnote 36 Footnote 37 Where an institution elects to include a regulatory event call in an instrument, the regulatory event call date should be defined as "the date specified in a letter from the Superintendent to the institution on which the instrument will no longer be recognized in full as eligible Tier 2 capital of the institution or included in Total regulatory capital". Return to footnote 37 Footnote 38 Institutions may use a broad index as a reference rate in which the issuing institution is a reference entity, however, the reference rate should not exhibit significant correlation with the institution's credit standing. If an institution plans to issue capital instruments where the margin is linked to a broad index in which the institution is a reference entity, the institution should ensure that the dividend/coupon is not credit-sensitive. Return to footnote 38 Footnote 39 An operating entity is an entity set up to conduct business with clients with the intention of earning a profit in its own right. Return to footnote 39 Footnote 40 [Basel Framework, 10.16 FAQ4 and FAQ7] Return to footnote 40 Footnote 41 The amount recognized as regulatory capital should be adjusted to account for any actual or foreseeable deferred tax liabilities or tax payments resulting from the conversion or write-down of the instrument. This adjustment should be made from the date of issuance. [Basel Framework, CAP 10.16 FAQ9] Return to footnote 41 Footnote 42 Any modification of, addition to, or renewal or extension of an instrument issued to a related party is subject to the legislative requirement that transactions with a related party be at terms and conditions that are at least as favourable to the institution as market terms and conditions. Return to footnote 42 Footnote 43 Category III SMSBs should use [Adjusted Total Assets + RWAOperational Risk], instead of RWA, in the calculation of the surplus Total capital of the subsidiary. Return to footnote 43 Footnote 44 Calculated using the local regulator's RWA calculation methodology, e.g. if the local regulator's requirements are based on Basel I rules, this calculation method can be used. The calculation must still be based on the minimum requirement plus the capital conservation buffer (i.e. 10.5% of RWA). Return to footnote 44 Footnote 45 This amount should exclude any intercompany exposures (e.g. loans or debentures) from the subsidiary to the parent that would boost the subsidiary's RWA. Return to footnote 45 Footnote 46 Assets that relate to the operation of the SPV may be excluded from this assessment if they are de minimus. Return to footnote 46 Footnote 47 Eligible allowances or reserves included in Tier 2 capital should be recorded as gross of tax effects. Return to footnote 47 Footnote 48 Category III SMSBs should use Adjusted Total Assets, instead of credit RWA, when calculating the general allowances eligible for inclusion in Tier 2 capital. Return to footnote 48 Footnote 49 Available at IFRS 9 Financial Instruments and Disclosures. Return to footnote 49 Footnote 50 Institutions that have partially implemented an IRB approach must meet the requirements in paragraph 41 above. Return to footnote 50 Footnote 51 Other resolution options, including the creation of a bridge bank, could be used to resolve a failing institution, either as an alternative to NVCC or, in a manner consistent with Principle 3(a), in conjunction with or following an NVCC conversion, and could also subject capital providers to loss. Return to footnote 51 Footnote 52 The BCBS rules permit national discretion in respect of requiring contingent capital instruments to be written off or converted to common stock upon a trigger event. OSFI has determined that conversion is more consistent with traditional insolvency consequences and reorganization norms and better respects the legitimate expectations of all stakeholders. Return to footnote 52 Footnote 53 The non-common capital of an institution that does not meet the NVCC requirement but otherwise satisfies the Basel III requirements may be, as permitted by applicable law, amended to meet the NVCC requirement. Return to footnote 53 Footnote 54 Any capital injection or equivalent support from the federal government or any provincial government or political subdivision or agent or agency thereof would need to comply with applicable legislation, including any prohibitions related to the issue of shares to governments. Return to footnote 54 Footnote 55 As liquidation is the baseline resolution mechanism for a failed institution, it is expected that the market values for capital instruments of a non-viable institution should, where such instruments are traded in a deep and liquid market, incorporate information related to the probability of insolvency and the likely recovery upon liquidation. Return to footnote 55 Footnote 56 For further reference, please refer to sections 2.1.1.3, 2.1.2.2. and 2.1.3.2 of this guideline. Return to footnote 56 Footnote 57 For greater certainty, instruments issued by foreign subsidiaries of institutions must include triggers that can be activated by both OSFI and the host authority in order to be recognized as capital on a group consolidated basis. [Basel Framework, CAP 10.11 FAQ18] Return to footnote 57 Footnote 58 Under the OSFI Act, FISC comprises OSFI, the Canada Deposit Insurance Corporation, the Bank of Canada, the Department of Finance, and the Financial Consumer Agency of Canada. Under the chairmanship of the Superintendent of Financial Institutions, these federal agencies meet regularly to exchange information relevant to the supervision of regulated financial institutions. This forum also provides for the coordination of strategies when dealing with troubled institutions. Return to footnote 58 Footnote 59 See, in particular, OSFI's Guide to Intervention for Federally-Regulated Deposit-Taking Institutions. Return to footnote 59 Footnote 60 The Superintendent retains the flexibility and discretion to deal with unforeseen events or circumstances on a case-by-case basis. Return to footnote 60 Footnote 61 Principles on Loss-Absorbing and Recapitalisation Capacity of G-SIBs in Resolution: Total Loss-absorbing Capacity (TLAC) Term Sheet (PDF). (FSB: November 2015). The regulatory adjustments for TLAC set out in this section relate to section 15 of the FSB TLAC Term Sheet. Return to footnote 61 Footnote 62 Tier 2 instruments that no longer count in full as regulatory capital (as a result of having a residual maturity of less than five years or due to Basel III transitioning rules) continue to be recognized in full as a Tier 2 instrument by the investing bank for the regulatory adjustments in this section. Similarly, instruments that no longer count towards TLAC as a result of having a residual maturity of less than 1 year continue to be recognized in full as Other TLAC Instruments by the investing bank for the regulatory adjustments in this section. Return to footnote 62 Footnote 63 For example, if a G-SIB resolution entity has funding that ranks pari passu with Excluded Liabilities equal to 5% of RWAs and receives partial recognition of these instruments as external TLAC equivalent to 3.5% RWAs, then an investing institution holding such instruments must include only 70% (i.e. 3.5/5) of such instruments in calculating its TLAC holdings. The same proportion should be applied by the investing institution to any indirect or synthetic investments in instruments ranking pari passu with Excluded Liabilities and eligible to be recognized as TLAC by virtue of the subordination exemptions set out in the FSB TLAC Term Sheet. Return to footnote 63 Footnote 64 November 1, 2018 for institutions with an October 31st year-end and January 1, 2019 for institutions with a December 31st year-end. Return to footnote 64 Footnote 65 An institution should calculate a goodwill amount as at the acquisition date by separating any excess of the acquisition cost over the investor's share of the net fair value of the identifiable assets and liabilities of the banking, financial or insurance entity. In accordance with applicable accounting standards, this goodwill amount may be adjusted for any subsequent impairment losses and reversal of impairment losses that can be assigned to the initial goodwill amount. [Basel Framework, CAP 30.7 FAQ1] Return to footnote 65 Footnote 66 This includes software intangibles. Return to footnote 66 Footnote 67 For regulatory capital purposes, a ROU should not be deducted from regulatory capital so long as the underlying asset being leased is a tangible asset. Where the underlying asset being leased is a tangible asset, the ROU asset asset should be included in the risk-based capital and leverage ratio denominators and should be risk-weighted at 100%, consistent with the risk weight applied to owned tangible assets. [Basel Framework, CAP 30.7 FAQ2] Return to footnote 67 Footnote 68 Does not permit offsetting of deferred tax assets across provinces. Return to footnote 68 Footnote 69 The 100% risk weight is not applicable to Category III SMSBs as these assets are included in Adjusted Total Assets in the Simplified Risk-Based Capital Ratio. Return to footnote 69 Footnote 70 Refer to section 7.2.2. of Chapter 7. Return to footnote 70 Footnote 71 Refer to paragraph 268 of Chapter 4. All forms of credit protection, including credit derivatives, are part of this scope of application apart from mortgage insurance purchased from a private mortgage insurer in Canada, which is subject to the rules in paragraph 274 of Chapter 4 or paragraph 147 of Chapter 5. Return to footnote 71 Footnote 72 Refer to the BCBS July 25, 2012 press release Regulatory treatment of valuation adjustments to derivative liabilities: final rule issued by the Basel Committee. Return to footnote 72 Footnote 73 Generally, institutions currently report this amount in Other Assets on the balance sheet. Return to footnote 73 Footnote 74 Where an institution acts as a market maker in its own capital instruments, the contractual obligation requiring deduction is deemed to commence upon the institution agreeing to purchase the security at an agreed price and either this offer has been accepted or cannot be withdrawn. [Basel Framework, CAP 30.18 FAQ1] Return to footnote 74 Footnote 75 Institutions may also be subject to restrictions or prohibitions on the holdings of their own securities under their governing statutes. Return to footnote 75 Footnote 76 All regulatory adjustments that are applicable to common shares also apply to membership shares and/or other CET1 instruments issued by federal credit unions. Return to footnote 76 Footnote 77 See paragraph 81 (and footnote 85) for the definition of significant investment. Return to footnote 77 Footnote 78 The 250% risk-weight is not applicable to Category III SMSBs as the amounts less than the 10% threshold are included in Adjusted Total Assets in the Simplified Risk-Based Capital Ratio. Return to footnote 78 Footnote 79 Examples of the types of activities that financial entities might be involved in include financial leasing, issuing credit cards, portfolio management, investment advisory, custodial and safekeeping services and other similar activities that are ancillary to the business of banking. [Basel Framework, CAP 30.22 FAQ2] Return to footnote 79 Footnote 80 The scope of this regulatory adjustment should be considered comprehensive. Institutions are encouraged to contact OSFI for further guidance in this area, relating to specific investments, where necessary. Institutions should also note that hedge funds should be considered within the scope of the required regulatory adjustment. Return to footnote 80 Footnote 81 For the purpose of this guideline, investments in the capital of banking, financial and insurance entities include investments in the capital of cooperative credit associations (i.e. Centrals), credit unions, and other cooperative financial institutions. Return to footnote 81 Footnote 82 See paragraph 84 (and footnote 87) for the definition of significant investment. Return to footnote 82 Footnote 83 Indirect holdings are exposures or parts of exposures that, if a direct holding loses its value, will result in a loss to the institution substantially equivalent to the loss in the value of the direct holding. Where an institution holds an investment in a mutual fund that is a pass-through security, it should be treated as an indirect holding in the pool of assets in the fund [Basel Framework, CAP 30.22]. Return to footnote 83 Footnote 84 Examples of indirect and synthetic holdings include: (i) the institution invests in the capital of an entity that is not consolidated for regulatory purposes and is aware that this entity has an investment in the capital of a financial institution. (ii) The institution enters into a total return swap on capital instruments of another financial institution. (iii) The institution provides a guarantee or credit protection to a third party in respect of the third party's investments in the capital of another financial institution. (iv) The institution owns a call option or has written a put option on the capital instruments of another financial institution. (vi) The institution has entered into a forward purchase agreement on the capital of another financial institution. [Basel Framework, CAP 99.11] Return to footnote 84 Footnote 85 In the case of a cash equity position and a short position on the same underlying exposure, where both positions are in the trading book, if the institution has a contractual right/obligation to sell a long position at a specific point in time and the counterparty in the contract has an obligation to purchase the long position if the bank exercises its right to sell, this point in time may be treated as the maturity of the long position. Therefore if these conditions are met, the maturity of the long position and the short position are deemed to be matched even if the maturity of the short position is within one year. [Basel Framework, CAP 30.22 FAQ6]. Return to footnote 85 Footnote 86 If the investment is issued out of a regulated financial entity and not included in regulatory capital in the relevant sector of the financial entity, it is not required to be deducted. Return to footnote 86 Footnote 87 For investments in financial and insurance entities, not subject to the Basel Framework eligibility criteria for capital instruments (as outlined in this guideline), the deduction should be applied from the higher tier of capital (CET1 being the highest) identified by the following two methods: The tier of capital (if any) the instrument qualifies for under the Basel Framework criteria. The tier of capital the instrument qualifies for under the most recent capital adequacy guidelines applicable to insurance entities regulated by OSFI. If the capital instrument of the entity in which the institution has invested does not meet the criteria for inclusion in regulatory capital under either the Basel III criteria, or the most recent capital adequacy guidelines applicable to insurance entities regulated by OSFI, it is to be considered common shares for the purposes of this deduction. Return to footnote 87 Footnote 88 For an institution that is a federal credit union, when applicable, guarantees or other capital enhancements must include potential capital calls from a provincial Central. Capital calls subject to a cap should be valued at the maximum amount of a potential capital call. Capital calls not subject to a cap should be valued at the maximum amount of a potential capital call the federal credit union could be subject to in severe but plausible scenarios. A federal credit union will be required to demonstrate that it has sufficient capital to absorb the maximum amount of a potential capital call in these scenarios. Return to footnote 88 Footnote 89 For Category III SMSBs, investments below the 10% threshold are included in Adjusted Total Assets in the Simplified Risk-Based Capital Ratio. Return to footnote 89 Footnote 90 The term "significant investment" refers to investments that are defined to be a substantial investment under section 10 of the Bank Act or the Trust and Loan Companies Act. Return to footnote 90 Footnote 91 See paragraph 81, bullet 8, for a notification requirement where the deduction is made at the insurance operating company level. Return to footnote 91 Footnote 92 The scope of this regulatory adjustment should be considered comprehensive. Institutions are encouraged to contact OSFI for further guidance in this area, relating to specific investments, where necessary. Institutions should also note that hedge funds should be considered within the scope of the required regulatory adjustment. Return to footnote 92 Footnote 93 Investments in entities that are outside the scope of regulatory consolidation refers to investments in entities that have not been consolidated at all or have not been consolidated in such a way as to result in their assets being included in the calculation of consolidated RWA of the group. This includes (i) investments in unconsolidated entities, including joint ventures carried on the equity method of accounting, (ii) investments in subsidiaries deconsolidated for regulatory capital purposes (including insurance subsidiaries), (iii) other facilities that are treated as capital by unconsolidated subsidiaries and by unconsolidated entities in which the institution has a significant investment. Further, the treatment for securitization exposures or vehicles that are deconsolidated for risk-based regulatory capital purposes pursuant to Chapter 6 of the CAR Guideline will be as outlined in that chapter. Return to footnote 93 Footnote 94 For the purposes of this guideline, investments in the capital of banking, financial and insurance entities include investments in the capital of cooperative credit associations (Centrals), credit unions, and other cooperative financial institutions. Return to footnote 94 Footnote 95 If institutions find it operationally burdensome to look through and monitor their exact exposures to the capital of other financial institutions as a result of their holding index securities, OSFI will permit institutions, subject to prior supervisory approval, to use a conservative estimate. Return to footnote 95 Footnote 96 In the case of a cash equity position and a short position on the same underlying exposure, where both positions are in the trading book, if the institution has a contractual right/obligation to sell a long position at a specific point in time and the counterparty in the contract has an obligation to purchase the long position if the bank exercises its right to sell, this point in time may be treated as the maturity of the long position. Therefore if these conditions are met, the maturity of the long position and the short position are deemed to be matched even if the maturity of the short position is within one year [Basel Framework, CAP 30.29 FAQ6]. Return to footnote 96 Footnote 97 An exception to this requirement is if the investment is issued out of a regulated financial entity and not included in regulatory capital in the relevant sector of the financial entity, it is not required to be deducted. Return to footnote 97 Footnote 98 See footnote 85 for further information on the treatment of investments in financial and insurance entities not subject to Basel III eligibility criteria for capital instruments. Return to footnote 98 Footnote 99 For an institution that is a federal credit union, when applicable, guarantees or other capital enhancements must include potential capital calls from a provincial Central. Capital calls subject to a cap should be valued at the maximum amount of a potential capital call. Capital calls not subject to a cap should be valued at the maximum amount of a potential capital call the federal credit union could be subject to in severe but plausible scenarios. A federal credit union will be required to demonstrate that it has sufficient capital to absorb the maximum amount of a potential capital call in these scenarios. Return to footnote 99 Footnote 100 For investments in insurance subsidiaries, CSM that have been included in the group’s consolidated CET1 capital pursuant to paragraph 3 should be added to this exposure. Return to footnote 100 Footnote 101 Institutions are required to notify OSFI's Capital Division, through their Lead Supervisors, if they intend to use the corresponding deduction approach outlined in this paragraph with relation to investments in insurance entities. Return to footnote 101 Footnote 102 For Category III SMSBs, any amounts not deducted from CET1 capital will be included in Adjusted Total Assets under the Simplified Risk-Based Capital Ratio. Return to footnote 102 Footnote 103 See footnote 85 for further information on the treatment of investments in financial and insurance entities not subject to Basel III eligibility criteria for capital instruments. Return to footnote 103 Footnote 104 See footnote 90. Return to footnote 104 Footnote 105 See footnote 85 for further information on the treatment of investments in financial and insurance entities not subject to Basel III eligibility criteria for capital instruments. Return to footnote 105 Footnote 106 For greater certainty, the application of the 10% and 5% thresholds, including the market-making exemption, described in section 2.3 of this guideline are not available in respect of holdings of an institution's own capital instruments and/or own Other TLAC Instruments. Return to footnote 106 Footnote 107 See footnote 83 for further information on the treatment of investments in financial and insurance entities not subject to Basel III eligibility criteria for capital instruments. Return to footnote 107 Footnote 108 See footnote 88. Return to footnote 108 Footnote 109 See footnote 83 for further information on the treatment of investments in financial and insurance entities not subject to Basel III eligibility criteria for capital instruments. Return to footnote 109 Footnote 110 Year 1 refers to the four fiscal quarters commencing in the quarter in which the institution continued as a federal credit union. Return to footnote 110 Footnote 111 The level of the base is fixed on the date of continuance and does not change thereafter. Return to footnote 111 Footnote 112 Federal credit unions should consult with OSFI's Capital Division to determine the appropriate tier of capital in which to assign non-qualifying instruments. Return to footnote 112 Footnote 113 If an institution fails to obtain a capital confirmation (or obtains a capital confirmation without disclosing all relevant material facts to OSFI), OSFI may, in its discretion, at any time determine that such capital does not comply with these principles and is to be excluded from an institution's available regulatory capital. Return to footnote 113 Footnote 114 Such legal opinion may contain standard assumptions and qualifications provided its overall substance is acceptable to OSFI. Return to footnote 114 Footnote 115 OSFI reserves the right to require a Canada Revenue Agency advance tax ruling to confirm such tax opinion if the tax consequences are subject to material uncertainty. Return to footnote 115 Footnote 116 OSFI reserves the right to require such accounting opinion to be an external opinion of a firm acceptable to OSFI if the accounting consequences are subject to material uncertainty. Return to footnote 116 Footnote 117 Institutions seeking further guidance on step-up calculations should contact OSFI's Capital Division. Return to footnote 117 Footnote * The actual amount that will be recognized may be lower than this maximum, either because the sum of the three specified items are below the 15% limit set out in this appendix, or due to the application of the 10% limit applied to each item. Return to footnote * Footnote ** At this point this is a "hypothetical" amount of CET1 in that it is used only for the purposes of determining the deduction of the specified items. Return to footnote **

Note

For institutions with a fiscal year ending October 31 or December 31, respectively.

I. Introduction

The Capital Adequacy Requirements (CAR) for banks (including federal credit unions), bank holding companies, federally regulated trust companies and federally regulated loan companies are set out in nine chapters, each of which has been issued as a separate document. This document should be read in conjunction with the other CAR chapters. The complete list of CAR chapters is as follows: Chapter 1 - Overview of Risk-based Capital Requirements Chapter 2 - Definition of Capital Chapter 3 - Operational Risk Chapter 4 - Credit Risk - Standardized Approach Chapter 5 - Credit Risk - Internal Ratings-Based Approach Chapter 6 - Securitization Chapter 7 - Settlement and Counterparty Risk Chapter 8 - Credit Valuation Adjustment (CVA) Risk Chapter 9 - Market Risk

Chapter 3 – Operational Risk

The requirements related to the Standardized Approach in this chapter (section 3.4) are drawn from the Basel Committee on Banking Supervision's (BCBS) Basel Framework dated December 15, 2019.^{Footnote 1} For reference, the Basel paragraph numbers that are associated with the text appearing in this chapter are indicated in square brackets at the end of each paragraph.^{Footnote 2}

3.1 Definition of operational risk

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk,^{Footnote 3} but excludes strategic and reputational risk. [Basel Framework, OPE 10.1]

3.2 Measurement methodologies

There are two methodologies for calculating operational risk capital: the Standardized Approach (SA); and, the Simplified Standardized Approach (SSA). Domestic Systemically Important Banks (D-SIBs) must use the Standardized Approach. Category I Small and Medium Sized Deposit-Taking Institutions (SMSBs) with annual Adjusted Gross Income^{Footnote 4} greater than $1.5 billion must also use the Standardized Approach. Category I SMSBs must calculate Adjusted Gross Income at each fiscal year-end. If annual Adjusted Gross Income is greater than $1.5 billion, the institution must notify OSFI within 60 days of the end of the fiscal year, and use the Standardized Approach for operational risk in the following fiscal year. Once a Category I institution crosses the $1.5 billion threshold, it must use the Standardized Approach for a minimum of two years. If, after two years, annual Adjusted Gross Income falls below $1.5 billion, the institution must notify OSFI and may revert to the Simplified Standardized Approach.^{Footnote 5} Category I SMSBs with annual Adjusted Gross Income less than $1.5 billion may apply to OSFI to use the SA if they have a minimum of five years of high-quality loss data (i.e. data meeting the minimum standard for loss data collection as outlined in section 3.4.2). If approved, an institution is not permitted to set the Internal Loss Multiplier (ILM) to less than one until OSFI has determined that they have 10 years of high-quality loss data. All other SMSBs must use the SSA.

3.3 The Simplified Standardized Approach

Institutions using the SSA must hold capital for operational risk (ORC) equal to 15% of average annual Adjusted Gross Income (AGI) over the previous 12 fiscal quarters: ORC SSA = ( AGI previous 12 fiscal quarters 3 ) × 15 % Where: ORC SSA = the operational risk capital charge under the Simplified Standardized Approach AGI previous 12 fiscal quarters = Adjusted Gross Income over the previous 12 fiscal quarters Risk-weighted assets (RWA) for operational risk are equal to 12.5 times ORC. Adjusted Gross Income is defined as the sum of the following: The lesser of (i) the absolute value of net interest income, and (ii) 2.25% of interest earning assets; Dividend income; The absolute value of fee and commission income; The absolute value of other income; The absolute value of net profit/loss (trading book); and The absolute value of net profit/loss (banking book). Adjusted Gross Income should (i) be gross of any provisions; (ii) be gross of operating expenses, and (iii) exclude extraordinary or irregular items as well as income derived from insurance. Institutions should refer to the reporting instructions in OSFI's Capital Adequacy Return for the specific line items in OSFI's P3 (Income Statement) and M4 (Balance Sheet) returns that should be used for each of the components of Adjusted Gross Income in the definition above. Newly incorporated institutions having fewer than 12 quarters of financial information should calculate the operational risk capital charge using available Adjusted Gross Income data to develop proxies for the missing portions of the required three years' data. Adjusted Gross Income should be adjusted to reflect acquired businesses and merged entities. Since the Adjusted Gross Income calculation is based on a rolling 12-quarter average, the most recent four quarters of Adjusted Gross Income for the acquired business or merged entity should be based on actual Adjusted Gross Income amounts reported by the acquired business or merged entity. If three years of historical financial data is not available for the acquired business or merged entity, the Adjusted Gross Income for the previous year may be used as a proxy for each of the other two years. When an institution using the SSA makes a divestiture, Adjusted Gross Income may be adjusted, with OSFI approval, to reflect this divestiture.

3.4 The Standardized Approach

The standardized approach methodology is based on the following components: the Business Indicator (BI) which is a financial-statement-based proxy for operational risk; the Business Indicator Component (BIC), which is calculated by multiplying the BI by a set of regulatory determined marginal coefficients; and the Internal Loss Multiplier (ILM), which is a scaling factor that is based on an institution's average historical losses and the BIC. [Basel Framework, OPE 25.1] Operational risk capital requirements under the Standardized Approach (ORCSA) are calculated by multiplying the BIC and the ILM, as shown in the formula below. Risk-weighted assets (RWA) for operational risk are equal to 12.5 times ORC. ORC SA = BIC × ILM [Basel Framework, OPE 25.2]

3.4.1 Components of the Standardized Approach

The BI comprises three components: the interest, leases and dividend component (ILDC), the services component (SC), and the financial component (FC). [Basel Framework, OPE 25.3] The BI is defined as: BI = ILDC + SC + FC In the formula below, a bar above a term indicates that it is calculated as the average over three years: t, t-1 and t-2, and:^{Footnote 6} ILDC = Min ⁡ [ Abs ⁡ ( Interest Income – Interest Expense ) ¯ ; 2.25 % × Interest Earning Assets ¯ ] + Dividend Income ¯ SC = Max ⁡ Fee and Commission Income ¯ ; Fee and Commission Expenses ¯ + Max ⁡ [ Other Operating Income ¯ ; Other Operating Expenses ¯ ] FC = Abs ⁡ ( Net P&L Trading Book ) ¯ + Abs ⁡ ( Net P&L Banking Book ) ¯ [Basel Framework, OPE 25.4 and Basel Framework, OPE 25.5] The definitions for each of the components of the BI are provided in Annex 3-1. [Basel Framework, OPE 25.6] The Business Indicator Component (BIC) is calculated as follows:^{Footnote 7} 12% of BI, plus 3% of BI above $1.5 billion (if any), plus 3% of BI above $45 billion (if any). [Basel Framework, OPE 25.7] An institution's internal operational risk loss experience affects the calculation of operational risk capital through the ILM. The ILM is defined as: ILM = ln ⁡ exp ⁡ 1 - 1 + LC BIC 0.8 where the Loss Component (LC) is equal to 15 times average annual operational risk losses, net of recoveries, incurred over the previous 10 years. The ILM is equal to one where the loss and business indicator components are equal. Where the LC is greater than the BIC, the ILM is greater than one. That is, an institution with losses that are high relative to its BIC is required to hold higher capital due to the incorporation of internal losses into the calculation methodology. Conversely, where the LC is lower than the BIC, the ILM is less than one. That is, an institution with losses that are low relative to its BIC is required to hold lower capital due to the incorporation of internal losses into the calculation methodology. [Basel Framework, OPE 25.8 and Basel Framework, OPE 25.9] The calculation of average losses in the Loss Component must be based on 10 years of high-quality annual loss data (i.e. data meeting the minimum standard for loss data collection as outlined in section 3.4.2). Institutions that do not have ten years of high-quality loss data must calculate the capital requirement using an ILM greater than or equal to one. In these cases, OSFI will require an institution to calculate capital requirements using fewer than 10 years of losses if the ILM using the available high-quality loss data is greater than 1 and OSFI believes the losses are representative of the institution's operational loss exposure. [Basel Framework, OPE 25.10] ORC is to be calculated and reported quarterly. Financial information used in the calculation of the BI should be up to and including the institution's most recent fiscal quarter-end. Operational risk losses used in the calculation of the LC may be reported on a one-quarter lag. Institutions should perform a reconciliation between the BI and Net Interest Income and Non-Interest Income^{Footnote 8} for the previous three years. This information should be available to OSFI upon request. At the consolidated level, the SA calculations use fully consolidated BI figures, which net all the intragroup income and expenses. [Basel Framework, OPE 10.4] A subsidiary institution using the SA should use its own consolidated income and loss experience in the calculation of BI and LC for the SA calculations, and is subject to the minimum standards for the use of loss data in the following sections. [Basel Framework OPE, 10.5 and Basel Framework, OPE 10.6]

3.4.2 Minimum standards for the use of loss data under the standardized approach

Institutions using the SA are required to use loss data as a direct input into the operational risk capital calculations. The soundness of data collection and the quality and integrity of the data are crucial to generating capital outcomes aligned with the institution's operational loss exposure. The minimum loss data standards are outlined in sections 3.4.3, 3.4.4, 3.4.5 and 3.4.7.^{Footnote 9} The quality of institutions' loss data will be reviewed by OSFI periodically. [Basel Framework OPE, 25.12] Institutions using the SA that do not meet the loss data standards^{Footnote 10} are required to hold capital that is at a minimum equal to 100% of the BIC (i.e. ILM greater than or equal to one). The exclusion of internal loss data due to non-compliance with the loss data standards, and the application of any resulting adjustment to the ILM, must be publicly disclosed. [Basel Framework OPE, 25.13]

3.4.3 General criteria on loss data identification, collection and treatment

The proper identification, collection and treatment of internal loss data are essential prerequisites to the capital calculation under the standardized approach. The general criteria for the use of the LC are as follows: [Basel Framework, OPE 25.14] Internally generated loss data calculations used for regulatory capital purposes must be based on a 10-year observation period. [Basel Framework, OPE 25.15] Internal loss data are most relevant when clearly linked to an institution's current business activities, technological processes and risk management procedures. Therefore, an institution must have robust, documented procedures and processes for the identification, collection and treatment of internal loss data. Such procedures and processes must be subject to validation before the use of the loss data within the operational risk capital requirement measurement methodology, and to regular independent reviews by internal and/or external audit functions. At a minimum, this would include effective and independent challenge by the institution's second line of defense, and periodic independent review by the third line of defense. [Basel Framework, OPE 25.16] For risk management purposes, and to assist in supervisory validation and/or review, institutions should map historical internal loss data into the relevant Level 1 supervisory categories as defined in Annex 3-2 and to provide this data to OSFI upon request. The institution must document criteria for allocating losses to the specified event types. [Basel Framework, OPE 25.17] An institution's internal loss data must be comprehensive and capture all material^{Footnote 11} activities and exposures from all appropriate subsystems and geographic locations.^{Footnote 12} [Basel Framework, OPE 25.18] For the purposes of the operational risk capital calculation, the minimum threshold, net of recoveries, for including a loss event in the data collection and calculation of average annual losses is set at $30,000.^{Footnote 13} [Basel Framework, OPE 25.18] Aside from information on gross loss amounts, the institution must collect information about the reference dates of operational risk events, including: the date when the event happened or first began ("date of occurrence"), where available; the date on which the institution became aware of the event ("date of discovery"); and the date (or dates) when a loss event results in a loss, reserve or provision against a loss being recognized in the institution's profit and loss (P&L) accounts ("date of accounting"). In addition, the institution must collect information on recoveries of gross loss amounts as well as descriptive information about the drivers or causes of the loss event.^{Footnote 14} The level of detail of any descriptive information should be commensurate with the size of the gross loss amount. [Basel Framework, OPE 25.19] Operational loss events related to credit risk and that are accounted for in credit risk RWAs should not be included in the loss data set. Operational loss events that relate to credit risk, but are not accounted for in credit risk RWAs should be included in the loss data set. [Basel Framework, OPE 25.20] Operational risk losses related to market risk are treated as operational risk for the purposes of calculating minimum regulatory capital under this framework and will therefore be subject to the standardized approach for operational risk. [Basel Framework, OPE 25.21] Institutions must have processes to independently review the comprehensiveness and accuracy of loss data. At a minimum, this would include effective and independent challenge by the institution's second line of defense, and periodic independent review by the third line of defense. [Basel Framework, OPE 25.22]

3.4.4 Specific criteria on loss data identification, collection and treatment

Building an acceptable loss data set from the available internal data requires that the institution develop policies and procedures to address several features, including gross loss definition, reference date and grouped losses. [Basel Framework, OPE 25.23] Gross loss is a loss before recoveries of any type. Net loss is defined as the loss after taking into account the impact of recoveries. The recovery is an independent occurrence, related to the original loss event, separate in time, in which funds or inflows of economic benefits are received from a third party.^{Footnote 15} [Basel Framework, OPE 25.24] Institutions must be able to identify the gross loss amounts, non-insurance recoveries, and insurance recoveries for all operational loss events. Institutions should use losses net of recoveries (including insurance recoveries) in the loss dataset. However, recoveries can be used to reduce losses only after the institution receives payment. Receivables do not count as recoveries. Verification of recovery payments received to net losses must be provided to OSFI upon request. [Basel Framework, OPE 25.25] The following items must be included in the gross loss computation of the loss data set: Direct charges, including impairments and settlements, to the institution's P&L accounts and write-downs due to the operational risk event; Costs incurred as a consequence of the event including: external expenses with a direct link to the operational risk event (e.g. legal expenses directly related to the event and fees paid to advisors, attorneys or suppliers); costs of repair or replacement, incurred to restore the position that was prevailing before the operational risk event; and uncollected revenue due to an operational risk event that can be quantified based on the contractual obligations of the institution's client or customer. Provisions or reserves accounted for in the P&L against the potential operational loss impact;^{Footnote 16} Losses stemming from operational risk events with a definitive financial impact, which are temporarily booked in transitory and/or suspense accounts and are not yet reflected in the P&L ("pending losses");^{Footnote 17} and Negative economic impacts booked in a financial accounting period, due to operational risk events impacting the cash flows or financial statements of previous financial accounting periods ("timing losses").^{Footnote 18} Timing losses should be included in the loss data set when they are due to operational risk events that span more than one financial accounting period.^{Footnote 19} ^{Footnote 20} [Basel Framework, OPE 25.26] The following items should be excluded from the gross loss computation of the loss data set: Costs of general maintenance contracts on property, plant or equipment; Internal or external expenditures to enhance the business after the operational risk losses: upgrades, improvements, risk assessment initiatives and enhancements; and Insurance premiums. [Basel Framework, OPE 25.27] Institutions must use the date of accounting for building the loss data set.^{Footnote 21} This includes using the date of accounting for including losses related to legal events in the loss dataset. For legal loss events, the date of accounting is the date when a legal reserve is established for the probable estimated loss in the P&L. [Basel Framework, OPE 25.28] Losses caused by a common operational risk event or by related operational risk events over time, but posted to the accounts over several years, should be allocated to the corresponding years of the loss database, in line with their accounting treatment. [Basel Framework, OPE 25.29]

3.4.5 Exclusion of losses from the Loss Component

Institutions may request OSFI approval to exclude certain operational loss events that are no longer relevant to the institution's risk profile. The exclusion of internal loss events should be rare and supported by strong justification. In evaluating the relevance of operational loss events to the institution's risk profile, OSFI will consider whether the cause of the loss event could occur in other areas of the institution's operations.^{Footnote 22} Taking settled legal exposures and divested businesses as examples, OSFI would expect the organization's analysis to demonstrate that there is no similar or residual legal exposure and that the excluded loss experience has no relevance to other continuing activities or products. [Basel Framework, OPE 25.30] The total loss amount and number of exclusions must be disclosed in accordance with the Pillar 3 requirements with appropriate narratives, including total loss amount and number of exclusions. [Basel Framework, OPE 25.31] A request for loss exclusions is subject to a materiality threshold such that the excluded loss event should be greater than 5% of the institution's average annual losses over the past 10 years. In addition, losses can only be eligible for exclusion after being included in an institution's operational risk loss database for a minimum of three years. Losses related to divested activities will not be subject to a minimum operational risk loss database retention period. [Basel Framework, OPE 25.32]

3.4.6 Exclusions of divested activities from the Business Indicator

Institutions may request OSFI approval to exclude divested activities from the calculation of the BI. Such exclusions must be disclosed in accordance with the Pillar 3 requirements. [Basel Framework, OPE 25.33]

3.4.7 Inclusion of BI items and operational loss events related to mergers and acquisitions

The measurement of the BI must include BI items that result from acquired businesses and merged entities. If three years of historical financial data is not available for an acquired business or merged entity, actual BI items for at least the previous year may be used for the BI calculation, and the BI items for the previous year may be used as a proxy for each of the other two years. Alternatively, institutions may use 125% of Adjusted Gross Income of the acquired business or merged entity (detailed in section 3.3) for the year prior to the merger or acquisition as a proxy for the acquired business or merged entity's BI. [Basel Framework, OPE 25.34] Institutions using the standardized approach must also include historical loss events from the acquired business or merged entity for the previous 10 years. If an acquired business or merged entity does not have historical high-quality loss data for the previous 10 years, the institution must estimate historical loss data for each of the years where data is missing for the purposes of calculating the LC (actual high-quality loss data should be used for those years where available). If the institution's ILM in the quarter prior to the merger or acquisition was less than or equal to one, operational losses for each missing year should be estimated as 1%^{Footnote 23} of the BI of the acquired business or merged entity at the time of acquisition.^{Footnote 24} If the institution's ILM in the quarter prior to the merger or acquisition was greater than one, estimated operational losses for each missing year of the acquired business or merged entity in the 10-year window should be estimated as x% of the BI of the acquired business or merged entity at the time of acquisition,^{Footnote 24} where x = average annual net losses for the past ten years reported in the quarter prior to the merger / acquisition BI reported in the quarter prior to the merger / acquisition Post-acquisition or merger, if the collection of actual loss data for the acquired business or merged entity is not feasible immediately, the institution may temporarily estimate operational risk loss amounts for the acquired business or merged entity, using the methodology detailed in paragraph 40(a) above.

Annex 3-1: Definition of Business Indicator components

[Basel Framework OPE 10.2] Business Indicator Definitions BI Component Income Statement or balance sheet items Description Typical sub-items Interest, lease and dividend Interest income Interest income from all financial assets and other interest income (includes interest income from financial and operating leases and profits from leased assets) Interest income from loans and advances, assets available for sale, assets held to maturity, trading assets, financial leases and operational leases Interest income from hedge accounting derivatives Other interest income Profits from leased assets Interest expenses Interest expenses from all financial liabilities and other interest expenses (includes interest expense from financial and operating leases, losses, depreciation and impairment of operating leased assets) Interest expenses from deposits, debt securities issued, financial leases, and operating leases Interest expenses from hedge accounting derivatives Other interest expenses Losses from leased assets Depreciation and impairment of operating leased assets Interest earning assets (balance sheet item)^{Footnote 25} Total gross outstanding loans, advances, interest bearing securities (including government bonds), and lease assets measured at the end of each financial year Dividend income Dividend income from investments in stocks and funds not consolidated in the institution's financial statements, including dividend income from non-consolidated subsidiaries, associates and joint ventures. Services Fee and commission income Income received from providing advice and services. Includes income received by the institution as an outsourcer of financial services. Fee and commission income from: Securities (issuance, origination, reception, transmission, execution of orders on behalf of customers) Clearing and settlement; Asset management; Custody; Fiduciary transactions; Payment services; Structured finance; Servicing of securitisations; Loan commitments Fee and commission expenses Expenses paid for receiving advice and services. Includes outsourcing fees paid by the institution for the supply of financial services, but not outsourcing fees paid for the supply of non-financial services (e.g. logistical, IT, human resources) Fee and commission expenses from: Clearing and settlement; Custody; Servicing of securitisations; Loan commitments and guarantees received; and Foreign transactions Other operating income Income from ordinary banking operations not included in other BI items but of similar nature (income from operating leases should be excluded) Rental income from investment properties Gains from non-current assets and disposal groups classified as held for sale not qualifying as discontinued operations (IFRS 5.37) Other operating expenses Expenses and losses from ordinary banking operations not included in other BI items but of similar nature and from operational loss events (expenses from operating leases should be excluded) Losses from non-current assets and disposal groups classified as held for sale not qualifying as discontinued operations (IFRS 5.37) Losses incurred as a consequence of operational loss events (e.g. fines, penalties, settlements, replacement cost of damaged assets), which have not been provisioned/reserved for in previous years Expenses related to establishing provisions/reserves for operational loss events Financial Net profit (loss) on the trading book Net profit/loss on trading assets and trading liabilities (derivatives, debt securities, equity securities, loans and advances, short positions, other assets and liabilities) Net profit/loss from hedge accounting Net profit/loss from exchange differences Net profit (loss) on the banking book Net profit/loss on financial assets and liabilities measured at fair value through profit and loss Realized gains/losses on financial assets and liabilities not measured at fair value through profit and loss (loans and advances, assets available for sale, assets held to maturity, financial liabilities measured at amortized cost Net profit/loss from hedge accounting Net profit/loss from exchange differences The following P&L items do not contribute to any of the items of the BI: Income and expenses from insurance or reinsurance businesses Premiums paid and reimbursements/payments received from insurance or reinsurance policies purchased (including deposit insurance premiums) Administrative expenses, including staff expenses, outsourcing fees paid for the supply of non-financial services (e.g. logistical, human resources, information technology - IT), and other administrative expenses (e.g. IT, utilities, telephone, travel, office supplies, postage) Recovery of administrative expenses including recovery of payments on behalf of customers (e.g. taxes debited to customers) Expenses of premises and fixed assets (except when these expenses result from operational loss events) Depreciation/amortization of tangible and intangible assets (except depreciation related to operating lease assets, which should be included in financial and operating lease expenses) Provisions/reversal of provisions (e.g. on pensions, commitments and guarantees given) except for provisions related to operational loss events Expenses due to share capital repayable on demand Impairment/reversal of impairment (e.g. on financial assets, non-financial assets, investments in subsidiaries, joint ventures and associates) Changes in goodwill recognized in profit or loss Corporate income tax (tax based on profits including current tax and deferred). [Basel Framework OPE 10.3]

Annex 3-2: Detailed Loss Event Type Classification

[Basel Framework OPE 25.17] Event-Type Category (Level 1) Definition Categories (Level 2) Activity Examples (Level 3) Internal fraud Losses due to acts of a type intended to defraud, misappropriate property or circumvent regulations, the law or company policy, excluding diversity/ discrimination events, which involves at least one internal party Unauthorized Activity Transactions not reported (intentional) Transaction type unauthorized (w/monetary loss) Mismarking of position (intentional) Theft and Fraud Fraud / credit fraud / worthless deposits Theft / extortion / embezzlement / robbery Misappropriation of assets Malicious destruction of assets Forgery Check kiting Smuggling Account take-over / impersonation / etc. Tax non-compliance / evasion (wilful) Bribes / kickbacks Insider trading (not on firm's account) External fraud Losses due to acts of a type intended to defraud, misappropriate property or circumvent the law, by a third party Theft and Fraud Theft/Robbery Forgery Check kiting Systems Security Hacking damage Theft of information (w/monetary loss) Employment Practices and Workplace Safety Losses arising from acts inconsistent with employment, health or safety laws or agreements, from payment of personal injury claims, or from diversity / discrimination events Employee Relations Compensation, benefit, termination issues Organized labour activity Safe Environment General liability (slip and fall, etc.) Employee health and safety rules events Workers compensation Diversity and Discrimination All discrimination types Clients, Products and Business Practices Losses arising from an unintentional or negligent failure to meet a professional obligation to specific clients (including fiduciary and suitability requirements), or from the nature or design of a product. Suitability, Disclosure and Fiduciary Fiduciary breaches / guideline violations Suitability / disclosure issues (KYC, etc.) Retail customer disclosure violations Breach of privacy Aggressive sales Account churning Misuse of confidential information Lender liability Improper Business or Market Practices Antitrust Improper trade / market practices Market manipulation Insider trading (on firm's account) Unlicensed activity Money laundering Product Flaws Product defects (unauthorized, etc.) Model errors Selection, Sponsorship and Exposure Failure to investigate client per guidelines Exceeding client exposure limits Advisory Activities Disputes over performance of advisory activities Damage to Physical Assets Losses arising from loss or damage to physical assets from natural disaster or other events. Disasters and other events Natural disaster losses Human losses from external sources (terrorism, vandalism) Business disruption and system failures Losses arising from disruption of business or system failures Systems Hardware Software Telecommunications Utility outage / disruptions Execution, Delivery and Process Management Losses from failed transaction processing or process management, from relations with trade counterparties and vendors Transaction Capture, Execution and Maintenance Miscommunication Data entry, maintenance or loading error Missed deadline or responsibility Model / system misoperation Accounting error / entity attribution error Other task misperformance Delivery failure Collateral management failure Reference Data Maintenance Monitoring and Reporting Failed mandatory reporting obligation Inaccurate external report (loss incurred) Customer Intake and Documentation Client permissions / disclaimers missing Legal documents missing / incomplete Customer / Client Account Management Unapproved access given to accounts Incorrect client records (loss incurred) Negligent loss or damage of client assets Trade counterparties Non-client counterparty misperformance Miscellaneous non-client counterparty disputes Vendors and suppliers Outsourcing Vendor disputes

Footnotes

Footnote 1 The Basel Framework Return to footnote 1 Footnote 2 Following the format: [Basel Framework, XXX yy.zz]. Return to footnote 2 Footnote 3 Legal risk includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements. Return to footnote 3 Footnote 4 Adjusted Gross Income is defined in paragraph 9 of this chapter. Return to footnote 4 Footnote 5 For example, if fiscal 2024 Adjusted Gross Income is greater than $1.5 billion for the first time, the institution must use the Standardized Approach starting in fiscal Q1 2026 and continue using the SA until, at a minimum, the end of fiscal 2027. Return to footnote 5 Footnote 6 Abs() represents the absolute value of the term or calculation within the brackets. The absolute value of net items (e.g. interest income – interest expense) should be calculated first year by year. Only after this year by year calculation should the average of the three years be calculated. Return to footnote 6 Footnote 7 For example, if an institution had a BI = $50 billion, the BIC = ($50B × 0.12) + [($50B -$1.5B) × 0.03] + [($50B − $45B) × 0.03] = $7.605 B. Return to footnote 7 Footnote 8 Net Interest and Non-Interest Income is line 22 from OSFI's P3 return. Return to footnote 8 Footnote 9 Institutions are also required to meet OSFI's Data Maintenance Expectations for Institutions Using the Standardized Approach for Operational Risk Capital Data. Return to footnote 9 Footnote 10 This includes Category I SMSBs with annual Adjusted Gross Income less than $1.5 billion that have been approved to use the SA, but do not have 10 years of high-quality loss data. These institutions must receive OSFI approval before they can set ILM<1 in the calculation of ORCSA. Return to footnote 10 Footnote 11 10 years of actual or estimated loss data must be included for all parts of an institution. Estimation of more than 10% of an institution's total loss data over the past 10 years using the methodology detailed in paragraph 40(a) is only permitted on a temporary basis. Where this is the case, the institution must inform OSFI and come below the 10% threshold in a timely manner in order to continue to meet the loss data standards. (see section 3.4.7). Return to footnote 11 Footnote 12 The financial impacts of events that an institution is responsible for should be included in the dataset as operational losses. For outsourced activities, the financial impacts of events that are paid by the outsourcer (rather than by the institution) are not operational losses to the institution. [Basel Framework, OPE 25.18 FAQ#1] Return to footnote 12 Footnote 13 Loss impacts denominated in a foreign currency should be converted using the same exchange rate that is used to convert the institution's financial statements of the period the loss impacts were accounted for. [Basel Framework, OPE 25.18 FAQ#2] Return to footnote 13 Footnote 14 Tax effects (e.g. reductions in corporate income tax liability due to operational losses) are not recoveries for purposes of the standardized approach for operational risk. Return to footnote 14 Footnote 15 Examples of recoveries are payments received from insurers, repayments received from perpetrators of fraud, and recoveries of misdirected transfers. Return to footnote 15 Footnote 16 When an institution makes a provision due to an operational loss event, such provision must be considered an operational loss immediately for the calculation of the Loss Component. When a charge-off (such as a settlement) eventually takes place later, only the difference between the initial provision and the charge-off (if any) should be added to the operational loss calculation. There should be no double counting of the same financial impacts in the calculation of operational losses. For example, if an institution takes a $1 million provision for a legal event in 2018, this should be included in the loss data for 2018. If the legal event is settled for $1.2 million in 2019, an additional $200,000 should be included in 2019. [Basel Framework, OPE 25.26 FAQ#1] Return to footnote 16 Footnote 17 For instance, the impact of some events (e.g. legal events, damage to physical assets) may be known and clearly identifiable before these events are recognized through the establishment of a reserve. Moreover, the way this reserve is established (e.g. the date of discovery) can vary across institutions or countries. Return to footnote 17 Footnote 18 Timing impacts typically relate to the occurrence of operational risk events that result in the temporary distortion of an institution's financial accounts (e.g. revenue overstatement, accounting errors and mark-to-market errors). While these events do not represent a true financial impact on the institution, (net impact over time is zero), if the error continues across more than one financial accounting period, it may represent a material misrepresentation of the institution's financial statements. Return to footnote 18 Footnote 19 For example, when an institution refunds a client that was overbilled due to an operational failure, if the refund is provided in the same financial accounting period as the overbilling took place and thus no misrepresentation of the institution's financial statements occurs, there is no operational loss. However, if the refund occurs in a subsequent financial accounting period to the overbilling, it is considered a timing loss and should be included in the loss dataset if it exceeds the $30,000 minimum threshold (note that in this case the prior overbilling cannot be netted against the payment to the client as a recovery). [Basel Framework, OPE 25.26 FAQ #2] Return to footnote 19 Footnote 20 For timing losses that are accounting errors, institutions must determine the threshold for inclusion of these events in the loss data set. This threshold may be greater than $30,000 but must be below the level used by the institution's external auditor for determining the summary of material misstatements within the annual financial statement audit. Accounting errors do not include errors in the mark-to-market valuation of financial assets or timing errors that involve third parties (e.g. customer over-billing or underpayment to third parties), which must be included in the loss data set when the amount of the timing loss exceeds $30,000. Return to footnote 20 Footnote 21 For losses from uncollected revenue (paragraph 31(b)(iii)), institutions may use either the date in which the revenue should have been collected, or the date on which the decision was made not to collect the revenue. Return to footnote 21 Footnote 22 This includes consideration of the extent to which the loss event was due to the lack of effective operational risk management policies, practices or controls within the institution. Return to footnote 22 Footnote 23 1% of BI is the implied level of annual losses for an institution with an ILM=1 and a marginal coefficient of 15%. Return to footnote 23 Footnote 24 Institutions may alternatively use 125% of Adjusted Gross Income (detailed in section 3.3) for the year prior to the merger or acquisition as a proxy for BI to calculate BI for an acquired business or merged entity at the time of acquisition. Return to footnote 24 Footnote 25 For clarity, all outstanding credit obligations, including those of non-accrued status (e.g. non-performing loans), in the balance sheet should be included in the interest-earning assets. [Basel Framework, OPE 10.2 FAQ #1] Return to footnote 25

Note

For institutions with a fiscal year ending October 31 or December 31, respectively. The Capital Adequacy Requirements (CAR) for banks (including federal credit unions), bank holding companies, federally regulated trust companies, and federally regulated loan companies are set out in nine chapters, each of which has been issued as a separate document. This chapter should be read in conjunction with the other CAR chapters. The complete list of CAR chapters is as follows: Chapter 1 - Overview of Risk-based Capital Requirements Chapter 2 - Definition of Capital Chapter 3 - Operational Risk Chapter 4 - Credit Risk – Standardized Approach Chapter 5 - Credit Risk – Internal Ratings-Based Approach Chapter 6 - Securitization Chapter 7 - Settlement and Counterparty Risk Chapter 8 - Credit Valuation Adjustment (CVA) Risk Chapter 9 - Market Risk Please refer to OSFI's Corporate Governance Guideline for OSFI's expectations of institution Boards of Directors in regard to the management of capital and liquidity.

Chapter 4 – Credit Risk – Standardized Approach

This chapter is drawn from the Basel Committee on Banking Supervision's (BCBS) Basel framework published on the BIS website.^{Footnote 1} For reference, the Basel paragraph numbers that are associated with the text appearing in this chapter are indicated in square brackets at the end of each paragraph.^{Footnote 2} Small and medium-sized deposit-taking institutions (SMSBs^{Footnote 3}) which fall into Categories I or II, as defined in OSFI's SMSB Capital and Liquidity Requirements Guideline,^{Footnote 4} are eligible to apply a simplified treatment to the following asset class groupings, provided the total exposure to the asset class grouping to which the simplified treatment is being applied does not exceed $500 million^{Footnote 5} : Banks, securities firms and other financials treated as banks as defined in section 4.1.4. Covered bonds as defined in section 4.1.5. Corporates, Small and Medium Size Enterprises (SMEs) treated as Corporates, securities firms and other financials treated as Corporates, and specialized lending (Project Finance, Object Finance, Commodity Finance) as defined in section 4.1.7. Qualifying revolving retail (including credit cards, charge cards, overdraft facilities and lines of credit) that meet the criteria set out in paragraph 83. Other qualifying retail (all exposures within the retail asset class as defined in section 4.1.9 excluding qualifying revolving retail exposures set out above) that meet the criteria set out in paragraph 83. Residential real estate (including Home Equity Lines of Credit) as defined in section 4.1.11. Commercial real estate as defined in section 4.1.12. The simplified treatments for the asset class grouping are described under the corresponding asset class. A summary of the asset classes for which the simplified treatment is available is provided in Appendix I and further detail regarding the application of the simplified treatment is provided in Appendix II.

4.1. Individual exposures

All exposures subject to the standardized approach should be risk-weighted net of specific allowances. Under IFRS 9, Stage 3 allowances and partial write-offs are considered to be specific allowances, while Stage 1 and Stage 2 allowances are considered to be general allowances. The risk weight categories apply to on-balance sheet and off-balance sheet credit equivalent amounts with the exception of items that are deducted from capital as regulatory adjustments pursuant to section 2.3 of Chapter 2. [Basel Framework, CRE 21.5] For certain asset classes (i.e. exposures to sovereigns and central banks, non-central government public sector entities, multilateral development banks, banks, securities firms and other financial institutions treated as banks, covered bonds, and corporates) risk weights under the standardized approach are assigned based on eligible credit ratings provided by external credit assessment institutions (ECAI) recognized by OSFI (see section 4.2 of this chapter). These mappings are reflected in tables 1 through 9 (with the exception of tables 2 and 6). A complete list of risk weight tables can be found in Appendix III. Consistent with the BCBS guidance on the assessment of credit risk^{Footnote 6} and paragraphs 20.12 to 20.14 of the Supervisory Review Process standard, institutions must perform due diligence to ensure that they have an adequate understanding, at origination and thereafter on a regular basis, of the risk profile and characteristics of their counterparties. In cases where ratings are used, due diligence is necessary to assess the risk of the exposure for risk management purposes and whether the risk weight applied is appropriate and prudent. The due diligence requirements do not apply to the exposures set out in paragraphs 10 to 19 of this chapter. The sophistication of the due diligence should be appropriate to the size and complexity of institutions' activities. Institutions must take reasonable and adequate steps to assess the operating and financial performance levels and trends through internal credit analysis and/or other analytics outsourced to a third party, as appropriate for each counterparty. Institutions must be able to access information about their counterparties on a regular basis to complete due diligence analyses. [Basel Framework, CRE 20.4] Due diligence analyses may include such elements as reviews of the entity's historical and projected financial information (e.g. as gained from annual reports, audited financial statements, and quarterly financial statements), industry and/or economic data, peer comparisons, and the entity's business plan projecting the activities and financial condition for the next 12 months. In addition, the due diligence analysis may rely on qualitative factors, such as the rated entity's governance framework, financial strategy, and the experience, credibility and competence of its management. A rating may be used while a due diligence review of the associated exposure is being conducted. New ratings (either due to an updated external rating from an External Credit Assessment Institution (ECAI), or the results of an institution's due diligence review) must be employed for capital purposes immediately upon the new rating being identified. Due diligence analyses should be completed at least annually. For exposures to entities belonging to consolidated groups, due diligence should, to the extent possible, be performed at the solo entity level to which there is a credit exposure. In evaluating the repayment capacity of the solo entity, institutions are expected to take into account the support of the group and the potential for it to be adversely impacted by problems in the group. [Basel Framework, CRE 20.5] Institutions should have in place effective internal policies, processes, systems and controls to ensure that the appropriate risk weights are assigned to counterparties. Institutions must be able to demonstrate to OSFI that their due diligence analyses are appropriate. As part of their supervisory review, OSFI will assess whether institutions have appropriately performed their due diligence analyses, and will take supervisory measures where these have not been done. [Basel Framework, CRE 20.6]

4.1.1. Exposures to sovereigns and central banks

Exposures to sovereigns and their central banks are risk weighted according to Table 1: Table 1: Risk weights for sovereign and central bank exposures External rating of sovereign^{Footnote 7} AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated Risk Weight 0% 20% 50% 100% 150% 100% [Basel Framework, CRE 20.7] Under the BCBS framework, national regulatory authorities have national discretion to allow a lower risk weight to be applied to institutions' exposures to their sovereign (or central bank) of incorporation^{Footnote 8} denominated in domestic currency and funded^{Footnote 9} in that currency.^{Footnote 10} Institutions operating in Canada that have exposures to sovereigns meeting the above criteria may use the lower risk weight assigned to those sovereigns by their national regulatory authority. [Basel Framework, CRE 20.8] For capital adequacy purposes, exposures to the Canadian sovereign and central bank are to be risk-weighted at 0%. Institutions should treat current tax assets^{Footnote 11} as sovereign exposures. For exposures to sovereigns, institutions may use country risk scores assigned by Export Credit Agencies (ECAs). To qualify, an ECA must publish its risk scores and subscribe to the methodology agreed by the Organisation for Economic Cooperation and Development (OECD). Institutions may choose to use the consensus risk scores of ECAs participating in the "Arrangement on Officially Supported Export Credits".^{Footnote 12} The OECD-agreed methodology establishes eight risk score categories associated with minimum export insurance premiums. These ECA risk scores correspond to risk weights as follows: Table 2: Risk weights for sovereign and central bank exposures ECA risk scores 0-1 2 3 4 to 6 7 Risk weight 0% 20% 50% 100% 150% [Basel Framework, CRE 20.9] Exposures to the Bank for International Settlements, the International Monetary Fund, the European Central Bank, the European Union, the European Stability Mechanism and the European Financial Stability Facility receive a 0% risk weight. [Basel Framework, CRE 20.10].

4.1.2. Exposures to non-central government public sector entities (PSEs)

PSEs are defined as: entities directly and wholly-owned by a government, school boards, hospitals, universities and social service programs that receive regular government financial support, and municipalities. Exposures to PSEs receive a risk weight that is one category higher than the sovereign risk weight: Table 3: Risk weights for PSE exposures External rating of sovereign AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated Sovereign risk weight 0% 20% 50% 100% 150% 100% PSE risk weight 20% 50% 100% 100% 150% 100% [Basel Framework, CRE 20.11] Exposures to all provincial and territorial governments and agents of the federal, provincial or territorial government whose debts are, by virtue of their enabling legislation, obligations of the parent government will receive the same risk weight as the Government of Canada. The PSE risk weight is meant for the financing of the PSE's own municipal and public services. Where PSEs other than Canadian provincial or territorial governments provide guarantees or other support arrangements other than in respect of the financing of their own municipal or public services, the PSE risk weight in Table 3 must not be used. Instead, the exposure to the PSE must be treated as a corporate exposure based on the external risk rating of the PSE. PSEs in foreign jurisdictions should be given the same capital treatment as that applied by the regulatory authorities in that jurisdiction. [Basel Framework, CRE 20.12]

4.1.3. Exposures to multilateral development banks

For the purposes of calculating capital requirements, a Multilateral Development Bank (MDB) is an institution created by a group of countries that provides financing and professional advice for economic and social development projects. MDBs have large sovereign memberships and may include both developed countries and/or developing countries. Each MDB has its own independent legal and operational status, but with a similar mandate and a considerable number of joint owners. [Basel Framework, CRE 20.13] A 0% risk weight will be applied to exposures to MDBs that fulfil to the BCBS's satisfaction the eligibility criteria provided below.^{Footnote 13} The BCBS will continue to evaluate eligibility on a case-by-case basis. The eligibility criteria for MDBs risk-weighted at 0% are: Very high quality long-term issuer ratings, i.e. a majority of an MDB's external assessments must be AAA,^{Footnote 14} Either the shareholder structure is comprised of a significant proportion of sovereigns with long-term issuer credit assessments of AA- or better, or the majority of the MDB's fund-raising is in the form of paid-in equity/capital and there is little or no leverage, Strong shareholder support demonstrated by the amount of paid-in capital contributed by the shareholders; the amount of further capital the MDBs have the right to call, if required, to repay their liabilities; and continued capital contributions and new pledges from sovereign shareholders, Adequate level of capital and liquidity (a case-by-case approach is necessary in order to assess whether each MDB's capital and liquidity are adequate), and Strict statutory lending requirements and conservative financial policies, which would include among other conditions a structured approval process, internal creditworthiness and risk concentration limits (per country, sector, and individual exposure and credit category), large exposures approval by the board or a committee of the board, fixed repayment schedules, effective monitoring of use of proceeds, status review process, and rigorous assessment of risk and provisioning to loan loss reserve. [Basel Framework, CRE 20.14] For exposures to all other MDBs, institutions will assign to their MDB exposures the corresponding "base" risk weights determined by the external ratings according to Table 4, and the following risk weights apply: Table 4: Risk weights for MDB exposures External rating of MDB AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated Risk weight 20% 30% 50% 100% 150% 50% [Basel Framework, CRE 20.15]

4.1.4. Exposures to banks

For the purposes of calculating capital requirements, an exposure to a deposit-taking institution or bank is defined as an exposure (including loans and senior debt instruments, unless considered as subordinated debt for the purposes of paragraph 78) to any federally and provincially regulated financial institution that is licensed to take deposits and lend money in the regular course of business and is subject to the appropriate prudential standards and level of supervision.^{Footnote 15} These include banks, trust or loan companies and co-operative credit societies. The treatment associated with subordinated bank debt and equities is addressed in paragraphs 70 to 78. [Basel Framework, CRE 20.16] The term bank refers to those institutions that are regarded as banks in the countries in which they are incorporated and are supervised by the appropriate banking supervisory or monetary authority. In general, banks will engage in the business of banking and have the power to accept deposits in the regular course of business. For banks incorporated in countries other than Canada, the definition of bank will be that used in the capital adequacy regulations of the host jurisdiction. Category I and II SMSBs may apply a "base" risk weight of 40% (and a risk weight of 20% for short-term exposures with an original maturity of three months or less) to exposures to banks (as defined in paragraphs 23 to 25), and securities firms and other financial institutions treated as banks (see paragraph 56), provided that these exposures do not cumulatively exceed $500 million. For institutions that do not qualify for the simplified treatment in paragraph 26, bank exposures will be risk-weighted based on the following hierarchy: External Credit Risk Assessment Approach (ECRA): This approach applies to all exposures to banks that are rated. Institutions will apply paragraphs 167 to 189 to determine which rating can be used and for which exposures. Standardized Credit Risk Assessment Approach (SCRA): This approach is for all exposures to banks that are unrated. [Basel Framework, CRE 20.17]

External Credit Risk Assessment Approach

Institutions will assign to all their bank exposures the "base" risk weights of the corresponding external ratings according to Table 5. Table 5: Risk weights for bank exposures under the ECRA External rating of counterparty AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- "Base" risk weight 20% 30% 50% 100% 150% Risk weight for short-term exposures 20% 20% 20% 50% 150% [Basel Framework, CRE 20.18] Exposures to banks with an original maturity of three months or less, as well as exposures to banks that arise from the movement of goods across national borders with an original maturity of six months or less^{Footnote 16} can be assigned a risk weight that corresponds to the risk weights for short term exposures in Table 5. For the purposes of identifying exposures to banks as short-term, the original maturity should be based on the drawn amount. [Basel Framework, CRE 20.19] Institutions must perform due diligence to ensure that the external ratings appropriately and conservatively reflect the creditworthiness of the bank counterparties. If the due diligence analysis reflects higher risk characteristics than that implied by the external rating bucket of the exposure (ie AAA to AA–; A+ to A– etc), the institution must assign a risk weight at least one bucket higher than the "base" risk weight determined by the external rating. Due diligence analysis must never result in the application of a lower risk weight than that determined by the external rating. [Basel Framework, CRE 20.20]

Standardized Credit Risk Assessment Approach

Under the SCRA, institutions may choose to apply a 100% risk weight to all their unrated bank exposures, with prior notification to OSFI. If an institution chooses to adopt this option, it must use the 100% risk weight for all of its unrated bank exposures. Alternatively, under the SCRA institutions may classify their unrated bank exposures into one of three risk-weight buckets (i.e. Grades A, B and C) and assign the corresponding risk weights in Table 6 below. For the purposes of the SCRA only, "published minimum regulatory requirements" in paragraphs 33 to 42 excludes liquidity standards. [Basel Framework, CRE 20.21] Table 6: Risk weights for bank exposures Credit risk assessment of counterparty Grade A Grade B Grade C "Base" risk weight 40% 75% 150% Bank risk weight for short-term exposures 20% 50% 150% Under the Standardized Credit Risk Assessment Approach, exposures to banks without an external credit rating may receive a risk weight of 30%, provided that the counterparty bank has a CET1 ratio which meets or exceeds 14% and a Tier 1 leverage ratio which meets or exceeds 5%. The counterparty bank must also satisfy all the requirements for Grade A classification in paragraphs 33 to 36. [Basel Framework, CRE 20.21]

SCRA: Grade A

Grade A refers to exposures to banks, where the counterparty bank has adequate capacity to meet its financial commitments (including repayments of principal and interest) in a timely manner, for the projected life of the assets or exposures and irrespective of the economic cycle and business conditions. For the purposes of this paragraph, an assessment of a counterparty bank's capacity to meet its financial commitments should be conducted at least annually [Basel Framework, CRE 20.22] A counterparty bank classified into Grade A must meet or exceed the published minimum regulatory requirements and buffers established by its national regulatory authority as implemented in the jurisdiction where it is incorporated, except for bank-specific minimum regulatory requirements or buffers that may be imposed through supervisory actions (e.g. via Pillar 2) and not made public. If such minimum regulatory requirements and buffers (other than bank-specific minimum requirements or buffers) are not publicly disclosed or otherwise made available by the counterparty bank then the counterparty bank must be assessed as Grade B or lower. [Basel Framework, CRE 20.23] For exposures to counterparty banks incorporated in Canada, a counterparty bank classified into Grade A must meet or exceed the published minimum regulatory requirements and buffers established in this guideline and in the Leverage Requirements Guideline.^{Footnote 17} Minimum regulatory capital requirements as a percentage of risk weighted assets in Canada, as set out in Chapter 1 of this guideline, are: 4.5% Common Equity Tier 1 (CET1) capital, 6.0% Tier 1 capital, 8.0% Total capital. In addition, banks are required to hold a Capital Conservation Buffer of 2.5% and a Countercyclical Buffer as set out in section 1.7.2 of this guideline. Banks designated by OSFI as Domestic Systemically Important Banks (D-SIB) are also required to hold a 1% D-SIB surcharge. Banks are required to have a minimum Leverage Ratio of 3%. Banks designated by OSFI as D-SIB are expected to maintain a leverage ratio that meets or exceeds 3.5% at all times. If, as part of its due diligence, an institution assesses that a counterparty bank does not meet the definition of Grade A in paragraphs 33 and 34, exposures to the counterparty bank must be classified as Grade B or Grade C. [Basel Framework, CRE 20.24]

SCRA: Grade B

Grade B refers to exposures to banks where the counterparty bank is subject to substantial credit risk, such as repayment capacities that are dependent on stable or favourable economic or business conditions. [Basel Framework, CRE 20.25] A counterparty bank classified into Grade B must meet or exceed the published minimum regulatory requirements (excluding buffers) established by its national supervisor as implemented in the jurisdiction where it is incorporated, except for bank-specific minimum regulatory requirements that may be imposed through supervisory actions (e.g. via Pillar 2) and not made public. If such minimum regulatory requirements are not publicly disclosed or otherwise made available by the counterparty bank, then the counterparty bank must be assessed as Grade C. [Basel Framework, CRE 20.26] For exposures to counterparty banks incorporated in Canada, a counterparty bank classified into Grade B must meet or exceed the published minimum regulatory requirements and buffers established in this guideline and in the Leverage Requirements Guideline. Institutions will classify all exposures that do not meet the requirements outlined in paragraphs 33 and 34 into Grade B, unless the exposure falls within Grade C under paragraphs 41 and 42. [Basel Framework, CRE 20.27]

SCRA: Grade C

Grade C refers to higher credit risk exposures to banks, where the counterparty bank has material default risks and limited margins of safety. For these counterparties, adverse business, financial, or economic conditions are very likely to lead, or have led, to an inability to meet their financial commitments. [Basel Framework, CRE 20.28] At a minimum, if any of the following triggers is breached, an institution must classify the exposure into Grade C: The counterparty bank does not meet the criteria for being classified as Grade B with respect to its published minimum regulatory requirements, as set out in paragraphs 37 and 38; or Where audited financial statements are required, the external auditor has issued an adverse audit opinion or has expressed substantial doubt about the counterparty bank's ability to continue as a going concern in its financial statements or audited reports within the previous 12 months. Even if these triggers are not breached, an institution may assess that the counterparty bank meets the definition in paragraph 41. In that case, the exposure to such counterparty bank must be classified into Grade C. [Basel Framework, CRE 20.29-20.30] Exposures to banks with an original maturity of three months or less, as well as exposures to banks that arise from the movement of goods across national borders with an original maturity of six months or less,^{Footnote 18} can be assigned a risk weight that corresponds to the risk weights for short term exposures in Table 6. [Basel Framework, CRE 20.31] To reflect transfer and convertibility risk under the SCRA, a risk-weight floor based on the risk weight applicable to exposures to the sovereign of the country where the bank counterparty is incorporated will be applied to the risk weight assigned to bank exposures. The sovereign floor applies when (i) the exposure is not in the local currency of the jurisdiction of incorporation of the debtor bank and (ii) for a borrowing booked in a branch of the debtor bank in a foreign jurisdiction, when the exposure is not in the local currency of the jurisdiction in which the branch operates. The sovereign floor will not apply to short-term (i.e. with a maturity below one year) self-liquidating, trade-related contingent items that arise from the movement of goods. [Basel Framework, CRE 20.32] Exposures to parents of banks that are non-financial institutions are treated as corporate exposures.

4.1.5. Exposures to covered bonds

Covered bonds are bonds issued by a bank or mortgage institution that are subject by law to special public supervision designed to protect bond holders.^{Footnote 19} Proceeds deriving from the issue of these bonds must be invested in conformity with the law in assets which, during the whole period of the validity of the bonds, are capable of covering claims attached to the bonds and which, in the event of the failure of the issuer, would be used on a priority basis for the reimbursement of the principal and payment of the accrued interest. [Basel Framework, CRE 20.33] Category I and II SMSBs may apply a risk weight of 20% to exposures to covered bonds provided that these exposures meet the criteria set out in paragraphs 48 to 51 and do not cumulatively exceed $500 million.

Eligible assets

In order to be eligible for the risk weights set out in paragraph 52, the underlying assets (the cover pool) of covered bonds as defined in paragraph 46 shall meet the requirements set out in paragraph 51 and shall include any of the following: Exposures to, or exposures guaranteed by, sovereigns, their central banks, public sector entities or multilateral development banks; Exposures secured by residential real estate that meet the criteria set out in paragraph 89 and with a loan-to-value ratio of 80% or lower; Exposures secured by commercial real estate that meets the criteria set out in paragraph 89 and with a loan-to-value ratio of 60% or lower; or Exposures to, or exposures guaranteed by banks that qualify for a 30% or lower risk weight. However, such assets cannot exceed 15% of the cover pool. [Basel Framework, CRE 20.34] The nominal value of the pool of assets assigned to the covered bond instrument(s) by its issuer should exceed its nominal outstanding value by at least 5%. The value of the pool of assets for this purpose does not need to be that required by the legislative framework. However, if the legislative framework does not stipulate a requirement of at least 5%, the issuing institution needs to publicly disclose on a regular basis that their cover pool meets the 5% requirement in practice. In addition to the primary assets listed in this paragraph, additional collateral may include substitution assets (cash or short term liquid and secure assets held in substitution of the primary assets to top up the cover pool for management purposes) and derivatives entered into for the purposes of hedging the risks arising in the covered bond program. [Basel Framework, CRE 20.35] The conditions set out in paragraphs 48 and 49 must be satisfied at the inception of the covered bond and throughout its remaining maturity. [Basel Framework, CRE 20.36]

Disclosure requirements

Exposures in the form of covered bonds are eligible for the treatment set out in paragraph 52, provided that the institution investing in the covered bonds can demonstrate to OSFI upon request that: it receives portfolio information at least on: (i) the value of the cover pool and outstanding covered bonds; (ii) the geographical distribution and type of cover assets, loan size, interest rate and currency risks; (iii) the maturity structure of cover assets and covered bonds; and (iv) the percentage of loans more than 90 days past due; and the issuer makes the information referred to in point (a) available to the institution at least semi-annually. [Basel Framework, CRE 20.37] Covered bonds that meet the criteria set out in paragraphs 48 to 51 shall be risk-weighted based on the issue-specific rating or the issuer's risk weight according to the rules outlined in paragraphs 167 to 189. For covered bonds with issue-specific ratings,^{Footnote 20} the risk weight shall be determined according to Table 7: Table 7: Risk weights for rated covered bond exposures Issue-specific rating of the covered bond AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- "Base" risk Weight 20% 30% 50% 100% 150% [Basel Framework, CRE 20.38] For unrated covered bonds, the risk weight would be inferred from the issuer's ECRA or SCRA risk weight according to Table 8: Table 8: Risk weights for unrated covered bond exposures Risk weights Risk weight of issuing institution 20% 30% 40% 50% 75% 100% 150% "Base" covered bond risk weight 20% 30% 40% 50% 75% 100% 150% [Basel Framework, CRE 20.38] Institutions must perform due diligence to ensure that the external ratings appropriately and conservatively reflect the creditworthiness of the covered bond and the issuing institution. If the due diligence analysis reflects higher risk characteristics than that implied by the external rating bucket of the exposure (i.e. AAA to AA–; A+ to A–; etc), the institution must assign a risk weight at least one bucket higher than the "base" risk weight determined by the external rating. Due diligence analysis must never result in the application of a lower risk weight than that determined by the external rating. [Basel Framework, CRE 20.39] Covered bonds that do not meet the criteria set out in paragraphs 48 and 51 should be risk-weighted based on the external rating of the issuing institution.

4.1.6. Exposures to securities firms and other financial institutions

Exposures to securities firms and other financial institutions will be treated as exposures to banks provided these firms are subject to prudential standards and a level of supervision equivalent to those applied to banks under the Basel III framework (including, in particular, capital and liquidity requirements).^{Footnote 21} For the purposes of this guideline, exposures to insurance companies regulated by OSFI should be treated as exposures to banks. Exposures to all other securities firms and financial institutions will be treated as exposures to corporates. [Basel Framework CRE 20.40]

4.1.7. Exposures to corporates

For the purposes of calculating capital requirements, exposures to corporates include exposures (loans, bonds, receivables, etc) to incorporated entities, associations, partnerships, proprietorships, trusts, funds and other entities with similar characteristics, except those which qualify for one of the other exposure classes. The treatment associated with subordinated debt and equities of these counterparties is addressed in paragraphs 70 to 78. The corporate exposure class includes exposures to insurance companies and other financial corporates that do not meet the definitions of exposures to banks, or securities firms and other financial institutions, as determined in paragraphs 23 and 56, respectively. The corporate exposure class does not include exposures to individuals. [Basel Framework CRE 20.41] Category I and II SMSBs may apply a risk weight of 100% to exposures to corporates, corporate SMEs (defined as corporate exposures where the reported annual sales for the consolidated group of which the corporate counterparty is a part is less than or equal to CAD $75 million for the most recent financial year), securities firms and other financial institutions treated as corporates (see paragraph 56), and specialized lending (see paragraphs 65 to 69), provided these exposures do not cumulatively exceed $500 million. For institutions that do not qualify for the simplified treatment in paragraph 58, the corporate exposure class differentiates between the following subcategories: General corporate exposures: Rated general corporate exposures must be risk-weighted according to either paragraph 60 or paragraph 61. Unrated general corporate exposures can be risk-weighted at 100% (together with all other corporate exposures as allowed in paragraph 60), or according to paragraph 62. Unrated exposures to Small and Medium Sized Enterprises (SMEs) must be treated according to paragraph 64. Specialized lending exposures (as defined in paragraph 65). [Basel Framework, CRE 20.41]

General corporate exposures

Institutions may apply a 100% risk weight to all corporate exposures, with prior notification to OSFI. However, if an institution chooses to adopt this option, it must use the 100% risk weight for all of its corporate exposures. Alternatively, institutions will assign "base" risk weights to their corporate exposures according to Table 9 and according to the rules for external ratings outlined in paragraphs 167 to 189. Institutions must perform due diligence to ensure that the external ratings appropriately and conservatively reflect the creditworthiness of the counterparties. If the due diligence analysis reflects higher risk characteristics than that implied by the external rating bucket of the exposure (i.e. AAA to AA–; A+ to A–; etc), the institution must assign a risk weight at least one bucket higher than the "base" risk weight determined by the external rating. Due diligence analysis must never result in the application of a lower risk weight than that determined by the external rating. Table 9: Risk weights for rated corporate exposures External rating of corporate AAA to AA- A+ to A- BBB+ to BBB- BB+ to BB- Below BB- Risk weight 20% 50% 75% 100% 150% [Basel Framework, CRE 20.42-20.43] Institutions may assign a 65% risk weight to unrated corporate exposures identified as "investment grade" in paragraph 63. Unrated corporate exposures that are not identified as "investment grade" pursuant to paragraph 63 will be assigned a risk weight of 150%. If an institution chooses not to identify all of its unrated corporate exposures as "investment grade" and "non-investment grade" according to paragraph 63, the risk weight for all of its unrated corporate exposures will be 100%.^{Footnote 22} [Basel Framework, CRE 20.44] Institutions may assign a 65% risk weight to unrated exposures to corporates, excluding SMEs as defined in paragraph 64, that qualify for an "investment grade." An "investment grade" corporate is a corporate entity that has been determined to have adequate capacity to meet its financial commitments in a timely manner and its ability to do so is assessed to be robust against adverse changes in the economic cycle and business conditions. The entity must be assessed as "investment grade" according to an institution's own internal credit grading system. When making this determination, the institution should assess the corporate entity against the investment grade definition taking into account the complexity of its business model, performance against industry and peers, and risks posed by the entity's operating environment. Moreover, the corporate entity (or its parent company) must either have: (1) securities outstanding on a recognized securities exchange; or (2) reported annual sales for the consolidated group of which the corporate counterparty is a part of more than CAD $75 million for the most recent financial year, and information on the corporate entity that institutions are able to access on a regular basis to complete due diligence analyses as described in paragraph 5 (e.g. annual reports, audited financial statements, quarterly financial statements, and business plans projecting the activities and financial condition for the next 12 months). [Basel Framework, CRE 20.46] For unrated exposures to corporate SMEs (defined as corporate exposures where the reported annual sales for the consolidated group of which the corporate counterparty is a part is less than or equal to CAD $75 million for the most recent financial year), an 85% risk weight will be applied. This treatment is to be applied independently of the option used for non-SMEs. Unrated exposures to SMEs that meet the criteria in paragraph 83 will be treated as regulatory retail SBE exposures and risk weighted at 75%. [Basel Framework, CRE 20.47]

Specialized lending

A corporate exposure will be treated as a specialized lending exposure if such lending possesses all of the following characteristics, either in legal form or economic substance: The exposure is not related to real estate and is within the definitions of object finance, project finance or commodities finance under paragraph 66. If the activity is related to real estate, the treatment would be determined in accordance with paragraphs 88 to 119; The exposure is to an entity (often a special purpose vehicle (SPV)) that was created specifically to finance and/or operate physical assets; The borrowing entity has few or no other material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed. The primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of the borrowing entity; and The terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates. [Basel Framework, CRE 20.48] The exposures described in paragraph 65 will be classified in one of the following three subcategories of specialized lending: Project finance refers to the method of funding in which the lender looks primarily to the revenues generated by a single project, both as the source of repayment and as security for the loan. This type of financing is usually for large, complex and expensive installations such as power plants, chemical processing plants, mines, transportation infrastructure, environment, media, and telecoms. Project finance may take the form of financing the construction of a new capital installation, or refinancing of an existing installation, with or without improvements. Object finance refers to the method of funding the acquisition of equipment (e.g. ships, aircraft, satellites, railcars, and fleets) where the repayment of the loan is dependent on the cash flows generated by the specific assets that have been financed and pledged or assigned to the lender. Commodities finance refers to short-term lending to finance reserves, inventories, or receivables of exchange-traded commodities (e.g. crude oil, metals, or crops), where the loan will be repaid from the proceeds of the sale of the commodity and the borrower has no independent capacity to repay the loan. [Basel Framework, CRE 20.49] Institutions will assign to their specialized lending exposures the risk weights determined by the issue-specific external ratings, if these are available, as provided in Table 9. Issuer ratings must not be used (i.e. paragraph 180 does not apply in the case of specialized lending exposures). [Basel Framework, CRE 20.50] For specialized lending exposures for which an issue-specific external rating is not available, the following risk weights will apply: Object and commodities finance exposures will be risk-weighted at 100%; Project finance exposures will be risk-weighted at 130% during the pre-operational phase and 100% during the operational phase. Project finance exposures in the operational phase which are deemed to be high quality, as described in paragraph 69, will be risk weighted at 80%. For this purpose, operational phase is defined as the phase in which the entity that was specifically created to finance the project has (i) a positive net cash flow that is sufficient to cover any remaining contractual obligation, and (ii) declining long term debt. [Basel Framework, CRE 20.51] A high quality project finance exposure refers to an exposure to a project finance entity that is able to meet its financial commitments in a timely manner and its ability to do so is assessed to be robust against adverse changes in the economic cycle and business conditions. The following conditions must also be met: The project finance entity is restricted from acting to the detriment of the creditors (e.g. by not being able to issue additional debt without the consent of existing creditors); The project finance entity has sufficient reserve funds or other financial arrangements to cover the contingency funding and working capital requirements of the project; The revenues are availability-based^{Footnote 23} or subject to a rate-of-return regulation or take-or-pay contract; The project finance entity's revenue depends on one main counterparty and this main counterparty shall be a central government, PSE or a corporate entity with a risk weight of 80% or lower; The contractual provisions governing the exposure to the project finance entity provide for a high degree of protection for creditors in case of a default of the project finance entity; The main counterparty or other counterparties which similarly comply with the eligibility criteria for the main counterparty will protect the creditors from the losses resulting from a termination of the project; All assets and contracts necessary to operate the project have been pledged to the creditors to the extent permitted by applicable law; and Creditors may assume control of the project finance entity in case of its default. [Basel Framework, CRE 20.52]

4.1.8. Subordinated debt, equity and other capital instruments

The treatment described in paragraphs 71 to 78 applies to subordinated debt, equity and other regulatory capital instruments issued by either corporates or other institutions, provided that such instruments are not deducted from regulatory capital or risk-weighted at 250% according to section 2.3.1 of Chapter 2 of this guideline. It also excludes equity investments in funds treated under paragraphs 145 to 163. [Basel Framework, CRE 20.53] Equity exposures are defined on the basis of the economic substance of the instrument. They include both direct and indirect ownership interests,^{Footnote 24} whether voting or non-voting, in the assets and income of a commercial enterprise or of a financial institution that is not consolidated or deducted. [Basel Framework, CRE 20.54] An instrument is considered to be an equity exposure if it meets all of the following requirements: It is irredeemable in the sense that the return of invested funds can be achieved only by the sale of the investment or sale of the rights to the investment or by the liquidation of the issuer; It does not embody an obligation on the part of the issuer; and It conveys a residual claim on the assets or income of the issuer. [Basel Framework, CRE 20.54] Additionally, any of the following instruments must be categorized as an equity exposure: An instrument with the same structure as those permitted as Tier 1 capital for banking organizations. An instrument that embodies an obligation on the part of the issuer and meets any of the following conditions: The issuer may defer indefinitely the settlement of the obligation; The obligation requires (or permits at the issuer's discretion) settlement by issuance of a fixed number of the issuer's equity shares; The obligation requires (or permits at the issuer's discretion) settlement by issuance of a variable number of the issuer's equity shares and (ceteris paribus) any change in the value of the obligation is attributable to, comparable to, and in the same direction as, the change in the value of a fixed number of the issuer's equity shares;^{Footnote 25} or The holder has the option to require that the obligation be settled in equity shares, unless either (i) in the case of a traded instrument, OSFI is content that the institution has demonstrated that the instrument trades more like the debt of the issuer than like its equity, or (ii) in the case of non-traded instruments, OSFI is content that the institution has demonstrated that the instrument should be treated as a debt position. In cases (i) and (ii), the institution may decompose the risks for regulatory purposes, with OSFI's consent. [Basel Framework, CRE 20.55] Debt obligations and other securities, partnerships, derivatives or other vehicles structured with the intent of conveying the economic substance of equity ownership are considered an equity holding.^{Footnote 26} This includes liabilities from which the return is linked to that of equities.^{Footnote 27} Conversely, equity investments that are structured with the intent of conveying the economic substance of debt holdings or securitization exposures would not be considered an equity holding.^{Footnote 28} [Basel Framework, CRE 20.56] Institutions will assign a risk weight of 400% to speculative unlisted equity exposures described in paragraph 76 and a risk weight of 250% to all other equity holdings, with the exception of those equity holdings referred to in paragraph 77. [Basel Framework, CRE 20.57] Speculative unlisted equity exposures are defined as equity investments in unlisted companies that are invested for short-term resale purposes, or are considered venture capital or similar investments which are subject to price volatility and are acquired in anticipation of significant future capital gains, or are held with trading intent.^{Footnote 29} Investments in unlisted equities of corporate clients with which the institution has or intends to establish a long-term business relationship and debt-equity swaps for corporate restructuring purposes would be excluded. [Basel Framework, CRE 20.58] Institutions may assign a risk weight of 100% to equity holdings made pursuant to national legislated programmes that provide significant subsidies for the investment to the institution and involve government oversight and restrictions on the equity investments. Such treatment can only be accorded to equity holdings up to an aggregate of 10% of the institution's Total capital. Examples of relevant government restrictions are limitations on the size and types of businesses in which the institution is investing, allowable amounts of ownership interests, geographical location and other pertinent factors that limit the potential risk of the investment to the institution. Equity investments made pursuant to the Specialized Financing (Banks) Regulations of the Bank Act qualify for this exclusion and are risk weighted at 100%.^{Footnote 30} [Basel Framework, CRE 20.59] Institutions will assign a risk weight of 150% to subordinated debt and capital instruments other than equities. Any liabilities that meet the definition of "other TLAC liabilities" according to section 2.3.1 of Chapter 2 of this guideline and that are not deducted from regulatory capital are considered to be subordinated debt for the purposes of this paragraph. [Basel Framework, CRE 20.60] Significant investments^{Footnote 31} in commercial entities that, in aggregate, exceed 10% of CET1 capital should be fully deducted in the calculation of CET1 capital. Amounts less than this threshold are subject to a 250% risk-weight. [Basel Framework, CRE 20.62]

4.1.9. Retail exposures

The retail exposure class excludes exposures within the real estate exposure class. The retail exposure class includes the following types of exposures: exposures to an individual person or persons, and exposures to SBEs (that meet the definition in paragraph 64 and the criteria set out in paragraph 83). [Basel Framework, CRE 20.63] Category I and II SMSBs may apply a risk weight of 75% to all revolving retail exposures (which include credit cards, charge cards, overdraft facilities and lines of credit) provided that these exposures meet the criteria set out in paragraph 83 and do not cumulatively exceed $500 million. Category I and II SMSBs may also separately apply a risk weight of 75% to non-revolving retail exposures (i.e. retail exposures excluding revolving retail exposures), provided that these exposures meet the criteria set out in paragraph 83 and do not cumulatively exceed $500 million. Exposures within the retail asset class will be treated according to paragraphs 83 to 87 below. For the purpose of determining risk-weighted assets, the retail exposure asset class consists of the following three sets of exposures: Regulatory retail exposures to transactors. Regulatory retail exposures that do not arise from exposures to transactors. Other retail exposures. [Basel Framework, CRE 20.64] Regulatory retail exposures are defined as retail exposures that meet all of the criteria listed below: Orientation criterion ─ the exposure is to an individual person or persons or to a small business. Product criterion ─ the exposure takes the form of any of the following: revolving credits and lines of credit (including credit cards, charge cards and overdrafts), personal term loans and leases (e.g. instalment loans, auto loans and leases, student and educational loans, personal finance) and small business facilities and commitments. Mortgage loans, derivatives and other securities (such as bonds and equities) whether listed or not, are specifically excluded from this category. Low value of individual exposures ─ the maximum aggregated retail exposure to one counterparty cannot exceed an absolute threshold of CAD $1.50 million. Small business loans extended through or guaranteed by an individual are subject to the same exposure threshold. Granularity criterion ─ no aggregated exposure to one counterparty^{Footnote 32} can exceed 0.2%^{Footnote 33} of the overall regulatory retail portfolio, unless an alternative measure of granularity has been specifically approved by OSFI to ensure sufficient diversification of the retail portfolio. Defaulted retail exposures are to be excluded from the overall regulatory retail portfolio when assessing the granularity criterion. [Basel Framework, CRE 20.65] Transactors are a sub-set of exposures under the qualifying revolving retail (QRR) asset class. QRR exposures are exposures to individuals that are revolving, unsecured, and uncommitted (both contractually and in practice). In this context, revolving exposures are defined as those where customers' outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by the institution. In addition, the maximum exposure to a single individual cannot exceed $150,000. Obligors are considered transactors in relation to facilities with an interest-free grace period, such as credit cards and charge cards, where the total accrued interest over the previous 12 months is less than $50. Obligors are considered transactors in relation to overdraft facilities or lines of credit if the facility has not been drawn down at any point in time over the preceding 12 months.^{Footnote 34} [Basel Framework, CRE 20.66] In cases where institutions are unable to ensure compliance with the retail thresholds (for both QRR and total aggregate exposures), they must be able to, on at least an annual basis, verify and document that the amount of exposures that breach these thresholds are less than 2% of retail exposures, and upon request, provide this documentation to OSFI. If the amount of exposures that breach the exposure threshold is above 2% of retail exposures, the institution must notify OSFI immediately and develop a plan to either reduce the materiality of these exposures or move these exposures to the Corporate asset class. "Other retail" exposures are defined as exposures to an individual person or persons that do not meet all of the criteria in paragraph 83. [Basel Framework, CRE 20.67] The risk weights that apply to exposures in the retail asset class are as follows: Regulatory retail exposures that arise from exposures to transactors (as defined in paragraph 84) will be risk-weighted at 15%. Regulatory retail exposures that do not arise from exposures to transactors (as defined in paragraph 84) will be risk-weighted at 75%. "Other retail" exposures will be risk weighted at 100%. [Basel Framework, CRE 20.68]

4.1.10. Real estate exposures

Real estate is immovable property that is land, including agricultural land and forest, or anything treated as attached to land, in particular buildings, in contrast to being treated as movable/personal property. The risk weights for real estate exposures are described in section 4.1.11 (residential real estate) and section 4.1.12 (commercial real estate). To apply the risk weights for real estate exposures set out in sections 4.1.11 and 4.1.12, the loan must meet the following six requirements: Finished property: the property securing the exposure must be fully completed. This requirement does not apply to forest and agricultural land. Loans to individuals that are secured by residential property under construction or land upon which residential property would be constructed, may apply the risk-weight treatments described in paragraph 97 provided that: (i) the property is a one-to-four family residential housing unit that will be the primary residence of the borrower^{Footnote 35} and the lending to the individual is not, in effect, indirectly financing land acquisition, development and construction exposures described in paragraph 110; or (ii) they meet the four qualifying criteria for regulatory retail exposures set out in paragraph 83. Legal enforceability: any claim on the property taken must be legally enforceable in all relevant jurisdictions. The collateral agreement and the legal process underpinning it must be such that they provide for the institution to realize the value of the property within a reasonable time frame. Claims over the property: the loan is a claim over the property where the lender institution holds the senior lien over the property, or a single institution holds the senior lien and any sequentially lower ranking lien(s) (i.e. no other party holds a senior or intervening lien on the property to which the collateral mortgage applies) over the same property. However, where junior liens provide the holder with a claim for collateral that is legally enforceable and constitute an effective credit risk mitigant, junior liens held by a different institution than the one holding the senior lien may also be recognized,^{Footnote 36} provided that: (i) each institution holding a lien on a property can initiate the sale of the property independently from other entities holding a lien on the property; (ii) where the sale of the property is not carried out by means of a public auction, entities holding a senior lien take reasonable steps to obtain a fair market value or the best price that may be obtained in the circumstances when exercising any power of sale on their own (i.e. it is not possible for the entity holding the senior lien to sell the property on its own at a discounted value in detriment of the junior lien);^{Footnote 37} and (iii) the loans are not more than 90 days past due and do not, collectively, exceed a loan-to-value (LTV) ratio of 80%. Ability of the borrower to repay: the borrower must meet the underwriting requirements set according to paragraph 90. Prudent value of property: the property must be valued according to the criteria in paragraph 92 for determining the value in the LTV ratio. Moreover, the value of the property must not depend materially on the performance of the borrower. Required documentation: all the information required at loan origination and for monitoring purposes must be properly documented, including information on the ability of the borrower to repay and on the valuation of the property. [Basel Framework, CRE 20.71] Institutions should have in place underwriting policies with respect to the granting of mortgage loans that include the assessment of the ability of the borrower to repay. Underwriting policies must define a metric(s) (such as the loan's debt service coverage ratio) and specify its (their) corresponding relevant level(s) to conduct such an assessment.^{Footnote 38} Underwriting policies must also be appropriate when the repayment of the mortgage loan depends materially on the cash flows generated by the property, including relevant metrics (such as an occupancy rate of the property). [Basel Framework, CRE 20.73] The LTV ratio is the amount of the loan divided by the value of the property. The value of the property will be maintained at the value measured at origination unless OSFI elects to require institutions to revise the property value downward. The value must be adjusted if an extraordinary, idiosyncratic event occurs resulting in a permanent reduction of the property value. If the value has been adjusted downwards, a subsequent upwards adjustment can be made but not to a higher value than the value at origination. Modifications made to the property that unequivocally increase its value could also be considered in the LTV. [Basel Framework, CRE 20.74] When calculating the LTV ratio, the loan amount will be reduced as the loan amortizes. The LTV ratio should be re-calculated upon any refinancing, and whenever deemed prudent. The LTV ratio must be prudently calculated in accordance with the following requirements: Amount of the loan: includes the outstanding loan amount and any undrawn committed amount of the mortgage loan.^{Footnote 39} The loan amount must be calculated gross of any provisions and other risk mitigants, except for pledged deposits accounts with the lending institution that meet all requirements for on-balance sheet netting and have been unconditionally and irrevocably pledged for the sole purposes of redemption of the mortgage loan.^{Footnote 40} Value of the property: the valuation must be assessed independently using prudently conservative valuation criteria. The valuation must be done independently from the institution's mortgage acquisition, loan processing and loan decision process. To ensure that the value of the property is appraised in a prudently conservative manner, the valuation must exclude expectations on price increases and must be adjusted to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan.^{Footnote 41} In addition, institutions should assess and adjust, as appropriate, the value of the property for the purposes of calculating the LTV ratio by considering relevant risk factors that make the underlying property more vulnerable to a significant house price correction or that may significantly affect the marketability of the property. If a market value can be determined, the valuation should not be higher than the market value.^{Footnote 42} [Basel Framework, CRE 20.75] Mortgage insurance in Canada is considered a guarantee and institutions may recognize the risk-mitigating effect of the guarantee where the operational requirements included in paragraphs 263 and 264 for guarantees as well as the additional operational requirements for mortgage insurance are met.^{Footnote 43} The risk weight applied to the insured mortgage after the recognition of the guarantee will be calculated according to paragraph 272 to 274. [Basel Framework, CRE 20.76]

4.1.11. Exposures secured by residential real estate

A residential property is an immovable property that has the nature of a dwelling and satisfies all applicable laws and regulations enabling the property to be occupied for housing purposes. A residential real estate exposure is an exposure secured by a residential property (such as individual condominium residences and one-to four-unit residences) made to a person(s) or guaranteed by a person(s), provided that such loans are not 90 days or more past due.^{Footnote 44} Investments in hotel properties and time-shares are excluded from the definition of qualifying residential property. [Basel Framework, CRE 20.77] Category I and II SMSBs may apply a risk weight of 35% to all residential real estate exposures with an LTV ratio equal to or below 80% and a risk weight of 75% all residential real estate exposures with an LTV ratio above 80%, provided that these exposures meet the criteria set out in paragraph 89 and do not cumulatively exceed $500 million. Guideline B-20 states: "OSFI expects that FRFIs will maintain adequate regulatory capital levels to properly reflect the risks being undertaken through the underwriting and/or acquisition of residential mortgages." Residential real estate exposures that do not meet OSFI's expectations related to Guideline B-20, are subject to either the risk weights outlined in Table 11 of Chapter 4 or to a 0.22 correlation (R) factor in paragraph 79 of Chapter 5.^{Footnote 45} ^{Footnote 46} For institutions that do not qualify for the simplified treatment in paragraph 95, residential real estate exposures are divided into two categories: General residential real estate: exposures where paragraph 100 (income-producing real estate), and paragraph 110 (land acquisition, development and construction) are not applicable. Income producing residential real estate: exposures where the criteria in paragraph 100 are met, but those in paragraph 110 (land acquisition, development and construction) are not applicable. Where the requirements for real estate exposures in paragraph 89 are met and provided that the exposure does not meet the requirements for income-producing residential real estate in paragraph 100 nor the requirements for land acquisition, development and construction in paragraph 110, the risk weight to be assigned to the total exposure amount will be determined based on the exposure's LTV ratio in Table 10. In calculating the LTV ratio for purposes of Home equity lines of credit (HELOC), a 75% credit conversion factor should be applied to the undrawn exposure of the HELOC. Table 10: Risk weights for general residential real estate exposures (Repayment is not materially dependent on cash flows generated by property) LTV ≤ 50% 50% < LTV ≤ 60% 60% < LTV ≤ 70% 70% < LTV ≤ 80% 80% < LTV ≤ 90% 90% < LTV ≤ 100% LTV > 100 Risk weight 20% 25% 30% 35% 40% 50% 70% [Basel Framework, CRE 20.82] For exposures where any of the requirements for real estate exposures described in paragraph 89 are not met and paragraphs 100 (income-producing real estate), and 110 (land acquisition, development and construction) are not applicable, the risk weight applicable will be the risk weight of the counterparty. For exposures to individuals and SBEs (as defined in paragraph 80) the risk weight applied will be 75%. For exposures to SMEs, the risk weight applied will be 85%. For exposures to other counterparties, the risk weight applied is the risk weight that would be assigned to an unsecured exposure to that counterparty. [Basel Framework, CRE 20.88-20.89] For an exposure to (i) a variable rate fixed-payment residential mortgage with an LTV above 65% for which payments are insufficient to cover the interest component of the mortgage for three or more consecutive months due to increases in interest rates; (ii) when the prospects for servicing the loan materially depend^{Footnote 47} on the cash flows generated by the property securing the loan rather than on the underlying capacity of the borrower to service the debt from other sources, and provided that paragraph 110 is not applicable, the exposure will be risk-weighted as follows: if the requirements for real estate exposures in paragraph 89 are met, according to the LTV ratio as set out in Table 11 below; and if any of the requirements for real estate exposures in paragraph 89 are not met, at 150%. Table 11: Risk weights for income-producing residential real estate exposures (Repayment is materially dependent on cash flows generated by property) LTV ≤ 50% 50% < LTV ≤ 60% 60% < LTV ≤ 70% 70% < LTV ≤ 80% 80% < LTV ≤ 90% 90% < LTV ≤ 100% LTV > 100 Risk weight 30% 35% 45% 50% 60% 75% 105% [Basel Framework, CRE 20.80 and 20.84] The primary source of these cash flows would generally be lease or rental payments, or the sale of the residential property. The distinguishing characteristic of these exposures compared to other residential real estate exposures is that both the servicing of the loan and the prospects for recovery in the event of default depend materially on the cash flows generated by the property securing the exposure. The loan should be considered materially dependent on cash flows generated by the property if more than 50% of the borrower's income used in the institution's assessment of the borrower's ability to service the loan is from cash flows generated by the residential property. Income generated from other residential real estate properties should not be considered when determining whether the loan is materially dependent on the borrower's income. Institutions may alternatively categorize all investment or rental properties, as identified using their internal property purpose indicators, as income producing and subject to the risk-weights in Table 11, provided that their internal policies for investment and rental properties can be shown, at OSFI's request, to require that less than 50% of the gross income from the property be used in the institution's assessment of the borrower's ability to service the loan. [Basel Framework, 20.79] The following types of exposures are excluded from the treatment described in paragraph 100 and are subject to the treatment described in paragraphs 98 to 99: An exposure secured by a property that is the borrower's primary residence; An exposure secured by residential real estate property to associations or cooperatives of individuals that are regulated under national law and exist with the only purpose of granting its members the use of a primary residence in the property securing the loans; and An exposure secured by residential real estate property to public housing companies and not-for-profit associations regulated under national law that exist to serve social purposes and to offer tenants long-term housing. [Basel Framework, CRE 20.81]

4.1.12. Exposures secured by commercial real estate

A commercial real estate exposure is an exposure secured by any immovable property that is not a residential real estate as defined in paragraph 94. [Basel Framework, CRE 20.78] Category I and II SMSBs may apply a risk weight of 100% to all commercial real estate exposures, provided that these exposures meet the criteria set out in paragraph 89 and do not cumulatively exceed $500 million. Commercial real estate exposures are divided into two categories: General commercial real estate: exposures where paragraphs 108 (income-producing real estate), and 110 (land acquisition, development and construction) are not applicable. Income producing commercial real estate: exposures where the criteria in paragraph 108 are met, but those in paragraph 110 (land acquisition, development and construction) are not applicable. Where the requirements in paragraph 89 are met and provided that paragraphs 108 and 110 are not applicable, the risk weight to be assigned to the total exposure amount will be determined based on the exposure's LTV ratio in Table 12. For the purpose of paragraphs 106 to 107, "risk weight of the counterparty" refers to 75% for exposures to individuals and SBEs (as defined in paragraph 80), 85% for exposures to SMEs and for exposures to other counterparties, the risk weight applied is the risk weight that would be assigned to an unsecured exposure to that counterparty. Table 12: Risk weights for general commercial real estate exposures (Repayment is not materially dependent on cash flows generated by property) LTV ≤ 60% LTV > 60% Risk weight Min (60%, RW of counterparty) RW of counterparty [Basel Framework, CRE 20.85] Where any of the requirements in paragraph 89 are not met and paragraphs 108 to 113 are not applicable, the risk weight applied will be the risk weight of the counterparty. [Basel Framework, CRE 20.88-20.89] When the prospects for servicing the loan materially depend^{Footnote 48} on the cash flows generated by the property securing the loan rather than on the underlying capacity of the borrower to service the debt from other sources,^{Footnote 49} and provided that paragraph 110 is not applicable, the exposure will be risk-weighted as follows: If the requirements in paragraph 89 are met, according to the LTV ratio as set out in the risk-weight Table 13 below; and If any of the requirements of paragraph 89 are not met, at 150%. Table 13: Risk weights for income-producing commercial real estate exposures (Repayment is materially dependent on cash flows generated by property) LTV ≤ 60% 60% < LTV ≤ 80% LTV > 80% Risk weight 70% 90% 110% [Basel Framework, CRE 20.87‐20.89] The primary source of these cash flows would generally be lease or rental payments, or the sale, of the commercial property. The distinguishing characteristic of these exposures compared to other commercial real estate exposures is that both the servicing of the loan and the recovery in the event of default depend materially on the cash flows generated by the property securing the exposure. The loan should be considered materially dependent on cash flows from the property if more than 50% of the borrower's income used in the institution's assessment of the borrower's ability to service the loan is from cash flows generated by the commercial property. Income generated from other commercial real estate properties should not be considered when determining whether the loan is materially dependent on the borrower's income. Institutions may alternatively categorize all investment or rental properties, as identified using their internal property purpose indicators, as income producing and subject to the risk-weights in Table 13, provided that their internal policies for investment and rental properties can be shown, at OSFI's request, to require that less than 50% of the gross income from the property be used in the institution's assessment of the borrower's ability to service the loan. [Basel Framework CRE 20.79 and CRE 20.80]

4.1.13. Land acquisition, development and construction exposures

Land acquisition, development and construction (ADC) exposures^{Footnote 50} refers to loans to companies or SPVs financing any of the land acquisition for development and construction purposes, or development and construction of any residential or commercial property. ADC exposures will be risk-weighted at 150%, unless they meet the criteria in paragraph 112. [Basel Framework, CRE 20.90] An ADC exposure is one for which the source of repayment is either the future uncertain sale of the property or cash flows which are substantially uncertain. Loans to corporates or SPVs where repayment of the loan depends on the credit quality of the corporate and not on the future income generated by the property, will be out of scope for the ADC treatment, and should be treated as a corporate exposure. Accordingly, ADC loans may be treated as corporate exposures provided any of the following criteria are met: (i) the property is being developed for the borrower's own use, with a reasonable expectation that no more than 50% of the total property will be leased; or (ii) based on a 3-year average, and for either the borrower or guarantor of an ADC loan, revenue generated from all ADC activities does not total more than 25% of the total revenue of the borrower or guarantor of the ADC loan. ADC exposures to residential real estate projects may be risk weighted at 100%, provided that the following criteria are met: Prudential underwriting standards meet the requirements in paragraph 90 where applicable; For construction projects, pre-sale contracts amount to over 50% of total contracts or equity at risk equivalent to at least 25% of the real estate's appraised as-completed value has been contributed by the borrower. Pre-sale contracts must be legally binding written contracts and the purchaser/renter must have made a substantial cash deposit which is subject to forfeiture if the contract is terminated. For land acquisition, LTV does not exceed 60%. In the event the institution holds the exposure in a subordinated or a mezzanine tranche of an ADC loan structure, the exposure should be risk-weighted at 300%. If an institution holds both the senior and the subordinated/mezzanine tranche(s) in the same ADC loan structure, the institution may treat the entire risk exposure as a single loan and use the risk weights in this section. [Basel Framework, CRE 20.91] High-rise residential construction projects (defined here as a building with five or more storeys) are only eligible for the 100% risk weight if the 50% pre-sale requirement is met. Purpose-built rental construction projects are excluded from this requirement and may continue to be eligible for the 100% risk weight if it meets the criteria set out in paragraph 112. A construction or development property can be considered residential if at least 50% of its square footage is intended for residential purposes. For mixed-use high-rise development projects, the percentage of total contracts that have been pre-sold should be based on the percentage of the overall project that has been pre-sold (i.e. residential and commercial combined). For mixed use low-rise projects, equity at risk should be calculated on a total project basis.

4.1.14. Reverse mortgages

The Standardized Approach must be used for reverse mortgage exposures. Reverse mortgages are non-recourse loans secured by property that have no defined term and no monthly repayment of principal and interest. The amount owing on a reverse mortgage grows with time as interest is accrued and deferred. The loan is generally repaid from the net proceeds of the sale (i.e. net of disposition costs) after the borrower has vacated the property. Reverse mortgage lenders are repaid the lesser of the fair market value of the home (less disposition costs) at the time it is sold and the amount of the loan. Assuming there is no event of default (for example, failure to pay property taxes and insurance, or failure to keep the home in a good state of repair), reverse mortgage lenders have no recourse to the borrower if the amount realized on the sale of the home is less than the amount owing on the reverse mortgage. A reverse mortgage exposure includes all advances, plus accrued interest and 40% of undrawn amounts, net of specific allowances. Undrawn amounts on reverse mortgages do not include future loan growth due to capitalizing interest. Undrawn amounts are treated as undrawn commitments and are subject to a credit conversion factor of 40%. A reverse mortgage exposure qualifies for the risk weights set out in Table 14 provided that all of the following conditions are met: Disposition costs on the mortgaged property and risk of appraisal error are not expected to exceed 15%-20% of the current appraised value The criteria for qualifying residential mortgages set out in section 4.1.11 are met (except that there is no requirement for recourse to the borrower for a deficiency) The value of the property must be appraised independently using prudently conservative valuation criteria. The valuation must be done independently from the institution's mortgage acquisition, loan processing and loan decision process. To ensure that the value of the property is appraised in a prudently conservative manner, the valuation must exclude expectations on price increases and must be adjusted to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan.^{Footnote 51} In addition, institutions should assess and adjust, as appropriate, the value of the property for the purposes of calculating the LTV by considering relevant risk factors that make the underlying property more vulnerable to a significant house price correction or that may significantly affect the marketability of the property. If a market value can be determined, the valuation should not be higher than the market value. Further, for a reverse mortgage to qualify for the risk weights set out in Table 14, the underwriting institution must have, at mortgage inception and at the time such risk weight is being considered, each of the following: Documented and prudent underwriting standards, including systematic methods for estimating expected occupancy term (which should at minimum refer to standard mortality tables), future real estate appreciation / depreciation, future interest rates on the reverse mortgage and determining appropriate levels for maximum initial LTVs and a maximum dollar amount that may be lent Documented procedures for monitoring loan to value ratios on an ongoing basis, based on outstanding loan amounts, including accrued interest, undrawn balances and up to date property values Documented procedures for obtaining independent reappraisals of the properties at regular intervals, not less than once every five years, with more frequent appraisals as loan to value ratios approach 80% A documented process to ensure timely reappraisal of properties in a major urban centre where resale home prices in that urban centre decline by more than 10% Documented procedures for ensuring that borrowers remain in compliance with loan conditions A rigorous method for stress testing the reverse mortgage portfolio that addresses expected occupancy, property value and interest rate assumptions Ongoing monitoring of reverse mortgage stress testing that is incorporated in the institution's Internal Capital Adequacy Assessment Process and capital planning process. For purposes of calculating risk weighted assets, current LTV is defined as: The reverse mortgage exposure (as defined in paragraph 115) divided by: The most recently appraised value of the property. Table 14 sets out the risk weights that apply to reverse mortgage exposures: Table 14: Risk weights for reverse mortgage exposures Current LTV Risk Weight ≤ 35% 30% > 35% and ≤ 55% 35% > 55% and ≤ 65% 45% > 65% and ≤ 80% 60% > 80% Partial deduction In particular: A reverse mortgage exposure that has a current LTV less than or equal to 35% is risk weighted at 30%. A reverse mortgage exposure that has a current LTV greater than 35%, but less than or equal to 55%, is risk weighted at 35%. A reverse mortgage exposure that has a current LTV greater than 55%, but less than or equal to 65%, is risk weighted at 45%. A reverse mortgage exposure that has a current LTV greater than 65%, but less than or equal to 80%, is risk weighted at 60%. Where a reverse mortgage exposure has a current LTV greater than 80%, the exposure amount that exceeds 80% LTV is deducted from Common Equity Tier 1 (CET1) capital. The remaining amount is risk-weighted at 100%. If a reverse mortgage exposure fails to meet the criteria set out in paragraphs 115 and 116, the exposure amount that exceeds 80% LTV is deducted from CET1 capital. The remaining amount is risk-weighted at 150%.

4.1.15. Mortgage-backed securities

Mortgage backed securities (MBS) will be risk-weighted as follows:^{Footnote 52} National Housing Act (NHA) MBS that are guaranteed by the Canada Mortgage and Housing Corporation (CMHC), will receive a risk weight of 0% in recognition of the fact that obligations incurred by CMHC are legal obligations of the Government of Canada. Pass-through mortgage-backed securities that are fully and specifically secured against residential mortgages (see section 4.1.11) that meet the requirements for real estate exposures in paragraph 89, and provided that the treatment for ADC exposures in paragraphs 110 to 113 is not applicable, will be risk weighted based on the underlying exposures' LTV ratios according to Tables 10 and 11. Risk weights of IPRE exposures as set out in Table 11 would only need to be included in the calculation of the risk weight of the MBS if IPRE exposures form a material portion of the underlying assets of the MBS. Pass-through mortgage-backed securities that are fully and specifically secured against commercial mortgages (see section 4.1.12) that meet the requirements for real estate exposures in paragraph 89, and provided that the treatment for ADC exposures in paragraphs 110 to 113 is not applicable, will be risk weighted based on the underlying exposures' LTV ratios according to Tables 12 and 13. Risk weights of IPRE exposures as set out in Table 13 would only need to be included in the calculation of the risk weight of the MBS if IPRE exposures form a material portion of the underlying assets of the MBS. Amounts receivable resulting from the sale of mortgages under NHA MBS programs should be risk-weighted at 250% according the treatment of other assets (see section 4.1.23). Where the underlying pool of assets is comprised of assets that would attract different risk weights, the risk weight of the securities will be the highest risk weight associated with the underlying assets. If an institution does not have access to the LTVs of all underlying mortgages, but only to the range of LTVs, then the risk weight for the MBS would be based on the upper bound of that range. Mortgage-backed securities that are of pass-through type and are effectively a direct holding of the underlying assets shall receive the risk-weight of the underlying assets, provided that all the following conditions are met: The underlying mortgage pool contains only mortgages that are fully performing when the mortgage-backed security is created. The securities must absorb their pro-rata share of any losses incurred. A special-purpose vehicle should be established for securitization and administration of the pooled mortgage loans. The underlying mortgages are assigned to an independent third party for the benefit of the investors in the securities who will then own the underlying mortgages. The arrangements for the special-purpose vehicle and trustee must provide that the following obligations are observed: If a mortgage administrator or a mortgage servicer is employed to carry out administration functions, the vehicle and trustee must monitor the performance of the administrator or servicer. The vehicle and/or trustee must provide detailed and regular information on structure and performance of the pooled mortgage loans. The vehicle and trustee must be legally separate from the originator of the pooled mortgage loans. The vehicle and trustee must be responsible for any damage or loss to investors created by their own or their mortgage servicer's mismanagement of the pooled mortgages. The trustee must have a first priority charge on underlying assets on behalf of the holders of the securities. The agreement must provide for the trustee to take clearly specified steps in cases when the mortgagor defaults. The holder of the security must have a pro-rata share in the underlying mortgage assets or the vehicle that issues the security must have only liabilities related to the issuing of the mortgage-backed security. The cash flows of the underlying mortgages must meet the cash flow requirements of the security without undue reliance on any reinvestment income. The vehicle or trustee may invest cash flows pending distribution to investors only in short-term money market instruments (without any material reinvestment risk) or in new mortgage loans. Mortgage-backed securities that do not meet these conditions will receive the risk-weight of the originating entity or SPV.

4.1.16. Risk weight multiplier to certain exposures with currency mismatch

For unhedged residential real estate exposures to individuals where the lending currency differs from the currency of the borrower's source of income, and where more than 10% of the borrower's income used to qualify for the loan is denominated in foreign currency, institutions will apply a 1.5 times multiplier to the applicable risk weight according to paragraphs 94 to 102, subject to a maximum risk weight of 150%. [Basel Framework, CRE 20.92] For the purposes of paragraph 122, an unhedged exposure refers to an exposure to a borrower that has no natural or financial hedge against the foreign exchange risk resulting from the currency mismatch between the currency of the borrower's income and the currency of the loan. A natural hedge exists where the borrower, in its normal operating procedures, receives foreign currency income that matches the currency of a given loan (e.g. remittances, rental incomes, salaries). A financial hedge generally includes a legal contract with a financial institution (e.g. forward contract). For the purposes of application of the multiplier, only these natural or financial hedges are considered sufficient where they cover at least 90% of the total loan instalment, regardless of the number of hedges. [Basel Framework, CRE 20.93]

4.1.17. Commitments

Commitments are arrangements that obligate an institution, at a client's request, to extend credit, purchase assets or issue credit substitutes. It includes any such arrangement that can be unconditionally cancelled by the institution at any time without prior notice to the obligor. It also includes any such arrangement that can be cancelled by the institution if the obligor fails to meet conditions set out in the facility documentation, including conditions that must be met by the obligor prior to any initial or subsequent drawdown under the arrangement. Counterparty risk weightings for OTC derivative transactions will not be subject to any specific ceiling. [Basel Framework, CRE 20.94] Normally, commitments involve a written contract or agreement and some form of consideration, such as a commitment fee. Note that unfunded mortgage commitments are treated as commitments for risk-based capital purposes when the borrower has accepted the commitment extended by the institution and all conditions related to the commitment have been fully satisfied.

4.1.18. Off-balance sheet items

Off-balance sheet items will be converted into credit exposure equivalent amounts through the use of credit conversion factors (CCF). In the case of commitments, the committed but undrawn amount of the exposure would be multiplied by the CCF. [Basel Framework, CRE 20.94] A 100% CCF will be applied to the following items: Direct credit substitutes, e.g. general guarantees of indebtedness or equivalent instruments backing financial claims (including standby letters of credit serving as financial guarantees for loans and securities) and acceptances (including endorsements with the character of acceptances). With a direct credit substitute, the risk of loss to the institution is directly dependent on the creditworthiness of the counterparty. Sale and repurchase agreements and asset sales with recourse where the credit risk remains with the institution. A repurchase agreement is a transaction that involves the sale of a security or other asset with the simultaneous commitment by the seller that, after a stated period of time, the seller will repurchase the asset from the original buyer at a pre-determined price. A reverse repurchase agreement consists of the purchase of a security or other asset with the simultaneous commitment by the buyer that, after a stated period of time, the buyer will resell the asset to the original seller at a pre-determined price. The lending of an institution's securities or the posting of securities as collateral by an institution, including instances where these arise out of repo-style transactions (i.e. repurchase/reverse repurchase and securities lending/securities borrowing transactions). The risk-weighting treatment for counterparty credit risk must be applied in addition to the credit risk charge on the securities or posted collateral, where the credit risk of the securities lent or posted as collateral remains with the institution. This paragraph does not apply to posted collateral related to derivative transactions that is treated in accordance with the counterparty credit risk standards. Forward asset purchases. A forward asset purchase is a commitment to purchase a loan, security, or other asset at a specified future date, usually on prearranged terms. Forward forward deposits. Forward forward deposits are agreements between two parties whereby one will pay and other receive an agreed rate of interest on a deposit to be placed by one party with the other at some pre-determined date in the future. Such deposits are distinct from future forward rate agreements in that, with forward/forwards, the deposit is actually placed. Partly paid shares and securities.^{Footnote 53} Partly paid shares and securities are transactions where only a part of the issue price or notional face value of a security purchased has been subscribed and the issuer may call for the outstanding balance (or a further installment), either on a date pre-determined at the time of issue or at an unspecified future date. These items are to be weighted according to the type of asset and not according to the type of counterparty with whom the transaction has been entered into. Off-balance sheet items that are credit substitutes not explicitly included in any other category. [Basel Framework, CRE 20.95] A 50% CCF will be applied to note issuance facilities (NIFs) and revolving underwriting facilities (RUFs) regardless of the maturity of the underlying facility. These are arrangements whereby a borrower may issue short-term notes, typically three to six months in maturity, up to a prescribed limit over an extended period of time, commonly by means of repeated offerings to a tender panel. If at any time the notes are not sold by the tender at an acceptable price, an underwriter (or group of underwriters) undertakes to buy them at a prescribed price. [Basel Framework, CRE 20.96] A 50% CCF will be applied to certain transaction-related contingent items (e.g. performance-related guarantees). Transaction-related contingencies relate to the ongoing business activities of a counterparty, where the risk of loss to the reporting institution depends on the likelihood of a future event that is independent of the creditworthiness of the counterparty. Essentially, transaction-related contingencies are guarantees that support particular performance of non- financial or commercial contracts or undertakings, rather than supporting customers' general financial obligations. Performance-related guarantees specifically exclude items relating to non- performance of financial obligations. [Basel Framework, CRE 20.97] Performance-related and non-financial guarantees include items such as: Performance bonds, warranties and indemnities. Performance standby letters of credit represent obligations backing the performance of non-financial or commercial contracts or undertakings. These include arrangements backing: Subcontractors' and supplies' performance Labour and material contracts Delivery of merchandise, bids or tender bonds Guarantees of repayment of deposits or prepayments in cases of non-performance Customs and excise bonds. The amount recorded for such bonds should be the reporting institution's maximum liability. A 40% CCF will be applied to commitments, regardless of the maturity of the underlying facility, unless they qualify for a lower CCF. [Basel Framework, CRE 20.98] A 25% CCF will be applied to undrawn balances of credit card and charge card exposures even if they meet the criteria in paragraph 134. A 20% CCF will be applied to both the issuing and confirming institutions of short-term (i.e. with a maturity below one year) self-liquidating trade letters of credit arising from the movement of goods (e.g. commercial and documentary letters of credit issued by the institution that are, or are to be, collateralized by the underlying shipment). Letters of credit issued on behalf of a counterparty back-to-back with letters of credit of which the counterparty is a beneficiary ("back-to-back" letters) should be reported as documentary letters of credit. Letters of credit advised by the institution for which the institution is acting as reimbursement agent should not be considered as a risk asset. [Basel Framework, CRE 20.99] A 10% CCF will be applied to commitments that are unconditionally cancellable at any time by the institution without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrower's creditworthiness. [Basel Framework, CRE 20.100] Where there is an undertaking to provide a commitment on an off-balance sheet item, institutions are to apply the lower of the two applicable CCFs.^{Footnote 54} [Basel Framework, CRE 20.101]

4.1.19. Exposures that give rise to counterparty credit risk

The credit equivalent amount of SFTs that expose an institution to counterparty credit risk is to be calculated under the comprehensive approach in paragraphs 230 to 255. The credit equivalent amount of OTC derivatives that expose an institution to counterparty credit risk is to be calculated under the rules for counterparty credit risk in paragraph 256. [Basel Framework, CRE 20.102] Institutions must closely monitor securities, commodities and foreign exchange transactions that have failed, starting from the first day they fail. A capital charge on failed transactions must be calculated in accordance with section 7.2 of Chapter 7 of this guideline. [Basel Framework, CRE 70.2] Institutions are exposed to the risk associated with unsettled securities, commodities, and foreign exchange transactions from trade date. Irrespective of the booking or the accounting of the transaction, unsettled transactions must be taken into account for regulatory capital requirements purposes. Where they do not appear on the balance sheet (ie settlement date accounting), the unsettled exposure amount will receive a 100% CCF. Institutions are encouraged to develop, implement and improve systems for tracking and monitoring the credit risk exposure arising from unsettled transactions as appropriate so that they can produce management information that facilitates timely action. Furthermore, when such transactions are not processed through a delivery-versus-payment (DvP) or payment-versus-payment (PvP) mechanism, institutions must calculate a capital charge as set forth in section 7.2 in Chapter 7 of this guideline. [Basel Framework, CRE 70.1, CRE 70.2, CRE 70.6, and CRE 70.10]

4.1.20. Credit derivatives

An institution providing credit protection through a first-to-default or second-to-default credit derivative is subject to capital requirements on such instruments. For first-to-default credit derivatives, the risk weights of the assets included in the basket must be aggregated up to a maximum of 1250% and multiplied by the nominal amount of the protection provided by the credit derivative to obtain the risk-weighted asset amount. For second-to-default credit derivatives, the treatment is similar; however, in aggregating the risk weights, the asset with the lowest risk-weighted amount can be excluded from the calculation. This treatment applies respectively for nth-to-default credit derivatives, for which the n-1 assets with the lowest risk- weighted amounts can be excluded from the calculation. [Basel Framework, CRE 20.103]

4.1.21. Defaulted exposures

For risk-weighting purposes under the standardized approach, a defaulted exposure is defined as one that is past due for more than 90 days, or is an exposure to a defaulted borrower. A defaulted borrower is a borrower in respect of whom any of the following events have occurred: Any material credit obligation that is past due for more than 90 days. Overdrafts will be considered as being past due once the customer has breached an advised limit or been advised of a limit smaller than current outstandings; Any material credit obligation is on non-accrued status (e.g. the lending institution no longer recognizes accrued interest as income or, if recognized, makes an equivalent amount of provisions); A write-off or account-specific provision is made as a result of a significant perceived decline in credit quality subsequent to the institution taking on any credit exposure to the borrower; Any credit obligation is sold at a material credit-related economic loss; A distressed restructuring of any credit obligation (ie a restructuring that may result in a diminished financial obligation caused by the material forgiveness, or postponement, of principal, interest or (where relevant) fees) is agreed by the institution; The borrower's bankruptcy or a similar order in respect of any of the borrower's credit obligations to the banking group has been filed; The borrower has sought or has been placed in bankruptcy or similar protection where this would avoid or delay repayment of any of the credit obligations to the banking group; or Any other situation where the institution considers that the borrower is unlikely to pay its credit obligations in full without recourse by the institution to actions such as realizing security. [Basel Framework, CRE 20.104] For retail exposures, the definition of default can be applied at the level of a particular credit obligation, rather than at the level of the borrower. As such, default by a borrower on one obligation does not require an institution to treat all other obligations to the banking group as defaulted. [Basel Framework, CRE 20.105] With the exception of residential real estate exposures treated under paragraph 143, the unsecured or unguaranteed portion of a defaulted exposure shall be risk-weighted net of specific provisions and partial write-offs as follows: 150% risk weight when specific provisions are less than 20% of the outstanding amount of the loan; and 100% risk weight when specific provisions are equal or greater than 20% of the outstanding amount of the loan. [Basel Framework, CRE 20.106] Defaulted residential real estate exposures where repayments do not materially depend on cash flows generated by the property securing the loan shall be risk-weighted net of specific provisions and partial write-offs at 100%. Guarantees or financial collateral which are eligible according to the credit risk mitigation framework might be taken into account in the calculation of the exposure in accordance with paragraph 93. [Basel Framework, CRE 20.107] For the purpose of defining the secured or guaranteed portion of the defaulted exposure, eligible collateral and guarantees will be the same as for credit risk mitigation purposes (see section 4.3). [Basel Framework, CRE 20.108]

4.1.22. Equity Investments in Funds

Chapter 2 of this guideline requires institutions to deduct certain direct and indirect investments in financial institutions from regulatory capital. Exposures, including underlying exposures held by funds, that are required to be deducted according to Chapter 2 should not be risk weighted and therefore are excluded from the treatment in paragraphs 146 to 163 below. Equity investments in funds that are held in the banking book must be treated in a manner consistent with one or more of the following three approaches, which vary in their risk sensitivity and conservatism: the "look-through approach" (LTA), the "mandate-based approach" (MBA), and the "fall-back approach" (FBA). The requirements set out in this section apply to institutions' equity investments in all types of funds, including off-balance sheet exposures (e.g. unfunded commitments to subscribe to a fund's future capital calls). [Basel Framework, CRE 60.1]

(i) The look-through approach

The LTA requires an institution to risk weight the underlying exposures of a fund as if the exposures were held directly by the institution. This is the most granular and risk-sensitive approach. It must be used when: there is sufficient and frequent information provided to the institution regarding the underlying exposures of the fund; and such information is verified by an independent third party. [Basel Framework, CRE 60.2] To satisfy condition (a) above, the frequency of financial reporting of the fund must be the same as, or more frequent than, that of the institution's and the granularity of the financial information must be sufficient to calculate the corresponding risk weights. To satisfy condition (b) above, there must be verification of the underlying exposures by an independent third party, such as the depository or the custodian institution or, where applicable, the management company.^{Footnote 55} [Basel Framework, CRE 60.3] Under the LTA institutions must risk weight all underlying exposures of the fund as if those exposures were directly held. This includes, for example, any underlying exposure arising from the fund's derivatives activities (for situations in which the underlying receives a risk weighting treatment under the calculation of the minimum risk-based capital requirements) and the associated counterparty credit risk (CCR) exposure. Instead of determining a credit valuation adjustment (CVA) charge associated with the fund's derivatives exposures in accordance with section 7.1.7 of Chapter 7, institutions must multiply the CCR exposure by a factor of 1.5 before applying the risk weight associated with the counterparty.^{Footnote 56} [Basel Framework, CRE 60.4] Institutions may rely on third-party calculations for determining the risk weights associated with their equity investments in funds (i.e. the underlying risk weights of the exposures of the fund) if they do not have adequate data or information to perform the calculations themselves. In such cases, the applicable risk weight shall be 1.2 times higher than the one that would be applicable if the exposure were held directly by the institution.^{Footnote 57} [Basel Framework, CRE 60.5] The following is an example of the calculation of RWA using the LTA: Consider a fund that replicates an equity index. Moreover, assume the following: The institution uses the Standardized Approach for credit risk when calculating its capital requirements; The institution owns 20% of the shares of the fund; The fund presents the following balance sheet: Assets: Cash: $20; Government bonds (AAA rated): $30; and Non-significant equity investments in commercial entities: $50 Liabilities: Notes payable $5 Equity Shares $95 Balance sheet exposures of $100 will be risk-weighted according to the risk weights applied for cash (RW=0%), government bonds (RW=0%), and non-significant equity holdings of commercial entities (RW = 250%). The leverage of the fund is 100/95≈1.05. Therefore, the risk-weighted assets for the institution's equity investment in the fund are calculated as follows: Avg RWfund × Leverage × Equity investment = ((RWAcash + RWAbonds + RWAequities)/TotalAssetsfund) × Leverage × Equity investment = (($20×0% + $30×0% + $50×250%)/$100)⊄× 1.05 × (20%×$95) = $24.9375

(ii) The mandate-based approach

The second approach, the MBA, provides a method for calculating regulatory capital that can be used when the conditions for applying the LTA are not met. [Basel Framework, CRE 60.6] Under the MBA institutions may use the information contained in a fund's mandate or in the national regulations governing such investment funds.^{Footnote 58} To ensure that all underlying risks are taken into account (including CCR) and that the MBA renders capital requirements no less than the LTA, the risk-weighted assets for the fund's exposures are calculated as the sum of the following three items: Balance sheet exposures (i.e. the funds' assets) are risk weighted assuming the underlying portfolios are invested to the maximum extent allowed under the fund's mandate in those assets attracting the highest capital requirements, and then progressively in those other assets implying lower capital requirements. If more than one risk weight can be applied to a given exposure, the maximum risk weight applicable must be used.^{Footnote 59} Whenever the underlying risk of a derivative exposure or an off-balance-sheet item receives a risk weighting treatment under the risk-based capital requirements, the notional amount of the derivative position or of the off-balance sheet exposure is risk weighted accordingly.^{Footnote 60} ^{Footnote 61} The CCR associated with the fund's derivative exposures is calculated using the Standardized Approach for measuring Counterparty Credit Risk (SACCR), set out in section 7.1.7 of Chapter 7 of this guideline. SACCR calculates the counterparty credit risk exposure of a netting set of derivatives by multiplying (i) the sum of the replacement cost and aggregate add-on for potential future exposure (PFE); by (ii) a multiplier set at 1.4. Whenever the replacement cost is unknown, the exposure measure for CCR will be calculated in a conservative manner by using the notional amount of the derivatives in each netting set as a proxy for the replacement cost. Whenever the aggregate add-on for PFE is unknown, it will be calculated as 15% of the sum of the notional values of the derivatives in the netting set.^{Footnote 62} The risk weight associated with the counterparty is applied to the counterparty credit risk exposure. Instead of determining a CVA charge associated with the fund's derivative exposures in accordance with Chapter 8 of this guideline, institutions must multiply the CCR exposure by a factor of 1.5 before applying the risk weight associated with the counterparty.^{Footnote 63} [Basel Framework, CRE 60.7] The following is an example of the calculation of the RWA using the MBA Consider a fund with assets of $100, where it is stated in the mandate that the fund replicates an equity index. In addition to being permitted to invest its assets in either cash or listed equities, the mandate allows the fund to take long positions in equity index futures up to a maximum nominal amount equivalent to the size of the fund's balance sheet ($100). This means that the total on balance sheet and off balance sheet exposures of the fund can reach $200. Consider also that a maximum financial leverage (fund assets/fund equity) of 1.1 applies according to the mandate. The bank holds 20% of the shares of the fund, which represents an investment of $18.18. First, the on-balance sheet exposures of $100 will be risk weighted according to the risk weights applied to listed equity exposures (RW=250%), i.e. RWAon-BS = $100 × 250% = $250. Second, we assume that the fund has exhausted its limit on derivative positions, ie CAD 100 notional amount. The RWA for the maximum notional amount of underlying the derivatives positions calculated by multiplying the following three amounts: (1) the SA credit conversion factor of 100% that is applicable to forward purchases; (2) the maximum exposure to the notional of $100; and (3) the applicable risk weight for listed equities under the SA which is 250%. Thus, RWAunderlying = 100% × $100 × 250% = $250. Third, we would calculate the counterparty credit risk associated with the derivative contract. As set out in paragraph 153: If we do not know the replacement cost related to the futures contract, we would approximate it by the maximum notional amount, i.e. $100. If we do not know the aggregate add-on for potential future exposure, we would approximate this by 15% of the maximum notional amount (i.e. 15% of $100 = $15). The CCR exposure is calculated by multiplying (i) the sum of the replacement cost and aggregate add-on for potential future exposure; by (ii) 1.4, which is the prescribed value of alpha. The counterparty credit risk exposure in this example, assuming the replacement cost and aggregate add-on amounts are unknown, is therefore $161 (= 1.4 × ($100 + $15)). Assuming the futures contract is cleared through a qualifying CCP, a risk weight of 2% applies, so that RWACCR = $161 × 2% = $3.2. There is no CVA charge assessed since the futures contract is cleared through a CCP. The RWA of the fund is hence obtained by adding RWAon-BS, RWAunderlying and RWACCR, i.e. $503.2 (= $250 + $250 + $3.2). The RWA ($503.2) will be divided by the total assets of the fund ($100) resulting in an average risk-weight of 503.2%. The bank's total RWA associated with its equity investment is calculated as the product of the average risk weight of the fund, the fund's maximum leverage and the size of the bank's equity investment. That is the bank's total associated RWA are 503.2% × 1.1 × $18.18 = $100.6.

(iii) The fall-back approach

Where neither the LTA nor the MBA is feasible, institutions are required to apply the FBA. Under the FBA, the institution's equity investment in the fund is to be deducted from CET1 capital. [Basel Framework, CRE 60.8]

(iv) Treatment of funds that invest in other funds

When an institution has an investment in a fund (e.g. Fund A) that itself has an investment in another fund (e.g. Fund B), which the institution identified by using either the LTA or the MBA, the risk weight applied to the investment of the first fund (i.e. Fund A's investment in Fund B) can be determined by using one of the three approaches set out above. For all subsequent layers (e.g. Fund B's investments in Fund C and so forth), the risk weights applied to an investment in another fund (Fund C) can be determined by using the LTA under the condition that the LTA was also used for determining the risk weight for the investment in the fund at the previous layer (Fund B). Otherwise, the FBA must be applied. [Basel Framework, CRE 60.9]

(v) Partial use of an approach

An institution may use a combination of the three approaches when determining the capital requirements for an equity investment in an individual fund, provided that the conditions set out in paragraphs 147 to 156 are met. [Basel Framework, CRE 60.10]

(vi) Exclusions to the look-through, mandate-based and fall-back approaches

Equity holdings in entities whose debt obligations qualify for a zero risk weight are excluded from the LTA, MBA and FBA approaches (including those publicly sponsored entities where a zero risk weight can be applied). [Basel Framework, CRE 60.11] Equity investments made pursuant to the Specialized Financing (Banks) Regulations of the Bank Act qualify for the exclusion contained in paragraph 77 and are risk weighted at 100%. Equity holdings made under legislated programmes can only be excluded up to an aggregate of 10% of an institution's total regulatory capital. [Basel Framework, CRE 60.12]

(vii) Leverage adjustment

Leverage is defined as the ratio of total assets to total equity. Leverage is taken into account in the MBA by using the maximum financial leverage permitted in the fund's mandate or in the national regulation governing the fund. [Basel Framework, CRE 60.13] When determining the capital requirement related to its equity investment in a fund, an institution must apply a leverage adjustment to the average risk weight of the fund, as set out in paragraph 162, subject to a cap of 1,250%.[Basel Framework, CRE 60.14] After calculating the total risk-weighted assets of the fund according to the LTA or the MBA, institutions will calculate the average risk weight of the fund (Avg RWfund) by dividing the total risk-weighted assets by the total assets of the fund. Using Avg RWfund and taking into account the leverage of a fund (Lvg), the risk-weighted assets for an institution's equity investment in a fund can be represented as follows: RWAinvestment = Avg RWfund × Lvg × equity investment [Basel Framework, CRE 60.15] The effect of the leverage adjustments depends on the underlying riskiness of the portfolio (ie the average risk weight) as obtained by applying the Standardized Approach or the IRB approaches for credit risk. The formula can therefore be re-written as: RWAinvestment = RWAfund × percentage of shares [Basel Framework, CRE 60.16]

4.1.23. Other assets

Other assets will be risk weighted as follows: 0% Risk weight cash and gold bullion held in the institution's own vaults or on an allocated basis to the extent backed by bullion liabilities, unrealized gains and accrued receivables on foreign exchange and interest rate-related off-balance sheet transactions where they have been included in the off-balance sheet calculations. 20% Risk weight cheques and other items in transit. 100% Risk weight premises, plant and equipment and other fixed assets, real estate and other investments (including non-consolidated investment participation in other companies), prepaid expenses, deferred charges, non-credit enhancing interest-only strips on transactions that are not subject to prepayment risk, right-of-use (ROU) assets where the leased asset is a tangible asset,^{Footnote 64} corporate and retail receivables for which the counterparty cannot be identified,^{Footnote 65} prepaid portfolio insurance (unamortized portion), subject to the following amortization expectations: the lesser of 5 years or the expected life (assuming no renewals) of the first term of the underlying mortgage loans or MBS pool, and all other assets. 250% Risk weight Items described as Threshold Deductions (basket) in Chapter 2 - Definition of Capital, section 2.3.1 which fall below the applicable thresholds. Deferred placement fees receivable, non-credit-enhancing interest-only strips, and any other assets that represent the present value of future spread income subject to prepayment risk. 1250% Risk weight The following securitization exposures: Credit-enhancing interest-only strips, net of any related gain on sale deducted from capital Certain unrated securitization exposures (refer to Chapter 6 – Securitization) Deduction from CET1 capital Non-payment/delivery on non-DvP and non-PvP transactions (refer to section 2.3.4 of Chapter 2 – Definition of Capital), Significant investments in commercial entities (refer to section 2.3.4 of Chapter 2 – Definition of Capital), and Intangible assets (refer to section 2.3.1 of Chapter 2 – Definition of Capital) Exposures to non-qualifying central counterparties (refer to section 7.1.9.2 of Chapter 7 – Settlement and Counterparty Risk) Any other assets that are required to be deducted from CET1 capital pursuant to Chapter 2 of this guideline. [Basel Framework, CRE 20.109-20.110 ]

4.1.24. Treatment of purchased receivables

Purchased retail receivables that meet the four criteria for regulatory retail exposures, as specified in paragraph 83, are risk weighted at 75%. Purchased receivables to corporate entities or exposures that do not meet the retail definition, are risk-weighted as corporate exposures as per section 4.1.7. In addition, as part of the institution's risk management processes, it should establish underwriting criteria and monitoring procedures for all purchased assets/receivables, particularly where an institution regularly purchases assets from a seller pursuant to a facility or program. Therefore, an institution is expected to: establish quality criteria both for receivables to be purchased and for the seller/servicer of the receivables, regularly monitor the purchased receivables to ensure they meet the criteria, regularly monitor the financial condition of the seller/servicer of the receivables, have legal certainty that the institution has ownership of the receivables and all associated cash remittances, have confidence that current and future advances or purchases can be repaid from the liquidation or collections from the receivables pool, periodically verify the accuracy of reports related to both the seller/servicer and the receivables/obligors, periodically verify the credit and collection policies of the seller/servicer, and establish procedures for monitoring adherence to all contractual terms by the seller/servicer and regular audits of critical phases of the program.

4.2. External credit assessments and the mapping process

4.2.1. The recognition process

For purposes of using external ratings for regulatory purposes, only credit assessments from credit rating agencies recognized by OSFI as external credit assessment institutions (ECAIs) will be allowed. OSFI's review of applicants in determining ECAI eligibility is consistent with the International Organization of Securities Commissions (IOSCO) Code of Conduct Fundamentals for Credit Rating Agencies.^{Footnote 66} As part of its recognition process,^{Footnote 67} OSFI determines whether a rating agency initially meets and subsequently continues to meet the criteria listed in paragraph 169. OSFI's recognition is provided only in respect of ECAI ratings for types of exposures where all criteria and conditions are met. As such, ECAIs may be recognized on a limited basis, e.g. by type of exposure or by jurisdiction. OSFI will communicate changes to recognized ECAIs through this guideline. [Basel Framework, CRE 21.1] OSFI will permit institutions to recognize credit ratings from the following rating agencies for capital adequacy purposes: DBRS Moody's Investors Service Standard and Poor's (S&P) Fitch Rating Services Kroll Bond Rating Agency, Inc. (KBRA)

4.2.2. Eligibility criteria

An ECAI must satisfy each of the following eight criteria. Objectivity: The methodology for assigning credit assessments must be rigorous, systematic, and subject to some form of validation based on historical experience. Moreover, assessments must be subject to ongoing review and responsive to changes in financial condition. Before being recognized by OSFI, an assessment methodology for each market segment, including rigorous backtesting, must have been established for at least one year and preferably three years. Independence: An ECAI should be independent and should not be subject to political or economic pressures that may influence the rating. In particular, an ECAI should not delay or refrain from taking a rating action based on its potential effect (economic, political or otherwise). The rating process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the CRA may be seen as creating a conflict of interest. Furthermore, an ECAI should separate operationally, legally and, if practicable, physically its rating business from other businesses and analysts. International access/transparency: The individual ratings, the key elements underlining the assessments and whether the issuer participated in the assessment process should be publically available on a non-selective basis, unless they are private ratings, which should be at least available to both domestic and foreign insitutions with legitimate interest and on equivalent terms. In addition, the ECAI's general procedures, methodologies and assumptions for arriving at ratings should be publicly available. Disclosure: An ECAI should disclose the following information: its code of conduct; the general nature of its compensation arrangements with assessed entities; any conflict of interest,^{Footnote 68} the ECAI's compensation arrangements,^{Footnote 69} its rating assessment methodologies, including the definition of default, the time horizon, and the meaning of each rating; the actual default rates experienced in each assessment category; and the transitions of the ratings, e.g. the likelihood of AA ratings becoming A over time. A rating should be disclosed as soon as practicably possible after issuance. When disclosing a rating, the information should be provided in plain language, indicating the nature and limitation of credit ratings and the risk of unduly relying on them to make investments. Resources: An ECAI should have sufficient resources to carry out high quality credit assessments. These resources should allow for substantial ongoing contact with senior and operational levels within the entities assessed in order to add value to the credit assessments. In particular, ECAIs should assign analysts with appropriate knowledge and experience to assess the creditworthiness of the type of entity or obligation being rated. Such assessments should be based on methodologies combining qualitative and quantitative approaches. Credibility: To some extent, credibility is derived from the criteria above. In addition, the reliance on an ECAI's external credit assessments by independent parties (investors, insurers, trading partners) is evidence of the credibility of the assessments of an ECAI. The credibility of an ECAI is also underpinned by the existence of internal procedures to prevent the misuse of confidential information. In order to be eligible for recognition, an ECAI does not have to assess firms in more than one country. No abuse of unsolicited ratings: ECAIs must not use unsolicited ratings to put pressure on entities to obtain solicited ratings. OSFI may initiate a review of an ECAI's continued recognition as eligible for capital adequacy purposes, if such behaviour is identified. Cooperation with OSFI: ECAIs should notify OSFI of any significant changes to methodologies and provide access to external ratings and other relevant data in order to support initial and continued determination of eligibility. [Basel Framework, CRE 21.2] Regarding the disclosure of conflicts on interest referenced in criterion (4) in paragraph 169 above, at a minimum, the following situations and their influence on the ECAI's credit rating methodologies or credit rating actions shall be disclosed: The ECAI is being paid to issue a credit rating by the rated entity or by the obligor, originator, underwriter, or arranger of the rated obligation; The ECAI is being paid by subscribers with a financial interest that could be affected by a credit rating action of the ECAI; The ECAI is being paid by rated entities, obligors, originators, underwriters, arrangers, or subscribers for services other than issuing credit ratings or providing access to the ECAI's credit ratings; The ECAI is providing a preliminary indication or similar indication of credit quality to an entity, obligor, originator, underwriter, or arranger prior to being hired to determine the final credit rating for the entity, obligor, originator, underwriter, or arranger; and The ECAI has a direct or indirect ownership interest in a rated entity or obligor, or a rated entity or obligor has a direct or indirect ownership interest in the ECAI. [Basel Framework, CRE 21.3] Regarding the disclosure of conflicts on interest referenced in criterion (4) in paragraph 169 above: An ECAI should disclose the general nature of its compensation arrangements with rated entities, obligors, lead underwriters, or arrangers. When the ECAI receives from a rated entity, obligor, originator, lead underwriter, or arranger compensation unrelated to its credit rating services, the ECAI should disclose such unrelated compensation as a percentage of total annual compensation received from such rated entity, obligor, lead underwriter, or arranger in the relevant credit rating report or elsewhere, as appropriate. An ECAI should disclose in the relevant credit rating report or elsewhere, as appropriate, if it receives 10% or more of its annual revenue from a single client (e.g. a rated entity, obligor, originator, lead underwriter, arranger, or subscriber, or any of their affiliates). [Basel Framework, CRE 21.4] In addition to the above criteria, OSFI requires that an ECAI be recognized as a designated rating organization by the Canadian Securities Administrators National Instrument 25-101 in order to be an eligible ECAI in Canada.

4.2.3. Implementation considerations

4.2.3.1. The mapping process

As part of the mapping process, OSFI will assign eligible ECAIs' ratings to the risk weights available under the standardized approach (i.e. deciding which rating categories correspond to which risk weights). The objective of this mapping process is a risk weight assignment consistent with that of the level of credit risk reflected in Tables 1 through 14 in this chapter. This process is intended to cover the full spectrum of risk weights. [Basel Framework, CRE 21.5] Long-term rating Standardized risk weight category DBRS Moody's S&P Fitch KBRA 1 (AAA to AA-) AAA to AA (low) Aaa to Aa3 AAA to AA- AAA to AA- AAA to AA- 2 (A+ to A-) A (high) to A (low) A1 to A3 A+ to A- A+ to A- A+ to A- 3 (BBB+ to BBB-) BBB (high) to BBB (low) Baa1 to Baa3 BBB+ to BBB- BBB+ to BBB- BBB+ to BBB- 4 (BB+ to BB-) BB (high) to BB (low) Ba1 to Ba3 BB+ to BB- BB+ to BB- BB+ to BB- 5 (B+ to B-) B (high) to B (low) B1 to B3 B+ to B- B+ to B- B+ to B- 6 Below B- CCC or lower Below B3 Below B- Below B- Below B- For mapping purposes OSFI considers factors such as: the size and scope of the pool of issuers that each ECAI covers, the range and meaning of the assessments that it assigns, and the definition of default used by the ECAI. [Basel Framework, CRE 21.6] The OSFI process for mapping of ratings into risk weights is intended to be consistent with BCBS guidance published in the Standardized approach – implementing the mapping process (April 2019).^{Footnote 70} [Basel Framework, CRE 21.7] Institutions must use the chosen ECAIs and their ratings consistently for each type of exposure where they have been recognized by OSFI as an eligible ECAI, for both risk weighting and risk management purposes. Institutions will not be allowed to "cherry-pick" the assessments provided by different ECAIs and to arbitrarily change the use of ECAIs. [Basel Framework, CRE 21.8]

4.2.3.2. Multiple external ratings

If there is only one rating by an ECAI chosen by an institution for a particular exposure, that rating should be used to determine the risk weight of the exposure. [Basel Framework, CRE 21.9] If there are two ratings by ECAIs chosen by an institution which map into different risk weights, the higher risk weight will be applied. [Basel Framework, CRE 21.10] If there are three or more ratings with different risk weights, the two ratings that correspond to the lowest risk weights should be referred to. If these give rise to the same risk weight, that risk weight should be applied. If different, the higher risk weight should be applied. [Basel Framework, CRE 21.11]

4.2.3.3. Determination of whether an exposure is rated: Issue-specific and issuer-specific ratings

Where an institution invests in a particular issue that has an issue-specific rating, the risk weight of the exposure will be based on this rating. Where the institution's exposure is not an investment in a specific rated issue, the following general principles apply. In circumstances where the borrower has a specific rating for an issued debt – but the institution's exposure is not an investment in this particular debt – a high-quality credit rating (one which maps into a risk weight lower than that which applies to an unrated exposure) on that specific debt may only be applied to the institution's unrated exposure if this exposure ranks in all respects pari passu or senior to the exposure with a rating. If not, the external rating cannot be used and the unassessed exposure will receive the risk weight for unrated exposures. In circumstances where the borrower has an issuer rating, this rating typically applies to senior unsecured exposures to that issuer. Consequently, only senior exposures to that issuer will benefit from a high-quality issuer rating. Other unassessed exposures of a highly rated issuer will be treated as unrated. If either the issuer or a single issue has a low-quality rating (mapping into a risk weight equal to or higher than that which applies to unrated exposures), an unassessed exposure to the same counterparty that ranks pari passu or is subordinated to either the senior unsecured issuer rating or the exposure with a low-quality rating will be assigned the same risk weight as is applicable to the low-quality rating. In circumstances where the issuer has a specific high-quality rating (one which maps into a lower risk weight) that only applies to a limited class of liabilities (such as a deposit rating or a counterparty risk rating), this may only be used in respect of exposures that fall within that class. [Basel Framework, CRE 21.12] Whether the institution intends to rely on an issuer- or an issue-specific rating, the rating must take into account and reflect the entire amount of credit risk exposure the institution has with regard to all payments owed to it. For example, if an institution is owed both principal and interest, the assessment must fully take into account and reflect the credit risk associated with repayment of both principal and interest. [Basel Framework, CRE 21.13] In order to avoid any double counting of credit enhancement factors, OSFI will not take into account any credit risk mitigation techniques if the credit enhancement is already reflected in the issue specific rating (see paragraph 194). [Basel Framework, CRE 21.14]

4.2.3.4. Domestic currency and foreign currency assessments

Where unrated exposures are risk weighted based on the rating of an equivalent exposure to that borrower, the general rule is that foreign currency ratings would be used for exposures in foreign currency. Domestic currency ratings, if separate, would only be used to risk weight exposures denominated in the domestic currency.^{Footnote 71} [Basel Framework, CRE 21.15]

4.2.3.5. Short-term/long-term assessments

For risk-weighting purposes, short-term ratings are deemed to be issue-specific. They can only be used to derive risk weights for exposures arising from the rated facility. They cannot be generalized to other short-term exposures, except under the conditions of paragraph 186. In no event can a short-term rating be used to support a risk weight for an unrated long-term exposure. Short-term ratings may only be used for short-term exposures against banks and corporates. The table below provides a framework for institutions' exposures to specific short-term facilities, such as a particular issuance of commercial paper: Table 15: Risk weights for issue-specific short-term ratings External rating A-1/P-1^{Footnote 72} A-2/P-2 A-3/P-3 Others^{Footnote 73} Risk weight 20% 50% 100% 150% [Basel Framework, CRE 21.16] Short-term rating Standardized Risk Weight Category DBRS Moody's S&P Fitch KBRA 1 (A-1/P-1) R-1 (high) to R-1 (low) P-1 A-1+, A-1 F1+, F1 K1+, K1 2 (A-2/P-2) R-2 (high) to R-2 (low) P-2 A-2 F2 K2 3 (A-3/P-3) R-3 P-3 A-3 F3 K3 4 Others Below R-3 NP All short-term ratings below A-3 Below F3 Below K3 If a short-term rated facility attracts a 50% risk-weight, unrated short-term exposures cannot attract a risk weight lower than 100%. If an issuer has a short-term facility with an assessment that warrants a risk weight of 150%, all unrated exposures, whether long-term or short-term, should also receive a 150% risk weight, unless the institution uses recognized credit risk mitigation techniques for such exposures. [Basel Framework, CRE 21.17] In cases where short-term ratings are available, the following interaction with the general preferential treatment for short-term exposures to banks as described in paragraph 29 will apply: The general preferential treatment for short-term exposures applies to all exposures to banks of up to three months original maturity when there is no specific short-term exposure assessment. When there is a short-term rating and such a rating maps into a risk weight that is more favourable (i.e. lower) or identical to that derived from the general preferential treatment, the short-term rating should be used for the specific exposure only. Other short-term exposures would benefit from the general preferential treatment. When a specific short-term rating for a short term exposure to a bank maps into a less favourable (higher) risk weight, the general short-term preferential treatment for interbank exposures cannot be used. All unrated short-term exposures should receive the same risk weighting as that implied by the specific short-term rating. [Basel Framework, CRE 21.18] When a short-term rating is to be used, the institution making the assessment needs to meet all of the eligibility criteria for recognizing ECAIs, as described in paragraph 169, in terms of its short-term ratings. [Basel Framework, CRE 21.19]

4.2.3.6. Level of application of the rating

External ratings for one entity within a corporate group cannot be used to risk weight other entities within the same group. [Basel Framework, CRE 21.20]

4.2.3.7. Unsolicited ratings

As a general rule, institutions should use solicited ratings from eligible ECAIs. Institutions can use unsolicited ratings in the same way as solicited ratings for sovereign ratings in cases were solicited ratings are not available. [Basel Framework, CRE 21.21]

4.3. Credit Risk Mitigation – Standardized Approach

4.3.1. Overarching Issues

(i) Introduction

Institutions use a number of techniques to mitigate the credit risks to which they are exposed. For example, exposures may be collateralized by first priority claims, in whole or in part with cash or securities, a loan exposure may be guaranteed by a third party, or an institution may buy a credit derivative to offset various forms of credit risk. Additionally institutions may agree to net loans owed to them against deposits from the same counterparty.^{Footnote 74} [Basel Framework, CRE 22.1] The framework set out in this section is applicable to banking book exposures that are risk-weighted under the standardized approach. [Basel Framework, CRE 22.2]

(ii) General requirements

No transaction in which credit risk mitigation (CRM) techniques are used shall receive a higher capital requirement than an otherwise identical transaction where such techniques are not used. [Basel Framework, CRE 22.3] The requirements set out in OSFI's Pillar 3 Disclosure Requirements Guideline^{Footnote 75} must be fulfilled for institutions to obtain capital relief in respect of any CRM techniques. [Basel Framework, CRE 22.4] The effects of CRM must not be double-counted. Therefore, no additional supervisory recognition of CRM for regulatory capital purposes will be granted on exposures for which the risk weight already reflects that CRM. Consistent with paragraph 181, principal-only ratings will also not be allowed within the CRM framework. [Basel Framework, CRE 22.5] While the use of CRM techniques reduces or transfers credit risk, it may simultaneously increase other risks (i.e. residual risks). Residual risks include legal, operational, liquidity and market risks. Therefore, institutions must employ robust procedures and processes to control these risks, including strategy; consideration of the underlying credit; valuation; policies and procedures; systems; control of roll-off risks; and management of concentration risk arising from the institution's use of CRM techniques and its interaction with the institution's overall credit risk profile. Where these risks are not adequately controlled, OSFI may impose additional capital charges or take other supervisory actions as outlined in OSFI's Supervisory Framework.^{Footnote 76} [Basel Framework, CRE 22.6] In order for CRM techniques to provide protection, the credit quality of the counterparty must not have a material positive correlation with the employed CRM technique or with the resulting residual risks (as defined in paragraph 195). For example, securities issued by the counterparty (or by any counterparty-related entity) provide little protection as collateral and are thus ineligible. [Basel Framework, CRE 22.7] In the case where an institution has multiple CRM techniques covering a single exposure (e.g. an institution has both collateral and a guarantee partially covering an exposure), the institution must subdivide the exposure into portions covered by each type of CRM technique (e.g. portion covered by collateral, portion covered by guarantee) and the risk-weighted assets of each portion must be calculated separately. When credit protection provided by a single protection provider has differing maturities, they must be subdivided into separate protection as well. [Basel Framework, CRE 22.8]

(iii) Legal requirements

In order for institutions to obtain capital relief for any use of CRM techniques, all documentation used in collateralized transactions, on-balance sheet netting agreements, guarantees and credit derivatives must be binding on all parties and legally enforceable in all relevant jurisdictions. Institutions must have conducted sufficient legal review to verify this and have a well-founded legal basis to reach this conclusion, and undertake such further review as necessary to ensure continuing enforceability. [Basel Framework, CRE 22.9]

(iv) General treatment of maturity mismatches

For the purposes of calculating risk-weighted assets, a maturity mismatch occurs when the residual maturity of a credit protection arrangement (e.g. hedge) is less than that of the underlying exposure. [Basel Framework, CRE 22.10] In the case of financial collateral, maturity mismatches are not allowed under the simple approach (see paragraph 223). [Basel Framework, CRE 22.11] Under the other approaches, when there is a maturity mismatch the credit protection arrangement may only be recognized if the original maturity of the arrangement is greater than or equal to one year, and its residual maturity is greater than or equal to three months. In such cases, credit risk mitigation may be partially recognized as detailed below in paragraph 202. [Basel Framework, CRE 22.12] When there is a maturity mismatch with recognized credit risk mitigants, the following adjustment applies Pa = P × t − 0.25 T − 0.25 Where: Pa = value of the credit protection adjusted for maturity mismatch P = credit protection amount (e.g. collateral amount, guarantee amount) adjusted for any haircuts t = min {T, residual maturity of the credit protection arrangement expressed in years} T = min {five years, residual maturity of the exposure expressed in years} [Basel Framework, CRE 22.13] The maturity of the underlying exposure and the maturity of the hedge must both be defined conservatively. The effective maturity of the underlying must be gauged as the longest possible remaining time before the counterparty is scheduled to fulfil its obligation, taking into account any applicable grace period. For the hedge, (embedded) options that may reduce the term of the hedge must be taken into account so that the shortest possible effective maturity is used. For example: where, in the case of a credit derivative, the protection seller has a call option, the maturity is the first call date. Likewise, if the protection buyer owns the call option and has a strong incentive to call the transaction at the first call date, for example because of a step-up in cost from this date on, the effective maturity is the remaining time to the first call date. [Basel Framework, CRE 22.14]

(v) Currency mismatches

Currency mismatches are allowed under all approaches. Under the simple approach there is no specific treatment for currency mismatches, given that a minimum risk weight of 20% (floor) is generally applied. Under the comprehensive approach and in case of guarantees and credit derivatives, a specific adjustment for currency mismatches is prescribed in paragraphs 240 and 277, respectively. [Basel Framework, CRE 22.15]

4.3.2. Overview of Credit Risk Mitigation Techniques

(i) Collateralized transactions

A collateralized transaction is one in which: institutions have a credit exposure or potential credit exposure; and that credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty. [Basel framework, CRE 22.16] Where institutions take eligible financial collateral, they may reduce their regulatory capital requirements through the application of CRM techniques. [Basel Framework, CRE 22.17] Institutions may opt for either: The simple approach, which replaces the risk weight of the counterparty with the risk weight of the collateral for the collateralized portion of the exposure (generally subject to a 20% floor as per paragraph 223); or The comprehensive approach, which allows a more precise offset of collateral against exposures, by effectively reducing the exposure amount by a volatility-adjusted value ascribed to the collateral. [Basel Framework, CRE 22.18] Detailed operational requirements for the simple approach and comprehensive approach are given in paragraphs 222 to 255. Institutions may operate under either, but not both, approaches in the banking book. [Basel Framework, CRE 22.19] For collateralized OTC transactions, exchange traded derivatives and long settlement transactions, institutions may use the standardized approach for counterparty credit risk (SA-CCR) or the Internal Models Method to calculate the exposure amount, in accordance with paragraph 256. Only those institutions that are subject to the market risk requirements as defined in section 1.3.2 of Chapter 1 of this guideline are eligible to apply to use IMM to calculate counterparty credit risk exposure amounts. [Basel Framework, CRE 22.20]

(ii) On-balance sheet netting

Where institutions have legally enforceable netting arrangements for loans and deposits that meet the conditions in paragraph 257 they may calculate capital requirements on the basis of net credit exposures as set out in that paragraph. [Basel Framework, CRE 22.21]

(iii) Guarantees and credit derivatives

Where guarantees or credit derivatives fulfil the minimum operational conditions set out in paragraphs 259 to 261, institutions may take account of the credit protection offered by such credit risk mitigation techniques in calculating capital requirements. [Basel Framework, CRE 22.22] A range of guarantors and protection providers are recognized and a substitution approach applies for capital requirement calculations. Only guarantees issued by or protection provided by entities with a lower risk weight than the counterparty lead to reduced capital charges for the guaranteed exposure, since the protected portion of the counterparty exposure is assigned the risk weight of the guarantor or protection provider, whereas the uncovered portion retains the risk weight of the underlying counterparty. [Basel Framework, CRE 22.23] Detailed conditions and operational requirements for guarantees and credit derivatives are given in paragraphs 259 to 280. [Basel Framework, CRE 22.24]

4.3.3. Collateralized transactions

(i) General Requirements

Before capital relief is granted in respect of any form of collateral, the standards set out below in paragraphs 214 to 221 must be met, irrespective of whether the simple or the comprehensive approach is used. Institutions that lend securities or post collateral must calculate capital requirements for both of the following: (i) the credit risk or market risk of the securities, if this remains with the institution; and (ii) the counterparty credit risk arising from the risk that the borrower of the securities may default. [Basel Framework, CRE 22.25] The legal mechanism by which collateral is pledged or transferred must ensure that the institution has the right to liquidate or take legal possession of it, in a timely manner, in the event of the default, insolvency or bankruptcy (or one or more otherwise-defined credit events set out in the transaction documentation) of the counterparty (and, where applicable, of the custodian holding the collateral). Additionally, institutions must take all steps necessary to fulfil those requirements under the law applicable to the institution's interest in the collateral for obtaining and maintaining an enforceable security interest, e.g. by registering it with a registrar, or for exercising a right to net or set off in relation to the title transfer of the collateral. [Basel Framework, CRE 22.26] For property taken as collateral, institutions may use title insurance in place of a title search to achieve compliance with paragraph 214. OSFI expects institutions that rely on title insurance to reflect the risk of non-performance on these insurance contracts in their estimates of LGD if this risk is material. Institutions must have clear and robust procedures for the timely liquidation of collateral to ensure that any legal conditions required for declaring the default of the counterparty and liquidating the collateral are observed, and that collateral can be liquidated promptly. [Basel Framework, CRE 22.27] Institutions must ensure that sufficient resources are devoted to the orderly operation of margin agreements with OTC derivative and securities-financing counterparties, as measured by the timeliness and accuracy of its outgoing margin calls and response time to incoming margin calls. Institutions must have collateral risk management policies in place to control, monitor and report: the risk to which margin agreements expose them (such as the volatility and liquidity of the securities exchanged as collateral); the concentration risk to particular types of collateral; the reuse of collateral (both cash and non-cash) including the potential liquidity shortfalls resulting from the reuse of collateral received from counterparties; and the surrender of rights on collateral posted to counterparties [Basel Framework, CRE 22.28] Where the collateral is held by a custodian, institutions must take reasonable steps to ensure that the custodian segregates the collateral from its own assets. [Basel Framework, CRE 22.29] A capital requirement must be applied on both sides of a transaction. For example, both repos and reverse repos will be subject to capital requirements. Likewise, both sides of a securities lending and borrowing transaction will be subject to explicit capital charges, as will the posting of securities in connection with derivatives exposures or with any other borrowing transaction. [Basel Framework, CRE 22.30] Where an institution, acting as an agent, arranges a repo-style transaction (ie repurchase/reverse repurchase and securities lending/borrowing transactions) between a customer and a third party and provides a guarantee to the customer that the third party will perform on its obligations, then the risk to the institution is the same as if the institution had entered into the transaction as a principal. In such circumstances, an institution must calculate capital requirements as if it were itself the principal. [Basel Framework, CRE 22.31] Transactions where an institution acts as an agent and provides a guarantee to the customer should be treated as a direct credit substitute (i.e. a separate netting set) unless the transaction is covered by a master netting arrangement.

(ii) The simple approach

(a) General requirements for the simple approach Under the simple approach, the risk weight of the counterparty is replaced by the risk weight of the collateral instrument collateralizing or partially collateralizing the exposure. [Basel Framework, CRE 22.32] For collateral to be recognized in the simple approach, it must be pledged for at least the life of the exposure and it must be marked to market and revalued with a minimum frequency of six months. Those portions of exposures collateralized by the market value of recognized collateral receive the risk weight applicable to the collateral instrument. The risk weight on the collateralized portion is subject to a floor of 20% except under the conditions specified in paragraphs 226 to 229. The remainder of the exposure must be assigned the risk weight appropriate to the counterparty. Maturity mismatches are not allowed under the simple approach (see paragraphs 199 and 200). [Basel Framework, CRE 22.33] (b) Eligible financial collateral under the simple approach The following collateral instruments are eligible for recognition in the simple approach: Cash (as well as certificates of deposit or comparable instruments issued by the lending institution) on deposit with the institution which is incurring the counterparty exposure.^{Footnote 77} ^{Footnote 78} Gold Debt securities rated by a recognized ECAI where these are either: at least BB- when issued by sovereigns or PSEs that are treated as sovereigns by the national regulatory authority; or at least BBB- when issued by other entities (including banks and securities firms); or at least A-3/P-3 for short-term debt instruments. Debt securities not rated by a recognized ECAI where these are: issued by a bank; and listed on a recognized exchange; and classified as senior debt; and all rated issues of the same seniority by the issuing institution must be rated at least BBB- or A-3/P-3 by a recognized ECAI; and the institution holding the securities as collateral has no information to suggest that the issue justifies a rating below BBB- or A-3/P-3 (as applicable) and OSFI is sufficiently confident about the market liquidity of the security. Equities (including convertible bonds) that are included in a main index. Undertakings for Collective Investments in Transferable Securities (UCITS) and mutual funds where: a price for the units is publicly quoted daily; and the UCITS/mutual fund is limited to investing in the instruments listed in this paragraph.^{Footnote 79} [Basel Framework, CRE 22.34] Resecuritizations as defined in Chapter 6 of this guideline are not eligible collateral. (c) Exemptions under the simple approach to the risk-weight floor Repo-style transactions that fulfil all of the following conditions are exempted from the risk-weight floor under the simple approach: Both the exposure and the collateral are cash or a sovereign security or PSE security qualifying for a 0% risk weight under the standardized approach; Both the exposure and the collateral are denominated in the same currency; Either the transaction is overnight or both the exposure and the collateral are marked to market daily and are subject to daily remargining; Following a counterparty's failure to remargin, the time that is required between the last mark-to-market before the failure to remargin and the liquidation of the collateral is considered to be no more than four business days; The transaction is settled across a settlement system proven for that type of transaction; The documentation covering the agreement is standard market documentation for repo-style transactions in the securities concerned; The transaction is governed by documentation specifying that if the counterparty fails to satisfy an obligation to deliver cash or securities or to deliver margin or otherwise defaults, then the transaction is immediately terminable; and Upon any default event, regardless of whether the counterparty is insolvent or bankrupt, the institution has the unfettered, legally enforceable right to immediately seize and liquidate the collateral for its benefit. [Basel Framework, CRE 22.36] Core market participants include, the following entities: Sovereigns, central banks and PSEs; Banks and securities firms; Other financial companies (including insurance companies) eligible for a 20% risk weight in the standardized approach; Regulated mutual funds that are subject to capital or leverage requirements; Regulated pension funds; and Qualifying central counterparties (QCCPs). [Basel Framework, CRE 22.37] Repo transactions that fulfil the requirement in paragraph 226 receive a 10% risk weight, as an exemption to the risk weight floor described in paragraph 223. If the counterparty to the transaction is a core market participant, institutions may apply a risk weight of 0% to the transaction. [Basel Framework, CRE 22.38] The 20% floor for the risk weight on a collateralized transaction does not apply and a 0% risk weight may be applied where the exposure and the collateral are denominated in the same currency, and either: the collateral is cash on deposit as defined in paragraph 224(a); or the collateral is in the form of sovereign/PSE securities eligible for a 0% risk weight, and its market value has been discounted by 20%. [Basel Framework, CRE 22.39]

(iii) The comprehensive approach

(a) General requirements for the comprehensive approach In the comprehensive approach, when taking collateral, institutions must calculate their adjusted exposure to a counterparty in order to take account of the risk mitigating effect of that collateral. Institutions must use the applicable supervisory haircuts to adjust both the amount of the exposure to the counterparty and the value of any collateral received in support of that counterparty to take account of possible future fluctuations in the value of either,^{Footnote 80} as occasioned by market movements. Unless either side of the transaction is cash or a zero haircut is applied, the volatility-adjusted exposure amount is higher than the nominal exposure and the volatility-adjusted collateral value is lower than the nominal collateral value. [Basel Framework, CRE 22.40] The size of the haircuts that banks must use depends on the prescribed holding period for the transaction. For the purposes of this guideline, the holding period is the period of time over which exposure or collateral values are assumed to move before the bank can close out the transaction. The supervisory prescribed minimum holding period is used as the basis for the calculation of the standard supervisory haircuts. [Basel Framework, CRE 22.41] The holding period, and thus the size of the individual haircuts depends on the type of instrument, type of transaction, residual maturity and the frequency of marking to market and remargining as provided in paragraphs 239 and 240. For example, repo-style transactions subject to daily marking-to-market and to daily remargining will receive a haircut based on a 5-business day holding period and secured lending transactions with daily mark-to-market and no remargining clauses will receive a haircut based on a 20-business day holding period. Haircuts must be scaled up using the square root of time formula depending on the frequency of remargining or marking to market. This formula is included in paragraph 248. [Basel Framework, CRE 22.42] Additionally, where the exposure and collateral are held in different currencies, institutions must apply an additional haircut to the volatility-adjusted collateral amount in accordance with paragraphs 240 and 277 to take account of possible future fluctuations in exchange rates. [Basel Framework, CRE 22.43] The effect of master netting agreements covering securities financing transactions can be recognized for the calculation of capital requirements subject to the conditions and requirements in paragraphs 252 to 255. Where SFTs are subject to a master netting agreement whether they are held in the banking book or trading book, an institution may choose not to recognize the netting effects in calculating capital. In that case, each transaction will be subject to a capital charge as if there were no master netting agreement. [Basel Framework, CRE 22.44] (b) Eligible financial collateral under the comprehensive approach The following collateral instruments are eligible for recognition in the comprehensive approach: All of the instruments in paragraph 224; Equities and convertible bonds which are not included in a main index but which are listed on a recognized exchange; UCITS/mutual funds which include the instruments in point (2) above. [Basel Framework, CRE 22.45] (c) Calculation of capital requirement for transactions secured by financial collateral For a collateralized transaction, the exposure amount after risk mitigation is calculated as follows: E ′ = max 0 , E × 1 + H e − C × 1 − H c − H fx where: E ′ = the exposure value after risk mitigation E = current value of the exposure He = haircut appropriate to the exposure C = the current value of the collateral received Hc = haircut appropriate to the collateral Hfx = haircut appropriate for currency mismatch between the collateral and exposure [Basel Framework, CRE 22.46] In the case of maturity mismatches, the value of the collateral received (collateral amount) must be adjusted in accordance with paragraphs 199 to 202. [Basel Framework, CRE 22.47] The exposure amount after risk mitigation ( E ′ ) must be multiplied by the risk weight of the counterparty to obtain the risk-weighted asset amount for the collateralized transaction. [Basel Framework, CRE 22.48]

Standard supervisory haircuts for comprehensive approach

These are the standard supervisory haircuts (assuming daily mark-to-market, daily remargining and a 10-business day holding period), expressed as percentages: Issue rating for debt securities Residual Maturity Sovereigns^{Footnote 81} Other issuers^{Footnote 82} Securitization Exposures^{Footnote 83} AAA to AA-/A-1 ≤ 1 year 0.5 1 2 >1 year, ≤ 3 years 2 3 8 >3 year, ≤ 5 years 2 4 8 >5 year, ≤ 10 years 4 6 16 > 10 years 4 12 16 A+ to BBB-/A-2/A-3/P-3 and unrated institution securities per para. 224 ≤ 1 year 1 2 4 >1 year, ≤ 3 years 3 4 12 >3 year, ≤ 5 years 3 6 12 >5 year, ≤ 10 years 6 12 24 > 10 years 6 20 24 BB+ to BB- All 15 Not eligible Not eligible Main index equities (including convertible bonds) and Gold 20 Other equities and convertible bonds listed on a recognized exchange 30 UCITS/Mutual funds Highest haircut applicable to any security in which the fund can invest, unless the institution can apply the look-through approach (LTA) for equity investments in funds, in which case the institution may use a weighted average of haircuts applicable to instruments held by the fund. Cash in the same currency^{Footnote 84} 0 [Basel Framework, CRE 22.49] The haircut for currency risk (Hfx) where exposure and collateral are denominated in different currencies is 8% (also based on a 10-business day holding period and daily mark-to-market). [Basel Framework, CRE 22.52] For SFTs and secured lending transactions, a haircut adjustment may need to be applied in accordance with paragraphs 245 to 248. [Basel Framework, CRE 22.53] Cash variation margin (VM) is not subject to any additional haircut provided the variation margin is posted in a currency that is agreed to and listed in the applicable contract.^{Footnote 85} Cash initial margin (IM) that is exchanged in a currency other than the termination currency (that is, the currency in which the institution will submit its claim upon a counterparty default) is subject to the additional haircut for foreign currency risk. For SFTs in which the institution lends, or posts as collateral, non-eligible instruments, the haircut to be applied on the exposure must be 30%. For transactions in which the institution borrows non-eligible instruments, credit risk mitigation may not be applied. [Basel Framework, CRE 22.54] Where the collateral is a basket of assets, the haircut (H) on the basket must be calculated as follows: H = ∑ i a i H i Where: ai is the weight of the asset (as measured by units of currency) in the basket and Hi the haircut applicable to that asset. [Basel Framework, CRE 22.55] (d) Adjustment for different holding periods and non-daily mark-to-market or re-margining For some transactions, depending on the nature and frequency of the revaluation and remargining provisions, different holding periods are appropriate and thus different haircuts must be applied. The framework for collateral haircuts distinguishes between repo-style transactions (i.e. repo/reverse repos and securities lending/borrowing), "other capital-market-driven transactions" (i.e. OTC derivatives transactions and margin lending) and secured lending. In capital-market-driven transactions and repo-style transactions, the documentation contains remargining clauses; in secured lending transactions, it generally does not. [Basel Framework, CRE 22.56] The minimum holding period for various products is summarized in the following table. Transaction type Minimum holding period Condition Repo-style transaction five business days daily remargining Other capital market transactions 10 business days daily remargining Secured lending 20 business days daily revaluation [Basel Framework, CRE 22.57] Regarding the minimum holding periods set out in paragraph 246, if a netting set includes both repo-style and other capital market transactions, the minimum holding period of ten business days must be used. Furthermore, a higher minimum holding period must be used in the following cases: For all netting sets where the number of trades exceeds 5,000 at any point during a quarter, a 20 business day minimum holding period for the following quarter must be used. For netting sets containing one or more trades involving illiquid collateral, a minimum holding period of 20 business days must be used. "Illiquid collateral" must be determined in the context of stressed market conditions and will be characterized by the absence of continuously active markets where a counterparty would, within two or fewer days, obtain multiple price quotations that would not move the market or represent a price reflecting a market discount. Examples of situations where trades are deemed illiquid for this purpose include, but are not limited to, trades that are not marked daily and trades that are subject to specific accounting treatment for valuation purposes (eg repo-style transactions referencing securities whose fair value is determined by models with inputs that are not observed in the market). If a bank has experienced more than two margin call disputes on a particular netting set over the previous two quarters that have lasted longer than the bank's estimate of the margin period of risk (as defined in CRE50.19), then for the subsequent two quarters the bank must use a minimum holding period that is twice the level that would apply excluding the application of this sub-paragraph. When the frequency of remargining or revaluation is longer than the minimum, the minimum haircut numbers will be scaled up depending on the actual number of business days between remargining or revaluation. The 10-business day haircuts provided in paragraph 239 are the default haircuts and these haircuts must be scaled up or down using the formula below: H = H 10 N R + T M - 1 10 where: H = haircut H10 = 10-business day haircut for instrument NR = actual number of business days between remargining for capital market transactions or revaluation for secured transactions. TM = minimum holding period for the type of transaction [Basel Framework, CRE 22.59] (e) Exemptions under the comprehensive approach for qualifying repo-style transactions involving core market participants For repo-style transactions with core market participants as defined in paragraph 227 and that satisfy the conditions in paragraph 226 OSFI will permit a haircut of zero. [Basel Framework, CRE 22.60] Under the comprehensive approach, OSFI applies a specific carve-out to repo-style transactions in securities issued by the Government of Canada and securities issued by Canadian provinces and territories. This carve out is available, provided the following conditions are satisfied: Both the exposure and the collateral are cash or a sovereign security or PSE security qualifying for a 0% risk weight in the standardized approach;^{Footnote 86} Both the exposure and the collateral are denominated in the same currency; Either the transaction is overnight or both the exposure and the collateral are marked-to-market daily and are subject to daily remargining; Following a counterparty's failure to remargin, the time that is required between the last mark-to-market before the failure to remargin and the liquidation^{Footnote 87} of the collateral is considered to be no more than four business days; The transaction is settled across a settlement system proven for that type of transaction; The documentation covering the agreement is standard market documentation for repo-style transactions in the securities concerned; Institutions applying this carve-out must be able to confirm that the above criteria are met. [Basel Framework, CRE 22.61] Canadian institutions may apply carve-outs permitted by other G-10^{Footnote 88} supervisors to repo-style transactions in securities issued by their domestic governments to business in those markets. For the purposes of the carve out core market participants are defined in paragraph 227. [Basel Framework, CRE 22.61] (f) Treatment under the comprehensive approach of SFTs covered by master netting agreements The effects of bilateral netting agreements covering securities financing transactions will be recognized on a counterparty-by-counterparty basis if the agreements are legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of whether the counterparty is insolvent or bankrupt. In addition, netting agreements must: provide the non-defaulting party the right to terminate and close-out in a timely manner all transactions under the agreement upon an event of default, including in the event of insolvency or bankruptcy of the counterparty; provide for the netting of gains and losses on transactions (including the value of any collateral) terminated and closed out under it so that a single net amount is owed by one party to the other; allow for the prompt liquidation or set-off of collateral upon the event of default; and be, together with the rights arising from the provisions required in (1) to (3) above, legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of the counterparty's insolvency or bankruptcy. [Basel Framework, CRE 22.62] Netting across positions in the banking and trading book will only be recognized when the netted transactions fulfil the following conditions: All transactions are marked to market daily;^{Footnote 89} and The collateral instruments used in the transactions are recognized as eligible financial collateral in the banking book. [Basel Framework, CRE 22.63] The formula in paragraph 255 will be used to calculate the counterparty credit risk capital requirements for SFTs with netting agreements. This formula includes the current exposure, an amount for systematic exposure of the securities based on the net exposure, an amount for the idiosyncratic exposure of the securities based on the gross exposure, and an amount for currency mismatch. All other rules regarding the calculation of haircuts under the comprehensive approach stated in paragraphs 230 to 251 equivalently apply for institutions using bilateral netting agreements for SFTs. [Basel Framework, CRE 22.64] For institutions using the standard supervisory haircuts for SFTs conducted under a master netting agreement must calculate their amount amount using the following formula: E' is the exposure value of the netting set after risk mitigation Ei is the current value of all cash and securities lent, sold with an agreement to repurchase or otherwise posted to the counterparty under the netting agreement Cj is the current value of all cash and securities borrowed, purchased with an agreement to resell or otherwise held by the bank under the netting agreement net exposure = ∑ s E s × H s gross exposure = ∑ s E s × H s Es is the net current value of each security issuance under the netting set (always a positive value) Hs is the haircut appropriate to Es as described in table of paragraph 239 Hs has a positive sign if the security is lent, sold with an agreement to repurchased, or transacted in manner similar to either securities lending or a repurchase agreement Hs has a negative sign if the security is borrowed, purchased with an agreement to resell, or transacted in a manner similar to either a securities borrowing or reverse repurchase agreement N is the number of security issues contained in the netting set (except that issuances where the value Es is less than one tenth of the value of the largest Es in the netting set are not included the count) Efx is the absolute value of the net position in each currency fx different from the settlement currency Hfx is the haircut appropriate for currency mismatch of currency fx E ′ = max 0 ; ∑ i E i − ∑ j C j + 0.4 × net exposure + 0.6 × gross exposure N + ∑ fx E fx × H fx ^{Footnote 90} [Basel Framework, CRE 22.65]

(iv) Collateralized OTC derivatives transactions

Under the Standardized Approach for Counterparty Credit Risk (SA-CCR) described in section 7.1.7 of Chapter 7, the counterparty credit risk charge for an individual contract will be calculated using the following formula, where: Alpha = 1.4; RC = the replacement cost calculated according to section 7.1.7.1 PFE = the potential future exposure calculated according to section 7.1.7.2 Exposure amount = alpha × ( RC + PFE ) [Basel Framework, CRE 22.66]

4.3.4. On-balance sheet netting

An institution may use the net exposure of loans and deposits as the basis for its capital adequacy calculation in accordance with the formula in paragraph 236, when the institution: has a well-founded legal basis for concluding that the netting or offsetting agreement is enforceable in each relevant jurisdiction regardless of whether the counterparty is insolvent or bankrupt; is able at any time to determine those assets and liabilities with the same counterparty that are subject to the netting agreement; monitors and controls its roll-off risks; and monitors and controls the relevant exposures on a net basis. [Basel Framework, CRE 22.68] When calculating the net exposure described in the paragraph above, assets (loans) are treated as exposure and liabilities (deposits) as collateral. The haircuts will be zero except when a currency mismatch exists. A 10-business day holding period will apply when daily mark-to-market is conducted and all the requirements contained in paragraphs 239, 248, and 199 to 202 will apply. [Basel Framework, CRE 22.69]

4.3.5. Guarantees and credit derivatives

(i) Operational requirements for guarantees and credit derivatives

If conditions set below are met, institutions can substitute the risk weight of the counterparty with the risk weight of the guarantor. [Basel Framework, CRE 22.70] A guarantee (counter-guarantee) or credit derivative must satisfy the following requirements: it represents a direct claim on the protection provider; it is explicitly referenced to specific exposures or a pool of exposures, so that the extent of the cover is clearly defined and incontrovertible; other than non-payment by a protection purchaser of money due in respect of the credit protection contract it is irrevocable; there is no clause in the contract that would allow the protection provider unilaterally to cancel the credit cover, change the maturity agreed ex-post, or that would increase the effective cost of cover as a result of deteriorating credit quality in the hedged exposure; it must be unconditional; there should be no clause in the protection contract outside the direct control of the institution that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the underlying counterparty fails to make the payment(s) due. [Basel Framework, CRE 22.71] In the case of maturity mismatches, the amount of credit protection that is provided must be adjusted in accordance with paragraphs 199 to 202. [Basel Framework, CRE 22.72]

(ii) Specific operational requirements for guarantees

In addition to the legal certainty requirements in paragraphs 198, in order for a guarantee to be recognized, the following conditions must be satisfied: On the qualifying default/non-payment of the counterparty, the institution may in a timely manner pursue the guarantor for any monies outstanding under the documentation governing the transaction. The guarantor may make one lump sum payment of all monies under such documentation to the institution, or the guarantor may assume the future payment obligations of the counterparty covered by the guarantee. The institution must have the right to receive any such payments from the guarantor without first having to take legal actions in order to pursue the counterparty for payment. The guarantee is an explicitly documented obligation assumed by the guarantor. Except as noted in the following sentence, the guarantee covers all types of payments the underlying obligor is expected to make under the documentation governing the transaction, for example notional amount, margin payments etc. Where a guarantee covers payment of principal only, interests and other uncovered payments should be treated as an unsecured amount in accordance with the rules for proportional cover in paragraph 275. [Basel Framework, CRE 22.73]

(iii) Specific operational requirements for mortgage insurance

A protection purchaser must establish internal policies and procedures to implement and ensure compliance with the protection provider(s) credit underwriting and other contractual requirements. In addition, institutions are expected to have appropriate policies and procedures in place to originate, underwrite and administer insured mortgages. If, as part of its supervisory work, OSFI determines that there is evidence that an institution has not implemented the required policies and procedures from paragraph 263, a supervisory assessment will be made to determine whether recognition of the mortgage insurance as a guarantee for credit risk mitigation purposes should be reduced by OSFI. As part of this assessment, OSFI may use, but will not rely on, information available from third parties. In determining the size of the reduction of the risk mitigating impact of mortgage insurance, OSFI will take into account the scope and severity of the deficiencies identified as well as the time required to address deficiencies noting that contractual obligations of the protection provider are not a substitute for inadequate policies and/or procedures on the part of the institution. This does not preclude OSFI from imposing additional capital requirements under Pillar 2 as per paragraph 195 of this chapter.

(iv) Specific operational requirements for credit derivatives

In addition to the legal certainty requirements in paragraph 198, in order for a credit derivative contract to be recognized, the following conditions must be satisfied: The credit events specified by the contracting parties must at a minimum cover: failure to pay the amounts due under terms of the underlying obligation that are in effect at the time of such failure (with a grace period that is closely in line with the grace period in the underlying obligation); bankruptcy, insolvency or inability of the obligor to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due, and analogous events; and restructuring^{Footnote 91} of the underlying obligation involving forgiveness or postponement of principal, interest or fees that results in a credit loss event (i.e. charge-off, specific provision or other similar debit to the profit and loss account). When restructuring is not specified as a credit event, refer to paragraph 266. If the credit derivative covers obligations that do not include the underlying obligation, section (7) below governs whether the asset mismatch is permissible. The credit derivative shall not terminate prior to expiration of any grace period required for a default on the underlying obligation to occur as a result of a failure to pay. In the case of a maturity mismatch, the provisions of paragraphs 199 to 202 must be applied. Credit derivatives allowing for cash settlement are recognized for capital purposes insofar as a robust valuation process is in place in order to estimate loss reliably. There must be a clearly specified period for obtaining post-credit-event valuations of the underlying obligation. If the reference obligation specified in the credit derivative for purposes of cash settlement is different than the underlying obligation, section (7) below governs whether the asset mismatch is permissible. If the protection purchaser's right/ability to transfer the underlying obligation to the protection provider is required for settlement, the terms of the underlying obligation must provide that any required consent to such transfer may not be unreasonably withheld. The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection provider of the occurrence of a credit event. A mismatch between the underlying obligation and the reference obligation under the credit derivative (i.e. the obligation used for purposes of determining cash settlement value or the deliverable obligation) is permissible if (a) the reference obligation ranks pari passu with or is junior to the underlying obligation, and (b) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place. A mismatch between the underlying obligation and the obligation used for purposes of determining whether a credit event has occurred is permissible if (a) the latter obligation ranks pari passu with or is junior to the underlying obligation, and (b) the underlying obligation and reference obligation share the same obligor (i.e. the same legal entity) and legally enforceable cross-default or cross-acceleration clauses are in place. [Basel Framework, CRE 22.74] When the restructuring of the underlying obligation is not covered by the credit derivative, but the other requirements in paragraph 265 are met, partial recognition of the credit derivative will be allowed. If the amount of the credit derivative is less than or equal to the amount of the underlying obligation, 60% of the amount of the hedge can be recognized as covered. If the amount of the credit derivative is larger than that of the underlying obligation, then the amount of eligible hedge is capped at 60% of the amount of the underlying obligation. [Basel Framework, CRE 22.75]

(v) Range of eligible guarantors (counter-guarantors)/protection providers and credit derivatives

Credit protection given by the following entities can be recognized when they have a lower risk weight than the counterparty: Sovereign entities,^{Footnote 92} PSEs, multilateral developments banks, banks, securities firms and other prudentially regulated financial institutions with a lower risk weight than the counterparty;^{Footnote 93} Other entities that are externally rated except when credit protection is provided to a securitzation exposure. This would include credit protection provided by a parent, subsidiary, and affiliate companies when they have a lower risk weight than the obligor. When credit protection is provided to a securitization exposure, other entities that currently are externally rated BBB- or better and that were externally rated A- or better at the time the credit protection was provided. This would include credit protection provided by parent, subsidiary, and affiliate companies when they have a lower risk weight than the obligor. [Basel Framework, CRE 22.76] An institution may not reduce the risk weight of an exposure to a third party because of a guarantee or credit protection provided by a related party (parent, subsidiary or affiliate) of the lending institution. This treatment follows the principle that guarantees within a corporate group are not a substitute for capital in the regulated Canadian institution. An exception is made for self-liquidating trade-related transactions that have a tenure of 360 days or less, are market-driven and are not structured to avoid the requirements of this guideline. The requirement that the transaction be "market-driven" necessitates that the guarantee or letter of credit is requested and paid for by the customer and/or that the market requires the guarantee in the normal course of business. Only credit default swaps and total return swaps that provide credit protection equivalent to guarantees are eligible for recognition.^{Footnote 94} The following exception applies: where an institution buys credit protection through a total return swap and records the net payments received on the swap as net income, but does not record offsetting deterioration in the value of the asset that is protected (either through reductions in fair value or by an addition to reserves), the credit protection will not be recognized. [Basel Framework, CRE 22.77] First-to-default and all other nth-to-default credit derivatives (i.e. by which an institution obtains credit protection for a basket of reference names and where the first- or nth–to-default among the reference names triggers the credit protection and terminates the contract) are not eligible as a credit risk mitigation technique and therefore cannot provide any regulatory capital relief. In transactions in which an institution provided credit protection through such instruments, it shall apply the treatment described in paragraph 139. [Basel Framework, CRE 22.78]

(vi) Risk-weight treatment of transactions in which eligible credit protection is provided

General risk weight treatment The general risk weight treatment for transactions in which eligible credit protection is provided is as follows: The protected portion is assigned the risk weight of the protection provider. The uncovered portion of the exposure is assigned the risk weight of the underlying counterparty. Materiality thresholds on payments below which the protection provider is exempt from payment in the event of loss are equivalent to retained first-loss positions. The portion of the exposure that is below a materiality threshold must be deducted from CET1 capital by the institution purchasing the credit protection. [Basel Framework, CRE 22.79] Residential mortgages insured under the NHA or equivalent provincial mortgage insurance programs may be assigned the risk weight of the guarantor, that is, the Government of Canada risk weight of 0%. Where a mortgage is comprehensively insured by a private sector mortgage insurer that has a backstop guarantee provided by the Government of Canada (for example, a guarantee made pursuant to section 22 of the Protection of Residential Mortgage or Hypothecary Insurance Act), institutions may recognize the risk-mitigating effect of the government guarantee by reporting the portion of the exposure that is covered by the Government of Canada backstop as if this portion were directly guaranteed by the Government of Canada. The remainder of the exposure should be treated as an insured mortgage in accordance with the rules set out in this chapter. To reflect the effect of the Government of Canada backstop guarantee on a privately insured mortgage exposure, institutions may separate the full amount of the privately insured mortgage exposure into a deductible portion and a backstop portion: the deductible portion is calculated as 10% of the original loan amount (i.e. the deductible portion grows as a percentage of the full amount of the total exposure as the mortgage amortizes), and is to be risk weighted according to paragraph 274; the backstop portion is the amount covered by the government guarantee (i.e. the total outstanding amount less the deductible portion), and is to be treated as a sovereign exposure as set out in section 4.1. For residential mortgages insured by a private mortgage insurer having a Government of Canada backstop guarantee, institutions may choose not to recognize the mortgage insurance and/or the Government of Canada backstop guarantee if doing so would result in a higher capital requirement. Accordingly, the loan should be risk weighted in one of the following three ways: As a loan to the private mortgage insurer recognizing the Government of Canada backstop. In this case, the deductible exposure defined in paragraph 273 can be risk weighted as either i) an exposure to the private mortgage insurer (according to paragraph 56) or ii) an exposure to the mortgage borrower (according to paragraphs 94 to 102), multiplied by a factor of 2.2.^{Footnote 95} The backstop exposure is treated as an exposure to the Governmnet of Canada. As an uninsured residential mortgage according to paragraphs 94 to 102. As a loan to the private mortgage insurer (without a Government of Canada backstop) according to paragraph 56. Where losses are shared pari passu on a pro rata basis between the institution and the guarantor, capital relief is afforded on a proportional basis, i.e. the protected portion of the exposure receives the treatment applicable to eligible guarantees/credit derivatives, with the remainder treated as unsecured. [Basel Framework, CRE 22.80] Where the institution transfers a portion of the risk of an exposure in one or more tranches to a protection seller or sellers and retains some level of risk of the loan and the risk transferred and the risk retained are of different seniority, institutions may obtain credit protection for either the senior tranches (e.g. second loss portion) or the junior tranche (e.g. first loss portion). In this case the rules as set out in Chapter 6 - Securitization will apply. [Basel Framework, CRE 20.81]

(vii) Currency mismatches

Where the credit protection is denominated in a currency different from that in which the exposure is denominated – i.e. there is a currency mismatch – the amount of the exposure deemed to be protected will be reduced by the application of a haircut HFX, using the formula: G A = G × 1 - H FX where: GA = adjusted amount of the credit protection G = nominal amount of the credit protection HFX = haircut appropriate for currency mismatch between the credit protection and underlying obligation. The currency mismatch haircut for a 10-business day holding period (assuming daily marking-to-market) is 8%. This haircut must be scaled up using the square root of time formula, depending on the frequency of revaluation of the credit protection as described in paragraph 248. [Basel Framework, CRE 22.82] A currency mismatch occurs when the currency an institution receives differs from the currency of the collateral held. A currency mismatch always occurs when an institution receives payments in more than one currency under a single contract. [Basel Framework, CRE 22.83]

(viii) Sovereign guarantees and counter-guarantees

Institutions may apply a lower risk weight to an exposures to the sovereign (or central bank) where the institution is incorporated and where the exposure is denominated in domestic currency and funded in that currency. This treatment applies to an exposure that is covered by a guarantee which is indirectly counter-guaranteed by a sovereign, provided that the following conditions are met: the sovereign counter-guarantee covers all credit risk elements of the exposure; both the original guarantee and the counter-guarantee meet all operational requirements for guarantees, except that the counter-guarantee need not be direct and explicit to the original exposure; and OSFI is satisfied that the cover is robust and that no historical evidence suggests that the coverage of the counter-guarantee is less than effectively equivalent to that of a direct sovereign guarantee. [Basel Framework, CRE 22.84]

Appendix I – Summary of the simplified treatment under the standardized approach

Category I and II institutions as defined in OSFI's SMSB Guideline^{Footnote 96} will be eligible to apply a simplified treatment to certain asset classes provided the total exposure to the asset class grouping to which the simplified treatment is being applied does not exceed $500 million. The following table provides a list of all of the asset classes outlined in this chapter and identifies those for which there is a simplified treatment available. For the remaining asset classes, there is no distinction between a simplified treatment and the more risk-sensitive treatment. Section Asset Class Simplified treatment 4.1.1 Sovereigns and central banks N/A 4.1.2 Non-central government public sector entities (PSEs) N/A 4.1.3 Multilateral development banks (MDBs) N/A 4.1.4 Banks Paragraph 26 4.1.5 Covered bonds Paragraph 47 4.1.6 Securities firms and other financial institutions Paragraph 26 4.1.7 Corporates Paragraph 58 4.1.8 Subordinated debt, equity and other capital instruments N/A 4.1.9 Retail exposures Paragraph 81 4.1.10 Real estate exposures N/A 4.1.11 Exposures secured by residential real estate Paragraph 95 4.1.12 Exposures secured by commercial real estate Paragraph 104 4.1.13 Land acquisition, development and construction N/A 4.1.14 Reverse mortgages N/A 4.1.15 Mortgage-backed securities N/A 4.1.16 Currency mismatch N/A 4.1.17 Commitments N/A 4.1.18 Off-balance sheet items N/A 4.1.19 Counterparty credit risk exposures N/A 4.1.20 Credit derivatives N/A 4.1.21 Defaulted exposures N/A 4.1.22 Equity investment in funds N/A 4.1.23 Other assets N/A 4.1.24 Purchased receivables N/A

Appendix II –Use of the Simplified Treatment for Credit Risk for Category I and II SMSBs

As per paragraph 2 of this chapter, Category I and II SMSBs are eligible to use a simplified treatment for certain asset classes where they have less than $500 million in total exposure.^{Footnote 97} The exposure amount is based on an average of the end-of-quarter amounts calculated at fiscal year-end using data points from the BCAR^{Footnote 98} regulatory return. The threshold calculation is performed on an annual basis.^{Footnote 99} If a Category I or II SMSB's position relative to the thresholds has changed from the previous year, the institution would be given one year to implement the applicable treatment. For example, if an asset class that was considered material becomes immaterial (by falling below the $500 million threshold), the Category I or II SMSB has the option to use the simplified treatment for the asset class effective Q1 of the following year. Conversely, if an asset class that was previously considered immaterial becomes material (by rising above the $500 million threshold), the Category I or II SMSB would be required to use the more risk sensitive treatment for the asset class effective Q1 of the following year. In addition, to ensure some stability in the capital treatment, once a Category I or II SMSB treats a portfolio as material or immaterial, it would be required to maintain that treatment for two years. The following examples illustrate how the exposure for an asset class would be calculated to determine if it is above or below the $500 million threshold. For Q2 2023, the threshold for Corporate exposures would be assessed using fiscal 2021 data:^{Footnote 100} Table 1: Total (measure 500 in BCAR Schedule 40.080) Q1 2021 Q2 2021 Q3 2021 Q4 2021 Average $510M $505M $507M $515M $509M Since the average using fiscal 2021 data is above $500 million, the Category I or II SMSB's Corporate exposures would be deemed material and capital requirements would need to be calculated using the regular treatment for fiscal years 2023 and 2024. In Q1 2024, the calculation would be performed again using fiscal 2023 data: Table 2: Total (measure 500 in BCAR Schedule 40.080) Q1 2023 Q2 2023 Q3 2023 Q4 2023 Average $490M $480M $485M $500M $489M Since the average exposure amount is below the $500 million threshold, the Category I or II SMSB would have the option of using the simplified treatment effective Q1 2025. If the Category I or II SMSB switched to the simplified treatment for 2025, it would be required to use this treatment for fiscal 2026 as well.

Appendix III – List of risk weight tables

Section Asset Class Table 4.1.1 Sovereigns and central banks Table 1, Table 2 4.1.2 Non-central government public sector entities (PSEs) Table 3 4.1.3 Multilateral development banks (MDBs) Table 4 4.1.4 Banks Table 5, Table 6 4.1.5 Covered bonds Table 7, Table 8 4.1.7 Corporates Table 9 4.1.11 Exposures secured by residential real estate Table 10, Table 11 4.1.12 Exposures secured by commercial real estate Table 12, Table 13 4.1.14 Reverse mortgages Table 14 4.2.3.5 Issue-specific short-term ratings Table 15

Footnotes

Footnote 1 The Basel Framework Return to footnote 1 Footnote 2 Following the format: [Basel Framework XXX yy.zz]. Return to footnote 2 Footnote 3 SMSBs are banks (including federal credit unions), bank holding companies, federally regulated trust companies, and federally regulated loan companies that have not been designated by OSFI as domestic systemically important banks (D-SIBs). This includes subsidiaries of SMSBs or D-SIBs that are banks (including federal credit unions), federally regulated trust companies or federally regulated loan companies. Return to footnote 3 Footnote 4 SMSB Capital and Liquidity Guideline. Return to footnote 4 Footnote 5 Total exposure includes both on and off balance sheet, net of Stage 3 allowances but before taking into account credit risk mitigation. Return to footnote 5 Footnote 6 OSFI Guideline IFRS 9 Financial Instruments and Disclosures, June 2016. Return to footnote 6 Footnote 7 This notation refers to the methodology used by Standard and Poor's. Refer to section 4.2.3 to determine the applicable risk weight using the rating methodology of other recognized ECAIs. Return to footnote 7 Footnote 8 In order to qualify for the lower risk weight, the institution needs to have a local presence (subsidiary or branch) in the country of the sovereign exposure. Return to footnote 8 Footnote 9 The institution would also have corresponding liabilities denominated in the domestic currency. Return to footnote 9 Footnote 10 This lower risk weight may be extended to the risk weighting of collateral and guarantees under the credit risk mitigation (CRM) framework. See section 4.3.2 of this chapter. Return to footnote 10 Footnote 11 Current tax assets are defined as an over installment of tax, or current year tax losses carried back to prior years that result in the recognition for accounting purposes of a claim or receivable from the government or local tax authority. Return to footnote 11 Footnote 12 The consensus country risk classifications of the Participants to the Arrangement on Officially Supported Export Credits are available on the OECD's website. Return to footnote 12 Footnote 13 MDBs currently eligible for a 0% risk weight are: the World Bank Group comprising the International Bank for Reconstruction and Development (IBRD), the International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA) and the International Development Association (IDA), the Asian Development Bank (ADB), the African Development Bank (AfDB), the European Bank for Reconstruction and Development (EBRD), the Inter-American Development Bank (IADB), the European Investment Bank (EIB), the European Investment Fund (EIF), the Nordic Investment Bank (NIB), the Caribbean Development Bank (CDB), the Islamic Development Bank (IDB), the Council of Europe Development Bank (CEDB), the International Finance Facility for Immunization (IFFIm), and the Asian Infrastructure Investment Bank (AIIB). Return to footnote 13 Footnote 14 MDBs that request to be added to the list of MDBs eligible for a 0% risk weight must comply with the AAA rating criterion at the time of the application. Once included in the list of eligible MDBs, the rating may be downgraded, but in no case lower than AA–. Otherwise, exposures to such MDBs will be subject to the treatment set out in paragraph 22. Return to footnote 14 Footnote 15 For internationally active banks, appropriate prudential standards (e.g. capital and liquidity requirements) and level of supervision should be in accordance with the Basel framework. For domestic banks, appropriate prudential standards are determined by the national supervisors but should include at least a minimum regulatory capital requirement. Return to footnote 15 Footnote 16 This may include on-balance sheet exposures such as loans and off-balance sheet exposures such as self liquidating trade-related contingent items. Return to footnote 16 Footnote 17 OSFI, Leverage Requirements Guideline, January 2022. Return to footnote 17 Footnote 18 This may include on-balance sheet exposures such as loans and off-balance sheet exposures such as self-liquidating trade-related contingent items. Return to footnote 18 Footnote 19 In Canada, CMHC's Covered Registered Bond Programs Guide establishes the legal framework for covered bond programs in Canada. Return to footnote 19 Footnote 20 An exposure is rated from the perspective of an institution if the exposure is rated by a recognized ECAI which has been nominated by the institution (i.e. the institution has informed OSFI of its intention to use the ratings of such ECAI for regulatory purposes in a consistent manner (see paragraph 176). In other words, if an external rating exists but the credit rating agency is not a recognized ECAI by OSFI, or the rating has been issued by an ECAI which has not been nominated by the institution, the exposure would be considered as being unrated from the perspective of the institution. Return to footnote 20 Footnote 21 That is, capital requirements that are comparable to those applied to banks in this guideline. Implicit in the meaning of the word "comparable" is that the securities firm (but not necessarily its parent) is subject to consolidated regulation and supervision with respect to any downstream affiliates. Return to footnote 21 Footnote 22 Paragraph 62 allows institutions to choose to identify whether their unrated corporate exposures meet the "investment grade" definition. Institutions may not choose to identify only a portion of their unrated corporate exposures. An institution that chooses to identify their "investment grade" unrated exposures must do so consistently for both pre-floor RWA and for the purposes of the output floor. Return to footnote 22 Footnote 23 Availability-based revenues mean that once construction is completed, the project finance entity is entitled to payments from its contractual counterparties (e.g. the government), as long as contract conditions are fulfilled. Availability payments are sized to cover operating and maintenance costs, debt service costs and equity returns as the project finance entity operates the project. Availability payments are not subject to swings in demand, such as traffic levels, and are adjusted typically only for lack of performance or lack of availability of the asset to the public. Return to footnote 23 Footnote 24 Indirect equity interests include holdings of derivative instruments tied to equity interests, and holdings in corporations, partnerships, limited liability companies or other types of enterprises that issue ownership interests and are engaged principally in the business of investing in equity instruments. Return to footnote 24 Footnote 25 For certain obligations that require or permit settlement by issuance of a variable number of the issuer's equity shares, the change in the monetary value of the obligation is equal to the change in the fair value of a fixed number of equity shares multiplied by a specified factor. Those obligations meet the conditions of item (c) if both the factor and the referenced number of shares are fixed. For example, an issuer may be required to settle an obligation by issuing shares with a value equal to three times the appreciation in the fair value of 1,000 equity shares. That obligation is considered to be the same as an obligation that requires settlement by issuance of shares equal to the appreciation in the fair value of 3,000 equity shares. Return to footnote 25 Footnote 26 Equities that are recorded as a loan but arise from a debt/equity swap made as part of the orderly realization or restructuring of the debt are included in the definition of equity holdings. However, these instruments may not attract a lower capital charge than would apply if the holdings remained in the debt portfolio. Return to footnote 26 Footnote 27 Supervisors may decide not to require that such liabilities be included where they are directly hedged by an equity holding, such that the net position does not involve material risk. Return to footnote 27 Footnote 28 OSFI may re-characterize debt holdings as equites for regulatory purposes to ensure the proper treatment of holdings under the supervisory review process. Return to footnote 28 Footnote 29 As in section 9.2 of this guideline, 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. Investments in unlisted equities of corporate clients with which the institution has or intends to establish a long-term business relationship and debt-equity swaps for corporate restructuring purposes would be excluded. Return to footnote 29 Footnote 30 This treatment is extended to a Canadian institution's foreign operations' holdings of equities made under nationally legislated programs of the countries in which they operate. Return to footnote 30 Footnote 31 Refer to section 2.3.1 of Chapter 2 for the definition of significant investment. Return to footnote 31 Footnote 32 Aggregated exposure means gross amount (i.e. not taking any credit risk mitigation into account) of all forms of retail exposures, excluding residential real estate exposures. In case of off-balance sheet claims, the gross amount would be calculated after applying credit conversion factors. In addition, "to one counterparty" means one or several entities that may be considered as a single beneficiary (e.g. in the case of a small business that is affiliated to another small business, the limit would apply to the institution's aggregated exposure on both businesses). Return to footnote 32 Footnote 33 To apply the 0.2% threshold of the granularity criterion, banks must: first, identify the full set of exposures in the retail exposure class (as defined by paragraph 80); second, identify the subset of exposure that meet product criterion and do not exceed the threshold for the value of aggregated exposures to one counterparty (as defined by criteria (a) and (b) in paragraph 83); and third, exclude any exposures that have a value greater than 0.2% of the subset before exclusions. Return to footnote 33 Footnote 34 New accounts will not be deemed transactors until the account has been open for at least 12 months and the definition of a transactor is satisfied. Return to footnote 34 Footnote 35 The primary residence of a borrower is the residence ordinarily inhabited by the borrower. Return to footnote 35 Footnote 36 Likewise, this would apply to junior liens held by the same institution that holds the senior lien in case there is an intermediate lien from another institution (ie the senior and junior liens held by the institution are not in sequential ranking order). Return to footnote 36 Footnote 37 Loans to individuals for the purchase of residential property that are provided as loans guaranteed by a highly rated monoline guarantor that is required to repay the institution in full if the borrower defaults, and where the institution has legal right to take a mortgage on the property in the event that the guarantor fails, may be treated as residential real estate exposures (rather than guaranteed loans) if the following additional conditions are met: the borrower shall be contractually committed not to grant any mortgage lien without the consent of the institution that granted the loan; the guarantor shall be either a bank or a financial institution subject to capital requirements comparable to those applied to banks or an insurance undertaking; the guarantor shall establish a fully-funded mutual guarantee fund or equivalent protection for insurance undertakings to absorb credit risk losses, whose calibration shall be periodically reviewed by its supervisors and subject to periodic stress testing; and the institution shall be contractually and legally allowed to take a mortgage on the property in the event that the guarantor fails. Return to footnote 37 Footnote 38 Metrics and levels for measuring the ability to repay should mirror the FSB Principles for sound residential mortgage underwriting practices (April 2012). Return to footnote 38 Footnote 39 If an institution grants different loans secured by the same property and they are sequential in ranking order (i.e. there is no intermediate lien from another institution), the different loans should be considered as a single exposure for risk-weighting purposes, and the amount of the loans should be added to calculate the LTV ratio. Return to footnote 39 Footnote 40 Where a junior lien held by a different institution than that holding the senior lien is recognized (in accordance with paragraph 89), the loan amount of the junior liens must include all other loans secured with liens of equal or higher ranking than the institution's lien securing the loan for purposes of defining the LTV bucket and risk weight for the junior lien. If there is insufficient information for ascertaining the ranking of the other liens, the institution should assume that these liens rank pari passu with the junior lien held by the institution. The institution will first determine the "base" risk weight based on Tables 10, 11, 12, or 13 as applicable and adjust the "base" risk weight by a multiplier of 1.25, for application to the loan amount of the junior lien. If the "base" risk weight corresponds to the lowest LTV bucket, the multiplier will not be applied. The resulting risk weight of multiplying the "base" risk weight by 1.25 will be capped at the risk weight applied to the exposure when the requirements in paragraph 89 are not met. Return to footnote 40 Footnote 41 In line with OSFI's Guideline B-20: Residential Mortgage Insurance Underwriting Practices and Procedures, FRFIs should have clear and transparent property valuation policies and procedures including a framework for critically reviewing and, where appropriate, effectively challenging the assumptions and methodologies underlying valuations and property appraisals. In assessing the value of a property, FRFIs should take a risk-based approach, and consider a combination of valuation tools and appraisal processes appropriate to the risk being undertaken. FRFIs should have robust processes in place for regularly monitoring, reviewing and updating their LTV ratio frameworks. The valuation process can include various methods such as on-site inspections, third-party appraisals and/or automated valuation tools. Return to footnote 41 Footnote 42 In the case where the mortgage loan is financing the purchase of the property, the value of the property for LTV ratio purposes will not be higher than the effective purchase price. Return to footnote 42 Footnote 43 An institution's use of mortgage insurance should mirror the FSB Principles for sound residential mortgage underwriting (April 2012). Return to footnote 43 Footnote 44 For residential property under construction described in paragraph 89, this means there should be an expectation that the property will satisfy all applicable laws and regulations enabling the property to be occupied for housing purposes. Return to footnote 44 Footnote 45 This treatment applies to all exposures secured by the same residential real estate collateral where one or more of the exposures do not meet OSFI's expectations related to Guideline B-20. Return to footnote 45 Footnote 46 Exposures for which paragraph 110 (land acquisition, development and construction) is applicable and exposures that do not meet the requirements of Chapter 4 paragraph 94 (regulatory real estate) are not eligible for this treatment. Return to footnote 46 Footnote 47 It is expected that the material dependence condition would predominantly apply to loans to corporates, SMEs or SPVs, but is not restricted to those borrower types. Return to footnote 47 Footnote 48 It is expected that the material dependence condition would predominantly apply to loans to corporates, SMEs or SPVs, but is not restricted to those borrower types. Return to footnote 48 Footnote 49 For such exposures, institutions may apply the treatment described in paragraph 106 subject to the following conditions: (i) the losses stemming from commercial real estate lending up to 60% of LTV must not exceed 0.3% of the outstanding loans in any given year and (ii) overall losses stemming from commercial real estate lending must not exceed 0.5% of the outstanding loans in any given year. If either of these tests are not satisfied in a given year, the eligibility of the exemption will cease and the exposures where the prospect for servicing the loan materially depend on cash flows generated by the property securing the loan rather than the underlying capacity of the borrower to service the debt from other sources will again be risk weighted according to paragraph 108 until both tests are satisfied again in the future. Institutions applying such treatment must publicly disclose whether these conditions are met. Return to footnote 49 Footnote 50 ADC exposures do not include the acquisition of forest or agricultural land, where there is no planning consent or intention to apply for planning consent. Return to footnote 50 Footnote 51 In line with OSFI's Guideline B-20: Residential Mortgage Insurance Underwriting Practices and Procedures, FRFIs should have clear and transparent property valuation policies and procedures including a framework for critically reviewing and, where appropriate, effectively challenging the assumptions and methodologies underlying valuations and property appraisals. In assessing the value of a property, FRFIs should take a risk-based approach, and consider a combination of valuation tools and appraisal processes appropriate to the risk being undertaken. FRFIs should have robust processes in place for regularly monitoring, reviewing and updating their LTV ratio frameworks. The valuation process can include various methods such as on-site inspections, third-party appraisals and/or automated valuation tools. Return to footnote 51 Footnote 52 For the treatment of mortgage-backed securities issued in tranches, refer to Chapter 6 – Securitization. Return to footnote 52 Footnote 53 These items are to be weighted according to the type of asset and not according to the type of counterparty with whom the transaction has been entered into. Return to footnote 53 Footnote 54 For example if an institution has a commitment to open short-term self liquidating trade letters of credit arising from the movement of goods, a 20% CCF will be applied (instead of a 40% CCF); and if an institution has an unconditionally cancellable commitment described in paragraph 134 to issue direct credit substitutes, a 10% CCF will be applied (instead of a 100% CCF). Return to footnote 54 Footnote 55 An external audit is not required. Return to footnote 55 Footnote 56 An institution is not required to apply the 1.5 factor for situations in which the CVA capital charge would not otherwise be applicable. This includes: (i) transactions with a central counterparty and (ii) securities financing transactions (SFTs), unless OSFI determines that the institution's CVA loss exposure arising from SFTs are material. Return to footnote 56 Footnote 57 For instance, any exposure that is subject to a 20% risk weight under the Standardized Approach would be weighted at 24% (1.2 × 20%) when the look through is performed by a third party. Return to footnote 57 Footnote 58 Information used for this purpose is not strictly limited to a fund's mandate or national regulations governing like funds. It may also be drawn from other disclosures of the fund. Return to footnote 58 Footnote 59 For instance, for investments in corporate bonds with no ratings restrictions, a risk weight of 150% must be applied. Return to footnote 59 Footnote 60 If the underlying is unknown, the full notional amount of derivative positions must be used for the calculation. Return to footnote 60 Footnote 61 If the notional amount of derivatives mentioned in paragraph 152 is unknown, it will be estimated conservatively using the maximum notional amount of derivatives allowed under the mandate. Return to footnote 61 Footnote 62 For instance, if both replacement cost and add-on components are unknown, the CCR exposure will be calculated as 1.4 × (sum of the notionals in the netting set + 0.15 × sum of the notionals in the netting set). Return to footnote 62 Footnote 63 A bank is not required to apply the 1.5 factor for situations in which the CVA capital charge would not otherwise be applicable. This includes: (i) transactions with a central counterparty and (ii) securities financing transactions (SFTs), unless OSFI determines that the bank's CVA loss exposure arising from SFTs is material. Return to footnote 63 Footnote 64 ROU assets where the leased asset is an intangible asset are subject to the same capital treatment as if the leased asset was owned, as specified in section 2.3.1 of this guideline. Return to footnote 64 Footnote 65 When the counterparty for a receivable can be identified, receivables (including from related entities) should be included under the appropriate asset class rather than in "other assets." Return to footnote 65 Footnote 66 Available at Code of Conduct Fundamentals for Credit Rating Agencies (PDF, 918 KB). Return to footnote 66 Footnote 67 The recognition process included completion of a self-assessment template and submission of data required to complete a mapping exercise (see paragraph 173). Return to footnote 67 Footnote 68 At a minimum, the following situations and their influence on the ECAI's credit rating methodologies or credit rating actions shal be disclosed: The ECAI is being paid to issue a credit rating by the rated entity or by the obligor, originator, underwriter, or arranger of the rated obligation; The ECAI is being paid by subscribers with a financial interest that could be affected by a credit rating action of the ECAI; The ECAI is being paid by rated entities, obligors, originators, underwriters, arrangers, or subscribers for services other than issuing credit ratings or providing access to the ECAI's credit ratings; The ECAI is providing a preliminary indication or similar indication of credit quality to an entity, obligor, originator, underwriter, or arranger prior to being hired to determine the final credit rating for the entity, obligor, originator, underwriter, or arranger; and The ECAI has a direct or indirect ownership interest in a rated entity or obligor, or a rated entity or obligor has a direct or indirect ownership interest in the ECAI. Return to footnote 68 Footnote 69 An ECAI should disclose the general nature of its compensation arrangements with rated entities, obligors, lead underwriters, or arrangers. When the ECAI receives from a rated entity, obligor, originator, lead underwriter, or arranger compensation unrelated to its credit rating services, the ECAI should disclose such unrelated compensation as a percentage of total annual compensation received from such rated entity, obligor, lead underwriter, or arranger in the relevant credit rating report or elsewhere, as appropriate. An ECAI should disclose in the relevant credit rating report or elsewhere, as appropriate, if it receives 10% or more of its annual revenue from a single client (eg a rated entity, obligor, originator, lead underwriter, arranger, or subscriber, or any of their affiliates). Return to footnote 69 Footnote 70 Standardised approach - implementing the mapping process. Return to footnote 70 Footnote 71 However, when an exposure arises through an institution's participation in a loan that has been extended, or has been guaranteed against convertibility and transfer risk, by certain MDBs, its convertibility and transfer risk can be considered to be effectively mitigated. To qualify, MDBs must have preferred creditor status recognized in the market and be included in section 4.1.3. In such cases, for risk weighting purposes, the borrower's domestic currency rating may be used instead of its foreign currency rating. In the case of a guarantee against convertibility and transfer risk, the local currency rating can be used only for the portion that has been guaranteed. The portion of the loan not benefiting from such a guarantee will be risk-weighted based on the foreign currency rating. Return to footnote 71 Footnote 72 The notations follow the methodology used by S&P and by Moody's Investors Service. The A-1 rating of S&P includes both A-1+ and A-1-. Return to footnote 72 Footnote 73 The "others" category includes all non-prime and B or C ratings. Return to footnote 73 Footnote 74 In this section, "counterparty" is used to denote a party to whom a bank has an on- or off-balance sheet credit exposure. That exposure may, for example, take the form of a loan of cash or securities (where the counterparty would traditionally be called the borrower), of securities posted as collateral, of a commitment or of exposure under an over-the-counter (OTC) derivatives contract. Return to footnote 74 Footnote 75 Pillar 3 Disclosure Requirements Return to footnote 75 Footnote 76 OSFI's Supervisory Framework Return to footnote 76 Footnote 77 Cash-funded credit linked notes issued by the institution against exposures in the banking book which fulfil the criteria for credit derivatives will be treated as cash-collateralized transactions. Return to footnote 77 Footnote 78 When cash on deposit, certificates of deposit or comparable instruments issued by the lending bank are held as collateral at a third-party bank in a non-custodial arrangement, if they are openly pledged/assigned to the lending bank and if the pledge/assignment is unconditional and irrevocable, the exposure amount covered by the collateral (after any necessary haircuts for currency risk) will receive the risk weight of the third-party bank. Return to footnote 78 Footnote 79 However, the use or potential use by a UCITS/mutual fund of derivative instruments solely to hedge investments listed in this paragraph and paragraph 235 shall not prevent units in that UCITS/mutual fund from being eligible financial collateral. Return to footnote 79 Footnote 80 Exposure amounts may vary where, for example, securities are being lent. Return to footnote 80 Footnote 81 "Sovereigns" includes PSEs that are treated as sovereigns by the national supervisor as well MDBs receiving a 0% risk weight. Return to footnote 81 Footnote 82 "Other issuers" includes PSEs which are not treated as sovereigns by the national supervisor. Return to footnote 82 Footnote 83 "Securitization exposures" are defined as those exposures that meet the definition set forth in Chapter 6. Return to footnote 83 Footnote 84 "Cash in the same currency" refers to eligible cash collateral specified in paragraph 224. Return to footnote 84 Footnote 85 Currencies listed in the CSA are not subject to additional haircuts. Return to footnote 85 Footnote 86 Note that where a national regulatory authority has designated domestic-currency claims on its sovereign or central bank to be eligible for a 0% risk weight in the standardized approach, such claims will satisfy this condition. Return to footnote 86 Footnote 87 This does not require the institution to always liquidate the collateral but rather to have the capability to do so within the given time frame. Return to footnote 87 Footnote 88 For the purposes of this paragraph, G-10 refers to participants in the General Arrangements to Borrow (GAB) agreement. Return to footnote 88 Footnote 89 The holding period for the haircuts will depend as in other repo-style transactions on the frequency of margining. Return to footnote 89 Footnote 90 The starting point for this formula is the formula in paragraph 236 which can also be presented as the following: E ′ = ( E − C ) + ( E × H e ) + ( C × H c ) + ( C × H fx ) . Return to footnote 90 Footnote 91 When hedging corporate exposures, this particular credit event is not required to be specified provided that: (i) A 100% vote is needed to amend maturity, principal, coupon, currency or seniority status of the underlying corporate exposure; and (ii) The legal domicile in which the corporate exposure is governed has a well-established bankruptcy code that allows for a company to reorganize/restructure and provides for an orderly settlement of creditor claims. If these conditions are not met, then the treatment in paragraph 266 may be eligible. Return to footnote 91 Footnote 92 This includes the Bank for International Settlements, the International Monetary Fund, the European Central Bank, the European Union, the European Stability Mechanism (ESM) and the European Financial Stability Facility (EFSF), as well as MDBs eligible for 0% risk weight as defined in section 4.1.3. Return to footnote 92 Footnote 93 A prudentially regulated financial institution is defined as: a legal entity supervised by a regulator that imposes prudential requirements consistent with international norms or a legal entity (parent company or subsidiary) included in a consolidated group where any substantial legal entity in the consolidated group is supervised by a regulator that imposes prudential requirements consistent with international norms. These include, but are not limited to, prudentially regulated insurance companies, broker/dealers, thrifts and futures commission merchants, and qualifying central counterparties as defined in Chapter 7 of this guideline. Return to footnote 93 Footnote 94 Cash-funded credit-linked notes issued by the bank against exposures in the banking book that fulfil all minimum requirements for credit derivatives are treated as cash-collateralized transactions. However, in this case the limitations regarding the protection provider as set out in paragraph 267 do not apply. Return to footnote 94 Footnote 95 The 2.2 factor aligns the private mortgage insurer and mortgage borrower risk-weights with the application of a 100% LGD as prescribed under the IRB approach in section 5.4.2 of this guideline. Return to footnote 95 Footnote 96 SMSB Capital and Liquidity Guideline. Return to footnote 96 Footnote 97 Total exposures includes both on and off balance sheet, net of Stage 3 allowances but before taking into account credit risk mitigation. Return to footnote 97 Footnote 98 Basel Capital Adequacy Reporting Return to footnote 98 Footnote 99 For the initial implementation in Q2 2023, the threshold calculation would be performed based on data from fiscal 2021 (using quarter-end data from Q1, Q2, Q3 and Q4 of 2021). Return to footnote 99 Footnote 100 In 2023 only, materiality threshold calculations are to be performed using two year old data (i.e, using fiscal 2021 data) to allow institutions to identify whether they are eligible to use the simplified treatment upon implementation of this guideline. Starting in Q1 2024, and for every year afterwards, data for the previous year is to be used to perform the materiality threshold calculations, with any changes only being implemented the following fiscal year. Return to footnote 100

Note

For institutions with a fiscal year ending October 31 or December 31, respectively. The Capital Adequacy Requirements (CAR) for banks (including federal credit unions), bank holding companies, federally regulated trust companies, and federally regulated loan companies are set out in nine chapters, each of which has been issued as a separate document. This document should be read in conjunction with the other CAR chapters. The complete list of CAR chapters is as follows: Chapter 1 - Overview of Risk-Based Capital Requirements Chapter 2 - Definition of Capital Chapter 3 - Operational Risk Chapter 4 - Credit Risk – Standardized Approach Chapter 5 - Credit Risk – Internal Ratings-Based Approach Chapter 6 - Securitization Chapter 7 - Settlement and Counterparty Risk Chapter 8 - Credit Valuation Adjustment (CVA) Risk Chapter 9 - Market Risk Please refer to OSFI's Corporate Governance Guideline for OSFI's expectations of institution Boards of Directors in regard to the management of capital and liquidity.

Chapter 5 - Credit Risk – Internal Ratings-Based Approach

This chapter is drawn from the Basel Committee on Banking Supervision (BCBS) Basel Framework published on the BIS website.^{Footnote 1} For reference, the Basel paragraph numbers that are associated with the text appearing in this chapter are indicated in square brackets at the end of each paragraph.^{Footnote 2}

5.1. Overview

This chapter of the guideline describes the IRB approach to credit risk. Subject to certain minimum conditions and disclosure requirements, institutions that have received OSFI approval to use the IRB approach may rely on their own internal estimates of risk components in determining the capital requirement for a given exposure. The risk components include measures of the probability of default (PD), loss given default (LGD), the exposure at default (EAD), and effective maturity (M). In some cases, institutions may be required to use a supervisory value as opposed to an internal estimate for one or more of the risk components. [Basel Framework, CRE 30.1] The IRB approach is based on measures of unexpected losses (UL) and expected losses (EL). The risk-weight functions, as outlined in section 5.3, produce capital requirements for the UL portion. Expected losses are treated separately, as outlined in section 5.7 and section 2.1.3.7 of Chapter 2. [Basel Framework, CRE 30.2] In this chapter, the asset classes eligible for the IRB approach are defined in section 5.2. Adoption of the IRB approach across all asset classes is also discussed in this section. The risk-weight functions that have been developed for separate asset classes are defined in section 5.3. For example, there is a risk-weight function for corporate exposures and another one for qualifying revolving retail exposures. The risk components, each of which is defined in section 5.4, serve as inputs to the risk-weight functions. The legal certainty standards for recognizing CRM as set out in section 4.3 apply for both the foundation and advanced IRB approaches. There are also unique treatments for specialized lending and purchased receivables that are defined in sections 5.5 and 5.6, followed by a description of the treatment of the EL component in section 5.7. The minimum requirements that institutions must satisfy to use the IRB approach are presented at the end of this chapter in section 5.8.

5.2. Mechanics of the IRB approach

In this section, first the asset classes (e.g. corporate exposures and retail exposures) eligible for the IRB approach are defined. Second, section 5.2.2 provides a description of the risk components to be used by institutions by asset class. Third, sections 5.2.3 outline an institution's adoption of the IRB approach at the asset class level and the related roll out requirements. In cases where an IRB treatment is not specified, institutions should refer to the treatment specified under the standardized approach, as outlined in Chapter 4 of this guideline, and the resulting risk-weighted assets are assumed to represent UL only. Moreover, institutions must apply the risk weights referenced in Chapter 4 to investments that are assessed against materiality thresholds. [Basel Framework, CRE 30.3] For securities lent or sold under repurchase agreements or under securities lending and borrowing transactions, institutions are required to hold capital for both the original exposure and the exposure to the counterparty of the repo-style transaction as described in section 5.4.

5.2.1 Categorization of exposures

Under the IRB approach, institutions must categorize banking book exposures into broad classes of assets with different underlying risk characteristics, subject to the definitions set out below. The broad classes of assets are (a) corporate, (b) sovereign, (c) public sector entity, (d) bank, (e) retail, and (f) equity. Within the corporate asset class, five sub-classes of specialized lending are separately identified. Within the retail asset class, three sub-classes are separately identified. Within the corporate and retail asset classes, a distinct treatment for purchased receivables may also apply provided certain conditions are met. For the equity asset class the IRB approach is not permitted, as outlined further in paragraph 49. For a discussion of the IRB treatment of securitization exposures, see Chapter 6 of this guideline. [Basel Framework, CRE 30.4] The classification of exposures in this way is broadly consistent with established institution practice. However, some institutions may use different definitions in their internal risk management and measurement systems. While it is not OSFI's intention to require institutions to change the way in which they manage their business and risks, institutions are required to apply the appropriate treatment to each exposure for the purposes of deriving their minimum capital requirement. Institutions must demonstrate to OSFI that their methodology for assigning exposures to different classes is appropriate and consistent over time. [Basel Framework, CRE 30.5] (i) Definition of corporate exposures In general, a corporate exposure is defined as a debt obligation or obligation under a derivative contract of a corporation, limited liability company, partnership, proprietorship or special purpose entities (including those created specifically to finance and /or operate physical assets). Institutions are permitted to distinguish separately exposures to small- and medium-sized entities (SME), as defined in paragraph 69. [Basel Framework, CRE 30.6] In addition to general corporates, five sub-classes of specialized lending (SL) are identified. Such lending possesses all the following characteristics, in legal form or economic substance: The exposure is typically to an entity (often a special purpose entity (SPE)) which was created specifically to finance and/or operate physical assets; The borrowing entity has little or no other material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed; The terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates; and As a result of the preceding factors, the primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of a broader commercial enterprise. [Basel Framework, CRE 30.7] The five sub-classes of specialized lending are project finance (PF), object finance (OF), commodities finance (CF), income-producing real estate (IPRE), and high-volatility commercial real estate (HVCRE). Each of these sub-classes is defined below. [Basel Framework, CRE 30.8] Project finance PF is a method of funding in which the lender looks primarily to the revenues generated by a single project, both as the source of repayment and as security for the exposure. This type of financing is usually for large, complex and expensive installations that might include, for example, power plants, chemical processing plants, mines, transportation infrastructure, environment, and telecommunications infrastructure. Project finance may take the form of financing of the construction of a new capital installation, or refinancing of an existing installation, with or without improvements. [Basel Framework, CRE 30.9] In such transactions, the lender is usually paid solely or almost exclusively out of the money generated by the contracts for the facility's output, such as the electricity sold by a power plant. The borrower is usually an SPE that is not permitted to perform any function other than developing, owning, and operating the installation. The consequence is that repayment depends primarily on the project's cash flow and on the collateral value of the project's assets. In contrast, if repayment of the exposure depends primarily on a well-established, diversified, credit-worthy, contractually obligated end user for repayment, it is considered a secured exposure to that end-user. [Basel Framework, CRE 30.10] Object finance OF refers to a method of funding the acquisition of physical assets (e.g. ships, aircraft, satellites, railcars, and fleets) where the repayment of the exposure is dependent on the cash flows generated by the specific assets that have been financed and pledged or assigned to the lender. A primary source of these cash flows might be rental or lease contracts with one or several third parties. In contrast, if the exposure is to a borrower whose financial condition and debt-servicing capacity enables it to repay the debt without undue reliance on the specifically pledged assets, the exposure should be treated as a collateralized corporate exposure. [Basel Framework, CRE 30.11] Commodities finance CF refers to structured short-term lending to finance reserves, inventories, or receivables of exchange-traded commodities (e.g. crude oil, metals, or crops), where the exposure will be repaid from the proceeds of the sale of the commodity and the borrower has no independent capacity to repay the exposure. This is the case when the borrower has no other activities and no other material assets on its balance sheet. The structured nature of the financing is designed to compensate for the weak credit quality of the borrower. The exposure's rating reflects its self-liquidating nature and the lender's skill in structuring the transaction rather than the credit quality of the borrower. [Basel Framework, CRE 30.12] Such lending can be distinguished from exposures financing the reserves, inventories, or receivables of other more diversified corporate borrowers. Institutions are able to rate the credit quality of the latter type of borrowers based on their broader ongoing operations. In such cases, the value of the commodity serves as a risk mitigant rather than as the primary source of repayment. [Basel Framework, CRE 30.13] Income-producing real estate lending IPRE lending refers to a method of providing funding to real estate (such as, office buildings to let, retail space, multifamily residential buildings, industrial or warehouse space, and hotels) where the prospects for repayment and recovery on the exposure depend primarily on the cash flows generated by the asset. The primary source of these cash flows would generally be lease or rental payments or the sale of the asset. The borrower may be, but is not required to be, an SPE, an operating company focused on real estate construction or holdings, or an operating company with sources of revenue other than real estate. The distinguishing characteristic of IPRE versus other corporate exposures that are collateralized by real estate is the strong positive correlation between the prospects for repayment of the exposure and the prospects for recovery in the event of default, with both depending primarily on the cash flows generated by a property. [Basel Framework, CRE 30.14] High-volatility commercial real estate HVCRE lending is the financing of commercial real estate that exhibits higher loss rate volatility (i.e. higher asset correlation) compared to other types of SL. HVCRE includes: Commercial real estate exposures in foreign jurisdictions secured by properties of types that are categorized by the relevant foreign national supervisor as sharing higher volatilities in portfolio default rates; (2) Loans financing any of the land acquisition, development and construction (ADC), as defined in Chapter 4, section 4.1.13 phases for properties of those types in such jurisdictions; and Loans financing ADC of any other properties (including Canadian properties) where the source of repayment at origination of the exposure is either the future uncertain sale of the property or cash flows whose source of repayment is substantially uncertain (e.g. the property has not yet been leased to the occupancy rate prevailing in that geographic market for that type of commercial real estate), unless the borrower has substantial equity at risk. “Substantial equity at risk” means that at least 25% of the real estate’s appraised as-completed value has been contributed by the borrower, as defined in Chapter 4, section 4.1.10 and 4.1.13. [Basel Framework, CRE 30.15] Commercial ADC loans exempted from the treatment as HVCRE loans on the basis of certainty of repayment of borrower equity are, however, ineligible for the additional reductions for SL exposures described in paragraph 160. Loans financing the construction of pre-sold one- to four-family residential properties are also excluded from the ADC category. [Basel Framework, CRE 30.15] The HVCRE risk weights still apply to Canadian loans financing ADC of properties where the source of repayment is uncertain without substantial equity at risk, as defined in Chapter 4, section 4.1.13, as well as Canadian institutions foreign operations’ loans on properties in jurisdictions where the national supervisor has designated specific property types as HVCRE. No other specific Canadian property types are designated as sharing higher volatilities in portfolio default rates. [Basel Framework, CRE 30.16] (ii) Definition of sovereign exposures This asset class covers all exposures to counterparties treated as sovereigns under the standardized approach. This includes all entities referred to in Chapter 4, section 4.1.1, as well as public sector entities (PSEs) that are treated as sovereigns in section 4.1.2, and multilateral development banks (MDBs) that meet the criteria for a 0% risk weight under section 4.1.3. [Basel Framework, CRE 30.17] (iii) Definition of public sector entity exposures This asset class covers all exposures to counterparties treated as public sector entities (PSEs) under the standardized approach as defined in section 4.1.2. (iv) Definition of bank exposures This asset class covers exposures to banks outlined in section 4.1.4, securities firms and other financial institutions set out in section 4.1.6 that are treated as exposures to banks, and MDBs that do not meet the criteria for a 0% risk weight under the standardized approach. Bank exposures also include covered bonds as defined in section 4.1.5. [Basel Framework, CRE 30.18] This asset class also includes exposures to the entities listed in paragraph 23 that are in the form of subordinated debt or regulatory capital instruments (which form their own asset class within the standardized approach), provided that such instruments: do not fall within the scope of equity exposures as defined in paragraph 30; are not deducted from regulatory capital or risk-weighted at 250% according to Chapter 2; and are not risk weighted at 1250% according to Chapter 4. [Basel Framework, CRE 30.18] (v) Definition of regulatory retail exposures A retail exposure is categorized as a regulatory retail exposure if it meets all of the six following criteria related to the nature of the borrowers and the size of the pool of exposures, otherwise the exposure is categorized as a non-regulatory retail exposure, and is subject to the Corporate SME risk-weight function: Nature of borrower or low value of individual exposures Exposures to individuals – such as revolving credits and lines of credit (e.g. credit cards, overdrafts, and retail facilities secured by financial instruments) as well as personal term loans and leases (e.g. instalment loans, auto loans and leases, student and educational loans, personal finance, and other exposures with similar characteristics) – are eligible for retail treatment regardless of exposure size. Residential mortgage loans^{Footnote 3} (including first and subsequent liens, term loans and revolving home equity lines of credit) are eligible for retail treatment regardless of exposure size so long as: the credit is secured by a one-to-four unit residence as set out in Chapter 4, section 4.1.10; the residence is or will be occupied by the borrower, or is rented, and is extended to: an individual, or a condominium association, cooperative, or similar body with the purpose of granting its members the use of a primary residence in the property securing the loan. Loans extended to small businesses and managed as retail exposures are eligible for retail treatment provided the total exposure of the banking group to a small business borrower (on a consolidated basis where applicable) is less than CAD $1.5 million. Small business loans extended through or guaranteed by an individual are subject to the same exposure threshold. The maximum aggregated retail exposure to one counterpart cannot exceed an absolute threshold of CAD $1.5 million. Aggregated exposures means the gross amount of all forms of retail exposures, excluding residential real estate exposures. The gross amount (before any credit risk mitigation) would include the credit equivalent amount (after applying the applicable credit conversion factor) of any off-balance sheet exposure. Small business loans extended through or guaranteed by an individual are to be aggregated with direct loans to the individual and are subject to the same exposure threshold. Size of the pool of exposures The exposure must be one of a large pool of exposures, which are managed by the institution on a pooled basis. Small business exposures below CAD $1.5 million may be treated as retail exposures if the institution treats such exposures in its internal risk management systems consistently over time and in the same manner as regulatory retail exposures. This requires that such an exposure be originated in a similar manner to regulatory retail exposures. Furthermore, it must not be managed individually in a way comparable to corporate exposures, but rather as part of a portfolio segment or pool of exposures with similar risk characteristics for purposes of risk assessment and quantification. However, this does not preclude regulatory retail exposures from being treated individually at some stages of the risk management process. The fact that an exposure is rated individually does not by itself deny the eligibility as a regulatory retail exposure. [Basel Framework, CRE 30.19 to 30.22] Within the retail asset class category, institutions are required to identify separately three sub-classes of exposures: residential mortgage loans as defined above, qualifying revolving retail exposures, as defined in paragraph 27, and all other regulatory retail exposures. [Basel Framework, CRE 30.23] (vi) Definition of qualifying revolving retail exposures All of the following criteria must be satisfied for a sub-portfolio to be treated as a qualifying revolving retail exposure (QRRE). These criteria must be applied at a sub-portfolio level consistent with the institution's segmentation of its retail activities generally. If credit cards are managed separately from lines of credit (LOC), then credit cards and LOCs may be considered as separate sub-portfolios. Segmentation at the national or country level (or below) should be the general rule. The exposures are revolving, unsecured, and uncommitted (both contractually and in practice). In this context, revolving exposures are defined as those where customers' outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by the institution. The exposures are to individuals. The maximum exposure to a single individual in the sub-portfolio is CAD $150,000 or less. Because the asset correlation assumptions for the QRRE risk-weight function are markedly below those for all other regulatory retail risk-weight functions at low PD values, institutions must demonstrate that the use of the QRRE risk-weight function is constrained to portfolios that have exhibited low volatility of loss rates, relative to their average level of loss rates, especially within the low PD bands. Data on loss rates for the sub-portfolio must be retained in order to allow analysis of the volatility of loss rates. OSFI must concur that treatment as a qualifying revolving retail exposure is consistent with the underlying risk characteristics of the sub-portfolio. [Basel Framework, CRE 30.24] The QRRE sub-class is split into exposures to transactors and revolvers. A QRRE transactor is an exposure to an obligor that meets the definition of a transactor set out in section 4.1.9 of Chapter 4. That is, the exposure is to an obligor in relation to a facility such as a credit card or charge card with an interest free grace period, where the total accrued interest over the previous 12 months is less than $50, or the exposure is in relation to an overdraft facility or a line of credit if the facility has not been drawn down at any point in time over the previous 12 months. All QRRE exposures that are not transactors are revolvers.^{Footnote 4} [Basel Framework, CRE 30.25] In cases where an institution is unable to ensure compliance with the retail thresholds (for both QRR in paragraph 27 and total aggregate exposures in paragraph 25), they must be able to, on at least an annual basis, verify and document that the amount of exposures that breach these thresholds are less than 2% of retail exposures, and upon request, provide this documentation to OSFI. If the amount of exposures that breach the exposure threshold is above the 2% threshold, the institution must notify OSFI immediately and develop a plan to either reduce the materiality of these exposures or move these exposures to the Corporate asset class. (vii) Definition of equity exposures This asset class covers exposures to equities as defined in section 4.1.8. [Basel Framework, CRE 30.26] (viii) Definition of eligible purchased receivables Eligible purchased receivables are divided into retail and corporate receivables as defined below. [Basel Framework, CRE 30.27] Retail receivables Purchased retail receivables, provided the purchasing institution complies with the IRB rules for retail exposures, are eligible for the top-down approach as permitted for retail exposures. The institution must also apply the minimum operational requirements as set forth in sections 5.6 and 5.8. [Basel Framework, CRE 30.28] Corporate receivables In general, for purchased corporate receivables, institutions are expected to assess the default risk of individual obligors as specified in sections 5.3.1 and 5.3.2 consistent with the treatment of other corporate exposures. However, the top-down approach may be used, provided that the purchasing institution's programme for corporate receivables complies with both the criteria for eligible receivables and the minimum operational requirements of this approach. The use of the top-down purchased receivables treatment is limited to situations where it would be an undue burden on an institution to be subjected to the minimum requirements for the IRB approach to corporate exposures that would otherwise apply. Primarily, it is intended for receivables that are purchased for inclusion in asset-backed securitization structures, but institutions may also use this approach, with the approval of OSFI, for appropriate on-balance sheet exposures that share the same features. [Basel Framework, CRE 30.29] OSFI may deny the use of the top-down approach for purchased corporate receivables depending on the institution's compliance with minimum requirements. In particular, to be eligible for the proposed 'top-down' treatment, purchased corporate receivables must satisfy the following conditions: The receivables are purchased from unrelated, third party sellers, and as such the institution has not originated the receivables either directly or indirectly. The receivables must be generated on an arm's-length basis between the seller and the obligor. (As such, intercompany accounts receivable and receivables subject to contra-accounts between firms that buy and sell to each other are ineligible.)^{Footnote 5} The purchasing institution has a claim on all proceeds from the pool of receivables or a pro-rata interest in the proceeds.^{Footnote 6} If any single receivable or group of receivables guaranteed by the same seller or made to the same obligor represents more than 4% of the pool of receivables, capital charges must be calculated using the minimum requirements for the bottom-up approach for corporate exposures. [Basel Framework, CRE 30.30] The existence of full or partial recourse to the seller does not automatically disqualify an institution from adopting this top-down approach, as long as the cash flows from the purchased corporate receivables are the primary protection against default risk as determined by the rules in paragraphs 173 to 176 for purchased receivables and the institution meets the eligibility criteria and operational requirements. [Basel Framework, CRE 30.31] (ix) Definition of a Commitment Commitments are defined as arrangements offered by the bank and accepted by the client that obligate an institution, at a client's request, to: Extend credit in the form of loans or participations in loans, lease financing receivables, mortgages (including the undrawn portion of HELOCs), overdrafts or acceptances; or Purchase loans, securities, or other assets; or Issue credit substitutes such as letters of credit and guarantees. This includes arrangements that can be: unconditionally cancelled by the institution at any time without prior notice to the obligor cancelled by the institution if the obligor fails to meet conditions set out in the facility documentation, including conditions that must be met by the obligor prior to any initial or subsequent drawdown under the arrangement. cancelled by the bank if the obligor fails to meet conditions set out in the facility documentation, including conditions that must be met by the obligor prior to any initial or subsequent drawdown under the arrangement Normally, commitments involve a written contract or agreement and some form of consideration, such as a commitment fee. Note that unfunded mortgage commitments are treated as commitments for risk-based capital purposes when the borrower has accepted the commitment extended by the institution and all conditions related to the commitment have been fully satisfied.

5.2.2 Foundation and advanced approaches

For each of the asset classes covered under the IRB framework, there are three key elements: Risk components ─ estimates of risk parameters provided by institutions some of which are supervisory estimates. Risk-weight functions ─ the means by which risk components are transformed into risk-weighted assets and therefore capital requirements. Minimum requirements ─ the minimum standards that must be met in order for an institution to use the IRB approach for a given asset class. [Basel Framework, CRE 30.32] For certain asset classes, two broad approaches are available: a foundation and an advanced approach. Under the foundation approach (FIRB approach), as a general rule, institutions provide their own estimates of PD and their own calculation of M and rely on supervisory estimates for other risk components. Under the advanced approach (AIRB approach), institutions provide their own estimates of PD, LGD and EAD, and their own calculation of M, subject to meeting minimum standards. For both the foundation and advanced approaches, institutions must always use the risk-weight functions provided in this guideline for the purpose of deriving capital requirements. The full suite of approaches is described below. [Basel Framework, CRE 30.33] For exposures to equities, as defined in paragraph 30, the IRB approaches are not permitted (see paragraph 49). In addition, the AIRB approach cannot be used for the following: Exposures to general corporates (i.e. exposures to corporates that are not classified as specialized lending) belonging to a group with total consolidated annual revenues greater than CAD $750 million. Exposures in the bank asset class as defined in paragraph 24, and other securities firms and financial institutions (including insurance companies and other financial institutions in the corporate asset class), including all exposures to financial institutions to which a 1.25 correlation parameter multiplier applies as referenced in paragraph 68.^{Footnote 7} [Basel Framework, CRE 30.34] In making the assessment for the revenue threshold in paragraph 39(1), the amounts must be as reported in the audited financial statements of the corporates or, for corporates that are part of consolidated groups, their consolidated groups (according to the accounting standard applicable to the ultimate parent of the consolidated group). The figures must be based either (i) on the average amounts calculated over the prior three years, or (ii) on the latest amounts available to the institution, updated at least every three years. Institutions are expected to choose an approach and use it consistently, where possible. However, institutions are requested to store the annual revenue data of corporate borrowers on and ongoing basis, even if only the latest amount is used for purposes of comparing against the threshold amount. [Basel Framework, CRE 30.35] Apart from the asset classes listed in paragraph 39, the FIRB approach may only be applied where insufficient loss data is available to apply the AIRB approach (such as for low-default portfolios), and the use of the approach for such asset classes is subject to OSFI approval. The size or materiality of a portfolio cannot, in isolation, justify applying the FIRB approach. (i) Corporate, sovereign, PSE and bank exposures Under the foundation approach, institutions must provide their own estimates of PD associated with each of their borrower grades, and must calculate M using the definition provided in paragraphs 130 to 142 but must use supervisory estimates for the other relevant risk components. The other risk components are LGD and EAD. [Basel Framework, CRE 30.36] Under the advanced approach, institutions must calculate the effective maturity (M)^{Footnote 8} and provide their own estimates of PD, LGD and EAD. [Basel Framework, CRE 30.37] There is an exception to this general rule (specified in paragraphs 42 and 43) for the five sub-classes of assets identified as SL. [Basel Framework, CRE 30.38] The SL categories: PF, OF, CF, IPRE, and HVCRE Institutions that do not meet the requirements for the estimation of PD under the corporate foundation approach for their SL exposures are required to map their internal risk grades to five supervisory categories, each of which is associated with a specific risk weight. This approach is termed the 'supervisory slotting criteria approach'. [Basel Framework, CRE 30.39] Institutions that meet the requirements for the estimation of PD are able to use the foundation approach to corporate exposures to derive risk weights for all classes of SL exposures except HVCRE. With the exception of exposures in specified in paragraph 20, there are no HVCRE exposures in Canada. However at the discretion of host regulators, institutions meeting the requirements for HVCRE exposures in foreign jurisdictions may be able to use a foundation approach that is similar in all respects to the corporate approach, with the exception of a separate risk-weight function as described in paragraph 76. [Basel Framework, CRE 30.40] Institutions that meet the requirements for the estimation of PD, LGD and EAD are permitted to use the advanced approach to corporate exposures to derive risk weights for all classes of SL exposures except HVCRE. With the exception of exposures in specified in paragraph 20, there are no HVCRE exposures in Canada. However at the discretion of host regulators, institutions meeting these requirements for HVCRE exposures in a foreign jurisdiction may be permitted to use an advanced approach that is similar in all respects to the corporate approach, with the exception of a separate risk-weight function as described in paragraph 76. [Basel Framework, CRE 30.41] (ii) Retail exposures For retail exposures, institutions must provide their own estimates of PD, LGD and EAD. There is no foundation approach for this asset class. [Basel Framework, CRE 30.42] (iii) Equity exposures The treatment of equity exposures is set out in Chapter 2 and section 4.1.8 of this guideline, with the exception of equity investment in funds. Equity investments in funds are subject to the requirements set out in section 4.1.22 of this guideline, with the following exceptions: Under the look-through approach (LTA): Institutions using an IRB approach must calculate the IRB risk components (i.e. PD of the underlying exposures and, where applicable, LGD and EAD) associated with the fund's underlying exposures (except where the underlying exposures are equity exposures, in respect of which the standardized approach must be used as required by paragraph 39). Institutions using an IRB approach may use the standardized approach for credit risk when applying risk weights to the underlying components of funds if they are permitted to do so under the provisions relating to the adoption of the IRB approach set out in earlier in this chapter in the case of directly held investments. In addition, when an IRB calculation is not feasible (e.g. the institution cannot assign the necessary risk components to the underlying exposures in a manner consistent with its own underwriting criteria), the methods set out in paragraph 50 must be used. Institutions may rely on third-party calculations for determining the risk weights associated with their equity investments in funds (i.e. the underlying risk weights of the exposures of the fund) if they do not have adequate data or information to perform the calculations themselves. In this case, the third party must use the methods set out in paragraph 50, with the applicable risk weight set 1.2 times higher than the one that would be applicable if the exposure were held directly by the institution. [Basel Framework, CRE 60.19] In cases when the IRB calculation is not feasible (paragraph 49 ii above), a third party is performing the calculation of risk weights (paragraph 49 above) or when the institution is using the mandate-based approach (MBA), the following methods must be used to determine the risk weights associated with the fund's underlying exposures: for securitization exposures, the Securitization External Ratings-Based Approach (SEC-ERBA) set out in section 6.6.2 of this guideline or the Securitization Standardized Approach (SEC-SA) set out in section 6.6.4 of this guideline if the institution is not able to use the SEC-ERBA; or a 1250% risk weight where the specified requirements for using the SEC-ERBA or SEC-SA are not met; and the Standardized Approach as described in chapter 4 of this guideline for all other exposures. [Basel Framework, CRE 60.20] (iv) Eligible purchased receivables The treatment of eligible purchased receivables potentially straddles two asset classes. For eligible corporate receivables, both a foundation and advanced approach are available subject to certain operational requirements being met. As noted in paragraph 33, for corporate purchased receivables institutions are in general expected to assess the default risk of individual obligors. The institution may use the AIRB treatment for purchased corporate receivables (paragraphs 175 and 176) only for exposures to individual corporate obligors that are eligible for the AIRB approach according to paragraphs 39 and 40. Otherwise, the FIRB treatment for purchased corporate receivables should be used. For eligible retail receivables, as with the retail asset class, only the AIRB approach is available. [Basel Framework, CRE 30.44] (v) Asset-backed securities Exposures to asset-backed securities that are tranched are treated as securitization exposures, defined under Chapter 6, Securitization. For other asset-backed securities, section 4.1.15 outlines the required criteria for capitalizing the exposure based on the underlying assets rather than the originator/SPV. If the criteria outlined in section in 4.1.15 are met and the institution has received IRB approval for the underlying assets, then the underlying assets may be treated as purchased receivables.

5.2.3 Adoption of the IRB approach across asset classes

Once an institution adopts an IRB approach for part of its holdings within an asset class, it is expected to extend it across all holdings within that asset class. In this context, the relevant asset classes are as follows: Sovereigns Public Sector Entities Banks Corporates (excluding specialized lending and purchased receivables) Specialized lending Corporate purchased receivables QRRE Retail residential mortgages All other regulatory retail (excluding purchased receivables) Retail purchased receivables [Basel Framework, CRE 30.45] OSFI recognizes that for many institutions it may not be practicable for various reasons to implement the IRB approach across all material asset classes and business units at the same time. Furthermore, once on IRB, data limitations may mean that institutions can meet the standards for the use of own estimates of LGD and EAD for some but not all of their exposures within an asset class at the same time (for example, exposures that are in the same asset class, but are in different business units). [Basel Framework, CRE 30.46] As such, OSFI may allow institutions to adopt a phased rollout of the IRB approach across an asset class. The phased rollout includes (i) adoption of IRB across the asset class within the same business unit; (ii) adoption of IRB across business units in the same banking group; and (iii) the move from the foundation approach to the advanced approach for certain risk components where use of the advanced approach is permitted. However, when an institution adopts an IRB approach for an asset class within a particular business unit (or in the case of retail exposures for an individual sub-class), it must apply the IRB approach to all exposures within that asset class (or sub-class) in that unit. [Basel Framework, CRE 30.47] If an institution intends to adopt an IRB approach for an asset class, it must produce an implementation plan, specifying to what extent and when it intends to roll out IRB approaches within the asset class and business units. The plan should be realistic, and must be agreed with OSFI. It should be driven by the practicality and feasibility of moving to the more advanced approaches, and not motivated by a desire to adopt an approach that minimizes its capital charge. During the roll-out period, OSFI will ensure that no capital relief is granted for intra-group transactions which are designed to reduce a banking group's aggregate capital charge by transferring credit risk among entities on the standardized approach, foundation and advanced IRB approaches. This includes, but is not limited to, asset sales or cross guarantees. [Basel Framework, CRE 30.48] Some exposures that are immaterial in terms of size and perceived risk profile may be exempt from the requirements paragraphs 55 and 56, subject to supervisory approval. Capital requirements for such operations will be determined according to the standardized approach, with OSFI determining whether an institution should hold more capital under Pillar 2 for such positions. [Basel Framework, CRE 30.49] Institutions adopting an IRB approach for an asset class are expected to continue to employ an IRB approach for that asset class. A voluntary return to the standardized or foundation approach is permitted only in extraordinary circumstances, such as divestiture of a large fraction of the institution's credit-related business, and must be approved by OSFI. [Basel Framework, CRE 30.50] Given the data limitations associated with SL exposures, an institution may remain on the supervisory slotting criteria approach for one or more of the PF, OF, CF, IPRE or HVCRE sub-classes, and move to the foundation or advanced approach for the other sub-classes. However, an institution should not move to the advanced approach for the HVCRE sub-class without also doing so for material IPRE exposures at the same time. [Basel Framework, CRE 30.51] Irrespective of the materiality, exposures to central counterparties arising from over-the-counter derivatives, exchange traded derivatives transactions and securities financing transactions must be treated according to the dedicated treatment laid down in section 7.1.8. [Basel Framework, CRE 30.52] Institutions adopting the IRB approaches are required to calculate their capital requirements using these approaches, as well as the standardized approach as set out in section 1.5. Institutions moving directly from the standardized to the IRB approaches will be subject to parallel calculations or impact studies in the years leading up to their adoption of the advanced approaches.

5.3. IRB approach risk weight functions

Section 5.3 presents the calculation of risk-weighted assets under the IRB approach for i) corporate, sovereign, PSE and bank exposures and ii) retail exposures. Risk-weighted assets are designed to address unexpected losses from exposures. The method for calculating expected losses, and for determining the difference between that measure and provisions is described in section 5.7. [Basel Framework, CRE 31.1]

Explanation of the risk-weight functions

Regarding the risk-weight functions for deriving risk weighted assets set out in section 5.3: Probability of default (PD) and loss-given-default (LGD) are measured as decimals. Exposure at default (EAD) is measured as currency (e.g. CAD), except where explicitly noted otherwise. ln denotes the natural logarithm and e the base of the natural logarithm. N(x) denotes the cumulative distribution function for a standard normal random variable (i.e. the probability that a normal random variable with mean zero and variance of one is less than or equal to x). The normal cumulative distribution function is, for example, available in Excel as the function NORMSDIST. G(z) denotes the inverse cumulative distribution function for a standard normal random variable (i.e. the value of x such that N(x) = z). The inverse of the normal cumulative distribution function is, for example, available in Excel as the function NORMSINV. [Basel Framework, CRE 31.2]

Risk-weighted assets for all exposures that are in default

The capital requirement (K) for a defaulted exposure is equal to the greater of zero and the difference between its LGD (described in paragraph 281) and the institution’s best estimate of expected loss (described in paragraph 284). The risk-weighted asset amount for the defaulted exposure is the product of K, 12.5, and the EAD. [Basel Framework, CRE 31.3]

5.3.1 RWA for corporate, sovereign, PSE, and bank exposures not in default

(i) Risk weight functions for corporate, sovereign, PSE, and bank exposures The derivation of risk-weighted assets is dependent on estimates of the PD, LGD, EAD and, in some cases, effective maturity (M), for a given exposure. [Basel Framework, CRE 31.4] For exposures not in default, the formula for calculating risk-weighted assets is: Correlation ( R ) = 0.12 × 1 − e − 50 × PD 1 − e − 50 + 0.24 × 1 − 1 − e − 50 × PD 1 − e − 50 Maturity adjustment ( b ) = 0.11852 − 0.05478 × ln ⁡ ⁡ ( PD ) 2 Capital requirement ( K ) = LGD × N G PD 1 − R + R 1 − R × G 0.999 − PD × LGD × 1 + M − 2.5 × b 1 − 1.5 × b ^{Footnote 9} Risk-weighted assets ( RWA ) = K × 12.5 × EAD Illustrative risk weights are shown in Appendix 5-1. [Basel Framework, CRE 31.5] The M used in the calculation of K in paragraph 66 is the effective maturity, calculated according to paragraphs 130 to 141, and the following term is used to refer to a specific part of the capital requirements formula: Full maturity adjustment = ( 1 + ( M − 2.5 ) × b ) ( 1 − 1.5 × b ) [Basel Framework, CRE 31.6] A multiplier of 1.25 is applied to the correlation parameter of all exposures to financial institutions meeting the following criteria: Regulated financial institutions whose total assets are greater than or equal to CAD $150 billion. The most recent audited financial statement of the parent company and consolidated subsidiaries must be used in order to determine asset size. For the purpose of this paragraph, a regulated financial institution is defined as a parent and its subsidiaries where any substantial legal entity in the consolidated group^{Footnote 10} is supervised by a regulator that imposes prudential requirements consistent with international norms. These include, but are not limited to, prudentially regulated Insurance Companies, Broker/Dealers, Banks, Thrifts and Futures Commission Merchants; Unregulated financial institutions, regardless of size. Unregulated financial institutions are, for the purposes of this paragraph, legal entities whose main business includes: the management of financial assets, lending, factoring, leasing, provision of credit enhancements, securitization, investments, financial custody, central counterparty services, proprietary trading and other financial services activities identified by regulatory authorities (including OSFI), including financial institutions or leveraged funds that are not subject to prudential solvency regulation. Correlation ( R_FI ) = 1.25 × 0.12 × 1 − e − 50 × PD 1 − e − 50 + 0.24 × 1 − 1 − e − 50 × PD 1 − e − 50 [Basel Framework, CRE 31.7] (ii) Firm-size adjustment for small- and medium-sized entities (SME) Under the IRB approach for corporate credits, institutions will be permitted to separately distinguish exposures to SME borrowers (defined as corporate exposures where the reported sales for the consolidated group of which the firm is a part is less than CAD $75 million) from those to large firms. A firm-size adjustment (i.e. 0.04 x (1- (S - 7.5)/67.5)) is made to the corporate risk weight formula for exposures to SME borrowers. S is expressed as total annual sales in millions of CAD with values of S falling in the range of equal to or less than CAD $75 million or greater than or equal to CAD $7.5 million. Reported sales of less than CAD $7.5 million will be treated as if they were equivalent to CAD $7.5 million for the purposes of the firm-size adjustment for SME borrowers. Correlation ( R ) = 0.12 × 1 − e − 50 × PD 1 − e − 50 + 0.24 × 1 − 1 − e − 50 × PD 1 − e − 50 − 0.04 × 1 − S − 7.5 67.5 [Basel Framework, CRE 31.8] Annual sales, rather than total assets, are to be used to measure borrower size, unless in limited circumstances an institution can demonstrate that it would be more appropriate to use the total assets of the borrower. OSFI is willing to consider limited recognition for classes of entities that always have much smaller sales than total assets, because assets are a more appropriate indicator in this case. The use of total assets should be a limited exception. The maximum reduction in the risk weight for SMEs is achieved when borrower size is CAD $7.5 million. For borrower sizes below CAD $7.5 million, borrower size is set equal to CAD $7.5 million. The adjustment shrinks to zero as borrower size approaches CAD $75 million. Additionally, the Corporate SME RWA formula must be used with $7.5 million for the annual sales amount for exposures to individuals for non-regulatory retail exposures. [Basel Framework, CRE 31.9] (iii) Risk weights for specialized lending Risk weights for PF, OF, CF, and IPRE Institutions that meet the requirements for the estimation of PD will be able to use the FIRB approach for the corporate asset class to derive risk weights for SL sub-classes. [Basel Framework, CRE 31.10] Institutions that meet the requirements for the estimation of PD and LGD and EAD (where relevant) will be able to use the AIRB approach for the corporate asset class to derive risk weights for SL sub-classes. [Basel Framework, CRE 31.10] Institutions that do not meet the requirements for the estimation of PD under the IRB approach for corporate exposures must follow the supervisory slotting approach outlined in section 5.5.1. [Basel Framework, CRE 31.10] Risk weights for HVCRE For Canadian exposures, the HVCRE category only applies to loans financing ADC properties where the source of repayment at origination is substantially uncertain without the borrower having substantial equity at risk. However, the HVCRE risk weights may apply more broadly to loans made by Canadian institutions' foreign operations that are secured by property types designated by the host supervisor as HVCRE, where the host supervisor has given the foreign operation approval to use the IRB approach. In this instance, a Canadian institution shall use the HVCRE risk weights required by the foreign supervisor in calculating its consolidated capital requirements for loans secured by these properties. Institutions will use the same formula for the derivation of HVCRE risk weights that is used for other SL exposures, except that they will apply the following asset correlation formula: Correlation ( R ) = 0.12 × 1 − e − 50 x PD 1 − e − 50 + 0.30 × 1 − 1 − e − 50 × PD 1 − e − 50 [Basel Framework, CRE 31.11] Institutions that do not meet the requirements for estimation of LGD and EAD for HVCRE exposures must use the supervisory parameters for LGD and EAD for corporate exposures or use the supervisory slotting approach for HVCRE exposures outlined in section 5.5.2. [Basel Framework, CRE 31.12]

5.3.2 RWA for retail exposures that are not in default

There are three separate risk-weight functions for retail exposures, as defined in paragraphs 79 to 81. Risk weights for retail exposures are based on separate assessments of PD and LGD as inputs to the risk-weight functions. None of the three retail risk-weight functions contain the explicit maturity adjustment component that is present in the risk weight function for exposures to banks, sovereigns, PSEs and corporates. Illustrative risk weights are shown in Appendix 5-1. [Basel Framework, CRE 31.13] (i) Residential mortgage exposures For exposures defined in paragraph 25 that are not in default and are secured or partly secured^{Footnote 11} by residential mortgages, risk weights will be assigned based on the following formula: Correlation (R) = 0.15 where repayment is not materially dependent on cash flows generated by the property;^{Footnote 12} or = 0.22 where one or more of the following applies and with the exception noted below: repayment is materially dependent on cash flows generated by the property^{Footnote 13} OSFI’s expectations related to Guideline B-20^{Footnote 14} are not met the mortgage is a variable rate fixed-payment residential mortgage with an LTV above 65% for which the payments are insufficient to cover the interest component of the mortgage for three or more consecutive months due to increases in interest rates. OSFI may exempt an institution from using the 0.22 correlation factor for a variable rate fixed payment mortgage described above if the institution can demonstrate, to OSFI’s satisfaction, that its estimates of IRB parameters account for this risk in a manner that is at least as conservative as increasing the correlation factor from 0.15 to 0.22. Capital requirement ( K ) = LGD × N G PD ( 1 − R ) + R 1 − R × G 0.999 − PD × LGD RWA = K × 12.5 × EAD [Basel Framework, CRE 31.14] (ii) Qualifying revolving retail exposures For qualifying revolving retail exposures as defined in paragraph 27 that are not in default, risk weights are defined based on the following formula: Correlation ⁡ R = 0.04 Capital requirement ( K ) = LGD × N G PD 1 − R + R 1 − R × G 0.999 − PD × LGD Risk-weighted assets = K × 12.5 × EAD [Basel Framework, CRE 31.15] (iii) All other regulatory retail exposures For all other regulatory retail exposures that are not in default, risk weights are assigned based on the following function, which allows correlation to vary with PD: Correlation ( R ) = 0.03 × 1 − e − 35 PD 1 − e − 35 + 0.16 × 1 − 1 − e − 35 × PD 1 − e − 35 Capital requirement ( K ) = LGD × N ( G PD 1 − R ) + R 1 − R × G ( 0.999 ) − PD × LGD Risk-weighted assets = K × 12.5 × EAD [Basel Framework, CRE 31.16]

5.4. IRB risk components

Section 5.4 presents the calculation of the risk components (PD, LGD, EAD, M) that are used in the formulas set out in section 5.3. In calculating these components, the legal certainty standards for recognizing credit risk mitigation (CRM) under the standardized approach as set out in section 4.3 apply for both the FIRB and AIRB approaches. [Basel Framework, CRE 32.1]

5.4.1 Risk components for corporate, sovereign, PSE, and bank exposures

Section 5.4.1 sets out the calculation of the risk components for corporate, sovereign, PSE, and bank exposures. In the case of an exposure that is guaranteed by a sovereign, the floors that apply to the risk components do not apply to that part of the exposure covered by the sovereign guarantee (i.e. any part of the exposure that is not covered by the guarantee is subject to the relevant floors). [Basel Framework, CRE 32.2] (i) Probability of default (PD) For corporate, sovereign, PSE and bank exposures, the PD is the one-year PD associated with the internal borrower grade to which that exposure is assigned. The PD of borrowers assigned to a default grade(s), consistent with the reference definition of default, is 100%. The minimum requirements for the derivation of the PD estimates associated with each internal borrower grade are outlined in paragraphs 274 to 276. [Basel Framework, CRE 32.3] With the exception of exposures in the sovereign asset class (including PSEs treated as sovereigns as defined in paragraph 21), the PD for each exposure that is used as input into the risk weight formula and the calculation of expected loss must not be less than 0.05%. [Basel Framework, CRE 32.4] (ii) Loss given default (LGD) An institution must provide an estimate of the LGD for each corporate, sovereign, PSE, and bank exposure. There are two approaches for deriving this estimate: a foundation approach and an advanced approach. As noted in paragraph 39, the advanced approach is not permitted for exposures to certain entities. [Basel Framework, CRE 32.5] LGD under the foundation approach: treatment of unsecured claims and non-recognized collateral Under the foundation approach, senior claims on sovereigns, PSEs, banks, securities firms and other financial institutions (including insurance companies and any financial institutions in the corporate asset class) that are not secured by recognized collateral will be assigned a 45% LGD. Senior claims on other corporates that are not secured by recognized collateral will be assigned a 40% LGD. [Basel Framework, CRE 32.6] All subordinated claims on corporates, sovereigns, PSEs and banks will be assigned a 75% LGD. A subordinated loan is a facility that is expressly subordinated to another facility. The legal definition of subordination applies for the purpose of this paragraph. [Basel Framework, CRE 32.7] LGD under the foundation approach: collateral recognition In addition to the eligible financial collateral recognized in the standardized approach, under the foundation IRB approach some other forms of collateral, known as eligible IRB collateral, are also recognized. These include receivables, specified commercial and residential real estate (CRE/RRE), and other collateral, where they meet the minimum requirements set out in paragraphs 335 to 351. For eligible financial collateral, the requirements are identical to the operational standards as set out in section 4.3. [Basel Framework, CRE 32.8] The methodology for the recognition of eligible financial collateral closely follows that outlined in the comprehensive approach to collateral in section 4.3.3 (iii). The simple approach to collateral presented in section 4.3.3 (ii) is not available to institutions applying the IRB approach. [Basel Framework, CRE 32.9] The effective LGD applicable to a collateralized transaction (LGD`) must be calculated as the exposure weighted average of the LGD applicable to the unsecured part of an exposure (LGDU) and the LGD applicable to the collateralized part of an exposure (LGDS). Specifically, the formula that follows must be used, where: E is the current value of the exposure (i.e. cash lent or securities lent or posted). In the case of securities lent or posted the exposure value has to be increased by applying the appropriate haircuts (HE) according to the comprehensive approach for financial collateral; ES is the current value of the collateral received after the application of the haircut applicable for the type of collateral (HC) and for any currency mismatches between the exposure and the collateral, as specified in the paragraphs 93 to 95. ES is capped at the value of E×(1 + HE); EU = E×(1 + HE) - ES. The terms Eu and ES are only used to calculate LGD`. Institutions must continue to calculate EAD without taking into account the presence of any collateral, unless otherwise specified; LGDU is that applicable for an unsecured exposure, as set out in paragraphs 87 and 88; LGDS is the LGD applicable to exposures secured by the type of collateral used in the transaction, as specified in paragraph 93; LGD` = LGD U × E U E · 1 + H E + LGD S × E S E · ( 1 + H E ) [Basel Framework, CRE 32.10] The following table specifies the LGDS and haircuts applicable when calculating ES in the formula set out in paragraph 92: Supervisory LGDs and Haircuts under the Foundation IRB Type of collateral LGDS Haircut Eligible financial collateral 0% As determined by the haircuts that apply in the comprehensive formula of the standardized approach for credit risk (see section 4.3.3 iii). The haircuts have to be adjusted for different holding periods and non-daily remargining or revaluation according to section 4.3.3 iii. Eligible receivables 20% 40% Eligible residential real estate / commercial real estate^{Footnote 15} 20% 40% Other eligible physical collateral 25% 40% Ineligible collateral N/A 100% [Basel Framework, CRE 32.11] When eligible collateral is denominated in a different currency to that of the exposure, the haircut for currency risk used to calculate ES is the same haircut that applies in the comprehensive approach (section 4.3.3 (iii) of Chapter 4). [Basel Framework, CRE 32.12] Institutions that lend securities or post collateral must calculate capital requirements for both of the following: (i) the credit risk or market risk of the securities, if this remains with the institution; and (ii) the counterparty credit risk arising from the risk that the borrower of the securities may default. Paragraphs 123 to 129 set out the calculation of the EAD arising from transactions that give rise to counterparty credit risk such as securities financing transactions. For such transactions where the collateral has been reflected through EAD, the LGD of the counterparty must be determined using the LGD specified for unsecured exposures, as set out in paragraph 87 and 88. [Basel Framework, CRE 32.13] LGD under the F-IRB approach: methodology for the treatment of pools of collateral In the case where an institution has obtained multiple types of collateral it may apply the formula set out in paragraph 92 sequentially for each individual type of collateral. In doing so, after each step of recognizing one individual type of collateral, the remaining value of the unsecured exposure (EU) will be reduced by the adjusted value of the collateral (ES) recognized in that step. In line with paragraph 92, the total of ES across all collateral types is capped at the value of E × (1+HE). This results in the formula that follows, where for each collateral type i: LGDSi is the LGD applicable to that form of collateral (as specified in paragraph 93). ESi is the current value of the collateral received after the application of the haircut applicable for the type of collateral (Hc) (as specified in paragraph 93). LGD` = LGD U × E U E × 1 + H E + ∑ i LGD S i × E S i E × ( 1 + H E ) [Basel Framework, CRE 32.14] LGD under the advanced approach Subject to certain additional minimum requirements specified below (and the conditions set out in paragraph 33), institutions may use their own internal estimates of LGD for corporate, PSE and sovereign exposures. LGD must be measured as the loss given default as a percentage of the EAD. Institutions eligible for the IRB approach that are unable to meet these additional minimum requirements must utilize the foundation LGD treatment described above. [Basel Framework, CRE 32.15] The LGD for each corporate and PSE exposure that is used as input into the risk weight formula and the calculation of expected loss must not be less than the parameter floors indicated in the table below (the floors do not apply to the LGD for exposures in the sovereign asset class): LGD Parameter Floors Wholesale classes LGD Unsecured Secured Corporate and PSE 25% Varying by collateral type: 0% financial 10% receivables 10% commercial or residential real estate 15% other physical 25% intangibles [Basel Framework, CRE 32.16] The LGD floors for secured exposures in the table above apply when the exposure is fully secured (i.e. the value of collateral after the application of haircuts exceeds the value of the exposure). The LGD floor for a partially secured exposure is calculated as a weighted average of the unsecured LGD floor for the unsecured portion and the secured LGD floor for the secured portion. That is, the following formula should be used to determine the LGD floor, where: LGDU floor and LGDS floor are the floor values for fully unsecured and fully secured exposures respectively, as specified in the table in paragraph 98. The other terms are defined as set out in paragraphs 92 and 93. Floor = LGD Ufloor × E U E × 1 + H E + LGD Sfloor × E S E × 1 + H E [Basel Framework, CRE 32.17] In cases where an institution has met the conditions to use their own internal estimates of LGD for a pool of unsecured exposures, and takes collateral against one of these exposures, it may not be able to model the effects of the collateral (i.e. it may not have enough data to model the effect of the collateral on recoveries). In such cases, the institution is permitted to apply the formula set out in paragraph 92 or 96, with the exception that the LGDU term would be the institution's own internal estimate of the unsecured LGD. To adopt this treatment the collateral must be eligible under the F-IRB and the institution's estimate of LGDU must not take account of any effects of collateral recoveries. [Basel Framework, CRE 32.18] The minimum requirements for the derivation of LGD estimates are outlined in section 5.8.6, (vii). [Basel Framework, CRE 32.19] Treatment of certain repo-style transactions under the IRB approaches Institutions that want to recognize the effects of master netting agreements on repo-style transactions for capital purposes must apply the methodology outlined in paragraph 124 for determining E` for use as the EAD in the calculation of counterparty credit risk. For institutions using the advanced approach, own LGD estimates would be permitted for the unsecured equivalent amount (E`) used to calculate counterparty credit risk. In both cases, in addition to counterparty credit risk, institutions must also calculate the capital requirements relating to any credit or market risk to which they remain exposed arising from the underlying securities in the master netting agreement. [Basel Framework, CRE 32.20] Treatment of guarantees and credit derivatives under the IRB approaches There are two approaches for recognition of credit risk mitigation (CRM) in the form of guarantees and credit derivatives in the IRB approach: a foundation approach for institutions using supervisory values of LGD, and an advanced approach for those institutions using their own internal estimates of LGD. [Basel Framework, CRE 32.21] Under either approach, CRM in the form of guarantees and credit derivatives must not reflect the effect of double default (see paragraph 305). As such, to the extent that the CRM is recognized by the institution, the adjusted risk weight will not be less than that of a comparable direct exposure to the protection provider. A comparable, direct exposure to the guarantor is one using the PD of the guarantor and the LGD for an unsecured exposure to the guarantor. In the case where a guarantor pledges additional collateral beyond that of the original borrower, this additional collateral may be reflected in the LGD of a comparable, direct exposure to the guarantor. Consistent with the standardized approach, institutions may choose not to recognize credit protection if doing so would result in a higher capital requirement. [Basel Framework, CRE 32.22] Treatment of guarantees and credit derivatives: recognition under the foundation approach For institutions using the foundation approach for LGD, the approach to guarantees and credit derivatives closely follows the treatment under the standardized approach as specified in section 4.3.5. The range of eligible guarantors is the same as under the standardized approach except that companies that are internally rated may also be recognized under the foundation approach. To receive recognition, the requirements outlined in section 4.3.5 must be met. [Basel Framework, CRE 32.23] Eligible guarantees from eligible guarantors will be recognized as follows: For the covered portion of the exposure, a risk weight is derived by taking: the risk-weight function appropriate to the type of guarantor, and the PD appropriate to the guarantor's borrower grade. The institution may replace the LGD of the underlying transaction with the LGD applicable to the guarantee taking into account seniority and any collateralization of a guaranteed commitment. For example, when an institution has a subordinated claim on the borrower but the guarantee represents a senior claim on the guarantor this may be reflected by using an LGD applicable for senior exposures (see paragraph 87) instead of an LGD applicable for subordinated exposures. In case the institution applies the standardized approach to direct exposures to the guarantor it may only recognize the guarantee by applying the standardized approach to the covered portion of the exposure. [Basel Framework, CRE 32.24] Although the PD component may be adjusted to lie somewhere between those of the guarantor and the obligor if the guarantor's PD is not appropriate, note that LGD may only be substituted and may not be adjusted. Paragraph 104 establishes a floor on the recognition of a guarantee. Therefore, the PD and LGD used for the covered portion of an exposure under the foundation approach must not result in a risk weight that is lower than that of a comparable direct exposure to the guarantor. While substituting both the PD and LGD of the guarantor for those of the borrower will result in a risk weight equal to that of a direct exposure to the guarantor, replacing or adjusting only one of these components could result in a risk weight that is lower. Notwithstanding, institutions are not permitted to combine a risk component of the guarantor with a component of the underlying obligation in the risk weight formula if doing so results in a risk weight lower than that of a comparable direct exposure to the guarantor. For guaranteed undrawn exposures, the CCF of the original borrower should be used. [Basel Framework, CRE 32.25] The uncovered portion of the exposure is assigned the risk weight associated with the underlying obligor. [Basel Framework, CRE 32.25] Where partial coverage exists, or where there is a currency mismatch between the underlying obligation and the credit protection, it is necessary to split the exposure into a covered and an uncovered amount. The treatment in the foundation approach follows that outlined in section 4.3.5 (vii) of Chapter 4, and depends upon whether the cover is proportional or tranched. [Basel Framework, CRE 32.26] Treatment of guarantees and credit derivatives: recognition under the AIRB approach Institutions using the advanced approach for estimating LGDs may reflect the risk-mitigating effect of guarantees and credit derivatives through either adjusting PD or LGD estimates. Whether adjustments are done through PD or LGD, they must be done in a consistent manner for a given guarantee or credit derivative type. For unconditional guarantees meeting the requirements for the recognition of guarantees under the foundation approach outlined in paragraphs 105 to 108, (including the operational requirements outlined in section 4.3.5 of Chapter 4) institutions may substitute both the PD and LGD of the obligor for those of the guarantor in cases where they have determined it is warranted. In doing so, institutions must not include the effect of double default in such adjustments. Thus, the adjusted risk weight must not be less than that of a comparable direct exposure to the protection provider. In the case where the institution applies the standardized approach to direct exposures to the guarantor it may only recognize the guarantee by applying the standardized approach to the covered portion of the exposure. In the case where the institution applies the foundation IRB approach to direct exposures to the guarantor it may only recognize the guarantee by determining the risk weight for the comparable direct exposure to the guarantor according to the foundation IRB approach. [Basel Framework, CRE 32.27] Under all circumstances the risk weight of a guaranteed exposure cannot be lower than that of a comparable direct claim on the guarantor. This assumes that any claim on the guarantor will be net of any recovery from the collateral pledged by the borrower. In determining the risk weight for a comparable direct exposure, institutions should take into account both the seniority and the exposure at default of the direct exposure. When an adjustment is made to PD, the risk weight function used for the guaranteed exposure should be that of the protection provider. However, when an adjustment is made to LGD the risk weight function used must be the one applicable to the original exposure. An institution relying on own-estimates of LGD has the option to adopt the treatment outlined above for banks under the foundation IRB approach (paragraphs 105 to 108), or to make an adjustment to its LGD estimate of the exposure to reflect the presence of the guarantee or credit derivative. Under this option, there are no limits to the range of eligible guarantors although the set of minimum requirements provided in paragraphs 307 to 309 concerning the type of guarantee must be satisfied. For credit derivatives, the requirements of paragraphs 314 and 315 must be satisfied.^{Footnote 16} For exposures for which an institution has permission to use its own estimates of LGD, the institution may recognize the risk mitigating effects of first-to-default credit derivatives, but may not recognize the risk mitigating effects of second-to-default or more generally nth-to-default credit derivatives. [Basel Framework, CRE 32.28] (iii) Exposure at Default (EAD) The following sections apply to both on and off-balance sheet positions: All exposures are measured gross of specific allowances^{Footnote 17} The EAD on drawn amounts should not be less than the sum of: the amount by which an institution's regulatory capital would be reduced if the exposure were written-off fully, and any specific allowances. When the difference between the instrument's EAD and the sum of (i) and (ii) is positive, this amount is termed a discount. The calculation of risk-weighted assets is independent of any discounts. Under the limited circumstances described in section 5.7.2, discounts may be included in the measurement of total eligible allowances for purposes of the EL-provision calculation set out in section 5.7. [Basel Framework, CRE 32.29] Exposure measurement for on-balance sheet items On-balance sheet netting of loans and deposits will be recognized subject to the same conditions as under the standardized approach (see section 4.3.4). Where currency or maturity mismatched on-balance sheet netting exists, the treatment follows the standardized approach, as set out in sections 4.3.1 (iv) and 4.3.1 (v). [Basel Framework, CRE 32.30] Exposure measurement for off-balance sheet items (with the exception of derivatives) For off-balance sheet items there are two approaches for the estimation of EAD: a foundation approach and an advanced approach. When only the drawn balances of revolving facilities have been securitized, institutions must ensure that they continue to hold required capital against the undrawn balances associated with the securitized exposures. [Basel Framework, CRE 32.31] In the foundation IRB approach, EAD is calculated as the committed but undrawn amount multiplied by a credit conversion factor (CCF). In the advanced approach, EAD for undrawn commitments may be calculated as the committed but undrawn amount multiplied by a CCF or derived from direct estimates of total facility EAD. In both the foundation and advanced IRB approaches, commitments are defined in paragraph 36. [Basel Framework, CRE 32.32] EAD under the foundation approach The types of instruments and the CCFs applied to them are the same as those in the standardized approach, as outlined in section 4.1.18. [Basel Framework, CRE 32.33] The amount to which the CCF is applied is the lower of the value of the unused committed credit line, and the value that reflects any possible constraining availability of the facility, such as the existence of a ceiling on the potential lending amount which is related to a borrower's reported cash flow. If the facility is constrained in this way, the institution must have sufficient line monitoring and management procedures to support this contention. [Basel Framework, CRE 32.34] Where a commitment is obtained on another off-balance sheet exposure, institutions under the foundation approach are to apply the lower of the applicable CCFs. [Basel Framework, CRE 32.35] EAD under the advanced approach Institutions which meet the minimum requirements for use of their own estimates of EAD (see paragraphs 289 to 298) will be allowed (for exposures for which AIRB is permitted, as per paragraph 38) to use their own internal estimates of EAD for undrawn revolving commitments^{Footnote 18} to extend credit, purchase assets or issue credit substitutes provided the exposure is not subject to a CCF of 100% in the foundation approach (see paragraph 118). Standardized approach CCFs must be used for all other off-balance sheet items (for example, undrawn non-revolving commitments), and must be used where the minimum requirements for own estimates of EAD are not met. [Basel Framework, CRE 32.36] Estimates of CCF for all non-sovereign exposures may not be lower than 50% of the applicable CCF in the standardized approach. [Basel Framework, CRE 32.36] Exposures that give rise to counterparty credit risk For exposures that give rise to counterparty credit risk according to section 7.1.2 (i.e. OTC derivatives, exchange-traded derivatives, long settlement transactions and securities financing transactions) the EAD is to be calculated as per the rules set forth in Chapter 7. [Basel Framework, CRE 32.37] For securities financing transactions (SFTs), institutions may recognize a reduction in the counterparty credit risk requirement arising from the effect of a master netting agreement providing that it satisfies the criteria set out in section 4.3.3 iii (e). The institution must calculate E`, which is the exposure to be used for the counterparty credit risk requirement taking account of the risk mitigation of collateral received, using the formula set out in section 4.3.3 iii (e). In calculating risk-weighted assets and expected loss (EL) amounts for the counterparty credit risk arising from the set of transactions covered by the master netting agreement, E` must be used as the EAD of the counterparty. [Basel Framework, CRE 32.38] As an alternative to the use of standard haircuts for the calculation of the counterparty credit risk charge for SFTs set out in paragraph 124, institutions may be permitted to use a value-at-risk (VaR) models approach to reflect price volatility of the exposures and the financial collateral. This approach can take into account the correlation effects between security positions. This approach applies to single SFTs and SFTs covered by netting agreements on a counterparty-by-counterparty basis, both under the condition that the collateral is revalued on a daily basis. This holds for the underlying securities being different and unrelated to securitizations. The master netting agreement must satisfy the criteria set out in section 4.3.3 iii (e). The VaR models approach is available to institutions that have received supervisory recognition for an internal market risk model according to Chapter 9. Institutions which have not received market risk model recognition can separately apply for supervisory recognition to use their internal value-at-risk (VaR) models for the calculation of potential price volatility for SFTs, provided the model meets the requirements of Chapter 9. Although the market risk standards have changed from a 99% VaR to a 97.5% expected shortfall, the VaR models approach to SFTs retains the use of a 99% VaR to calculate the counterparty credit risk for SFTs. The VaR model needs to capture risk sufficient to pass the backtesting and profit and loss attribution tests from Chapter 9. The default risk charge described in Chapter 9 is not required in the VaR model for SFTs. [Basel Framework, CRE 32.39] The quantitative and qualitative criteria for recognition of internal market risk models for SFTs are in principle the same as in of Chapter 9. The minimum liquidity horizon or the holding period for SFTs is 5 business days for margined repo-style transactions, rather than the 10 business days in Chapter 9. For other transactions eligible for the VaR models approach, the 10 business day holding period will be retained. The minimum holding period should be adjusted upwards for market instruments where such a holding period would be inappropriate given the liquidity of the instrument concerned. [Basel Framework, CRE 32.40] The calculation of the exposure E` for institutions using their internal model to calculate their counterparty credit risk charge will be as follows, where institutions will use the previous day's VaR number: E` = max ⁡ { 0 , [ ( ∑ E − ∑ C ) + VaR output from internal model ] } [Basel Framework, CRE 32.41] Subject to supervisory approval, instead of using the VaR approach, institutions may also calculate an effective expected positive exposure for repo-style and other similar SFTs, in accordance with the Internal Models Method set out in the counterparty credit risk standards in Chapter 7. [Basel Framework, CRE 32.42] As in the standardized approach, for transactions where the conditions in section 4.3.3 ii (c) are met, and the counterparty is a core market participant, the haircuts specified under the comprehensive approach do not apply, and instead a zero H applies. A netting set that contains any transaction that does not meet the requirements in section 4.3.3 ii (c) of the standardized approach is not eligible for this treatment. [Basel Framework, CRE 32.43] (iv) Effective maturity (M) Institutions using the FIRB approach for an exposure are required to calculate an explicit M adjustment consistent with the AIRB approach as defined below. [Basel Framework, CRE 32.44] The exemption described in this paragraph does not apply when lending to borrowers in Canada, but institutions may follow the local treatment for international exposures. Some foreign supervisors may exempt facilities to certain smaller domestic corporate borrowers from the explicit maturity adjustment if the reported sales (i.e. turnover) as well as total assets for the consolidated group of which the firm is a part of are less than CAD $750 million. The consolidated group must be a domestic company based in the foreign country where the exemption is applied to qualify for this exemption. If adopted by a foreign supervisor, all exposures to qualifying smaller domestic firms in that jurisdiction will be assumed to have an average maturity of 2.5 years. [Basel Framework, CRE 32.45] Except as noted in paragraph 137, the effective maturity (M) is subject to a floor of one year and a cap of five years. [Basel Framework, CRE 32.46] For an instrument subject to a determined cash flow schedule, effective maturity M is defined as follows, where CFt denotes the cash flows (principal, interest payments and fees) contractually payable by the borrower in period t. Effective Maturity ( M ) = ∑ t t × C F t / ∑ t C F t [Basel Framework, CRE 32.47] If an institution is not in a position to calculate the effective maturity of the contracted payments as noted above, it is allowed to use a more conservative measure of M such as that it equals the maximum remaining time (in years) that the borrower is permitted to take to fully discharge its contractual obligation (principal, interest, and fees) under the terms of loan agreement. Normally, this will correspond to the nominal maturity of the instrument. [Basel Framework, CRE 32.48] For derivatives subject to a master netting agreement, the effective maturity is defined as the weighted average maturity of the transactions within the netting agreement. Further, the notional amount of each transaction should be used for weighting the maturity. [Basel Framework, CRE 32.49] For revolving exposures, effective maturity must be determined using the maximum contractual termination date of the facility. Institutions must not use the repayment date of the current drawing. [Basel Framework, CRE 32.50] The one-year floor does not apply to certain short-term exposures, comprising fully or nearly-fully collateralized^{Footnote 19} capital market-driven transactions (i.e. OTC derivatives transactions and margin lending) and repo-style transactions (i.e. repos/reverse repos and securities lending/borrowing) with an original maturity of less then one year, where the documentation contains daily remargining clauses. For all eligible transactions the documentation must require daily revaluation, and must include provisions that must allow for the prompt liquidation or setoff of the collateral in the event of default or failure to re-margin. The maturity of such transactions must be calculated as the greater of one-day, and the effective maturity (M, consistent with the definition above), except for transactions subject to a master netting agreement, where the floor is determined by the minimum holding period for the transaction type, as required by paragraph 140. [Basel Framework, CRE 32.51] The one-year floor, set out in paragraph 132, also does not apply to the following exposures: Short-term self-liquidating trade transactions. Import and export letters of credit and similar transactions should be accounted for at their actual remaining maturity. Issued as well as confirmed letters of credit that are: short term (i.e. have a maturity below one year) and self-liquidating. [Basel Framework, CRE 32.52] In addition to the transactions considered in paragraph 137, other short-term exposures with an original maturity of less than one year that are not part of an institution's ongoing financing of an obligor may be eligible for exemption from the one-year floor. The types of short-term exposures that are eligible for this treatment include transactions such as: Repo-style transactions, interbank loans and deposits and other economically equivalent products with a maturity of under one-year that might not fall within the scope of paragraph 137. Some short-term self-liquidating trade transactions that do not fall within the scope of paragraph 138. Import and export letters of credit and similar transactions could be accounted for at their actual remaining maturity; Some exposures arising from settling securities purchases and sales. This also includes overdrafts arising from failed securities settlements provided that such overdrafts do not continue more than a short, fixed number of business days; Some exposures arising from cash settlements by wire transfer, including overdrafts arising from failed transfers provided that such overdrafts do not continue more than a short, fixed number of business days; and Some exposures to banks arising from foreign exchange settlements; and Some short-term loans and deposits. [Basel Framework, CRE 32.53] For transactions falling within the scope of paragraph 137 subject to a master netting agreement, the effective maturity is defined as the weighted average maturity of the transactions. A floor equal to the minimum holding period for the transaction type set out in section 4.3.3 iii (d) will apply to the average. Where more than one transaction type is contained in the master netting agreement a floor equal to the highest holding period will apply to the average. Further, the notional amount of each transaction should be used for weighting maturity. [Basel Framework, CRE 32.54] Where there is no explicit adjustment, the effective maturity (M) assigned to all exposures is set at 2.5 years unless otherwise specified in paragraph 130. [Basel Framework, CRE 32.55] Treatment of maturity mismatches The treatment of maturity mismatches under IRB is identical to that in the standardized approach (see section 4.3.1 (iv)). [Basel Framework, CRE 32.56]

5.4.2 Risk Components for retail exposures

This section sets out the calculation of the risk components for retail exposures. In the case of an exposure that is guaranteed by a sovereign, the floors that apply to the risk components do not apply to that part of the exposure covered by the sovereign guarantee (i.e. any part of the exposure that is not covered by the guarantee is subject to the relevant floors). [Basel Framework, CRE 32.57] (i) Probability of default (PD) and loss given default (LGD) For each identified pool of retail exposures, institutions are expected to provide an estimate of the PD and LGD associated with the pool, subject to the minimum requirements as set out in section 5.8. Additionally, the PD for retail exposures is the greater of: the one-year PD associated with the internal borrower grade to which the pool of retail exposures is assigned; and 0.10% for revolver QRRE exposures (see paragraph 28 for the definition of revolvers) and 0.05% for all other exposures. The LGD for each exposure that is used as input into the risk weight formula and the calculation of expected loss must not be less than the parameter floors indicated in the table below: LGD Parameter Floors Retail classes LGD Unsecured Secured QRRE (incl. transactors and revolvers) 50% N/A Residential mortgages N/A 10% All other regulatory retail 30% Varying by collateral type: 0% financial 10% receivables 10% commercial or residential real estate 15% other physical [Basel Framework, CRE 32.58] Regarding the LGD parameter floors set out in the table above, the LGD floors for partially secured exposures in the “all other regulatory retail” category should be calculated according to the formula set out in paragraph 99. The LGD floor for residential mortgages is fixed at 10% irrespective of the level of collateral provided by the property. [Basel Framework, CRE 32.59] The 10% floor on LGD for residential mortgages does not apply to any portion of a residential mortgage that is guaranteed or otherwise insured by the Government of Canada. To reflect the effect of the Government of Canada backstop guarantee on a privately insured mortgage exposure, institutions may separate the full amount of the privately insured mortgage exposure into a deductible portion and a backstop portion: the deductible portion is calculated as 10% of the original loan amount (i.e. the deductible portion grows as a percentage of the full amount of the total exposure as the mortgage amortizes), and is to be risk weighted according to paragraph 147(1); the backstop portion is the amount covered by the government guarantee (i.e. the total outstanding amount less the deductible portion), and is to be treated as a sovereign exposure. For residential mortgages insured by a private mortgage insurer having a Government of Canada backstop guarantee, the loan should be risk weighted in one of the following three ways: A loan to the private mortgage insurer with a Government of Canada backstop. In this case, the deductible exposure defined in paragraph 146 is treated as a guaranteed exposure. It can be risk weighted using either i) the PD of the private mortgage insurer (using the risk weight function described in paragraphs 66 to 68) or ii) the PD of the original mortgage borrower (and the risk weight function for residential mortgages in paragraph 79). In both cases, a LGD of 100% must be used. The backstop exposure is treated as an exposure to the Government of Canada. An uninsured residential mortgage using the original borrower's PD and LGD. A loan to the private mortgage insurer (without a Government of Canada backstop) using either i) the PD of the original borrower and an LGD adjusted to incorporate the effect of the guarantee or ii) the PD of the private mortgage insurer and the LGD of the original borrower. In both cases, the resulting RWA cannot be less than that of a comparable direct exposure to the private mortgage insurer (which is the risk weight determined using the private mortgage insurer’s PD and the LGD used for an unsecured facility to the private mortgage insurer). Consistent with the standardized approach, institutions may choose not to recognize the mortgage insurance and/or Government of Canada backstop guarantee if doing so would result in a higher capital requirement. (ii) Recognition of guarantees and credit derivatives Institutions may reflect the risk-reducing effects of guarantees and credit derivatives, either in support of an individual obligation or a pool of exposures, through an adjustment of either the PD or LGD estimate, subject to the minimum requirements in paragraphs 300 to 315. Whether adjustments are done through PD or LGD, they must be done in a consistent manner for a given guarantee or credit derivative type. In case the institution applies the standardized approach to direct exposures to the guarantor it may only recognize the guarantee by applying the standardized approach risk weight to the covered portion of the exposure. [Basel Framework, CRE 32.60] Consistent with the requirements outlined above for corporate, sovereign, PSE, and bank exposures, institutions must not include the effect of double default in such adjustments. The adjusted risk weight must not be less than that of a comparable direct exposure to the protection provider. Consistent with the standardized approach, institutions may choose not to recognize credit protection if doing so would result in a higher capital requirement. [Basel Framework, CRE 32.61] (iii) Exposure at default (EAD) Both on and off-balance sheet retail exposures are measured gross of specific allowances.^{Footnote 20} The EAD on drawn amounts should not be less than the sum of (i) the amount by which an institution's regulatory capital would be reduced if the exposure were written-off fully, and (ii) any specific allowances. When the difference between the instrument's EAD and the sum of (i) and (ii) is positive, this amount is termed a discount. The calculation of risk-weighted assets is independent of any discounts. Under the limited circumstances described in paragraph 186, discounts may be included in the measurement of total eligible allowances for purposes of the EL-provision calculation set out in section 5.7. [Basel Framework, CRE 32.62] On-balance sheet netting of loans and deposits of an institution to or from a retail customer will be permitted subject to the same conditions outlined in section 4.3.4. Institutions must use their own estimates of CCFs for undrawn revolving commitments not subject to a CCF of 100% in the standardized approach (see section 4.1.18) and the minimum requirements in paragraphs 289 to 297 and 299 are satisfied. Foundation approach CCFs must be used for all other off-balance sheet items (for example, for all undrawn non-revolving commitments), and must be used where the minimum requirements for own estimates of EAD are not met. [Basel Framework, CRE 32.63] Regarding own estimates of EAD, the EAD for each exposure that is used as input into the risk weight formula and the calculation of expected loss is subject to a floor that is the sum of: the on balance sheet amount; and 50% of the off balance sheet exposure using the applicable CCF in the standardized approach. [Basel Framework, CRE 32.64] For retail exposures with uncertain future drawdown such as credit cards, institutions must take into account their history and/or expectation of additional drawings prior to default in their overall calibration of loss estimates. In particular, where an institution does not reflect conversion factors for undrawn lines in its EAD estimates, it must reflect in its LGD estimates the likelihood of additional drawings prior to default. Conversely, if the institution does not incorporate the possibility of additional drawings in its LGD estimates, it must do so in its EAD estimates. [Basel Framework, CRE 32.65] When only the drawn balances of revolving retail facilities have been securitized, institutions must ensure that they continue to hold required capital against the undrawn balances associated with the securitized exposures using the IRB approach to credit risk for commitments. This means that for such facilities, institutions must reflect the impact of CCFs in their EAD estimates rather than in the LGD estimates. [Basel Framework, CRE 32.66] To the extent that foreign exchange and interest rate commitments exist within an institution's retail portfolio for IRB purposes, institutions are not permitted to provide their internal assessments of credit equivalent amounts. Instead, the rules for the standardized approach continue to apply. [Basel Framework, CRE 32.67]

5.5. Supervisory slotting approach for specialized lending

This section sets out the calculation of risk-weighted assets and expected losses for specialized lending (SL) exposures subject to the supervisory slotting approach. The method for determining the difference between expected losses and provisions is set out in section 5.7. [Basel Framework, CRE 33.1]

5.5.1 Risk weights for specialized lending (PF, OF, CF and IPRE)

For project finance (PF), object finance (OF), commodities finance (CF) and income producing real estate (IPRE) exposures, institutions that do not meet the requirements for the estimation of PD under the corporate IRB approach will be required to map their internal grades to five supervisory categories, each of which is associated with a specific risk weight. The slotting criteria on which this mapping must be based are provided in Appendix 5-2. The risk weights for unexpected losses (UL) associated with each supervisory category are: Supervisory categories and unexpected loss (UL) risk weights for other SL exposures Strong Good Satisfactory Weak Default 70% 90% 115% 250% 0% [Basel Framework, CRE 33.2] Although institutions are expected to map their internal ratings to the supervisory categories for specialized lending using the slotting criteria provided in Appendix 5-2, each supervisory category broadly corresponds to a range of external credit assessments as outlined below. Broad Mapping between Supervisory Categories and External Ratings Strong Good Satisfactory Weak Default BBB- or better BB+ or BB BB- or B+ B to C- Not applicable [Basel Framework, CRE 33.3] OSFI may allow institutions to assign preferential risk weights of 50% to "strong" exposures, and 70% to "good" exposures, provided they have a remaining maturity of less than 2.5 years or OSFI determines that institutions' underwriting and other risk characteristics are substantially stronger than specified in the slotting criteria for the relevant supervisory risk category. [Basel Framework, CRE 33.4]

5.5.2 Risk weights for specialized lending (HVCRE)

The HVCRE risk weights in paragraphs 162 and 76 apply to Canadian institution foreign operations' loans on properties in jurisdictions where the national supervisor has designated specific property types as HVCRE and to Canadian properties where the source of repayment at origination of the exposure is substantially uncertain, and the borrower does not have substantial equity at risk. For HVCRE exposures, institutions that do not meet the requirements for estimation of PD, must map their internal grades to five supervisory categories, each of which is associated with a specific risk weight. The slotting criteria on which this mapping must be based are the same as those for IPRE, as provided in Appendix 5-2. The risk weights associated with each category are: Supervisory categories and UL risk weights for high-volatility commercial real estate Strong Good Satisfactory Weak Default 95% 120% 140% 250% 0% [Basel Framework, CRE 33.5] As indicated in paragraph 159, each supervisory category broadly corresponds to a range of external credit assessments. [Basel Framework, CRE 33.6] Following the direction of the host supervisor, institutions may assign preferential risk weights of 70% to "strong" exposures, and 95% to "good" exposures, provided they have a remaining maturity of less than 2.5 years or the supervisor determines that institutions' underwriting and other risk characteristics are substantially stronger than specified in the slotting criteria for the relevant supervisory risk category. [Basel Framework, CRE 33.7]

5.5.3 Expected loss (EL) for SL exposures subject to the supervisory slotting criteria

For SL exposures subject to the supervisory slotting criteria, the EL amount is determined by multiplying 8% by the risk-weighted assets produced from the appropriate risk weights, as specified below, multiplied by EAD. [Basel Framework, CRE 33.8] The risk weights for SL, other than HVCRE, are as follows: Strong Good Satisfactory Weak Default 5% 10% 35% 100% 625% [Basel Framework, CRE 33.9] Where, at national discretion, a host supervisor allows institutions to assign preferential risk weights to other SL exposures falling into the "strong" and "good" supervisory categories as outlined in paragraph 160, the corresponding EL risk weight is 0% for "strong" exposures, and 5% for "good" exposures. [Basel Framework, CRE 33.10] The risk weights for HVCRE are as follows: Strong Good Satisfactory Weak Default 5% 5% 35% 100% 625% [Basel Framework, CRE 33.11] Even where, at national discretion, supervisors allow institutions to assign preferential risk weights to HVCRE exposures falling into the "strong" and "good" supervisory categories as outlined in paragraph 164, the corresponding EL risk weight will remain at 5% for both "strong" and "good" exposures. [Basel Framework, CRE 33.12]

5.6. Rules for Purchased Receivables

Section 5.6 presents the method of calculating the UL capital requirements for purchased receivables. For such assets, there are IRB capital charges for both default risk and dilution risk. Section 5.6.1 discusses the calculation of risk-weighted assets for default risk. The calculation of risk-weighted assets for dilution risk is provided in section 5.6.2. The method of calculating expected losses, and for determining the difference between that measure and provisions, is described in section 5.7. [Basel Framework, CRE 34.1]

5.6.1 Risk-weighted assets for default risk

For receivables belonging unambiguously to one asset class, the IRB risk weight for default risk is based on the risk-weight function applicable to that particular exposure type, as long as the institution can meet the qualification standards for this particular risk-weight function. For example, if institutions cannot comply with the standards for qualifying revolving retail exposures (defined in paragraph 27), they should use the risk-weight function for all other regulatory retail exposures. For hybrid pools containing mixtures of exposure types, if the purchasing institution cannot separate the exposures by type, the risk-weight function producing the highest capital requirements for the exposure types in the receivable pool applies. [Basel Framework, CRE 34.2] (i) Purchased retail receivable For purchased retail receivables, an institution must meet the risk quantification standards for retail exposures but can utilize external and internal reference data to estimate the PDs and LGDs. The estimates for PD and LGD (or EL) must be calculated for the receivables on a stand-alone basis; that is, without regard to any assumption of recourse or guarantees from the seller or other parties. [Basel Framework, CRE 34.3] (ii) Purchased corporate receivables For purchased corporate receivables the purchasing institution is expected to apply the existing IRB risk quantification standards for the bottom-up approach. However, for eligible purchased corporate receivables, and subject to OSFI permission, an institution may employ the following top-down procedure for calculating IRB risk weights for default risk: The purchasing institution will estimate the pool's one-year EL for default risk, expressed in percentage of the exposure amount (i.e. the total EAD amount to the institution by all obligors in the receivables pool). The estimated EL must be calculated for the receivables on a stand-alone basis; that is, without regard to any assumption of recourse or guarantees from the seller or other parties. The treatment of recourse or guarantees covering default risk (and/or dilution risk) is discussed separately below. Given the EL estimate for the pool's default losses, the risk weight for default risk is determined by the risk-weight function for corporate exposures.^{Footnote 21} As described below, the precise calculation of risk weights for default risk depends on the institution's ability to decompose EL into its PD and LGD components in a reliable manner. Institutions can utilize external and internal data to estimate PDs and LGDs. However, the advanced approach will not be available for institutions that use the foundation approach for corporate exposures (this excludes large corporate exposures, which are ineligible under the advanced IRB approach). [Basel Framework, CRE 34.4] Foundation IRB treatment The risk weight under the foundation IRB treatment is determined as follows: If the purchasing institution is unable to decompose EL into its PD and LGD components in a reliable manner, the risk weight is determined from the corporate risk-weight function using the following specifications: If the institution can demonstrate that the exposures are exclusively senior claims to corporate borrowers: An LGD of 40% can be used. PD will be calculated by dividing the EL using this LGD. EAD will be calculated as the outstanding amount minus the capital charge for dilution prior to credit risk mitigation (KDilution). EAD for a revolving purchase facility is the sum of the current amount of receivables purchased plus 40% of any undrawn purchase commitments minus KDilution. If the institution cannot demonstrate that the exposures are exclusively senior claims to corporate borrowers: PD is the institution's estimate of EL LGD will be 100%. EAD will be calculated as the outstanding amount minus KDilution. EAD for a revolving purchase facility is the sum of the current amount of receivables purchased plus 40% of any undrawn purchase commitments minus KDilution. If the purchasing institution is able to estimate PD in a reliable manner, the risk weight is determined from the corporate risk-weight functions according to the specifications for LGD, M and the treatment of guarantees under the foundation approach as given in paragraphs 87 to 96, 102 to 108, and 130. [Basel Framework, CRE 34.5] Advanced IRB treatment Under the AIRB approach, if the purchasing institution can estimate either the pool's default-weighted average loss rates given default (as defined in paragraph 281) or average PD in a reliable manner, the institution may estimate the other parameter based on an estimate of the expected long-run loss rate. The institution may (i) use an appropriate PD estimate to infer the long-run default-weighted average loss rate given default, or (ii) use a long-run default-weighted average loss rate given default to infer the appropriate PD. In either case, the LGD used for the IRB capital calculation for purchased receivables cannot be less than the long-run default-weighted average loss rate given default and must be consistent with the concepts defined in paragraph 281. The risk weight for the purchased receivables will be determined using the institution's estimated PD and LGD as inputs to the corporate risk-weight function. Similar to the foundation IRB treatment, EAD will be the amount outstanding minus KDilution. EAD for a revolving purchase facility will be the sum of the current amount of receivables purchased plus 40% of any undrawn purchase commitments minus KDilution (thus, institutions using the AIRB approach will not be permitted to use their internal EAD estimates for undrawn purchase commitments). [Basel Framework, CRE 34.6] For drawn amounts, M will equal the pool's exposure-weighted average effective maturity (as defined in paragraphs 132 to 141). This same value of M will also be used for undrawn amounts under a committed purchase facility provided the facility contains effective covenants, early amortization triggers, or other features that protect the purchasing institution against a significant deterioration in the quality of the future receivables it is required to purchase over the facility's term. Absent such effective protections, the M for undrawn amounts will be calculated as the sum of (a) the longest-dated potential receivable under the purchase agreement and (b) the remaining maturity of the purchase facility. [Basel Framework, CRE 34.7]

5.6.2 Risk-weighted assets for dilution risk

Dilution refers to the possibility that the receivable amount is reduced through cash or non-cash credits to the receivable's obligor.^{Footnote 22} For both corporate and retail receivables, unless the institution can demonstrate to OSFI that the dilution risk for them is immaterial, the treatment of dilution risk must be the following: At the level of either the pool as a whole (top-down approach) or the individual receivables making up the pool (bottom-up approach), the purchasing institution will estimate the one-year EL for dilution risk, also expressed in percentage of the receivables amount. Institutions can utilize external and internal data to estimate EL. As with the treatments of default risk, this estimate must be computed on a stand-alone basis; that is, under the assumption of no recourse or other support from the seller or third-party guarantors. For the purpose of calculating risk weights for dilution risk, the corporate risk-weight function must be used with the following settings: The PD must be set equal to the estimated EL. The LGD must be set at 100%. An appropriate maturity treatment applies when determining the capital requirement for dilution risk. If an institution can demonstrate that the dilution risk is appropriately monitored and managed to be resolved within one year, the supervisor may allow the institution to apply a one-year maturity. [Basel Framework, CRE 34.8] This treatment will be applied regardless of whether the underlying receivables are corporate or retail exposures, and regardless of whether the risk weights for default risk are computed using the standard IRB treatments or, for corporate receivables, the top-down treatment described above. [Basel Framework, CRE 34.9]

5.6.3 Treatment of purchase price discounts for receivables

In many cases, the purchase price of receivables will reflect a discount (not to be confused with the discount concept defined in paragraphs 151 and 114) that provides first loss protection for default losses, dilution losses or both. To the extent a portion of such a purchase price discount will be refunded to the seller based on the performance of the receivables, the purchaser may recognize this refundable amount as first loss protection under the securitization framework outlined in Chapter 6, while the seller providing such a refundable purchase price discount must treat the refundable amount as a first loss position under Chapter 6. Non-refundable purchase price discounts for receivables do not affect either the EL-provision calculation in section 5.7 or the calculation of risk-weighted assets. [Basel Framework, CRE 34.10] When collateral or partial guarantees obtained on receivables provide first loss protection (collectively referred to as mitigants in this paragraph), and these mitigants cover default losses, dilution losses, or both, they may also be treated as first loss protection under the IRB securitization framework (see paragraph 93 of Chapter 6). When the same mitigant covers both default and dilution risk, institutions using the Securitization Internal Ratings-Based Approach (SEC-IRBA) that are able to calculate an exposure-weighted LGD must do so as defined in paragraph 102 of Chapter 6. [Basel Framework, CRE 34.11]

5.6.4 Recognition of credit risk mitigants

Credit risk mitigants will be recognized generally using the same type of framework as set forth in paragraphs 103 to 113. In particular, a guarantee provided by the seller or a third party will be treated using the existing IRB rules for guarantees, regardless of whether the guarantee covers default risk, dilution risk, or both. If the guarantee covers both the pool's default risk and dilution risk, the institution will substitute the risk weight for an exposure to the guarantor in place of the pool's total risk weight for default and dilution risk. If the guarantee covers only default risk or dilution risk, but not both, the institution will substitute the risk weight for an exposure to the guarantor in place of the pool's risk weight for the corresponding risk component (default or dilution). The capital requirement for the other component will then be added. If a guarantee covers only a portion of the default and/or dilution risk, the uncovered portion of the default and/or dilution risk will be treated as per the existing CRM rules for proportional or tranched coverage (i.e. the risk weights of the uncovered risk components will be added to the risk weights of the covered risk components). [Basel Framework, CRE 34.12]

5.7. Treatment of expected losses and recognition of allowances

Section 5.7. discusses the calculation of expected losses (EL) under the IRB approach, and the method by which the difference between allowances (e.g. specific allowances or general allowances^{Footnote 23}) and EL may be included in or must be deducted from regulatory capital, as outlined in section 2.1.3.7. [Basel Framework, CRE 35.1]

5.7.1 Calculation of expected losses

An institution must sum the EL amount (defined as EL multiplied by EAD) associated with its exposures to which the IRB approach is applied (excluding the EL associated with securitization exposures) to obtain a total EL amount. The treatment of EL for securitization exposures is described in paragraph 42 of Chapter 6. [Basel Framework, CRE 35.2] (i) Expected loss for exposures other than SL subject to the supervisory slotting criteria Institutions must calculate an EL as PD x LGD for corporate, sovereign, PSE, bank, and retail exposures not in default. For corporate, sovereign, PSE, bank, and retail exposures that are in default, institutions must use their best estimate of expected loss as defined in paragraph 284 for exposures subject to the advanced approach and for exposures subject to the foundation approach institutions must use the supervisory LGD. For SL exposures subject to the supervisory slotting criteria EL is calculated as described in paragraphs 165 to 168. Securitization exposures do not contribute to the EL amount, as set out in paragraph 42 of Chapter 6. [Basel Framework, CRE 35.3] (ii) Expected loss for SL exposures subject to the supervisory slotting criteria The calculation of EL for SL exposures subject to the supervisory slotting criteria is outlined section 5.5.3.

5.7.2 Calculation of provisions

(i) Exposures subject to IRB approach Total eligible allowances are defined as the sum of all allowances (e.g. specific allowances or general allowances) that are attributed to exposures treated under the IRB approach. In addition, total eligible allowances may include any discounts on defaulted assets that are treated under the IRB approach. Specific allowances set aside against securitization exposures must not be included in total eligible allowances. [Basel Framework, CRE 35.4] (ii) Portion of exposures subject to the standardized approach Institutions using the standardized approach for a portion of their credit risk exposures, (see section 5.2.3), must determine the portion of general allowances attributed to the standardized or IRB treatment of allowances (see section 2.1.3.7) according to the method outlined in paragraphs 188 and 189. [Basel Framework, CRE 35.5] When one approach to determining credit risk-weighted assets (i.e. standardized or IRB approach) is used exclusively within an entity, general allowances booked within the entity using the standardized approach should be attributed to the standardized treatment. Similarly, general allowances booked within entities exclusively using the IRB approach should be attributed to the total eligible allowances as defined in paragraph 186. [Basel Framework, CRE 35.6] In other cases, institutions should rely on their internal methods for allocating general allowances for recognition in capital under either the standardized or IRB approach, which must align with the institution’s public and internal reporting. [Basel Framework, CRE 35.7]

5.7.3 Treatment of EL and provisions

As specified in section 2.1.3.7, institutions using the IRB approach must compare the total amount of total eligible allowances (as defined in paragraph 186) with the total EL amount as calculated within the IRB approach (as defined in paragraph 183). In addition, section 2.1.3.7 outlines the treatment for that portion of an institution that is subject to the standardized approach to credit risk when the institution uses both the standardized and IRB approaches. [Basel Framework, CRE 35.8] If specific allowances exceed the EL amount on defaulted assets, the difference cannot be used to offset the EL amount on non-defaulted assets nor recognized in capital. OSFI will not require any additional processes to operationalize paragraph 191 over and above what is already being done for the assessment of specific and general allowances, credit reviews, and the self-assessment process. [Basel Framework, CRE 35.9]

5.8. Minimum requirements for IRB approach

This section presents the minimum requirements for entry and ongoing use of the IRB approach. The minimum requirements are set out in the following 11 sections Composition of minimum requirements Compliance with minimum requirements Rating system design Risk rating system operations Corporate governance and oversight Use of internal ratings Risk quantification Validation of internal estimates Supervisory LGD and EAD estimates Requirements for recognition of leasing, and Disclosure requirements [Basel Framework, CRE 36.1] The minimum requirements in the sections that follow cut across asset classes. Therefore, more than one asset class may be discussed within the context of a given minimum requirement. [Basel Framework, CRE 36.2]

5.8.1 Composition of minimum requirements

To be eligible for the IRB approach an institution must demonstrate to OSFI that it meets certain minimum requirements at the outset and on an ongoing basis. Many of these requirements are in the form of objectives that a qualifying institution's risk rating systems must fulfil. The focus is on institutions' abilities to rank order and quantify risk in a consistent, reliable and valid fashion. [Basel Framework, CRE 36.3] The overarching principle behind these requirements is that rating and risk estimation systems and processes provide for a meaningful assessment of borrower and transaction characteristics; a meaningful differentiation of risk; and reasonably accurate and consistent quantitative estimates of risk. Furthermore, the systems and processes must be consistent with internal use of these estimates. [Basel Framework, CRE 36.4] The minimum requirements set out in this chapter apply to all asset classes unless noted otherwise. The standards related to the process of assigning exposures to borrower or facility grades (and the related oversight, validation, etc.) apply equally to the process of assigning retail exposures to pools of homogenous exposures, unless noted otherwise. [Basel Framework, CRE 36.5] The minimum requirements set out in this chapter apply to both foundation and advanced approaches unless noted otherwise. Generally, all IRB institutions must produce their own estimates of PD^{Footnote 24} and must adhere to the overall requirements for rating system design, operations, controls, and corporate governance, as well as the requisite requirements for estimation and validation of PD measures. Institutions wishing to use their own estimates of LGD and EAD must also meet the incremental minimum requirements for these risk factors included in paragraphs 281 to 315. [Basel Framework, CRE 36.6]

5.8.2 Compliance with minimum requirements

To be eligible for an IRB approach, an institution must demonstrate to OSFI that it meets the IRB requirements in this chapter, at the outset and on an ongoing basis. Institutions' overall credit risk management practices must also be consistent with the evolving sound practices guidance issued by OSFI. [Basel Framework, CRE 36.7] There may be circumstances when an institution is not in complete compliance with all the minimum requirements. Where this is the case, the institution must produce a plan for a timely return to compliance, and seek approval from OSFI, or the institution must demonstrate that the effect of such non-compliance is immaterial in terms of the risk posed to the institution. Failure to produce an acceptable plan or satisfactorily implement the plan or to demonstrate immateriality will lead OSFI to reconsider the institution's eligibility for the IRB approach. Furthermore, for the duration of any non-compliance, OSFI will consider the need for the institution to hold additional capital under Pillar 2 or will take other appropriate supervisory action. [Basel Framework, CRE 36.8]

5.8.3 Rating system design

The term "rating system" comprises all of the methods, processes, controls, and data collection and IT systems that support the assessment of credit risk, the assignment of internal risk ratings, and the quantification of default and loss estimates. [Basel Framework, CRE 36.9] Within each asset class, an institution may utilize multiple rating methodologies/systems. For example, an institution may have customized rating systems for specific industries or market segments (e.g. middle market and large corporate). If an institution chooses to use multiple systems, the rationale for assigning a borrower to a rating system must be documented and applied in a manner that best reflects the level of risk of the borrower. Institutions must not allocate borrowers across rating systems inappropriately to minimize regulatory capital requirements (i.e. cherry-picking by choice of rating system). Institutions must demonstrate that each system used for IRB purposes is in compliance with the minimum requirements at the outset and on an ongoing basis. [Basel Framework, CRE 36.10] (i) Rating dimensions Standards for corporate, sovereign, PSE, and bank exposures A qualifying IRB rating system must have two separate and distinct dimensions: (i) the risk of borrower default, and (ii) transaction-specific factors. [Basel Framework, CRE 36.11] The first dimension must be oriented to the risk of borrower default. Separate exposures to the same borrower must be assigned to the same borrower grade, irrespective of any differences in the nature of each specific transaction. There are two exceptions to this. Firstly, in the case of country transfer risk, where an institution may assign different borrower grades depending on whether the facility is denominated in local or foreign currency. Secondly, when the treatment of associated guarantees to a facility may be reflected in an adjusted borrower grade. In either case, separate exposures may result in multiple grades for the same borrower. An institution must articulate in its credit policy the relationship between borrower grades in terms of the level of risk each grade implies. Perceived and measured risk must increase as credit quality declines from one grade to the next. The policy must articulate the risk of each grade in terms of both a description of the probability of default risk typical for borrowers assigned the grade and the criteria used to distinguish that level of credit risk. [Basel Framework, CRE 36.12] The second dimension must reflect transaction-specific factors, such as collateral, seniority, product type, etc. For exposures subject to the foundation IRB approach, this requirement can be fulfilled by the existence of a facility dimension, which reflects both borrower and transaction-specific factors. For example, a rating dimension that reflects EL by incorporating both borrower strength (PD) and loss severity (LGD) considerations would qualify. Likewise a rating system that exclusively reflects LGD would qualify. Where a rating dimension reflects EL and does not separately quantify LGD, the supervisory estimates of LGD must be used. [Basel Framework, CRE 36.13] For institutions using the advanced approach, facility ratings must reflect exclusively LGD. These ratings can reflect any and all factors that can influence LGD including, but not limited to, the type of collateral, product, industry, and purpose. Borrower characteristics may be included as LGD rating criteria only to the extent they are predictive of LGD. Institutions may alter the factors that influence facility grades across segments of the portfolio as long as they can satisfy OSFI that it improves the relevance and precision of their estimates. [Basel Framework, CRE 36.14] Institutions using the supervisory slotting criteria for the SL sub-class are exempt from this two-dimensional requirement for these exposures. Given the interdependence between borrower/transaction characteristics in exposures subject to the supervisory slotting approaches, institutions may satisfy the requirements under this heading through a single rating dimension that reflects EL by incorporating both borrower strength (PD) and loss severity (LGD) considerations. This exemption does not apply to institutions using either the general corporate foundation or advanced approach for the SL sub-class. [Basel Framework, CRE 36.15] Standards for retail exposures Rating systems for retail exposures must be oriented to both borrower and transaction risk, and must capture all relevant borrower and transaction characteristics. Institutions must assign each exposure that falls within the definition of retail for IRB purposes into a particular pool. Institutions must demonstrate that this process provides for a meaningful differentiation of risk, provides for a grouping of sufficiently homogenous exposures, and allows for accurate and consistent estimation of loss characteristics at a pool level. [Basel Framework, CRE 36.16] For each pool, institutions must estimate PD, LGD, and EAD. Multiple pools may share identical PD, LGD and EAD estimates. At a minimum, institutions should consider the following risk drivers when assigning exposures to a pool: Borrower risk characteristics (e.g. borrower type, demographics such as age/occupation); Transaction risk characteristics, including product and/or collateral types (e.g. loan to value measures, seasoning,^{Footnote 25} guarantees; and seniority (e.g. first vs. second lien)). Institutions must explicitly address cross‑collateral provisions where present. Delinquency of exposure: Institutions are expected to separately identify exposures that are delinquent and those that are not. [Basel Framework, CRE 36.17] (ii) Rating structure Standards for corporate, sovereign, PSE, and bank exposures An institution must have a meaningful distribution of exposures across grades with no excessive concentrations, on both its borrower-rating and its facility-rating scales. [Basel Framework, CRE 36.18] To meet this objective, an institution must have a minimum of seven borrower grades for non-defaulted borrowers and one for those that have defaulted. Institutions with lending activities focused on a particular market segment may satisfy this requirement with the minimum number of grades. [Basel Framework, CRE 36.19] A borrower grade is defined as an assessment of borrower risk on the basis of a specified and distinct set of rating criteria, from which estimates of PD are derived. The grade definition must include both a description of the degree of default risk typical for borrowers assigned the grade and the criteria used to distinguish that level of credit risk. Furthermore, "+" or "-" modifiers to alpha or numeric grades will only qualify as distinct grades if the institution has developed complete rating descriptions and criteria for their assignment, and separately quantifies PDs for these modified grades. [Basel Framework, CRE 36.20] Institutions with loan portfolios concentrated in a particular market segment and range of default risk must have enough grades within that range to avoid undue concentrations of borrowers in particular grades. Significant concentrations within a single grade or grades must be supported by convincing empirical evidence that the grade or grades cover reasonably narrow PD bands and that the default risk posed by all borrowers in a grade fall within that band. [Basel Framework, CRE 36.21] There is no specific minimum number of facility grades for institutions using the advanced approach for estimating LGD. An institution must have a sufficient number of facility grades to avoid grouping facilities with widely varying LGDs into a single grade. The criteria used to define facility grades must be grounded in empirical evidence. [Basel Framework, CRE 36.22] Institutions using the supervisory slotting criteria for the SL asset classes must have at least four grades for non-defaulted borrowers, and one for defaulted borrowers. The requirements for SL exposures that qualify for the corporate foundation and advanced approaches are the same as those for general corporate exposures. [Basel Framework, CRE 36.23] Standards for retail exposures For each pool identified, the institution must be able to provide quantitative measures of loss characteristics (PD, LGD, and EAD) for that pool. The level of differentiation for IRB purposes must ensure that the number of exposures in a given pool is sufficient so as to allow for meaningful quantification and validation of the loss characteristics at the pool level. There must be a meaningful distribution of borrowers and exposures across pools. A single pool must not include an undue concentration of the institution's total retail exposure. [Basel Framework, CRE 36.24] (iii) Rating criteria An institution must have specific rating definitions, processes and criteria for assigning exposures to grades within a rating system. The rating definitions and criteria must be both plausible and intuitive and must result in a meaningful differentiation of risk. The grade descriptions and criteria must be sufficiently detailed to allow those charged with assigning ratings to consistently assign the same grade to borrowers or facilities posing similar risk. This consistency should exist across lines of business, departments and geographic locations. If rating criteria and procedures differ for different types of borrowers or facilities, the institution must monitor for possible inconsistency, and must alter rating criteria to improve consistency when appropriate. Written rating definitions must be clear and detailed enough to allow third parties, such as internal audit or an equally independent function and OSFI, to understand the assignment of ratings, to replicate rating assignments and evaluate the appropriateness of the grade/pool assignments. The criteria must also be consistent with the institution's internal lending standards and its policies for handling troubled borrowers and facilities. [Basel Framework, CRE 36.25] To ensure that institutions are consistently taking into account available information, they must use all relevant and material information in assigning ratings to borrowers and facilities. Information must be current. The less information an institution has, the more conservative must be its assignments of exposures to borrower and facility grades or pools. An external rating can be the primary factor determining an internal rating assignment; however, the institution must ensure that it considers other relevant information. [Basel Framework, CRE 36.26] Exposure subject to the supervisory slotting approach Institutions using the supervisory slotting criteria for SL exposures must assign exposures to their internal rating grades based on their own criteria, systems and processes, subject to compliance with the requisite minimum requirements. Institutions must then map these internal rating grades into the five supervisory rating categories. Tables 1 to 4 in Annex 5-2 provide, for each sub-class of SL exposures, the general assessment factors and characteristics exhibited by the exposures that fall under each of the supervisory categories. Each lending activity has a unique table describing the assessment factors and characteristics. [Basel Framework, CRE 36.27] OSFI recognizes that the criteria that institutions use to assign exposures to internal grades will not perfectly align with criteria that define the supervisory categories; however, institutions must demonstrate that their mapping process has resulted in an alignment of grades which is consistent with the preponderance of the characteristics in the respective supervisory category. Institutions should take special care to ensure that any overrides of their internal criteria do not render the mapping process ineffective. [Basel Framework, CRE 36.28] (iv) Rating assignment horizon Although the time horizon used in PD estimation is one year (as described in paragraph 260), institutions are expected to use a longer time horizon in assigning ratings. [Basel Framework, CRE 36.29] A borrower rating must represent the institution's assessment of the borrower's ability and willingness to contractually perform despite adverse economic conditions or the occurrence of unexpected events. The range of economic conditions that are considered when making assessments must be consistent with current conditions and those that are likely to occur over a business cycle within the respective industry/geographic region. Rating systems should be designed in such a way that idiosyncratic or industry-specific changes are a driver of migrations from one category to another, and business cycle effects may also be a driver. [Basel Framework, CRE 36.30] PD estimates for borrowers that are highly leveraged or for borrowers whose assets are predominantly traded assets must reflect the performance of the underlying assets based on periods of stressed volatilities. For highly leveraged counterparties where there is likely a significant vulnerability to market risk, the bank must assess the potential impact on the counterparty's ability to perform that arises from periods of stressed volatilities when assigning a rating and corresponding PD to that counterparty under the IRB framework. The reference to highly levered borrowers is intended to capture hedge funds or any other equivalently highly leveraged counterparties that are financial entities. [Basel Framework, CRE 36.31] Given the difficulties in forecasting future events and the influence they will have on a particular borrower's financial condition, an institution must take a conservative view of projected information. Furthermore, where limited data are available, an institution must adopt a conservative bias to its analysis. [Basel Framework, CRE 36.32] (v) Use of models The requirements in this section apply to statistical models and other mechanical methods used to assign borrower or facility ratings or in the estimation of PDs, LGDs, or EADs. Credit scoring models and other mechanical rating procedures generally use only a subset of available information. Although mechanical rating procedures may sometimes avoid some of the idiosyncratic errors made by rating systems in which human judgement plays a large role, mechanical use of limited information is also a source of rating errors. Credit scoring models and other mechanical procedures are permissible as the primary or partial basis of rating assignments, and may play a role in the estimation of loss characteristics. Sufficient human judgement and human oversight is necessary to ensure that all relevant and material information, including that which is outside the scope of the model, is also taken into consideration, and that the model is used appropriately. [Basel Framework, CRE 36.33] The burden is on the institution to satisfy OSFI that a model or procedure has good predictive power and that regulatory capital requirements will not be distorted as a result of its use. The variables that are input to the model must form a reasonable set of predictors. The model must be accurate on average across the range of borrowers or facilities to which the institution is exposed and there must be no known material biases. [Basel Framework, CRE 36.33] The institution must have in place a process for vetting data inputs into a statistical default or loss prediction model which includes an assessment of the accuracy, completeness and appropriateness of the data specific to the assignment of an approved rating. [Basel Framework, CRE 36.33] The institution must demonstrate that the data used to build the model are representative of the population of the institution's actual borrowers or facilities. [Basel Framework, CRE 36.33] When combining model results with human judgement, the judgement must take into account all relevant and material information not considered by the model. The institution must have written guidance describing how human judgement and model results are to be combined. [Basel Framework, CRE 36.33] The institution must have procedures for human review of model-based rating assignments. Such procedures should focus on finding and limiting errors associated with known model weaknesses and must also include credible ongoing efforts to improve the model's performance. [Basel Framework, CRE 36.33] The institution must have a regular cycle of model validation that includes monitoring of model performance and stability; review of model relationships; and testing of model outputs against outcomes. [Basel Framework, CRE 36.33] (vi) Documentation of rating system design Institutions must document in writing their rating systems' design and operational details. The documentation must evidence institutions' compliance with the minimum standards, and must address topics such as portfolio differentiation, rating criteria, responsibilities of parties that rate borrowers and facilities, definition of what constitutes a rating exception, parties that have authority to approve exceptions, frequency of rating reviews, and management oversight of the rating process. An institution must document the rationale for its choice of internal rating criteria and must be able to provide analyses demonstrating that rating criteria and procedures are likely to result in ratings that meaningfully differentiate risk. Rating criteria and procedures must be periodically reviewed to determine whether they remain fully applicable to the current portfolio and to external conditions. In addition, an institution must document a history of major changes in the risk rating process, and such documentation must support identification of changes made to the risk rating process subsequent to the last supervisory review. The organization of rating assignment, including the internal control structure, must also be documented. [Basel Framework, CRE 36.34] Institutions must document the specific definitions of default and loss used internally and demonstrate consistency with the reference definitions set out in paragraphs 265 to 273. [Basel Framework, CRE 36.35] If the institution employs statistical models in the rating process, the institution must document their methodologies. This material must: Provide a detailed outline of the theory, assumptions and/or mathematical and empirical basis of the assignment of estimates to grades, individual obligors, exposures, or pools, and the data source(s) used to calibrate the model; Establish a rigorous statistical process (including out-of-time and out-of-sample performance tests) for validating the model; and Indicate any circumstances under which the model does not work effectively. [Basel Framework, CRE 36.36] Use of a model obtained from a third-party vendor that claims proprietary technology is not a justification for an exemption from documentation or any other of the requirements for internal rating systems. The burden is on the model's vendor and the institution to satisfy OSFI. [Basel Framework, CRE 36.37]

5.8.4 Risk rating system operations

(i) Coverage of ratings For corporate, sovereign, PSE, and bank exposures, each borrower and all recognized guarantors must be assigned a rating and each exposure must be associated with a facility rating as part of the loan approval process. Similarly, for retail exposures, each borrower must be assigned to a pool as part of the loan approval process. [Basel Framework, CRE 36.38] Each separate legal entity to which the institution is exposed must be separately rated. An institution must have policies acceptable to OSFI regarding the treatment of individual entities in a connected group including circumstances under which the same rating may or may not be assigned to some or all related entities. Those policies must include a process for the identification of specific wrong way risk for each legal entity to which the institution is exposed. Transactions with counterparties where specific wrong way risk has been identified need to be treated differently when calculating the EAD for such exposures (see section 7.1.5.6 of Chapter 7). [Basel Framework, CRE 36.39] (ii) Integrity of rating process Standards for corporate, sovereign, PSE, and bank exposures Rating assignments and periodic rating reviews must be completed or approved by a party that does not directly stand to benefit from the extension of credit. Independence of the rating assignment process can be achieved through a range of practices that will be carefully reviewed by OSFI. These operational processes must be documented in the institution's procedures and incorporated into the institution's policies. Credit policies and underwriting procedures must reinforce and foster the independence of the rating process. [Basel Framework, CRE 36.40] Borrowers and facilities must have their ratings refreshed at least on an annual basis. Certain credits, especially higher risk borrowers or problem exposures, must be subject to more frequent review. In addition, institutions must initiate a new rating if material information on the borrower or facility comes to light. [Basel Framework, CRE 36.41] The institution must have an effective process to obtain and update relevant and material information on the borrower's financial condition, and on facility characteristics that affect LGDs and EADs (such as the condition of collateral). Upon receipt, the institution needs to have a procedure to update the borrower's rating in a timely fashion. [Basel Framework, CRE 36.42] Standards for retail exposures An institution must review the loss characteristics and delinquency status of each identified pool on at least an annual basis. It must also review the status of individual borrowers within each pool as a means of ensuring that exposures continue to be assigned to the correct pool. This requirement may be satisfied by review of a representative sample of exposures in the pool. [Basel Framework, CRE 36.43] (iii) Overrides For rating assignments based on expert judgement, institutions must clearly articulate the situations in which an institution's officers may override the outputs of the rating process, including how and to what extent such overrides can be used and by whom. For model-based ratings, the institution must have guidelines and processes for monitoring cases where human judgement has overridden the model's rating, variables were excluded or inputs were altered. These guidelines must include identifying personnel that are responsible for approving these overrides. Institutions must identify overrides and separately track their performance. [Basel Framework, CRE 36.44] (iv) Data maintenance An institution must collect and store data on key borrower and facility characteristics to provide effective support to its internal credit risk measurement and management process, to enable the institution to meet the other requirements in this document, and to serve as a basis for supervisory reporting. These data should be sufficiently detailed to allow retrospective re-allocation of obligors and facilities to grades. For example if increasing sophistication of the internal rating system suggests that finer segregation of portfolios can be achieved. Furthermore, institutions must collect and retain data on aspects of their internal ratings as required under OSFI's Pillar 3 Disclosure Requirements. [Basel Framework, CRE 36.45] For corporate, sovereign, PSE, and bank exposures Institutions must maintain rating histories on borrowers and recognized guarantors, including the rating since the borrower/guarantor was assigned an internal grade, the dates the ratings were assigned, the methodology and key data used to derive the rating and the person/model responsible. The identity of borrowers and facilities that default, and the timing and circumstances of such defaults, must be retained. Institutions must also retain data on the PDs and realized default rates associated with rating grades and ratings migration in order to track the predictive power of the borrower rating system. [Basel Framework, CRE 36.46] Institutions using the advanced IRB approach must also collect and store a complete history of data on the LGD and EAD estimates associated with each facility and the key data used to derive the estimate and the person/model responsible. Institutions must also collect data on the estimated and realized LGDs and EADs associated with each defaulted facility. Institutions that reflect the credit risk mitigating effects of guarantees/credit derivatives through LGD must retain data on the LGD of the facility before and after evaluation of the effects of the guarantee/credit derivative. Information about the components of loss or recovery for each defaulted exposure must be retained, such as amounts recovered, source of recovery (e.g. collateral, liquidation proceeds and guarantees), time period required for recovery, and administrative costs. [Basel Framework, CRE 36.47] Institutions under the foundation approach which utilize supervisory estimates are encouraged to retain the relevant data (i.e. data on loss and recovery experience for exposures under the foundation approach, data on realized losses for institutions using the supervisory slotting criteria for SL). [Basel Framework, CRE 36.48] For retail exposures Institutions must retain data used in the process of allocating exposures to pools, including data on borrower and transaction risk characteristics used either directly or through use of a model, as well as data on delinquency. Institutions must also retain data on the estimated PDs, LGDs and EADs, associated with pools of exposures. For defaulted exposures, institutions must retain the data on the pools to which the exposure was assigned over the year prior to default and the realized outcomes on LGD and EAD. [Basel Framework, CRE 36.49] (v) Stress tests used in assessment of capital adequacy An IRB institution must have in place sound stress testing processes for use in the assessment of capital adequacy. Stress testing must involve identifying possible events or future changes in economic conditions that could have unfavourable effects on an institution's credit exposures and assessment of the institution's ability to withstand such changes. Examples of scenarios that could be used are (i) economic or industry downturns; (ii) market-risk events; and (iii) liquidity conditions. [Basel Framework, CRE 36.50] In addition to the more general tests described above, the institution must perform a credit risk stress test to assess the effect of certain specific conditions on its IRB regulatory capital requirements. The test to be employed would be one chosen by the institution, subject to OSFI review. The test to be employed must be meaningful and reasonably conservative. Individual institutions may develop different approaches to undertaking this stress test requirement, depending on their circumstances. For this purpose, the objective is not to require institutions to consider worst-case scenarios. The institution's stress test in this context should, however, consider at least the effect of mild recession scenarios. In this case, one example might be to use two consecutive quarters of zero growth to assess the effect on the institution's PDs, LGDs and EADs, taking account – on a conservative basis – of the institution's international diversification. [Basel Framework, CRE 36.51] Whatever method is used, the institution must include a consideration of the following sources of information. First, an institution's own data should allow estimation of the ratings migration of at least some of its exposures. Second, institutions should consider information about the impact of smaller deterioration in the credit environment on an institution's ratings, giving some information on the likely effect of bigger, stress circumstances. Third, institutions should evaluate evidence of ratings migration in external ratings. This would include the institution broadly matching its buckets to rating categories. [Basel Framework, CRE 36.52] Where an institution operates in several markets, it does not need to test for such conditions in all of those markets, but an institution should stress portfolios containing the vast majority of its total exposures. [Basel Framework, CRE 36.53]

5.8.5 Corporate governance and oversight

(i) Corporate governance All material aspects of the rating and estimation processes must be approved by the institution's senior management. Senior management must possess a general understanding of the institution's risk rating system and detailed comprehension of its associated management reports. [Basel Framework, CRE 36.54] Senior management also must have a good understanding of the rating system's design and operation, and must approve material differences between established procedure and actual practice. Management must also ensure, on an ongoing basis, that the rating system is operating properly. Management and staff in the credit control function must meet regularly to discuss the performance of the rating process, areas needing improvement, and the status of efforts to improve previously identified deficiencies. [Basel Framework, CRE 36.55] Internal ratings must be an essential part of the reporting to these parties. Reporting must include risk profile by grade, migration across grades, estimation of the relevant parameters per grade, and comparison of realized default rates (and LGDs and EADs for institutions on advanced approaches) against expectations. Reporting frequencies may vary with the significance and type of information and the level of the recipient. [Basel Framework, CRE 36.56] (ii) Credit risk control Institutions must have independent credit risk control units that are responsible for the design or selection, implementation and performance of their internal rating systems. The unit(s) must be functionally independent from the personnel and management functions responsible for originating exposures. Areas of responsibility must include: Testing and monitoring internal grades; Production and analysis of summary reports from the institution's rating system, to include historical default data sorted by rating at the time of default and one year prior to default, grade migration analyses, and monitoring of trends in key rating criteria; Implementing procedures to verify that rating definitions are consistently applied across departments and geographic areas; Reviewing and documenting any changes to the rating process, including the reasons for the changes; and Reviewing the rating criteria to evaluate if they remain predictive of risk. Changes to the rating process, criteria or individual rating parameters must be documented and retained for OSFI to review. [Basel Framework, CRE 36.57] A credit risk control unit must actively participate in the development, selection, implementation and validation of rating models. It must assume oversight and supervision responsibilities for any models used in the rating process, and ultimate responsibility for the ongoing review and alterations to rating models. [Basel Framework, CRE 36.58] (iii) Internal and external audit Internal audit or an equally independent function must review at least annually the institution's rating system and its operations, including the operations of the credit function and the estimation of PDs, LGDs and EADs. Areas of review include adherence to all applicable minimum requirements. Internal audit must document its findings. [Basel Framework, CRE 36.59]

Use of internal ratings

Internal ratings and default and loss estimates must play an essential role in the credit approval, risk management, internal capital allocations, and corporate governance functions of institutions using the IRB approach. Ratings systems and estimates designed and implemented exclusively for the purpose of qualifying for the IRB approach and used only to provide IRB inputs are not acceptable. It is recognized that institutions will not necessarily be using exactly the same estimates for both IRB and all internal purposes. For example, pricing models are likely to use PDs and LGDs relevant to the life of the asset. Where there are such differences, an institution must document them and demonstrate their reasonableness to OSFI. [Basel Framework, CRE 36.60] An institution must have a credible track record in the use of internal ratings information. Thus, the institution must demonstrate that it has been using a rating system that was broadly in line with the minimum requirements articulated in this guideline for at least the three years prior to qualification. An institution using the advanced IRB approach must demonstrate that it has been estimating and employing LGDs and EADs in a manner that is broadly consistent with the minimum requirements for use of own estimates of LGDs and EADs for at least the three years prior to qualification. Improvements to an institution's rating system will not render an institution non-compliant with the three-year requirement. [Basel Framework, CRE 36.61]

5.8.6 Risk quantification

(i) Overall requirements for estimation Structure and intent This section addresses the broad standards for own-estimates of PD, LGD, and EAD. Generally, all institutions using the IRB approaches must estimate a PD^{Footnote 26} for each internal borrower grade for corporate, sovereign, PSE, and bank exposures or for each pool in the case of retail exposures. [Basel Framework, CRE 36.62] PD estimates must be a long-run average of one-year default rates for borrowers in the grade, with the exception of retail exposures. Requirements specific to PD estimation are provided in paragraphs 274 to 279. Institutions on the advanced approach must estimate an appropriate LGD (as defined in paragraphs 281 to 286) for each of its facilities (or retail pools). For exposures subject to the advanced approach, institutions must also estimate an appropriate long-run default-weighted average EAD for each of its facilities as defined in paragraphs 289 and 290. Requirements specific to EAD estimation appear in paragraphs 289 to 299. For corporate, sovereign, PSE, and bank exposures, institutions that do not meet the requirements for own-estimates of EAD or LGD, above, must use the supervisory estimates of these parameters. Standards for use of such estimates are set out in paragraphs 332 to 351. [Basel Framework, CRE 36.63] Internal estimates of PD, LGD, and EAD must incorporate all relevant, material and available data, information and methods. An institution may utilize internal data and data from external sources (including pooled data). Where internal or external data is used, the institution must demonstrate that its estimates are representative of long run (PD) or downturn (LGD and EAD) experience. [Basel Framework, CRE 36.64] Estimates must be grounded in historical experience and empirical evidence, and not based purely on subjective or judgmental considerations. Any changes in lending practice or the process for pursuing recoveries over the observation period must be taken into account. An institution's estimates must promptly reflect the implications of technical advances and new data and other information, as it becomes available. Institutions must review their estimates on a yearly basis or more frequently. [Basel Framework, CRE 36.65] The population of exposures represented in the data used for estimation, and lending standards in use when the data were generated, and other relevant characteristics should be closely matched to or at least comparable with those of the institution's exposures and standards. The institution must also demonstrate that economic or market conditions that underlie the data are relevant to current and foreseeable conditions. For estimates of LGD and EAD, institutions must take into account paragraphs 281 to 299. The number of exposures in the sample and the data period used for quantification must be sufficient to provide the institution with confidence in the accuracy and robustness of its estimates. The estimation technique must perform well in out-of-sample tests. [Basel Framework, CRE 36.66] In general, estimates of PDs, LGDs, and EADs are likely to involve unpredictable errors. In order to avoid over-optimism, an institution must add to its estimates a margin of conservatism that is related to the likely range of errors. Where methods and data are less satisfactory and the likely range of errors is larger, the margin of conservatism must be larger. [Basel Framework, CRE 36.67] (ii) Definition of default A default is considered to have occurred with regard to a particular obligor when either or both of the two following events have taken place. The institution considers that the obligor is unlikely to pay its credit obligations to the banking group in full, without recourse by the institution to actions such as realizing security (if held). The obligor is past due more than 90 days on any material credit obligation to the banking group. Overdrafts will be considered as being past due once the customer has breached an advised limit or been advised of a limit smaller than current outstandings. [Basel Framework, CRE 36.68] The elements to be taken as indications of unlikeliness to pay include: The institution puts the credit obligation on non-accrued status. The institution makes a charge-off or specific allowance resulting from a significant perceived decline in credit quality subsequent to the institution taking on the exposure. The institution sells the credit obligation at a material credit-related economic loss. The institution consents to a distressed restructuring of the credit obligation where this is likely to result in a diminished financial obligation caused by the material forgiveness, or postponement, of principal, interest or (where relevant) fees. The institution has filed for the obligor's bankruptcy or a similar order in respect of the obligor's credit obligation to the banking group. The obligor has sought or has been placed in bankruptcy or similar protection where this would avoid or delay repayment of the credit obligation to the banking group. [Basel Framework, CRE 36.69] Additional guidance on indications of unlikeliness to pay can be found in OSFI Implementation Notes, IFRS 9 Guidance and applicable accounting standards. [Basel Framework, CRE 36.70] For retail exposures, the definition of default can be applied at the level of a particular facility, rather than at the level of the obligor. As such, default by a borrower on one obligation does not require an institution to treat all other obligations to the banking group as defaulted. In addition, for QRRE exposures, institutions may wait until an obligor is more than 180 days past due on any material obligation to the banking group (instead of the 90 days mentioned in paragraph 265) prior to determining that a default has occurred. A mortgage and HELOC issued as part of the same combined loan product (CLP) are to be considered a single facility. That is, if a retail borrower is deemed to have defaulted on either the mortgage or the HELOC portion of the CLP, it is deemed to have defaulted on both. [Basel Framework, CRE 36.71] An institution must record actual defaults on IRB exposure classes using this reference definition. An institution must also use the reference definition for its estimation of PDs, and (where relevant) LGDs and EADs. In arriving at these estimations, an institution may use external data available to it that is not itself consistent with that definition, subject to the requirements set out in paragraph 275. However, in such cases, institutions must demonstrate to OSFI that appropriate adjustments to the data have been made to achieve broad equivalence with the reference definition. [Basel Framework, CRE 36.72] If the institution considers that a previously defaulted exposure's status is such that no trigger of the reference definition any longer applies, the institution must rate the borrower and estimate LGD as they would for a non-defaulted facility. Should the reference definition subsequently be triggered, a second default would be deemed to have occurred. [Basel Framework, CRE 36.73] (iii) Re-ageing The institution must have clearly articulated and documented policies in respect of the counting of days past due, in particular in respect of the re-ageing of the facilities and the granting of extensions, deferrals, renewals and rewrites to existing accounts. At a minimum, the re-ageing policy must include: (a) approval authorities and reporting requirements; (b) minimum age of a facility before it is eligible for re-ageing; (c) delinquency levels of facilities that are eligible for re-ageing; (d) maximum number of re-ageings per facility; and (e) a reassessment of the borrower's capacity to repay. These policies must be applied consistently over time, and must support the 'use test' (i.e. if an institution treats a re-aged exposure in a similar fashion to other delinquent exposures more than the past-due cut off point, this exposure must be recorded as in default for IRB purposes). [Basel Framework, CRE 36.74] (iv) Treatment of overdrafts Authorized overdrafts must be subject to a credit limit set by the institution and brought to the knowledge of the client. Any break of this limit must be monitored; if the account were not brought under the limit after 90 to 180 days (subject to the applicable past-due trigger), it would be considered as defaulted. Non-authorized overdrafts will be associated with a zero limit for IRB purposes. Thus, days past due commence once any credit is granted to an unauthorized customer; if such credit were not repaid within 90 to 180 days, the exposure would be considered in default. Institutions must have in place rigorous internal policies for assessing the creditworthiness of customers who are offered overdraft accounts. [Basel Framework, CRE 36.75] (v) Definition of loss for all asset classes The definition of loss used in estimating LGD is economic loss. When measuring economic loss, all relevant factors should be taken into account. This must include material discount effects and material direct and indirect costs associated with collecting on the exposure. Institutions must not simply measure the loss recorded in accounting records, although they must be able to compare accounting and economic losses. The institution's own workout and collection expertise significantly influences their recovery rates and must be reflected in their LGD estimates, but adjustments to estimates for such expertise must be conservative until the institution has sufficient internal empirical evidence of the impact of its expertise. [Basel Framework, CRE 36.76] (vi) Requirements specific to PD estimation Corporate, sovereign, PSE, and bank exposures Institutions must use information and techniques that take appropriate account of the long-run experience when estimating the average PD for each rating grade. For example, institutions may use one or more of the three specific techniques set out below: internal default experience, mapping to external data, and statistical default models. [Basel Framework, CRE 36.77] Institutions may have a primary technique and use others as a point of comparison and potential adjustment. OSFI will not be satisfied by mechanical application of a technique without supporting analysis. Institutions must recognize the importance of judgmental considerations in combining results of techniques and in making adjustments for limitations of techniques and information. For all methods listed below, institutions must estimate a PD for each rating grade based on the observed historical average one-year default rate that is a simple average based on number of obligors (count weighted). Weighting approaches, such as EAD weighting, are not permitted. An institution may use data on internal default experience for the estimation of PD. An institution must demonstrate in its analysis that the estimates are reflective of underwriting standards and of any differences in the rating system that generated the data and the current rating system. Where only limited data are available, or where underwriting standards or rating systems have changed, the institution must add a greater margin of conservatism in its estimate of PD. The use of pooled data across institutions may also be recognized. An institution must demonstrate that the internal rating systems and criteria of other institutions in the pool are comparable with its own. Institutions may associate or map their internal grades to the scale used by an external credit assessment institution or similar institution and then attribute the default rate observed for the external institution's grades to the institution's grades. Mappings must be based on a comparison of internal rating criteria to the criteria used by the external institution and on a comparison of the internal and external ratings of any common borrowers. Biases or inconsistencies in the mapping approach or underlying data must be avoided. The external institution's criteria underlying the data used for quantification must be oriented to the risk of the borrower and not reflect transaction characteristics. The institution's analysis must include a comparison of the default definitions used, subject to the requirements in paragraph 265 to 270. The institution must document the basis for the mapping. An institution is allowed to use a simple average of default-probability estimates for individual borrowers in a given grade, where such estimates are drawn from statistical default prediction models. The institution's use of default probability models for this purpose must meet the standards specified in paragraph 224. [Basel Framework, CRE 36.78] Irrespective of whether an institution is using external, internal, or pooled data sources, or a combination of the three, for its PD estimation, the length of the underlying historical observation period used must be at least five years for at least one source. If the available observation period spans a longer period for any source, and this data are relevant and material, this longer period must be used. The data should include a representative mix of good and bad years and must at a minimum include 10% of data from downturn (or bad) years. To determine the downturn period, institutions may use their existing process for determine a downturn period with respect to LGDs. However, if an institution deems a separate process more suitable for determining downturn years for PDs (e.g. due to lag effects between PDs and LGDs), it may do so. The 10% minimum is to be measured in the number of years used to calibrate parameter estimates. For example, if a PD model is based on 10 years of data, then at least 1 year from that 10 years must be a downturn year. For datasets with less than 10% of data coming from downturn years, there are multiple ways institutions could adjust their estimates to compensate for the lack of downturn years. For example, institutions could put more weight on the downturn data in the dataset or incorporate margins of conservatism into their estimates. Institutions are asked to consult with OSFI on their approach used to adjust their estimates where datasets do not include at least 10% of data from downturn years. [Basel Framework, CRE 36.79] Retail exposures Given the institution-specific basis of assigning exposures to pools, institutions must regard internal data as the primary source of information for estimating loss characteristics. Institutions are permitted to use external data or statistical models for quantification provided a strong link can be demonstrated between (a) the institution's process of assigning exposures to a pool and the process used by the external data source, and (b) between the institution's internal risk profile and the composition of the external data. In all cases institutions must use all relevant and material data sources as points of comparison. [Basel Framework, CRE 36.80] One method for deriving long-run average estimates of PD and default-weighted average loss rates given default (as defined in paragraph 281) for retail would be based on an estimate of the expected long-run loss rate. An institution may (i) use an appropriate PD estimate to infer the long-run default-weighted average loss rate given default, or (ii) use a long-run default-weighted average loss rate given default to infer the appropriate PD. In either case, it is important to recognize that the LGD used for the IRB capital calculation cannot be less than the long-run default-weighted average loss rate given default and must be consistent with the concepts defined in paragraph 281. [Basel Framework, CRE 36.81] Irrespective of whether institutions are using external, internal, pooled data sources, or a combination of the three, for their estimation of loss characteristics, the length of the underlying historical observation period used must be at least five years. If the available observation spans a longer period for any source, and these data are relevant, this longer period must be used. The data should include a representative mix of good and bad years of the economic cycle relevant for the portfolio. The data should include a representative mix of good and bad years and must at a minimum include 10% of data from downturn (or bad) years. To determine the downturn period, institutions may use their existing process for determine a downturn period with respect to LGDs. However, if an institution deems a separate process more suitable for determining downturn years for PDs (e.g. due to lag effects between PDs and LGDs), it may do so.The PD should be based on the observed historical average one-year default rate. The 10% minimum is to be measured in the number of years used to calibrate parameter estimates. For example, if a PD model is based on 10 years of data, then at least 1 year from that 10 years must be a downturn year. For datasets with less than 10% of data coming from downturn years, there are multiple ways institutions could adjust their estimates to compensate for the lack of downturn years. For example, institutions could put more weight on the downturn data in the dataset or incorporate margins of conservatism into their estimates. Institutions are asked to consult with OSFI on their approach used to adjust their estimates where datasets do not include at least 10% of data from downturn years. [Basel Framework, CRE 36.82] Retail Margin lending Institutions have the option of using either the standardized approach without credit risk mitigation or the retail IRB approach using the method outlined in paragraph 278 that treats all margin loans as a single risk segment. Prime brokerage business may not be classified as a retail exposure. Standardized approach without credit risk mitigation Notwithstanding that institutions are required to use the IRB approach for retail, appropriately margined retail loans are not considered a significant credit risk. Therefore retail margin loans are eligible for a permanent waiver to use the standardized approach without credit risk mitigation. IRB approach This approach is permitted for institutions that wish to extend IRB retail methods to retail margin loans as a single risk segment. In such a case the institution would be eligible to derive either a PD or LGD for the segment from the segment's expected long-run loss rate (see paragraph 278). (vii) Requirements specific to own-LGD estimates Standards for all asset classes An institution must estimate an LGD for each facility that aims to reflect economic downturn conditions where necessary to capture the relevant risks. This LGD cannot be less than the long-run default-weighted average loss rate given default calculated based on the average economic loss^{Footnote 27} of all observed defaults within the data source for that type of facility. In addition, an institution must take into account the potential for the LGD of the facility to be higher than the default-weighted average during a period when credit losses are substantially higher than average. For certain types of exposures, loss severities may not exhibit such cyclical variability and LGD estimates may not differ materially from the long-run default-weighted average. However, for other exposures, this cyclical variability in loss severities may be important and institutions will need to incorporate it into their LGD estimates. For this purpose, institutions may use averages of loss severities observed during periods of high credit losses, forecasts based on appropriately conservative assumptions, or other similar methods. Appropriate estimates of LGD during periods of high credit losses might be formed using either internal and/or external data. [Basel Framework, CRE 36.83] In its analysis, the institution must consider the extent of any dependence between the risk of the borrower and that of the collateral or collateral provider. Cases where there is a significant degree of dependence must be addressed in a conservative manner. Any currency mismatch between the underlying obligation and the collateral must also be considered and treated conservatively in the institution's assessment of LGD. [Basel Framework, CRE 36.84] LGD estimates must be grounded in historical recovery rates and, when applicable, must not solely be based on the collateral's estimated market value. This requirement recognizes the potential inability of institutions to gain both control of their collateral and liquidate it expeditiously. To the extent, that LGD estimates take into account the existence of collateral, institutions must establish internal requirements for collateral management, operational procedures, legal certainty and risk management process that are generally consistent with those required for the foundation IRB approach. [Basel Framework, CRE 36.85] Recognizing the principle that realized losses can at times systematically exceed expected levels, the LGD assigned to a defaulted asset should reflect the possibility that the institution would have to recognize additional, unexpected losses during the recovery period. For each defaulted asset, the institution must also construct its best estimate of the expected loss on that asset based on current economic circumstances and facility status. The amount, if any, by which the LGD on a defaulted asset exceeds the institution's best estimate of expected loss on the asset represents the capital requirement for that asset, and should be set by the institution on a risk-sensitive basis in accordance with section 5.3. Instances where the best estimate of expected loss on a defaulted asset is less than the sum of specific^{Footnote 28} allowances on that asset will attract supervisory scrutiny and must be justified by the institution. [Basel Framework, CRE 36.86] Additional standards for corporate, sovereign, PSE, and bank exposures Estimates of LGD must be based on a minimum data observation period that should ideally cover at least one complete economic cycle but must in any case be no shorter than a period of seven years for at least one source. If the available observation period spans a longer period for any source, and the data are relevant, this longer period must be used. [Basel Framework, CRE 36.87] Additional standards for retail exposures The minimum data observation period for LGD estimates for retail exposures is five years. The less data an institution has, the more conservative it must be in its estimation. [Basel Framework, CRE 36.88] Downturn LGD Floor Effective November 1, 2016, new exposures secured by residential real estate^{Footnote 29} located in Canada are subject to a downturn LGD (DLGD) floor equivalent to the sum of the segment's long-run default-weighted average LGD and an add-on. DLGD Floor = Bank's Estimate of Long Run LGD + Add-on Where the value of DLGD Floor is capped at a maximum value of 100%. The DLGD floor is applied at the loan level to the pre-mitigation^{Footnote 30} DLGD. The add-on formula is as follows: Add-on = Max ⁡ ( CLTV − 80 % × 100 % − ∆ P , 0 ) − Max ⁡ CLTV − 80 % , 0 CLTV Where: CLTV (Current Loan-To-Value) is defined as the ratio of the exposure at default^{Footnote 31} over the updated property value. ∆P (Price Correction) is defined as the decrease in house prices necessary to reach a determined level of house prices. For example, if house prices were 10% lower 12 quarters ago than they are today, ∆P would be 10% and the corrected house prices would be equal to 90% of their current value. If, according to the methodology explained in Appendix 5-3, there is a threshold breach, then ∆P is subject to a minimum value of 25%: ∆ P = max ⁡ ⁡ 1 − House Price Value 12 quarters ago Current House Price Value × 100 % , 25 % Otherwise, ∆P is not constrained and is defined as follows: ∆ P = max ⁡ ⁡ 1 − House Price Value 12 quarters ago Current House Price Value × 100 % , 0 % The calculation of ∆P is performed using data from the Teranet – National Bank House Price Index^TM (“Teranet index”). Institutions will be required to use the data from all 32 of the public metropolitan area indices, as of January 1, 2022, in the Teranet index for exposures located in the corresponding metropolitan areas^{Footnote 32} and the composite-11 for loans outside of those 32 cities. Quarterly recalculation of the floor is required. A list of the 32 public metropolitan area indicies has been provided in section B of Appendix 5-3. When multiple loans are secured by the same property, the cumulative CLTV (CCLTV) represents the sum of the exposures at default of all loans with equal or higher seniority, divided by the updated value of the property. CLTV is the ratio of the sum of the exposure at default of all equally ranked loans over the updated value of the property. The following formula applies when multiple loans are secured by the same property: Add-on = Max ⁡ Min ( CLTV , Max ⁡ C CLTV − 80 % × 100 % − ∆ P , 0 ) − Max ⁡ C CLTV − 80 % , 0 CLTV , 0 The DLGD floor must be considered as an additional requirement to the 10% LGD floor described in paragraph 98, specifically the 10% LGD floor will be applied after the application of the floor described in this paragraph. Institutions are required to notify OSFI's Capital Division through their Lead Supervisors when the thresholds specified in Appendix 5-3 are initially breached and the minimum price correction is applied. Similarly, institutions should notify OSFI when the application of the minimum price correction is no longer required. These notifications should be made to OSFI prior to the beginning of the quarter in which the minimum price correction applies (or is no longer applied). (viii) Requirements specific to own-EAD estimates Standards for all asset classes EAD for an on-balance sheet or off-balance sheet item is defined as the expected gross exposure of the facility upon default of the obligor.^{Footnote 33} For on-balance sheet items, institutions must estimate EAD at no less than the current drawn amount, subject to recognizing the effects of on-balance sheet netting as specified in the foundation approach. The minimum requirements for the recognition of netting are the same as those under the foundation approach. The additional minimum requirements for internal estimation of EAD under the advanced approach, therefore, focus on the estimation of EAD for off-balance sheet items (excluding transactions that expose institutions to counterparty credit risk as set out in Chapter 7). Institutions using the advanced approach must have established procedures in place for the estimation of EAD for off-balance sheet items. These must specify the estimates of EAD to be used for each facility type. Institutions estimates of EAD should reflect the possibility of additional drawings by the borrower up to and after the time a default event is triggered. Where estimates of EAD differ by facility type, the delineation of these facilities must be clear and unambiguous. [Basel Framework, CRE 36.89] Under the advanced approach, institutions must assign an estimate of EAD for each facility. It must be an estimate of the long-run default-weighted average EAD for similar facilities and borrowers over a sufficiently long period of time, but with a margin of conservatism appropriate to the likely range of errors in the estimate. If a positive correlation can reasonably be expected between the default frequency and the magnitude of EAD, the EAD estimate must incorporate a larger margin of conservatism. Moreover, for exposures for which EAD estimates are volatile over the economic cycle, the institution must use EAD estimates that are appropriate for an economic downturn, if these are more conservative than the long-run average. For institutions that have been able to develop their own EAD models, this could be achieved by considering the cyclical nature, if any, of the drivers of such models. Other institutions may have sufficient internal data to examine the impact of previous recession(s). However, some institutions may only have the option of making conservative use of external data. Moreover, where an institution bases its estimates on alternative measures of central tendency (such as the median or a higher percentile estimate) or only on 'downturn' data, it should explicitly confirm that the basic downturn requirement of the framework is met, i.e. the institution's estimates do not fall below a (conservative) estimate of the long-run default-weighted average EAD for similar facilities. [Basel Framework, CRE 36.90] The criteria by which estimates of EAD are derived must be plausible and intuitive, and represent what the institution believes to be the material drivers of EAD. The choices must be supported by credible internal analysis by the institution. The institution must be able to provide a breakdown of its EAD experience by the factors it sees as the drivers of EAD. An institution must use all relevant and material information in its derivation of EAD estimates. Across facility types, an institution must review its estimates of EAD when material new information comes to light and at least on an annual basis. [Basel Framework, CRE 36.91] Due consideration must be paid by the institution to its specific policies and strategies adopted in respect of account monitoring and payment processing. The institution must also consider its ability and willingness to prevent further drawings in circumstances short of payment default, such as covenant violations or other technical default events. Institutions must also have adequate systems and procedures in place to monitor facility amounts, current outstandings against committed lines and changes in outstandings per borrower and per grade. The institution must be able to monitor outstanding balances on a daily basis. [Basel Framework, CRE 36.92] Institutions' EAD estimates must be developed using a 12-month fixed-horizon approach (i.e. for each observation in the reference data set, default outcomes must be linked to relevant obligor and facility characteristics twelve months prior to default.) This does not preclude relevant additional obligor and facility information from less than twelve months prior to default to be used in estimates of EAD. In addition, the use of a 12-month fixed horizon approach does not prevent the institution from using information from facilities that defaulted within twelve months of the origination of the facility. [Basel Framework, CRE 36.93] As set out in paragraph 263, institutions' EAD estimates should be based on reference data that reflect the obligor, facility and institution management practice characteristics of the exposures to which the estimates are applied. Consistent with this principle, EAD estimates applied to particular exposures should not be based on data that comingle the effects of disparate characteristics or data from exposures that exhibit different characteristics (e.g. same broad product grouping but different customers that are managed differently by the institution). The estimates should be based on appropriately homogenous segments. Alternatively, the estimates should be based on an estimation approach that effectively disentangles the impact of the different characteristics exhibited within the relevant dataset. Practices that generally do not comply with this principle include use of estimates based or partly based on: SME/mid-market data being applied to large corporate obligors. Data from commitments with 'small' unused limit availability being applied to facilities with 'large' unused limit availability. Data from obligors already identified as problematic at reference date being applied to current obligors with no known issues (e.g. customers at reference date who were already delinquent, watchlisted by the institution, subject to recent institution-initiated limit reductions, blocked from further drawdowns or subject to other types of collections activity). Data that has been affected by changes in obligors' mix of borrowing and other credit-related products over the observation period unless that data has been effectively mitigated for such changes, e.g. by adjusting the data to remove the effects of the changes in the product mix. OSFI expects institutions to demonstrate a detailed understanding of the impact of changes in customer product mix on EAD reference data sets (and associated EAD estimates) and that the impact is immaterial or has been effectively mitigated within each institution's estimation process. Institutions' analyses in this regard will be actively challenged by OSFI. Effective mitigation would not include: setting floors to credit conversion factor (CCF)/EAD observations; use of obligor-level estimates that do not fully cover the relevant product transformation options or inappropriately combine products with very different characteristics (e.g. revolving and non-revolving products); adjusting only 'material' observations affected by product transformation; generally excluding observations affected by product profile transformation (thereby potentially distorting the representativeness of the remaining data). [Basel Framework, CRE 36.94] A well-known feature of the commonly used undrawn limit factor (ULF) approach^{Footnote 34} to estimating CCFs is the region of instability associated with facilities close to being fully drawn at reference date. Institutions should ensure that their EAD estimates are effectively quarantined from the potential effects of this region of instability. An acceptable approach could include using an estimation method other than the ULF approach that avoids the instability issue by not using potentially small undrawn limits that could approach zero in the denominator or, as appropriate, switching to a method other than the ULF as the region of instability is approached, e.g. a limit factor, balance factor or additional utilization factor approach.^{Footnote 35} Note that, consistent with paragraph 294, including limit utilization as a driver in EAD models could quarantine much of the relevant portfolio from this issue but, in the absence of other actions, leaves open how to develop appropriate EAD estimates to be applied to exposures within the region of instability. Common but ineffective approaches to mitigating this issue include capping and flooring reference data (e.g. observed CCFs at 100 per cent and zero respectively) or omitting observations that are judged to be affected. [Basel Framework, CRE 36.95] EAD reference data must not be capped to the principal amount outstanding or facility limits. Accrued interest, other due payments and limit excesses should be included in EAD reference data. [Basel Framework, CRE 36.96] For transactions that expose institutions to counterparty credit risk, estimates of EAD must fulfil the requirements set forth in Chapter 7. [Basel Framework, CRE 36.97] Additional standards for corporate, sovereign, PSE, and bank exposures Estimates of EAD must be based on a time period that must ideally cover a complete economic cycle but must in any case be no shorter than a period of seven years. If the available observation period spans a longer period for any source, and the data are relevant, this longer period must be used. EAD estimates must be calculated using a default-weighted average and not a time-weighted average. [Basel Framework, CRE 36.98] Additional standards for retail exposures The minimum data observation period for EAD estimates for retail exposures is five years. The less data an institution has, the more conservative it must be in its estimation. [Basel Framework, CRE 36.99] (ix) Minimum requirements for assessing effect of guarantees and credit derivatives Standards for corporate, sovereign, and PSE exposures where own estimates of LGD are used and standards for retail exposures Guarantees When an institution uses its own estimates of LGD, it may reflect the risk-mitigating effect of guarantees through an adjustment to PD or LGD estimates. The option to adjust LGDs is available only to those institutions that have been approved to use their own internal estimates of LGD. For retail exposures, where guarantees exist, either in support of an individual obligation or a pool of exposures, an institution may reflect the risk-reducing effect either through its estimates of PD or LGD, provided this is done consistently. In adopting one or the other technique, an institution must adopt a consistent approach, both across types of guarantees and over time. [Basel Framework, CRE 36.100] The benefits of credit risk mitigation from both borrowers and guarantors can be recognized for capital purposes only if an institution can establish that it can simultaneously and independently realize on both the benefits (e.g. collateral provided by the borrower and a third party guarantee). In a scenario where a bank has obtained both collateral and a guarantee for a particular exposure and it cannot establish that it can simultaneously and independently realize on the benefits of both, the risk mitigating benefits of the collateral will be recognized. Any recognition of the mitigating effect of a guarantee arrangement under the Canada Small Business Financing Act must recognize the risk of non-performance by the guarantor due to a cap on the total claims that can be made on defaulted loans covered by the guarantee arrangement. The following requirements will apply to institutions that reflect the effect of guarantees through adjustments to the LGD: No recognition of double default: Paragraph 109 of the Framework permits institutions to adjust either PD or LGD to reflect guarantees, but paragraph 305 and paragraph 109 stipulate that the risk weight resulting from these adjustments must not be lower than that of a comparable exposure to the guarantor (see the discussion in paragraph 305 below). An institution using LGD adjustments must demonstrate that its methodology does not incorporate the effects of double default. Furthermore, the institution must demonstrate that its LGD adjustments do not incorporate implicit assumptions about the correlation of guarantor default to that of the obligor. No recognition of double recovery: Since collateral is reflected through an adjustment to LGD, an institution using a separate adjustment to LGD to reflect a guarantee must be able to distinguish the effects of the two sources of mitigation and to demonstrate that its methodology does not incorporate double recovery. Requirement to track guarantor PDs: Any institution that measures credit risk comprehensively must track exposures to guarantors for the purpose of assessing concentration risk, and by extension must still track the guarantors' PDs. Requirement to recognize the possibility of guarantor default in the adjustment: Any LGD adjustment must fully reflect the likelihood of guarantor default – an institution may not assume that the guarantor will always perform under the guarantee. For this purpose, it will not be sufficient only to demonstrate that the risk weight resulting from an LGD adjustment is no lower than that of the guarantor. Requirement for credible data: Any estimates used in an LGD adjustment must be based on credible, relevant data, and the relation between the source data and the amount of the adjustment should be transparent. Institutions should also analyse the degree of uncertainty inherent in the source data and resulting estimates. Use of consistent methodology for similar types of guarantees: Under paragraph 109, an institution must use the same method for all guarantees of a given type. This means that an institution will be required to have one single method for guarantees, one for credit default swaps, one for insurance, and so on. Institutions will not be permitted to selectively choose the exposures having a particular type of guarantee to receive an LGD adjustment, and any adjustment methodology must be broadly applicable to all exposures that are mitigated in the same way. In all cases, both the borrower and all recognized guarantors must be assigned a borrower rating at the outset and on an ongoing basis. An institution must follow all minimum requirements for assigning borrower ratings set out in this document, including the regular monitoring of the guarantor's condition and ability and willingness to honour its obligations. Consistent with the requirements in paragraphs 243 and 244, an institution must retain all relevant information on the borrower absent the guarantee and the guarantor. In the case of retail guarantees, these requirements also apply to the assignment of an exposure to a pool, and the estimation of PD. [Basel Framework, CRE 36.101] In no case can the institution assign the guaranteed exposure an adjusted PD or LGD such that the adjusted risk weight would be lower than that of a comparable, direct exposure to the guarantor. A comparable, direct exposure to the guarantor is one using the PD of the guarantor and the LGD for an unsecured exposure to the guarantor. If the case where a guarantor pledges additional collateral beyond that of the original borrower, this additional collateral may be reflected in the LGD of a comparable, direct exposure to the guarantor. Consistent with the standardized approach, institutions may choose not to recognize credit protection if doing so would result in a higher capital requirement. Neither criteria nor rating processes are permitted to consider possible favourable effects of imperfect expected correlation between default events for the borrower and guarantor for purposes of regulatory minimum capital requirements. As such, the adjusted risk weight must not reflect the risk mitigation of "double default." [Basel Framework, CRE 36.102] In case the institution applies the standardized approach to direct exposures to the guarantor, the guarantee may only be recognized by treating the covered portion of the exposure as a direct exposure to the guarantor under the standardized approach. Similarly, in case the institution applies the foundation IRB approach to direct exposures to the guarantor, the guarantee may only be recognized by applying the foundation IRB approach to the covered portion of the exposure. Alternatively, institutions may choose to not recognize the effect of guarantees on their exposures. [Basel Framework, CRE 36.103] Eligible guarantors and guarantees There are no restrictions on the types of eligible guarantors. The institution must, however, have clearly specified criteria for the types of guarantors it will recognize for regulatory capital purposes. [Basel Framework, CRE 36.104] An institution may not reduce the risk weight of an exposure to a third party on account of a guarantee or credit protection provided by a related party (parent, subsidiary or affiliate) of the institution. This treatment follows the principle that guarantees within a corporate group are not a substitute for capital in the regulated Canadian institution. An exception is made for self-liquidating trade-related transactions that have a tenure of 360 days or less, are market-driven and are not structured to avoid the requirements of OSFI guidelines. The requirement that the transaction be "market-driven" necessitates that the guarantee or letter of credit is requested and paid for by the customer and/or that the market requires the guarantee in the normal course. The guarantee must be evidenced in writing, non-cancellable on the part of the guarantor, in force until the debt is satisfied in full (to the extent of the amount and tenor of the guarantee) and legally enforceable against the guarantor in a jurisdiction where the guarantor has assets to attach and enforce a judgement. The guarantee must also be unconditional; there should be no clause in the protection contract outside the direct control of the institution that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment(s) due. However, under the advanced IRB approach, guarantees that only cover loss remaining after the institution has first pursued the original obligor for payment and has completed the workout process may be recognized. [Basel Framework, CRE 36.105] In case of guarantees where the institution applies the standardized approach to the covered portion of the exposure, the scope of guarantors and the minimum requirements as under the standardized approach apply. [Basel Framework, CRE 36.106] Adjustment criteria An institution must have clearly specified criteria for adjusting borrower grades or LGD estimates (or in the case of retail and eligible purchased receivables, the process of allocating exposures to pools) to reflect the impact of guarantees for regulatory capital purposes. These criteria must be as detailed as the criteria for assigning exposures to grades consistent with paragraphs 216 and 217, and must follow all minimum requirements for assigning borrower or facility ratings set out in this document. [Basel Framework, CRE 36.107] The criteria must be plausible and intuitive, and must address the guarantor's ability and willingness to perform under the guarantee. The criteria must also address the likely timing of any payments and the degree to which the guarantor's ability to perform under the guarantee is correlated with the borrower's ability to repay. The institution's criteria must also consider the extent to which residual risk to the borrower remains, for example a currency mismatch between the guarantee and the underlying exposure. [Basel Framework, CRE 36.108] In adjusting borrower grades or LGD estimates (or in the case of retail and eligible purchased receivables, the process of allocating exposures to pools), institutions must take all relevant available information into account. [Basel Framework, CRE 36.109] Credit derivatives The minimum requirements for guarantees are relevant also for single-name credit derivatives. Additional considerations arise in respect of asset mismatches. The criteria used for assigning adjusted borrower grades or LGD estimates (or pools) for exposures hedged with credit derivatives must require that the asset on which the protection is based (the reference asset) cannot be different from the underlying asset, unless the conditions outlined in the foundation approach are met. [Basel Framework, CRE 36.110] In addition, the criteria must address the payout structure of the credit derivative and conservatively assess the impact this has on the level and timing of recoveries. The institution must also consider the extent to which other forms of residual risk remain. [Basel Framework, CRE 36.111] For banks using foundation LGD estimates The minimum requirements outlined in paragraphs 300 to 315 apply to institutions using the foundation LGD estimates with the following exceptions: The institution is not able to use an 'LGD-adjustment' option; and The range of eligible guarantees and guarantors is limited to those outlined in paragraph 105. [Basel Framework, CRE 36.112] (x) Requirements specific to estimating PD and LGD (or EL) for qualifying purchased receivables The following minimum requirements for risk quantification must be satisfied for any purchased receivables (corporate or retail) making use of the top-down treatment of default risk and/or the IRB treatments of dilution risk. [Basel Framework, CRE 36.113] The purchasing institution will be required to group the receivables into sufficiently homogeneous pools so that accurate and consistent estimates of PD and LGD (or EL) for default losses and EL estimates of dilution losses can be determined. In general, the risk bucketing process will reflect the seller's underwriting practices and the heterogeneity of its customers. In addition, methods and data for estimating PD, LGD, and EL must comply with the existing risk quantification standards for retail exposures. In particular, quantification should reflect all information available to the purchasing institution regarding the quality of the underlying receivables, including data for similar pools provided by the seller, by the purchasing institution, or by external sources. The purchasing institution must determine whether the data provided by the seller are consistent with expectations agreed upon by both parties concerning, for example, the type, volume and on-going quality of receivables purchased. Where this is not the case, the purchasing institution is expected to obtain and rely upon more relevant data. [Basel Framework, CRE 36.114] Minimum operational requirements An institution purchasing receivables has to justify that current and future advances can be repaid from the liquidation of (or collections against) the receivables pool. To qualify for the top-down treatment of default risk, the receivable pool and overall lending relationship should be closely monitored and controlled. Specifically, an institution will have to demonstrate the following: Legal certainty; Effectiveness of monitoring systems; Effectiveness of work-out systems; Effectiveness of systems for controlling collateral, credit availability, and cash; and Compliance with the institution's internal policies and procedures. [Basel Framework, CRE 36.1115] Legal certainty The structure of the facility must ensure that under all foreseeable circumstances the institution has effective ownership and control of the cash remittances from the receivables, including incidences of seller or servicer distress and bankruptcy. When the obligor makes payments directly to a seller or servicer, the institution must verify regularly that payments are forwarded completely and within the contractually agreed terms. As well, ownership over the receivables and cash receipts should be protected against bankruptcy 'stays' or legal challenges that could materially delay the lender's ability to liquidate/assign the receivables or retain control over cash receipts. [Basel Framework, CRE 36.116] Effectiveness of monitoring systems The institution must be able to monitor both the quality of the receivables and the financial condition of the seller and servicer. In particular: The institution must (a) assess the correlation among the quality of the receivables and the financial condition of both the seller and servicer, and (b) have in place internal policies and procedures that provide adequate safeguards to protect against such contingencies, including the assignment of an internal risk rating for each seller and servicer. The institution must have clear and effective policies and procedures for determining seller and servicer eligibility. The institution or its agent must conduct periodic reviews of sellers and servicers in order to verify the accuracy of reports from the seller/servicer, detect fraud or operational weaknesses, and verify the quality of the seller's credit policies and servicer's collection policies and procedures. The findings of these reviews must be well documented. The institution must have the ability to assess the characteristics of the receivables pool, including (a) over-advances; (b) history of the seller's arrears, bad debts, and bad debt allowances; (c) payment terms, and (d) potential contra accounts. The institution must have effective policies and procedures for monitoring on an aggregate basis single-obligor concentrations both within and across receivables pools. The institution must receive timely and sufficiently detailed reports of receivables ageings and dilutions to: (a) ensure compliance with the institution's eligibility criteria and advancing policies governing purchased receivables, and (b) provide an effective means with which to monitor and confirm the seller's terms of sale (e.g. invoice date ageing) and dilution. [Basel Framework, CRE 36.117] Effectiveness of work-out systems An effective programme requires systems and procedures not only for detecting deterioration in the seller's financial condition and deterioration in the quality of the receivables at an early stage, but also for addressing emerging problems pro-actively. In particular, The institution should have clear and effective policies, procedures, and information systems to monitor compliance with (a) all contractual terms of the facility (including covenants, advancing formulas, concentration limits, early amortization triggers, etc.) as well as (b) the institution's internal policies governing advance rates and receivables eligibility. The institution's systems should track covenant violations and waivers as well as exceptions to established policies and procedures. To limit inappropriate draws, the institution should have effective policies and procedures for detecting, approving, monitoring, and correcting over-advances. The institution should have effective policies and procedures for dealing with financially weakened sellers or servicers and/or deterioration in the quality of receivable pools. These include, but are not necessarily limited to, early termination triggers in revolving facilities and other covenant protections, a structured and disciplined approach to dealing with covenant violations, and clear and effective policies and procedures for initiating legal actions and dealing with problem receivables. [Basel Framework, CRE 36.118] Effectiveness of systems for controlling collateral, credit availability, and cash The institution must have clear and effective policies and procedures governing the control of receivables, credit, and cash. In particular, Written internal policies must specify all material elements of the receivables purchase programme, including the advancing rates, eligible collateral, necessary documentation, concentration limits, and how cash receipts are to be handled. These elements should take appropriate account of all relevant and material factors, including the seller's/servicer's financial condition, risk concentrations, and trends in the quality of the receivables and the seller's customer base. Internal systems must ensure that funds are advanced only against specified supporting collateral and documentation (such as servicer attestations, invoices, shipping documents, etc.) [Basel Framework, CRE 36.119] Compliance with the institution's internal policies and procedures Given the reliance on monitoring and control systems to limit credit risk, the institution should have an effective internal process for assessing compliance with all critical policies and procedures, including: Regular internal and/or external audits of all critical phases of the institution's receivables purchase programme. Verification of the separation of duties (i) between the assessment of the seller/servicer and the assessment of the obligor and (ii) between the assessment of the seller/servicer and the field audit of the seller/servicer. [Basel Framework, CRE 36.120] An institution's effective internal process for assessing compliance with all critical policies and procedures should also include evaluations of back office operations, with particular focus on qualifications, experience, staffing levels, and supporting systems. [Basel Framework, CRE 36.121]

5.8.7 Validation of internal estimates

Institutions must have a robust system in place to validate the accuracy and consistency of rating systems, processes, and the estimation of all relevant risk components. An institution must demonstrate to OSFI that the internal validation process enables it to assess the performance of internal rating and risk estimation systems consistently and meaningfully. [Basel Framework, CRE 36.122] Institutions must regularly compare realized default rates with estimated PDs for each grade and be able to demonstrate that the realized default rates are within the expected range for that grade. Institutions using the advanced IRB approach must complete such analysis for their estimates of LGDs and EADs. Such comparisons must make use of historical data that are over as long a period as possible. The methods and data used in such comparisons by the institution must be clearly documented by the institution. This analysis and documentation must be updated at least annually. [Basel Framework, CRE 36.123] Institutions must also use other quantitative validation tools and comparisons with relevant external data sources. The analysis must be based on data that are appropriate to the portfolio, are updated regularly, and cover a relevant observation period. Institutions' internal assessments of the performance of their own rating systems must be based on long data histories, covering a range of economic conditions, and ideally one or more complete business cycles. [Basel Framework, CRE 36.124] Institutions must demonstrate that quantitative testing methods and other validation methods do not vary systematically with the economic cycle. Changes in methods and data (both data sources and periods covered) must be clearly and thoroughly documented. [Basel Framework, CRE 36.125] Institutions must have well-articulated internal standards for situations where deviations in realized PDs, LGDs and EADs from expectations become significant enough to call the validity of the estimates into question. These standards must take account of business cycles and similar systematic variability in default experiences. Where realized values continue to be higher than expected values, institutions must revise estimates upward to reflect their default and loss experience. [Basel Framework, CRE 36.126] Where institutions rely on supervisory, rather than internal, estimates of risk parameters, they are encouraged to compare realized LGDs and EADs to those set by the OSFI. The information on realized LGDs and EADs should form part of the institution's assessment of economic capital. [Basel Framework, CRE 36.127]

5.8.8 Supervisory LGD and EAD estimates

Institutions under the foundation IRB approach, which do not meet the requirements for own-estimates of LGD and EAD above, must meet the minimum requirements described in the standardized approach to receive recognition for eligible financial collateral (as set out in Chapter 4). They must meet the following additional minimum requirements in order to receive recognition for additional collateral types. [Basel Framework, CRE 36.128] (i) Definition of eligibility of CRE and RRE as collateral Eligible CRE and RRE collateral for corporate, sovereign, PSE, and bank exposures are defined as: Collateral where the risk of the borrower is not materially dependent upon the performance of the underlying property or project, but rather on the underlying capacity of the borrower to repay the debt from other sources. As such, repayment of the facility is not materially dependent on any cash flow generated by the underlying CRE/RRE serving as collateral; and Additionally, the value of the collateral pledged must not be materially dependent on the performance of the borrower. This requirement is not intended to preclude situations where purely macro-economic factors affect both the value of the collateral and the performance of the borrower. [Basel Framework, CRE 36.129] Income producing real estate that falls under the SL asset class is specifically excluded from recognition as collateral for corporate exposures. [Basel Framework, CRE 36.130] (ii) Operational requirements for eligible CRE/RRE Subject to meeting the definition above, CRE and RRE will be eligible for recognition as collateral for corporate claims only if all of the following operational requirements are met. Legal enforceability: any claim on a collateral taken must be legally enforceable in all relevant jurisdictions, and any claim on collateral must be properly filed on a timely basis. Collateral interests must reflect a perfected lien (i.e. all legal requirements for establishing the claim have been fulfilled). Furthermore, the collateral agreement and the legal process underpinning it must be such that they provide for the institution to realize the value of the collateral within a reasonable timeframe. Objective market value of collateral: the collateral must be valued at or less than the current fair value under which the property could be sold under private contract between a willing seller and an arm's-length buyer on the date of valuation. Frequent revaluation: the institution is expected to monitor the value of the collateral on a frequent basis and at a minimum once every year. More frequent monitoring is suggested where the market is subject to significant changes in conditions. Statistical methods of evaluation (e.g. reference to house price indices, sampling) may be used to update estimates or to identify collateral that may have declined in value and that may need re-appraisal. A qualified professional must evaluate the property when information indicates that the value of the collateral may have declined materially relative to general market prices or when a credit event, such as default, occurs. Junior liens: Residential and commercial real estate may be recognized as collateral for FIRB only when the institution's collateral interest is the first lien on the property, and there is no more senior or intervening claim.^{Footnote 36} Junior liens are recognized as collateral only where the institution holds the senior lien and where no other party holds an intervening lien on the property. Where junior liens are recognized the institution must first take the haircut value of the collateral, then reduce it by the sum of all loans with liens that rank higher than the junior lien, the remaining value is the collateral that supports the loan with the junior lien. In cases where liens are held by third parties that rank pari passu with the lien of the institution, only the proportion of the collateral (after the application of haircuts and reductions due to the value of loans with liens that rank higher than the lien of the institution) that is attributable to the institution may be recognized. [Basel Framework, CRE 36.131] Additional collateral management requirements are as follows: The types of CRE and RRE collateral accepted by the institution and lending policies (advance rates) when this type of collateral is taken must be clearly documented. The institution must take steps to ensure that the property taken as collateral is adequately insured against damage or deterioration. The institution must monitor on an ongoing basis the extent of any permissible prior claims (e.g. tax) on the property. The institution must appropriately monitor the risk of environmental liability arising in respect of the collateral, such as the presence of toxic material on a property. [Basel Framework, CRE 36.132] (iii) Requirements for recognition of financial receivables Definition of eligible receivables Eligible financial receivables are claims with an original maturity of less than or equal to one year where repayment will occur through the commercial or financial flows related to the underlying assets of the borrower. This includes both self-liquidating debt arising from the sale of goods or services linked to a commercial transaction and general amounts owed by buyers, suppliers, renters, national and local governmental authorities, or other non-affiliated parties not related to the sale of goods or services linked to a commercial transaction. Eligible receivables do not include those associated with securitizations, sub-participations or credit derivatives. [Basel Framework, CRE 36.133] Operational requirements Legal certainty The legal mechanism by which collateral is given must be robust and ensure that the lender has clear rights over the proceeds from the collateral. [Basel Framework, CRE 36.134] Institutions must take all steps necessary to fulfil local requirements in respect of the enforceability of security interest, e.g. by registering a security interest with a registrar. There should be a framework that allows the potential lender to have a perfected first priority claim over the collateral. [Basel Framework, CRE 36.135] All documentation used in collateralized transactions must be binding on all parties and legally enforceable in all relevant jurisdictions. Institutions must have conducted sufficient legal review to verify this and have a well-founded legal basis to reach this conclusion, and undertake such further review as necessary to ensure continuing enforceability. [Basel Framework, CRE 36.136] The collateral arrangements must be properly documented, with a clear and robust procedure for the timely collection of collateral proceeds. Institutions' procedures should ensure that any legal conditions required for declaring the default of the customer and timely collection of collateral are observed. In the event of the obligor's financial distress or default, the institution should have legal authority to sell or assign the receivables to other parties without consent of the receivables' obligors. [Basel Framework, CRE 36.137] Risk management The institution must have a sound process for determining the credit risk in the receivables. Such a process should include, among other things, analyses of the borrower's business and industry (e.g. effects of the business cycle) and the types of customers with whom the borrower does business. Where the institution relies on the borrower to ascertain the credit risk of the customers, the institution must review the borrower's credit policy to ascertain its soundness and credibility. [Basel Framework, CRE 36.138] The margin between the amount of the exposure and the value of the receivables must reflect all appropriate factors, including the cost of collection, concentration within the receivables pool pledged by an individual borrower, and potential concentration risk within the institution's total exposures. [Basel Framework, CRE 36.139] The institution must maintain a continuous monitoring process that is appropriate for the specific exposures (either immediate or contingent) attributable to the collateral to be utilized as a risk mitigant. This process may include, as appropriate and relevant, ageing reports, control of trade documents, borrowing base certificates, frequent audits of collateral, confirmation of accounts, control of the proceeds of accounts paid, analyses of dilution (credits given by the borrower to the issuers) and regular financial analysis of both the borrower and the issuers of the receivables, especially in the case when a small number of large-sized receivables are taken as collateral. Observance of the institution's overall concentration limits should be monitored. Additionally, compliance with loan covenants, environmental restrictions, and other legal requirements should be reviewed on a regular basis. [Basel Framework, CRE 36.140] The receivables pledged by a borrower should be diversified and not be unduly correlated with the borrower. Where the correlation is high, e.g. where some issuers of the receivables are reliant on the borrower for their viability or the borrower and the issuers belong to a common industry, the attendant risks should be taken into account in the setting of margins for the collateral pool as a whole. Receivables from affiliates of the borrower (including subsidiaries and employees) will not be recognized as risk mitigants. [Basel Framework, CRE 36.141] The institution should have a documented process for collecting receivable payments in distressed situations. The requisite facilities for collection should be in place, even when the institution normally looks to the borrower for collections. [Basel Framework, CRE 36.142] Requirements for recognition of other physical collateral OSFI will allow for recognition of the credit risk mitigating effect of certain other physical collateral when the following conditions are met: The institution demonstrates to the satisfaction of OSFI that there are liquid markets for disposal of collateral in an expeditious and economically efficient manner. Institutions must carry out a reassessment of this condition both periodically and when information indicates material changes in the market. The institution demonstrates to the satisfaction of OSFI that there are well established, publicly available market prices for the collateral. Institutions must also demonstrate that the amount they receive when collateral is realized does not deviate significantly from these market prices. [Basel Framework, CRE 36.143] In order for a given institution to receive recognition for additional physical collateral, it must meet all the standards in paragraphs 335 and 336, subject to the following modifications. With the sole exception of permissible prior claims specified in footnote 36 in paragraph 335, only first liens on, or charges over, collateral are permissible. As such, the institution must have priority over all other lenders to the realized proceeds of the collateral. The loan agreement must include detailed descriptions of the collateral and the right to examine and revalue the collateral whenever this is deemed necessary by the lending institution. The types of physical collateral accepted by the institution and policies and practices in respect of the appropriate amount of each type of collateral relative to the exposure amount must be clearly documented in internal credit policies and procedures and available for examination and/or audit review. Institutions' credit policies with regard to the transaction structure must address appropriate collateral requirements relative to the exposure amount, the ability to liquidate the collateral readily, the ability to establish objectively a price or market value, the frequency with which the value can readily be obtained (including a professional appraisal or valuation), and the volatility of the value of the collateral. The periodic revaluation process must pay particular attention to "fashion-sensitive" collateral to ensure that valuations are appropriately adjusted downward of fashion, or model-year, obsolescence as well as physical obsolescence or deterioration. In cases of inventories (e.g. raw materials, work-in-process, finished goods, dealers' inventories of autos) and equipment, the periodic revaluation process must include physical inspection of the collateral. [Basel Framework, CRE 36.144] General Security Agreements, and other forms of floating charge, can provide the lending institution with a registered claim over a company's assets. In cases where the registered claim includes both assets that are not eligible as collateral under the foundation IRB and assets that are eligible as collateral under the foundation IRB, the institution may recognize the latter. Recognition is conditional on the claims meeting the operational requirements set out in paragraphs 332 to 348. [Basel Framework, CRE 36.145]

5.8.9 Requirements for recognition of leasing

Leases other than those that expose the institution to residual value risk (see paragraph 351) will be accorded the same treatment as exposures collateralized by the same type of collateral. The minimum requirements for the collateral type must be met (CRE/RRE or other collateral). In addition, the institution must also meet the following standards: Robust risk management on the part of the lessor with respect to the location of the asset, the use to which it is put, its age, and planned obsolescence; A robust legal framework establishing the lessor's legal ownership of the asset and its ability to exercise its rights as owner in a timely fashion; and The difference between the rate of depreciation of the physical asset and the rate of amortization of the lease payments must not be so large as to overstate the CRM attributed to the leased assets. [Basel Framework, CRE 36.146] Leases that expose the institution to residual value risk will be treated in the following manner. Residual value risk is the institution's exposure to potential loss due to the fair value of the equipment declining below its residual estimate at lease inception. The discounted lease payment stream will receive a risk weight appropriate for the lessee's financial strength (PD) and supervisory or own-estimate of LGD, whichever is appropriate. The residual value will be risk-weighted at 100%. [Basel Framework, CRE 36.147]

5.8.10 Disclosure requirements

In order to be eligible for the IRB approach, institutions must meet the disclosure requirements set out in OSFI's Pillar 3 disclosure requirements Guideline. These are minimum requirements for use of IRB: failure to meet these will render institutions ineligible to use the relevant IRB approach. [Basel Framework, CRE 36.148]

Appendix 5-1 - Illustrative IRB Risk Weights

Table 1 provides illustrative risk weights calculated for four asset class types under the IRB approach to credit risk. Each set of risk weights for unexpected loss (UL) was produced using the appropriate risk-weight function of the risk-weight functions set out in this chapter. The inputs used to calculate the illustrative risk weights include measures of the PD, LGD, and an assumed effective maturity (M) of 2.5 years. [Basel Framework, CRE 99.2] A firm-size adjustment applies to exposures made to small- and medium-sized entity (SME) borrowers (defined as corporate exposures where the reported sales for the consolidated group of which the firm is a part is less than CAD $75 million). Accordingly, the firm size adjustment was made in determining the second set of risk weights provided in column two given that the turnover of the firm receiving the exposure is assumed to be CAD $7.5 million. [Basel Framework, CRE 99.3] Table 1: Illustrative IRB risk weights for UL Asset class LGD Corporate Exposures Residential Mortgages All other regulatory Retail Exposures Qualifying Revolving Retail Exposures 40% 40% 45% 25% 45% 85% 50% 85% Turnover ($ millions) 50 5 n/a n/a n/a n/a n/a n/a Maturity 2.5 years 2.5 years n/a n/a n/a n/a n/a n/a PD: 0.05% 17.47% 13.69% 6.23% 3.46% 6.63% 12.52% 1.68% 2.86% 0.10% 26.36% 20.71% 10.69% 5.94% 11.16% 21.08% 3.01% 5.12% 0.25% 43.97% 34.68% 21.30% 11.83% 21.15% 39.96% 6.40% 10.88% 0.40% 55.75% 43.99% 29.94% 16.64% 28.42% 53.69% 9.34% 15.88% 0.50% 61.88% 48.81% 35.08% 19.49% 32.36% 61.13% 11.16% 18.97% 0.75% 73.58% 57.91% 46.46% 25.81% 40.10% 75.74% 15.33% 26.06% 1.00% 82.06% 64.35% 56.40% 31.33% 45.77% 86.46% 19.14% 32.53% 1.30% 89.73% 70.02% 67.00% 37.22% 50.80% 95.95% 23.35% 39.70% 1.50% 93.86% 72.99% 73.45% 40.80% 53.37% 100.81% 25.99% 44.19% 2.00% 102.09% 78.71% 87.94% 48.85% 57.99% 109.53% 32.14% 54.63% 2.50% 108.58% 83.05% 100.64% 55.91% 60.90% 115.03% 37.75% 64.18% 3.00% 114.17% 86.74% 111.99% 62.22% 62.79% 118.61% 42.96% 73.03% 4.00% 124.07% 93.37% 131.63% 73.13% 65.01% 122.80% 52.40% 89.08% 5.00% 133.20% 99.79% 148.22% 82.35% 66.42% 125.45% 60.83% 103.41% 6.00% 141.88% 106.21% 165.52% 90.29% 67.73% 127.94% 68.45% 116.37% 10.00% 171.63% 130.23% 204.41% 113.56% 75.54% 142.69% 93.21% 158.47% 15.00% 196.92% 152.81% 235.72% 130.96% 88.60% 167.36% 115.43% 196.23% 20.00% 211.76% 167.48% 253.12% 140.62% 100.28% 189.41% 131.09% 222.86%

Appendix 5-2 - Supervisory Slotting Criteria for Specialized Lending

[Basel Framework, CRE 33.13-33.16] Table 1a ─ Financial strength ─ Supervisory Rating Grades for Project Finance Exposures blank Strong Good Satisfactory Weak Market conditions Few competing suppliers or substantial and durable advantage in location, cost, or technology. Demand is strong and growing Few competing suppliers or better than average location, cost, or technology but this situation may not last. Demand is strong and stable Project has no advantage in location, cost, or technology. Demand is adequate and stable Project has worse than average location, cost, or technology. Demand is weak and declining Financial ratios (e.g. debt service coverage ratio (DSCR), loan life coverage ratio (LLCR), project life coverage ratio (PLCR), and debt-to-equity ratio) Strong financial ratios considering the level of project risk; very robust economic assumptions Strong to acceptable financial ratios considering the level of project risk; robust project economic assumptions Standard financial ratios considering the level of project risk Aggressive financial ratios considering the level of project risk Stress analysis The project can meet its financial obligations under sustained, severely stressed economic or sectoral conditions The project can meet its financial obligations under normal stressed economic or sectoral conditions. The project is only likely to default under severe economic conditions The project is vulnerable to stresses that are not uncommon through an economic cycle, and may default in a normal downturn The project is likely to default unless conditions improve soon Table 1b ─ Financial structure ─ Supervisory Rating Grades for Project Finance Exposures blank Strong Good Satisfactory Weak Duration of the credit compared to the duration of the project Useful life of the project significantly exceeds tenor of the loan Useful life of the project exceeds tenor of the loan Useful life of the project exceeds tenor of the loan Useful life of the project may not exceed tenor of the loan Amortization schedule Amortizing debt Amortizing debt Amortizing debt repayments with limited bullet payment Bullet repayment or amortizing debt repayments with high bullet repayment Table 1c ─ Political and legal environment ─ Supervisory Rating Grades for Project Finance Exposures blank Strong Good Satisfactory Weak Political risk, including transfer risk, considering project type and mitigants Very low exposure; strong mitigation instruments, if needed Low exposure; satisfactory mitigation instruments, if needed Moderate exposure; fair mitigation instruments High exposure; no or weak mitigation instruments Force majeure risk (war, civil unrest, etc.), Low exposure Acceptable exposure Standard protection Significant risks, not fully mitigated Government support and project's importance for the country over the long term Project of strategic importance for the country (preferably export-oriented). Strong support from Government Project considered important for the country. Good level of support from Government Project may not be strategic but brings unquestionable benefits for the country. Support from Government may not be explicit Project not key to the country. No or weak support from Government Stability of legal and regulatory environment (risk of change in law) Favourable and stable regulatory environment over the long term Favourable and stable regulatory environment over the medium term Regulatory changes can be predicted with a fair level of certainty Current or future regulatory issues may affect the project Acquisition of all necessary supports and approvals for such relief from local content laws Strong Satisfactory Fair Weak Enforceability of contracts, collateral and security Contracts, collateral and security are enforceable Contracts, collateral and security are enforceable Contracts, collateral and security are considered enforceable even if certain non-key issues may exist There are unresolved key issues in respect if actual enforcement of contracts, collateral and security Table 1d ─ Transaction characteristics ─ Supervisory Rating Grades for Project Finance Exposures blank Strong Good Satisfactory Weak Design and technology risk Fully proven technology and design Fully proven technology and design Proven technology and design – start-up issues are mitigated by a strong completion package Unproven technology and design; technology issues exist and/or complex design Table 1e ─ Construction risk ─ Supervisory Rating Grades for Project Finance Exposures blank Strong Good Satisfactory Weak Permitting and siting All permits have been obtained Some permits are still outstanding but their receipt is considered very likely Some permits are still outstanding but the permitting process is well defined and they are considered routine Key permits still need to be obtained and are not considered routine. Significant conditions may be attached Type of construction contract Fixed-price date-certain turnkey construction EPC (engineering and procurement contract) Fixed-price date-certain turnkey construction EPC Fixed-price date-certain turnkey construction contract with one or several contractors No or partial fixed-price turnkey contract and/or interfacing issues with multiple contractors Completion guarantees Substantial liquidated damages supported by financial substance and/or strong completion guarantee from sponsors with excellent financial standing Significant liquidated damages supported by financial substance and/or completion guarantee from sponsors with good financial standing Adequate liquidated damages supported by financial substance and/or completion guarantee from sponsors with good financial standing Inadequate liquidated damages or not supported by financial substance or weak completion guarantees Track record and financial strength of contractor in constructing similar projects. Strong Good Satisfactory Weak Table 1f ─ Operating risk ─ Supervisory Rating Grades for Project Finance Exposures blank Strong Good Satisfactory Weak Scope and nature of operations and maintenance (O&M) contracts Strong long-term O&M contract, preferably with contractual performance incentives, and/or O&M reserve accounts Long-term O&M contract, and/or O&M reserve accounts Limited O&M contract or O&M reserve account No O&M contract: risk of high operational cost overruns beyond mitigants Operator's expertise, track record, and financial strength Very strong, or committed technical assistance of the sponsors Strong Acceptable Limited/weak, or local operator dependent on local authorities Table 1g ─ Off-take risk ─ Supervisory Rating Grades for Project Finance Exposures blank Strong Good Satisfactory Weak (a) If there is a take-or-pay or fixed-price off-take contract: Excellent creditworthiness of off-taker; strong termination clauses; tenor of contract comfortably exceeds the maturity of the debt Good creditworthiness of off-taker; strong termination clauses; tenor of contract exceeds the maturity of the debt Acceptable financial standing of off-taker; normal termination clauses; tenor of contract generally matches the maturity of the debt Weak off-taker; weak termination clauses; tenor of contract does not exceed the maturity of the debt (b) If there is no take-or-pay or fixed-price off-take contract: Project produces essential services or a commodity sold widely on a world market; output can readily be absorbed at projected prices even at lower than historic market growth rates Project produces essential services or a commodity sold widely on a regional market that will absorb it at projected prices at historical growth rates Commodity is sold on a limited market that may absorb it only at lower than projected prices Project output is demanded by only one or a few buyers or is not generally sold on an organized market Table 1h ─ Supply risk ─ Supervisory Rating Grades for Project Finance Exposures blank Strong Good Satisfactory Weak Price, volume and transportation risk of feed-stocks; supplier's track record and financial strength Long-term supply contract with supplier of excellent financial standing Long-term supply contract with supplier of good financial standing Long-term supply contract with supplier of good financial standing – a degree of price risk may remain Short-term supply contract or long-term supply contract with financially weak supplier – a degree of price risk definitely remains Reserve risks (e.g. natural resource development) Independently audited, proven and developed reserves well in excess of requirements over lifetime of the project Independently audited, proven and developed reserves in excess of requirements over lifetime of the project Proven reserves can supply the project adequately through the maturity of the debt Project relies to some extent on potential and undeveloped reserves Table 1i ─ Strength of Sponsor ─ Supervisory Rating Grades for Project Finance Exposures blank Strong Good Satisfactory Weak Sponsor's track record, financial strength, and country/sector experience Strong sponsor with excellent track record and high financial standing Good sponsor with satisfactory track record and good financial standing Adequate sponsor with adequate track record and good financial standing Weak sponsor with no or questionable track record and/or financial weaknesses Sponsor support, as evidenced by equity, ownership clause and incentive to inject additional cash if necessary Strong. Project is highly strategic for the sponsor (core business – long-term strategy) Good. Project is strategic for the sponsor (core business – long-term strategy) Acceptable. Project is considered important for the sponsor (core business) Limited. Project is not key to sponsor's long-term strategy or core business Table 1j ─ Security Package ─ Supervisory Rating Grades for Project Finance Exposures blank Strong Good Satisfactory Weak Assignment of contracts and accounts Fully comprehensive Comprehensive Acceptable Weak Pledge of assets, taking into account quality, value and liquidity of assets First perfected security interest in all project assets, contracts, permits and accounts necessary to run the project Perfected security interest in all project assets, contracts, permits and accounts necessary to run the project Acceptable security interest in all project assets, contracts, permits and accounts necessary to run the project Little security or collateral for lenders; weak negative pledge clause Lender's control over cash flow (e.g. cash sweeps, independent escrow accounts) Strong Satisfactory Fair Weak Strength of the covenant package (mandatory prepayments, payment deferrals, payment cascade, dividend restrictions…) Covenant package is strong for this type of project Project may issue no additional debt Covenant package is satisfactory for this type of project Project may issue extremely limited additional debt Covenant package is fair for this type of project Project may issue limited additional debt Covenant package is Insufficient for this type of project Project may issue unlimited additional debt Reserve funds (debt service, O&M, renewal and replacement, unforeseen events, etc.) Longer than average coverage period, all reserve funds fully funded in cash or letters of credit from highly rated bank Average coverage period, all reserve funds fully funded Average coverage period, all reserve funds fully funded Shorter than average coverage period, reserve funds funded from operating cash flows Table 2a ─ Financial strength ─ Supervisory Rating Grades for Income-Producing Real Estate Exposures and High-Volatility Commercial Real Estate Exposures blank Strong Good Satisfactory Weak Market conditions The supply and demand for the project's type and location are currently in equilibrium. The number of competitive properties coming to market is equal or lower than forecasted demand The supply and demand for the project's type and location are currently in equilibrium. The number of competitive properties coming to market is roughly equal to forecasted demand Market conditions are roughly in equilibrium. Competitive properties are coming on the market and others are in the planning stages. The project's design and capabilities may not be state of the art compared to new projects Market conditions are weak. It is uncertain when conditions will improve and return to equilibrium. The project is losing tenants at lease expiration. New lease terms are less favourable compared to those expiring Financial ratios and advance rate The property's debt service coverage ratio (DSCR) is considered strong (DSCR is not relevant for the construction phase) and its loan to value ratio (LTV) is considered low given its property type. Where a secondary market exists, the transaction is underwritten to market standards The DSCR (not relevant for development real estate) and LTV are satisfactory.Where a secondary market exists, the transaction is underwritten to market standards The property's DSCR has deteriorated and its value has fallen, increasing its LTV The property's DSCR has deteriorated significantly and its LTV is well above underwriting standards for new loans Stress analysis The property's resources, contingencies and liability structure allow it to meet its financial obligations during a period of severe financial stress (e.g. interest rates, economic growth) The property can meet its financial obligations under a sustained period of financial stress (e.g. interest rates, economic growth). The property is likely to default only under severe economic conditions During an economic downturn, the property would suffer a decline in revenue that would limit its ability to fund capital expenditures and significantly increase the risk of default The property's financial condition is strained and is likely to default unless conditions improve in the near term Table 2b ─ Cash-flow predictability ─ Supervisory Rating Grades for Income-Producing Real Estate Exposures and High-Volatility Commercial Real Estate Exposures blank Strong Good Satisfactory Weak (a) For complete and stabilized property. The property's leases are long-term with creditworthy tenants and their maturity dates are scattered. The property has a track record of tenant retention upon lease expiration. Its vacancy rate is low. Expenses (maintenance, insurance, security, and property taxes) are predictable Most of the property's leases are long-term, with tenants that range in creditworthiness. The property experiences a normal level of tenant turnover upon lease expiration. Its vacancy rate is low. Expenses are predictable Most of the property's leases are medium rather than long-term with tenants that range in creditworthiness. The property experiences a moderate level of tenant turnover upon lease expiration. Its vacancy rate is moderate. Expenses are relatively predictable but vary in relation to revenue The property's leases are of various terms with tenants that range in creditworthiness. The property experiences a very high level of tenant turnover upon lease expiration. Its vacancy rate is high. Significant expenses are incurred preparing space for new tenants (b) For complete but not stabilized property Leasing activity meets or exceeds projections. The project should achieve stabilization in the near future Leasing activity meets or exceeds projections. The project should achieve stabilization in the near future Most leasing activity is within projections; however, stabilization will not occur for some time Market rents do not meet expectations. Despite achieving target occupancy rate, cash flow coverage is tight due to disappointing revenue (c) For construction phase The property is entirely pre-leased through the tenor of the loan or pre-sold to an investment grade tenant or buyer, or the institution has a binding commitment for take-out financing from an investment grade lender The property is entirely pre-leased or pre-sold to a creditworthy tenant or buyer, or the institution has a binding commitment for permanent financing from a creditworthy lender Leasing activity is within projections but the building may not be pre-leased and there may not exist a take-out financing. The institution may be the permanent lender The property is deteriorating due to cost overruns, market deterioration, tenant cancellations or other factors. There may be a dispute with the party providing the permanent financing Table 2c ─ Asset characteristics ─ Supervisory Rating Grades for Income-Producing Real Estate Exposures and High-Volatility Commercial Real Estate Exposures blank Strong Good Satisfactory Weak Location Property is located in highly desirable location that is convenient to services that tenants desire Property is located in desirable location that is convenient to services that tenants desire The property location lacks a competitive advantage The property's location, configuration, design and maintenance have contributed to the property's difficulties Design and condition Property is favoured due to its design, configuration, and maintenance, and is highly competitive with new properties Property is appropriate in terms of its design, configuration and maintenance. The property's design and capabilities are competitive with new properties Property is adequate in terms of its configuration, design and maintenance Weaknesses exist in the property's configuration, design or maintenance Property is under construction Construction budget is conservative and technical hazards are limited. Contractors are highly qualified Construction budget is conservative and technical hazards are limited. Contractors are highly qualified Construction budget is adequate and contractors are ordinarily qualified Project is over budget or unrealistic given its technical hazards. Contractors may be under qualified Table 2d ─ Strength of Sponsor/ Developer ─ Supervisory Rating Grades for Income-Producing Real Estate Exposures and High-Volatility Commercial Real Estate Exposures blank Strong Good Satisfactory Weak Financial capacity and willingness to support the property. The sponsor/developer made a substantial cash contribution to the construction or purchase of the property. The sponsor/developer has substantial resources and limited direct and contingent liabilities. The sponsor/ developer's properties are diversified geographically and by property type The sponsor/developer made a material cash contribution to the construction or purchase of the property. The sponsor/developer's financial condition allows it to support the property in the event of a cash flow shortfall. The sponsor/developer's properties are located in several geographic regions The sponsor/developer's contribution may be immaterial or non-cash. The sponsor/ developer is average to below average in financial resources The sponsor/developer lacks capacity or willingness to support the property Reputation and track record with similar properties. Experienced management and high sponsors' quality. Strong reputation and lengthy and successful record with similar properties Appropriate management and sponsors' quality. The sponsor or management has a successful record with similar properties Moderate management and sponsors' quality. Management or sponsor track record does not raise serious concerns Ineffective management and substandard sponsors' quality. Management and sponsor difficulties have contributed to difficulties in managing properties in the past Relationships with relevant real estate actors Strong relationships with leading actors such as leasing agents Proven relationships with leading actors such as leasing agents Adequate relationships with leasing agents and other parties providing important real estate services Poor relationships with leasing agents and/or other parties providing important real estate services Table 2e ─ Security Package ─ Supervisory Rating Grades for Income-Producing Real Estate Exposures and High-Volatility Commercial Real Estate Exposures blank Strong Good Satisfactory Weak Nature of lien Perfected first lien^{Footnote 37} Perfected first lien^{Footnote 36} Perfected first lien^{Footnote 36} Ability of lender to foreclose is constrained Assignment of rents (for projects leased to long-term tenants) The lender has obtained an assignment. They maintain current tenant information that would facilitate providing notice to remit rents directly to the lender, such as a current rent roll and copies of the project's leases The lender has obtained an assignment. They maintain current tenant information that would facilitate providing notice to the tenants to remit rents directly to the lender, such as current rent roll and copies of the project's leases The lender has obtained an assignment. They maintain current tenant information that would facilitate providing notice to the tenants to remit rents directly to the lender, such as current rent roll and copies of the project's leases The lender has not obtained an assignment of the leases or has not maintained the information necessary to readily provide notice to the building's tenants Quality of the insurance coverage Appropriate Appropriate Appropriate Substandard Table 3a ─ Financial strength ─ Supervisory Rating Grades for Object Finance Exposures blank Strong Good Satisfactory Weak Market conditions Demand is strong and growing, strong entry barriers, low sensitivity to changes in technology and economic outlook Demand is strong and stable. Some entry barriers, some sensitivity to changes in technology and economic outlook Demand is adequate and stable, limited entry barriers, significant sensitivity to changes in technology and economic outlook Demand is weak and declining, vulnerable to changes in technology and economic outlook, highly uncertain environment Financial ratios (debt service coverage ratio and loan-to-value ratio) Strong financial ratios considering the type of asset. Very robust economic assumptions Strong / acceptable financial ratios considering the type of asset. Robust project economic assumptions Standard financial ratios for the asset type Aggressive financial ratios considering the type of asset Stress analysis Stable long-term revenues, capable of withstanding severely stressed conditions through an economic cycle Satisfactory short-term revenues. Loan can withstand some financial adversity. Default is only likely under severe economic conditions Uncertain short-term revenues. Cash flows are vulnerable to stresses that are not uncommon through an economic cycle. The loan may default in a normal downturn Revenues subject to strong uncertainties; even in normal economic conditions the asset may default, unless conditions improve Market liquidity Market is structured on a worldwide basis; assets are highly liquid Market is worldwide or regional; assets are relatively liquid Market is regional with limited prospects in the short term, implying lower liquidity Local market and/or poor visibility. Low or no liquidity, particularly on niche markets Table 3b ─ Political and legal environment ─ Supervisory Rating Grades for Object Finance Exposures blank Strong Good Satisfactory Weak Political risk, including transfer risk Very low; strong mitigation instruments, if needed Low; satisfactory mitigation instruments, if needed Moderate; fair mitigation instruments High; no or weak mitigation instruments Legal and regulatory risks Jurisdiction is favourable to repossession and enforcement of contracts Jurisdiction is favourable to repossession and enforcement of contracts Jurisdiction is generally favourable to repossession and enforcement of contracts, even if repossession might be long and/or difficult Poor or unstable legal and regulatory environment. Jurisdiction may make repossession and enforcement of contracts lengthy or impossible Table 3c ─ Transaction characteristics ─ Supervisory Rating Grades for Object Finance Exposures blank Strong Good Satisfactory Weak Financing term compared to the economic life of the asset Full payout profile/minimum balloon. No grace period Balloon more significant, but still at satisfactory levels Important balloon with potentially grace periods Repayment in fine or high balloon Table 3d ─ Operating risk ─ Supervisory Rating Grades for Object Finance Exposures blank Strong Good Satisfactory Weak Permits / licensing All permits have been obtained; asset meets current and foreseeable safety regulations All permits obtained or in the process of being obtained; asset meets current and foreseeable safety regulations Most permits obtained or in process of being obtained, outstanding ones considered routine, asset meets current safety regulations Problems in obtaining all required permits, part of the planned configuration and/or planned operations might need to be revised Scope and nature of O&M contracts Strong long-term O&M contract, preferably with contractual performance incentives, and/or O&M reserve accounts (if needed) Long-term O&M contract, and/or O&M reserve accounts (if needed) Limited O&M contract or O&M reserve account (if needed) No O&M contract: risk of high operational cost overruns beyond mitigants Operator's financial strength, track record in managing the asset type and capability to re-market asset when it comes off-lease Excellent track record and strong re-marketing capability Satisfactory track record and re-marketing capability Weak or short track record and uncertain re-marketing capability No or unknown track record and inability to re‑market the asset Table 3e ─ Asset characteristics ─ Supervisory Rating Grades for Object Finance Exposures blank Strong Good Satisfactory Weak Configuration, size, design and maintenance (i.e. age, size for a plane) compared to other assets on the same market Strong advantage in design and maintenance. Configuration is standard such that the object meets a liquid market Above average design and maintenance. Standard configuration, maybe with very limited exceptions - such that the object meets a liquid market Average design and maintenance. Configuration is somewhat specific, and thus might cause a narrower market for the object Below average design and maintenance. Asset is near the end of its economic life. Configuration is very specific; the market for the object is very narrow Resale value Current resale value is well above debt value Resale value is moderately above debt value Resale value is slightly above debt value Resale value is below debt value Sensitivity of the asset value and liquidity to economic cycles Asset value and liquidity are relatively insensitive to economic cycles Asset value and liquidity are sensitive to economic cycles Asset value and liquidity are quite sensitive to economic cycles Asset value and liquidity are highly sensitive to economic cycles Table 3f ─ Strength of sponsor ─ Supervisory Rating Grades for Object Finance Exposures blank Strong Good Satisfactory Weak Operator's financial strength, track record in managing the asset type and capability to re-market asset when it comes off-lease Excellent track record and strong re-marketing capability Satisfactory track record and re-marketing capability Weak or short track record and uncertain re-marketing capability No or unknown track record and inability to re-market the asset Sponsors' track record and financial strength Sponsors with excellent track record and high financial standing Sponsors with good track record and good financial standing Sponsors with adequate track record and good financial standing Sponsors with no or questionable track record and/or financial weaknesses Table 3g ─ Security Package ─ Supervisory Rating Grades for Object Finance Exposures blank Strong Good Satisfactory Weak Asset control Legal documentation provides the lender effective control (e.g. a first perfected security interest, or a leasing structure including such security) on the asset, or on the company owning it Legal documentation provides the lender effective control (e.g. a perfected security interest, or a leasing structure including such security) on the asset, or on the company owning it Legal documentation provides the lender effective control (e.g. a perfected security interest, or a leasing structure including such security) on the asset, or on the company owning it The contract provides little security to the lender and leaves room to some risk of losing control on the asset Rights and means at the lender's disposal to monitor the location and condition of the asset The lender is able to monitor the location and condition of the asset, at any time and place (regular reports, possibility to lead inspections) The lender is able to monitor the location and condition of the asset, almost at any time and place The lender is able to monitor the location and condition of the asset, almost at any time and place The lender is able to monitor the location and condition of the asset are limited Insurance against damages Strong insurance coverage including collateral damages with top quality insurance companies Satisfactory insurance coverage (not including collateral damages) with good quality insurance companies Fair insurance coverage (not including collateral damages) with acceptable quality insurance companies Weak insurance coverage (not including collateral damages) or with weak quality insurance companies Table 4a ─ Financial strength ─ Supervisory Rating Grades for Commodities Finance Exposures blank Strong Good Satisfactory Weak Degree of over-collateralization of trade Strong Good Satisfactory Weak Table 4b ─ Political and legal environment ─ Supervisory Rating Grades for Commodities Finance Exposures blank Strong Good Satisfactory Weak Country risk No country risk Limited exposure to country risk (in particular, offshore location of reserves in an emerging country) Exposure to country risk (in particular, offshore location of reserves in an emerging country) Strong exposure to country risk (in particular, inland reserves in an emerging country) Mitigation of country risks Very strong mitigation: Strong offshore mechanisms Strategic commodity 1st class buyer Strong mitigation: Offshore mechanisms Strategic commodity Strong buyer Acceptable mitigation: Offshore mechanisms Less strategic commodity Acceptable buyer Only partial mitigation: No offshore mechanisms Non-strategic commodity Weak buyer Table 4c ─ Asset characteristics ─ Supervisory Rating Grades for Commodities Finance Exposures blank Strong Good Satisfactory Weak Liquidity and susceptibility to damage Commodity is quoted and can be hedged through futures or OTC instruments. Commodity is not susceptible to damage Commodity is quoted and can be hedged through OTC instruments. Commodity is not susceptible to damage Commodity is not quoted but is liquid. There is uncertainty about the possibility of hedging. Commodity is not susceptible to damage Commodity is not quoted. Liquidity is limited given the size and depth of the market. No appropriate hedging instruments. Commodity is susceptible to damage Table 4d ─ Strength of sponsor ─ Supervisory Rating Grades for Commodities Finance Exposures blank Strong Good Satisfactory Weak Financial strength of trader Very strong, relative to trading philosophy and risks Strong Adequate Weak Track record, including ability to manage the logistic process Extensive experience with the type of transaction in question. Strong record of operating success and cost efficiency Sufficient experience with the type of transaction in question. Above average record of operating success and cost efficiency Limited experience with the type of transaction in question. Average record of operating success and cost efficiency Limited or uncertain track record in general. Volatile costs and profits Trading controls and hedging policies Strong standards for counterparty selection, hedging, and monitoring Adequate standards for counterparty selection, hedging, and monitoring Past deals have experienced no or minor problems Trader has experienced significant losses on past deals Quality of financial disclosure Excellent Good Satisfactory Financial disclosure contains some uncertainties or is insufficient Table 4e ─ Security package ─ Supervisory Rating Grades for Commodities Finance Exposures blank Strong Good Satisfactory Weak Asset control First perfected security interest provides the lender legal control of the assets at any time if needed First perfected security interest provides the lender legal control of the assets at any time if needed At some point in the process, there is a rupture in the control of the assets by the lender. The rupture is mitigated by knowledge of the trade process or a third party undertaking as the case may be Contract leaves room for some risk of losing control over the assets. Recovery could be jeopardized Insurance against damages Strong insurance coverage including collateral damages with top quality insurance companies Satisfactory insurance coverage (not including collateral damages) with good quality insurance companies Fair insurance coverage (not including collateral damages) with acceptable quality insurance companies Weak insurance coverage (not including collateral damages) or with weak quality insurance companies

Appendix 5-3 - Determining the application of a minimum house price correction in the calculation of the DLGD floor

This appendix describes how institutions that have received the supervisory approval to use the advanced IRB approach for exposures secured by residential real estate are to calculate the Supplementary Capital Requirement indicators (SCRIs) for the purpose of determining whether the minimum price correction (∆P) of 25% is applied in the calculation of the add-on used to calculate the DLGD floor required by paragraph 287. The data sources necessary to calculate the SCRIs are outlined in section A of this Appendix. The Teranet – National Bank National Composite House Price Index ("Teranet index")^{Footnote 38} is used to measure house prices and Statistics Canada household disposable income and population data is used to measure the per capita income. An SCRI is to be determined for the 11 metropolitan areas in the Teranet Composite 11 index. For each metropolitan area, an SCRI is calculated on a quarterly basis and is determined as follows: H I × s where, H is the smoothed value of the Teranet index for a metropolitan area as determined in section B; I is the per capita income value as determined in section C; and s is the scaling factor for the particular metropolitan area as indicated in section D. OSFI will review the use of the 11 metropolitan areas and may decide to expand the calculation of SCRIs outside of these 11 metropolitan areas in the future. For exposures outside of the 11 metropollitan areas, there is no SCRI calculation required. The SCRI for a metropolitan area is compared to a threshold value for that particular area as defined in section E. If the SCRI exceeds the threshold value for that metropolitan area, then the minimum price correction of 25% is applied at the beginning of an institution's next quarterly fiscal reporting period for exposures in that metropolitan area,^{Footnote 39} according to the schedule presented in section F. An example illustrating how to calculate SCRIs is provided in section G.

A. Data sources

Institutions need to access the following data sources to calculate the SCRIs. Teranet index data source: Teranet index, monthly (June 2005 = 100, Monthly to present) Per capita income data sources: Statistics Canada Current and Capital Accounts – Households, quarterly – table 36-10-0112-01 (formerly CANSIM table 380-0072) Statistics Canada Labour force survey estimates (LFS) characteristics monthly, seasonally adjusted and trend cycle – table 14-10-0287-01 (formerly CANSIM table 282-0087)

B. Metropolitan area house price indices

The Teranet index values are available on a monthly basis for the following 32 census metropolitan areas, the 11 cities of the Ternet Composite 11 index have been bolded*: British Columbia Abbotsford-Mission Kelowna Vancouver* Victoria* Alberta Calgary* Edmonton* Lethbridge Manitoba Winnipeg* Ontario Barrie Belleville Brantford Guelph Hamilton* Kingston Kitchener-Cambridge-Waterloo London Oshawa Ottawa-Gatineau* Peterborough St. Catherines-Niagara Sudbury Thunder Bay Toronto* Windsor Quebec Montreal* Quebec City* Sherbrooke Trois-Rivieres Maritimes Moncton Saint John St. John's Halifax* The Teranet indices for the metropolitan areas as published are not seasonally adjusted. Given the seasonal nature of the housing market, the indices need to be smoothed to ensure the stability of the SCRIs. Without smoothing, there is a risk that an index could exhibit short-term fluctuations above and below its threshold, which would not be a desirable outcome. Therefore, a simplified approach is used to determine the smoothed Teranet indices for use in the SCRIs; an average of the last 12 months of the Teranet index’s monthly metropolitan area values for the 11 cities of the Teranet Composite 11 index must be calculated.

C. Calculation of the per capita income

The per capita income for use in the SCRI is determined as: Per capita income = 1,000 × Household disposable income Population where, The "Household disposable income" is a quarterly data series from the table 36-10-0112-01. The data characteristics for this table necessary to calculate the per capita income are: Estimates = Household disposable income (× 1,000,000) Geography = Canada Seasonal adjustment = Seasonally adjusted at annual rates The "Population" is a monthly data series and is part of the table 14-10-0287-01. The data characteristics for this table necessary to calculate the per capita income are: Labour force characteristics = Population (× 1,000) Geography = Canada Sex = Both sexes Age group = 15 years and over Data type = Seasonally adjusted To determine the "Per capita income" on a quarterly basis, the "Population" data series must be converted from a monthly basis to a quarterly basis by calculating a three month average of the data series.

D. Calculation of metropolitan area SCRIs

The quarterly SCRI before scaling for each metropolitan area is determined as: SCRI before scaling = Smoothed calendar quarter-end Teranet house price index for a metropolitan area Per capita income The SCRI for a metropolitan area needs to be scaled before being compared to the threshold value to determine whether the minimum price correction is applicable for exposures in that area. The SCRIs are determined by multiplying the ratio of the smoothed Teranet index for a metropolitan area over the per capita income by the scaling factors in the following table. Metropolitan area Scaling factor Calgary 2,500 Edmonton 2,100 Halifax 1,900 Hamilton 2,000 Montréal 2,500 Ottawa-Gatineau 2,400 Québec 1,700 Toronto 3,300 Vancouver 4,200 Victoria 3,300 Winnipeg 1,400

E. Threshold values

Each metropolitan area has its own threshold value that has been determined by OSFI using an algorithm that ensured consistency across metropolitan areas.^{Footnote 40} Threshold values will remain stable over time but are subject to periodic review. The following table shows the threshold values for each metropolitan area used to determine whether exposures in a given area are subject to the minimum price correction. For each metropolitan area, if the calculated SCRI has breached its threshold value then a minimum price correction of 25% will apply to exposures in that area in the calculation of the DLGD floor for the next quarterly fiscal reporting period. Metropolitan area Threshold values Calgary 10.0 Edmonton 9.0 Halifax 8.5 Hamilton 9.5 Montréal 11.0 Ottawa-Gatineau 11.0 Québec 9.0 Toronto 14.0 Vancouver 18.5 Victoria 12.5 Winnipeg 7.5 Exposures in those areas remain subject to the minimum price correction until the SCRI for a metropolitan area falls below the threshold value. In this case, the minimum price correction would be removed in the next quarterly fiscal reporting period.

F. Timing of calculation

The following table provides a summary of the timing for performing the SCRI calculation and determining when the minimum price correction applies. blank Reporting quarter for which the SCRI applies SCRI calculations performed Month used for housing price index Data used for per capita income Financial Institutions with an October Y/E Q1 October 1 August June Q2 January 1 November September Q3 April 1 February December Q4 July 1 May March Financial Institutions with a December Y/E Q1 December 1 October September Q2 March 1 January December Q3 June 1 April March Q4 September 1 July June

G. Example

This example illustrates how to calculate the SCRIs for Q3 2016 for October year-end institutions and Q2 2016 for December year-end institutions for the 11 metropolitan areas in the Teranet index. Step 1: Calculation of metropolitan area smoothed Teranet indices The following table provides the monthly Teranet values for the 11 metropolitan areas for the last 11 months of 2015 and two first months of 2016 as well as the January 2016 and February 2016 smoothed values (determined as the average of the previous 12 months) rounded to the second decimal. Reference Date Calgary Edmonton Halifax Hamilton Montréal February 2015 184.10 181.24 136.72 157.60 146.42 March 2015 184.45 181.93 138.36 157.07 147.49 April 2015 184.85 183.11 139.39 156.99 148.92 May 2015 178.84 184.28 142.62 157.97 151.34 June 2015 183.23 184.27 142.05 161.85 152.61 July 2015 179.75 182.93 140.56 166.27 153.10 August 2015 186.70 182.02 140.05 170.33 152.35 September 2015 187.98 182.04 142.71 172.53 151.72 October 2015 186.51 182.33 140.30 172.08 151.32 November 2015 184.20 180.77 138.32 172.52 151.65 December 2015 181.10 180.21 140.45 171.51 149.74 January 2016 179.79 179.24 140.31 173.30 147.92 February 2016 178.09 179.40 136.25 172.64 146.19 January 2016 smoothed 183.46 182.03 140.15 165.84 150.38 February 2016 smoothed 182.96 181.88 140.11 167.09 150.36 Reference Date Ottawa- Gatineau Québec Toronto Vancouver Victoria Winnipeg February 2015 137.65 173.46 165.99 188.66 140.04 192.88 March 2015 137.20 176.09 166.42 189.14 139.70 193.33 April 2015 136.30 179.12 166.44 189.20 139.47 197.00 May 2015 138.30 180.71 169.10 191.58 140.19 197.39 June 2015 140.58 179.74 171.86 193.90 143.87 196.80 July 2015 143.75 178.61 175.91 196.94 146.36 195.89 August 2015 144.64 176.59 178.75 198.08 145.89 197.08 September 2015 143.88 173.15 179.79 201.20 147.08 194.32 October 2015 143.00 172.84 180.35 202.42 147.55 198.09 November 2015 141.22 173.58 180.53 205.15 150.15 197.48 December 2015 139.19 174.52 180.82 207.40 150.17 194.55 January 2016 137.77 173.82 180.51 209.17 151.25 195.16 February 2016 137.28 174.98 180.93 215.95 152.62 195.45 January 2016 smoothed 140.29 176.02 174.71 197.74 145.14 195.83 February 2016 smoothed 140.26 176.15 175.95 200.01 146.19 196.05 Step 2: Calculation of the per capita income Given the following values for the data series "Household disposable income" (table 36-10-0112-01) and "Population" data series (table 14-10-0287-01), the per capita income for Q4 2015 is determined as follows. The average population is rounded to the first decimal. Data series 2015 Statistics Canada data estimates Household disposable income Q4 1,131,400 Population October 29,377.5 Population November 29,401.2 Population December 29,419.0 Population Q4 (Average of October – December) 29,399.2 Then the per capita income for Q4 2015 is: 1,000 × 1,131,400 29,399.2 = 38,484.0 The per capita income value is rounded to the first decimal. Step 3: Calculation of metropolitan area SCRIs Using the February 2016 smoothed Teranet values for the 11 metropolitan areas and the per capita income for Q4 2015, the SCRIs before and after scaling for Q3 2016 for October year-end institutions are presented in the table below. For institutions with their fiscal year ending in December, January 2016 smoothed Teranet values along with the per capita income for Q4 2015 would be used to determine the SCRIs applicable for their Q2 2016. The SCRI before scaling is rounded to the fifth decimal, while the final SCRI is rounded to the second decimal. Metropolitan area February 2016 Teranet index smoothed (H) Q3 2016 SCRI before scaling H I Scaling Factor(s) Q3 2016 SCRIs H I × s Calgary 183.46 0.00477 2,500 11.92 Edmonton 182.03 0.00473 2,100 9.93 Halifax 140.15 0.00364 1,900 6.92 Hamilton 165.84 0.00431 2,000 8.62 Montréal 150.38 0.00391 2,500 9.77 Ottawa-Gatineau 140.29 0.00365 2,400 8.75 Québec 176.02 0.00457 1,700 7.78 Toronto 174.71 0.00454 3,300 14.98 Vancouver 197.74 0.00514 4,200 21.58 Victoria 145.14 0.00377 3,300 12.45 Winnipeg 196.05 0.00509 1,400 7.13 Where for example the Calgary SCRI before scaling H I is determined as: 183.46 38,484.0 = 0.00477 The SCRI would be calculated as: 0.00477 × 2,500 = 11.92 As the threshold value is set at 10.0 for Calgary, the minimum price correction of 25% would therefore apply for the Q3-2016 reporting quarter for institutions with an October year-end and Q2-2016 for institutions with a December year-end. ∆P in the add-on formula of paragraph 287 would then be equal to 25% and the add-on itself would be equal to the following: Add-on = Max ⁡ CLTV − 80 % × 100 % − 25 % , 0 − Max ⁡ CLTV − 80 % , 0 CLTV = Max ⁡ CLTV − 60 % , 0 − Max ⁡ CLTV − 80 % , 0 CLTV

Footnotes

Footnote 1 The Basel Framework Return to footnote 1 Footnote 2 Following the format: [Basel Framework XXX yy.zz]. Return to footnote 2 Footnote 3 Loans that meet the conditions set out in the second footnote to section 4.1.10 (footnote 35) of Chapter 4 are also eligible to be included in the IRB retail residential mortgage subclass. Return to footnote 3 Footnote 4 New accounts will be deemed revolvers until the account has been open for at least 12 months and the definition of a transactor is satisfied. Return to footnote 4 Footnote 5 Contra-accounts involve a customer buying from and selling to the same firm. The risk is that debts may be settled through payments in kind rather than cash. Invoices between the companies may be offset against each other instead of being paid. This practice can defeat a security interest when challenged in court. Return to footnote 5 Footnote 6 Claims on tranches of the proceeds (first loss position, second loss position, etc.) would fall under the securitization treatment. Return to footnote 6 Footnote 7 Exposures to sovereign are not excluded from the advanced IRB approach (see paragraphs 23 and 24). Return to footnote 7 Footnote 8 At the discretion of the host regulator, certain domestic exposures in a foreign jurisdiction may be exempt from the calculation of M (see paragraph 130). Return to footnote 8 Footnote 9 If this calculation results in a negative capital charge for any individual sovereign exposure, institutions should apply a zero capital charge for that exposure. Return to footnote 9 Footnote 10 The term “consolidated group” is defined in paragraph 40 above. Return to footnote 10 Footnote 11 This means that risk weights for residential mortgages also apply to the unsecured portion of such residential mortgages. Return to footnote 11 Footnote 12 As defined in section 4.1.11 of Chapter 4 of this guideline. Return to footnote 12 Footnote 13 Ibid Return to footnote 13 Footnote 14 Ibid Return to footnote 14 Footnote 15 This includes exposures to covered bonds as defined in section 4.1.5 of chapter 4. Return to footnote 15 Footnote 16 When credit derivatives do not cover the restructuring of the underlying obligation, the partial recognition set out in paragraph 266 of Chapter 4 applies. Return to footnote 16 Footnote 17 Under IFRS 9, Stage 3 allowances and partial write-offs are considered to be specific allowances, while Stage 1 and Stage 2 allowances are considered to be general allowances. Return to footnote 17 Footnote 18 A revolving loan facility is one that lets a borrower obtain a loan where the borrower has the flexibility to decide how often to withdraw from the loan and at what time intervals. A revolving facility allows the borrower to drawdown, repay and re-draw loans advanced to it. Facilities that allow prepayments and subsequent redraws of those prepayments are considered as revolving. Return to footnote 18 Footnote 19 The intention is to include both parties of a transaction meeting these conditions where neither of the parties is systematically under-collateralized. Return to footnote 19 Footnote 20 Under IFRS 9, Stage 3 allowances and partial write-offs are considered to be specific allowances, while Stage 1 and Stage 2 allowances are considered to be general allowances. Return to footnote 20 Footnote 21 The firm-size adjustment for SME, as defined in paragraph 68, will be the weighted average by individual exposure of the pool of purchased corporate receivables. If the institution does not have the information to calculate the average size of the pool, the firm-size adjustment will not apply. Return to footnote 21 Footnote 22 Examples include offsets or allowances arising from returns of goods sold, disputes regarding product quality, possible debts of the borrower to a receivables obligor, and any payment or promotional discounts offered by the borrower (e.g. a credit for cash payments within 30 days). Return to footnote 22 Footnote 23 Under IFRS 9, Stage 3 allowances and partial write-offs are considered to be specific allowances, while Stage 1 and Stage 2 allowances are considered to be general allowances. Return to footnote 23 Footnote 24 Institutions are not required to produce their own estimates of PD for exposures subject to the supervisory slotting approach. Return to footnote 24 Footnote 25 For each pool where the institutions estimate PD and LGD, they should analyse the representativeness of the age of the facilities (in terms of time since origination for PD and time since the date of default for LGD) in the data used to derive the estimates of the institution's actual facilities. In some jurisdictions default rates peak several years after origination or recovery rates show a low point several years after default, as such institutions should adjust the estimates with an adequate margin of conservatism to account for the lack of representativeness as well as anticipated implications of rapid exposure growth. Return to footnote 25 Footnote 26 Institutions are not required to produce their own estimates of PD for exposures subject to the supervisory slotting approach. Return to footnote 26 Footnote 27 Post-default advances and corresponding accrued interest can be captured in LGD or EAD estimates, provided it is done consistently across the institution. Return to footnote 27 Footnote 28 Under IFRS 9, Stage 3 allowances and partial write-offs are considered to be specific allowances, while Stage 1 and Stage 2 allowances are considered to be general allowances. Return to footnote 28 Footnote 29 Exposures secured by residential real estate refer to all retail lending products for which the collateral is residential real estate. New exposures include newly originated mortgages, refinances, and renewals. Return to footnote 29 Footnote 30 The DLGD floor applies to new insured mortgages effective November 1, 2017. Return to footnote 30 Footnote 31 The estimation of the exposure at default must be performed according to the requirements specified in this chapter. Return to footnote 31 Footnote 32 The metropolitan areas' geographical limits are determined using Statistics Canada's definition of Census Metropolitan Areas. Return to footnote 32 Footnote 33 Post-default advances and corresponding accrued interest can be captured in LGD or EAD estimates, provided it is done consistently across the institution. Return to footnote 33 Footnote 34 A specific type of CCF, where predicted additional drawings in the lead-up to default are expressed as a percentage of the undrawn limit that remains available to the obligor under the terms and conditions of a facility, i.e. EAD=B0=Bt+ULF[Lt –Bt], where B0 = facility balance at date of default; Bt = current balance (for predicted EAD) or balance at reference date (for observed EAD); Lt = current limit (for predicted EAD) or limit at reference date (for realized/observed EAD). Return to footnote 34 Footnote 35 A limit factor (LF) is a specific type of CCF, where the predicted balance at default is expressed as a percentage of the total limit that is available to the obligor under the terms and conditions of a credit facility, i.e. EAD=B0= LF[Lt], where B0 = facility balance at date of default; Bt = current balance (for predicted EAD) or balance at reference date (for observed EAD); Lt = current limit (for predicted EAD) or limit at reference date (for realized/observed EAD). A balance factor (BF) is a specific type of CCF, where the predicted balance at default is expressed as a percentage of the current balance that has been drawn down under a credit facility, i.e. EAD=B0=BF[Bt]. An additional utilization factor (AUF) is a specific type of CCF, where predicted additional drawings in the lead-up to default are expressed as a percentage of the total limit that is available to the obligor under the terms and conditions of a credit facility, i.e. EAD = B0 = Bt + AUF[Lt]. Return to footnote 35 Footnote 36 In some jurisdictions, first liens are subject to the prior right of preferential creditors, such as outstanding tax claims and employees' wages. Return to footnote 36 Footnote 37 Lenders in some markets extensively use loan structures that include junior liens. Junior liens may be indicative of this level of risk if the total LTV inclusive of all senior positions does not exceed a typical first loan LTV. Return to footnote 37 Footnote 38 In the future, OSFI may consider using equivalent house price indices with the same geographic coverage. Return to footnote 38 Footnote 39 The metropolitan areas geographical limits are determined using Statistics Canada definition of Census Metropolitan Areas. Return to footnote 39 Footnote 40 In particular, the threshold value for a particular metropolitan area is given by the formula: Threshold = Average SCRI + K , where K = α × Average SCRI + β × Standard Deviation , and where the quantities α and β are the same for all metropolitan areas and are assumed to be non-negative. The average and standard deviation are specific to each metropolitan area and are determined based on the experience over historical periods that are not considered to be outside the tail of the distribution. Return to footnote 40

Note

For institutions with a fiscal year ending October 31 or December 31, respectively. The Capital Adequacy Requirements (CAR) for banks (including federal credit unions), bank holding companies, federally regulated trust companies, and federally regulated loan companies are set out in nine chapters, each of which has been issued as a separate document. This document, Chapter 6 – Securitization, should be read in conjunction with the other CAR chapters. The complete list of CAR chapters is as follows: Chapter 1 - Overview of Risk-Based Capital Requirements Chapter 2 - Definition of Capital Chapter 3 - Operational Risk Chapter 4 - Credit Risk - Standardized Approach Chapter 5 - Credit Risk - Internal Ratings-Based Approach Chapter 6 - Securitization Chapter 7 - Settlement and Counterparty Risk Chapter 8 - Credit Valuation Adjustment (CVA) Risk Chapter 9 - Market Risk Please refer to OSFI's Corporate Governance Guideline for OSFI's expectations of institution Boards of Directors in regard to the management of capital and liquidity.

Chapter 6 – Securitization

This chapter is drawn from the Basel Committee on Banking Supervision's (BCBS) Basel framework published on the BIS website,^{Footnote 1} effective December 15, 2019. For reference, the Basel text paragraph numbers that are associated with the text appearing in this chapter are indicated in square brackets at the end of each paragraph.^{Footnote 2} The securitization framework is to be applied in determining the risk-weighted capital treatment applicable to all securitization exposures that meet the definitions and operational requirements below regardless of accounting treatment. For greater clarity, and to ensure consistency with paragraph 5 below, all exposures to mortgage-backed securities that do not involve tranching with associated subordination of credit risk (e.g. NHA MBS) will not be considered securitization exposures for risk-based capital purposes under the securitization framework. Such exposures are to be treated for risk-based capital purposes according to the applicable sections of Chapter 4 or Chapter 5 of this guideline.

6.1 Scope and definitions of transactions covered under the securitization framework

Institutions must apply the securitization framework for determining regulatory capital requirements on exposures arising from traditional and synthetic securitizations or similar structures that contain features common to both. Since securitizations may be structured in many different ways, the capital treatment of a securitization exposure must be determined on the basis of its economic substance rather than its legal form. Similarly, OSFI will look to the economic substance of a transaction to determine whether it should be subject to the securitization framework for purposes of determining regulatory capital. Institutions are encouraged to consult with OSFI when there is uncertainty about whether a given transaction should be considered a securitization. For example, transactions involving cash flows from real estate (e.g. rents) may be considered specialized lending exposures, if warranted. [Basel Framework, CRE 40.1] A traditional securitization is a structure where the cash flow from an underlying pool of exposures is used to service at least two different stratified risk positions or tranches reflecting different degrees of credit risk. Payments to the investors depend upon the performance of the specified underlying exposures, as opposed to being derived from an obligation of the entity originating those exposures. The stratified/tranched structures that characterize securitizations differ from ordinary senior/subordinated debt instruments in that junior securitization tranches can absorb losses without interrupting contractual payments to more senior tranches, whereas subordination in a senior/subordinated debt structure is a matter of priority of rights to the proceeds of liquidation. [Basel Framework, CRE 40.2] A synthetic securitization is a structure with at least two different stratified risk positions or tranches that reflect different degrees of credit risk where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of funded (e.g. credit-linked notes) or unfunded (e.g. credit default swaps) credit derivatives or guarantees that serve to hedge the credit risk of the portfolio. Accordingly, the investors' potential risk is dependent upon the performance of the underlying pool. Operational requirements applicable to synthetic securitizations are detailed in section 6.3.2 below. [Basel Framework, CRE 40.3] Institutions' exposures to a securitization are hereafter referred to as "securitization exposures". Securitization exposures can include but are not restricted to the following: asset-backed securities, mortgage-backed securities, credit enhancements, liquidity facilities, loans to securitization vehicles to fund the acquisition of assets, interest rate or currency swaps, credit derivatives and tranched cover as described in Chapter 4, paragraph 276. Reserve accounts, such as cash collateral accounts, recorded as an asset by the originating institution must also be treated as securitization exposures. [Basel Framework, CRE 40.4] A resecuritization exposure is a securitization exposure in which the risk associated with an underlying pool of exposures is tranched and at least one of the underlying exposures is a securitization exposure. In addition, an exposure to one or more resecuritization exposures is a resecuritization exposure. An exposure resulting from the retranching of a securitization exposure is not a resecuritization if the institution is able to demonstrate that the cash flows to and from the institution can be replicated in all circumstances and conditions by an exposure to the securitization of a pool of assets that contains no securitization exposures. For resecuritization exposures, institutions must apply the SEC-SA, with the adjustments in section 6.7. [Basel Framework, CRE 40.5 and 40.48] Underlying instruments in the pool being securitized may include but are not restricted to the following: loans, commitments, asset-backed and mortgage-backed securities, corporate bonds, equity securities, and private equity investments. The underlying pool may include one or more exposures. [Basel Framework, CRE 40.6]

6.2. Definitions and general terminology

6.2.1.1. Originating institution / Originator

For risk-based capital purposes, an institution is considered to be an originator with regard to a certain securitization if it meets either of the following conditions: The institution originates directly or indirectly underlying exposures included in the securitization; or The institution serves as a sponsor of an asset-backed commercial paper (ABCP) conduit or similar programme that acquires exposures from third-party entities. In the context of such programmes, an institution would generally be considered a sponsor and, in turn, an originator if it, in fact or in substance, manages or advises the programme, places securities into the market, or provides liquidity and/or credit enhancements. [Basel Framework, CRE 40.7]

6.2.1.2. Asset-backed commercial paper (ABCP) programme

An ABCP programme predominately issues commercial paper to third-party investors with an original maturity of one year or less and is backed by assets or other exposures held in a bankruptcy-remote, special purpose entity. [Basel Framework, CRE 40.8]

6.2.1.3. Clean-up call

A clean-up call is an option that permits the securitization exposures (e.g. asset-backed securities) to be called before all of the underlying assets or securitization exposures have been repaid. In the case of traditional securitizations, this is generally accomplished by the originator repurchasing the remaining assets in the securitization structure once the pool balance or outstanding securities have fallen below some specified level. In the case of a synthetic transaction, the clean-up call may take the form of a clause that extinguishes the credit protection. [Basel Framework, CRE 40.9]

6.2.1.4. Credit enhancement

A credit enhancement is a contractual arrangement in which the institution or third party retains or assumes a securitization exposure and, in substance, provides some degree of added protection to other parties to the transaction. [Basel Framework, CRE 40.10]

6.2.1.5. Credit-enhancing interest-only strip

A credit-enhancing interest-only strip (I/O) is an on-balance sheet asset that: represents a valuation of cash flows related to future margin income, and is subordinated. Credit-enhancing interest-only strips, net of any increases in equity capital resulting from securitization transactions must be risk-weight at 1250%, as noted in paragraph 41. Valuations of cash flows related to future margin income that are not subordinated are referred to as non-credit enhancing interest only strips, and must be risk-weighted either i) according to Chapter 4, section 4.1.23, or ii) when a tranche rating provided by a rating agency is available that satisfies the Operational requirements for external credit assessments outlined in section 6.6.2.3, SEC-ERBA can be applied. [Basel Framework, CRE 40.11]

6.2.1.6. Early amortization

An early amortization provision is a mechanism that, once triggered, accelerates the reduction of the investor's interest in the underlying exposures of a securitization of revolving credit facilities and allows investors to be paid out prior to the originally stated maturity of the securities issued. A securitization of revolving credit facilities is a securitization in which one or more underlying exposures represent, directly or indirectly, current or future draws on a revolving credit facility. Examples of revolving credit facilities include but are not limited to credit card exposures, home equity lines of credit, commercial lines of credit and other lines of credit. [Basel Framework, CRE 40.12]

6.2.1.7. Excess spread

Excess spread (or future margin income) is defined as gross finance charge collections and other income received by the trust or special purpose entity (SPE, as defined below) minus certificate interest, servicing fees, charge-offs, and other senior trust or SPE expenses. [Basel Framework, CRE 40.13]

6.2.1.8. Implicit support

Implicit support arises when an institution provides support to a securitization in excess of its predetermined contractual obligation. Implicit support is discussed further in section 6.8. [Basel Framework, CRE 40.14]

6.2.1.9. Internal Ratings-Based (IRB) pool

For risk-based capital purposes, an IRB pool means a securitization pool for which an institution is able to use an IRB approach to calculate capital requirements for all underlying exposures given that it has OSFI approval to apply IRB for the type of underlying exposure (including the asset class and geography of those exposures) and it has sufficient information to calculate IRB requirements for these exposures (from a type of data source that is consistent with the IRB approval). OSFI expects institutions that have IRB approval for an underlying pool of exposures to treat that pool as an IRB pool. An institution that has sufficient information to calculate the IRB requirements for exposures, but cannot treat an underlying pool, for which it has an OSFI-approved IRB approach, as an IRB pool is expected to demonstrate to OSFI why it cannot calculate capital requirements for the underlying pool of exposures using an IRB approach. However, institutions must consult with OSFI prior to treating an IRB pool as such in the following circumstances: transactions that have highly complex loss allocations, tranches whose credit enhancement could be eroded for reasons other than portfolio losses, or tranches of portfolios with high internal correlations (such as portfolios with high exposure to single sectors or with high geographic concentration). [Basel Framework, CRE 40.15]

6.2.1.10. Mixed pool

For risk-based capital purposes, a mixed pool means a securitization pool for which an institution is able to calculate IRB parameters for some, but not all, underlying exposures in a securitization. [Basel Framework, CRE 40.16]

6.2.1.11. Non-performing loan securitization

A non-performing loan securitization (NPL securitization) means a securitization where the underlying pool's variable W, as defined in paragraph 126, is equal to or higher than 90% at the origination cut-off date and at any subsequent date on which assets are added to or removed from the underlying pool due to replenishment, restructuring, or any other relevant reason. The underlying pool of exposures of an NPL securitization may only comprise loans, loan-equivalent financial instruments or tradable instruments used for the sole purpose of loan subparticipation as referred to in paragraph 29(d). Loan-equivalent financial instruments include, for example, bonds not listed on a trading venue. For the avoidance of doubt, an NPL securitization may not be backed by exposures to other securitizations. NPL securitization must apply the framework laid out in section 6.12. [Basel Framework, CRE 40.48 and CRE 45.1]

6.2.1.12. Standardized Approach (SA) pool

For risk-based capital purposes, an SA pool means a securitization pool for which an institution does not have approval to calculate IRB parameters for any underlying exposures, or for which, while the institution has approval to calculate IRB parameters for some or all of the types of underlying exposures, it is unable to calculate IRB parameters for any underlying exposures due to lack of relevant data, or is prohibited by OSFI from treating the pool as an IRB pool pursuant to paragraph 18. [Basel Framework, CRE 40.17]

6.2.1.13. Senior securitization exposure (tranche)

A securitization exposure (tranche) is considered to be a senior exposure (tranche) if it is effectively backed or secured by a first claim on the entire amount of the assets in the underlying securitized pool.^{Footnote 3} While this generally includes only the most senior position within a securitization transaction, in some instances there may be other claims that, in a technical sense, may be more senior in the waterfall (e.g. a swap claim) but may be disregarded for the purpose of determining which positions are treated as senior. Different maturities of several senior tranches that share pro rata loss allocation shall have no effect on the seniority of these tranches, since they benefit from the same level of credit enhancement. The material effects of differing tranche maturities are captured by maturity adjustments on the risk weights to be assigned to the securitization exposures. For example: In a typical synthetic securitization, an unrated tranche would be treated as a senior tranche, provided that all of the conditions for inferring a rating from a lower tranche that meets the definition of a senior tranche are fulfilled. In a traditional securitization where all tranches above the first-loss piece are rated, the most highly rated position would be treated as a senior tranche. When there are several tranches that share the same rating, only the most senior tranche in the cash flow waterfall would be treated as senior (unless the only difference among them is the effective maturity). Also, when the different ratings of several senior tranches only result from a difference in maturity, all of these tranches should be treated as a senior tranche. Usually a liquidity facility supporting an ABCP programme would not be the most senior position within the programme; the commercial paper, which benefits from the liquidity support, typically would be the most senior position. However, a liquidity facility may be viewed as covering all losses on the underlying receivables pool that exceed the amount of overcollateralization/reserves provided by the seller and as being most senior if it is sized to cover all of the outstanding commercial paper and other senior debt supported by the pool, so that no cash flows from the underlying pool could be transferred to the other creditors until any liquidity draws were repaid in full. In such a case, the liquidity facility can be treated as a senior exposure. Otherwise, if these conditions are not satisfied, or if for other reasons the liquidity facility constitutes a mezzanine position in economic substance rather than a senior position in the underlying pool, the liquidity facility should be treated as a non-senior exposure. [Basel Framework, CRE 40.18]

6.2.1.14. Servicer cash advances or facilities

An institution may be contractually obligated to provide funds to an SPE to ensure an uninterrupted flow of payments to investors in the SPE's securities, solely under the unusual circumstance that payments from the underlying assets have not been received due to temporary timing differences. An institution that provides such support is typically referred to as a servicing agent and the funds provided are typically referred to as servicer advances. Servicer cash advances or facilities must meet the following requirements: The servicers are entitled to full reimbursement and this right is senior to other claims on cash flows from the underlying pool of exposures, Servicer advances may not be made to offset shortfalls in cash flows that arise from defaulted assets, The total value of cash advances is limited to the total amount transferable for that collection period, The servicing agent must perform an assessment of the likelihood of repayment of the servicer advances based on prudent lending standards.

6.2.1.15. Special purpose entity (SPE)

An SPE is a corporation, trust, or other entity organized for a specific purpose, the activities of which are limited to those appropriate to accomplish the purpose of the SPE, and the structure of which is intended to isolate the SPE from the credit risk of an originator or seller of assets or exposures held by the SPE. SPEs, normally a trust or similar entity, are commonly used as financing vehicles in which assets or exposures are sold to the SPE in exchange for cash or other assets funded by debt issued by the SPE. [Basel Framework, CRE 40.21]

6.2.1.16. Tranche maturity

For risk-based capital purposes, tranche maturity (MT) is the tranche's remaining effective maturity in years and can be measured at the institution's discretion in either of the following manners: As the dollar weighted-average maturity of the contractual cash flows of the tranche: M T = ∑ t t C F t ∕ ∑ t C F t where CFt denotes the cash flows (principal, interest payments and fees) contractually payable to the tranche in period t. The contractual payments to the tranche may be used without regard to the cash flows of the underlying securitized assets only when such payments are unconditional and not dependent on the actual performance of the securitized assets. Where payments to the tranche are dependent on the performance of the securitized assets, institutions must separately model the cash flows of the underlying assets and the contractual cash waterfall of the securitization to estimate the cash flows payable to the reference tranche in each period. The cash flow model for the underlying assets should assume no defaults. If at least five years of prepayment data for the same asset class in the same country is available to the institution, prepayments on the underlying assets should be assumed to be the lowest of: The prepayment rate assumed in the base case of the transaction pricing or hedging of the transaction, The lowest historically observed (a) annualized quarterly portfolio prepayment rate or (b) annualized prepayment rate derived from historical vintage origination curves, determined in either instance over the longest available period for the same originator, or if less than five years of data from the same originator is available, for the same asset class in the same country (minimum five-year period), and The average observed prepayment rate through the life of the specific transaction (minimum one year of data). The resulting annual prepayment rate will be subject to a cap of 20%. If less than five years of prepayment data for comparable assets are available, zero prepayments should be assumed. If one of the above three approaches is unavailable (for example, the third approach is unavailable until one year of transaction data is available), then the approach would not be considered in the calculation of prepayment rates. For securitization transactions with revolving periods (including equivalent exposures, such as drawn securitization commitments) the weighted-average cash flow methodology may be applied, however the cash flow model for the underlying assets should be determined by adjusting the scheduled maturity of each exposure that matures before the end of the revolving period to the sum of: The exposure's current maturity, and The longest permitted maturity of an exposure that is eligible to be added to the securitized portfolio during the revolving period. This adjustment should be made as many times as necessary until the adjusted maturity of each exposure extends past the end of the revolving period. The adjustment should be re-calculated at least quarterly with updated information from the pool. No adjustment is made to the maturity of an exposure if the exposure is scheduled to mature after the end of the revolving period. The periodic cash flows for each underlying exposure should be assumed to continue to be collected until the adjusted maturity date, and these adjusted cash flows should be used when calculating the weighted-average maturity of the contractual cash flows of the tranche. Any undrawn portion may remain undrawn under this calculation. If the necessary payment information are not available, the calculation on the basis of final legal maturity shall be used. On the basis of the final legal maturity of the tranche, as: M T = 1 + ( M L − 1 ) × 80 % Where MLis the final legal maturity of the tranche, not including any time periods defined by law solely for purpose of instituting legal action by an investor or against an obligor in the asset pool. In all cases, MT will have a floor of one year and a cap of five years. [Basel Framework, CRE 40.22] When determining the maturity of a securitization exposure, institutions should take into account the maximum period of time they are exposed to potential losses from the securitized assets. In cases where an institution provides a commitment, the institution should calculate the maturity of the securitization exposure resulting from this commitment either by applying the approach outlined in paragraph 26(a) or as the sum of the contractual maturity of the commitment and the longest maturity of the asset(s) to which the institution is exposed after a draw has occurred. Any contractual limits on the maturity of the assets in the pool may be used in this calculation of maturity, such that the maturity of a commitment may be calculated as a weighted-average of the longest-dated assets that may contractually be included in the pool rather than the single longest-dated asset that may be added. The same treatment applies to all other instruments where the risk of the commitment/protection provider is not limited to losses realized until the maturity of that instruments (e.g. total return swaps). In cases where concentration limits have been placed on relevant maturities, institutions have performed due diligence and reviewed historical information on assets being originated, and institutions have received a no adverse selection representation on the pools being securitized, the maturity of the commitment may be calculated as the sum of the contractual maturity of the commitment and the projected dollar weighted average maturity of a new draw under the commitment. [Basel Framework, CRE 40.23] For credit protection instruments that are only exposed to losses that occur up to the maturity of that instrument, an institution would be allowed to apply the contractual maturity of the instrument and would not have to look through to the protected portion. [Basel Framework, CRE 40.23]

6.3. Operational requirements for the recognition of risk transference

6.3.1. Operational requirements for traditional securitizations

An originating institution may exclude securitized exposures that are reported on their balance sheet from the calculation of risk-weighted assets only if all of the following conditions have been met. Institutions meeting these conditions must still hold regulatory capital against any securitization exposures they retain. Significant credit risk associated with the underlying exposures has been transferred to third parties. An originating institution is required to establish policies and procedures to ensure that significant credit risk is being assessed and all operational requirements met for all securitized assets if the originating institution intends to exclude the securitized assets from the calculation of risk-weighted assets. These policies must include how the risk transfer will be assessed on an ongoing basis and should be available for review by OSFI upon request. In addition to the policies and procedures noted above, originating institutions must meet the following quantitative test in order to determine that significant credit risk has been transferred to third parties; The capital required for exposures retained by the originating institution in the securitization structure following issuance must be no more than 40% of the capital required for the pool of assets supporting all tranches of the securitization structure, that is, a reduction in risk-weighted assets of at least 60%, including an EL-adjustment for IRB pools. The risk-weighted assets for the exposures retained should be calculated in accordance with this chapter, including the application of any relevant risk weight caps, but excluding any risk weight floors. For purposes of this test, the pool of assets supporting all tranches is defined as the assets associated with one or more series of notes issued by the SPE. For clarity, the pool of assets generally excludes the retained interest or seller's interest in a pool of assets including the undrawn balances of revolving facilities where only drawn balances have been securitized. Under this test, the risk-weighted asset amounts for the retained positions and for the pool of assets must be calculated by using consistent risk-based approaches. In particular, if the standardized credit risk approach is utilized by the originating institution for the asset pool, the institution must calculate capital required for the retained positions under the SEC-SA. If the internal ratings-based approach is used for the asset pool, the SEC-IRBA must be used for the retained positions. The hierarchy of approaches should be followed when risk weighting the exposure outside of this test. Once met, this assessment of significant risk transfer will also apply for the purposes of the capital floor without a separate test being required. The quantitative test specified in (b) does not need to be met if all positions retained by the institution are risk-weighted at 1250%.^{Footnote 4} The originating institution does not maintain effective or indirect control over the transferred exposures. The exposures are legally isolated from the institution in such a way (e.g. through the sale of assets or through subparticipation) that the exposures are put beyond the reach of the institution and its creditors, even in bankruptcy or receivership. Institutions should obtain a legal opinion^{Footnote 5} that confirms true sale. The originating institution is deemed to have maintained effective control over the transferred credit risk exposures if it: (i) is able to repurchase from the transferee the previously transferred exposures in order to realize their benefits; or (ii) is obligated to retain the risk of the transferred exposures. The originating institution's retention of servicing rights to the exposures will not necessarily constitute indirect control of the exposures. The securities issued are not obligations of the originating institution. Thus, investors who purchase the securities only have claim to the underlying pool of exposures. The transferee is an SPE and the holders of the beneficial interests in that entity have the right to pledge or exchange them without restriction. Clean-up calls must satisfy the conditions set out in section 6.3.4. The securitization does not contain clauses that (i) require the originating institution to alter the underlying exposures such that the pool's credit quality is improved unless this is achieved by selling exposures to independent and unaffiliated third parties at market prices; (ii) allow for increases in a retained first loss position or credit enhancement provided by the originating institution after the transaction's inception; or (iii) increase the yield payable to parties other than the originating institution, such as investors and third-party providers of credit enhancements, in response to a deterioration in the credit quality of the underlying pool. There must be no termination options/triggers except eligible clean-up calls, termination for specific changes in tax and regulation or early amortization provisions such as those set out in paragraph 32. The originating institution must not own any share capital in a company, nor may it be the beneficiary of a trust, used as an SPE for purchasing and securitizing financial assets. For this purpose, share capital includes all classes of common and preferred share capital. The originating institution's name must not be included in the name of a company or trust used as an SPE, nor may any connection be implied with the institution by, for example, using a symbol closely associated with the institution. If, however, the institution is performing a specific function for a particular transaction or transactions (e.g. collecting and transmitting payments or providing enhancement), this may be indicated in the offering circular (subject to the Name Use Regulations). The originating institution must not have any of its directors, officers or employees on the board of directors of a company used as an SPE, unless the SPE's board has at least three members. Where the board consists of three or more members, the institution may not have more than one director. Where the SPE is a trust, the beneficiary and the indenture trustee and/or the issuer trustee must be third parties independent of the institution. The originating institution does not lend to the SPE on a subordinated basis. An exception to this criterion is available if the subordinated loan is provided by an institution to an SPE to cover initial transaction or set-up costs. Such a loan may be risk-weighted 1250% as long as the loan is capped at its original amount; amortized over the life of the securities issued by the SPE; and the loan is not available as a form of enhancement to the assets or securities issued. The institution must not support, except as provided elsewhere in this guideline, any losses suffered by the SPE, or investors in it, or bear any of the recurring expenses of the SPE. [Basel Framework, CRE 40.24]

6.3.2. Operational requirements for synthetic securitizations

For synthetic securitizations, the use of credit risk mitigation (CRM) techniques (i.e. collateral, guarantees and credit derivatives) for hedging the underlying exposure may be recognized for risk-based capital purposes only if the conditions outlined below are satisfied: Credit risk mitigants must comply with the requirements as set out in section 4.3 of this guideline. Eligible collateral is limited to that specified in section 4.3.3. Eligible collateral pledged by SPEs may be recognized. Eligible guarantors are defined in section 4.3.5. Institutions cannot recognize SPEs as eligible guarantors in the securitization framework. Institutions must transfer significant credit risk associated with the underlying exposure to third parties, consistent with paragraphs 29 (a) through (c). The instruments used to transfer credit risk cannot contain terms or conditions that limit the amount of credit risk transferred, such as those provided below: Clauses that materially limit the credit protection or credit risk transference (e.g. an early amortization provision in a securitization of revolving credit facilities that effectively subordinates the institution's interest; significant materiality thresholds below which credit protection is deemed not to be triggered even if a credit event occurs; or clauses that allow for the termination of the protection due to deterioration in the credit quality of the underlying exposures); Clauses that require the originating institution to alter the underlying exposures to improve the pool's average credit quality; Clauses that increase the institutions' cost of credit protection in response to deterioration in the pool's quality; Clauses that increase the yield payable to parties other than the originating institution, such as investors and third-party providers of credit enhancements, in response to a deterioration in the credit quality of the reference pool; and Clauses that provide for increases in a retained first loss position or credit enhancement provided by the originating institution after the transaction's inception. An institution should obtain a legal opinion that confirms the enforceability of the contract. Clean-up calls must satisfy the conditions set out in section 6.3.4. [Basel Framework, CRE 40.25]

6.3.3. Operational requirements for early amortization provisions

A securitization is deemed to fail the operational requirements set out in paragraphs 29 or 30 if the institution: originates/sponsors a securitization transaction that includes one or more revolving credit facilities, and the securitization transaction incorporates an early amortization or similar provision that, if triggered, would: subordinate the institution's senior or pari passu interest in the underlying revolving credit facilities to the interest of other investors; subordinate the institution's subordinated interest to an even greater degree relative to the interests of other parties; or in other ways increase the institution's exposure to losses associated with the underlying revolving credit facilities. [Basel Framework, CRE 40.26] If a securitization transaction meets the operational requirements set forth in paragraphs 29 and 30 and contains one of the following types of early amortization provisions, an originating institution may exclude the securitized portion of the underlying exposures associated with such a transaction from the calculation of risk-weighted assets, but must still hold regulatory capital against any securitization exposures it retains in connection with the transaction: replenishment structures where the underlying exposures do not revolve and the early amortization ends the ability of the institution to add new exposures; transactions of revolving credit facilities containing early amortization features that mimic term structures (i.e. where the risk on the underlying revolving credit facilities does not return to the originating institution) and where the early amortization provision in a securitization of revolving credit facilities does not effectively result in subordination of the originator's interest; structures where an institution securitizes one or more revolving credit facilities and where investors remain fully exposed to future drawdowns by borrowers even after an early amortization event has occurred; or the early amortization provision is solely triggered by events not related to the performance of the underlying assets or the selling institution, such as material changes in tax laws or regulations. [Basel Framework, CRE 40.27]

6.3.4. Operational requirements and treatment of clean-up calls

For securitization transactions that include a clean-up call, no capital will be required due to the presence of a clean-up call if all the following conditions are met: the exercise of the clean-up call must not be mandatory, in form or in substance, but rather must be at the discretion of the originating institution; the clean-up call must not be structured to avoid allocating losses to credit enhancements or positions held by investors or otherwise structured to provide credit enhancement; and the clean-up call must only be exercisable when 10% or less of the original underlying portfolio, or securities issued remains, or, for synthetic securitizations, when 10% or less of the original reference portfolio value remains. [Basel Framework, CRE 40.28] Securitization transactions that include a clean-up call that does not meet all of the criteria stated in paragraph 33 result in a capital requirement for the originating institution. For a traditional securitization, the underlying exposures must be treated as if they were not securitized. Additionally, institutions must not recognize in regulatory capital any gain-on-sale, as defined in paragraph 41. For synthetic securitizations, the institution purchasing protection must hold capital against the entire amount of the securitized exposures as if they did not benefit from any credit protection. If a synthetic securitization incorporates a call (other than a clean-up call) that effectively terminates the transaction and the purchased credit protection on a specific date, the institution must treat the transaction in accordance with paragraph 159. [Basel Framework, CRE 40.29] If a clean-up call, when exercised, is found to serve as a credit enhancement, the exercise of the clean-up call must be considered a form of implicit support provided by the institution and must be treated in accordance with the supervisory guidance on implicit support pertaining to securitization transactions described in section 6.8. [Basel Framework, CRE 40.30]

6.4. Due diligence requirements

For an institution to use the risk weight approaches of the securitization framework, it must have the information specified in paragraphs 37 to 39. Otherwise the institution must assign a 1250% risk weight to any securitization for which it cannot perform the required level of due diligence. [Basel Framework, CRE 40.31] As a general rule, an institution must, on an ongoing basis, have a comprehensive understanding of the risk characteristics of its individual securitization exposures, whether on- or off-balance sheet, as well as the risk characteristics of the pools underlying its securitization exposures. [Basel Framework, CRE 40.32] Institutions must be able to access performance information on the underlying pools on an ongoing basis in a timely manner. Such information may include, as appropriate: exposure type; percentage of loans 30, 60 and 90 days past due; default rates; prepayment rates; loans in foreclosure; property type; occupancy; average credit scope or other measures of credit worthiness; average loan-to-value ratio; and industry and geographical diversification. For resecuritizations, institutions should have information not only on the underlying securitization tranches, such as the issuer name and credit quality, but also on the characteristics and performance of the pools underlying the securitization tranches. [Basel Framework, CRE 40.33] An institution must have a thorough understanding of all structural features of a securitization transaction that would materially impact the performance of the institution's exposures to the transaction, such as the contractual waterfall and waterfall-related triggers, credit enhancements, liquidity enhancements, market value triggers, and deal-specific definitions of default. [Basel Framework, CRE 40.34]

6.5. Treatment of securitization exposures

6.5.1. Calculation of capital requirements and risk-weighted assets

Regulatory capital is required for institutions' securitization exposures, including those arising from the provision of credit risk mitigants to a securitization transaction, investments in asset-backed securities, retention of a subordinated tranche, and extension of a liquidity facility or credit enhancement, as set forth in the following sections. Repurchased securitization exposures must be treated as retained securitization exposures. Institutions whose only involvement in securitization transactions is the collection of interest and principal and is under no obligation to remit funds unless received to the SPE or trustees, is not required to hold capital for performing this role. [Basel Framework, CRE 40.35] Institutions must deduct from Common Equity Tier 1 capital any increase in equity capital resulting from a securitization transaction, such as receivables associated with expected future margin income (FMI) resulting in a gain-on-sale that is recognized in regulatory capital. Similarly, credit-enhancing interest-only strips will be risk-weighted at 1250%, other unrated interest-only strips that are subject to prepayment risk will be risk-weighted at 250%, and other unrated interest-only strips that are not subject to prepayment risk will be risk-weighted at 100%, consistent with section 4.1.23 of Chapter 4. Credit risk mitigation techniques outlined in section 4.3 of Chapter 4 may be applied to interest-only strips risk-weighted as described above. Rated interest-only strips may be treated under SEC-ERBA, which is described in section 6.6.2 of this chapter. [Basel Framework, CAP 30.14] For the purposes of the expected loss (EL) provision calculation as set out section 5.7 of this guideline, securitization exposures do not contribute to the EL amount. Similarly, neither general nor specific allowances^{Footnote 6} against securitization exposures or underlying assets still held on the balance sheet of the originator are to be included in the measurement of eligible allowances. However, originating institutions can offset 1250% risk-weighted securitization exposures by reducing the securitization exposure amount by the amount of their specific allowances on underlying assets of that transaction and non-refundable purchase price discounts on such underlying assets. Specific allowances on securitization exposures will be taken into account in calculating the exposure amount, as defined in paragraphs 44 and 47. General allowances on underlying securitization exposures are not to be taken into account in any calculation. [Basel Framework, CRE 40.36] The risk-weighted amount of a securitization exposure is computed by multiplying the exposure amount, as defined in paragraphs 44 and 47, by the appropriate risk weight determined in accordance with the hierarchy of approaches in paragraphs 51 to 57. Risk weight caps for senior exposures in accordance with paragraphs 134 and 135 or overall caps in accordance with paragraphs 136 to 141 may apply. Overlapping exposures will be risk-weighted as defined in paragraphs 48 to 50. [Basel Framework, CRE 40.37]

6.5.1.1. Securitization exposure amount

For risk-based capital purposes, the exposure amount of a securitization exposure is the sum of the on-balance sheet amount of the exposure, or carrying value – which takes into account purchase discounts or writedowns/specific provisions taken by the institution on this securitization exposure – and the off-balance sheet exposure amount, where applicable. [Basel Framework, CRE 40.19] Securitization commitments are arrangements that obligate an institution to purchase or fund securitization exposures at a client's request, normally involving a written contract or agreement and some form of consideration, such as a commitment fee. Institutions may exempt certain securitization facilities from the definition of commitments provided that the following conditions are met: the institution receives no fees or commissions to establish or maintain the facilities; the client is required to apply to the institution for the initial and each subsequent drawdown; the institution has full authority, regardless of the fulfilment by the client of the conditions set out in the facility documentation, over the execution of each drawdown; and the institution's decision on the execution of each drawdown is only made after assessing the creditworthiness of the client immediately prior to drawdown. An institution must measure the exposure amount of its off-balance sheet securitization exposures as follows: For credit risk mitigants sold or purchased by the institution, use the treatment set out in paragraphs 150 to 156. For derivative contracts other than credit risk derivatives contracts, such as interest rate or currency swaps sold or purchased by the institution, use the measurement approach that the institution would use under the counterparty credit risk framework as outlined in Chapter 7 of this guideline. For the undrawn portion of securitization commitments extended to a client to fund the securitization of client vehicle acquisition of assets^{Footnote 7} in the securitization subject to asset eligibility criteria, use a credit conversion factor (CCF) of 40%. If contractually provided for, servicers may advance cash to ensure an uninterrupted flow of payments to investors so long as the servicer is entitled to full reimbursement and this right is senior to other claims on cash flows from the underlying pool of exposures. The undrawn portion of such servicer cash advances or facilities that are unconditionally cancellable without prior notice receive a CCF of 10%. For other securitization commitments that are not credit risk mitigants, use a CCF of 100%. [Basel Framework, CRE 40.20]

6.5.1.2. Treatment of overlapping exposures

For the purpose of calculating capital requirements, an institution's exposure A that overlaps another exposure B if in all circumstances the institution will preclude any loss for the institution on exposure B by fulfilling its obligations with respect to exposure A. For example, if an institution provides full credit support to some notes and holds a portion of these notes, its full credit support obligation precludes any loss from its exposure to the notes. If an institution can verify that fulfilling its obligations with respect to exposure A will preclude a loss from its exposure to B under all circumstances, the institution does not need to calculate risk-weighted assets for its exposure to B. [Basel Framework, CRE 40.38] To arrive at an overlap, an institution may, for purposes of calculating capital requirements, split or expand^{Footnote 8} its exposures. For example, a liquidity facility may not be contractually required to cover defaulted assets or may not fund an ABCP programme in certain circumstances. For capital purposes, such a situation would not be regarded as an overlap to the notes issued by the ABCP conduit. However, the institution may calculate risk-weighted assets for the liquidity facility as if it were expanded (either in order to cover defaulted assets or in terms of trigger events) to preclude all losses on the notes. In such a case, the institution would only need to calculate capital requirements on the liquidity facility. [Basel Framework, CRE 40.39] Overlap could also be recognized between relevant capital charges for exposures in the trading book and capital charges for exposures in the banking book, provided that the institution is able to calculate and compare the capital charge for the relevant exposures. [Basel Framework, CRE 40.40]

6.5.2. Hierarchy of approaches

Securitization exposures will be treated differently depending on the type of underlying exposures and/or type of information available to the institution. Securitization exposures to which none of the approaches laid out in paragraphs 52 to 57 can be applied must be assigned a 1250% risk weight. [Basel Framework, CRE 40.41]

6.5.2.1. Securitization exposures of IRB pools

An institution must use the Securitization Internal Ratings-Based Approach (SEC-IRBA) as described in paragraphs 58 to 106 for a securitization exposure of an IRB pool as defined in paragraph 18, unless otherwise determined by OSFI. Institutions with investor or sponsor exposures to IRB pools (i.e. excluding other originator exposures) that materially benefit from excess spread may treat those exposures as SA pools, so long as the exposure is externally rated or is an exposure to an ABCP conduit that issues externally rated paper. [Basel Framework, CRE 40.42]

6.5.2.2. Securitization exposures of SA pools

If an institution cannot use the SEC-IRBA, it must use the Securitization External Ratings-Based Approach (SEC-ERBA) as described in paragraphs 107 to 113 for a securitization exposure to an SA pool as defined in paragraph 21 provided that the institution has an external credit assessment that meets the operational requirements for an external credit assessment in paragraph 114 or there is an inferred rating that meets the operational requirements for inferred ratings in paragraphs 115 and 116. [Basel Framework, CRE 40.43] Institutions may use the Internal Assessment Approach (SEC-IAA) as described in paragraphs 117 to 120 for an unrated securitization exposure (e.g. liquidity facilities and credit enhancements) to an SA pool within an ABCP programme. In order to use the SEC-IAA, an institution must have OSFI approval to use the IRB approach. An institution must obtain OSFI's agreement on whether and when it can apply the SEC-IAA to its securitization exposures, especially where the institution can apply the IRB for some, but not all, underlying exposures. To ensure appropriate capital levels, OSFI may review an institution's use of the SEC-IAA. [Basel Framework, CRE 40.44] An institution that cannot use the SEC-ERBA or a SEC-IAA for its exposures to an SA pool may use the Standardized Approach (SEC-SA) as described in paragraphs 121 to 132. [Basel Framework, CRE 40.45]

6.5.2.3. Securitization exposures of mixed pools

Where an institution can calculate KIRB on at least 95% of the underlying exposure amounts of a securitization, the institution must apply the SEC-IRBA calculating the capital charge for the underlying pool as: d × K IRB + 1 − d × K SA where d is the percentage of the exposure amount of underlying exposures for which the institution can calculate KIRB over the exposure amount of all underlying exposures; and KIRB and KSA are as defined in paragraphs 59 and 122, respectively. [Basel Framework, CRE 40.46] Where the institution cannot calculate KIRB on at least 95% of the underlying exposures, the institution must use the hierarchy for securitization exposures of SA pools as set out in paragraphs 53 to 55. [Basel Framework, CRE 40.47]

6.6. Approaches

6.6.1. Internal Ratings-Based Approach (SEC-IRBA)

To calculate capital requirements for a securitization exposure to an IRB pool, an institution must use the SEC-IRBA and the following institution-supplied inputs: the IRB capital charge had the underlying exposures not been securitized (KIRB), the tranche attachment point (A), the tranche detachment point (D) and the supervisory parameter p, as defined below. Where the only difference between exposures to a transaction is related to maturity, A and D will be the same. [Basel Framework, CRE 44.1]

6.6.1.1. Definition of KIRB

KIRB is the ratio of (a) the IRB capital requirement (including the expected loss portion and, where applicable, dilution risk as discussed in section 6.6.1.4) for the underlying exposures in the pool to (b) the exposure amount of the pool (e.g. the sum of drawn amounts related to securitized exposures plus the EAD associated with undrawn commitments related to securitized exposures).^{Footnote 9} ^{Footnote 10} KIRB is expressed in decimal form (e.g. a capital charge equal to 15% of the pool would be expressed as 0.15). [Basel Framework, CRE 44.2] Notwithstanding the clarification in paragraph 56 for mixed pools, quantity (a) above must be calculated in accordance with applicable minimum IRB standards as set forth in Chapter 5 of this guideline as if the exposures in the pool were held directly by the institution. This calculation should reflect the effects of any credit risk mitigant that is applied on the underlying exposures (either individually or to the entire pool), and hence benefits all of the securitization exposures. [Basel Framework, CRE 44.3] For structures involving an SPE, all of the SPE's exposures related to the securitization are to be treated as exposures in the pool. Exposures related to the securitization that should be treated as exposures in the pool could include assets in which the SPE may have invested a reserve account, such as a cash collateral account or claims against counterparties resulting from interest swaps or currency swaps. In particular, in the case of swaps other than credit derivatives, the numerator of KIRB must include the positive current market value multiplied by the risk weight of the swap provider multiplied by 8%. In contrast, the denominator should not take into account such a swap, as such a swap would not provide a credit enhancement to any tranche. The institution may exclude the SPE's exposures from the pool for capital calculation purposes if the institution can demonstrate to OSFI that the risk of the SPE's exposures does not affect the institution's securitization exposure or is immaterial (for example, because it has been mitigated). [Basel Framework, CRE 44.4] Certain best market practices can eliminate or at least significantly reduce the potential risk from a default of a swap provider. Examples of such features could be: cash collateralization of the market value in combination with an agreement of prompt additional payments in case of an increase of the market value of the swap; and minimum credit quality of the swap provider with the obligation to post collateral or present an alternative swap provider without any costs for the SPE in the event of a credit deterioration on the part of the original swap provider. If OSFI is satisfied with these risk mitigants and accepts that the contribution of these exposures to the risk of the holder of a securitization exposure is insignificant, OSFI may allow the institution to exclude these exposures from the KIRB calculation. [Basel Framework, CRE 44.4] In the case of funded synthetic securitizations, any proceeds of the issuances of credit-linked notes or other funded obligations of the SPE that serve as collateral for the repayment of the securitization exposure in question and for which the institution cannot demonstrate to OSFI that it is immaterial must be included in the calculation of KIRB if the default risk of the collateral is subject to the tranched loss allocation. As in the case of swaps other than credit derivatives, the numerator of KIRB (i.e. quantity (a)) must include the exposure amount of the collateral multiplied by its risk weight multiplied by 8%, but the denominator should be calculated without recognition of the collateral. [Basel Framework, CRE 44.5] In cases where an institution has set aside a specific provision or has a non-refundable purchase price discount on an exposure in the pool, both the IRB capital requirement and the exposure amount of the pool as defined by quantity (a) and quantity (b) in paragraph 59 must be calculated using the gross amount of the exposure without the specific provision and/or non-refundable purchase price discount. [Basel Framework, CRE 44.10]

6.6.1.2. The top-down approach to calculating KIRB for purchased receivables

To calculate KIRB for any securitized exposure or portion thereof, the treatment described in paragraphs 66 to 83 may be used, if according to IRB minimum requirements: for non-retail assets, it would be an undue burden on an institution to assess the default risk of individual obligors; and for retail assets, an institution is unable to primarily rely on internal data. All other IRB minimum requirements must be met by the institution. [Basel Framework, CRE 44.6] OSFI may deny the use of a top-down approach for eligible purchased receivables for securitized exposures depending on the institution's compliance with minimum requirements. The top-down approach is not eligible to be applied to any pool of concentrated exposures where any single asset or group of assets lent to the same obligor represents more than 4% of the pool of assets. [Basel Framework, CRE 44.8] Eligible purchased receivables are divided into retail and corporate receivables as defined below. [Basel Framework, CRE 30.27] Purchased retail receivables, provided the purchasing institution complies with the IRB rules for retail exposures, are eligible for the top-down approach as permitted within the existing standards for retail exposures. The institution must also apply the minimum operational requirements as set forth in sections 5.6 and 5.8 of Chapter 5 of this guideline. [Basel Framework, CRE 30.28] In general, for purchased corporate receivables, institutions are expected to assess the default risk of individual obligors as specified in section 5.3.1 of Chapter 5 of this guideline consistent with the treatment of other corporate exposures. However, the top-down approach may be used for an entire securitized pool or a sub-pool, provided that the purchasing institution's programme for corporate receivables complies with both the criteria for eligible receivables and the minimum operational requirements of this approach. The use of the top-down purchased receivables treatment is limited to situations where it would be an undue burden on an institution to be subjected to the minimum requirements for the IRB approach to corporate exposures that would otherwise apply. Primarily, it is intended for receivables that are purchased for inclusion in asset-backed securitization structures, but institutions may also use this approach, with OSFI approval, for appropriate on-balance sheet exposures that share the same features. [Basel Framework, CRE 30.29] In general, for any pool or sub-pool of securitized non-retail exposures, to be eligible for the top-down approach, the following conditions must be met: The assets are purchased from unrelated, third-party sellers, and as such, the institution has not originated the receivables either directly or indirectly. The assets must be generated on an arm's-length basis between the seller and the obligor. As such, intercompany accounts receivable and receivables that are subject to contra-accounts between firms that buy and sell to each other are ineligible.^{Footnote 11} The institution must have a claim on all proceeds from the pool of securitized exposures that have been allocated to the institution's exposure in the securitization in accordance with the terms of the related securitization documentation. If any single asset or group of assets guaranteed by the same seller represents more than 4% of the pool of assets, capital charges must be calculated using the minimum requirements for the bottom-up approach for corporate exposures. [Basel Framework, CRE 30.30] The existence of full or partial recourse to the seller, does not automatically disqualify an institution from adopting the top-down approach, as long as the cash flows from the non-retail assets are the primary protection against default risk as determined by paragraphs 74 to 78 and the institution meets the eligibility criteria and operational requirements. [Basel Framework, CRE 30.31] Risk-weighted assets for default risk For receivables belonging unambiguously to one asset class, the IRB risk weight for default risk is based on the risk-weight function applicable to that particular exposure type, as long as the institution can meet the qualification standards for this particular risk-weight function. For example, if institutions cannot comply with the standards for qualifying revolving retail exposures (defined in section 5.2.1 (vi) of Chapter 5 of this guideline), they should use the risk-weight function for other retail exposures. For hybrid pools containing mixtures of exposure types, if the purchasing institution cannot separate the exposures by type, the risk-weight function producing the highest capital requirements for the exposure types in the receivable pool applies. [Basel Framework, CRE 34.2] For purchased retail receivables, an institution must meet the risk quantification standards for retail exposures but can utilize external and internal reference data to estimate the PDs and LGDs. The estimates for PD and LGD (or EL) must be calculated for the receivables on a stand-alone basis; that is, without regard to any assumption of recourse or guarantees from the seller or other parties. If the purchasing institution is able to determine an expected long-run loss rate (EL), but not reliable estimates for PD or LGD, then a PD for the pool may be estimated by assuming an LGD of 100%. The expected long-run loss rate used to determine the PD in this way must contain sufficient conservatism consistent with section 5.8.6 (i) of Chapter 5 of this guideline. [Basel Framework, CRE 34.3] For purchased corporate receivables the purchasing institution is expected to apply the existing IRB risk quantification standards for the bottom-up approach. However, for eligible purchased corporate receivables, and subject to OSFI permission, an institution may employ the following top-down procedure for calculating IRB risk weights for default risk: The purchasing institution will estimate the pool's one-year EL for default risk, expressed in percentage of the exposure amount (i.e. the total EAD amount to the institution by all obligors in the receivables pool). The estimated EL must be calculated for the receivables on a stand-alone basis; that is, without regard to any assumption of recourse or guarantees from the seller or other parties. The treatment of recourse or guarantees covering default risk (and/or dilution risk) is discussed in paragraph 79 below. Given the EL estimate for the pool's default losses, the risk weight for default risk is determined by the risk-weight function for corporate exposures.^{Footnote 12} As described below, the precise calculation of risk weights for default risk depends on the institution's ability to decompose EL into its PD and LGD components in a reliable manner. Institutions can utilize external and internal data to estimate PDs and LGDs. However, the advanced approach will not be available for institutions that use the foundation approach for corporate exposures. [Basel Framework, CRE 34.4] Foundation IRB treatment If the purchasing institution is unable to decompose EL into its PD and LGD components in a reliable manner, the risk weight is determined from the corporate risk-weight function using the following specifications: if the institution can demonstrate that the exposures are exclusively senior claims to corporate borrowers: An LGD of 40% can be used. PD will be calculated by dividing the EL using this LGD. EAD will be calculated as the outstanding amount minus the capital charge for dilution prior to credit risk mitigation (KDilution). EAD for a revolving purchase facility is the sum of the current amount of receivables purchased plus 40% of any undrawn purchase commitments minus KDilution. If the institution cannot demonstrate that the exposures are exclusively senior claims to corporate borrowers: PD is the institution's estimate of EL. LGD will be 100%. EAD will be calculated as outstanding amount minus KDilution. EAD for a revolving purchase facility is the sum of the current amount of receivables purchased plus 40% of any undrawn purchase commitments minus KDilution. [Basel Framework, CRE 34.5] If the purchasing institution is able to estimate PD in a reliable manner, the risk weight is determined from the corporate risk-weight functions according to the specifications for LGD, M and the treatment of guarantees under the foundation approach as given in Chapter 5 – Internal Ratings Based Approach section 5.4.1. [Basel Framework, CRE 34.5] Advanced IRB treatment If the purchasing institution can estimate either the pool's default-weighted average loss rates given default (as defined in section 5.8.6 (vii) of Chapter 5) or average PD in a reliable manner, the institution may estimate the other parameter based on an estimate of the expected long-run loss rate. The institution may (i) use an appropriate PD estimate to infer the long-run default-weighted average loss rate given default, or (ii) use a long-run default-weighted average loss rate given default to infer the appropriate PD. In either case, it is important to recognize that the LGD used for the IRB capital calculation for purchased receivables cannot be less than the long-run default-weighted average loss rate given default and must be consistent with the concepts defined in section 5.8.6 (vii) of Chapter 5. The risk weight for the purchased receivables will be determined using the institution's estimated PD and LGD as inputs to the corporate risk-weight function. If the purchasing institution is unable to estimate LGD in a reliable manner that is consistent with the concepts defined in section 5.8.6 (vii) of Chapter 5, an LGD of 100% must be used. Similar to the foundation IRB treatment, EAD will be the amount outstanding minus KDilution. EAD for a revolving purchase facility will be the sum of the current amount of receivables purchased plus 75% of any undrawn purchase commitments minus KDilution (thus, institutions using the advanced IRB approach will not be permitted to use their internal EAD estimates for securitized undrawn purchase commitments). [Basel Framework, CRE 34.6] For drawn amounts, M will equal the pool's exposure-weighted average effective maturity (as defined in section 5.4.1 (iv) of Chapter 5 of this guideline). This same value of M will also be used for undrawn amounts under a committed purchase facility provided the facility contains effective covenants, early amortization triggers, or other features that protect the purchasing institution against a significant deterioration in the quality of the future receivables it is required to purchase over the facility's term. Absent such effective protections, the M for undrawn amounts will be calculated as the sum of (a) the longest-dated potential receivable under the purchase agreement and (b) the remaining maturity of the purchase facility. [Basel Framework, CRE 34.7] Credit risk mitigants will be recognized generally using the same type of framework as set forth in Chapter 5 of this guideline. In particular, a guarantee provided by the seller or a third party will be treated using the existing IRB rules for guarantees, regardless of whether the guarantee covers default risk, dilution risk, or both. If the guarantee covers both the pool's default risk and dilution risk, the institution will substitute the risk weight for an exposure to the guarantor in place of the pool's total risk weight for default and dilution risk. If the guarantee covers only default risk or dilution risk, but not both, the institution will substitute the risk weight for an exposure to the guarantor in place of the pool's risk weight for the corresponding risk component (default or dilution). The capital requirement for the other component will then be added. If a guarantee covers only a portion of the default and/or dilution risk, the uncovered portion of the default and/or dilution risk will be treated as per the existing CRM rules for proportional or tranched coverage (i.e. the risk weights of the uncovered risk components will be added to the risk weights of the covered risk components). [Basel Framework, CRE 34.12] Adjustment criteria An institution must have clearly specified criteria surrounding the allocation of exposures to pools to reflect the impact of guarantees for regulatory capital purposes. These criteria must be as detailed as the criteria for assigning exposures to grades consistent with section 5.8.3 (iii) of Chapter 5 of this guideline, and must follow all minimum requirements for assigning borrower or facility ratings set out in this guideline. [Basel Framework, CRE 36.107] In allocating exposures to pools, institutions must take all relevant available information into account. [Basel Framework, CRE 36.109] Requirements specific to estimating PD and LGD (or EL) for qualifying securitized exposures The following minimum requirements for risk quantification must be satisfied for any securitized exposure (retail or non-retail) making use of the top-down treatment of default risk and/or the IRB treatments of dilution risk. [Basel Framework, CRE 36.113] The institution calculating KIRB will be required to group the securitized assets into sufficiently homogeneous pools so that accurate and consistent estimates of PD and LGD (or EL) for default losses and EL estimates of dilution losses can be determined. In general, the risk bucketing process will reflect the seller's underwriting practices and the heterogeneity of its customers. In addition, methods and data for estimating PD, LGD, and EL must comply with the existing risk quantification standards for retail exposures. In particular, quantification should reflect all information available to the institution calculating KIRB regarding the quality of the underlying receivables, including data for similar pools provided by the seller, by the institution calculating KIRB, or by external sources. The institution calculating KIRB must determine whether the data provided by the seller are consistent with expectations agreed upon by both parties concerning, for example, the type, volume and on-going quality of receivables purchased. Where this is not the case, the institution calculating KIRB is expected to obtain and rely upon more relevant data. [Basel Framework, CRE 36.114]

6.6.1.3. Minimum operational requirements for the top-down approach

An institution calculating KIRB has to justify confidence that current and future advances can be repaid from the liquidation of (or collections against) the receivables pool. To qualify for the top-down treatment of default risk, the receivable pool and overall lending relationship should be closely monitored and controlled. Specifically, an institution will have to demonstrate: Legal certainty (see paragraph 85). Effectiveness of monitoring systems (see paragraph 86). Effectiveness of work-out systems (see paragraph 87). Effectiveness of systems for controlling collateral, credit availability, and cash (see paragraph 88). Compliance with the institution's internal policies and procedures (see paragraphs 89 and 90). [Basel Framework, CRE 36.115] Legal certainty The structure of the facility must ensure that under all foreseeable circumstances the institution has effective ownership and control of the cash remittances from the receivables, including incidences of seller or servicer distress and bankruptcy. When the obligor makes payments directly to a seller or servicer, the institution must verify regularly that payments are forwarded completely and within the contractually agreed terms. As well, ownership over the receivables and cash receipts should be protected against bankruptcy 'stays' or legal challenges that could materially delay the lender's ability to liquidate/assign the receivables or retain control over cash receipts. [Basel Framework, CRE 36.116] Effectiveness of monitoring systems The institution must be able to monitor both the quality of the receivables and the financial condition of the seller and servicer. In particular: The institution must: assess the correlation among the quality of the receivables and the financial condition of both the seller and servicer, and have in place internal policies and procedures that provide adequate safeguards to protect against such contingencies, including the assignment of an internal risk rating for each seller and servicer. The institution must have clear and effective policies and procedures for determining seller and servicer eligibility. The institution or its agent must conduct periodic reviews of sellers and servicers in order to verify the accuracy of reports from the seller/servicer, detect fraud or operational weaknesses, and verify the quality of the seller's credit policies and servicer's collection policies and procedures. The findings of these reviews must be well documented. The institution must have the ability to assess the characteristics of the receivables pool, including over-advances; history of the seller's arrears, bad debts, and bad debt allowances; payment terms; and potential contra accounts. The institution must have effective policies and procedures for monitoring on an aggregate basis single-obligor concentrations both within and across receivables pools. The institution must receive timely and sufficiently detailed reports of receivables ageings and dilutions to: (a) ensure compliance with the institution's eligibility criteria and advancing policies governing purchased receivables; and provide an effective means with which to monitor and confirm the seller's terms of sale (e.g. invoice date ageing) and dilution. [Basel Framework, CRE 36.117] Effectiveness of work-out systems An effective programme requires systems and procedures not only for detecting deterioration in the seller's financial condition and deterioration in the quality of the receivables at an early stage, but also for addressing emerging problems pro-actively. In particular, The securitization structure should have clear and effective policies, procedures, and information systems to monitor compliance with (a) all contractual terms of the facility (including covenants, advancing formulas, concentration limits, early amortization triggers, etc.) as well as (b) the institution's internal policies governing advance rates and receivables eligibility. The institution's systems should track covenant violations and waivers as well as exceptions to established policies and procedures. To limit inappropriate draws, the institution should have effective policies and procedures for detecting, approving, monitoring, and correcting over-advances. The institution should have effective policies and procedures for dealing with financially weakened sellers or servicers and/or deterioration in the quality of receivable pools. These include, but are not necessarily limited to, early termination triggers in revolving facilities and other covenant protections, a structured and disciplined approach to dealing with covenant violations, and clear and effective policies and procedures for initiating legal actions and dealing with problem receivables. [Basel Framework, CRE 36.118] Effectiveness of systems for controlling collateral, credit availability, and cash [Basel Framework, CRE 36.119] The institution must have clear and effective policies and procedures governing the control of receivables, credit, and cash. In particular, Written internal policies must specify all material elements of the receivables purchase programme, including the advancing rates, eligible collateral, necessary documentation, concentration limits, and how cash receipts are to be handled. These elements should take appropriate account of all relevant and material factors, including the seller's/servicer's financial condition, risk concentrations, and trends in the quality of the receivables and the seller's customer base. Internal systems must ensure that funds are advanced only against specified supporting collateral and documentation (such as servicer attestations, invoices, shipping documents, etc.) Compliance with the institution's internal policies and procedures Given the reliance on monitoring and control systems to limit credit risk, the institution should have an effective internal process for assessing compliance with all critical policies and procedures, including Regular internal and/or external audits of all critical phases of the institution's receivables purchase programme. Verification of the separation of duties (i) between the assessment of the seller/servicer and the assessment of the obligor and (ii) between the assessment of the seller/servicer and the field audit of the seller/servicer. [Basel Framework, CRE 36.120] An institution's effective internal process for assessing compliance with all critical policies and procedures should also include evaluations of back-office operations, with particular focus on qualifications, experience, staffing levels, and supporting systems. [Basel Framework, CRE 36.121] If an institution cannot meet the requirements in paragraphs 85 to 89, it must instead ensure that it meets these requirements through a party to the securitization acting for and in the interest of the investors in the securitization, in accordance with the terms of the related securitization documents. Specifically, requirements for effective control and ownership must be met for all proceeds from the pool of securitized exposures that have been allocated to the institution's exposure to the securitization. [Basel Framework, CRE 44.9]

6.6.1.4. Treatment of dilution risk

Dilution risk in a securitization must be recognized if it is material, as demonstrated by the institution to OSFI (see section 5.6.2 of Chapter 5), whereby the provisions of paragraphs 59 to 63 shall apply. [Basel Framework, CRE 44.11] Where default and dilution risk are treated in an aggregate manner (e.g. an identical reserve or overcollateralization is available to cover losses for both risks), in order to calculate capital requirements for the securitization exposure, an institution must determine KIRB for dilution risk and default risk, respectively, and combine them into a single KIRB prior to applying the SEC-IRBA. Appendix 6-3.A provides an illustration of such a calculation. [Basel Framework, CRE 44.12] In certain circumstances, pool level credit enhancement will not be available to cover losses from either credit risk or dilution risk. In the case of separate waterfalls for credit risk and dilution risk, an institution should refer to Appendix 6-3.B which includes an example of how such calculations could be performed in a prudent manner. [Basel Framework, CRE 44.13]

6.6.1.5. Definition of attachment point (A) and detachment point (D)

The input A represents the threshold at which losses within the underlying pool would first be allocated to the securitization exposure. This input, which is a decimal value between zero and one, equals the greater of: zero; and the ratio of: the outstanding balance of all underlying assets in the securitization minus the outstanding balance of all tranches that rank senior or pari passu to the tranche that contains the securitization exposure of the institution (including the exposure itself) to the outstanding balance of all underlying assets in the securitization (including any over-collateralization). [Basel Framework, CRE 44.14] The input D represents the threshold at which losses within the underlying pool result in a total loss of principal for the tranche in which a securitization exposure resides. This input, which is a decimal value between zero and one, equals the greater of (a) zero and (b) the ratio of (i) the outstanding balance of all underlying assets in the securitization minus the outstanding balance of all tranches that rank senior to the tranche that contains the securitization exposure of the institution to (ii) the outstanding balance of all underlying assets in the securitization (including any over-collateralization). [Basel Framework, CRE 44.15] For the calculation of A and D: (i) overcollateralization and funded reserve accounts must be recognized as tranches; and (ii) the assets forming these reserve accounts must be recognized as underlying assets. Only the loss-absorbing part of the funded reserve accounts that provide credit enhancement can be recognized as tranches and underlying assets. Unfunded reserve accounts, such as those to be funded from future receipts from the underlying exposures (e.g. unrealized excess spread) and assets that do not provide credit enhancement like pure liquidity support, currency or interest-rate swaps, or cash collateral accounts related to these instruments must not be included in the above calculation of A and D. Institutions should take into consideration the economic substance of the transaction and apply these definitions conservatively in the light of the structure. [Basel Framework, CRE 44.16]

6.6.1.6. Formulation of supervisory parameter (p)

The supervisory parameter p in the context of the SEC-IRBA is as follows: p = max 0 . 3 , A + B ∕ N + C × K IRB + D × LGD + E × M T , where: 0.3 denotes the p-parameter floor; N is the effective number of loans in the underlying pool, calculated as described in paragraph 101; KIRB is the capital charge of the underlying pool (as defined in paragraph 59); LGD is the exposure-weighted average loss given default of the underlying pool, calculated as described in paragraph 102); MT is the maturity of the tranche calculated according to paragraphs 26 and 27; and the parameters A, B, C, D, and E are determined according to the following look-up table: Parameters to determine supervisory parameter p Asset class Seniority / granularity A B C D E Wholesale Senior, granular (N>= 25) 0 3.56 -1.85 0.55 0.07 Senior, non-granular (N< 25) 0.11 2.61 -2.91 0.68 0.07 Non-senior, granular (N>= 25) 0.16 2.87 -1.03 0.21 0.07 Non-senior, non-granular (N< 25) 0.22 2.35 -2.46 0.48 0.07 Retail Senior 0 0 -7.48 0.71 0.24 Non-Senior 0 0 -5.78 0.55 0.27 [Basel Framework, CRE 44.17] If the underlying IRB pool consists of retail and wholesale exposures, the pool should be divided into one retail and one wholesale subpool and, for each subpool, a separate p-parameter (and the corresponding input parameters N, KIRB and LGD) should be estimated. Subsequently, a weighted average p-parameter for the transaction should be calculated on the basis of the p-parameters of each subpool and the nominal size of the exposures in each subpool. [Basel Framework, CRE 44.18] If an institution applies the SEC-IRBA to a mixed pool as described in paragraph 56, the calculation of the p-parameter should be based on the IRB underlying assets only. The SA underlying assets should not be considered for this purpose. [Basel Framework, CRE 44.19]

6.6.1.7. Calculation of effective number of exposures (N)

The effective number of exposures is calculated as: N = ∑ i EAD i 2 ∑ i EAD i 2 where EADi represents the exposure at default associated with the i^th instrument in the pool. Multiple exposures to the same obligor must be consolidated (i.e. treated as a single instrument). [Basel Framework, CRE 44.20]

6.6.1.8. Calculation of exposure-weighted average LGD

The exposure-weighted average LGD is calculated as follows: LGD = ∑ i LGD i × EAD i ∑ i EAD i where LGDi represents the average LGD associated with all exposures to the i^th obligor. When default and dilution risks for purchased receivables are treated in an aggregate manner (e.g. a single reserve or overcollateralization is available to cover losses from either source) within a securitization, the LGD input must be constructed as a weighted average of the LGD for default risk and the 100% LGD for dilution risk. The weights are the stand-alone IRB capital charges for default risk and dilution risk, respectively. [Basel Framework, CRE 44.21]

6.6.1.9. Simplified method for computing N and LGD

Under the conditions outlined below, institutions may employ a simplified method for calculating the effective number of exposures and the exposure-weighted average LGD. Let Cm in the simplified calculation denote the share of the pool corresponding to the sum of the largest m exposures (e.g. a 15% share corresponds to a value of 0.15). The level of m is set by each institution. If the share of the pool associated with the largest exposure, C1, is no more than 0.03 (or 3%), then for purposes of the SEC-IRBA the institution may set LGD as 0.50 and N equal to the following amount: N = C 1 × C m + C m − C 1 × max ⁡ 1 − m × C 1 , 0 m − 1 - 1 Alternatively, if only C1 is available and this amount is no more than 0.03, then the institution may set LGD as 0.50 and N as 1/C1. [Basel Framework, CRE 44.22]

6.6.1.10. Calculation of risk weight

The formulation of the SEC-IRBA is as follows: K SEC - IRBA = e a × u - e a × l a ( u - l ) Where K SEC - IRBA is the capital requirement per unit of securitization exposure under the SEC-IRBA is a function of three variables, labelled a, u and l. The constant e is the base of the natural logarithms (which equals 2.71828). The variables a, u and l are defined as follows: a = - 1 p × K IRB u = D − K IRB l = max ⁡ ( A − K IRB , 0 ) [Basel Framework, CRE 44.23] The risk weight assigned to a securitization exposure when applying the SEC-IRBA is calculated as follows: When D for a securitization exposure is less than or equal to KIRB, the exposure must be assigned a risk weight of 1,250%. When A for a securitization exposure is greater than or equal to KIRB, the risk weight of the exposure, expressed as a percentage, would equal KSEC-IRBA multiplied by 12.5. When A is less than KIRB and D is greater than KIRB, the applicable risk weight is a weighted average of 1,250% and 12.5 multiplied by KSEC-IRBA according to the following formula: RW = 12.5 × K IRB − A D − A + D − K IRB × 12.5 × K SEC-IRBA D − A The risk weight for market risk hedges such as currency or interest rate swaps will be inferred from a securitization exposure that is pari passu to the swaps or, if such an exposure does not exist, from the next subordinated tranche. [Basel Framework, CRE 44.25] The resulting risk weight is subject to a floor risk weight of 15%. [Basel Framework, CRE 44.26]

6.6.2. External Ratings-Based Approach (SEC-ERBA)

For a securitization exposure that is externally rated, or for which an inferred rating is available, risk-weighted assets under the SEC-ERBA will be determined by multiplying securitization exposure amounts (as defined in paragraph 44 and 47) by the appropriate risk weights as determined by paragraphs 108 to 113, provided that the operational criteria in sections 6.6.2.3 and 6.6.2.4 are met.^{Footnote 13} [Basel Framework, CRE 42.1]

6.6.2.1. Short-term ratings

[Basel Framework, CRE 42.2] For exposures with a short-term rating, or when an inferred rating based on a short-term rating is available, the following risk weights will apply: Table 1: SEC-ERBA risk weights for short-term ratings blank External credit assessment A–1/P–1 A–2/P–2 A–3/P–3 All other ratings Risk weight 15% 50% 100% 1250%

6.6.2.2. Long-term ratings

[Basel Framework, CRE 42.4] For exposures with a long-term rating, or when an inferred rating based on a long-term rating is available, the risk weights depend on (i) the external rating grade or an available inferred rating; (ii) the seniority of the position; (iii) the tranche maturity; and (iv) in the case of non-senior tranches, the tranche thickness. [Basel Framework, CRE 42.3] Specifically, for exposures with a long-term rating, risk weights will be determined according to Table 2 and will be adjusted for tranche maturity (calculated according to paragraphs 26 and 27), and tranche thickness for non-senior tranches according to paragraph 111. Table 2: SEC-ERBA risk weights for long-term ratings Rating Senior tranche Tranche maturity (MT) Non-senior (thin) tranche Tranche maturity (MT) 1 year 5 years 1 year 5 years AAA 15% 20% 15% 70% AA+ 15% 30% 15% 90% AA 25% 40% 30% 120% AA- 30% 45% 40% 140% A+ 40% 50% 60% 160% A 50% 65% 80% 180% A- 60% 70% 120% 210% BBB+ 75% 90% 170% 260% BBB 90% 105% 220% 310% BBB- 120% 140% 330% 420% BB+ 140% 160% 470% 580% BB 160% 180% 620% 760% BB- 200% 225% 750% 860% B+ 250% 280% 900% 950% B 310% 340% 1050% 1050% B- 380% 420% 1130% 1130% CCC+/CCC/CCC- 460% 505% 1250% 1250% Below CCC- 1250% 1250% 1250% 1250% The risk weight assigned to a securitization exposure when applying the SEC-ERBA is calculated as follows: To account for tranche maturity, institutions shall use linear interpolation between the risk weights for one and five years. To account for tranche thickness, institutions shall calculate the risk weight for non-senior tranches as follows: Risk weight = risk weight from table after adjusting for maturity × 1 − min T , 50 % where T equals tranche thickness, and is measured as D minus A, as defined, respectively, in paragraphs 95 and 96. [Basel Framework, CRE 42.5] In the case of market risk hedges such as currency or interest rate swaps, the risk weight will be inferred from a securitization exposure that is pari passu to the swaps or, if such an exposure does not exist, from the next subordinated tranche. [Basel Framework, CRE 42.6] The resulting risk weight is subject to a floor risk weight of 15%. In addition, the resulting risk weight should never be lower than the risk weight corresponding to a senior tranche of the same securitization with the same rating and maturity. [Basel Framework, CRE 42.7]

6.6.2.3. Operational requirements for external credit assessments

[Basel Framework, CRE 42.8] The following operational criteria concerning the use of external credit assessments apply in the securitization framework: To be eligible for risk-weighting purposes, the external credit assessment must take into account and reflect the entire amount of credit risk the institution is exposed to including all payments owed to it. For example, if an institution is owed both principal and interest, the assessment must fully take into account and reflect the credit risk associated with timely repayment of both principal and interest. The external credit assessments must be from an eligible ECAI as recognized by OSFI in accordance with section 4.2 of Chapter 4 of this guideline with the following exception. In contrast with bullet three of paragraph 169 of Chapter 4, an eligible credit assessment, procedures, methodologies, assumptions, and the key elements underlining the assessments must be publicly available, on a non-selective basis and free of charge.^{Footnote 14} In other words, a rating must be published in an accessible form and included in the ECAI's transition matrix. Also, loss and cash-flow analysis as well as sensitivity of ratings to changes in the underlying rating assumptions should be publicly available. Consequently, ratings that are made available only to the parties to a transaction do not satisfy this requirement. Eligible ECAIs must have a demonstrated expertise in assessing securitizations, which may be evidenced by strong market acceptance. Where two or more eligible ECAIs can be used and these assess the credit risk of the same securitization exposure differently, section 4.2.3.2 of Chapter 4 will apply. Institutions will not be allowed to "cherry-pick" the assessments provided by different ECAIs and may not arbitrarily change the use of ECAIs, consistent with paragraph 176 of Chapter 4 of this guideline. Further to this, an institution, party to the rating agency selection process, that selects a junior tranche to be rated by an ECAI and does not select that same ECAI to rate the senior rated tranche of the securitization will be seen as cherry-picking, and that junior tranche will be required to be treated as if it were unrated by that ECAI. Ratings on junior securitization tranches may be used: in cases where the ECAI rating the junior tranche also rates the senior rated tranche, in cases where the senior tranche is unrated, and in all cases where the institution is not party to the rating agency selection process. Where CRM is provided to specific underlying exposures or the entire pool by an eligible guarantor as defined in section 4.3.5 (v) of Chapter 4 of this guideline, and is reflected in the external credit assessment assigned to a securitization exposure(s), the risk weight associated with that external credit assessment should be used. In order to avoid any double counting, no additional capital recognition is permitted. If the CRM provider is not recognized as an eligible guarantor under section 4.3.5 (v) of Chapter 4 the covered securitization exposures should be treated as unrated. In the situation where a credit risk mitigant solely protects a specific securitization exposure within a given structure (e.g. asset-backed security tranche) and this protection is reflected in the external credit assessment, the institution must treat the exposure as if it is unrated and then apply the CRM treatment outlined in section 4.3 of Chapter 4, to recognize the hedge. An institution is not permitted to use any external credit assessment for risk-weighting purposes where the assessment is at least partly based on unfunded support provided by the institution. For example, if an institution buys ABCP where it provides an unfunded securitization exposure extended to the ABCP programme (e.g. liquidity facility or credit enhancement), and that unfunded exposure plays a role in determining the credit assessment on the ABCP, the institution must treat the ABCP as if it were not rated. The institution must continue to hold capital against the other securitization exposure it provides (e.g. against the liquidity facility and/or credit enhancement).

6.6.2.4. Operational requirements for inferred ratings

[Basel Framework, CRE 42.10] In accordance with the hierarchy of approaches determined in paragraphs 51 to 56, an institution must infer a rating for an unrated position and use the SEC-ERBA provided that the requirements set out in paragraph 116 are met. These requirements are intended to ensure that the unrated position is senior in all respects to an externally rated securitization exposure termed the "reference securitization exposure". The application of an inferred rating means that the external rating applicable to the "reference securitization exposure" will be applied to the senior unrated position. [Basel Framework, CRE 42.9] The following operational requirements must be satisfied to recognize inferred ratings. The reference securitization exposure (e.g. asset-backed subsidiary) must rank pari passu or be subordinate in all respects to the unrated securitization exposure. Credit enhancements, if any, must be taken into account when assessing the relative subordination of the unrated exposure and the reference securitization exposure. For example, if the reference securitization exposure benefits from any third-party guarantees or other credit enhancements that are not available to the unrated exposure, then the latter cannot be assigned an inferred rating based on the reference securitization exposure. The maturity of the reference securitization exposure must be equal to or longer than that of the unrated exposure. On an ongoing basis, any inferred rating must be updated continuously to reflect any subordination of the unrated position or changes in the external rating of the reference securitization exposure. The external rating of the reference securitization exposure must satisfy the general requirements for recognition of external ratings as delineated in paragraph 114.

6.6.3. Internal Assessment Approach (SEC-IAA)

Subject to OSFI agreement, an institution may use its internal assessments of the credit quality of the securitization exposures extended to ABCP programmes (e.g. liquidity facilities and credit enhancements) provided the institution's internal assessment process meets the operational requirements set out below. Internal assessments of exposures provided to ABCP programmes must be mapped to equivalent external ratings of an ECAI. Those rating equivalents are used to determine the appropriate risk weights under the SEC-ERBA for the exposures. [Basel Framework, CRE 43.1] An institution's internal assessment process must meet the following operational requirements in order to use internal assessments in determining the IRB capital requirement arising from liquidity facilities, credit enhancements, or other exposures extended to an ABCP programme. For the unrated exposure to qualify for the SEC-IAA, the ABCP must be externally rated. The ABCP itself is subject to the SEC-ERBA. The internal assessment of the credit quality of a securitization exposure to the ABCP programme must be based on a recognized ECAI criteria and methodology for the asset type purchased and must be the equivalent of at least investment grade when initially assigned to an exposure. In addition, the internal assessment must be used in the institution's internal risk management processes, including management information and economic capital systems, and generally must meet all the relevant requirements of the IRB framework. In order for institutions to use the SEC-IAA, OSFI must be satisfied (i) that the ECAI meets the ECAI eligibility criteria outlined in section 4.2 of Chapter 4 of this guideline and (ii) with the ECAI rating methodologies used in the process. In addition, institutions must document and maintain the necessary records in order to be able to demonstrate to the satisfaction of OSFI how these internal assessments correspond with the relevant ECAI's standards. For instance, when calculating the credit enhancement level in the context of the SEC-IAA, OSFI may, if warranted, disallow on a full or partial basis any seller-provided recourse guarantees or excess spread, or any other first loss credit enhancements that provide limited protection to the institution. The institution's internal assessment process must identify gradations of risk. Internal assessments must correspond to the external ratings of ECAIs so that OSFI can determine which internal assessment corresponds to each external rating category of the ECAIs. The institution's internal assessment process, particularly the stress factors for determining credit enhancement requirements, must be at least as conservative as the publicly available rating criteria of the major ECAIs that are externally rating the ABCP programme's commercial paper for the asset type being purchased by the programme. However, institutions should consider, to some extent, all publicly available ECAI ratings methodologies in developing their internal assessments. In the case where (i) the commercial paper issued by an ABCP programme is externally rated by two or more ECAIs and (ii) the different ECAIs' benchmark stress factors require different levels of credit enhancement to achieve the same external rating equivalent, the institution must apply the ECAI stress factor that requires the most conservative or highest level of credit protection. For example, if one ECAI required enhancement of 2.5 to 3.5 times historical losses for an asset type to obtain a single A rating equivalent and another required 2 to 3 times historical losses, the institution must use the higher range of stress factors in determining the appropriate level of seller-provided credit enhancement. To externally rate the institution's exposure, an institution must not choose to apply the methodologies of only those ECAIs that generally have relatively less restrictive rating methodologies. In addition, if there are changes in the methodology of one of the selected ECAIs, including the stress factors, that adversely affect the external rating of the programme's commercial paper, then the revised rating methodology must be considered in evaluating whether the internal assessments assigned to ABCP programme exposures are in need of revision. An institution cannot utilize an ECAI's rating methodology to derive an internal assessment if the ECAI's process or rating criteria is not publicly available. However, institutions should consider the non-publicly available methodology – to the extent that they have access to such information ─ in developing their internal assessments, particularly if it is more conservative than the publicly available criteria. In general, if the ECAI rating methodologies for an asset or exposure are not publicly available, then the SEC-IAA cannot be used. However, in certain instances, for example, for new or uniquely structured transactions, which are not currently addressed by the rating criteria of an ECAI rating the programme's commercial paper, an institution may discuss the specific transaction with OSFI to determine whether the SEC-IAA may be applied to the related exposures. Internal or external auditors, an ECAI, or the institution's internal credit review or risk management function must perform regular reviews of the internal assessment process and assess the validity of those internal assessments. If the institution's internal audit, credit review, or risk management functions perform the reviews of the internal assessment process, then these functions must be independent of the ABCP programme business line, as well as the underlying customer relationships. The institution must track the performance of its internal assessments over time to evaluate the performance of the assigned internal assessments and make adjustments, as necessary, to its assessment process when the performance of the exposures routinely diverges from the assigned internal assessments on those exposures. The ABCP programme must have credit and investment guidelines, i.e. underwriting standards, for the ABCP programme. In the consideration of an asset purchase, the ABCP programme (i.e. the programme administrator) should develop an outline of the structure of the purchase transaction. Factors that should be discussed include the type of asset being purchased; type and monetary value of the exposures arising from the provision of liquidity facilities and credit enhancements; loss waterfall; and legal and economic isolation of the transferred assets from the entity selling the assets. A credit analysis of the asset seller's risk profile must be performed and should consider, for example, past and expected future financial performance; current market position; expected future competitiveness; leverage, cash flow, and interest coverage; and debt rating. In addition, a review of the seller's underwriting standards, servicing capabilities, and collection processes should be performed. The ABCP programme's underwriting policy must establish minimum asset eligibility criteria that, among other things, exclude the purchase of assets that are significantly past due or defaulted; limit excess concentration to individual obligor or geographic area; and limit the tenor of the assets to be purchased. The ABCP programme should have collections processes established that consider the operational capability and credit quality of the servicer. The programme should mitigate to the extent possible seller/servicer risk through various methods, such as triggers based on current credit quality that would preclude co-mingling of funds and impose lockbox arrangements that would help ensure the continuity of payments to the ABCP programme. The aggregate estimate of loss on an asset pool that the ABCP programme is considering purchasing must consider all sources of potential risk, such as credit and dilution risk. If the seller-provided credit enhancement is sized based on only credit-related losses, then a separate reserve should be established for dilution risk, if dilution risk is material for the particular exposure pool. In addition, in sizing the required enhancement level, the institution should review several years of historical information, including losses, delinquencies, dilutions, and the turnover rate of the receivables. Furthermore, the institution should evaluate the characteristics of the underlying asset pool (e.g. weighted average credit score) and should identify any concentrations to an individual obligor or geographical region and the granularity of the asset pool. The ABCP programme must incorporate structural features into the purchase of assets in order to mitigate potential credit deterioration of the underlying portfolio. Such features may include wind down triggers specific to a pool of exposures. [Basel Framework, CRE 43.2] The exposure amount of the securitization exposure to the ABCP programme must be assigned to the risk weight in the SEC-ERBA appropriate to the credit rating equivalent assigned to the institution's exposure. [Basel Framework, CRE 43.3] If an institution's internal assessment process is no longer considered adequate, OSFI may preclude the institution from applying the SEC-IAA to its ABCP exposures, both existing and newly originated, for determining the appropriate capital treatment until the institution has remedied the deficiencies. In this instance, the institution must revert to the SEC-SA described in paragraphs 121 to 132. [Basel Framework, CRE 43.4]

6.6.4. Standardized Approach (SEC-SA)

To calculate capital requirements for a securitization exposure to an SA pool using the SEC-SA, an institution would use a supervisory formula and the following institution-supplied inputs: the SA capital charge had the underlying exposures not been securitized (KSA); the ratio of delinquent underlying exposures to total underlying exposures in the securitization pool (W); the tranche attachment point (A); and the tranche detachment point (D). The inputs A and D are defined above in paragraphs 95 and 96, respectively. Where the only difference between exposures to a transaction is related to maturity, A and D will be the same. KSA and W are defined below in paragraphs 122 to 124 and 126. [Basel Framework, CRE 41.1] KSA is defined as the weighted-average capital charge of the entire portfolio of performing underlying exposures, calculated using the risk-weighted asset amounts in Chapter 4 of this guideline in relation to the sum of the exposure amounts of underlying exposures (excluding the risk weights from section 4.1.21), multiplied by 8%. This calculation should reflect the effects of any credit risk mitigant that is applied to the underlying exposures (either individually or to the entire pool), and hence benefits all of the securitization exposures. KSA is expressed as a decimal between zero and one (that is, a weighted-average risk weight of 100% means that KSA would equal 0.08). [Basel Framework, CRE 41.2] For structures involving an SPE, all of the SPE's exposures related to the securitization are to be treated as exposures in the pool. Exposures related to the securitization that should be treated as exposures in the pool include assets in which the SPE may have invested, comprising reserve accounts, cash collateral accounts and claims against counterparties resulting from interest swaps or currency swaps.^{Footnote 15} The institution can exclude the SPE's exposures from the pool for capital calculation purposes if the institution can demonstrate to OSFI that the risk does not affect its particular securitization exposure or that the risk is immaterial – for example, because it has been mitigated.^{Footnote 16} [Basel Framework, CRE 41.3] In the case of funded synthetic securitizations, any proceeds of the issuances of credit-linked notes or other funded obligations of the SPE that serve as collateral for the repayment of the securitization exposure in question, and for which the institution cannot demonstrate to OSFI that they are immaterial, have to be included in the calculation of KSA if the default risk of the collateral is subject to the tranched loss allocation.^{Footnote 17} [Basel Framework, CRE 41.4] In cases where an institution has set aside a specific provision or has a non-refundable purchase price discount on an exposure in the pool, KSA must be calculated using the gross amount of the exposure without the specific provision and/or non-refundable purchase price discount. [Basel Framework, CRE 41.5] The variable W equals the ratio of the sum of the nominal amount of delinquent underlying exposures (as defined in paragraph 127) to the nominal amount of underlying exposures. [Basel Framework, CRE 41.6] Delinquent underlying exposures are underlying exposures that are 90 days or more past due, subject to bankruptcy or insolvency proceedings, in the process of foreclosure, held as real estate owned, or in default, where default is defined within the securitization deal documents. [Basel Framework, CRE 41.7] The inputs KSA and W are used as inputs to calculate KA, as follows: K A = 1 − W × K SA + 0.5 × W In case an institution does not know the delinquency status, as defined above, for no more than 5% of underlying exposures in the pool, the institution may still use the SEC-SA by adjusting its calculation of KA as follows, where KA represents the default-adjusted capital required for the underlying assets and 'EADSubpool 1 where W known' and 'EADSubpool 2 where W unknown' should sum to 'EAD Total': K A = EAD Subpool 1 where W known EAD Total × K A Subpool 1 where W known + EAD Subpool 2 where W unknown EAD Total If the institution does not know the delinquency status for more than 5%, the securitization exposure must be risk weighted at 1,250%. [Basel Framework, CRE 41.8 - 41.10] Capital requirements are calculated under the SEC-SA as follows: K SEC-SA = e a × u − e a × l a ( u − l ) where KSEC-SA is the capital requirement per unit of the securitization exposure and the variables a, u, and l are defined as follows: a = − 1 ( p × K A ) u = D − K A 1 = max A − K A , 0 [Basel Framework, CRE 41.11] The supervisory parameter p in the context of the SEC-SA is set equal to 1 for a securitization exposure that is not a resecuritization exposure. [Basel Framework, CRE 41.12] The risk weight assigned to a securitization exposure when applying the SEC-SA would be calculated as follows: When D for a securitization exposure is less than or equal to KA, the exposure must be assigned a risk weight of 1,250%. When A for a securitization exposure is greater than or equal to KA, the risk weight of the exposure, expressed as a percentage, would equal KSEC-SA multiplied by 12.5. When A is less than KA and D is greater than KA, the applicable risk weight is a weighted average of 1,250% and 12.5 multiplied by KSEC-SA according to the following formula: RW = K A − A D − A × 12.5 + D − K A D − A × 12.5 × K SEC-SA The risk weight for market risk hedges such as currency or interest rate swaps will be inferred from a securitization exposure that is pari passu to the swaps or, if such an exposure does not exist, from the next subordinated tranche. [Basel Framework, CRE 41.14] The resulting risk weight is subject to a floor risk weight of 15%. [Basel Framework, CRE 41.15] When an institution applies the SEC-SA to an unrated junior exposure in a transaction where the more senior tranches (exposures) are rated and no rating can be inferred for the junior exposure, the resulting risk weight under SEC-SA for the junior unrated exposure shall not be lower than the risk weight for the next more senior rated exposure. [Basel Framework, CRE 41.15]

6.6.5. Caps for securitization exposures

6.6.5.1. Maximum risk weight for senior exposures

Institutions may apply a "look-through" approach to senior securitization exposures, whereby the senior securitization exposure could receive a maximum risk weight equal to the exposure weighted-average risk weight applicable to the underlying exposures, provided that the institution has knowledge of the composition of the underlying exposures at all times. The applicable risk weight under the IRB framework would be inclusive of the expected loss portion multiplied by 12.5. In particular: In the case of pools where the institution uses exclusively the SA or the IRB approach, the risk weight cap for senior exposures would equal the exposure weighted-average risk weight that would apply to the underlying exposures under the SA or IRB framework, respectively. In the case of mixed pools, when applying the SEC-IRBA, the SA part of the underlying pool would receive the corresponding SA risk weight, while the IRB portion would receive IRB risk weights. When applying the SEC-SA or the SEC-ERBA, the risk weight cap for senior exposures would be based on the SA exposure weighted-average risk weight of the underlying assets, whether or not they are originally IRB. [Basel Framework, CRE 40.50] Where the risk weight cap results in a lower risk weight than the floor risk weight of 15%, the risk weight resulting from the cap should be used. [Basel Framework, CRE 40.51]

6.6.5.2. Maximum capital requirements

An institution (originating institution or investor) using the SEC-IRBA for a securitization exposure may apply a maximum capital requirement for the securitization exposures it holds equal to the IRB capital requirement (including the expected loss portion) that would have been assessed against the underlying exposures had they not been securitized and treated under the appropriate sections of the IRB framework outlined in Chapter 5 of this guideline and paragraph 137. [Basel Framework, CRE 40.52] In the case of mixed pools, the overall cap should be calculated by adding up the capital before securitization; that is, by adding up the capital required under the general credit risk framework for the IRB and for the SA part of the underlying pool. [Basel Framework, CRE 40.52] An originating institution using the SEC-ERBA or SEC-SA for a securitization exposure may apply a maximum capital requirement for the securitization exposures it holds equal to the capital requirement that would have been assessed against the underlying exposures had they not been securitized as described in paragraph 139. [Basel Framework, CRE 40.53] In the case of mixed pools, the overall cap should also be calculated by adding up the capital before securitization; that is, by adding up the capital required under the general credit risk framework for the IRB and the SA part of the underlying pool, respectively. The IRB part of the capital requirement includes the expected loss portion. [Basel Framework, CRE 40.53] In order to apply a maximum capital charge to an institution's securitization exposure, an institution will need the following inputs: The largest proportion of interest that the institution holds for each tranche of a given pool (P). In particular: For an institution that has one or more securitization exposure(s) that reside in a single tranche of a given pool, P equals the proportion (expressed as a percentage) of securitization exposure(s) that the institution holds in that given tranche (calculated as the total nominal amount of the institution's securitization exposure(s) in the tranche) divided by the nominal amount of the tranche. For an institution that has securitization exposures that reside in different tranches of a given securitization, P equals the maximum proportion of interest across tranches, where the proportion of interest for each of the different tranches should be calculated as described above. Capital charge for underlying pool (KP): For an IRB pool, KP equals KIRB as defined in paragraphs 59 to 94 multiplied by the exposure amount of the underlying pool. For an SA pool, KP equals KSA as defined in paragraph 122 to 125 multiplied by the exposure amount of the underlying pool. For a mixed pool, KP equals the exposure-weighted average capital charge of the underlying pool using KSA for the proportion of the underlying pool for which the institution cannot calculate KIRB, and KIRB for the proportion of the underlying pool for which an institution can calculate KIRB. The maximum aggregated capital requirement for an institution's securitization exposures in the same transaction will be equal to KP × P. [Basel Framework, CRE 40.54] In applying the capital charge cap, the entire amount of any gain on sale and credit-enhancing interest-only strips arising from the securitization transaction must be deducted in accordance with paragraph 41. [Basel Framework, CRE 40.55]

6.7. Treatment of resecuritization exposures

For resecuritization exposures, institutions must apply the SEC-SA specified in paragraphs 121 to 132, with the following adjustments: the capital requirement of the underlying securitization exposures is calculated using the securitization framework; delinquencies (W) are set to zero for any exposure to a securitization tranche in the underlying pool; and the supervisory parameter p is set equal to 1.5, rather than 1 as for securitization exposures. [Basel Framework, CRE 41.16] If the underlying portfolio of a resecuritization consists of a pool of exposures to securitization tranches in addition to other assets, institutions may separate the exposures to securitization tranches from exposures to assets that are not securitizations. The KA parameter should be calculated for each subset individually, applying separate W parameters; these are calculated in accordance with paragraphs 126 to 127 in the subsets where the exposures are to assets that are not securitization tranches, and set to zero where the exposures are to securitization tranches. The KA for the resecuritization exposure is then obtained as the nominal exposure weighted-average of the KA's for each subset considered. [Basel Framework, CRE 41.17] The resulting risk weight is subject to a floor risk weight of 100%. [Basel Framework, CRE 41.18] The caps described in paragraphs 134 to 141 cannot be applied to resecuritization exposures. [Basel Framework, CRE 41.19]

6.8. Implicit Support

The provision of implicit or non-contractual support by an institution can include the following: the purchase of deteriorating credit exposures; purchasing assets from the underlying pool at above market prices; increasing the originator-provided first loss position; or an institution indirectly through other lending arrangements achieving the same result. Such support signals to the market that there is no clean break for the securitized assets and therefore the exclusion of these assets from the originator's calculation of regulatory capital is not justified. When an originating institution believes that the future actions it takes with respect to a securitization structure may meet the definition of implicit support, the institution must advise OSFI and seek a determination of the ensuing regulatory capital impact. In determining the capital impact, OSFI will consider factors, including but not limited to, the notice provided to OSFI or other method of discovery, the rationale for any structural change to the securitization, any change in credit quality of the asset pool or if any additional enhancements or non-contractual support is provided by third parties at market terms and conditions. As a general principle, when it has been determined that an institution has provided implicit support to a securitization, it must, at a minimum, hold capital against all of the exposures associated with the securitization transaction as if they had not been securitized. Additionally, institutions would not be permitted to recognize in regulatory capital any gain-on-sale, as defined in paragraph 41. Furthermore, the institution is required to disclose publicly that (a) it has provided non-contractual support and (b) the capital impact of doing so. [Basel Framework, CRE 40.49] If it is determined that implicit support has or will be provided, OSFI will advise the institution of the time period of the capital penalty, which will equal the later of two years or the maturity of all notes issued benefiting from the implicit support. If an institution is found to have provided implicit support on more than one occasion, it can expect to be prevented from gaining favourable capital treatment on all securitized assets for five years and will be subject to the disclosure requirements noted above.

6.9. Treatment of credit risk mitigation for securitization exposures

6.9.1. Eligible credit risk mitigation techniques for protection buyers

An institution may recognize credit protection purchased on a securitization exposure when calculating capital requirements subject to the following: Collateral recognition is limited to that permitted under the credit risk mitigation framework – in particular, section 4.3.2 (i) of Chapter 4 when the institution applies the SEC-ERBA or SEC-SA, and paragraph 89 of Chapter 5 when the institution applies the SEC- IRBA. Collateral pledged by SPEs may be recognized; Credit protection provided by the entities listed in section 4.3.5 (v) of Chapter 4 may be recognized. SPEs cannot be recognized as eligible guarantors; and Where guarantees or credit derivatives fulfil the minimum operational conditions as specified in section 4.3.5 of Chapter 4, institutions can take account of such credit protection in calculating capital requirements for securitization exposures. [Basel Framework, CRE 40.56]

6.9.1.1. Full or proportional cover

When an institution provides full (or pro rata) credit protection to a securitization exposure, the institution must calculate its capital requirements as if it directly holds the portion of the securitization exposure on which it has provided credit protection (taking into account the definition of tranche maturity specified in paragraphs 26 and 27). [Basel Framework, CRE 40.57] Provided that the conditions set out in paragraph 150 are met, the institution buying full (or pro rata) credit protection may recognize the credit risk mitigation on the securitization exposure in accordance with the CRM framework. [Basel Framework, CRE 40.58]

6.9.1.2. Tranched protection

In the case of tranched credit protection, the original securitization tranche will be decomposed into protected and unprotected sub-tranches:^{Footnote 18} The protection provider must calculate its capital requirement as if directly exposed to the particular sub-tranche of the securitization exposure on which it is providing protection, and as determined by the hierarchy of approaches for securitization exposures and according to paragraphs 154 to 156. Provided that the conditions set out in paragraph 150 are met, the protection buyer may recognize tranched protection on the securitization exposure. In doing so, it must calculate capital requirements for each sub-tranche separately and as follows: For the resulting unprotected exposure(s), capital requirements will be calculated as determined by the hierarchy of approaches for securitization exposures and according to paragraphs 154 to 156. For the guaranteed/protected portion, capital requirements will be calculated according to the applicable CRM framework (in accordance with the definition of tranche maturity given in paragraphs 26 and 27). [Basel Framework, CRE 40.59] If, according to the hierarchy of approaches determined by paragraphs 51 to 56, the institution must use the SEC-IRBA or SEC-SA, the parameters A and D should be calculated separately for each of the sub-tranches as if the latter would have been directly issued as separate tranches at the inception of the transaction. The value for KIRB (respectively KSA) will be computed on the underlying portfolio of the original transaction. [Basel Framework, CRE 40.60] If, according to the hierarchy of approaches determined by paragraphs 51 to 56, the institution must use the SEC-ERBA for the original securitization exposure, the relevant risk weights for the different sub-tranches will be calculated subject to the following: [Basel Framework, CRE 40.61] For the sub-tranche of highest priority,^{Footnote 19} the institution will use the risk weight of the original securitization exposure. For a sub-tranche of lower priority: Institutions must infer a rating from one of the subordinated tranches in the original transaction. The risk weight of the sub-tranche of lower priority will then be determined by applying the inferred rating and the SEC-ERBA. Thickness input T will be computed for the sub-tranche of lower priority only. Should it not be possible to infer a rating, the risk weight for the sub-tranche of lower priority will be computed using the SEC-SA applying the adjustments to the determination of A and D described in paragraph 154. The risk weight for this sub-tranche will be obtained as the greater of a) the risk weight determined through the application of the SEC-SA with the adjusted A, D points and b) the SEC-ERBA risk weight of the original securitization exposure prior to recognition of protection Under all approaches, a lower-priority sub-tranche must be treated as a non-senior securitization exposure even if the original securitization exposure prior to protection qualifies as senior as defined in paragraph 22. [Basel Framework, CRE 40.62]

6.9.2. Maturity mismatches

A maturity mismatch exists when the residual maturity of a hedge is less than that of the underlying exposure. [Basel Framework, CRE 40.63] When protection is bought on a securitization exposure(s), for the purpose of setting regulatory capital against a maturity mismatch, the capital requirement will be determined in accordance with section 4.3.1 (iv) of Chapter 4. When the exposures being hedged have different maturities, the longest maturity must be used. [Basel Framework, CRE 40.64] When protection is bought on assets to create a synthetic securitization, maturity mismatches may arise in the context of the securitizations (when, for example, an institution uses credit derivatives to transfer part or all of the credit risk of a specific pool of assets to third parties). When the credit derivatives unwind, the transaction will terminate. This implies that the effective maturity of all the tranches of the synthetic securitization may differ from that of the underlying assets or exposures. Institutions that synthetically securitize exposures held on their balance sheet by purchasing tranched credit protection must treat such maturity mismatches in the following manner: For securitization exposures that are assigned a risk weight of 1,250%, maturity mismatches are not taken into account. For all other securitization exposures, the institution must apply the maturity mismatch treatment set forth in section 4.3.1 (iv) of Chapter 4. When the exposures being hedged have different maturities, the longest maturity must be used. [Basel Framework, CRE 40.65]

6.10. 'Simple, transparent, and comparable' (STC) securitizations

6.10.1. Scope and identification of STC securitizations

Only traditional securitizations (including exposures to ABCP conduits and exposures to transactions financed by ABCP conduits) fall within the scope of the STC framework. Exposures to securitizations that are STC-compliant will be subject to capital requirements as determined by paragraphs 166 to 171. [Basel Framework, CRE 40.66] For regulatory capital purposes, the following will be considered STC-compliant: Exposures to traditional securitizations that meet all the criteria in Appendix 6-1. Exposures to ABCP conduits and/or transactions financed by ABCP conduits,^{Footnote 20} where the conduit and/or transactions financed by it meet the relevant criteria in Appendix 6-2 as described in the 'scope of application for capital purposes' section of the appendix. [Basel Framework, CRE 40.67]

6.10.2 Compliance with the STC criteria for capital purposes

The originating institution must disclose to investors all necessary information at the transaction level to allow investors to determine whether the securitization is STC-compliant. Based on the information provided by the originating institution, the investor must make its own assessment of the securitization's STC compliance status as defined in paragraph 161 before applying the alternative treatment in paragraphs 166 to 171. [Basel Framework, CRE 40.68] For retained positions where the originating institution has achieved significant risk transfer in accordance with paragraphs 29 to 31, the determination shall be made only by the originating institution retaining the position. [Basel Framework, CRE 40.69] STC criteria need to be met at all times. Checking the compliance with some of the criteria might only be necessary at origination (or at the time of initiating the exposure, in case of guarantees or liquidity facilities) of an STC securitization. Notwithstanding, investors and holders of the securitization positions are expected to take into account developments that may invalidate the previous compliance assessment, for example deficiencies in the frequency and content of the investor reports, in the alignment of interest, or changes in the transaction documentation at variance with relevant STC criteria. [Basel Framework, CRE 40.70] In cases where the criteria refer to underlying assets – including, but not limited to Criteria D1 and D2 - and the pool is dynamic, the compliance with the criteria will be subject to dynamic checks every time an underlying account is added to the pool. [Basel Framework, CRE 40.71]

6.10.3. Alternative capital treatment for STC-compliant securitizations

Securitization transactions that are assessed as STC-compliant for capital purposes as defined in paragraph 161 shall be subject to capital requirements under the securitization framework, taking into account that: When the SEC-IRBA is used, paragraphs 167 and 168 are applicable instead of paragraphs 98 and 106, respectively; When the SEC-ERBA is used, paragraphs 167, 169, and 170 are applicable instead of paragraphs 108, 110, and 113, respectively; When the SEC-SA is used, paragraphs 167 and 171 are applicable instead of paragraphs 130 and 132 respectively. [Basel Framework, CRE 41.20, 42.15, and 44.27] Under all three approaches, the resulting risk weight is subject to a floor risk weight of 10% for senior tranches, and 15% for non-senior tranches. [Basel Framework, CRE 41.22, 42.14, and 44.29]

6.10.3.1. Internal Ratings-Based Approach (SEC-IRBA)

The supervisory parameter p in SEC-IRBA for an exposure to an STC securitization is as follows: p = max 0.3 , 0.5 × A + B N + C × K IRB + D × LGD + E × M T , where: 0.3 denotes the p-parameter floor; N is the effective number of loans in the underlying pool, calculated as described in paragraph 101; KIRB is the capital charge of the underlying pool (as defined in paragraph 59); LGD is the exposure-weighted average loss given default of the underlying pool, calculated as described in paragraph 102); MT is the maturity of the tranche calculated according to paragraphs 26 and 27; and the parameters A, B, C, D, and E are determined according to the following look-up table: Parameters to determine supervisory parameter p Asset class Seniority / granularity A B C D E Wholesale Senior, granular (N>= 25) 0 3.56 -1.85 0.55 0.07 Senior, non-granular (N< 25) 0.11 2.61 -2.91 0.68 0.07 Non-senior, granular (N>= 25) 0.16 2.87 -1.03 0.21 0.07 Non-senior, non-granular (N< 25) 0.22 2.35 -2.46 0.48 0.07 Retail Senior 0 0 -7.48 0.71 0.24 Non-Senior 0 0 -5.78 0.55 0.27 [Basel Framework, CRE 44.28]

6.10.3.2. External Ratings-Based Approach (SEC-ERBA)

For exposures with short-term ratings, or when an inferred rating based on a short-term rating is available, the following risk weights shall apply: Table 1': SEC-ERBA risk weights for short-term ratings for STC securitizations blank External credit assessment A–1/P–1 A–2/P–2 A–3/P–3 All other ratings Risk weight 10% 30% 60% 1,250% [Basel Framework, CRE 42.12] [Basel Framework, CRE 42.13] For exposures with long-term ratings, risk weights will be determined according to Table 2 and will be adjusted for tranche maturity (calculated according to paragraphs 26 and 27), and tranche thickness for non-senior tranches according to paragraph 111. Table 2': SEC-ERBA risk weights for long-term ratings for STC securitizations Rating Senior tranche Tranche maturity (MT) Non-senior (thin) tranche Tranche maturity (MT) 1 year 5 years 1 year 5 years AAA 10% 10% 15% 40% AA+ 10% 15% 15% 55% AA 15% 20% 15% 70% AA- 15% 25% 25% 80% A+ 20% 30% 35% 95% A 30% 40% 60% 135% A- 35% 40% 95% 170% BBB+ 45% 55% 150% 225% BBB 55% 65% 180% 255% BBB- 70% 85% 270% 345% BB+ 120% 135% 405% 500% BB 135% 155% 535% 655% BB- 170% 195% 645% 740% B+ 225% 250% 810% 855% B 280% 305% 945% 945% B- 340% 380% 1015% 1015% CCC+/CCC/CCC- 415% 455% 1250% 1250% Below CCC- 1250% 1250% 1250% 1250%

6.10.3.3. Standardized Approach (SEC-SA)

The supervisory parameter p in the context of the SEC-SA is set equal to 0.5 for an exposure to an STC securitization. [Basel Framework, CRE 41.21]

6.11. Treatment of securitization exposures under the capital floor

Institutions subject to the capital floor as specified in section 1.5 of Chapter 1 of this guideline must use one of the following approaches when calculating the capital floor for securitization exposures: the external ratings-based approach (SEC-ERBA) described in section 6.6.2 the standardized approach (SEC-SA) described in section 6.6.4, or a risk-weight of 1250% The internal ratings based approach (SEC-IRBA) and internal assessment approach (SEC-IAA) described in sections 6.6.1, and 6.6.3 respectively are ineligible for use under the capital floor. STC-compliant securitizations are eligible to use the alternative capital treatments for the above approaches described in sections 6.10.3.2 and 6.10.3.3, and subject to the floor described in paragraph 167. Institutions are expected to follow the hierarchy of approaches outlined in section 6.5.2 when determining which of the above approaches to use for an exposure under the capital floor. The caps described in section 6.6.5 may be applied to exposures under the capital floor so long as the pool underlying the exposure is treated as an SA pool for the purpose of the cap.

6.12 Treatment of non-performing loan (NPL) securitizations

An institution is precluded from applying the SEC-IRBA to an exposure to an NPL securitization where the institution uses the foundation approach as referred to in section 5.2.2 of Chapter 5 to calculate the KIRB of the underlying pool of exposures. [Basel Framework, CRE 45.3] The risk weight applicable to exposures to NPL securitizations according to SEC-IRBA (section 6.6.1), SEC-SA (section 6.6.4) or the look-through approach (section 6.6.5.1) is floored at 100%. [Basel Framework, CRE 45.4] Where, according to the hierarchy of approaches in section 6.5.2 the institution must use the SEC-IRBA or the SEC-SA, an institution may apply a risk weight of 100% to the senior tranche of an NPL securitization provided that the NPL securitization is a traditional securitization and the sum of the non-refundable purchase price discounts (NRPPD) calculated as described in paragraph 179 is equal to or higher than 50% of the outstanding balance of the pool of exposures. [Basel Framework, CRE 45.5] For the purposes of paragraph 178, NRPPD is the difference between the outstanding balance of the exposures in the underlying pool and the price at which these exposures are sold by the originator to the securitization entity, when neither originator nor the original lender are reimbursed for this difference. In cases where the originator underwrites tranches of the NPL securitization for subsequent sale, the NRPPD may include the differences between the nominal amount of the tranches and the price at which these tranches are first sold to unrelated third parties. For any given piece of a securitization tranche, only the initial sale from the originator to investors is taken into account in the determination of NRPPD. The purchase prices of subsequent re-sales are not considered. [Basel Framework, CRE 45.6] An originator or sponsor institution may apply the capital requirement cap specified in section 6.6.5.2 to the aggregated capital requirement for its exposures to the same NPL securitization. The same applies to an investor institution, provided that it is using the SEC-IRBA for an exposure to the NPL securitization. [Basel Framework, CRE 45.7]

Appendix 6-1 STC criteria for term securitizations for regulatory capital purposes

This appendix describes the 16 criteria that must all be met in order for a true-sale term securitization exposure to qualify for the alternative capital treatment described in section 6.10. [Basel Framework, CRE 40.72]

6-1.A. Asset risk

A1. Nature of assets

In simple, transparent and comparable securitizations, the assets underlying the securitization should be credit claims or receivables that are homogeneous. In assessing homogeneity, consideration should be given to asset type jurisdiction, legal system and currency. [Basel Framework, CRE 40.73] Homogeneity should be assessed on the basis of common risk drivers, including similar risk factors and risk profiles. [Basel Framework, CRE 40.73] The nature of the assets should be such that investors would not need to analyse and assess materially different legal and/or credit risk factors and risk profiles when carrying out risk analysis and due diligence checks. [Basel Framework, CRE 40.73] As more exotic asset classes require more complex and deeper analysis, credit claims or receivables should have contractually identified periodic payment streams relating to rental,^{Footnote 21} principal, interest, or principal and interest payments. Any referenced interest payments or discount rates should be based on commonly encountered market interest rates,^{Footnote 22} but should not reference complex or complicated formulae or exotic derivatives.^{Footnote 23} Interest rate caps and/or floors would not automatically be considered exotic. [Basel Framework, CRE 40.73] Credit claims or receivables included in the securitization should have standard obligations, in terms of rights to payments and/or income from assets and that result in a periodic and well-defined stream of payments to investors. For the purposes of this criterion, credit card facilities should be deemed to result in a periodic and well-defined stream of payments to investors. [Basel Framework, CRE 40.73] Repayment of noteholders should mainly rely on the principal and interest proceeds from the securitized assets. Partial reliance on refinancing or re-sale of the asset securing the exposure may occur provided that re-financing is sufficiently distributed within the pool. [Basel Framework, CRE 40.73]

A2. Asset performance history

In order to provide investors with sufficient information on an asset class to conduct appropriate due diligence and access to a sufficiently rich data set to enable a more accurate calculation of expected loss in different stress scenarios, verifiable loss performance data, such as delinquency^{Footnote 24} and default data, should be available for credit claims and receivables with substantially similar risk characteristics to those being securitized, for a time period long enough to permit meaningful evaluation by investors. Sources of and access to data and the basis for claiming similarity to credit claims or receivables being securitized should be clearly disclosed to all market participants. [Basel Framework, CRE 40.74] In addition to the asset performance history, it is important that both the originator and the original lender should have a minimum track record in originating assets similar to those securitized, for example to avoid an originate-to-distribute model. Therefore, for capital purposes, investors must determine whether the performance history of the originator and the original lender for substantially similar claims or receivables to those being securitized has been established for an "appropriately long period of time". This performance history must be no shorter than a period of seven years for non-retail exposures. For retail exposures, the minimum performance history is five years. These data requirements apply irrespective of the credit risk approach used to determine capital requirements on the underlying pool. [Basel Framework, CRE 40.74] Additional consideration that is not part of the criterion^{Footnote 25} In addition to the history of the asset class within a jurisdiction, investors should consider whether the originator, sponsor, servicer and other parties with a fiduciary responsibility to the securitization have an established performance history for substantially similar credit claims or receivables to those being securitized and for an appropriately long period of time. [Basel Framework, CRE 40.74] It is not the intention of the criteria to form an impediment to the entry of new participants to the market, but rather that investors should take into account the performance history of the asset class and the transaction parties when deciding whether to invest in a securitization. [Basel Framework, CRE 40.74]

A3. Payment status

Non-performing credit claims and receivables are likely to require more complex and heightened analysis. The originator/sponsor must represent that credit claims or receivables being transferred to the securitization do not, at the time of inclusion in the pool, include obligations that are in default (typically defined in the transaction's legal documents) or delinquent so as to be obligations for which the transferor (e.g. the originator/sponsor) or parties to the securitization (e.g. the servicer or a party with a fiduciary responsibility) are aware of evidence indicating a material increase in expected losses or of enforcement actions. In a transaction structure in which the seller sells all receivables including defaulted or delinquent receivables, no funding should be provided against the defaulted receivables or provisions must be included in the transaction documentation requiring the seller to repurchase such ineligible receivables. [Basel Framework, CRE 40.75] To prevent credit claims or receivables arising from credit-impaired borrowers from being transferred to the securitization, the originator/sponsor should verify that a representative sample of credit claims or receivables in an underlying asset pool materially meet the following conditions: the obligor has not been the subject of an insolvency or debt restructuring process due to financial difficulties within three years prior to the date of origination;^{Footnote 26} ^{Footnote 27} and, the obligor does not have a credit assessment by an ECAI or a credit score^{Footnote 28} indicating a significant risk of default; and the credit claim or receivable is not currently subject to a dispute between the obligor and the seller. [Basel Framework, CRE 40.75] The assessment of these conditions should be carried out by the originator/sponsor no earlier than 45 days prior to the closing date, or, in the case of revolving transactions, no earlier than 45 days prior to new exposures being added to the transaction. Additionally, at the time of this assessment, there should to the best knowledge of the originator/sponsor be no evidence indicating likely deterioration in the performance status of the credit claim or receivable. [Basel Framework, CRE 40.75] Additionally, at the time of their inclusion in the pool, at least one payment should have been made on the underlying exposures, except where the sponsor has analyzed performance history for an appropriately long period of time for claims or receivables substantially similar to those being securitized, or in the case of revolving asset trust structures such as those for credit card receivables, trade receivables, and other exposures payable in a single instalment, at maturity. [Basel Framework, CRE 40.75]

A4. Consistency of underwriting

Investor analysis should be simpler and more straightforward where the securitization is of credit claims or receivables that satisfy materially non-deteriorating origination standards. To ensure that the quality of the securitized credit claims and receivables is not affected by changes in underwriting standards, the originator should make representations to investors that any credit claims or receivables being transferred to the securitization have been originated in the ordinary course of the originator's business to materially non-deteriorating underwriting standards. Where underwriting standards materially change, the originator should disclose the timing and purpose of such changes. Underwriting standards should not be less stringent than those applied to credit claims and receivables retained on the balance sheet. [Basel Framework, CRE 40.76] These should be credit claims or receivables which have satisfied materially non-deteriorating underwriting criteria and for which the obligors have been assessed as having the ability and volition to make timely payments on obligations; or on granular pools of obligors originated in the ordinary course of the originator's business where expected cash flows have been modelled to meet stated obligations of the securitization under prudently stressed loan loss scenarios. [Basel Framework, CRE 40.76] In all circumstances, all credit claims or receivables must be originated in accordance with sound and prudent underwriting criteria based on an assessment that the obligor has the "ability and volition to make timely payments" on its obligations. [Basel Framework, CRE 40.76] The originator/sponsor of the securitization is expected, where underlying credit claims or receivables have been acquired from third parties, to review the underwriting standards (i.e. to check their existence and assess their quality) of these third parties and to ascertain that they (i.e. the original lender) have assessed the obligors' "ability and volition to make timely payments on obligations". [Basel Framework, CRE 40.76]

A5. Asset selection and transfer

Whilst recognizing that credit claims or receivables transferred to a securitization will be subject to defined criteria (e.g. the size of the obligation, the age of the borrower or the LTV of the property, debt-to-income, and/or debt service coverage ratios), the performance of the securitization should not rely upon the ongoing selection of assets through active management^{Footnote 29} on a discretionary basis of the securitization's underlying portfolio. [Basel Framework, CRE 40.77] Credit claims or receivables transferred to a securitization should satisfy clearly defined eligibility criteria. Credit claims or receivables transferred to a securitization after the closing date may not be actively selected, actively managed or otherwise cherry-picked on a discretionary basis. Investors should be able to assess the credit risk of the asset pool prior to their investment decisions. [Basel Framework, CRE 40.77] In order to meet the principle of true sale, the securitization should effect true sale such that the underlying credit claims or receivables: are enforceable against the obligor and their enforceability is included in the representations and warranties of the securitization; are beyond the reach of the seller, its creditors or liquidators and are not subject to material re-characterisation or clawback risks; are not effected through credit default swaps, derivatives or guarantees, but by a transfer^{Footnote 30} of the credit claims or the receivables to the securitization; and demonstrate effective recourse to the ultimate obligation for the underlying credit claims or receivables and are not a securitization of other securitizations. [Basel Framework, CRE 40.78] In applicable jurisdictions, securitizations employing transfers of credit claims or receivables by other means should demonstrate the existence of material obstacles preventing true sale at issuance (e.g. the immediate realization of transfer tax or the requirement to notify obligors of the transfer) and should clearly demonstrate the method of recourse to ultimate obligors (e.g. equitable assignment, perfected contingent transfer). In such jurisdictions, any conditions where the transfer of the credit claims or receivable is delayed or contingent upon specific events and any factors affecting timely perfection of claims by the securitization should be clearly disclosed. [Basel Framework, CRE 40.79] The originator should provide representations and warranties that the credit claims or receivables being transferred to the securitization are not subject to any condition or encumbrance that can be foreseen to adversely affect enforceability in respect of collections due. [Basel Framework, CRE 40.79]

A6. Initial and ongoing data

To assist investors in conducting appropriate due diligence prior to investing in a new offering, sufficient loan-level data or, in the case of granular pools, summary stratification data on the relevant risk characteristics of the underlying pool, in each case in accordance with applicable laws, should be available to potential investors before pricing of a securitization. [Basel Framework, CRE 40.80] To assist investors in conducting appropriate and ongoing monitoring of their investments' performance and so that investors that wish to purchase a securitization in the secondary market have sufficient information to conduct appropriate due diligence, timely loan-level data or granular pool stratification data on the risk characteristics of the underlying pool, in each case in accordance with applicable laws, and standardized investor reports should be readily available to current and potential investors at least quarterly throughout the life of the securitization. Cut-off dates of the loan-level or granular pool stratification data should be aligned with those used for investor reporting. [Basel Framework, CRE 40.80] To provide a level of assurance that the reporting of the underlying credit claims or receivables is accurate and that the underlying credit claims or receivables meet the eligibility requirements, the initial portfolio should be reviewed for conformity with the eligibility requirements by an appropriate legally accountable and independent third party, such as an independent accounting practice or the calculation agent or management company for the securitization. [Basel Framework, CRE 40.80] For non-revolving transactions the review should confirm that the credit claims or receivables transferred to the securitization meet the portfolio eligibility requirements. The review could, for example, be undertaken on a representative sample of the initial portfolio, with the application of a minimum confidence level. The verification report need not be provided but its results, including any material exceptions, should be disclosed in the initial offering documentation. The review (and related disclosure) described in paragraph 27 is not required for revolving transactions. [Basel Framework, CRE 40.80]

6-1.B. Structural risk

B1. Redemption cash flows

Liabilities subject to the refinancing risk of the underlying credit claims or receivables are likely to require more complex and heightened analysis. To help ensure that the underlying credit claims or receivables do not need to be refinanced over a short period of time, there should not be a reliance on the sale or refinancing of the underlying credit claims or receivables in order to repay the liabilities, unless the underlying pool of credit claims or receivables is sufficiently granular and has sufficiently distributed repayment profiles. Rights to receive income from the assets specified to support redemption payments should be considered as eligible credit claims or receivables in this regard (e.g. associated savings plans designed to repay principal at maturity). [Basel Framework, CRE 40.81]

B2. Currency and interest rate asset and liability mismatches

To reduce the payment risk arising from the different interest rate and currency profiles of assets and liabilities and to improve investors' ability to model cash flows, interest rate and foreign currency risks should be appropriately mitigated at all times, and if any hedging transaction is executed the transaction should be documented according to industry-standard master agreements. Only derivatives used for genuine hedging of asset and liability mismatches of interest rate and / or currency should be allowed. [Basel Framework, CRE 40.82] The term "appropriately mitigated" should be understood as not necessarily requiring a completely perfect hedge. The appropriateness of the mitigation of interest rate and foreign currency through the life of the transaction must be demonstrated by making available to potential investors, in a timely and regular manner, quantitative information including the fraction of notional amounts that are hedged, as well as sensitivity analysis that illustrates the effectiveness of the hedge under extreme but plausible scenarios. [Basel Framework, CRE 40.82] If hedges are not performed through derivatives, then those risk-mitigating measures are only permitted if they are specifically created and used for the purpose of hedging an individual and specific risk, and not multiple risks at the same time (such as credit and interest rate risks). Non-derivative risk mitigation measures must be fully funded and available at all times. [Basel Framework, CRE 40.82]

B3. Payment priorities and observability

To prevent investors being subjected to unexpected repayment profiles during the life of a securitization, the priorities of payments for all liabilities in all circumstances should be clearly defined at the time of securitization and appropriate legal comfort regarding their enforceability should be provided. [Basel Framework, CRE 40.83] To ensure that junior noteholders do not have inappropriate payment preference over senior noteholders that are due and payable, throughout the life of a securitization, or, where there are multiple securitizations backed by the same pool of credit claims or receivables, throughout the life of the securitization programme, junior liabilities should not have payment preference over senior liabilities which are due and payable. The securitization should not be structured as a "reverse" cash flow waterfall such that junior liabilities are paid where due and payable senior liabilities have not been paid. [Basel Framework, CRE 40.83] To help provide investors with full transparency over any changes to the cash flow waterfall, payment profile or priority of payments that might affect a securitization, all triggers affecting the cash flow waterfall, payment profile or priority of payments of the securitization should be clearly and fully disclosed both in offering documents and in investor reports, with information in the investor report that clearly identifies the breach status, the ability for the breach to be reversed and the consequences of the breach. Investor reports should contain information that allows investors to monitor the evolution over time of the indicators that are subject to triggers. Any triggers breached between payment dates should be disclosed to investors on a timely basis in accordance with the terms and conditions of all underlying transaction documents. [Basel Framework, CRE 40.83] Securitizations featuring a revolving period should include provisions for appropriate early amortization events and/or triggers of termination of the revolving period, including, notably: (i) deterioration in the credit quality of the underlying exposures; (ii) a failure to acquire sufficient new underlying exposures of similar credit quality; and (iii) the occurrence of an insolvency-related event with regard to the originator or the servicer. [Basel Framework, CRE 40.84] Following the occurrence of a performance-related trigger, an event of default or an acceleration event, the securitization positions should be repaid in accordance with a sequential amortization priority of payments, in order of tranche seniority, and there should not be provisions requiring immediate liquidation of the underlying assets at market value. [Basel Framework, CRE 40.85] To assist investors in their ability to appropriately model the cash flow waterfall of the securitization, the originator/sponsor should make available to investors, both before pricing of the securitization and on an ongoing basis, a liability cash flow model or information on the cash flow provisions allowing appropriate modelling of the securitization cash flow waterfall. [Basel Framework, CRE 40.86] To ensure that debt forgiveness, forbearance, payment holidays and other asset performance remedies that may affect investors can be clearly identified, policies and procedures, definitions, remedies and actions relating to delinquency, default or restructuring of underlying debtors should be provided in clear and consistent terms, such that investors can clearly identify debt forgiveness, forbearance, payment holidays, restructuring and other asset performance remedies that may affect their investment performance^{Footnote 31} on an ongoing basis. [Basel Framework, CRE 40.87]

B4. Voting and enforcement rights

To help ensure clarity for securitization note holders of their rights and ability to control and enforce on the underlying credit claims or receivables, upon insolvency of the originator/sponsor, all voting and enforcement rights related to the credit claims or receivables should be transferred to the securitization. Investors' rights in the securitization should be clearly defined in all circumstances, including the rights of senior versus junior note holders. [Basel Framework, CRE 40.88]

B5. Documentation disclosure and legal review

To help investors to fully understand the terms, conditions, legal and commercial information prior to investing in a new offering^{Footnote 32} and to ensure that this information is set out in a clear and effective manner for all programmes and offerings, sufficient initial offering^{Footnote 33} and draft underlying^{Footnote 34} documentation should be made available to investors and potential investors within a reasonably sufficient period of time prior to pricing, or when legally permissible, such that the investor is provided with full disclosure of the legal and commercial information and comprehensive risk factors needed to make informed investment decisions. Final offering documents should be available from the closing date and all final underlying transaction documents shortly thereafter. These should be composed such that readers can readily find, understand and use relevant information. [Basel Framework, CRE 40.89] To ensure that all the securitization's underlying documentation has been subject to appropriate review prior to publication, the terms and documentation of the securitization should be reviewed by an appropriately experienced third-party legal practice, such as a legal counsel already instructed by one of the transaction parties, e.g. by the arranger or the trustee. Investors should be notified in a timely fashion of any changes in such documents that have an impact on the structural risks in the securitization. [Basel Framework, CRE 40.89]

B6. Alignment of interest

In order to align the interests of those responsible for the underwriting of the credit claims or receivables with those of investors, the originator/sponsor of the credit claims or receivables should retain a material net economic exposure and demonstrate a financial incentive in the performance of these assets following their securitization. [Basel Framework, CRE 40.90]

6-1.C. Fiduciary and servicer risk

C1. Fiduciary and contractual responsibilities

To help ensure servicers have extensive workout expertise, thorough legal and collateral knowledge and a proven track record in loss mitigation, such parties should be able to demonstrate expertise in the servicing of the underlying credit claims or receivables, supported by a management team with extensive industry experience. The servicer should at all times act in accordance with reasonable and prudent standards. Policies, procedures and risk management controls should be well documented and adhere to good market practices and relevant regulatory regimes. There should be strong systems and reporting capabilities in place. [Basel Framework, CRE 40.91] The party or parties with fiduciary responsibility should act on a timely basis in the best interests of the securitization note holders, and both the initial offering and all underlying documentation should contain provisions facilitating the timely resolution of conflicts between different classes of note holders by the trustees, to the extent permitted by applicable law. [Basel Framework, CRE 40.92] The party or parties with fiduciary responsibility to the securitization and to investors should be able to demonstrate sufficient skills and resources to comply with their duties of care in the administration of the securitization vehicle. [Basel Framework, CRE 40.92] To increase the likelihood that those identified as having a fiduciary responsibility towards investors as well as the servicer execute their duties in full on a timely basis, remuneration should be such that these parties are incentivized and able to meet their responsibilities in full and on a timely basis. [Basel Framework, CRE 40.92] In assessing whether "strong systems and reporting capabilities are in place", well documented policies, procedures and risk management controls, as well as strong systems and reporting capabilities, may be substantiated by a third-party review for non-banking entities. [Basel Framework, CRE 40.91] Institutions are subject to an ongoing assessment of their internal reporting systems and capabilities, as outlined in Criterion 7 of Principle 15 of the Basel Core Principles for Effective Banking Supervision. To ensure an assessment that is comparable with that of banking entities, other non-bank originating entities not subject to the Basel Core Principles should provide proof of an independent assessment of their reporting capabilities. Evidence of a suitable third-party review can be based on the supervisory regime applicable to this entity (if such supervision covers internal reporting systems).

C2. Transparency to investors

To help provide full transparency to investors, assist investors in the conduct of their due diligence and to prevent investors being subject to unexpected disruptions in cash flow collections and servicing, the contractual obligations, duties and responsibilities of all key parties to the securitization, both those with a fiduciary responsibility and of the ancillary service providers, should be defined clearly both in the initial offering and all underlying documentation. Provisions should be documented for the replacement of servicers, bank account providers, derivatives counterparties and liquidity providers in the event of failure or non-performance or insolvency or other deterioration of creditworthiness of any such counterparty to the securitization. [Basel Framework, CRE 40.93] To enhance transparency and visibility over all receipts, payments and ledger entries at all times, the performance reports to investors should distinguish and report the securitization's income and disbursements covering items, as applicable, such as scheduled principal, redemption principal, scheduled interest, prepaid principal, past due interest and fees and charges, delinquent, defaulted and restructured amounts under debt forgiveness and payment holidays, including accurate accounting for amounts attributable to principal and interest deficiency ledgers. [Basel Framework, CRE 40.93] The terms "initial offering" and "underlying transaction documentation" should be understood in the context defined by Criterion B5. The term "income and disbursements" should also be understood as including deferment, forbearance, and repurchases among the items described. [Basel Framework, CRE 40.93]

6-1.D. Additional criteria for capital purposes

D1. Credit risk of underlying exposures

At the portfolio cut-off date the underlying exposures have to meet the conditions under the Standardized Approach for credit risk (Chapter 4), and after taking into account any eligible credit risk mitigation, for being assigned a risk weight equal to or smaller than: 40% on an exposure-weighted average basis for the portfolio where the exposures are loans secured by residential mortgages or fully guaranteed residential loans; 50% on an individual exposure basis where the exposure is a loan secured by a commercial mortgage; 75% on an individual exposure basis where the exposure is a retail exposure; or 100% on an exposure-weighted average basis for the portfolio for any other exposure. [Basel Framework, CRE 40.94]

D2. Granularity of the pool

At the portfolio cut-off date, the aggregated value of all exposures to a single obligor shall not exceed 1%^{Footnote 35} of the aggregated outstanding exposure value of all exposures in the portfolio. This definition of granularity helps to ensure that granular asset portfolios would be at a level where statistical approaches to model losses can be employed, as opposed to having to review the credit quality of individual exposures. [Basel Framework, CRE 40.95]

Appendix 6-2 STC criteria for short-term securitizations for regulatory capital purposes

This appendix describes the 19 criteria that must be met in order for a securitization exposure to an ABCP conduit or transaction financed by an ABCP conduit to qualify for the alternative capital treatment described in section 6.10. Terms and definitions ABCP conduit / conduit The special purpose vehicle which can issue commercial paper ABCP programme The programme of commercial paper issued by an ABCP conduit assets / asset pool The credit claims and/or receivables underlying a transaction in which the ABCP conduit holds a beneficial interest investor The holder of commercial paper issued under an ABCP programme, or any type of exposure to the conduit representing a financing liability of the conduit, such as loans obligor The borrower underlying a credit claim or a receivable that is part of an asset pool seller A party that (i) concluded (in its capacity as original lender) the original agreement that created the obligations or potential obligations (under a credit claim or a receivable) of an obligor or purchased the obligations or potential obligations from the original lender(s), and (ii) transferred those assets through a transaction or passed on the interest^{Footnote 36} to the ABCP conduit sponsor Sponsor of an ABCP conduit. It may also be noted that other relevant parties with a fiduciary responsibility in the management and administration of the ABCP conduit could also undertake control of some of the responsibilities of the sponsor transaction An individual transaction in which the ABCP conduit holds a beneficial interest. A transaction may qualify as a securitization, but may also be a direct asset purchase, the acquisition of undivided interest in a revolving pool of asset, a secured loan etc. [BCBS CF, CRE 40.96]

Scope of application

For an ABCP conduit to be considered STC, the following criteria need to be met both at the conduit level and transaction level.

Scope of application for capital purposes

For exposures to an ABCP conduit (e.g. exposure arising from investing in the commercial papers issued by the ABCP programme or sponsoring arrangements at the conduit/programme level), compliance with the short-term STC capital criteria is only achieved if the criteria are satisfied at both the conduit and transaction levels. [Basel Framework, CRE 40.97] In the case of exposures to individual transactions financed by an ABCP conduit, compliance with the short-term STC capital criteria is considered to be achieved if the criteria relevant to the transaction level are satisfied for the transactions to which support is provided. [Basel Framework, CRE 40.98]

6-2.A Asset risk

A1. Nature of assets

Relevant to the Conduit level The sponsor should make representations and warranties to investors that the subsections of Criterion A1 defined at transaction-level are met, and explain how this is the case on an overall basis. Only if specified should this be done for each transaction. [Basel Framework, CRE 40.99] Provided that each individual underlying transaction is homogeneous in terms of asset type, a conduit may be used to finance transactions of different asset types. [Basel Framework, CRE 40.99] Programme wide credit enhancement should not prevent a conduit from qualifying for STC, regardless of whether such enhancement technically creates re-securitization. [Basel Framework, CRE 40.99] Relevant to the Transaction level The assets underlying a transaction in a conduit should be credit claims or receivables that are homogeneous, in terms of asset type. [Basel Framework, CRE 40.100] Homogeneity should be assessed on the basis of common risk drivers, including similar risk factors and risk profiles. [Basel Framework, CRE 40.101] The nature of assets should be such that there would be no need to analyze and assess materially different legal and/or credit risk factors and risk profiles when carrying out risk analysis and due diligence checks for the transaction. [Basel Framework, CRE 40.101] The assets underlying each individual transaction in a conduit should not be composed of "securitization exposures" as defined in paragraph 5 of this chapter. This requirement is met if the transaction has the same economic characteristics as the purchase of the pool of underlying assets with a refundable purchase price discount, regardless of the legal form of the transaction. [Basel Framework, CRE 40.100 and 40.104] Credit claims or receivables underlying a transaction in a conduit should have contractually identified periodic payment streams relating to rental,^{Footnote 37} principal, interest, or principal and interest payments. Credit claims or receivables generating a single payment stream would equally qualify as eligible. Any referenced interest payments or discount rates should be based on commonly encountered market interest rates,^{Footnote 38} but should not reference complex or complicated formulae or exotic derivatives.^{Footnote 39} Interest rate caps and/or floors are not automatically considered "exotic derivatives". [Basel Framework, CRE 40.100 and 40.103] Credit claims or receivables included in the securitization should have standard obligations, in terms of rights to payments and/or income from assets and that result in a periodic and well-defined stream of payments to investors. For the purposes of this criterion, credit card facilities should be deemed to result in a periodic and well-defined stream of payments to investors. [Basel Framework, CRE 40.101] Repayment of the securitization exposure should mainly rely on the principal and interest proceeds from the securitized assets. Partial reliance on refinancing or re-sale of the asset securing the exposure may occur provided that re-financing is sufficiently distributed within the pool. [Basel Framework, CRE 40.101] Examples of "commonly encountered market interest rates" include: interbank rates and rates set by monetary policy authorities, such as CDOR, Enhanced CORRA, LIBOR, EURIBOR, the Bank of Canada's target for the overnight rate, the Fed Funds Rate; and sectoral rates reflective of a lender's cost of funds, such as internal interest rates that directly reflect the market costs of a bank's funding or that of a subset of institutions. [Basel Framework, CRE 40.102]

A2. Asset performance history

Relevant to the Conduit level In order to provide investors with sufficient information on the performance history of the asset types backing the transactions, the sponsor should make available to investors, sufficient loss performance data of claims and receivables with substantially similar risk characteristics, such as delinquency and default data of similar claims, and for a time period long enough to permit meaningful evaluation. The sponsor should disclose to investors the sources of such data and the basis for claiming similarity to credit claims or receivables financed by the conduit. Such loss performance data may be provided on a stratified basis.^{Footnote 40} [Basel Framework, CRE 40.105] Relevant to the Transaction level In order to provide the sponsor with sufficient information on the performance history of each asset type backing the transactions and to conduct appropriate due diligence and to have access to a sufficiently rich data set to enable a more accurate calculation of expected loss in different stress scenarios, verifiable loss performance data, such as delinquency^{Footnote 41} and default data, should be available for credit claims and receivables with substantially similar risk characteristics to those being financed by the conduit, for a time period long enough to permit meaningful evaluation by the sponsor. [Basel Framework, CRE 40.106] The sponsor of the securitization, as well as the original lender who underwrites the assets, must have sufficient experience in the risk analysis/underwriting of exposures or transactions with underlying exposures similar to those securitized. The sponsor should have well documented procedures and policies regarding the underwriting of transactions and the ongoing monitoring of the performance of the securitized exposures. The sponsor should ensure that the seller(s) and all other parties involved in the origination of the receivables have experience in originating same or similar assets, and are supported by a management with industry experience. For the purpose of meeting the short-term STC capital criteria, investors must request confirmation from the sponsor that the performance history of the originator and the original lender for substantially similar claims or receivables to those being securitized has been established for an "appropriately long period of time". This performance history must be no shorter than a period of five years for non-retail exposures. For retail exposures, the minimum performance history is three years. [Basel Framework, CRE 40.107]

A3. Payment status

Relevant to the Conduit level The sponsor should, to the best of its knowledge and based on representations from sellers, make representations and warranties to investors that Criterion A3 at the transaction level is met with respect to each transaction. [Basel Framework, CRE 40.108] Relevant to the Transaction level The sponsor should obtain representations from sellers that the credit claims or receivables underlying each individual transaction are not, at the time of acquisition of the interests to be financed by the conduit, in default (typically defined in the transaction's legal documents) or delinquent so as to be subject to a material increase in expected losses or of enforcement actions. In a transaction structure in which the seller sells all receivables including defaulted or delinquent receivables, no funding should be provided against the defaulted receivables or provisions must be included in the transaction documentation requiring the seller to repurchase such ineligible receivables. [Basel Framework CRE 40.109] To prevent credit claims or receivables arising from credit-impaired borrowers from being transferred to the securitization, the original seller or sponsor should verify that a representative sample of credit claims or receivables in an underlying asset pool materially meet the following conditions for each transaction: the obligor has not been the subject of an insolvency or debt restructuring process due to financial difficulties in the three years prior to the date of origination;^{Footnote 42} ^{Footnote 43} the obligor does not have a credit assessment by an external credit assessment institution or a credit score^{Footnote 44} indicating a significant risk of default; and the credit claim or receivable is not currently subject to a dispute between the obligor and the seller. [Basel Framework, CRE 40.110] The assessment of these conditions should be carried out by the original seller or sponsor no earlier than 45 days prior to acquisition of the transaction by the conduit or, in the case of replenishing transactions, no earlier than 45 days prior to new exposures being added to the transaction. In addition, at the time of the assessment, there should to the best knowledge of the seller or sponsor be no evidence indicating likely deterioration in the performance status of the credit claim or receivable. [Basel Framework, CRE 40.111] Further, at the time of their inclusion in the pool, at least one payment should have been made on the underlying exposures, except where the sponsor has analyzed performance history for an appropriately long period of time for substantially similar claims or receivables substantially similar to those being securitized, or in the case of replenishing asset trust structures such as those for credit card receivables, trade receivables, and other exposures payable in a single instalment, at maturity. [Basel Framework, CRE 40.111]

A4. Consistency of underwriting

Relevant to the Conduit level The sponsor should make representations and warranties to investors that: it has taken steps to verify that for the transactions in the conduit, any underlying credit claims and receivables have been subject to consistent materially non-deteriorating underwriting standards, and explain how. when there are material changes to underwriting standards, it will receive from sellers disclosure about the timing and purpose of such changes. The sponsor should also inform investors of the material selection criteria applied when selecting sellers (including where they are not financial institutions). [Basel Framework, CRE 40.112 and 40.113] Relevant to the Transaction level The sponsor should ensure that sellers in transactions with the conduit make representations to it that: any credit claims or receivables being transferred to or through a transaction held by the conduit have been originated or purchased in the ordinary course of the seller's business to materially non-deteriorating underwriting standards. Those underwriting standards should also not be less stringent than those applied to credit claims and receivables retained on the balance sheet of the seller and not financed by the conduit; and the obligors have been assessed as having the ability and volition to make timely payments on obligations. [Basel Framework, CRE 40.114] The sponsor should also ensure that sellers disclose to it the timing and purpose of material changes to underwriting standards. [Basel Framework , CRE 40.115] In all circumstances, all credit claims or receivables must be originated in accordance with sound and prudent underwriting criteria based on an assessment that the obligor has the "ability and volition to make timely payments" on its obligations.^{Footnote 45} [Basel Framework, CRE 40.116] The sponsor of the securitization is expected, where underlying credit claims or receivables have been acquired from third parties, to review the underwriting standards (i.e. to check their existence and assess their quality) of these third parties and to ascertain that they have assessed the obligors' "ability and volition to make timely payments" on their obligations. [Basel Framework, CRE 40.116]

A5. Asset selection and transfer

Relevant to the Conduit level The sponsor should: provide representations and warranties to investors about the checks, in nature and frequency, it has conducted regarding enforceability of underlying assets. disclose to investors the receipt of appropriate representations and warranties from sellers that the credit claims or receivables being transferred to the transactions in the conduit are not subject to any condition or encumbrance that can be foreseen to adversely affect enforceability in respect of collections due. [Basel Framework, CRE 40.117] The standardized investor reports which are made readily available to current and potential investors at least monthly should include the following information: materially relevant data on the credit quality and performance of underlying assets, which may include data allowing investors to identify dilution, delinquencies and defaults, restructured receivables, forbearance, repurchases, losses, recoveries and other asset performance remedies in the pool; the form and amount of credit enhancement provided by the seller and sponsor at transaction and conduit levels, respectively; materially relevant information on the support provided by the sponsor; and the status and definitions of relevant triggers (such as performance, termination or counterparty replacement triggers). [Basel Framework, CRE 40.126] Relevant to the Transaction level The sponsor should ensure that credit claims or receivables transferred to or through a transaction financed by the conduit: satisfy clearly defined eligibility criteria; are not actively selected after the closing date, actively managed^{Footnote 46} or otherwise cherry-picked on a discretionary basis. [Basel Framework, CRE 40.118] The sponsor should be able to assess thoroughly the credit risk of the asset pool prior to its decision to provide support to any given transaction or to the conduit. [Basel Framework, CRE 40.118] The sponsor should ensure that the transactions in the conduit effect true sale such that the underlying credit claims or receivables: are enforceable against the obligor; are beyond the reach of the seller, its creditors or liquidators and are not subject to material re-characterization or clawback risks; are not effected through credit default swaps, derivatives or guarantees, but by a transfer^{Footnote 47} of the credit claims or the receivables to the transaction; and demonstrate effective recourse to the ultimate obligation for the underlying credit claims or receivables and are not a re-securitization position. [Basel Framework, CRE 40.119] The sponsor should ensure that in applicable jurisdictions, for conduits employing transfers of credit claims or receivables by other means, sellers can demonstrate to it the existence of material obstacles preventing true sale at issuance^{Footnote 48} and should clearly demonstrate the method of recourse to ultimate obligors.^{Footnote 49} In such jurisdictions, any conditions where the transfer of the credit claims or receivables is delayed or contingent upon specific events and any factors affecting timely perfection of claims by the conduit should be clearly disclosed. [Basel Framework, CRE 40.120] The sponsor should ensure that it receives from the individual sellers (either in their capacity as original lender or servicer) representations and warranties that the credit claims or receivables being transferred to or through the transaction are not subject to any condition or encumbrance that can be foreseen to adversely affect enforceability in respect of collections due. [Basel Framework, CRE 40.121]

A6. Initial and ongoing data

Relevant to the Conduit level To assist investors in conducting appropriate due diligence prior to investing in a new programme offering, the sponsor should provide to potential investors sufficient aggregated data that illustrate the relevant risk characteristics of the underlying asset pools in accordance with applicable laws. [Basel Framework, CRE 40.123] To assist investors in conducting appropriate and ongoing monitoring of their investments' performance and so that investors who wish to purchase commercial paper have sufficient information to conduct appropriate due diligence, the sponsor should provide timely and sufficient aggregated data that provide the relevant risk characteristics of the underlying pools in accordance with applicable laws. The sponsor should ensure that standardized investor reports are readily available to current and potential investors at least monthly. Cut off dates of the aggregated data should be aligned with those used for investor reporting. [Basel Framework, CRE 40.123] The standardized investor reports which are made readily available to current and potential investors at least monthly should include the following information: materially relevant data on the credit quality and performance of underlying assets, including data allowing investors to identify dilution, delinquencies and defaults, restructured receivables, forbearance, repurchases, losses, recoveries and other asset performance remedies in the pool; the form and amount of credit enhancement provided by the seller and sponsor at transaction and conduit levels, respectively; relevant information on the support provided by the sponsor; and the status and definitions of relevant triggers (such as performance, termination or counterparty replacement triggers). [Basel Framework, CRE 40.126] Relevant to the Transaction level The sponsor should ensure that the individual sellers (in their capacity of servicers) provide it with: sufficient asset level data in accordance with applicable laws or, in the case of granular pools, summary stratification data on the relevant risk characteristics of the underlying pool before transferring any credit claims or receivables to such underlying pool. timely asset level data in accordance with applicable laws or granular pool stratification data on the risk characteristics of the underlying pool on an ongoing basis. Those data should allow the sponsor to fulfil its fiduciary duty at the conduit level in terms of disclosing information to investors including the alignment of cut off dates of the asset level or granular pool stratification data with those used for investor reporting. [Basel Framework, CRE 40.124] The seller may delegate some of these tasks and, in this case, the sponsor should ensure that there is appropriate oversight of the outsourced arrangements. [Basel Framework, CRE 40.125]

6-2.B Structural risk

B1. Redemption cash flow

Relevant to the Transaction level Unless the underlying pool of credit claims or receivables is sufficiently granular and has sufficiently distributed repayment profiles, the sponsor should ensure that the repayment of the credit claims or receivables underlying any of the individual transactions relies primarily on the general ability and willingness of the obligor to pay rather than the possibility that the obligor refinances or sells the collateral and that such repayment does not primarily rely on the drawing of an external liquidity facility provided to this transaction. [Basel Framework, CRE 40.132] For capital purposes, sponsors cannot use support provided by their own liquidity and credit facilities towards meeting this criterion. For the avoidance of doubt, the requirement that the repayment shall not primarily rely on the drawing of an external liquidity facility does not apply to exposures in the form of the notes issued by the ABCP conduit. [Basel Framework, CRE 40.133]

B2. Currency and interest rate asset and liability mismatches

Relevant to the Conduit level The sponsor should ensure that any payment risk arising from different interest rate and currency profiles: (i) not mitigated at transaction-level; or (ii) arising at conduit level; are appropriately mitigated. [Basel Framework, CRE 40.134] The sponsor should provide sufficient information to investors to allow them to assess how the payment risk arising from the different interest rate and currency profiles of assets and liabilities are appropriately mitigated, whether at the conduit or at transaction level. [Basel Framework, CRE 40.134] The term "appropriately mitigated" should be understood as not necessarily requiring a completely perfect hedge. The appropriateness of the mitigation of interest rate and foreign currency risks through the life of the transaction must be demonstrated by making available, in a timely and regular manner, quantitative information including the fraction of notional amounts that are hedged, as well as sensitivity analysis that illustrates the effectiveness of the hedge under extreme but plausible scenarios. [Basel Framework, CRE 40.136] The sponsor should ensure that derivatives are only used for genuine hedging purposes and that hedging transactions are documented according to industry-standard master agreements. [Basel Framework, CRE 40.134] The use of risk-mitigating measures other than derivatives is permitted only if the measures are specifically created and used for the purpose of hedging an individual and specific risk. Nonderivative risk mitigation measures must be fully funded and available at all times. [Basel Framework, CRE 40.136] Relevant to the Transaction level To reduce the payment risk arising from the different interest rate and currency profiles of assets and liabilities, if any, and to improve the sponsor's ability to analyze cash flows of transactions, the sponsor should ensure that interest rate and foreign currency risks are appropriately mitigated.^{Footnote 50} [Basel Framework, CRE 40.135] The sponsor should ensure that derivatives are only used for genuine hedging purposes and that hedging transactions are documented according to industry-standard master agreements. [Basel Framework, CRE 40.135] The use of risk-mitigating measures other than derivatives is permitted only if the measures are specifically created and used for the purpose of hedging an individual and specific risk. Nonderivative risk mitigation measures must be fully funded and available at all times. [Basel Framework, CRE 40.136]

B3. Payment priorities and observability

Relevant to the Conduit level The commercial paper issued by the ABCP programme should not include extension options or other features which may extend the final maturity of the asset-backed commercial paper, where the right of trigger does not belong exclusively to investors. The sponsor should: make representations and warranties to investors that Criterion B3 is met at a transaction level and in particular, that it has the ability to appropriately analyze the cash flow waterfall for each transaction which qualifies as a securitization; and make available to investors a summary (illustrating the functioning) of these waterfalls and of the credit enhancement available at programme level and transaction level. [Basel Framework, CRE 40.137] Relevant to the Transaction level To prevent the conduit from being subjected to unexpected repayment profiles from the transactions, the sponsor should ensure that: priorities of payments are clearly defined at the time of acquisition of the interests in these transactions by the conduit; and appropriate legal comfort regarding the enforceability is provided. [Basel Framework, CRE 40.138] For all transactions which qualify as a securitization, the sponsor should ensure that all triggers affecting the cash flow waterfall, payment profile or priority of payments are clearly and fully disclosed to the sponsor both in the transactions' documentation and reports, with information in the reports that clearly identifies any breach status, the ability for the breach to be reversed and the consequences of the breach. Reports should contain information that allows sponsors to assess the likelihood of a trigger being breached or reversed. Any triggers breached between payment dates should be disclosed to sponsors on a timely basis in accordance with the terms and conditions of the transaction documents. [Basel Framework, CRE 40.139] For any of the transactions where the beneficial interest held by the conduit qualifies as a securitization position, the sponsor should ensure that any subordinated positions do not have inappropriate payment preference over payments to the conduit (which should always rank senior to any other position) and which are due and payable. [Basel Framework, CRE 40.140] Transactions featuring a revolving period should include provisions for appropriate early amortization events and/or triggers of termination of the revolving period, including, notably: deterioration in the credit quality of the underlying exposures; a failure to replenish sufficient new underlying exposures of similar credit quality; and the occurrence of an insolvency related event with regard to the individual sellers. [Basel Framework, CRE 40.141] To ensure that debt forgiveness, forbearance, payment holidays, restructuring, dilution and other asset performance remedies that affect the securitization can be clearly identified, policies and procedures, definitions, remedies and actions relating to delinquency, default, dilution or restructuring of underlying debtors should be provided in clear and consistent terms, such that the sponsor can clearly identify debt forgiveness, forbearance, payment holidays, restructuring, dilution and other asset performance remedies that may affect their performance^{Footnote 51} on an ongoing basis. [Basel Framework, CRE 40.142] For each transaction which qualifies as a securitization, the sponsor should ensure it receives both before the conduit acquires a beneficial interest in the transaction and on an ongoing basis, the liability cash flow analysis or information on the cash flow provisions allowing appropriate analysis of the cash flow waterfall of these transactions. [Basel Framework, CRE 40.143]

B4. Voting and enforcement rights

Relevant to the Conduit level To provide clarity to investors, the sponsor should make sufficient information available in order for investors to understand their enforcement rights on the underlying credit claims or receivables in the event of insolvency of the sponsor. [Basel Framework, CRE 40.144] Relevant to the Transaction level For each transaction, the sponsor should ensure, in particular upon insolvency of the seller or where the obligor is in default on its obligation, that, if applicable, all voting and enforcement rights related to the credit claims or receivables are: transferred to the conduit; and clearly defined under all circumstances, including with respect to the rights of the conduit versus other parties with an interest (e.g. sellers), where relevant. [Basel Framework, CRE 40.145]

B5. Documentation disclosure and legal review

Relevant to the Conduit level To help investors understand fully the terms, conditions, and legal information prior to investing in a new programme offering and to ensure that this information is set out in a clear and effective manner for all programme offerings, the sponsor should ensure that sufficient initial offering documentation for the ABCP programme is provided to investors and potential investors within a reasonably sufficient period of time prior to issuance, such that the investor is provided with full disclosure of the legal information and comprehensive risk factors needed to make informed investment decisions. [Basel Framework, CRE 40.146] These should be composed such that readers can readily find, understand and use relevant information. The sponsor should ensure that the terms and documentation of a conduit and the ABCP programme it issues are reviewed and verified by an appropriately experienced and independent legal practice prior to publication and in the case of material changes. The sponsor should notify investors in a timely fashion of any changes in such documents that have an impact on the structural risks in the ABCP programme. [Basel Framework, CRE 40.147] Relevant to the Transaction level To understand fully the terms, conditions and legal information prior to including a new transaction in the ABCP conduit and ensure that this information is set out in a clear and effective manner, the sponsor should ensure that it receives sufficient initial offering documentation for each transaction and that it is provided within a reasonably sufficient period of time prior to the inclusion in the conduit, with full disclosure of the legal information and comprehensive risk factors needed to supply liquidity and/or credit support facilities. The initial offering document for each transaction should be composed such that readers can readily find, understand and use relevant information. [Basel Framework, CRE 40.148] The sponsor should also ensure that the terms and documentation of a transaction are reviewed and verified by an appropriately experienced and independent legal practice prior to the acquisition of the transaction and in the case of material changes. [Basel Framework, CRE 40.148]

B6. Alignment of interest

Relevant to the Conduit level In order to align the interests of those responsible for the underwriting of the credit claims and receivables with those of investors, a material net economic exposure should be retained by the sellers or the sponsor at transaction level, or by the sponsor at the conduit level. [Basel Framework, CRE 40.149] Ultimately, the sponsor should disclose to investors how and where a material net economic exposure is retained by the seller at transaction level or by the sponsor at transaction or conduit level, and demonstrate the existence of a financial incentive in the performance of the assets. [Basel Framework, CRE 40.149]

B7. Full support

Relevant to the Conduit level The sponsor should provide the liquidity facility(ies) and the credit protection support^{Footnote 52} for any ABCP programme issued by a conduit. Such facility(ies) and support should ensure that investors are fully protected against credit risks, liquidity risks and any material dilution risks of the underlying asset pools financed by the conduit. As such, investors should be able to rely on the sponsor to ensure timely and full repayment of the commercial paper. [Basel Framework, CRE 40.127] While liquidity and credit protection support at both the conduit level and transaction level can be provided by more than one sponsor, the majority of the support (assessed in terms of coverage) has to be made by a single sponsor (referred to as the "main sponsor").^{Footnote 53} An exception can however be made for a limited period of time, where the main sponsor has to be replaced due to a material deterioration in its credit standing. [Basel Framework, CRE 40.128] The full support provided should be able to irrevocably and unconditionally pay the ABCP liabilities in full and on time. The list of risks provided in Criterion B7 that have to be covered is not comprehensive but rather provides typical examples. [Basel Framework, CRE 40.120] Under the terms of the liquidity facility agreement: Upon specified events affecting its creditworthiness, the sponsor shall be obliged to collateralize its commitment in cash to the benefit of the investors or otherwise replace itself with another liquidity provider. If the sponsor does not renew its funding commitment for a specific transaction or the conduit in its entirety, the sponsor shall collateralize its commitments regarding a specific transaction or, if relevant, to the conduit in cash at the latest 30 days prior to the expiration of the liquidity facility, and no new receivables should be purchased under the affected commitment. [Basel Framework, CRE 40.130] The sponsor should provide investors with full information about the terms of the liquidity facility (facilities) and the credit support provided to the ABCP conduit and the underlying transactions (in relation to the transactions, redacted where necessary to protect confidentiality). [Basel Framework, CRE 40.131]

B8. Cap on maturity transformation

Relevant to the Conduit level Maturity transformation undertaken through ABCP conduits should be limited. The sponsor should verify and disclose to investors that the weighted average maturity of all the transactions financed under the ABCP conduit is three years or less. [Basel Framework, CRE 40.150] This number should be calculated as the higher of: the exposure-weighted average residual maturity of the conduit's beneficial interests held or the assets purchased by the conduit in order to finance the transactions of the conduit^{Footnote 54} and; the exposure-weighted average maturity of the underlying assets financed by the conduit calculated by: taking an exposure-weighted average of residual maturities of the underlying assets in each pool and then taking an exposure-weighted average across the conduit of the pool-level averages as calculated in Step 2a. [Basel Framework, CRE 40.150] Where it is impractical for the sponsor to calculate the pool-level weighted average maturity in Step 2a (because the pool is very granular or dynamic), sponsors may instead use the maximum maturity of the assets in the pool as defined in the legal agreements governing the pool (e.g. investment guidelines). [Basel Framework, CRE 40.150]

6-2. C Fiduciary and servicer risk

C1. Fiduciary and contractual responsibilities

Relevant to the Conduit level The sponsor should, based on the representations received from seller(s) and all other parties responsible for originating and servicing the asset pools, make representations and warranties to investors that: the various criteria defined at the level of each underlying transaction are met, and explain how; Seller(s)'s policies, procedures and risk management controls are well-documented, adhere to good market practices and comply with the relevant regulatory regimes; and that strong systems and reporting capabilities are in place to ensure appropriate origination and servicing of the underlying assets. [Basel Framework, CRE 40.152] The sponsor should be able to demonstrate expertise in providing liquidity and credit support to in the context of ABCP conduits, and is supported by a management team with extensive industry experience. [Basel Framework, CRE 40.153] The sponsor should at all times act in accordance with reasonable and prudent standards. Policies, procedures and risk management controls of the sponsor should be well documented and the sponsor should adhere to good market practices and relevant regulatory regime. There should be strong systems and reporting capabilities in place at the sponsor. [Basel Framework, CRE 40.153] The party or parties with fiduciary responsibility should act on a timely basis in the best interests of the investors. [Basel Framework, CRE 40.153] Relevant to the Transaction level The sponsor should ensure that it receives representations from the seller(s) and all other parties responsible for originating and servicing the asset pools that they: have well-documented procedures and policies in place to ensure appropriate servicing of the underlying assets; have expertise in the origination of same or similar assets to those in the asset pools; have extensive servicing and workout expertise, thorough legal and collateral knowledge and a proven track record in loss mitigation for the same or similar assets; have expertise in the servicing of the underlying credit claims or receivables; and are supported by a management team with extensive industry experience. [Basel Framework, CRE 40.154] In assessing whether "strong systems and reporting capabilities are in place", well documented policies, procedures and risk management controls, as well as strong systems and reporting capabilities, may be substantiated by a third-party review for sellers that are non-banking entities. Evidence of a suitable third-party review can be based on the supervisory regime applicable to this entity (if such supervision covers internal reporting systems). [Basel Framework, CRE 40.155]

C2. Transparency to investors

Relevant to the Conduit level To help provide full transparency to investors and to assist them in their conduct of their due diligence, the sponsor should ensure that the contractual obligations, duties and responsibilities of all key parties to the conduit, both those with a fiduciary responsibility and the ancillary service providers, are defined clearly both in the initial offering and any relevant underlying documentation^{Footnote 55} of the conduit and the ABCP programme it issues. [Basel Framework, CRE 40.156] The sponsor should also make representations and warranties to investors that the duties and responsibilities of all key parties are clearly defined at transaction level. [Basel Framework, CRE 40.157] The sponsor should ensure that the initial offering documentation disclosed to investors contains adequate provisions regarding the replacement of key counterparties of the conduit (e.g. bank account providers and derivatives counterparties) in the event of failure or non-performance or insolvency or deterioration of creditworthiness of any such counterparty. [Basel Framework, CRE 40.158] The sponsor should also make representations and warranties to investors that provisions regarding the replacement of key counterparties at transaction level are well-documented. [Basel Framework, CRE 40.159] The sponsor should provide sufficient information to investors about the liquidity facility(ies) and credit support provided to the ABCP programme for them to understand its functioning and key risks. [Basel Framework, CRE 40.160] Relevant to the Transaction level The sponsor should conduct due diligence with respect to the transactions on behalf of the investors. [Basel Framework, CRE 40.161] To assist the sponsor in meeting its fiduciary and contractual obligations, the duties and responsibilities of all key parties to all transactions (both those with a fiduciary responsibility and of the ancillary service providers) should be defined clearly in all underlying documentation of these transactions and made available to the sponsor. [Basel Framework, CRE 40.161] The sponsor should ensure that provisions regarding the replacement of key counterparties (in particular the servicer or liquidity provider) in the event of failure or non-performance or insolvency or other deterioration of any such counterparty for the transactions are well-documented (in the documentation of these individual transactions). [Basel Framework, CRE 40.162] To enhance transparency and visibility over all receipts, payments and ledger entries at all times, the sponsor should ensure that for all transactions the performance reports include all of the transactions' income and disbursements covering items, as applicable, such as scheduled principal, redemption principal, scheduled interest, prepaid principal, past due interest and fees and charges, delinquent, defaulted, restructured and diluted amounts, as well as accurate accounting for amounts attributable to principal and interest deficiency ledgers. [Basel Framework, CRE 40.163]

C3. Financial institution

Relevant to the Conduit level The sponsor should be a financial institution that is licensed to take deposits from the public, and is subject to appropriate prudential standards and levels of supervision.^{Footnote 56} [Basel Framework, CRE 40.151]

6-2. D Additional criteria for capital purposes

D1. Credit risk of the underlying exposures

Relevant to the Transaction level At the date of acquisition of the assets, the underlying exposures have to meet the conditions under the Standardized Approach for credit risk and, after account is taken of any eligible credit risk mitigation, be assigned a risk weight equal to or smaller than: 40% on an exposure-weighted average basis for the portfolio where the exposures are loans secured by residential mortgages or fully guaranteed residential loans; 50% on an individual exposure basis where the exposure is a loan secured by a commercial mortgage; 75% on an individual exposure basis where the exposure is a retail exposure; or 100% on an exposure-weighted average basis for the portfolio for any other exposure. [Basel Framework, CRE 40.164]

D2. Granularity of the pool

Relevant to the Conduit level At the date of acquisition of any assets securitized by one of the conduits' transactions, the aggregated value of all exposures to a single obligor at that date shall not exceed 2%^{Footnote 57} of the aggregated outstanding exposure value of all exposures in the programme. [Basel Framework, CRE 40.165] In the case of trade receivables where the credit risk of those trade receivables is fully covered by credit protection, provided that the protection provider is a financial institution, only the portion of the trade receivables remaining after taking into account the effective of any purchase price discount and overcollateralization shall be included in the determination of whether the 2% limit is breached.

Appendix 6- 3 Illustrative examples for recognition of dilution risk when applying the SEC-IRBA to securitization exposures

The following examples are provided to illustrate the recognition of dilution risk according to paragraphs 93 and 94.

6-3.A. Common waterfall for default and dilution losses

In this example, it is assumed that losses resulting from either defaults or dilution within the securitized pool will be subject to a common waterfall, i.e. the loss allocation process does not distinguish between different sources of losses within the pool. Pool description:^{Footnote 58} Pool of $1,000,000 of corporate receivables N = 100 M = 2.5 years^{Footnote 59} PDDilution = 0.55% LGDDilution = 100% PDDefault = 0.95% LGDDefault = 45% Capital structure: Tranche A = senior note of $700,000 Tranche B = second-loss guarantee of $250,000 Tranche C = purchase discount of $50,000 Final legal maturity of transaction/all tranches = 2.875 years; i.e. MT = 2.5 years^{Footnote 60}

RWA calculation:

Step 1: Calculate KIRB,Dilution and KIRB,Default for the underlying portfolio: K IRB,Dilution = $1,000,000 × 161.44% × 8% + 0.55% × 100% ∕ $1,000,000 = 13.47% K IRB,Default = ( $1,000,000 – $136,900 ) x 90.62% × 8% + 0.95% × 45% $1,000,000 = 6.69% ^{Footnote 61} Step 2: Calculate KIRB,Pool K IRB , Pool = K IRB , Dilution + K IRB , Default = 13.47% + 6.69% = 20.16% Step 3: Apply the SEC-IRBA to the three tranches Pool parameters N = 100 LGD Pool = LGD Default × K IRB,Default + LGD Dilution × K IRB,Dilution / K IRB,Pool = 45% × 6.69% + 100% × 13.47% 20.16% = 81.87% Tranche parameters MT = 2.5 years Attachment and detachment points Tranche structure blank Attachment point Detachment point Tranche A 30% 100% Tranche B 5% 30% Tranche C 0% 5% Resulting risk-weighted exposure amounts blank SEC-IRBA risk weight RWA Tranche A 21.22% $148,540 Tranche B 1013.85% $2,534,625 Tranche C 1250% $625,000

6-3. B Non-common waterfall for default and dilution losses

In this example, it is assumed that the securitization transaction does not have one common waterfall for losses due to defaults and dilutions, i.e. for the determination of the risk of a specific tranche it is not only relevant what losses might be realized within the pool but also if those losses are resulting from default or a dilution event. As the SEC-IRBA assumes that there is one common waterfall, it cannot be applied without adjustments. The following example illustrates one possible scenario and a possible adjustment specific to this scenario. While this example is a useful reference, an institution should consult with OSFI as to how the capital calculation should be performed (see paragraph 94). Pool description:^{Footnote 62} Pool of $1,000,000 of corporate receivables N = 100 M = 2.5 years^{Footnote 63} PDDilution = 0.55% LGDDilution = 100% PDDefault = 0.95% LGDDefault = 45% Capital structure: Tranche A = senior note of $950,000 Tranche C = purchase discount of $50,000 Tranches A and C will cover both default and dilution losses. In addition, the structure also contains a second-loss guarantee of $250,000 (Tranche B)^{Footnote 64} that covers only dilution losses exceeding a threshold of $50,000 up to maximum aggregated amount of $300,000, which leads to the following two waterfalls: Default waterfall Tranche A = senior note of $950,000 Tranche C = purchase discount of $50,000^{Footnote 65} Dilution waterfall Tranche A = senior note of $700,000 Tranche B = second-loss guarantee of $250,000 Tranche C = purchase discount of $50,000^{Footnote 66} MT of all three tranches = 2.5 years

Treatment of Tranche C

Tranche C is treated as described in Example A.

Treatment of Tranche B

Tranche B (second-loss guarantee) is exposed only to dilution risk, but not to default risk. Therefore, KIRB, for the purpose of calculating a capital requirement for Tranche B, can be limited to KIRB,Dilution. However, as the holder of Tranche B cannot be sure that Tranche C will still be available to cover the first dilution losses when they are realized – because the credit enhancement might already be depleted due to earlier default losses – to ensure a prudent treatment, it cannot recognize the purchase discount as credit enhancement for dilution risk. In the capital calculation, the institution providing Tranche B should assume that $50,000 of the securitized assets have already been defaulted and hence Tranche C is no longer available as credit enhancement and the exposure of the underlying assets has been reduced to $950,000. When calculating KIRB for Tranche B, the institution can assume that KIRB is not affected by the reduced portfolio size. RWA calculation for Tranche B: Step 1: Calculate KIRB,Pool K IRB , Pool = K IRB , Dilution = 13.47% Step 2: Apply the SEC-IRBA Pool parameters N = 100 LGD Pool = LGD Dilution = 100% Tranche parameters MT = 2.5 years Attachment point = 0% Detachment point = $250,000 / $950,000 = 26.32% Resulting risk-weighted exposure amounts blank SEC-IRBA risk weight RWA Tranche B 886.94% $2,217,350

Treatment of Tranche A

The holder of Tranche A (senior note) will take all default losses not covered by the purchase discount and all dilution losses not covered by the purchase discount or the second-loss guarantee. A possible treatment for Tranche A would be to add KIRB,Default and KIRB,Dilution (as in Example A), but not to recognize the second-loss guarantee as credit enhancement at all because it is covering only dilution risk. Although this is a simple approach, it is also fairly conservative. Therefore the following alternative for the senior tranche could be considered: Calculate the RWA amount for Tranche A under the assumption that it is only exposed to losses resulting from defaults. This assumption implies that Tranche A is benefiting from a credit enhancement of $50,000. Calculate the RWA amounts for Tranche C and (hypothetical) Tranche A' under the assumption that they are only exposed to dilution losses. Tranche A' should be assumed to absorb losses above $300,000 up to $1,000,000. With respect to dilution losses, this approach would recognize that the senior tranche investor cannot be sure if the purchase price discount will still be available to cover those losses when needed as it might have already been used for defaults. Consequently, from the perspective of the senior investor, the purchase price discount could only be recognized for the calculation of the capital requirement for default or dilution risk but not for both.^{Footnote 67} ^{Footnote 68} Sum up the RWA amounts under (i) and (ii) to determine the final RWA amount for the senior note investor. RWA calculation for Tranche A: Step 1: Calculate RWA for (i) Pool parameters K IRB , Pool = K IRB , Default = 6.69% LGD Pool = LGD Default = 45% Tranche parameters MT = 2.5 years Attachment point = $50,000 / $1,000,000 = 5% Detachment point = $1,000,000 / $1,000,000 = 100% Resulting risk-weighted exposure amounts blank SEC-IRBA risk weight RWA Component (i) 51.67% $490,865 Step 2: Calculate RWA for (ii) Pool parameters K IRB , Pool = K IRB , Dilution = 13.47% LGD Pool = LGD Dilution = 100% Tranche parameters MT = 2.5 years Attachment and detachment points Tranche structure blank Attachment point Detachment point Tranche A' 30% 100% Tranche C 0% 5% Resulting risk-weighted exposure amounts blank SEC-IRBA risk weight RWA Tranche A' 11.16% $78,120 Tranche C 1250% $625,000 Step 3: Sum up the RWA of components (i) and (ii) Final RWA amount for investor in Tranche A = $490,865 + $78,120 + $625,000 = $1,193,985 Implicit risk weight for Tranche A = MAX (15%, $1,193,985 / $950,000) = 125.68%

Footnotes

Footnote 1 The Basel Framework Return to footnote 1 Footnote 2 Following the format: [Basel Framework, XXX yy.zz]. Return to footnote 2 Footnote 3 If a senior tranche is retranched or partially hedged (i.e. not on a pro rata basis), only the new senior part would be treated as senior for capital purposes. Return to footnote 3 Footnote 4 Vanilla interest rate and/or currency swap exposures to the securitization are not considered retained positions for the purposes of this paragraph. Return to footnote 4 Footnote 5 Legal opinion is not limited to legal advice from qualified legal counsel, but allows written advice from in-house lawyers. Return to footnote 5 Footnote 6 Under IFRS 9, Stage 3 allowances and partial write-offs are considered to be specific allowances, while Stage 1 and Stage 2 allowances are considered to be general allowances. Return to footnote 6 Footnote 7 Institutions extend securitization commitments to their clients directly or through an ABCP conduit. The undrawn amount of a securitization commitment is equal to the difference, if any, between the notional amount of the securitization commitment and the amount that the client has drawn and is outstanding on the date of determination (sometimes referred to as the utilized amount of the securitization commitment). When an institution extends a securitization commitment directly to a client, the 40% CCF applies to the undrawn amount of the securitization commitment. For the purposes of determining the backstop facility exposure to an ABCP conduit, when the securitization commitment to the client is provided through an ABCP conduit, the 40% factor would be applied to the undrawn amount of the securitization commitment to the client the same as when an institution provides a securitization commitment directly to the client. Return to footnote 7 Footnote 8 That is, splitting exposures into portions that overlap with another exposure held by the institution and other portions that do not overlap; and expanding exposures by assuming for capital purposes that obligations with respect to one of the overlapping exposures are larger than those established contractually. The latter could be done, for instance, by expanding either the trigger events to exercise the facility and/or the extent of the obligation. Return to footnote 8 Footnote 9 KIRB must also include the unexpected loss and the expected loss associated with defaulted exposures in the underlying pool. Return to footnote 9 Footnote 10 Undrawn balances should not be included in the calculation of KIRB in cases where only the drawn balances of revolving facilities have been securitized. Return to footnote 10 Footnote 11 Contra-accounts involve a customer buying from and selling to the same firm. The risk is that debts may be settled through payments in kind rather than cash. Invoices between the companies may be offset against each other instead of being paid. This practice can defeat a security interest when challenged in court. Return to footnote 11 Footnote 12 The firm-size adjustment for SME, as defined in section 5.3.1 (ii) of Chapter 5 of this guideline, will be the weighted average by individual exposure of the pool of purchased corporate receivables. If the institution does not have the information to calculate the average size of the pool, the firm-size adjustment will not apply. Return to footnote 12 Footnote 13 The rating designations used in Tables 1 and 2 are for illustrative purposes only and do not indicate any preference for, or endorsement of, any particular external assessment system. See section 4.2 of Chapter 4 for mapping of ratings for recognized ECAIs. Return to footnote 13 Footnote 14 Where the eligible credit assessment is not publicly available free of charge, the ECAI should provide an adequate justification, within its own publicly available code of conduct, in accordance with the "comply or explain" nature of the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies. Return to footnote 14 Footnote 15 That is, splitting exposures into portions that overlap with another exposure held by the institution and other portions that do not overlap; and expanding exposures by assuming for capital purposes that obligations with respect to one of the overlapping exposures are larger than those established contractually. The latter could be done, for instance, by expanding either the trigger events to exercise the facility and/or the extent of the obligation. Return to footnote 15 Footnote 16 KIRB must also include the unexpected loss and expected loss associated with defaulted exposures in the underlying pool. Return to footnote 16 Footnote 17 As in the case of swaps other than credit derivatives, the numerator of KIRB (i.e.: quantity (a)) must include the exposure amount of the collateral times its risk weight times 8%, but the denominator should be calculated without recognition of the collateral. Return to footnote 17 Footnote 18 The envisioned decomposition is theoretical and it should not be viewed as a new securitization transaction. The resulting sub-tranches should not be considered resecuritizations solely due to the presence of the credit protection. Return to footnote 18 Footnote 19 'Sub-tranche of highest priority' only describes the relative priority of the decomposed tranche. The calculation of the risk weight of each sub-tranche is independent from the question if this sub-tranche is protected (i.e. risk is taken by the protection provider) or is unprotected (i.e. risk is taken by the protection buyer). Return to footnote 19 Footnote 20 Institutions may apply the short term criteria to other exposures only if the exposures were evaluated using the same or similar processes and information and meet all relevant criteria for inclusion into an ABCP conduit sponsored by the institution. Return to footnote 20 Footnote 21 Payments on operating and financing leases are typically considered to be rental payments rather than payments of principal and interest. Return to footnote 21 Footnote 22 Commonly encountered market interest rates may include rates reflective of a lender's cost of funds, to the extent that sufficient data are provided to investors to allow them to assess their relation to other market rates. Examples of these would include: (i) interbank rates and rates set by monetary policy authorities, such as CDOR, Enhanced CORRA, LIBOR, EURIBOR, the Bank of Canada's target for the overnight rate, and the Fed Funds Rate; and (ii) sectoral rates reflective of a lender's cost of funds, such as internal interest rates that directly reflect the market costs of an institution's funding or that of a subset of institutions. Return to footnote 22 Footnote 23 The Global Association of Risk Professionals (GARP) defines an exotic instrument as a financial asset or instrument with features making it more complex than simpler, plain vanilla products. Return to footnote 23 Footnote 24 Delinquency disclosures may vary by asset class; however, 30+ day delinquencies should be disclosed for most asset classes. Return to footnote 24 Footnote 25 This "additional consideration" may form part of investors' due diligence process, but does not form part of the criteria when determining whether a securitization can be considered STC. Return to footnote 25 Footnote 26 This condition would not apply to borrowers that previously had credit incidents but were subsequently removed from credit registries as a result of the borrower cleaning their records. This is the case in jurisdictions in which borrowers have the "right to be forgotten". Return to footnote 26 Footnote 27 Original sellers or sponsors may satisfy this verification requirement through an assessment of related metrics that can be shown to address an obligor's financial difficulty, insolvency or debt restructuring over the prescribed period of time. Return to footnote 27 Footnote 28 For this purpose, a credit score may be from a credit rating bureau (such as a FICO score), or may be an internal score (such as from the original lender). Return to footnote 28 Footnote 29 Provided they are not actively selected or otherwise cherry-picked on a discretionary basis, the addition of credit claims or receivables during the revolving periods or their substitution or repurchasing due to the breach of representations and warranties do not represent active portfolio management. Return to footnote 29 Footnote 30 The requirement should not affect jurisdictions whose legal frameworks provide for a true sale with the same effects as described above, but by means other than a transfer of the credit claims or receivables. Return to footnote 30 Footnote 31 If agreements were in place for the originator/sponsor to repurchase loans at market rates prior to modification then the loan modification policies would not affect the investment performance and so would not need to be disclosed. Return to footnote 31 Footnote 32 For the avoidance of doubt, any type of securitization should be allowed to fulfil the requirements of Criterion B5 once it meets its prescribed standards of disclosure and legal review. Return to footnote 32 Footnote 33 For example, draft offering circular, draft offering memorandum, draft offering document or draft prospectus, such as a "red herring". Return to footnote 33 Footnote 34 For example, any relevant agreements, contracts, terms; and any other relevant underlying documentation, including legal opinions. Return to footnote 34 Footnote 35 For corporate exposures, the applicable maximum concentration threshold can be increased to 2% if the securitization transaction benefits from a loss absorbing credit enhancement, as defined in paragraph 13, which covers at least the first 10% of losses. Subordinated tranche(s) for the purposes of a loss absorbing credit enhancement used to meet this requirement shall not be eligible for the STC capital treatment. Return to footnote 35 Footnote 36 For instance, transactions in which assets are sold to a special purpose entity sponsored by an institution's customer and then either a security interest in the assets is granted to the ABCP conduit to secure a loan made by the ABCP conduit to the sponsored special purpose entity, or an undivided interest is sold to the ABCP conduit. Return to footnote 36 Footnote 37 Payments on operating and financing leases are typically considered to be rental payments rather than payments of principal and interest. Return to footnote 37 Footnote 38 Commonly encountered market interest rates may include rates reflective of a lender's cost of funds, to the extent sufficient data is provided to the sponsors to allow them to assess their relation to other market rates. Return to footnote 38 Footnote 39 The Global Association of Risk Professionals (GARP) defines an exotic instrument as a financial asset or instrument with features making it more complex than simpler, plain vanilla, products. Return to footnote 39 Footnote 40 Stratified means by way of example: all materially relevant data on the conduit's composition (outstanding balances, industry sector, obligor concentrations, maturities, etc.) and conduit's overview; all materially relevant data on the credit quality and performance of underlying transactions, allowing investors to identify collections, and as applicable, debt restructuring, forgiveness, forbearance, payment holidays, repurchases, delinquencies and defaults. Return to footnote 40 Footnote 41 Delinquency disclosures may vary by asset class; however, 30+ day delinquencies should be disclosed for most asset classes. Return to footnote 41 Footnote 42 This condition would not apply to borrowers that previously had credit incidents but were subsequently removed from credit registries as a result of the borrowers cleaning their records. This is the case in jurisdictions in which borrowers have the "right to be forgotten". Return to footnote 42 Footnote 43 Original sellers or sponsors may satisfy this verification requirement through an assessment of related metrics that can be shown to address an obligor's financial difficulty, insolvency or debt restructuring over the prescribed period of time. Return to footnote 43 Footnote 44 For this purpose, a credit score may be from a credit rating bureau (such as a FICO score), or may be an internal score (such as from the original lender). Return to footnote 44 Footnote 45 There is no obligation for the seller to perform this assessment itself. Return to footnote 45 Footnote 46 Provided they are not actively selected or otherwise cherry picked on a discretionary basis, the addition of credit claims or receivables during the revolving periods, their substitution or repurchasing due to the breach of representations and warranties or their repurchases for sale to term securitizations do not represent active portfolio management. Return to footnote 46 Footnote 47 This requirement should not affect jurisdictions whose legal frameworks provide for a true sale with the same effects as described above, but by means other than a transfer of the credit claims or receivables. Return to footnote 47 Footnote 48 For instance, the immediate realization of transfer tax or the requirement to notify all obligors of the transfer. Return to footnote 48 Footnote 49 For instance, equitable assignment, perfected contingent transfer. Return to footnote 49 Footnote 50 The term "appropriately mitigated" should be understood as not necessarily requiring a completely perfect hedge and should not be seen from an accounting perspective. Return to footnote 50 Footnote 51 If agreements were in place for the originator/sponsor to repurchase loans at market rates prior to modification then the loan modification policies would not affect the investment performance and so would not need to be disclosed. Return to footnote 51 Footnote 52 A sponsor can provide full support either at ABCP programme level or at transaction level, i.e. by fully supporting each transaction within an ABCP programme. Return to footnote 52 Footnote 53 "Liquidity and credit protection support" refers to support provided by the sponsors. Any support provided by the seller is excluded. Return to footnote 53 Footnote 54 Including purchased securitization notes, loans, asset-backed deposits and purchased credit claims and/or receivables held directly on the conduit's balance sheet. Return to footnote 54 Footnote 55 "Underlying documentation" does not refer to the documentation of the underlying transactions. Return to footnote 55 Footnote 56 Prudential standards and the level of supervision should be comparable to those under the Basel II framework (including, in particular, risk-based capital requirements comparable to those applied in this guideline). Return to footnote 56 Footnote 57 For corporate exposures, the applicable maximum concentration threshold can be increased to 3% if the securitization transaction benefits from a loss-absorbing credit enhancement, as defined in paragraph 94, which covers at least the first 10% of losses. Subordinated tranche(s) retained for the purposes of a loss absorbing credit enhancement by the sellers or sponsor shall not be eligible for the STC capital treatment. Return to footnote 57 Footnote 58 For the sake of simplicity, it is assumed that all exposures have the same size, same PD, same LGD and same maturity. Return to footnote 58 Footnote 59 For the sake of simplicity, the possibility described in paragraph 369 to set MDilution = 1 is not used in this example. Return to footnote 59 Footnote 60 The rounding of the maturity calculation is shown for example purposes. Return to footnote 60 Footnote 61 As described in paragraph 73, when calculating the default risk of exposures with non-immaterial dilution risk "EAD will be calculated as the outstanding amount minus the capital charge for dilution prior to credit risk mitigation". Return to footnote 61 Footnote 62 See footnote 23. Return to footnote 62 Footnote 63 See footnote 24. Return to footnote 63 Footnote 64 For the sake of simplicity, it is assumed that the second loss guarantee is cash-collateralized. Return to footnote 64 Footnote 65 Subject to the condition that it is not already being used for realized dilution losses. Return to footnote 65 Footnote 66 Subject to the condition that it is not already being used for realized default losses. Return to footnote 66 Footnote 67 In this example, the purchase price discount was recognized in the default risk calculation, but institutions could also choose to use it for the dilution risk calculation. Return to footnote 67 Footnote 68 In this example, it is assumed that the second-loss dilution guarantee explicitly covers dilution losses above $50,000 up to $300,000. If the guarantee instead covered $250,000 dilution losses after the purchase discount has been depleted (irrespective of whether the purchase discount has been used for dilution or default losses), then the senior note holder should assume that he is exposed to dilution losses from $250,000 up to $1,000,000 (instead of $0 to $50,000 + $300,000 to $1,000,000). Return to footnote 68

Note

For institutions with a fiscal year ending October 31 or December 31, respectively. The Capital Adequacy Requirements (CAR) for banks (including federal credit unions), bank holding companies, federally regulated trust companies, federally regulated loan companies and cooperative retail associations, collectively referred to as 'institutions', are set out in nine chapters, each of which has been issued as a separate document. This document, Chapter 7 – Settlement and Counterparty Risk, should be read in conjunction with the other CAR chapters. The complete list of CAR chapters is as follows: Chapter 1 - Overview Chapter 2 - Definition of Capital Chapter 3 - Operational Risk Chapter 4 - Credit Risk – Standardized Approach Chapter 5 - Credit Risk – Internal Ratings-Based Approach Chapter 6 - Securitization Chapter 7 - Settlement and Counterparty Risk Chapter 8 - Credit Valuation Adjustment (CVA) Risk Chapter 9 - Market Risk Please refer to OSFI's Corporate Governance Guideline for OSFI's expectations of institution Boards of Directors in regard to the management of capital and liquidity.

Chapter 7 – Settlement and Counterparty Risk

This chapter is drawn from the Basel Committee on Banking Supervision (BCBS) Basel framework, published on the BIS website,^{Footnote 1} effective December 15, 2019. For reference, the Basel paragraph numbers that are associated with the text appearing in this chapter are indicated in square brackets at the end of each paragraph.^{Footnote 2}

7.1. Treatment of counterparty credit risk and cross-product netting

This rule identifies permissible methods for estimating the Exposure at Default (EAD) or the exposure amount for instruments with counterparty credit risk under this guideline.^{Footnote 3} Institutions may seek OSFI approval to make use of an Internal Modelling Method (IMM) meeting the requirements and specifications identified herein. As an alternative institutions may also use the Standardized Approach for Counterparty Credit Risk (SA-CCR). [Basel Framework, CRE 53.1]

7.1.1 Definitions and general terminology

This section defines terms that will be used throughout this chapter. 7.1.1.1 General terms Counterparty Credit Risk (CCR) is the risk that the counterparty to a transaction could default before the final settlement of the transaction's cash flows. An economic loss would occur if the transactions or portfolio of transactions with the counterparty has a positive economic value at the time of default. Unlike an institution's exposure to credit risk through a loan, where the exposure to credit risk is unilateral and only the lending institution faces the risk of loss, CCR creates a bilateral risk of loss: the market value of the transaction can be positive or negative to either counterparty to the transaction. The market value is uncertain and can vary over time with the movement of underlying market factors. A central counterparty (CCP) is a clearing house that interposes itself between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer and thereby ensuring the future performance of open contracts. A CCP becomes a counterparty to trades with market participants through novation, an open offer system, or another legally binding arrangement. For the purposes of the capital framework, a CCP is a financial institution. A qualifying central counterparty (QCCP) is an entity that is licensed to operate as a CCP (including a license granted by way of confirming an exemption), and is permitted by the appropriate regulator/overseer to operate as such with respect to the products offered. This is subject to the provision that the CCP is based and prudentially supervised in a jurisdiction where the relevant regulator/overseer has established, and publicly indicated that it applies to the CCP on an ongoing basis, domestic rules and regulations that are consistent with the CPSS-IOSCO Principles for Financial Market Infrastructures. Where the CCP is in a jurisdiction that does not have a CCP regulator applying the Principles to the CCP, then OSFI may make the determination of whether the CCP meets this definition. In addition, for a CCP to be considered as a QCCP, the requirements in paragraph 204 must be met to permit each clearing member institution to calculate its capital requirement for its default fund contributions. A clearing member is a member of, or a direct participant in, a CCP that is entitled to enter into a transaction with the CCP, regardless of whether it enters into trades with a CCP for its own hedging, investment or speculative purposes or whether it also enters into trades as a financial intermediary between the CCP and other market participants.^{Footnote 4} A client is a party to a transaction with a CCP through either a clearing member acting as a financial intermediary, or a clearing member guaranteeing the performance of the client to the CCP. Initial margin means a clearing member's or client's funded collateral posted to the CCP to mitigate the potential future exposure of the CCP to the clearing member arising from the possible future change in the value of their transactions. For the purposes of the calculation of counterparty credit risk capital requirements, initial margin does not include contributions to a CCP for mutualized loss sharing arrangements (i.e. in case a CCP uses initial margin to mutualize losses among the clearing members, it will be treated as a default fund exposure). Initial margin may include excess collateral, in cases where the CCP may prevent the clearing member and the clearing member may prevent the client from withdrawing the excess. Variation margin means a clearing member's or client's funded collateral posted on a daily or intraday basis to a CCP based upon price movements of their transactions. Trade exposures (in section 7.1.8) include the current^{Footnote 5} and potential future exposure of a clearing member or a client to a CCP arising from OTC derivatives, exchange traded derivatives transactions or securities financing transactions (SFTs), as well as initial margin. Default funds, also known as clearing deposits or guaranty fund contributions (or any other names), are clearing members' funded or unfunded contributions towards, or underwriting of, a CCP's mutualized loss sharing arrangements. The description given by a CCP to its mutualized loss sharing arrangements is not determinative of its status as a default fund; rather, the substance of such arrangements will govern its status. Offsetting transaction means the transaction leg between the clearing member and the CCP when the clearing member acts on behalf of a client (e.g. when a clearing member clears or novates a client's trade). A multi-level client structure is one in which institutions can centrally clear as indirect clients; that is, when clearing services are provided to the institution by an institution which is not a direct clearing member, but is itself a client of a clearing member or another clearing client. For exposures between clients and clients of clients, we use the term "higher-level client" for the institution providing clearing services; and the term "lower level client" for the institution clearing through that client. [Basel Framework, CRE 50.6] 7.1.1.2 Transaction types Long Settlement Transactions are transactions where a counterparty undertakes to deliver a security, a commodity, or a foreign exchange amount against cash, other financial instruments, or commodities, or vice versa, at a settlement or delivery date that is contractually specified as more than the lower of the market standard for this particular instrument and five business days after the date on which the institution enters into the transaction. Securities Financing Transactions (SFTs) are transactions such as repurchase agreements, reverse repurchase agreements, security lending and borrowing, and margin lending transactions, where the value of the transactions depends on market valuations and the transactions are often subject to margin agreements. Margin Lending Transactions are transactions in which an institution extends credit in connection with the purchase, sale, carrying or trading of securities. Margin lending transactions do not include other loans that happen to be secured by securities collateral. Generally, in margin lending transactions, the loan amount is collateralized by securities whose value is greater than the amount of the loan. [Basel Framework, CRE 50.14] 7.1.1.3 Netting sets, hedging sets, and related terms Netting Set is a group of transactions with a single counterparty that are subject to a legally enforceable bilateral netting arrangement and for which netting is recognized for regulatory capital purposes under Chapter 4 or the Cross-Product Netting Rules set forth in this chapter. Each transaction that is not subject to a legally enforceable bilateral netting arrangement that is recognized for regulatory capital purposes should be interpreted as its own netting set for the purpose of these rules. Hedging Set is a set of transactions within a single netting set within which full or partial offsetting is recognized for purposes of calculating the potential future exposure (PFE) add-on of the SA-CCR. Margin Agreement is a contractual agreement or provisions to an agreement under which one counterparty must supply collateral to a second counterparty when an exposure of that second counterparty to the first counterparty exceeds a specified level. Margin Threshold is the largest amount of an exposure that remains outstanding until one party has the right to call for collateral. Margin Period of Risk is the time period from the last exchange of collateral covering a netting set of transactions with a defaulting counterpart until that counterpart is closed out and the resulting market risk is re-hedged. Effective Maturity under the Internal Model Method for a netting set with maturity greater than one year is the ratio of the sum of expected exposure over the life of the transactions in a netting set discounted at the risk-free rate of return divided by the sum of expected exposure over one year in a netting set discounted at the risk-free rate. This effective maturity may be adjusted to reflect rollover risk by replacing expected exposure with effective expected exposure for forecasting horizons under one year. The formula is given in paragraph 35. Cross-Product Netting refers to the inclusion of transactions of different product categories within the same netting set pursuant to the Cross-Product Netting Rules set out in this chapter. Current Market Value (CMV) refers to the net market value of the portfolio of transactions within the netting set with the counterparty. Both positive and negative market values are used in computing CMV. [ Basel Framework, CRE 50.15] 7.1.1.4 Distributions Distribution of Market Values is the forecast of the probability distribution of net market values of transactions within a netting set for some future date (the forecasting horizon) given the realized market value of those transactions up to the present time. Distribution of Exposures is the forecast of the probability distribution of market values that is generated by setting forecast instances of negative net market values equal to zero (this takes account of the fact that, when the institution owes the counterparty money, the institution does not have an exposure to the counterparty). Risk-Neutral Distribution is a distribution of market values or exposures at a future time period where the distribution is calculated using market implied values such as implied volatilities. Actual Distribution is a distribution of market values or exposures at a future time period where the distribution is calculated using historic or realized values such as volatilities calculated using past price or rate changes. [Basel Framework, CRE 50.22 to 50.25] 7.1.1.5 Exposure measures and adjustments Current Exposure is the larger of zero, or the market value of a transaction or portfolio of transactions within a netting set with a counterparty that would be lost upon the default of the counterparty, assuming no recovery on the value of those transactions in bankruptcy. Current exposure is often also called Replacement Cost. Peak Exposure is a high percentile (typically 95% or 99%) of the distribution of exposures at any particular future date before the maturity date of the longest transaction in the netting set. A peak exposure value is typically generated for many future dates up until the longest maturity date of transactions in the netting set. Expected Exposure is the mean (average) of the distribution of exposures at any particular future date before the longest-maturity transaction in the netting set matures. An expected exposure value is typically generated for many future dates up until the longest maturity date of transactions in the netting set. Effective Expected Exposure at a specific date is the maximum expected exposure that occurs at that date or any prior date. Alternatively, it may be defined for a specific date as the greater of the expected exposure at that date, or the effective exposure at the previous date. In effect, the Effective Expected Exposure is the Expected Exposure that is constrained to be non-decreasing over time. Expected Positive Exposure (EPE) is the weighted average over time of expected exposures where the weights are the proportion that an individual expected exposure represents of the entire time interval. When calculating the minimum capital requirement, the average is taken over the first year or, if all the contracts in the netting set mature before one year, over the time period of the longest-maturity contract in the netting set. Effective Expected Positive Exposure (Effective EPE) is the weighted average over time of effective expected exposure over the first year, or, if all the contracts in the netting set mature before one year, over the time period of the longest-maturity contract in the netting set where the weights are the proportion that an individual expected exposure represents of the entire time interval. Credit Valuation Adjustment is an adjustment to the mid-market valuation of the portfolio of trades with a counterparty. This adjustment reflects the market value of the credit risk due to any failure to perform on contractual agreements with a counterparty. This adjustment may reflect the market value of the credit risk of the counterparty or the market value of the credit risk of both the institution and the counterparty. One-Sided Credit Valuation Adjustment is a credit valuation adjustment that reflects the market value of the credit risk of the counterparty to the firm, but does not reflect the market value of the credit risk of the institution to the counterparty. Debit Valuation Adjustment is a valuation adjustment that reflects the market value of the credit risk of the institution to the counterparty (i.e. changes in the reporting institution's own credit risk), but does not reflect the market value of the credit risk of the counterparty to the institution. [Added by OSFI] [Basel Framework, CRE 50.26 to 50.33] 7.1.1.6 CCR-related risks Rollover Risk is the amount by which expected positive exposure is understated when future transactions with a counterpart are expected to be conducted on an ongoing basis, but the additional exposure generated by those future transactions is not included in calculation of expected positive exposure. General Wrong-Way Risk arises when the probability of default of counterparties is positively correlated with general market risk factors. Specific Wrong-Way Risk arises when the exposure to a particular counterpart is positively correlated with the probability of default of the counterparty due to the nature of the transactions with the counterparty. [Basel Framework, CRE 50.34 to 50.36]

7.1.2 Scope of application

Banks must calculate a counterparty credit risk charge for all exposures that give rise to counterparty credit risk, with the exception of those transactions listed in paragraphs 10 and 11 below. The categories of transaction that give rise to counterparty credit risk are: OTC Derivatives; Exchange-traded derivatives (ETDs); Long Settlement transactions; and Securities Financing Transactions (SFTs). [Basel Framework, CRE 51.4] Such instruments generally exhibit the following abstract characteristics: the transactions generate a current exposure or market value; the transactions have an associated random future market value based on market variables; the transactions generate an exchange of future payments or an exchange of a financial instrument (including commodities) against payment; the transactions are undertaken with an identified counterparty against which a unique probability of default can be determined.^{Footnote 6} [Basel Framework, CRE 51.5] Other common characteristics of the transactions to be covered may include the following: collateral may be used to mitigate risk exposure and is inherent in the nature of some transactions; short-term financing may be a primary objective in that the transactions mostly consist of an exchange of one asset for another (cash or securities) for a relatively short period of time, usually for the business purpose of financing. The two sides of the transactions are not the result of separate decisions but form an indivisible whole to accomplish a defined objective; netting may be used to mitigate the risk; positions are frequently valued (most commonly on a daily basis), according to market variables. remargining may be employed. [Basel Framework, CRE 51.6]

7.1.3 Methods for Computing CCR Exposure

For the transaction types listed in paragraph 4 above, banks must calculate their counterparty credit risk exposure, or exposure at default (EAD),^{Footnote 7} using one of the methods set out in paragraphs 8 to 9 below. The methods vary according to the type of the transaction, the counterparty to the transaction, and whether the bank has received supervisory approval to use the method (if such approval is required). [Basel Framework, CRE 51.7] For exposures that are not cleared through a central counterparty (CCP) the following methods must be used to calculate the counterparty credit risk exposure: The standardized approach for measuring counterparty credit risk exposures (SA-CCR), which is set out in section 7.1.7. This method is to be used for exposures arising from OTC derivatives, exchange-traded derivatives and long settlement transactions. This method must be used if the bank does not have approval to use the internal model method (IMM). The simple approach or comprehensive approach to the recognition of collateral, which are both set out in the credit risk mitigation section of the standardized approach to credit risk (see Chapter 4, section 4.3). These methods are to be used for securities financing transactions (SFTs) and must be used if the bank does not have approval to use the value-at-risk (VaR) models or the IMM. The VaR models approach, which is set out in Chapter 4, section 4.3. The VaR models approach may be used to calculate EAD for SFTs, subject to supervisory approval, as an alternative to the method set out in (2) above. The IMM, which is set out in 7.1.5. This method may be used, subject to supervisory approval, as an alternative to the methods to calculate counterparty credit risk exposures set out in (1) and (2) above (for all of the exposures referenced in those bullets). [Basel Framework, CRE 51.8] For exposures that are cleared through a CCP, banks must apply the method set out in section 7.1.8. This method covers: the exposures of a bank to a CCP when the bank is a clearing member of the CCP; the exposures of a bank to its clients, when the bank is a clearing member and acts as an intermediary between the client and the CCP; and the exposures of a bank to a clearing member of a CCP, when the bank is a client of the clearing member and the clearing member is acting as an intermediary between the bank and the CCP. [Basel Framework, CRE 51.8] Exposures arising from the settlement of cash transactions (equities, fixed income, spot FX and spot commodities) are not subject to this treatment.^{Footnote 8} The settlement of cash transactions remains subject to the treatment described in section 7.2. [Basel Framework, CRE 51.10] As an exception to the requirements of paragraph 4 above, banks are not required to calculate a counterparty credit risk charge for the following types of transactions (i.e. the exposure amount or EAD for counterparty credit risk for the transaction will be zero): Credit derivative protection purchased by the bank against a banking book exposure, or against a counterparty credit risk exposure. In such cases, the bank will determine its capital requirement for the hedged exposure according to the criteria and general rules for the recognition of credit derivatives within the standardized approach or IRB approach to credit risk (i.e. substitution approach). Sold credit default swaps in the banking book where they are treated in the framework as a guarantee provided by the bank and subject to a credit risk charge for the full notional amount. [Basel Framework, CRE 51.16] Under the methods outlined above, the exposure amount or EAD for a given counterparty is equal to the sum of the exposure amounts or EADs calculated for each netting set with that counterparty,^{Footnote 9} subject to the exception outlined in paragraph 13. [Basel Framework, CRE 51.11] The exposure or EAD for a given OTC derivative counterparty is defined as the greater of zero, and the difference between the following: the sum of EADs across all netting sets with the counterparty, and the credit valuation adjustment (CVA) for that counterparty which has already been recognized by the bank as an incurred write-down (i.e. a CVA loss). This CVA loss is calculated without taking into account any offsetting debit valuation adjustments or funding valuation adjustments deducted from capital under Chapter 2 of this guideline. This reduction of EAD by incurred CVA losses does not apply to the determination of the CVA risk capital requirement. [Basel Framework, CRE 51.13] RWAs for a given OTC derivative counterparty may be calculated as the applicable risk weight under the standardized or IRB approach multiplied by the outstanding EAD of the counterparty. [Basel Framework, CRE 51.12]

7.1.4 Approval to adopt an internal modelling method to estimate EAD

An institution (meaning the individual legal entity or a group) that wishes to adopt an internal modelling method to measure exposure or EAD for regulatory capital purposes must seek OSFI approval. IMM is available both for institutions that adopt the internal ratings-based approach to credit risk and for institutions for which the standardized approach to credit risk applies to all of their credit risk exposures. Only institutions subject to the market risk rules of Chapter 9 of this guideline are permitted to apply for the use of the IMM. The institution must meet all of the requirements given in section 7.1.5. [Basel Framework, CRE 53.1] An institution may also choose to adopt an internal modelling method to measure CCR for regulatory capital purposes for its exposures or EAD to only OTC derivatives, to only SFTs, or to both, subject to the appropriate recognition of netting specified below in section 7.1.6. The institution must apply the method to all relevant exposures within that category, except for those that are immaterial in size and risk. During the initial implementation of the internal models method, an institution may use the SACCR for a portion of its business. The institution must submit a plan to OSFI to bring all material exposures for that category of transactions under the IMM. [Basel Framework, CRE 53.2] For all OTC derivative transactions and for all long settlement transactions for which an institution has not received OSFI approval to use the internal models method, the institution must use the SA-CCR. [Basel Framework, CRE 53.3] Exposures or EAD arising from long settlement transactions can be determined using either of the methods identified in this guideline regardless of the methods chosen for treating OTC derivatives and SFTs. In computing capital requirements for long settlement transactions, institutions that hold permission to use the internal ratings-based approach may opt to apply the risk weights under the standardized approach for credit risk on a permanent basis and irrespective to the materiality of such positions. [Basel Framework, CRE 53.4] After adoption of the internal model method, the institution must comply with the above requirements on a permanent basis. Only under exceptional circumstances or for immaterial exposures can an institution revert to the SA-CCR for all or part of its exposure. In all cases, the institution must obtain approval from OSFI to do so and demonstrate that reversion to a less sophisticated method does not lead to an arbitrage of the regulatory capital rules. [Basel Framework, CRE 53.5]

7.1.5 Internal Model Method: measuring exposure and minimum requirements

7.1.5.1 Exposure amount or EAD under the internal model method CCR exposure or EAD is measured at the level of the netting set as defined in sections 7.1.1 and 7.1.6. A qualifying internal model for measuring counterparty credit exposure must specify the forecasting distribution for changes in the market value of the netting set attributable to changes in market variables, such as interest rates, foreign exchange rates, etc. The model then computes the firm's CCR exposure for the netting set at each future date given the changes in the market variables. For margined counterparties, the model may also capture future collateral movements. Institutions may include eligible financial collateral as defined in section 4.3.3 and Chapter 9 in their forecasting distributions for changes in the market value of the netting set, if the quantitative, qualitative and data requirements for internal model method are met for the collateral. [Basel Framework, CRE 53.6] To determine the default risk capital charge for counterparty credit risk for exposures subject to the IMM, institutions must use the greater of the portfolio-level capital charge (not including the CVA charge in Chapter 8) based on Effective EPE using current market data and the portfolio-level capital charge based on Effective EPE using a stress calibration. The stress calibration should be a single consistent stress calibration for the whole portfolio of counterparties. The greater of Effective EPE using current market data and the stress calibration should be applied on a total portfolio level and not on a counterparty by counterparty basis. [Basel Framework, CRE 53.7] OSFI expects institutions to have in place a policy for verifying the adequacy of, and updating, their choice of stress period. This policy would have to be approved in advance by OSFI as part of the IMM model approval process. Changes to this policy would constitute a major modification of the IMM model. To the extent that an institution recognizes collateral in exposure amount or EAD via current exposure, an institution would not be permitted to recognize the benefits in its estimates of LGD. As a result, the institution would be required to use an LGD of an otherwise similar uncollateralized facility. In other words, it would be required to use an LGD that does not include collateral that is already included in EAD. [Basel Framework, CRE 53.8] Under the IMM, the institution need not employ a single model. Although the following text describes an internal model as a simulation model, no particular form of model is required. Analytical models are acceptable so long as they are subject to OSFI review, meet all of the requirements set forth in this section and are applied to all material exposures subject to a CCR-related capital charge as noted above, with the exception of long settlement transactions, which are treated separately, and with the exception of those exposures that are immaterial in size and risk. [Basel Framework, CRE 53.9] Expected exposure or peak exposure measures should be calculated based on a distribution of exposures that accounts for the possible non-normality of the distribution of exposures, including the existence of leptokurtosis ("fat tails"), where appropriate. [Basel Framework, CRE 53.10] When using an internal model, exposure amount or EAD is calculated as the product of alpha times Effective EPE, as specified below (except for counterparties that have been identified as having explicit specific wrong-way risk or specific right-way risk – see paragraph 65): EAD = α × Effective EPE (1) [Basel Framework, CRE 53.11] Effective EPE ("Expected Positive Exposure") is computed by estimating expected exposure ( EE t ) as the average exposure at future date t, where the average is taken across possible future values of relevant market risk factors, such as interest rates, foreign exchange rates, etc. The internal model estimates EE as a series of future dates t 1 , t 2 , t 3 …^{Footnote 10}. Specifically, "Effective EE" is computed recursively, where the current date is denoted as t 0 and Effective EE t0 equals current exposure: Effective EE tk = max ( Effective EE tk − 1 , EE tk ) (2) where the current date is denoted as t 0 and Effective EE t0 equals current exposure. [Basel Framework, CRE 53.12] In this regard, "Effective EPE" is the average Effective EE during the first year of future exposure. If all contracts in the netting set mature before one year, EPE is the average of expected exposure until all contracts in the netting set mature. Effective EPE is computed as a weighted average of Effective EE: Effective EPE = ∑ k = 1 min ( 1 year , maturity ) Effective EE t k × ∆ t k (3) where the weights ∆t k = t k − t k-1 allows for the case when future exposure is calculated at dates that are not equally spaced over time. [Basel Framework, CRE 53.13] Alpha (α) is set equal to 1.4. [Basel Framework, CRE 53.14] OSFI retains discretion to require a higher alpha based on a firm's CCR exposures. Factors that may require a higher alpha include the low granularity of counterparties; particularly high exposures to general wrong-way risk; particularly high correlation of market values across counterparties; and other institution-specific characteristics of CCR exposures. [Basel Framework, CRE 53.15] 7.1.5.2 Own estimates for alpha Institutions may seek OSFI approval to compute internal estimates of alpha subject to a floor of 1.2, where alpha equals the ratio of economic capital from a full simulation of counterparty exposure across counterparties (numerator) and economic capital based on EPE (denominator), assuming they meet certain operating requirements. Eligible institutions must meet all the operating requirements for internal estimates of EPE and must demonstrate that their internal estimates of alpha capture in the numerator the material sources of stochastic dependency of distributions of market values of transactions or of portfolios of transactions across counterparties (e.g. the correlation of defaults across counterparties and between market risk and default). [Basel Framework, CRE 53.16] In the denominator, EPE must be used as if it were a fixed outstanding loan amount. [Basel Framework, CRE 53.17] To this end, institutions must ensure that the numerator and denominator of alpha are computed in a consistent fashion with respect to the modelling methodology, parameter specifications and portfolio composition. The approach used must be based on the firm's internal economic capital approach, be well-documented and be subject to independent validation. In addition, institutions must review their estimates on at least a quarterly basis, and more frequently when the composition of the portfolio varies over time. Institutions must assess the model risk given the significant variation in estimates of alpha can arise from the possibility for mis-specification in the models used for the numerator, especially where convexity is present. The assessment of model risk must be part of the independent model validation and approval process and model performance monitoring. [Basel Framework, CRE 53.18] Where appropriate, volatilities and correlations of market risk factors used in the joint simulation of market and credit risk should be conditioned on the credit risk factor to reflect potential increases in volatility or correlation in an economic downturn. Internal estimates of alpha should take account of the granularity of exposures. [Basel Framework, CRE 53.19] 7.1.5.3 Maturity If the original maturity of the longest-dated contract contained in the set is greater than one year, the formula for effective maturity (M) in Chapter 5 is replaced with the following: M = ∑ k = 1 t k ≤ 1year Effective EE k × ∆ t k × df k + ∑ t k > 1year maturity EE k × ∆ t k × df k ∑ k = 1 t k ≤ 1year Effective EE k × ∆ t k × df k where df k is the risk-free discount factor for future time period t k and the remaining symbols are defined above. Similar to the treatment under corporate exposures, M has a cap of five years.^{Footnote 11} [Basel Framework, CRE 53.20] For netting sets in which all contracts have an original maturity of less than one year, the formula for effective maturity (M) in Chapter 5 is unchanged and a floor of one year applies, with the exception of short-term exposures as described in Chapter 5 - Internal Ratings Based Approach, section 5.4.1 (iv). [Basel Framework, CRE 53.21] For derivative contracts subject to paragraph 65 (SWWR) and structured such that on specified dates any outstanding exposure is settled and the terms are reset so that the fair value of the contract is zero, the remaining maturity equals the time until the next reset date. 7.1.5.4 Margin agreements If the netting set is subject to a margin agreement and the internal model captures the effects of margining when estimating EE, the model's EE measure may be used directly in equation (2). Such models are noticeably more complicated than models of EPE for unmargined counterparties. As such, they are subject to a higher degree of supervisory scrutiny before they are approved, as discussed below. [Basel Framework, CRE 53.22] An EPE model must also include transaction-specific information in order to capture the effects of margining. It must take into account both the current amount of margin and margin that would be passed between counterparties in the future. Such a model must account for the nature of margin agreements (unilateral or bilateral), the frequency of margin calls, the margin period of risk, the thresholds of unmargined exposure the institution is willing to accept, and the minimum transfer amount. Such a model must either model the mark-to-market change in the value of collateral posted or apply this guideline's rules for collateral. [Basel Framework, CRE 53.23] For transactions subject to daily re-margining and mark-to-market valuation, a supervisory floor of five business days for netting sets consisting only of repo-style transactions, and 10 business days for all other netting sets is imposed on the margin period of risk used for the purpose of modelling EAD with margin agreements. In the following cases a higher supervisory floor is imposed: for all netting sets where the number of trades exceeds 5,000 at any point during a quarter, a supervisory floor of 20 business days is imposed for the margin period of risk for the following quarter; for netting sets containing one or more trades involving either illiquid collateral, or an OTC derivative that cannot be easily replaced, a supervisory floor of 20 business days is imposed for the margin period of risk. For these purposes, "Illiquid collateral" and "OTC derivatives that cannot be easily replaced" must be determined in the context of stressed market conditions and will be characterized by the absence of continuously active markets where a counterparty would, within two or fewer days, obtain multiple price quotations that would not move the market or represent a price reflecting a market discount (in the case of collateral) or premium (in the case of an OTC derivative). Examples of situations where trades are deemed illiquid for this purpose include, but are not limited to, trades that are not marked daily and trades that are subject to specific accounting treatment for valuation purposes (e.g. OTC derivatives or repo-style transactions referencing securities whose fair value is determined by models with inputs that are not observed in the market). in addition, an institution must consider whether trades or securities it holds as collateral are concentrated in a particular counterparty and if that counterparty exited the market precipitously whether the institution would be able to replace its trades. [Basel Framework, CRE 53.24] If an institution has experienced more than two margin call disputes on a particular netting set over the previous two quarters that have lasted longer than the applicable margin period of risk (before consideration of this provision), then the institution must reflect this history appropriately by using a margin period of risk that is at least double the supervisory floor for that netting set for the subsequent two quarters. In the case of derivatives subject to Guideline E-22, this paragraph only applies to variation margin call disputes. [Basel Framework, CRE 53.25] For re-margining with a periodicity of N-days, the margin period of risk should be at least equal to the supervisory floor, F, plus the N days minus one day. That is, Margin Period of Risk = F + N − 1 . [Basel Framework, CRE 53.26] Institutions using the IMM must not capture the effect of a reduction of EAD due to any clause in a collateral agreement that requires receipt of collateral when counterparty credit quality deteriorates. [Basel Framework, CRE 53.27] 7.1.5.5 Model validation In order to assure itself that institutions using models have counterparty credit risk management systems that are conceptually sound and implemented with integrity, OSFI will specify a number of qualitative criteria that institutions would have to meet before they are permitted to use a models-based approach. The extent to which institutions meet the qualitative criteria may influence the level at which OSFI will set the multiplication factor referred to in paragraph 29 (Alpha). Only those institutions in full compliance with the qualitative criteria will be eligible for application of the minimum multiplication factor. The qualitative criteria include: the institution must conduct a regular programme of backtesting, i.e. an ex-post comparison of the risk measures^{Footnote 12} generated by the model against realized risk measures, as well as comparing hypothetical changes based on static positions with realized measures; the institution must carry out an initial validation and an ongoing periodic review of its IMM model and the risk measures generated by it. The validation and review must be independent of the model developers; senior management should be actively involved in the risk control process and must regard credit and counterparty credit risk control as an essential aspect of the business to which significant resources need to be devoted. In this regard, the daily reports prepared by the independent risk control unit must be reviewed by a level of management with sufficient seniority and authority to enforce both reductions of positions taken by individual traders and reductions in the institution's overall risk exposure; the institution's internal risk measurement exposure model must be closely integrated into the day-to-day risk management process of the institution. Its output should accordingly be an integral part of the process of planning, monitoring and controlling its counterparty credit risk profile; the risk measurement system should be used in conjunction with internal trading and exposure limits. In this regard, exposure limits should be related to the institution's risk measurement model in a manner that is consistent over time and that is well understood by traders, the credit function and senior management; institutions should have a routine in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the risk measurement system. The institution's risk measurement system must be well documented, for example, through a risk management manual that describes the basic principles of the risk management system and that provides an explanation of the empirical techniques used to measure counterparty credit risk; an independent review of the risk measurement system should be carried out regularly in the institution's own internal auditing process. This review should include both the activities of the business trading units and of the independent risk control unit. A review of the overall risk management process should take place at regular intervals (ideally no less than once a year) and should specifically address, at a minimum: the adequacy of the documentation of the risk management system and process; the organization of the risk control unit; the integration of counterparty credit risk measures into daily risk management; the approval process for counterparty credit risk models used in the calculation of counterparty credit risk used by front office and back office personnel; the validation of any significant change in the risk measurement process; the scope of counterparty credit risks captured by the risk measurement model; the integrity of the management information system; the accuracy and completeness of position data; the verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources; the accuracy and appropriateness of volatility and correlation assumptions; the accuracy of valuation and risk transformation calculations; and the verification of the model's accuracy as described in paragraphs 45 to 48. the ongoing validation of counterparty credit risk models, including backtesting, must be reviewed periodically by a level of management with sufficient authority to decide the course of action that will be taken to address weaknesses in the models. [Basel Framework, CRE 53.28] Institutions must document the process for initial and ongoing validation of their IMM model to a level of detail that would enable a third party to recreate the analysis. Institutions must also document the calculation of the risk measures generated by the models to a level of detail that would allow a third party to re-create the risk measures. This documentation must set out the frequency with which backtesting analysis and any other ongoing validation will be conducted, how the validation is conducted with respect to data flows and portfolios and the analyses that are used. [Basel Framework, CRE 53.29] Institutions must define criteria with which to assess their EPE models and the models that input into the calculation of EPE and have a written policy in place that describes the process by which unacceptable performance will be determined and remedied. [Basel Framework, CRE 53.30] Institutions must define how representative counterparty portfolios are constructed for the purposes of validating an EPE model and its risk measures. [Basel Framework, CRE 53.31] When validating EPE models and its risk measures that produce forecast distributions, validation must assess more than a single statistic of the model distribution. [Basel Framework, CRE 53.32] As part of the initial and ongoing validation of an IMM model and its risk measures, the following requirements must be met: an institution must carry out backtesting using historical data on movements in market risk factors prior to OSFI approval. Backtesting must consider a number of distinct prediction time horizons out to at least one year, over a range of various start (initialization) dates and covering a wide range of market conditions; institutions must backtest the performance of their EPE model and the model's relevant risk measures as well as the market risk factor predictions that support EPE. For collateralized trades, the prediction time horizons considered must include those reflecting typical margin periods of risk applied in collateralized/margined trading, and must include long time horizons of at least one year; the pricing models used to calculate counterparty credit risk exposure for a given scenario of future shocks to market risk factors must be tested as part of the initial and ongoing model validation process. These pricing models may be different from those used to calculate Market Risk over a short horizon. Pricing models for options must account for the non-linearity of option value with respect to market risk factors; an EPE model must capture transaction specific information in order to aggregate exposures at the level of the netting set. Institutions must verify that transactions are assigned to the appropriate netting set within the model; static, historical backtesting on representative counterparty portfolios must be a part of the validation process. At regular intervals, an institution must conduct such backtesting on a number of representative counterparty portfolios. The representative portfolios must be chosen based on their sensitivity to the material risk factors and correlations to which the institution is exposed. In addition, IMM institutions need to conduct backtesting that is designed to test the key assumptions of the EPE model and the relevant risk measures, e.g. the modelled relationship between tenors of the same risk factor, and the modelled relationships between risk factors; significant differences between realized exposures and the forecast distribution could indicate a problem with the model or the underlying data that OSFI would require the institution to correct. Under such circumstances, OSFI may require additional capital to be held while the problem is being solved; the performance of EPE models and its risk measures must be subject to good backtesting practice. The backtesting programme must be capable of identifying poor performance in an EPE model's risk measures; institutions must validate their EPE models and all relevant risk measures out to time horizons commensurate with the maturity of trades for which exposure is calculated using an internal modelling method; the pricing models used to calculate counterparty exposure must be regularly tested against appropriate independent benchmarks as part of the ongoing model validation process; the ongoing validation of an institution's EPE model and the relevant risk measures include an assessment of recent performance; the frequency with which the parameters of an EPE model are updated needs to be assessed as part of the validation process; under the IMM, a measure that is more conservative than the metric used to calculate regulatory EAD for every counterparty, may be used in place of alpha times Effective EPE with prior approval from OSFI. The degree of relative conservatism will be assessed upon initial OSFI approval and at the regular supervisory reviews of the EPE models. The institution must validate the conservatism regularly; the ongoing assessment of model performance needs to cover all counterparties for which the models are used; the validation of IMM models must assess whether or not the institution level and netting set exposure calculations of EPE are appropriate. [Basel Framework, CRE 53.33] In the case where the pricing model used to calculate counterparty credit risk exposure is different than the pricing model used to calculate Market Risk over a short horizon, OSFI expects institutions to provide documented justification for the use of two different pricing models, including an assessment of the resulting model risk. 7.1.5.6 Operational requirements for EPE models In order to be eligible to adopt an internal model for estimating EPE arising from CCR for regulatory capital purposes, an institution must meet the following operational requirements. These include meeting the requirements related to the qualifying standards on CCR Management, a use test, stress testing, identification of wrong-way risk, and internal controls. [Basel Framework, CRE 53.34] Qualifying standards on CCR Management The institution must satisfy its supervisor that, in addition to meeting the operational requirements identified in paragraphs 53 to 82 below, it adheres to sound practices for CCR management. [Basel Framework, CRE 53.35] Use test The distribution of exposures generated by the internal model used to calculate effective EPE must be closely integrated into the day-to-day CCR management process of the institution. For example, the institution could use the peak exposure from the distributions for counterparty credit limits or expected positive exposure for its internal allocation of capital. The internal model's output must accordingly play an essential role in the credit approval, counterparty credit risk management, internal capital allocations, and corporate governance of institutions that seek approval to apply such models for capital adequacy purposes. Models and estimates designed and implemented exclusively to qualify for the internal models method are not acceptable. [Basel Framework, CRE 53.36] An institution must have a credible track record in the use of internal models that generate a distribution of exposures to CCR. Thus, the institution must demonstrate that it has been using an internal model to calculate the distributions of exposures upon which the EPE calculation is based that meets broadly the minimum requirements for at least one year prior to approval. [Basel Framework, CRE 53.37] Institutions employing the internal model method must have an independent control unit that is responsible for the design and implementation of the firm's CCR management system, including the initial and ongoing validation of the internal model. This unit must control input data integrity and produce and analyze reports on the output of the firm's risk measurement model, including an evaluation of the relationship between measures of risk exposure and credit and trading limits. This unit must be independent from business credit and trading units; it must be adequately staffed; it must report directly to senior management of the firm. The work of this unit should be closely integrated into the day-to-day credit risk management process of the firm. Its output should accordingly be an integral part of the process of planning, monitoring and controlling the firm's credit and overall risk profile. [Basel Framework, CRE 53.38] Institutions applying the IMM must have a collateral management unit that is responsible for calculating and making margin calls, managing margin call disputes and reporting levels of independent amounts, initial margins and variation margins accurately on a daily basis. This unit must control the integrity of the data used to make margin calls, and ensure that it is consistent and reconciled regularly with all relevant sources of data within the institution. This unit must also track the extent of reuse of collateral (both cash and non-cash) and the rights that the institution gives away to its respective counterparties for the collateral that it posts. These internal reports must indicate the categories of collateral assets that are reused, and the terms of such reuse including instrument, credit quality and maturity. The unit must also track concentration to individual collateral asset classes accepted by the institutions. Senior management must allocate sufficient resources to this unit for its systems to have an appropriate level of operational performance, as measured by the timeliness and accuracy of outgoing calls and response time to incoming calls. Senior management must ensure that this unit is adequately staffed to process calls and disputes in a timely manner even under severe market crisis, and to enable the institution to limit its number of large disputes caused by trade volumes. [Basel Framework, CRE 53.39] The institution's collateral management unit must produce and maintain appropriate collateral management information that is reported on a regular basis to senior management. Such internal reporting should include information on the type of collateral (both cash and non-cash) received and posted, as well as the size, aging and cause for margin call disputes. This internal reporting should also reflect trends in these figures. [Basel Framework, CRE 53.40] An institution employing the IMM must ensure that its cash management policies account simultaneously for the liquidity risks of potential incoming margin calls in the context of exchanges of variation margin or other margin types, such as initial or independent margin, under adverse market shocks, potential incoming calls for the return of excess collateral posted by counterparties, and calls resulting from a potential downgrade of its own public rating. The institution must ensure that the nature and horizon of collateral reuse is consistent with its liquidity needs and does not jeopardize its ability to post or return collateral in a timely manner. [Basel Framework, CRE 53.41] The internal model used to generate the distribution of exposures must be part of a counterparty risk management framework that includes the identification, measurement, management, approval and internal reporting of counterparty risk.^{Footnote 13} This framework must include the measurement of usage of credit lines (aggregating counterparty exposures with other credit exposures) and economic capital allocation. In addition to EPE (a measure of future exposure), an institution must measure and manage current exposures. Where appropriate, the institution must measure current exposure gross and net of collateral held. The use test is satisfied if an institution uses other counterparty risk measures, such as peak exposure or potential future exposure (PFE), based on the distribution of exposures generated by the same model to compute EPE. [Basel Framework, CRE 53.42] An institution is not required to estimate or report EE daily, but to meet the use test it must have the systems capability to estimate EE daily, if necessary, unless it demonstrates to OSFI that its exposures to CCR warrant some less frequent calculation. It must choose a time profile of forecasting horizons that adequately reflects the time structure of future cash flows and maturity of the contracts. For example, an institution may compute EE on a daily basis for the first 10 days, once a week out to one month, once a month out to 18 months, once a quarter out to five years and beyond five years in a manner that is consistent with the materiality and composition of the exposure. [Basel Framework, CRE 53.43] Exposure must be measured out to the life of all contracts in the netting set (not just to the one-year horizon), monitored and controlled. The institution must have procedures in place to identify and control the risks for counterparties where exposure rises beyond the one-year horizon. Moreover, the forecasted increase in exposure must be an input into the firm's internal economic capital model. [Basel Framework, CRE 53.44] Stress testing An institution must have in place sound stress testing processes for use in the assessment of capital adequacy. These stress measures must be compared against the measure of EPE and considered by the institution as part of its internal capital adequacy assessment process. Stress testing must also involve identifying possible events or future changes in economic conditions that could have unfavourable effects on a firm's credit exposures and assessment of the firm's ability to withstand such changes. Examples of scenarios that could be used are; (i) economic or industry downturns, (ii) market-place events, or (iii) decreased liquidity conditions. [Basel Framework, CRE 53.45] Institutions must have a comprehensive stress testing program for counterparty credit risk. The stress testing program must include the following elements: institutions must ensure complete trade capture and exposure aggregation across all forms of counterparty credit risk (not just OTC derivatives) at the counterparty-specific level in a sufficient time frame to conduct regular stress testing; for all counterparties, institutions should produce, at least monthly, exposure stress testing of principal market risk factors (e.g. interest rates, FX, equities, credit spreads, and commodity prices) in order to proactively identify, and when necessary, reduce outsized concentrations to specific directional sensitivities; institutions should apply multi-factor stress testing scenarios and assess material non-directional risks (i.e. yield curve exposure, basis risks, etc.) at least quarterly. Multiple-factor stress tests should, at a minimum, aim to address scenarios in which a) severe economic or market events have occurred; b) broad market liquidity has decreased significantly; and c) the market impact of liquidating positions of a large financial intermediary. These stress tests may be part of institution-wide stress testing; stressed market movements have an impact not only on counterparty exposures, but also on the credit quality of counterparties. At least quarterly, institutions should conduct stress testing applying stressed conditions to the joint movement of exposures and counterparty creditworthiness; exposure stress testing (including single factor, multifactor and material non-directional risks) and joint stressing of exposure and creditworthiness should be performed at the counterparty-specific, counterparty group (e.g. industry and region), and aggregate institution-wide CCR levels; stress tests results should be integrated into regular reporting to senior management. The analysis should capture the largest counterparty-level impacts across the portfolio, material concentrations within segments of the portfolio (within the same industry or region), and relevant portfolio and counterparty specific trends; the severity of factor shocks should be consistent with the purpose of the stress test. When evaluating solvency under stress, factor shocks should be severe enough to capture historical extreme market environments and/or extreme but plausible stressed market conditions. The impact of such shocks on capital resources should be evaluated, as well as the impact on capital requirements and earnings. For the purpose of day-to-day portfolio monitoring, hedging, and management of concentrations, institutions should also consider scenarios of lesser severity and higher probability; institutions should consider reverse stress tests to identify extreme, but plausible, scenarios that could result in significant adverse outcomes; senior management must take a lead role in the integration of stress testing into the risk management framework and risk culture of the institution and ensure that the results are meaningful and proactively used to manage counterparty credit risk. At a minimum, the results of stress testing for significant exposures should be compared to guidelines that express the institution's risk appetite and elevated for discussion and action when excessive or concentrated risks are present. [Basel Framework, CRE 53.46] Wrong-way risk Institutions must identify exposures that give rise to a greater degree of general wrong-way risk. Stress testing and scenario analyses must be designed to identify risk factors that are positively correlated with counterparty credit worthiness. Such testing needs to address the possibility of severe shocks occurring when relationships between risk factors have changed. Institutions should monitor general wrong way risk by product, by region, by industry, or by other categories that are germane to the business. Reports should be provided to senior management on a regular basis that communicate wrong way risks and the steps that are being taken to manage that risk. [Basel Framework, CRE 53.47] An institution is exposed to "specific wrong-way risk" (SWWR) if future exposure to a specific counterparty is highly correlated with the counterparty's probability of default. For example, a company writing put options on its own stock creates wrong-way exposures for the buyer that is specific to the counterparty. An institution must have procedures in place to identify, monitor and control cases of SWWR, beginning at the inception of a trade and continuing through the life of the trade. To calculate the CCR capital charge, the instruments for which there exists a legal connection between the counterparty and the underlying issuer, and for which specific wrong way risk has been identified, are not considered to be in the same netting set as other transactions with the counterparty. Furthermore, for single-name credit default swaps where there exists a legal connection between the counterparty and the underlying issuer, and where SWWR has been identified, EAD in respect of such swap counterparty exposure equals the full expected loss in the remaining fair value of the underlying instruments assuming the underlying issuer is in liquidation. The use of the full expected loss in remaining fair value of the underlying instrument allows the institution to recognize, in respect of such swap, the market value that has been lost already and any expected recoveries. Accordingly LGD for Advanced or Foundation IRB institutions must be set to 100% for such swap transactions.^{Footnote 14} For institutions using the standardized approach for credit risk, the risk weight to use is that of an unsecured transaction. For equity derivatives, bond options, securities financing transactions etc. referencing a single company where there exists a legal connection between the counterparty and the underlying company, and where SWWR has been identified, EAD equals the value of the transaction under the assumption of a jump-to-default of the underlying security. Inasmuch this makes re-use of possibly existing (market risk) calculations (for IRC) that already contain an LGD assumption, the LGD must be set to 100%. LGD for Advanced and Foundation IRB banks will be that of an unsecured exposure. For institutions using the standardized approach for credit risk, the risk weight of an unsecured transaction should be used. The counterparty credit risk arising from trades where SWWR has been identified can be mitigated through either prepayment or the collection of independent collateral amounts. If a counterparty prepays the notional amount of the exposure for a trade where SWWR has been identified, or a portion of it, then the EAD for that trade may be reduced by the amount of the prepayment. In situations where independent collateral amounts have been collected, the EAD for those trades may be reduced by the independent collateral amount (after any applicable haircuts) provided one of the following situations applies: The independent collateral amount is legally pledged to cover risk solely on the trade for which SWWR has been identified; or Both counterparties to the trade where SWWR has been identified agree that the independent collateral amount is posted to account for the SWWR trade and this independent amount is managed internally as such. [Basel Framework, CRE 53.48] Right-Way Risk An institution is exposed to "specific right-way risk" (SRWR) if the future exposure to a specific counterparty is highly inversely correlated with the counterparty's probability of default. An example of SRWR are warrants, which can be a component of call spread overlay trades written by the counterparty on the counterparty's stock. There are transactions where SRWR is present and, given the structure of these, institutions will have a zero EAD to the counterparty if the counterparty defaults. Where an institution has identified SRWR, only the trade types identified in paragraph 69 below, and subject to due diligence,^{Footnote 15} are permitted to receive a zero EAD. Institutions wishing to add other trade types should contact OSFI's Capital Division for prior permission. Permitted trade types include: An equity warrant, or option in each case written by the counterparty on the counterparty's own stock purchased as part of a call spread overlay transaction, where a bond hedge has also been purchased. Call spread overlay transactions involve a counterparty issuing convertible bonds and wishing to synthetically increase the conversion price. Issuer forward as well as issuer range forward sales of equity whereby the institution has also simultaneously shorted the shares of the counterparty. Issuer and issuer range forward sales of equity are typically done by a counterparty, with future capital expenditures or other funding needs, wishing to lock in a favourable current stock price or range of stock prices without needing to issue shares until the maturity of the forward or range forward transaction. Accelerated share repurchase agreements whereby counterparties provide an institution with funds to buy back shares in a defined period of time (typically under six months). Integrity of Modelling Process Other operational requirements focus on the internal controls needed to ensure the integrity of model inputs; specifically, the requirements address the transaction data, historical market data, frequency of calculation, and valuation models used in measuring EPE. [Basel Framework, CRE 53.49] The internal model must reflect transaction terms and specifications in a timely, complete, and conservative fashion. Such terms include, but are not limited to, contract notional amounts, maturity, reference assets, collateral thresholds, margining arrangements, netting arrangements, etc. The terms and specifications must reside in a secure database that is subject to formal and periodic audit. The process for recognizing netting arrangements must require signoff by legal staff to verify the legal enforceability of netting and be input into the database by an independent unit. The transmission of transaction terms and specifications data to the internal model must also be subject to internal audit and formal reconciliation processes must be in place between the internal model and source data systems to verify on an ongoing basis that transaction terms and specifications are being reflected in EPE correctly or at least conservatively. [Basel Framework, CRE 53.50] When the Effective EPE model is calibrated using historic market data, the institution must employ current market data to compute current exposures and at least three years of historical data must be used to estimate parameters of the model. Alternatively, market implied data may be used to estimate parameters of the model. In all cases, the data must be updated quarterly or more frequently if market conditions warrant. To calculate the Effective EPE using a stress calibration, the institution must also calibrate Effective EPE using three years of data that include a period of stress to the credit default spreads of an institution's counterparties or calibrate Effective EPE using market implied data from a suitable period of stress. The following process will be used to assess the adequacy of the stress calibration: The institution must demonstrate, at least quarterly, that the stress period coincides with a period of increased CDS or other credit spreads – such as loan or corporate bond spreads – for a representative selection of the institution's counterparties with traded credit spreads. In situations where the institution does not have adequate credit spread data for a counterparty, the institution should map each counterparty to specific credit spread data based on region, internal rating and business types. The exposure model for all counterparties must use data, either historic or implied, that includes the data from the stressed credit period, and must use such data in a manner consistent with the method used for the calibration of the Effective EPE model to current data. [Basel Framework, CRE 53.52] When two different calibration methods are used for different parameters within the Effective EPE model, OSFI expects institutions' model development and validation groups to provide documented justification for the choice of calibration methods that includes an assessment of the resulting model risk. If an institution wished to recognize in its EAD calculations for OTC derivatives the effect of collateral other than cash of the same currency as the exposure itself, then it must model collateral jointly with the exposure. If the institution is not able to model collateral jointly with the exposure then it must use either haircuts that meet the standards of the financial collateral comprehensive method with own haircut estimates or the standard supervisory haircuts. [Basel Framework, CRE 53.52] If the internal model includes the effect of collateral on changes in the market value of the netting set, the institution must model collateral other than cash of the same currency as the exposure itself jointly with the exposure in its EAD calculations for securities-financing transactions. [Basel Framework, CRE 53.53] The EPE model (and modifications made to it) must be subject to an internal model validation process. The process must be clearly articulated in firms' policies and procedures. The validation process must specify the kind of testing needed to ensure model integrity and identify conditions under which assumptions are violated and may result in an understatement of EPE. The validation process must include a review of the comprehensiveness of the EPE model, for example such as whether the EPE model covers all products that have a material contribution to counterparty risk exposures. [Basel Framework, CRE 53.54] The use of an internal model to estimate EPE, and hence the exposure amount or EAD, of positions subject to a CCR capital charge will be conditional upon the explicit OSFI approval. [Basel Framework, CRE 53.55] The BCBS has issued guidance regarding the use of internal models to estimate certain parameters of risk and determine minimum capital charges against those risks. OSFI requires that institutions seeking to make use of internal models to estimate EPE meet similar requirements regarding, for example, the integrity of the risk management system, the skills of staff that will rely on such measures in operational areas and in control functions, the accuracy of models, and the rigour of internal controls over relevant internal processes. As an example, institutions seeking to make use of an internal model to estimate EPE must demonstrate that they meet the Committee's general criteria for institutions seeking to make use of internal models to assess market risk exposures, but in the context of assessing counterparty credit risk.^{Footnote 16} [Basel Framework, CRE 53.56] The Internal Capital Adequacy Assessment Program provides general background and specific guidance to cover counterparty credit risks that may not be fully covered by the Pillar 1 process. [Basel Framework, CRE 53.57] No particular form of model is required to qualify to make use of an internal model. Although this text describes an internal model as a simulation model, other forms of models, including analytic models, are acceptable subject to OSFI approval and review. Institutions that seek recognition for the use of an internal model that is not based on simulations must demonstrate to OSFI that the model meets all operational requirements. [Basel Framework, CRE 53.58] For an institution that qualifies to net transactions, the institution must have internal procedures to verify that, prior to including a transaction in a netting set, the transaction is covered by a legally enforceable netting contract that meets the applicable requirements of section 7.1.7.1 and section 4.3.3 of Chapter 4, or the Cross-Product Netting Rules set forth in this chapter. [Basel Framework, CRE 53.59] For an institution that makes use of collateral to mitigate its CCR, the institution must have internal procedures to verify that, prior to recognizing the effect of collateral in its calculations, the collateral meets the appropriate legal certainty standards as set out in Chapter 4. [Basel Framework, CRE 53.60]

7.1.6 Cross-product netting rules^{Footnote 17}

Institutions that receive approval to estimate their exposures to CCR using the internal model method may include within a netting set SFTs, or both SFTs and OTC derivatives subject to a legally valid form of bilateral netting that satisfies the legal and operational criteria for a Cross-Product Netting Arrangement defined below. The institution must also have satisfied any prior approval or other procedural requirements set out by OSFI for the purposes of recognizing a Cross-Product Netting Arrangement. [Basel Framework, CRE 53.62] 7.1.6.1 Legal Criteria The institution has executed a written, bilateral netting agreement with the counterparty that creates a single legal obligation, covering all included bilateral master agreements and transactions ("Cross-Product Netting Arrangement"), such that the institution would have either a claim to receive or obligation to pay only the net sum of the positive and negative (i) close-out values of any included individual master agreements and (ii) mark-to-market values of any included individual transactions (the "Cross-Product Net Amount"), in the event a counterparty fails to perform due to any of the following: default, bankruptcy, liquidation or similar circumstances. [Basel Framework, CRE 53.63] The institution has written and reasoned legal opinions that conclude with a high degree of certainty that, in the event of a legal challenge, relevant courts or administrative authorities would find the firm's exposure under the Cross-Product Netting Arrangement to be the Cross-Product Net Amount under the laws of all relevant jurisdictions. In reaching this conclusion, legal opinions must address the validity and enforceability of the entire Cross-Product Netting Arrangement under its terms and the impact of the Cross-Product Netting Arrangement on the material provisions of any included bilateral master agreement. The laws of "all relevant jurisdictions" are: (i) the law of the jurisdiction in which the counterparty is chartered and, if the foreign branch of a counterparty is involved, then also under the law of the jurisdiction in which the branch is located, (ii) the law that governs the individual transactions, and (iii) the law that governs any contract or agreement necessary to effect the netting. A legal opinion must be generally recognized as such by the legal community in the firm's home country or a memorandum of law that addresses all relevant issues in a reasoned manner. [Basel Framework, CRE 53.64] The institution has internal procedures to verify that, prior to including a transaction in a netting set, the transaction is covered by legal opinions that meet the above criteria. [Basel Framework, CRE 53.65] The institution undertakes to update legal opinions as necessary to ensure continuing enforceability of the Cross-Product Netting Arrangement in light of possible changes in relevant law. [Basel Framework, CRE 53.66] The Cross-Product Netting Arrangement does not include a walkaway clause. A walkaway clause is a provision which permits a non-defaulting counterparty to make only limited payments, or no payment at all, to the estate of the defaulter, even if the defaulter is a net creditor. [Basel Framework, CRE 53.67] Each included bilateral master agreement and transaction included in the Cross-Product Netting Arrangement satisfies applicable legal requirements for recognition of credit risk mitigation techniques in Chapter 4.3. [Basel Framework, CRE 53.68] The institution maintains all required documentation in its files. [Basel Framework, CRE 53.69] 7.1.6.2 Operational Criteria OSFI is satisfied that the effects of a Cross-Product Netting Arrangement are factored into the firm's measurement of a counterparty's aggregate credit risk exposure and that the institution manages its counterparty credit risk on such basis. [Basel Framework, CRE 53.70] Credit risk to each counterparty is aggregated to arrive at a single legal exposure across products covered by the Cross-Product Netting Arrangement. This aggregation must be factored into credit limit and economic capital processes. [Basel Framework, CRE 53.71]

7.1.7 Standardized Approach for Counterparty Credit Risk

Institutions that do not have approval to apply the internal models method must use the SA-CCR method. SA-CCR can be used for OTC derivatives, exchange-traded derivatives and long settlement transactions; SFTs are subject to the treatments set out under the Internal Model Method of this chapter or in Chapter 4 of the CAR Guideline. EAD is to be calculated separately for each netting set. It is determined as follows: EAD = alpha × ( RC + PFE ) ^{Footnote 18} where: alpha = 1.4, RC = the replacement cost calculated according to paragraphs 98 to 114, and PFE = the amount for potential future exposure calculated according to paragraphs 115 to 168 [Basel Framework, CRE 52.1] The replacement cost (RC) and the PFE components are calculated differently for margined and unmargined netting sets. Margined netting sets are covered by a margin agreement under which the bank's counterparty has to post variation margin; all other netting sets, including those covered by a one-way margin agreement where only the bank posts variation margin, are treated as unmargined for the purposes of the SA-CCR. The EAD for a margined netting set is capped at the EAD of the same netting set calculated on an unmargined basis. [Basel Framework, CRE 52.2] The EAD for sold options that are outside netting and margin agreements can be set to zero. [Basel Framework, CRE 52.2, FAQ #1] For credit derivatives where the bank is the protection seller and that are outside netting and margin agreements, the EAD may be capped at the amount of unpaid premiums. Institutions have the option to remove such credit derivatives from their legal netting sets and treat them as individual unmargined transactions in order to apply the cap. [Basel Framework, CRE 52.2, FAQ #2] Non-linear products where no specific treatment exists under the SACCR can be decomposed in a manner similar to paragraph 131. Linear products may not be decomposed. [Basel Framework, CRE 52.1, FAQ #3] 7.1.7.1 RC and NICA For unmargined transactions, the RC intends to capture the loss that would occur if a counterparty were to default and were closed out of its transactions immediately. The PFE add-on represents a potential conservative increase in exposure over a one-year time horizon from the present date (i.e. the calculation date). [Basel Framework, CRE 52.3] For margined trades, the RC intends to capture the loss that would occur if a counterparty were to default at the present or at a future time, assuming that the closeout and replacement of transactions occur instantaneously. However, there may be a period (the margin period of risk) between the last exchange of collateral before default and replacement of the trades in the market. The PFE add-on represents the potential change in value of the trades during this time period. [Basel Framework, CRE 52.4] In both cases, the haircut applicable to noncash collateral in the replacement cost formulation represents the potential change in value of the collateral during the appropriate time period (one year for unmargined trades and the margin period of risk for margined trades). [Basel Framework, CRE 52.5] Cash variation margin (VM) is not subject to any additional haircut provided the variation margin is posted in a currency that is agreed to and listed in the applicable contract.^{Footnote 19} Cash initial margin (IM) that is exchanged in a currency other than the termination currency (that is, the currency in which the institution will submit its claim upon a counterparty default) is subject to the additional haircut for foreign currency risk. Replacement cost is calculated at the netting set level, whereas PFE add-ons are calculated for each asset class within a given netting set and then aggregated (see paragraphs 115 to 168). [Basel Framework, CRE 52.6] For capital adequacy purposes, institutions may net transactions (e.g. when determining the RC component of a netting set) subject to novation under which any obligation between an institution and its counterparty to deliver a given currency on a given value date is automatically amalgamated with all other obligations for the same currency and value date, legally substituting one single amount for the previous gross obligations. Institutions may also net transactions subject to any legally valid form of bilateral netting not covered in the preceding sentence, including other forms of novation.^{Footnote 20} In every such case where netting is applied, an institution must satisfy its OSFI that it has: A netting contract with the counterparty or other agreement which creates a single legal obligation, covering all included transactions, such that the institution would have either a claim to receive or obligation to pay only the net sum of the positive and negative mark-to-market values of included individual transactions in the event a counterparty fails to perform due to any of the following: default, bankruptcy, liquidation or similar circumstances;^{Footnote 21} Written and reasoned legal reviews that, in the event of a legal challenge, the relevant courts and administrative authorities would find the institution's exposure to be such a net amount under: The law of the jurisdiction in which the counterparty is chartered and, if the foreign branch of a counterparty is involved, then also under the law of the jurisdiction in which the branch is located; The law that governs the individual transactions; and The law that governs any contract or agreement necessary to affect the netting. OSFI, after consultation when necessary with other relevant supervisors, must be satisfied that the netting is enforceable under the laws of each of the relevant jurisdictions.^{Footnote 22} Procedures in place to ensure that the legal characteristics of netting arrangements are kept under review in light of the possible changes in relevant law. [Basel Framework, CRE 52.7] There are two formulations of replacement cost depending on whether the trades with a counterparty are subject to a margin agreement. Where a margin agreement exists, the formulation could apply both to bilateral transactions and central clearing relationships. The formulation also addresses the various arrangements that an institution may have to post and/or receive collateral that may be referred to as initial margin. [Basel Framework, CRE 52.9] A. Formulation for unmargined transactions For unmargined transactions (that is, where VM is not exchanged, but collateral other than VM may be present), RC is defined as the greater of: (i) the current market value of the derivative contracts less net haircut collateral held by the institution (if any), and (ii) zero. This is consistent with the use of replacement cost as the measure of current exposure, meaning that when the institution owes the counterparty money it has no exposure to the counterparty if it can instantly replace its trades and sell collateral at current market prices. Mathematically: RC = max { V − C , 0 } where V is the value of the derivative transactions in the netting set and C is the haircut value of net collateral held, which is calculated in accordance with the NICA methodology defined in paragraph 112. For this purpose, the value of non-cash collateral posted by the institution to its counterparty is increased and the value of the non-cash collateral received by the institution from its counterparty is decreased using haircuts (which are the same as those that apply to repo-style transactions) for the time periods described in paragraph 100. [Basel Framework, CRE 52.10 and 52.11] In the above formulation, it is assumed that the replacement cost representing today's exposure to the counterparty cannot go less than zero. However, institutions sometimes hold excess collateral (even in the absence of a margin agreement) or have out-of-the-money trades which can further protect the institution from the increase of the exposure. As discussed in paragraphs 116 to 118, the SA-CCR would allow such over-collateralization and negative mark-to market value to reduce PFE, but would not affect replacement cost. [Basel Framework, CRE 52.12] Bilateral transactions with a one-way margining agreement in favour of the institution's counterparty (that is, where an institution posts, but does not collect, collateral) must be treated as unmargined transactions. [Basel Framework, CRE 52.10, FAQ #1] B. Formulation for margined transactions The RC formula for margined transactions builds on the RC formula for unmargined transactions. It also employs concepts used in standard margining agreements, as discussed more fully below. [Basel Framework, CRE 52.13] The RC for margined transactions in the SA-CCR is defined as the greatest exposure that would not trigger a call for VM, taking into account the mechanics of collateral exchanges in margining agreements. Such mechanics include, for example, "Threshold", "Minimum Transfer Amount" and "Independent Amount" in the standard industry documentation,^{Footnote 23} which are factored into a call for VM.^{Footnote 24} [Basel Framework, CRE 52.14] C. Incorporating NICA into replacement cost One objective of the SA-CCR is to more fully reflect the effect of margining agreements and the associated exchange of collateral in the calculation of CCR exposures. The following paragraphs address how the exchange of collateral is incorporated into the SA-CCR. [Basel Framework, CRE 52.15] To avoid confusion surrounding the use of terms initial margin and independent amount which are used in various contexts and sometimes interchangeably, the term independent collateral amount (ICA) is introduced. ICA represents (i) collateral (other than VM) posted by the counterparty that the institution may seize upon default of the counterparty, the amount of which does not change in response to the value of the transactions it secures and/or (ii) the Independent Amount (IA) parameter as defined in standard industry documentation. ICA can change in response to factors such as the value of the collateral or a change in the number of transactions in the netting set. [Basel Framework, CRE 52.16] Because both an institution and its counterparty may be required to post ICA, it is necessary to introduce a companion term, net independent collateral amount (NICA), to describe the amount of collateral that an institution may use to offset its exposure on the default of the counterparty. NICA does not include collateral that an institution has posted to a segregated, bankruptcy remote account, which presumably would be returned upon the bankruptcy of the counterparty. That is, NICA represents any collateral (segregated or unsegregated) posted by the counterparty less the unsegregated collateral posted by the institution. With respect to IA, NICA takes into account the differential of IA required for the institution minus IA required for the counterparty. [Basel Framework, CRE 52.17] For margined trades, the replacement cost is: RC = max { V − C ; TH + MTA − NICA ; 0 } Where: V and C are defined as in the unmargined formulation, except that C now includes the net variation margin amount, where the amount received by the institution is accounted with a positive sign and the amount posted by the institution is accounted with a negative sign, TH is the positive threshold before the counterparty must send the institution collateral, and MTA is the minimum transfer amount applicable to the counterparty. [Basel Framework, CRE 52.18] TH + MTA − NICA represents the largest exposure that would not trigger a VM call and it contains levels of collateral that need always to be maintained. For example, without initial margin or IA, the greatest exposure that would not trigger a variation margin call is the threshold plus any minimum transfer amount. In the adapted formulation, NICA is subtracted from TH + MTA. This makes the calculation more accurate by fully reflecting both the actual level of exposure that would not trigger a margin call and the effect of collateral held and/or posted by an institution. The calculation is floored at zero, recognizing that the institution may hold NICA in excess of TH + MTA, which could otherwise result in a negative replacement cost. [Basel Framework, CRE 52.19] 7.1.7.2 PFE Add-ons The PFE add-on consists of (i) an aggregate add-on component, which consists of add-ons calculated for each asset class and (ii) a multiplier that allows for the recognition of excess collateral or negative mark-to-market value for the transactions. Mathematically: PFE = multiplier × AddOn aggregate Where AddOn aggregate is the aggregate add-on component and multiplier is defined as a function of three inputs: V, C and AddOn aggregate . The paragraphs below describe the inputs that enter into the calculation of the add-on formulas in more detail, and set out the formula for each asset class. [Basel Framework, CRE 52.20] 7.1.7.3 Recognition of excess collateral and negative mark-to-market As a general principle, over-collateralization should reduce capital requirements for counterparty credit risk. In fact, many institutions hold excess collateral (i.e. collateral greater than the net market value of the derivatives contracts) precisely to offset potential increases in exposure represented by the add-on. As discussed in paragraphs 105 and 113, collateral may reduce the replacement cost component of the exposure under the SA-CCR. The PFE component also reflects the risk-reducing property of excess collateral. [Basel Framework, CRE 52.21] For prudential reasons and in line with Basel Committee direction, OSFI applied a multiplier to the PFE component that decreases as excess collateral increases, without reaching zero (the multiplier is floored at 5% of the PFE add-on). When the collateral held is less than the net market value of the derivative contracts ("under-collateralization"), the current replacement cost is positive and the multiplier is equal to one (i.e. the PFE component is equal to the full value of the aggregate add-on). Where the collateral held is greater than the net market value of the derivative contracts ("over-collateralization"), the current replacement cost is zero and the multiplier is less than one (i.e. the PFE component is less than the full value of the aggregate add-on). [Basel Framework, CRE 52.22] This multiplier will also be activated when the current value of the derivative transactions is negative. This is because out-of-the-money transactions do not currently represent an exposure and have less chance to go in-the-money. Mathematically: multiplier = min 1 ; Floor + 1 − Floor × e V − C 2 × 1 − Floor × AddOn aggregate where exp(…) equals to the exponential function, Floor is 5%, V is the value of the derivative transactions in the netting set, and C is the haircut value of net collateral held. [Basel Framework, CRE 52.23] 7.1.7.4 Aggregation across asset classes Diversification benefits across asset classes are not recognized. Instead, the respective add-ons for each asset class are simply aggregated. Mathematically: AddOn aggregate = ∑ a AddOn a where the sum of each asset class add-on is taken. [Basel Framework, CRE 52.25] 7.1.7.5 Allocation of derivative transactions to one or more asset classes The designation of a derivative transaction to an asset class is be made on the basis of its primary risk driver. Most derivative transactions have one primary risk driver, defined by its reference underlying instrument (e.g. an interest rate curve for an interest rate swap, a reference entity for a credit default swap, a foreign exchange rate for a FX call option, etc). When this primary risk driver is clearly identifiable, the transaction will fall into one of the asset classes described above. [Basel Framework, CRE 52.26] For more complex trades that may have more than one risk driver (e.g. multi-asset or hybrid derivatives), institutions must take sensitivities and volatility of the underlying into account for determining the primary risk driver. OSFI may also require more complex trades to be allocated to more than one asset class, resulting in the same position being included in multiple classes. In this case, for each asset class to which the position is allocated, institutions must determine appropriately the sign and delta adjustment of the relevant risk driver. [Basel Framework, CRE 52.27 and 52.28] 7.1.7.6 General steps for calculating the add-on For each transaction, the primary risk factor or factors need to be determined and attributed to one or more of the five asset classes: interest rate, foreign exchange, credit, equity or commodity. The add-on for each asset class is calculated using asset-class-specific formulas that represent a stylized Effective EPE calculation under the assumption that all trades in the asset class have zero current mark-to-market value (i.e. they are at-the-money). [Basel Framework, CRE 52.29] Although the add-on formulas are asset class-specific, they have a number of features in common. To determine the add-on, transactions in each asset class are subject to adjustment in the following general steps: The effective notional (D) must be calculated for each derivative (i.e. each individual trade) in the netting set. The effective notional is a measure of the sensitivity of the trade to movements in the underlying risk factors (i.e. interest rates, exchange rates, credit spreads, equity prices and commodity prices). The effective notional is calculated as the product of the following parameters (i.e. D = d × MF × δ ): The adjustment notional (d). The adjusted notional is a measure of the size of the trade. For derivatives in the foreign exchange asset class this is simply the notional value of the foreign currency leg of the derivative contracted, converted to the domestic currency. For derivatives in the equity and commodity asset classes, it is simply the current price of the relevant share or unit of commodity multiplied by the number of shares/units that the derivative references. For derivatives in the interest rate and credit asset classes, the notional amount is adjusted by a measure of the duration of the instrument to account for the fact that the value of the instruments with longer durations are more sensitive to movements in underlying risk factors (i.e. interest rates and credit spreads). The maturity factor (MF). The maturity factor is a parameter that takes account of the time period over which the potential future exposure is calculated. The calculation of the maturity factor varies depending on whether the netting set is margined or unmargined. The supervisory delta (δ). The supervisory delta ensures the effective notional takes into account the direction of the trade, i.e. whether the trade is long or short, by having a positive or negative sign. It is also takes into account whether the trade has a non-linear relationship with the underlying risk factor (which is the case for options and collateralized debt obligation tranches). A supervisory factor (SF) is identified for each individual trade in the netting set. The supervisory factor is the supervisory specified change in value of the underlying risk factor on which the potential future exposure calculation is based, which has been calibrated to take into account the volatility of underlying risk factors. The trades within each asset class are separated into supervisory specified hedging sets. The purpose of the hedging sets is to group together trades within the netting set where long and short positions should be permitted to offset each other in the calculation of the potential future exposure. Aggregation formulas are applied to aggregate the effective notionals and supervisory factors across all trades within each hedging set and finally at the asset-class level to give the asset class level add-on. The method of aggregation varies between assets classes and for credit, equity and commodity derivatives. It also involves the application of supervisory correlation parameters to capture diversification of the trades and basis risk. [Basel Framework, CRE 52.30] 7.1.7.7 Time Period Parameters Mi, Ei, Si, and Ti Four time period parameters are used in the SA-CCR (all expressed in years): For all asset classes, the maturity M i of a contract is the time period (starting today) until the latest day when the contract may still be active. This time period appears in the maturity factor defined in paragraphs 139 to 144 that scales down adjusted notional for unmargined trades for all asset classes. If a derivative contract has another derivative contract as its underlying (for example, a swaption) and may be physically exercised into the underlying contract (i.e. an institution would assume a position in the underlying contract in the event of exercise), then maturity of the contract is the time period until the final settlement date of the underlying derivative contract. For interest rate and credit derivatives, S i is the period of time (starting today) until the start of the time period referenced by an interest rate or credit contract. If the derivative references the value of another interest rate or credit instrument (e.g. swaption or bond option), the time period must be determined on the basis of the underlying instrument. S i appears in the definition of supervisory duration defined in paragraph 126. For interest rate and credit derivatives, E i is the period of time (starting today) until the end of the time period referenced by an interest rate or credit contract. If the derivative references the value of another interest rate or credit instrument (e.g. swaption or bond option), the time period must be determined on the basis of the underlying instrument. E i appears in the definition of supervisory duration defined in paragraph 126. In addition, E i is used for allocating derivatives in the interest rate asset class to maturity buckets, which are used in the calculation of the add-on (see paragraph 146). For options in all asset classes, T i is the time period (starting today) until the latest contractual exercise date as referenced by the contract. This period shall be used for the determination of the option delta in paragraph 132. Unless otherwise specified, time periods between dates should be measured in years. [Basel Framework, CRE 52.31] Table 1 includes example transactions and provides each transaction's related maturity M i , start date S i and end date E i . In addition, the option delta in paragraph 132 depends on the latest contractual exercise date T i (not separately shown in the table). Table 1 Instrument M i S i E i Interest rate or credit default swap maturing in 10 years 10 years 0 10 years 10-year interest rate swap, forward starting in 5 years 15 years 5 years 15 years Forward rate agreement for time period starting in 6 months and ending in 12 months 1 year 0.5 year 1 year Cash-settled European swaption referencing 5-year interest rate swap with exercise date in 6 months 0.5 year 0.5 year 5.5 years Physically-settled European swaption referencing 5-year interest rate swap with exercise date in 6 months 5.5 years 0.5 year 5.5 years 10-year Bermudan swaption with annual exercise dates 10 years 1 year 10 years Interest rate cap or floor specified for semi-annual interest rate with maturity 5 years 5 years 0 5 years Option on a bond maturing in 5 years with the latest exercise date in 1 year 1 year 1 year 5 years 3-month Eurodollar futures that matures in 1 year^{Footnote 25} 1 year 1 year 1.25 years Futures on 20-year treasury bond that matures in 2 years 2 years 2 years 22 years 6-month option on 2-year futures on 20-year treasury bond 2 years 2 years 22 years [Basel Framework, CRE 52.32] 7.1.7.8 Trade-level Adjusted Notional (for trade I): d i (a) The adjusted notionals are defined at the trade level and take into account both the size of a position and its maturity dependency, if any. [Basel Framework, CRE 52.33] For interest rate and credit derivatives, the trade-level adjusted notional is the product of the trade notional amount, converted to the domestic currency, and the supervisory duration SD i (i.e. d i = notional × SD i ) which is given by the formula below. The calculated value of SD i is floored at 10 business days.^{Footnote 26} If the start date has occurred (e.g. an ongoing interest rate swap), S i must be set to zero. SD i = e - 0.05 × S i − e - 0.05 × E i 0.05 [Basel Framework, CRE 52.34] For foreign exchange derivatives, the adjusted notional is defined as the notional of the foreign currency leg of the contract, converted to the domestic currency. If both legs of a foreign exchange derivative are denominated in currencies other than the domestic currency, the notional amount of each leg is converted to the domestic currency and the leg with the larger domestic currency value is the adjusted notional amount. [Basel Framework, CRE 52.35] For equity and commodity derivatives, the adjusted notional is defined as the product of the current price of one unit of the stock or commodity (e.g. a share of equity or barrel of oil) and the number of units referenced by the trade. For equity and commodity volatility transactions, the underlying volatility or variance referenced by the transactions should replace the unit price and the contractual notional should replace the number of units. [Basel Framework, CRE 52.36] In many cases the trade notional amount is stated clearly and fixed until maturity. When this is not the case, institutions must use the following rules to determine the trade notional amount. Where the notional is a formula of market values, the institution must enter the current market values to determine the trade notional amount. For all interest rate and credit derivatives with variable notional amounts specified in the contract (such as amortizing and accreting swaps), institutions must use the average notional over the remaining life of the swap as the trade notional amount. The average should be calculated as "time weighted". The averaging described in this paragraph does not cover transactions where the notional varies due to price changes (typically FX, equity and commodity derivatives). Leveraged swaps must be converted to the notional of the equivalent unleveraged swap, that is, where all rates in a swap are multiplied by a factor, the stated notional must be multiplied by the factor on the interest rates to determine the trade notional amount. For a derivative contract with multiple exchanges of principal, the notional is multiplied by the number of exchanges of principal in the derivative contract to determine the trade notional amount. For a derivative contract that is structured such that on specified dates any outstanding exposure is settled and the terms are reset so that the fair value of the contract is zero, the remaining maturity equals the time until the next reset date. Consistent with the above point, trades with daily settlement should be treated as unmargined transactions with a maturity factor given by the first formula in paragraph 139 with the parameter M i set to its floor value of 10 business days. For trades subject to daily margining, the maturity factor is given by the second formula of paragraph 143 depending on the margin period of risk (MPOR), which can be as low as five business days. Note that, the parameter E i defines the maturity bucket for the purpose of netting. [Basel Framework, CRE 52.32, FAQ #1] Calculation of effective notional for options For the purposes of effective notional calculations (i.e. D = d × MF × δ ), single-payment options must be treated as follows: For European, Asian, American and Bermudan put and call options, the supervisory delta must be calculated using the simplified Black-Scholes formula in paragraph 133. In the case of Asian options, the underlying price must be set equal to the current value of the average used in the payoff. In the case of American and Bermudan options, the latest allowed exercise date must be used as the exercise date T i in the formula. For Bermudan swaptions, the start date S i must be equal to the earliest allowed exercise date, while the end date E i must be equal to the end date of the underlying swap. For digital options (also known as binary options), the payoff of each digital option (bought or sold) with strike K i must be approximated via the "collar" combination of bought and sold European options of the same type (call or put) with the strikes set equal to 0.95 × K i and 1.05 × K i . The size of the position in the collar components must be such that the digital payoff is reproduced exactly outside of the region between the two strikes. The effective notional is then computed for the bought and sold European components of the collar separately, using the option formulas for the supervisory delta in paragraph 132 (the exercise date T i and the current value of the underlying P i of the digital option must be used). The absolute value of the digital option effective notional must be capped by the ratio of the digital payoff to the relevant supervisory factor. If a trade's payoff can be represented as a combination of European option payoffs (e.g. collar, butterfly/calendar spread, straddle, strangle, etc.), each European option component must be treated as a separate trade. [Basel Framework, CRE 52.42] For the purposes of effective notional calculations, multi-payment options must be represented as a combination of single-payment options. In particular, interest rate caps/floors may be represented as a combination of single-payment options. In particular, interest rate caps/floors may be represented as the portfolio of individual caplets/floorlets, each of which is a European option on the floating interest rate over a specific coupon period. For each caplet/floorlet, S i and T i are the time periods starting from the current date to the start of the coupon period, while E i is the time period starting from the current date to the end of the coupon period. [Basel Framework, CRE 52.43] 7.1.7.9 Supervisory delta adjustments: δ i The supervisory delta adjustment parameters are also defined at the trade level and are applied to the adjusted notional amounts to reflect the direction of the transaction and its non-linearity. [Basel Framework, CRE 52.38] The delta adjustments for all derivatives are defined as follows: Delta for Instruments that are not Options or CDO Tranches δ i Long in the primary risk factor^{Footnote 27} Short in the primary risk factor^{Footnote 28} Instruments that are not options or CDO tranches +1 -1 Delta for Options δ i Bought Sold Call Options^{Footnote 29} + Φ ln ⁡ P i K i + 0.5 × σ 2 × T i σ i × T i − Φ ln ⁡ P i K i + 0.5 × σ 2 × T i σ i × T i Put Options − Φ − ln ⁡ P i K i + 0.5 × σ 2 × T i σ i × T i + Φ − ln ⁡ P i K i + 0.5 × σ 2 × T i σ i × T i With the following parameters that institutions must determine appropriately: P i : Underlying price (spot, forward, average, etc.) K i : Strike price T i : Latest contractual exercise date of the option The supervisory volatility of an option is specified on the basis of supervisory factor applicable to the trade (see Table 2 in paragraph 162). Delta for CDO Tranches δ i Purchased (long protection) Sold (short protection) CDO tranche^{Footnote 30} + 15 1 + 14 × A i × 1 + 14 × D i − 15 1 + 14 × A i × 1 + 14 × D i With the following parameters that institutions must determine appropriately: A i : Attachment point of the CDO tranche D i : Detachment point of the CDO tranche Whenever appropriate, the forward (rather than spot) value of the underlying in the supervisory delta adjustments formula should be used in order to account for the risk-free rate as well as for possible cash flows prior to the option expiry (such as dividends). [Basel Framework, CRE 52.39 to 52.41] [Basel Framework, CRE 52.40, FAQ #2] For cases where the term P/K is either zero or negatives such that the term In(P/K) cannot be computed, the following adjustments should be made: institutions must incorporate a shift in the price value and strike value by adding λ, where λ represents the presumed lowest possible extent to which interest rates in the respective currency can become negative.^{Footnote 31} For commodity derivatives, institutions must incorporate a shift in the price value and strike value by adding λ, where λ represents the presumed lowest possible extent to which prices in that particular commodity can become negative.^{Footnote 32} Therefore, the Delta δ i for a transaction i in such cases is calculated as: Delta for options if Term P/K is Zero or Negative Delta(δ) Bought Sold Call Options + Φ ln ⁡ ( P i + λ j ) ( K i + λ j ) + 0.5 × σ i 2 × T i σ i × T i − Φ ln ⁡ ( P i + λ j ) ( K i + λ j ) + 0.5 × σ i 2 × T i σ i × T i Put Options − Φ − ln ⁡ P i + λ j K i + λ j − 0.5 × σ i 2 × T i σ i × T i + Φ − ln ⁡ P i + λ j K i + λ j − 0.5 × σ i 2 × T i σ i × T i The same parameter must be used consistently for all interest rate options in the same currency and all commodity options on the same commodity type. Institutions should select a value of λ j , which is low but still gives a positive K i + λ j value. 7.1.7.10 Supervisory Factors: SFi Supervisory factors ( SF i ) are used, together with aggregation formulas, to convert the effective notional amounts into the add-on for each hedging set. Each factor has been calibrated to reflect the Effective EPE of a single at-the-money linear trade of unit notional and one-year maturity. This includes the estimate of realized volatilities assumed by supervisors for each underlying asset class. The supervisory factors are listed in Table 2 in paragraph 162. [Basel Framework, CRE 52.44] 7.1.7.11 Hedging Sets The hedging sets in the different asset classes are defined as follows, except for those described in paragraphs 137 and 138. Interest rate derivatives consist of a separate hedging set for each currency; FX derivatives consist of a separate hedging set for each currency pair; Credit derivatives consist of a single hedging set; Equity derivatives consist of a single hedging set; Commodity derivatives consist of four hedging sets defined for broad categories of commodity derivatives: energy, metals, agricultural and other commodities. [Basel Framework, CRE 52.45] Derivatives that reference the basis between two risk factors and are denominated in a single currency^{Footnote 33} (basis transactions) must be treated within separate hedging sets within the corresponding asset class. There is a separate hedging set^{Footnote 34} for each pair of risk factors (i.e. for each specific basis). Examples of specific bases include three-month Libor versus six-month Libor, three-month Libor versus three-month T-Bill, one-month Libor versus OIS rate, Brent Crude oil versus Henry Hub gas. For hedging sets consisting of basis transactions, the supervisory factor applicable to a given asset class must be multiplied by one-half. Basket equity derivatives comprised of 10 or less effective constituents^{Footnote 35} may be decomposed into their underlying constituents. Baskets comprised of more than 10 effective constituents should be treated as indices. [Basel Framework, CRE 52.46] Derivatives that reference the volatility of a risk factor (volatility transactions) must be treated within separate hedging sets within the corresponding asset class. Volatility hedging sets must follow the same hedging set construction outlined in paragraph 136 (for example, all equity volatility transactions form a single hedging set). Examples of volatility transactions include variance and volatility swaps, options on realized or implied volatility. For hedging sets consisting of volatility transactions, the supervisory factor applicable to a given asset class must be multiplied by a factor of five. [Basel Framework, CRE 52.36] 7.1.7.12 Maturity Factors The minimum time risk horizons for an unmargined transaction is the lesser of one year and remaining maturity of the derivative contract, floored at 10 business days. Therefore, the calculation of the effective notional for an unmargined transaction includes the following maturity factor, where M i is the remaining maturity floored by 10 business days: MF i ( umargined ) = min M i ; 1 year 1 year [Basel Framework, CRE 52.48] The maturity parameter ( M i ) is expressed in years but is subject to a floor of 10 business days. Banks should use standard market convention to convert business days into years, and vice versa. For example, 250 business days in a year, which results in a floor of 10/250 years for M i . [Basel Framework, CRE 52.49] For margined transactions, the maturity factor is calculated using the minimum margin period of risk (MPOR), subject to specified floors. That is, institutions must first estimate the margin period of risk (as defined in section 7.1.1.3) for each of their netting sets. They must then use the higher of their estimated margin period of risk and the relevant floor in the calculation of the maturity factor (defined in paragraph 143). The floors for the margin period of risk are as follows: Ten business days for non-centrally cleared derivative transactions subject to daily margin agreements. The sum of nine business days plus the re-margining period for non-centrally cleared transactions that are not subject to daily margin agreements. The relevant floors for centrally cleared transactions are prescribed in section 7.1.8. [Basel Framework, CRE 52.50] The following are exceptions to the floors on the minimum margin period of risk set out in paragraph 141 above: For netting sets consisting of 5,000 transactions that are not with a central counterparty or client cleared trades, the floor on the margin period of risk is 20 business days. For netting sets containing one or more trades involving either illiquid inbound variation margin, or an OTC derivative that cannot be easily replaced, the floor on the margin period of risk is 20 business days. For these purposes, "Illiquid inbound variation margin" and "OTC derivatives that cannot be easily replaced" must be determined in the context of stressed market conditions and will be characterized by the absence of continuously active markets where a counterparty would, within two or fewer days, obtain multiple price quotations that would not move the market or represent a price reflecting a market discount (in the case of collateral) or premium (in the case of an OTC derivative). Examples of situations where trades are deemed illiquid for this purpose include, but are not limited to, trades that are not marked daily and trades that are subject to specific accounting treatment for valuation purposes (e.g. OTC derivatives transactions referencing securities whose fair value is determined by models with inputs that are not observed in the market). If an institution has experienced more than two margin call disputes on a particular netting set over the previous two quarters that have lasted longer than the applicable margin period of risk (before considering this provision), then the institution must reflect this history appropriately by doubling the applicable supervisory floor on the margin period of risk for that netting set for the subsequent two quarters. In the case of non-centrally cleared derivatives subject to Guideline E-22 (Margin Requirements for non-centrally Cleared Derivatives), the previous bullet point only applies to variation margin call disputes. [Basel Framework, CRE 52.51] The calculation of the effective notional for a margined transaction includes the following maturity factor, where MPORi is the margin period of risk appropriate for the margin agreement containing the transaction i (subject to floors set out in paragraphs 141 and 142 above): MF i margined = 3 2 × MPOR i 1 year [Basel Framework, CRE 52.52] The margin period of risk (MPORi) is often expressed in days, but the calculation of the maturity factor for margined netting sets references one year in the denominator. Banks should use standard market convention to convert business days into years, and vice-versa. For example, one year can be converted into 250 business days in the denominator of the MF formula if MPOR is expressed in business days. Alternatively, the MPOR expressed in business days can be converted into years by dividing it by 250. [Basel Framework, CRE 52.53] 7.1.7.13 Supervisory correlation parameters: ρ i (a) These parameters only apply to the PFE add-on calculation for equity, credit and commodity derivatives, and are set out in Table 2 in paragraph 162. For these asset classes, the supervisory correlation parameters are derived from a single-factor model and specify the weight between systematic and idiosyncratic components. This weight determines the degree of offset between individual trades, recognizing that imperfect hedges provide some, but not perfect, offset. Supervisory correlation parameters do not apply to interest rate and foreign exchange derivatives. [Basel Framework, CRE 52.54] Asset Class Level Add-ons 7.1.7.14 Add-on for interest rate derivatives^{Footnote 36} The add-on for interest rate derivatives captures the risk of interest rate derivatives of different maturities being imperfectly correlated. It does this by allocating trades to maturity buckets, in which full offsetting of long and short positions is permitted, and by using an aggregation formula that only permits limited offsetting between transactions in different maturity buckets. This allocation of derivatives to maturity buckets and the process of aggregation are only used in the interest rate derivative asset class. [Basel Framework, CRE 52.56] The add-on for interest rate derivatives within a netting set is calculated using the following steps. Step 1: Calculate the effective notional for each trade in the netting set that is in the rate derivative asset class. The is calculated as the product of the following three terms (i) the adjusted notional of the trade (d); (ii) the supervisory delta adjustment of the trade (δ); and (iii) the maturity factor (MF). That is, for each trade i, D i = d i × δ i × MF i . Step 2: Allocate the trades in the interest rate derivative asset class to hedging sets. In the interest rate derivative asset class the hedging sets consist of all the derivatives that reference the same currency. Step 3: Within each hedging set, allocate each of the trades to the following three maturity buckets: less than one year (bucket 1), between one and five years (bucket 2) and more than five years (bucket 3). Step 4: Calculate the effective notional of each maturity bucket by adding together all the trade-level effective notionals calculated in step 1 of the trades within the maturity bucket. Let D B1 , D B2 and D B3 be the effective notionals of the buckets 1, 2 and 3 respectively. Step 5: Calculate the effective notional of the hedging set ( EN HS ) by using either of the two following aggregation formulas (the latter to be used if the banks chooses not to recognize offsets between long and short positions across maturity buckets): Offset formula: E N HS = D B1 2 + D B2 2 + D B3 2 + 1.4 × D B1 × D B2 + 1.4 × D B2 × D B3 + 0.6 × D B1 × D B3 1 2 No offset formula: EN HS = D B1 + D B2 + D B3 Step 6: Calculate the hedging set level add-on ( AddOn HS ) by multiplying the effective notional of the hedging set ( EN HS ) by the prescribed supervisory factor ( SF HS ). The prescribed supervisory factor in the interest rate asset class is set to 0.5%, which means AddOn HS = EN HS × 0.005 . Step 7: Calculate the asset class level add-on (AddOn^IR) by adding together all of the hedging set level add-ons calculated in step 6. AddOn IR = ∑ HS AddOn HS [Basel Framework, CRE 52.57] 7.1.7.15 Add-on for foreign exchange derivatives The steps to calculate the add-on for foreign exchange derivatives are similar to the steps for the interest rate derivative asset class, except that there is no allocation of trades to maturity buckets (which means that there is full offsetting of long and short positions within the hedging set of the foreign exchange derivative asset class). [Basel Framework, CRE 52.58] The add-on for foreign exchange derivative asset class (AddOn^FX) within a netting set is calculated using the following steps: Step 1: Calculate the effective notional for each trade in the netting set that is in the foreign exchange derivative asset class. This is calculated as the product of the following three terms: (i) the adjusted notional of the trade (d); (ii) the supervisory delta adjustment of the trade^{Footnote 37} (δ); and (iii) the maturity factor (MF). That is, for each trade i, D i = d i × δ i × MF i . Step 2: Allocate the trade in the foreign exchange derivative asset class to hedging sets. In the foreign exchange derivative asset class the hedging sets consist of all the derivatives that reference the same currency pair. Step 3: Calculate the effective notional of each hedging set ( EN HS ) by adding together the trade level effective notionals calculated in step 1. Step 4: Calculate the hedging set level add-on ( AddOn HS ) by multiplying the absolute value of the effective notional of the hedging set ( EN HS ) by the prescribed supervisory factor ( SF HS ). The prescribed supervisory factor in the foreign exchange derivative asset class is set at 4%, which means that AddOn HS = | EN HS | × 0.04 . Step 5: Calculate the asset class level add-on ( AddOn FX ) by adding together all of the hedging set level add-ons calculated in step 4. AddOn FX = ∑ HS AddOn HS [Basel Framework, CRE 52.59] 7.1.7.16 Add-on for credit derivatives The calculation of the add-on for the credit derivative asset class only gives full recognition of the offsetting of long and short positions for derivatives that reference the same entity (e.g. the same corporate issuer of bonds). Partial offsetting is recognized between derivatives that reference different entities in step 4 below. [Basel Framework, CRE 52.60] The add-on for the credit derivative asset class (AddOn^Credit) within a netting set is calculated using the following steps: Step 1: Calculate the effective notional for each trade in the netting set that is in the credit derivative asset class. This is calculated as the product of the following three terms: (i) the adjusted notional of the trade (d); (ii) the supervisory delta adjustment of the trade (δ); and (iii) the maturity factor (MF). That is, for each trade i, D i = d i × δ i × MF i . Step 2: Calculate the combined effective notional for all derivatives that reference the same entity. Each separate credit index that is referenced by derivatives in the credit derivative asset class should be treated as a separate entity. The combined effective notional of the entity ( EN entity ) is calculated by adding together the trade level effective notionals calculated in step 1 that reference that entity. Step 3: Calculate the add-on for each entity ( AddOn entity ) by multiplying the combined effective notional for that entity calculated in step 2 by the supervisory factor that is specified for that entity ( SF entity ). The supervisory factors vary according to the credit rating of the entity in the case of single name derivatives, and whether the index is considered investment grade or non-investment grade in the case of derivatives that reference an index. The supervisory factors are set out in Table 2 in paragraph 162. Step 4: Calculate the asset class level add-on ( AddOn Credit ) by using the formula that follows. In the formula the summations are across all entities referenced by the derivatives, AddOn entity is the add-on amount calculated in step 3 for each entity referenced by the derivatives and ρ entity is the supervisory prescribed correlation factor corresponding to the entity. As set out in Table 2 in paragraph 162, the correlation factor is 50% for single entities and 80% for indices. AddOn Credit = ∑ entity ρ entity × AddOn entity 2 + ∑ entity 1 − ρ entity 2 × AddOn entity 2 1 2 [Basel Framework, CRE 52.61] The formula to recognized partial offsetting in step 4 above, is a single-factor model, which divides the risk of the credit derivative asset class into a systemic component and an idiosyncratic component. The entity level add-ons are allowed to offset each other fully in the systemic component, whereas, there is no offsetting benefit in the idiosyncratic component. These two components are weighted by a correlation factor which determines the degree of offsetting/hedging benefit within the credit derivative asset class. The higher the correlation factor, the higher the importance of the systemic component, hence the higher the degree of offsetting benefits. [Basel Framework, CRE 52.62] It should be noted that a higher or lower correlation does not necessarily mean a higher or lower capital charge. For portfolios consisting of long and short credit positions, a high correlation factor would reduce the charge. For portfolios consisting exclusively of long positions (or short positions), a higher correlation factor would increase the charge. If most of the risk consists of systematic risk, then individual reference entities would be highly correlated and long and short positions should offset each other. If, however, most of the risk is idiosyncratic to a reference entity, then individual long and short positions would not be effective hedges for each other. [Basel Framework, CRE 52.63] The use of a single hedging set for credit derivatives implies that credit derivatives from different industries and regions are equally able to offset the systematic component of an exposure, although they would not be able to offset the idiosyncratic portion. This approach recognizes that meaningful distinctions between industries and/or regions are complex and difficult to analyze for global conglomerates. [Basel Framework, CRE 52.64] 7.1.7.17 Add-on for equity derivatives The calculation of the add-on for the equity derivative asset class is very similar to the calculation of the add-on for the credit derivative asset class. It only gives full recognition of the offsetting of long and short positions for derivatives that reference the same entity (e.g. the same corporate issuer of shares). Partial offsetting is recognized between derivatives that reference different entities in step 4 below. [Basel Framework CRE 52.65] The add-on for the equity derivative asset class ( AddOn Equity ) within a netting set is calculated using the following steps: Step 1: Calculate the effective notional for each trade in the netting set that is in the equity derivative asset class. This is calculated as the product of the following three terms: (i) the adjusted notional of the trade (d); (ii) the supervisory delta adjustment of the trade (δ); and (iii) the maturity factor (MF). That is, for each trade i, D i = d i × δ i × MF i . Step 2: Calculate the combined effective notional for all derivatives that reference the same entity. Each separate equity index that is referenced by derivatives in the equity derivative asset class should be treated as a separate entity. The combined effective notional of the entity ( EN entity ) is calculated by adding together the trade level effective notionals calculated in step 1 that reference that entity. Step 3: Calculate the add-on for each entity ( AddOn entity ) by multiplying the combined effective notional for that entity calculated in step 2 by the supervisory factor that is specified for that entity ( SF entity ). The supervisory factors are set out in Table 2 of paragraph 162 and vary according to whether the entity is a single name ( SF entity = 32%) or an index ( SF entity = 20%). Step 4: Calculate the asset class level add-on ( AddOn Equity ) by using the formula that follows. In the formula the summations are across all entities referenced by the derivatives, AddOn entity is the add-on amount calculated in step 3 for each entity referenced by the derivatives and ρ entity is the supervisory prescribed correlation factor corresponding to the entity. As set out in Table 2 in paragraph 162, the correlation factor is 50% for single entities and 80% for indices. AddOn Equity = ∑ entity ρ entity × AddOn entity 2 + ∑ entity 1 − ρ entity 2 × AddOn entity 2 1 2 [Basel Framework, CRE 52.66] The calibration of the supervisory factors for equity derivatives rely on estimates of the market volatility of equity indices, with the application of a conservative beta factor^{Footnote 38} to translate this estimate into an estimate of individual volatilities. [Basel Framework, CRE 52.67] Institutions are not permitted to make any modelling assumptions in the calculation of the PFE add-ons, including estimating individual volatilities or taking publicly available estimates of beta. This is a pragmatic approach to ensure a consistent implementation across jurisdictions but also to keep the add-on calculation relatively simple and prudent. Therefore, only two values of supervisory factors have been defined for equity derivatives, one for single entities and one for indices. [Basel Framework, CRE 52.68] 7.1.7.18 Add-on for commodity derivatives The calculation of the add-on for the commodity derivative asset class is similar to the calculation of the add-on for the credit and equity derivative asset classes. It recognizes the full offsetting of long and short positions for derivatives that reference the same type of underlying commodity. It also allows partial offsetting between derivatives that reference different types of commodity, however, this partial offsetting is only permitted within each of the four hedging sets of the commodity derivative asset class, where the different commodity types are more likely to demonstrate some stable, meaningful joint dynamics. Offsetting between hedging sets is not recognized (e.g. a forward contract on crude oil cannot hedge a forward contract on corn). [Basel framework, CRE 52.69] The add-on for the commodity derivative asset class ( AddOn Commodity ) within a netting set is calculated using the following steps: Step 1: Calculate the effective notional for each trade in the netting set that is in the commodity derivative asset class. This is calculated as the product of the following three terms: (i) the adjusted notional of the trade (d); (ii) the supervisory delta adjustment of the trade (δ); and (iii) the maturity factor (MF). That is, for each trade i, D i = d i × δ i × MF i . Step 2: Allocate the trades in the commodity derivative asset class to hedging sets. In the commodity derivative asset class there are four hedging sets consisting of derivatives that reference: energy, metals, agriculture and other commodities. Step 3: Calculate the combined effective notional for all derivatives within each hedging set that reference the same commodity type (e.g. all derivatives that reference copper within the metals hedging set). The combined effective notional of the commodity type ( EN ComType ) is calculated by adding together the trade level effective notionals calculated in step 1 that reference the commodity type. Step 4: Calculate the add-on for each commodity type ( AddOn ComType ) within each hedging set by multiplying the combined effective notional for that commodity calculated in step 3 by the supervisory factor that is specified for that commodity type ( SF ComType ). The supervisory factors are set out in Table 2 in paragraph 162 and are set to 40% for electricity derivatives and 18% for derivatives that reference all other types of commodities. Step 5: Calculate the add-on for each of the four commodity hedging sets ( AddOn HS ) by using the formula that follows. In the formula the summations are across all commodity types within the hedging set, AddOn ComType is the add-on amount calculated in step 4 for each commodity type and ρ ComType is the supervisory prescribed correlation factor corresponding to the commodity type. As set out in Table 2 of paragraph 162, the correlation factor is set to 40% for all commodity types. AddOn HS = ∑ ComType ρ ComType × AddOn ComType 2 + ∑ ComType 1 − ρ ComType 2 × AddOn ComType 2 1 2 Step 6: Calculate the asset class level add-on ( AddOn Commodity ) by adding together all of the hedging set level add-ons calculated in step 5: AddOn Commodity = ∑ HS AddOn HS [Basel Framework, CRE 52.70] Regarding the calculation steps above, defining individual commodity types is operationally difficult. In fact, it is impossible to fully specify all relevant distinctions between commodity types so that all basis risk is captured. For example crude oil could be a commodity type within the energy hedging set, but in certain cases this definition could omit a substantial basis risk between different types of crude oil (West Texas Intermediate, Brent, Saudi Light, etc). Also, the four commodity type hedging sets have been defined without regard to characteristics such as location and quality. For example, the energy hedging set contains commodity types such as crude oil, electricity, natural gas and coal. OSFI may require banks to use more refined definitions of commodities when they are significantly exposed to the basis risk of different products within those commodity types. [Basel Framework, CRE 52.71] Supervisory Specific Parameters [Basel Framework, CRE 52.72] Table 2 includes the supervisory factors, correlations and supervisory option volatility add-ons for each asset class and subclass. Table 2 – Summary Table of Supervisory Parameters Asset Class Subclass Supervisory factor Correlation Supervisory option volatility^{Footnote 39} Interest Rate N/A 0.50% N/A 50% Foreign Exchange N/A 4.0% N/A 15% Credit, Single Name AAA 0.38% 50% 100% Credit, Single Name AA 0.38% 50% 100% Credit, Single Name A 0.42% 50% 100% Credit, Single Name BBB 0.54% 50% 100% Credit, Single Name BB 1.06% 50% 100% Credit, Single Name B 1.6% 50% 100% Credit, Single Name CCC 6.0% 50% 100% Credit, Index IG 0.38% 80% 80% Credit, Index SG 1.06% 80% 80% Equity, Single Name N/A 32% 50% 120% Equity, Index N/A 20% 80% 75% Commodity Electricity 40% 40% 150% Commodity Oil/Gas 18% 40% 70% Commodity Metals 18% 40% 70% Commodity Agricultural 18% 40% 70% Commodity Other 18% 40% 70% For credit derivatives where the institution is the protection seller and that are outside netting and margin agreements, the EAD may be capped to the amount of unpaid premiums. Institutions have the option to remove such credit derivatives from their legal netting sets and treat them as individual un-margined transactions in order to apply the cap. For add-on factors, refer to Table 2 of paragraph 162. For a basis transaction hedging set, the supervisory factor applicable to its relevant asset class must be multiplied by one-half. For a volatility transaction hedging set, the supervisory factor applicable to its relevant asset class must be multiplied by a factor of five. [Basel Framework 52.73] 7.1.7.19 Treatment of multiple margin agreements and multiple netting sets If multiple margin agreements apply to a single netting set, (for example: one Credit Support Annex [CSA] for VM and one for Initial Margin [IM]), all collateral collected against the netting set in question can be used to offset exposures as if it were collected in a single netting set, provided the institution has performed sufficient legal review to ensure the requirements of paragraph 103 are satisfied. When multiple CSAs apply to an individual netting set, the RC and PFE are calculated as follows: RC The V and C terms should consider all transactions within a netting set, across all CSAs; and The TH + MTA - NICA is the sum of the thresholds and MTAs across all CSA agreement. PFE In the multiplier term, similarly to RC, the V and C terms should consider all transactions in the netting set across all CSA agreements; and The margin period of risk applied to calculate effective notionals is specific to the individual CSA to which a trade belongs. [Basel Framework, CRE 52.74] If a single margin agreement applies to several netting sets, special treatment is necessary because it is problematic to allocate the common collateral to individual netting sets. The replacement cost at any given time is determined by the sum of two terms. The first term is equal to the unmargined current exposure of the institution to the counterparty aggregated across all netting sets within the margin agreement reduced by the positive current net collateral (i.e. collateral is subtracted only when the institution is a net holder of collateral). The second term is non-zero only when the institution is a net poster of collateral: it is equal to the current net posted collateral (if there is any) reduced by the unmargined current exposure of the counterparty to the institution aggregated across all netting sets within the margin agreement. Net collateral available to the institution should include both VM and NICA. Mathematically, RC for the entire margin agreement is: RC MA = max ∑ NS ∈ MA max V NS ; 0 − max C MA ; 0 ; 0 + max ∑ NS ∈ MA min V NS ; 0 − min C MA ; 0 ; 0 where the summation NS∈MA is across the netting sets covered by the margin agreement (hence the notation), V NS is the current mark-to-market value of the netting set NS and C MA is the cash equivalent value of all currently available collateral under the margin agreement. [Basel Framework 52.75] Where a single margin agreement applies to several netting sets as described in paragraph 166, collateral will be exchanged based on mark-to-market values that are netted across all transactions covered under the margin agreement, irrespective of netting sets. That is, collateral exchanged on a net basis may not be sufficient to cover PFE. In this situation, therefore, the PFE add-on must be calculated according to the unmargined methodology. Netting set-level PFEs are then aggregated. Mathematically: PFE MA = ∑ NS ∈ MA PFE NS ( unmargined ) where PFE NS (unmargined) is the PFE add-on for the netting set NS calculated according to the unmargined requirements. For the calculation of the multiplier of the PFE of each individual netting set covered by a single margin agreement or collateral amount, the available collateral C (which, in the case of a variation margin agreement, includes variation margin posted or received) should be allocated to the netting sets as follows: If the institution is a net receiver of collateral (C>0), all of the individual amounts allocated to the individual netting sets must also be positive or zero. Netting sets with positive market values must first be allocated collateral up to the amount of those market values. Only after all positive market values have been compensated may surplus collateral be attributed freely among all netting sets. If the institution is a net provider of collateral (C<0), all of the individual amounts allocated to the individual netting sets must also be negative or zero. Netting sets with negative market values must first be allocated collateral up to the amount of their market values. If the collateral provided is larger than the sum of the negative market values, then all multipliers must be set equal to 1 and no allocation is necessary. The allocated parts must add up to the total collateral available for the margin agreement. Apart from these limitations, institutions may allocate available collateral at their discretion. The multiplier is then calculated per netting set according to paragraph 118 taking the allocated amount of collateral into account. [Basel Framework 52.76] Eligible collateral which is taken outside a netting set, but is available to a bank to offset losses due to counterparty default on one netting set only, should be treated as an independent collateral amount associated with the netting set and used within the calculation of replacement cost in paragraph 105 when the netting set is unmargined and in paragraph 113 when the netting set is margined. Eligible collateral which is taken outside a netting set, and is available to a bank to offset losses due to counterparty default on more than one netting set, should be treated as collateral taken under a margin agreement applicable to multiple netting sets, in which case the treatment in paragraphs 166 and 167 applies. If eligible collateral is available to offset losses on non-derivatives exposures as well as exposures determined using the SA-CCR, only that portion of the collateral assigned to the derivatives may be used to reduce the derivatives exposure. 7.1.7.20 Treatment of trades subject to Specific Wrong-Way Risk and Specific Right-Way Risk The requirements for trades where SWWR or SRWR has been identified outlined in paragraphs 65 and 66, respectively, also apply to trades where the exposure is measured using the SACCR.

7.1.8 Central Counterparties

When the clearing member-to-client leg of an exchange-traded derivative transaction is conducted under a bilateral agreement, both the client and the clearing member are to capitalize that transaction as an OTC derivative.^{Footnote 40} This treatment also applies to transactions between lower-level clients and higher-level clients in a multi-level client structure. [Basel Framework, CRE 54.2] Regardless of whether a CCP is classified as a QCCP, an institution retains the responsibility to ensure that it maintains adequate capital for its exposures. Under the ICAAP, an institution should consider whether it might need to hold capital in excess of the minimum capital requirements if, for example, (i) its dealings with a CCP give rise to more risky exposures or (ii) where, given the context of that institution's dealings, it is unclear that the CCP meets the definition of a QCCP or (iii) an external assessment such as an International Monetary Fund Financial Sector Assessment Program has found material shortcomings in the CCP or regulation of CCPs, and the CCP and/or CCP regulator have not since publicly addressed the identified issues. [Basel Framework, CRE 54.3] Where the institution is acting as a clearing member, the institution should assess through appropriate scenario analysis and stress testing whether the level of capital held against exposures to a CCP adequately addresses the inherent risks of those transactions. This assessment will include potential future or contingent exposures resulting from future drawings on default fund commitments, and/or from secondary commitments to take over or replace offsetting transactions from clients of another clearing member in case of this clearing member defaulting or becoming insolvent. [Basel Framework, CRE 54.4] An institution must monitor and report to senior management on a regular basis all of its exposures to CCPs, including exposures arising from trading through a CCP and exposures arising from CCP membership obligations such as default fund contributions. [Basel Framework, CRE 54.5] Where an institution is clearing derivative, SFT and/or long settlement transactions through a Qualifying CCP (QCCP) as defined in paragraph 3, then paragraphs 175 to 207 of this Chapter will apply. In the case of non-qualifying CCPs, paragraphs 208 and 209 of this Chapter will apply. Within three months of a central counterparty ceasing to qualify as a QCCP, unless OSFI requires otherwise, the trades with a former QCCP may continue to be capitalized as though they are with a QCCP. After that time, the bank's exposures with such a central counterparty must be capitalized according to paragraphs 208 and 209 of this Chapter. [Basel Framework, CRE 54.6] 7.1.8.1 Exposures to Qualifying CCPs A. Trade exposures (i) Clearing member exposures to CCPs Where an institution acts as a clearing member of a CCP for its own purposes, a risk weight of 2% must be applied to the institution's trade exposure to the CCP in respect of OTC derivatives, exchange-traded derivative transactions, SFTs and long-settlement transactions. Where the clearing member offers clearing services to clients, the 2% risk weight also applies to the clearing member's trade exposure to the CCP that arises when the clearing member is obligated to reimburse the client for any losses suffered due to changes in the value of its transactions in the event that the CCP defaults. The risk weight applied to collateral posted to the CCP by the institution must be determined in accordance with paragraphs 185 to 188. [Basel Framework, CRE 54.7] The exposure amount for such trade exposure is to be calculated in accordance with this chapter using the IMM or the SACCR, as consistently applied by such an institution to such an exposure in the ordinary course of its business, or Chapter 4 for collateralized transactions. In applying these methods: The 20-day floor for the margin period of risk (MPOR) as established in the first bullet point of paragraph 40 (IMM) and 142 (SACCR) dealing with the number of transactions will not apply, provided that the netting set does not contain illiquid collateral or exotic trades and provided there are no disputed trades. This refers to exposure calculations under the IMM and the SACCR as well as for the holding periods entering the exposure calculation of repo-style transactions in Chapter 4. In all cases, a minimum MPOR of 10 days must be used for the calculation of trade exposures to CCPs for OTC derivatives. Where CCPs retain variation margin against certain trades (e.g. where CCPs collect and hold variation margin against positions in exchange-traded or OTC forwards), and the member collateral is not protected against the insolvency of the CCP, the minimum time risk horizon applied to institutions' trade exposures on those trades must be the lesser of one year and the remaining maturity of the transaction, with a floor of 10 business days. [Basel Framework, CRE 54.8] The methods for calculating counterparty credit risk exposures, when applied to bilateral trading exposures (i.e. non-CCP counterparties), require banks to calculate exposures for each individual netting set. However, netting arrangements for CCPs are not as standardized as those for OTC netting agreements in the context of bilateral trading. As a consequence, paragraph 178 below makes certain adjustments to the methods for calculating counterparty credit risk exposure to permit netting under certain conditions for exposures to CCPs. [Basel Framework, CRE 54.9] Where settlement is legally enforceable on a net basis in an event of default and regardless of whether the counterparty is insolvent or bankrupt, the total replacement cost of all contracts relevant to the trade exposure determination can be calculated as a net replacement cost if the applicable close-out netting sets meet the requirements set out in: Paragraphs 252 and, where applicable, also 253 of Chapter 4 in the case of repo-style transactions, Paragraph 103 of this Chapter in the case of derivative transactions, and Paragraphs 83 to 92 of this Chapter in the case of cross-product netting. To the extent that the rules referenced above include the term "master agreement" or the phrase "a netting contract with a counterparty or other agreement", this terminology must be read as including any enforceable arrangement that provides legally enforceable rights of set-off.^{Footnote 41} If the institution cannot demonstrate that netting agreements meet these requirements, each single transaction will be regarded as a netting set of its own for the calculation of trade exposure. [Basel Framework, CRE 54.10 and 54.11] (ii) Clearing member exposures to clients The clearing member will always capitalize its exposure (including potential CVA risk exposure) to clients as bilateral trades, irrespective of whether the clearing member guarantees the trade or acts as an intermediary between the client and the CCP. However, to recognize the shorter close-out period for cleared client transactions, clearing members can capitalize the exposure to their clients applying a margin period of risk of at least five days in IMM or SA-CCR.^{Footnote 42} [Basel Framework, CRE 54.12] If a clearing member collects collateral from a client for client cleared trades and this collateral is passed on to the CCP, the clearing member may recognize this collateral for both the CCP-clearing member leg and the clearing member-client leg of the client cleared trade. Therefore, initial margin posted by clients to their clearing member mitigates the exposure the clearing member has against these clients. The same treatment applies, in an analogous fashion, to multi-level client structures (between a higher level client and a lower level client). [Basel Framework, CRE 54.13] (iii) Client exposures Subject to the two conditions set out in paragraph 182 below being met, the treatment set out in paragraphs 175 to 178 above (i.e. the treatment of clearing member exposures to CCPs) also applies to the following: An institution's exposure to a clearing member where: The institution is a client of the clearing member; and The transactions arise as a result of the clearing member active as a financial intermediary (i.e. the clearing member completes an offsetting transaction with a CCP). An institution's exposure to a CCP resulting from a transactions with the CCP where: The institution is a client of a clearing member; and The clearing member guarantees the performance of the institution's exposure to the CCP. Exposures of lower-level clients to higher-level clients in a multi-level client structure, provided that for all clients levels in-between the two conditions in paragraph 182 below are met. [Basel Framework, CRE 54.14] The two conditions referenced in paragraph 181 above are: The offsetting transactions are identified by the CCP as client transactions and collateral to support them is held by the CCP and/or the clearing member, as applicable, under arrangements that prevent any losses to the client due to: (a) the default or insolvency of the clearing member; (b) the default or insolvency of the clearing member's other clients; and (c) the joint default or insolvency of the clearing member and any of its other clients. Regarding the condition set out in this paragraph: Upon the insolvency of the clearing member, there must be no legal impediment (other than the need to obtain a court order to which the client is entitled) to the transfer of the collateral belonging to clients of a defaulting clearing member to the CCP, to one or more other surviving clearing members or to the client or the client's nominee. The client must have conducted a sufficient legal review (and undertake such further review as necessary to ensure continuing enforceability) and have a well founded basis to conclude that, in the event of legal challenge, the relevant courts and administrative authorities would find that such arrangements mentioned above would be legal, valid, binding and enforceable under the relevant laws of the relevant jurisdiction(s). Relevant laws, regulation, rules, contractual, or administrative arrangements provide that the offsetting transactions with the defaulted or insolvent clearing member are highly likely to continue to be indirectly transacted through the CCP, or by the CCP, if the clearing member defaults or becomes insolvent. In such circumstances, the client positions and collateral with the CCP will be transferred at market value unless the client requests to close out the position at market value. Regarding the condition set out in this paragraph, if there is a clear precedent for transactions being ported at a CCP and industry intent for this practice to continue, then these factors must be considered when assessing if trades are highly likely to be ported. The fact that CCP documentation does not prohibit client trades from being ported is not sufficient to say they are highly likely to be ported. [Basel Framework, CRE 54.15] Where a client is not protected from losses in the case that the clearing member and another client of the clearing member jointly default or become jointly insolvent, but all other conditions in the preceding paragraph are met, a risk weight of 4% will apply to the client's exposure to the clearing member, or to the higher level client, respectively. [Basel Framework, CRE 53.16] Where the institution is a client of the clearing member and the requirements in paragraphs 181 to 183 are not met, the institution will capitalize its exposure (including potential CVA risk exposure) to the clearing member as a bilateral trade. [Basel Framework, CRE 54.17] (iv) Treatment of posted collateral In all cases, any assets or collateral posted must, from the perspective of the institution posting such collateral, receive the risk weights that otherwise applies to such assets or collateral under the capital adequacy framework, regardless of the fact that such assets have been posted as collateral.^{Footnote 43} That is, collateral posted must receive the banking book or trading book treatment it would receive if it had not been posted to the CCP. [Basel Framework, CRE 54.18] In addition to the requirements in paragraph 185 above, the posted assets or collateral are subject to counterparty credit risk requirements, regardless of whether they are in the banking or trading book. This includes the increase in the counterparty credit risk exposure due to the application of haircuts. The counterparty credit risk requirements arise where assets or collateral of a clearing member or client are posted with a CCP or a clearing member and are not held in a bankruptcy remote manner. In such cases, the institution posting such assets or collateral must also recognize the credit risk based upon the assets or collateral being exposed to risk of loss based on the creditworthiness of the entity holding such assets or collateral, as described further below. [Basel Framework, CRE 54.19] Where such collateral is included in the definition of trade exposures and the entity holding the collateral is the CCP, the following risk weights apply where the assets or collateral is not held on a bankruptcy-remote basis: For institutions that are clearing members a risk-weight of 2% applies. For institutions that are clients of clearing members: A 2% risk weight applies if the conditions in paragraph 181 and 182 are met; or A 4% risk weight applied if the conditions in paragraph 183 are met [Basel Framework, CRE 54.20] Where such collateral is included in the definition of trades exposures, there is no capital requirement for counterparty credit risk exposures if the collateral is: (a) held by a custodian;^{Footnote 44} and (b) bankruptcy remote from the CCP. Regarding this paragraph, all forms of collateral are included, such as: cash, securities, other pledged assets, and excess initial or variation margin, also called overcollateralization, that is held by a custodian, and is bankruptcy remote from the CCP, is not subject to a capital requirement for counterparty credit risk exposure to such bankruptcy remote custodian (i.e. the related risk weight or EAD is equal to zero). [Basel Framework, CRE 54.21] The relevant risk weight of the CCP will apply to assets or collateral posted by a bank that do not meet the definition of trade exposures (for example, treating the exposure as a financial institution under the standardized approach or internal ratings-based approach to credit risk). [Basel Framework, CRE 54.22] Regarding the calculation of the exposure, or EAD, where banks use the SA-CCR to calculate exposures, collateral posted which is not held in a bankruptcy remote manner must be accounted for in the net independent collateral amount term in accordance with paragraph 110 to 114. For banks using IMM models, the alpha multiplier must be applied to the exposure on posted collateral. [Basel Framework, CRE 54.23] B. Default fund exposures Where a default fund is shared between products or types of business with settlement risk only (e.g. equities and bonds) and products or types of business which give rise to counterparty credit risk (i.e. OTC derivatives, exchange-traded derivatives, SFTs or long settlement transactions), all of the default fund contributions will receive the risk weight determined according to the formulae and methodology set forth below, without apportioning to different classes or types of business or products. However, where the default fund contributions from clearing members are segregated by product types and only accessible for specific product types, the capital requirements for those default fund exposures determined according to the formulae and methodology set forth below must be calculated for each specific product giving rise to counterparty credit risk. In case the CCP's prefunded own resources are shared among product types, the CCP will have to allocate those funds to each of the calculations, in proportion to the respective product specific EAD. [Basel Framework, CRE 54.24] Whenever an institution is required to capitalize for exposures arising from default fund contributions to a QCCP, clearing member institutions will apply the following approach. [Basel Framework, CRE 54.25] Clearing member institutions will apply a risk weight to their default fund contributions determined according to a risk sensitive formula that considers (i) the size and quality of a qualifying CCP's financial resources, (ii) the counterparty credit risk exposures of such CCP, and (iii) the application of such financial resources via the CCP's loss bearing waterfall, in the case of one or more clearing member defaults. The clearing member institution's risk sensitive capital requirement for its default fund contribution ( K CM i ) must be calculated using the formulae and methodology set forth below. This calculation may be performed by a CCP, institution, supervisor or other body with access to the required data, as long as the conditions in paragraphs 204 to 206 are met. [Basel Framework, CRE 54.26] The clearing member bank's risk-sensitive capital requirement for its default fund contribution ( K CMi ) is calculated in two steps: Calculate the hypothetical capital requirement of the CCP due to its counterparty credit risk exposures to all of its clearing members and their clients. Calculate the capital requirement for the clearing member institution. [Basel Framework, CRE 54.27] Hypothetical Capital Requirement of the CCP The first step in calculating the clearing member institution's capital requirement for its default fund contribution is to calculate the hypothetical capital requirement of the CCP ( K CCP ) due to its counterparty credit risk exposures to all of its clearing members and their clients. K CCP is a hypothetical capital requirement for a CCP, calculated on a consistent basis for the sole purpose of determining the capitalization of clearing member default fund contributions; it does not represent the actual capital requirements for a CCP which may be determine by a CCP and its supervisor. [Basel Framework, CRE 54.28] K CCP is calculated using the following formula K CCP = ∑ CM i EAD i × RW × capital ratio where RW is a risk weight of 20%.^{Footnote 45} Capital ratio means 8%. CM is the clearing member. EAD i is the exposure amount of the CCP to CM 'i', including both the CM's own transactions and client transactions guaranteed by the CM, and all values of collateral held by the CCP (including the CM's prefunded default fund contribution) against these transactions, relating to the valuation at the end of the regulatory reporting date before the margin called on the final margin call of that day is exchanged. The sum is over all clearing member accounts. [Basel Framework, CRE 54.29] Where clearing members provide client clearing services, and client transactions and collateral are held in separate (individual or omnibus) sub-accounts to the clearing member's proprietary business, each such client sub-account should enter the sum in paragraph 196 separately, i.e. the member EAD in the formula above is then the sum of the client sub-account EADs and any house sub-account EAD. This will ensure that client collateral cannot be used to offset the CCP's exposures to clearing members' proprietary activity in the calculation of K CCP . If any of these sub-accounts contains both derivatives and SFTs, the EAD of that sub-account is the sum of the derivative EAD and the SFT EAD. [Basel Framework, CRE 54.30] In the case that collateral is held against an account containing both SFTs and derivatives, the prefunded initial margin provided by the member or client must be allocated to the SFT and derivatives exposures in proportion to the respective product specific EADs, calculated according to Chapter 4 for SFTs and the SACCR in this chapter (without including the effects of collateral) for derivatives. [Basel Framework, CRE 54.31] If the default fund contributions of the member ( DF i ) are not split with regard to client and house sub-accounts, they must be allocated per sub-account according to the respective fraction the initial margin of that sub-account has in relation to the total initial margin posted by or for the account of the clearing member. [Basel Framework, CRE 54.32] For derivatives, EAD i is calculated as the bilateral trade exposure the CCP has against the clearing member using the SACCR.^{Footnote 46} ^{Footnote 47} In applying the SACCR: A MPOR of 10 days must be used to calculate the CCP's potential future exposure to its clearing members on derivatives transactions (the 20 day floor on the MPOR for netting sets with more than 5,000 trades does not apply). All collateral held by a CCP to which that CCP has a legal claim in the event of the default of the member or client, including default fund contributions of that member (DFi), is used to offset the CCP's exposure to that member or client, through inclusion in the PFE multiplier in accordance with paragraphs 117 to 118 of this Chapter. [Basel Framework, CRE 54.33] For SFTs, EAD is equal to max ( EBRM i − IM i − DF i ; 0 ) , where EBRM i denotes the exposure value to clearing member 'i' before risk mitigation under Chapter 4; where, for the purposes of this calculation, variation margin that has been exchanged (before the margin called on the final margin call of that day) enters into the mark-to-market value of the transactions; IM i is the initial margin collateral posted by the clearing member with the CCP; DF i is the prefunded default fund contribution by the clearing member that will be applied upon such clearing member's default, either along with or immediately following such member's initial margin, to reduce the CCP loss. [Basel Framework, CRE 54.34] As regards the calculation in this first step (i.e. paragraphs 195 to 201): Any haircuts to be applied for SFTs must be the standard supervisory haircuts in Chapter 4. The holding periods for SFT calculations in Chapter 4 and those. The netting sets that are applicable to regulated clearing members are the same as those referred to in paragraph 177. For all other clearing members, they need to follow the netting rules as laid out by the CCP based upon notification of each of its clearing members. OSFI can demand more granular netting sets than laid out by the CCP. [Basel Framework, CRE 54.35] Capital Requirement for Each Clearing Member The second step in calculating the clearing member institution's capital requirement for its default fund contributions ( K CMi ) is to apply the following formula: K CM i = max K CCP × DF i pref DF CCP + DF CM pref ; 8 % × 2 % × DF i pref where K CMi is the capital requirements on the default contribution of member i; DF CM pref is the total prefunded default fund contributions from clearing members; DF CCP is the CCP's prefunded own resources (e.g. contributed capital, retained earnings, etc), which are contributed to the default waterfall, where these are junior or pari passu to prefunded member contributions; and DF i pref is the prefunded default fund contributions provided by clearing member i. [Basel Framework, CRE 54.36] The CCP, institution, OSFI or other body with access to the required data, must make a calculation of K CCP , DF CM pref , and DF CCP in such a way to permit the supervisor of the CCP to oversee those calculations, and it must share sufficient information of the calculation results to permit each clearing member to calculate their capital requirement for the default fund and for the supervisor of such clearing member to review and confirm such calculations. [Basel Framework, CRE 54.37] K CCP must be calculated on a quarterly basis at a minimum; although national supervisors may require more frequent calculations in case of material changes (such as the CCP clearing a new product). The CCP, institution, supervisor or other body that did the calculations must make available to the home supervisor of any clearing member sufficient aggregate information about the composition of the CCP's exposures to clearing members and information provided to the clearing member for the purposes of the calculation of K CCP , DF CM pref , and DF CCP . Such information must be provided no less frequently than OSFI would require for monitoring the risk of the clearing member that it supervises. [Basel Framework, CRE 54.38] K CCP and K CMi must be recalculated at least quarterly, and should also be recalculated when there are material changes to the number or exposure of cleared transactions or material changes to the financial resources of the CCP. [Basel Framework, CRE 54.39] C. Cap with regard to QCCPs Where the sum of an institution's capital charges for exposures to a qualifying CCP due to its trade exposure and default fund contribution is higher than the total capital charge that would be applied to those same exposures if the CCP were for a non-qualifying CCP, as outlined in paragraphs 208 and 209 of this Chapter, the latter total capital charge shall be applied. [Basel Framework, CRE 54.40] 7.1.9.1 Exposures to Non-qualifying CCPs Institutions must apply the standardized approach for credit risk in Chapter 4, according to the category of the counterparty, to their trade exposure to a non-qualifying CCP. [Basel Framework, CRE 54.41] Institutions must deduct from CET1 capital their amount of default fund contributions to a non-qualifying CCP. For the purposes of this paragraph, the default fund contributions of such institutions will include both the funded and the unfunded contributions which are liable to be paid should the CCP so require. Where there is a liability for unfunded contributions (i.e. unlimited binding commitments) OSFI will determine in its Pillar 2 assessments the amount of unfunded commitments which must be deducted from CET1 capital amounts. [Basel Framework, CRE 54.42]

7.2. Capital treatment for failed trades and non-DvP transactions

[previously Annex 3]

The capital requirement for failed trades and non-DvP transactions outlined in this Chapter applies in addition to (i.e. it does not replace) the requirements for the transactions themselves under this framework.

7.2.1 Overarching principles

Institutions should continue to develop, implement and improve systems for tracking and monitoring the credit risk exposures arising from unsettled and failed transactions as appropriate for producing management information that facilitates action on a timely basis. [Basel Framework, CRE 70.2] Transactions settled through a delivery-versus-payment system (DvP),^{Footnote 48} providing simultaneous exchanges of securities for cash, expose firms to a risk of loss on the difference between the transaction valued at the agreed settlement price and the transaction valued at current market price (i.e. positive current exposure). Transactions where cash is paid without receipt of the corresponding receivable (securities, foreign currencies, gold, or commodities) or, conversely, deliverables were delivered without receipt of the corresponding cash payment (non-DvP, or free-delivery) expose firms to a risk of loss on the full amount of cash paid or deliverables delivered. The current rules set out specific capital charges that address these two kinds of exposures. [Basel Framework, CRE 70.3 and 70.4] The following capital treatment is applicable to all transactions on securities, foreign exchange instruments, and commodities that give rise to a risk of delayed settlement or delivery. This includes transactions through recognized clearing houses and central counterparties that are subject to daily mark-to-market and payment of daily variation margins and that involve a mismatched trade.^{Footnote 49} The treatment does not apply to the instruments that are subject to the counterparty credit risk requirements set out in section 7.1 or the credit risk mitigation section of chapter 4 of this guideline (i.e. over-the-counter derivatives, exchange-traded derivatives, long settlement transactions, securities financing transactions). [Basel Framework, CRE 70.5] In cases of a system wide failure of a settlement, clearing system or central counterparty, a national supervisor may use its discretion to waive capital charges until the situation is rectified. [BCBS June 2006 Annex 3 par 4] and [Basel Framework, CRE 70.7] Failure of a counterparty to settle a trade in itself will not be deemed a default for purposes of credit risk under this guideline. [Basel Framework, CRE 70.8] In applying a risk weight to failed free-delivery exposures, institutions using the IRB approach for credit risk may assign PDs to counterparties for which they have no other banking book exposure on the basis of the counterparty's external rating. Institutions using the Advanced IRB approach may use a 45% LGD in lieu of estimating LGDs so long as they apply it to all failed trade exposures. Alternatively, institutions using the IRB approach may opt to apply the standardized approach risk weights or a 100% risk weight. [Basel Framework, CRE 70.10]

7.2.2 Capital requirements

For DvP transactions, if the payments have not yet taken place five business days after the settlement date, firms must calculate a capital charge by multiplying the positive current exposure of the transaction by the appropriate factor, according to the Table 3. Table 3 Number of working days after the agreed settlement date Corresponding risk multiplier From 5 to 15 8% From 16 to 30 50% From 31 to 45 75% 46 or more 100% [Basel Framework, CRE 70.9] For non-DvP transactions (i.e. free deliveries), after the first contractual payment/delivery leg, the institution that has made the payment will treat its exposure as a loan if the second leg has not been received by the end of the business day.^{Footnote 50} This means that an institution under the IRB approach will apply the appropriate IRB formula set out in this guideline, for the exposure to the counterparty, in the same way as it does for all other banking book exposures. Similarly, institutions under the standardized approach will use the standardized risk weights set forth in this guideline. However, when exposures are not material, institutions may choose to apply a uniform 100% risk-weight to these exposures, in order to avoid the burden of a full credit assessment. If five business days after the second contractual payment/delivery date the second leg has not yet effectively taken place, the institution that has made the first payment leg will deduct from capital the full amount of the value transferred plus replacement cost, if any. This treatment will apply until the second payment/delivery leg is effectively made. [Basel Framework, CRE 70.4]

Footnotes

Footnote 1 The Basel Framework Return to footnote 1 Footnote 2 Following the format: [Basel Framework XXX yy.zz]. Return to footnote 2 Footnote 3 In this document, the terms "exposure at default" and "exposure amount" are used together in order to identify measures of exposure under both an internal ratings-based (IRB) and a standardized approach for credit risk. Return to footnote 3 Footnote 4 For the purposes of this chapter, where a CCP has a link to a second CCP, that second CCP is to be treated as a clearing member of the first CCP. Whether the second CCP's collateral contribution to the first CCP is treated as initial margin or a default fund contribution will depend upon the legal arrangement between the CCPs. OSFI should be consulted to determine the treatment of this initial margin and default fund contributions. Return to footnote 4 Footnote 5 For the purposes of this definition, the current exposure of a clearing member includes the variation margin due to the clearing member but not yet received. Return to footnote 5 Footnote 6 Transactions for which the probability of default is defined on a pooled basis are not included in this treatment of CCR. Return to footnote 6 Footnote 7 The terms "exposure" and "EAD" are used interchangeably in the counterparty credit risk chapters of the credit risk standard. This reflects the fact that the amounts calculated under the counterparty credit risk rules must typically be used as either the "exposure" within the standardized approach to credit risk, or the EAD within the internal ratings-based (IRB) approach to credit risk, as described in paragraph 13. Return to footnote 7 Footnote 8 For contributions to prepaid default funds covering settlement-risk-only products, the applicable risk weight is 0%. Return to footnote 8 Footnote 9 Where a single margin agreement applies to multiple netting sets and the SA-CCR is used, refer to paragraphs 166 to 167. Return to footnote 9 Footnote 10 In theory, the expectations should be taken with respect to the actual probability distribution of future exposure and not the risk-neutral one. OSFI recognizes that practical considerations may make it more feasible to use the risk-neutral one. As a result, OSFI will not mandate which kind of forecasting distribution to employ. Return to footnote 10 Footnote 11 Conceptually, M equals the effective credit duration of the counterparty exposure. A bank that uses an internal model to calculate a one-sided credit valuation adjustment (CVA) can use the effective credit duration estimated by such a model in place of the above formula with prior approval of OSFI. Return to footnote 11 Footnote 12 "Risk measures" refers not only to Effective EPE, the risk measure used to derive regulatory capital, but also to the other risk measures used in the calculation of Effective EPE such as the exposure distribution at a series of future dates, the positive exposure distribution at a series of future dates, the market risk factors used to derive those exposures and the values of the constituent trades of a portfolio. Return to footnote 12 Footnote 13 This section draws heavily on the Counterparty Risk Management Policy Group's paper, Improving Counterparty Risk Management Practices (June 1999). Return to footnote 13 Footnote 14 Note that the recoveries may also be possible on the underlying instrument beneath such swap. The capital requirements for such underlying exposure are to be calculated without reduction for the swap which introduces wrong way risk. Generally this means that such underlying exposure will receive the risk weight and capital treatment associated with an unsecured transaction (i.e. assuming such underlying exposure is an unsecured credit exposure). Return to footnote 14 Footnote 15 Trade types listed in paragraph 69 do not automatically qualify for a zero EAD. Banks must perform their due diligence to ensure the trade would have a zero EAD if the counterparty were to default. Return to footnote 15 Footnote 16 Amendment to the Capital Accord to Incorporate Market Risk, Basel Committee on banking Supervision (1996), Part B.1., "General Criteria". Return to footnote 16 Footnote 17 These Cross-Product Netting Rules apply specifically to netting across SFTs, or to netting across both SFTs and OTC derivatives, for purposes of regulatory capital computation under IMM. They do not revise or replace the rules that apply to recognition of netting within the OTC derivatives, repo-style transaction, and margin lending transaction product categories under this guideline. The rules in this guideline continue to apply for purposes of regulatory capital recognition of netting within product categories under IMM or other relevant methodology. Return to footnote 17 Footnote 18 EAD can be set to zero for sold options that are outside of netting and margin agreements. Options sold outside of a margin agreement but inside a netting agreement do not qualify for EAD to be set at zero. Return to footnote 18 Footnote 19 Currencies listed in the CSA are not subject to additional haircuts. Return to footnote 19 Footnote 20 In instances where trades are removed from the netting set in which they naturally belong and are moved to a separate netting set solely for the purposes of calculating EAD, it is permissible to allocate collateral to these transactions. An example of such an instance would be Specific Wrong Way Risk (WWR) transactions which are required to each be moved to their own standalone netting set. Return to footnote 20 Footnote 21 The netting contract must not contain any clause which, in the event of default of a counterparty, permits a non-defaulting counterparty to make limited payments only, or no payments at all, to the estate of the defaulting party, even if the defaulting party is a net creditor. Return to footnote 21 Footnote 22 Thus, if any of these supervisors is dissatisfied about enforceability under its laws, the netting contract or agreement will not meet this condition and neither counterparty could obtain supervisory benefit. Return to footnote 22 Footnote 23 For example, the 1992 (Multicurrency-Cross Border) Master Agreement and the 2002 Master Agreement published by the International Swaps & Derivatives Association, Inc. (ISDA Master Agreement). The ISDA Master Agreement includes the ISDA CSA: the 1994 Credit Support Annex (Security Interest – New York Law), or, as applicable, the 1995 Credit Support Annex (Transfer – English Law) and the 1995 Credit Support Deed (Security Interest – English Law). Return to footnote 23 Footnote 24 For example, in the ISDA Master Agreement, the term "Credit Support Amount", or the overall amount of collateral that must be delivered between the parties, is defined as the greater of the Secured Party's Exposure plus the aggregate of all Independent Amounts applicable to the Pledgor minus all Independent Amounts applicable to the Secured Party, minus the Pledgor's Threshold and zero. Return to footnote 24 Footnote 25 Eurodollar example does not include the effect of margining or settlement and would apply only in the case where a futures contract were neither margined nor settled. Concerning the end date ( E i ), the value of 1.25 years applies. Note that per paragraph 146, the parameter E i defines the maturity bucket for the purpose of netting. This means that the trade of this example will be attributed to the intermediate maturity bucket "between one and five years" and not to the short maturity bucket "less than one year" irrespective of daily settlement Return to footnote 25 Footnote 26 There is a distinction between the time period of the underlying transaction and the remaining maturity of the derivative contract. For example, a European interest rate swaption with expiry of one year and the term of the underlying swap of five years has Si = one year and Ei = six years. Return to footnote 26 Footnote 27 "Long in the primary risk factor" means that the market value of the instrument increases when the value of the primary risk factor increases. Return to footnote 27 Footnote 28 "Short in the primary risk factor" means that the market value of the instrument decreases when the value of the primary risk factor increases. Return to footnote 28 Footnote 29 The symbol Φ in these equations represents the standard normal cumulative distribution function. Return to footnote 29 Footnote 30 First-to-default, second-to-default and subsequent-to-default credit derivative transactions should be treated as CDO tranches under the SACCR. For an nth-to-default transaction on a pool of m reference names, banks must use an attachment point of A=(n–1)/m and a detachment point of D=n/m in order to calculate the supervisory delta formula set out paragraph 133. Return to footnote 30 Footnote 31 This assumes for the strike price that K i + λ j is also greater than zero, otherwise a greater value needs to be chosen for λ j . λ adjustment values which are unique to each currency. Return to footnote 31 Footnote 32 This assumes for the strike price that K i + λ j is also greater than zero, otherwise a greater value needs to be chosen for λ j . λ adjustment values which are unique to each commodity type. Return to footnote 32 Footnote 33 Derivatives with two floating legs that are denominated in different currencies (such as cross-currency swaps) are not subject to this treatment; rather, they should be treated as non-basis foreign exchange contracts. Return to footnote 33 Footnote 34 Within this hedging set, long and short positions are determined with respect to the basis. Return to footnote 34 Footnote 35 Number of effective constituents = ∑ i share price i × number of shares i 2 ∑ i share price i × number of shares i 2 Return to footnote 35 Footnote 36 Inflation derivatives may be treated in the same manner as interest rate derivatives. Derivatives referencing inflation rates for the same currency should form a separate hedging set and should be subjected to the same 0.5% supervisory factor. AddOn amounts from inflation derivatives must be added to Addon IR mentioned in step 7 of the paragraph 147. Return to footnote 36 Footnote 37 For foreign exchange options, the ordering of the respective currency pair will impact the calculation of the supervisory delta adjustment. As such, for each currency pair, the same ordering convention must be used consistently across an institution and over time. The convention is to be chosen in such a way that it corresponds best to the market practice for how derivatives in the respective currency pair are usually quoted and traded. Return to footnote 37 Footnote 38 The beta of an individual equity measures the volatility of the stock relative to a broad market index. A value of beta greater than one means the individual equity is more volatile than the index. The greater the beta is, the more volatile the stock. The beta is calculated by running a linear regression of the stock on the broad index. Return to footnote 38 Footnote 39 For swaptions for all currencies, a 50% supervisory option volatility should be used. Return to footnote 39 Footnote 40 For this purpose, the treatment in paragraph 179 would also apply. Return to footnote 40 Footnote 41 This is to take account of the fact that netting arrangements for CCPs are not as standardized as those for OTC netting agreements in the context of bilateral trading; however, netting is generally provided for in CCP rules. Return to footnote 41 Footnote 42 The reduced EAD should also be used for the calculation of both the Advanced and Standardized CVA capital charge. Return to footnote 42 Footnote 43 Collateral posted must receive the banking book or trading book treatment it would receive if it had not been posted to the CCP. In addition, this collateral is subject to the CCR framework of the Basel rules, regardless of whether it is in the banking or trading book. This includes the increase due to haircuts under either the standardized supervisory haircuts or the own estimates. Return to footnote 43 Footnote 44 In this paragraph, the word "custodian" may include a trustee, agent, pledgee, secured creditor or any other person that holds property in a way that does not give such person a beneficial interest in such property and will not result in such property being subject to legally-enforceable claims by such persons creditors, or to a court-ordered stay of the return of such property, if such person becomes insolvent or bankrupt. Return to footnote 44 Footnote 45 The 20% risk weight is a minimum requirement. As with other parts of the capital adequacy framework, OSFI may increase the risk weight. An increase in such risk weight would be appropriate if, for example, the clearing members in a CCP are not highly rated. Any such increase in risk weight is to be communicated by the affected institutions to the person completing this calculation. Return to footnote 45 Footnote 46 A MPOR of 10 days must be used to calculate the CCP's potential future exposure to its clearing members on derivatives transactions Return to footnote 46 Footnote 47 For exposures to QCCPs located in jurisdictions where the SA-CCR has not been implemented the EAD may be computed using the current exposure method as described (PDF, 132 KB). Return to footnote 47 Footnote 48 For the purpose of this guideline, DvP transactions include payment-versus-payment (PvP) transactions. Return to footnote 48 Footnote 49 An exposure value of zero for counterparty credit risk can be attributed to payment transactions (e.g. funds transfer transactions) and other spot transactions that are outstanding with a central counterparty (e.g. a clearing house), when the central counterparty CCR exposures with all participants in its arrangements are fully collateralized on a daily basis. Return to footnote 49 Footnote 50 If the dates when two payment legs are made are the same according to the time zones where each payment is made, it is deemed that they are settled on the same day. For example, if a bank in Tokyo transfers Yen on day X (Japan Standard Time) and receives corresponding US Dollar via CHIPS on day X (US Eastern Standard Time), the settlement is deemed to take place on the same value date. Return to footnote 50

Note

For institutions with a fiscal year ending October 31 or December 31, respectively. The Capital Adequacy Requirements (CAR) for banks, banks holding companies, and trust and loan companies, collectively referred to as 'institutions', are set out in nine chapters, each of which has been issued as a separate document. This document, Chapter 8 – Credit Valuation Adjustment (CVA) Risk, should be read in conjunction with the other CAR chapters. The complete list of CAR chapters is as follows: Chapter 1 - Overview Chapter 2 - Definition of Capital Chapter 3 - Operational Risk Chapter 4 - Credit Risk - Standardized Approach Chapter 5 - Credit Risk - Internal Ratings-Based Approach Chapter 6 - Securitization Chapter 7 - Settlement and Counterparty Risk Chapter 8 - Credit Valuation Adjustment (CVA) Risk Chapter 9 - Market Risk Please refer to OSFI's Corporate Governance Guideline for OSFI's expectations of institution Boards of Directors in regard to the management of capital and liquidity.

Chapter 8 – Credit Valuation Adjustment (CVA) Risk

8.1 Definitions and application

Institutions that are required to determine market risk capital requirements for trading book positions (see Chapter 9) must meet the requirements of this chapter. The risk-weighted assets for credit value adjustment risk are determined by multiplying the capital requirements calculated as set out in this chapter by 12.5. [Basel Framework, MAR 50.1] In the context of this document, CVA stands for credit valuation adjustment specified at a counterparty level. CVA reflects the adjustment of default risk-free prices of derivatives and securities financing transactions (SFTs) due to a potential default of the counterparty. [Basel Framework, MAR 50.2] Unless explicitly specified otherwise, the term CVA in this document means regulatory CVA. Regulatory CVA may differ from CVA used for accounting purposes as follows: regulatory CVA excludes the effect of the institution's own default; and several constraints reflecting best practice in accounting CVA are imposed on calculations of regulatory CVA. [Basel Framework, MAR 50.3] CVA risk is defined as the risk of losses arising from changing CVA values in response to changes in counterparty credit spreads and market risk factors that drive prices of derivative transactions and SFTs. [Basel Framework, MAR 50.4] The capital requirements for CVA risk must be calculated by all institutions involved in covered transactions in both banking book and trading book. Covered transactions include: all derivatives except those transacted directly with a qualified central counterparty and except those transactions meeting the conditions of paragraph 181 to paragraph 183 of Chapter 7; and SFTs that are fair-valued by an institution for accounting purposes, if OSFI determines that the institution's CVA loss exposures arising from SFT transactions are material. In case the institution deems the exposures immaterial, the institution must justify its assessment to OSFI by providing relevant supporting documentation. For the purpose of CVA capital requirement, SFTs that are fair-valued for accounting purposes and for which an institution records zero for CVA reserves for accounting purposes are included in the scope of covered transactions if the CVA risk of those SFTs is deemed material as described in the above sub-paragraph (2). [Basel Framework, MAR 50.5] The CVA risk capital requirements are calculated for an institution's "CVA portfolio" on a standalone basis. The CVA portfolio includes CVA for an institution's entire portfolio of covered transactions and eligible CVA hedges. [Basel Framework, MAR 50.6] Two approaches are available for calculating CVA capital requirements: the standardized approach (SA-CVA) and the basic approach (BA-CVA). Institutions must use the BA-CVA unless they receive approval from OSFI to use the SA-CVA.^{Footnote 1} [Basel Framework, MAR 50.7] Institutions that have received approval of OSFI to use the SA-CVA may carve out from the SA-CVA calculations any number of netting sets. CVA capital requirements for all carved-out netting sets must be calculated using the BA-CVA. When applying the carve-out, a legal netting set may also be split into two synthetic netting sets, one containing the carved-out transactions subject to the BA-CVA and the other subject to the SA-CVA, subject to one or both of the following conditions: the split is consistent with the treatment of the legal netting set used by the institution for calculating accounting CVA (e.g. where certain transactions are not processed by the front office/accounting exposure model); or OSFI approval to use the SA-CVA is limited and does not cover all transactions within a legal netting set. [Basel Framework, MAR 50.8] Institutions that are below the materiality threshold specified in subsection (1) may opt not to calculate its CVA capital requirements using the SA-CVA or BA-CVA and instead choose an alternative treatment. Any institution whose aggregate notional amount of non-centrally cleared derivatives is less than or equal to 100 billion euro is deemed as being below the materiality threshold. Any institution below the materiality threshold may choose to set its CVA capital requirement equal to 100% of the institution's capital requirement for counterparty credit risk (CCR). CVA hedges are not recognized under this treatment. If chosen, this treatment must be applied to the institution's entire portfolio instead of the BA-CVA or the SA-CVA. OSFI, however, can remove this option if it determines that CVA risk resulting from the institution's derivative positions materially contributes to the institution's overall risk. [Basel Framework, MAR 50.9] Eligibility criteria for CVA hedges are specified in paragraph 17 to paragraph 19 for the BA-CVA and in paragraph 37 to paragraph 39 for the SA-CVA. [Basel Framework, MAR 50.10] CVA hedging instruments can be external (i.e. with an external counterparty) or internal (i.e. with one of the institution's trading desks). All external CVA hedges (including both eligible and ineligible external CVA hedges) that are covered transactions must be included in the CVA calculation of the counterparty providing to the hedge. All eligible external CVA hedges must be excluded from an institution's market risk capital requirement calculations under Chapter 9. Ineligible external CVA hedges are treated as trading book instruments and are capitalized under Chapter 9. An internal CVA hedge involves two perfectly offsetting positions: one of the CVA desk and the opposite position of the trading desk: If an internal CVA hedge is ineligible, both positions belong to the trading book where they cancel each other, so there is no impact on either the CVA portfolio or the trading book. If an internal CVA hedge is eligible, the CVA desk's position is part of the CVA portfolio where it is capitalized as set out in this chapter, while the trading desk's position is part of the trading book where it is capitalized as set out in Chapter 9. If an internal CVA hedge involves an instrument that is subject to curvature risk, default risk charge or the residual risk add-on under the standardized approach as set out in Chapter 9, it can be eligible only if the trading desk that is the CVA desk's internal counterparty executes a transaction with an external counterparty that exactly offsets the trading desk's position with the CVA desk. [Basel Framework, MAR 50.11] Institutions that use the BA-CVA or the SA-CVA for calculating CVA capital requirements may cap the maturity adjustment factor at 1 for all netting sets contributing to CVA capital requirements when they calculate CCR capital requirements under the Internal Ratings Based (IRB) approach. [Basel Framework, MAR 50.12]

8.2 Basic approach for credit valuation adjustment risk

The BA-CVA calculations may be performed either via the reduced version or the full version. An institution under the BA-CVA approach can choose whether to implement the full version or the reduced version at its discretion. However, all institutions using the BA-CVA must calculate the reduced version of BA-CVA capital requirements as the reduced BA-CVA is also part of the full BA-CVA capital calculations as a conservative means to limit hedging recognition. Institutions under the BA-CVA approach must capitalize any market risk hedges of accounting CVA according to Chapter 9, Market Risk. The full version recognizes counterparty credit spread hedges and is intended for institutions that hedge CVA risk. The reduced version eliminates the element of hedging recognition from the full version. The reduced version is designed to simplify BA-CVA implementation for less sophisticated institutions that do not hedge CVA. [Basel Framework, MAR 50.13]

8.2.1 Reduced version of the BA-CVA (hedges are not recognized)

The capital requirements for CVA risk under the reduced version of the BA-CVA (DSBA-CVA × Kreduced, where the discount scalar DSBA-CVA = 0.65) are calculated as follows (where the summations are taken over all counterparties that are within scope of the CVA charge), where: SCVAc is the CVA capital requirement that counterparty c would receive if considered on a stand-alone basis (referred to as "stand-alone CVA capital" – see the paragraph below for its calculation); The supervisory correlation parameter is ρ = 50%. Its square, ρ²=25%, represents the correlation between credit spreads of any two counterparties.^{Footnote 2} In the formula below, the effect of ρ is to recognize the fact that the CVA risk to which an institution is exposed is less than the sum of the CVA risk for each counterparty, given that the credit spreads of counterparties are typically not perfectly correlated; and The first term under the square root in the formula below aggregates the systematic components of CVA risk, and the second term under the square root aggregates the idiosyncratic components of CVA risk. K reduced = ρ ⋅ ∑ c SCVA C 2 + 1 - ρ 2 ⋅ ∑ c SCVA C 2 [Basel Framework, MAR 50.14] The stand-alone CVA capital requirements for counterparty c that are used in the formula in the paragraph above (SCVAc) are calculated as follows (where the summation is across all netting sets with the counterparty), where: RWc is the risk weight for counterparty c that reflects the volatility of its credit spread. These risk weights are based on a combination of sector and credit quality of the counterparty as prescribed in the paragraph below. MNS is the effective maturity for the netting set NS. For institutions that have OSFI's approval to use the IMM, MNS is calculated as per paragraphs 35 and 36 of Chapter 7, with the exception that the five-year cap in paragraph 35 is not applied. For institutions that do not have OSFI approval to use the IMM, MNS is calculated according to paragraph 132 to paragraph 140 of Chapter 5, with the exception that the five-year cap in paragraph 132 of Chapter 5 is not applied. EADNS is the exposure at default (EAD) of the netting set NS, calculated in the same way as the institution calculates it for minimum capital requirements for CCR. DFNS is a supervisory discount factor. It is 1 for institutions using the IMM to calculate EAD, and is 1 - e - 0.05 ⋅ M N S 0.05 ⋅ M N S for institutions not using the IMM.^{Footnote 3} α = 1.4.^{Footnote 4} SCVA C = 1 α ⋅ RW C ⋅ ∑ NS M NS ⋅ EAD NS ⋅ DF NS [Basel Framework, MAR 50.15] The supervisory risk weights (RWc) are given in Table 1. Credit quality is specified as either investment grade (IG), high yield (HY), or not rated (NR). Where there are no external ratings or where external ratings are not recognized within a jurisdiction, institutions may, subject to OSFI's approval, map the internal rating to an external rating and assign a risk weight corresponding to either IG or HY.^{Footnote 5} Otherwise, the risk weights corresponding to NR is to be applied. Table 1 Supervisory risk weights, RWC Sector of counterparty Credit quality of counterparty IG HY and NR Sovereigns including central banks and multilateral development banks 0.5% 2.0% Local government, government-backed non-financials, education and public administration 1.0% 4.0% Financials including government-backed financials 5.0% 12.0% Basic materials, energy, industrials, agriculture, manufacturing, mining and quarrying 3.0% 7.0% Consumer goods and services, transportation and storage, administrative and support service activities 3.0% 8.5% Technology, telecommunications 2.0% 5.5% Health care, utilities, professional and technical activities 1.5% 5.0% Other sector 5.0% 12.0% [Basel Framework, MAR 50.16]

8.2.2 Full version of the BA-CVA (hedges are recognized)

As set out in paragraph 13 the full version of the BA-CVA recognizes the effect of counterparty credit spread hedges. Only transactions used for the purpose of mitigating the counterparty credit spread component of CVA risk, and managed as such, can be eligible hedges. [Basel Framework, MAR 50.17] Only single-name credit default swaps (CDS), single-name contingent CDS, risk participation agreements and index CDS can be eligible CVA hedges. [Basel Framework, MAR 50.18] Eligible single-name credit instruments must: reference the counterparty directly; or reference an entity legally related to the counterparty, where legally related refers to cases where the reference name and the counterparty are either a parent and its subsidiary or two subsidiaries of a common parent; or reference an entity that belongs to the same sector and region as the counterparty. [Basel Framework, MAR 50.19] Institutions that intend to use the full version of BA-CVA must calculate the reduced version (Kreduced) as well. Under the full version, capital requirements for CVA risk DSBA-CVA × Kfull is calculated as follows, where DSBA-CVA = 0.65, and β=0.25 is the supervisory parameter that is used to provide a floor that limits the extent to which hedging can reduce the capital requirements for CVA risk: K full = β ⋅ K reduced + 1 - β ⋅ K hedged [Basel Framework, MAR 50.20] The part of capital requirements that recognizes eligible hedges (Khedged) is calculated as follows (where the summations are taken over all counterparties c that are within scope of the CVA charge), where: Both the stand-alone CVA capital (SCVAC) and the correlation parameter (ρ) are defined in exactly the same way as for the reduced version calculation of the BA-CVA. SNHC is a quantity that gives recognition to the reduction in CVA risk of the counterparty c arising from the institution's use of single-name hedges of credit spread risk. See paragraph 23 for its calculation. IH is a quantity that gives recognition to the reduction in CVA risk across all counterparties arising from the institution's use of index hedges. See paragraph 24 for its calculation. HMAC is a quantity characterizing hedging misalignment, which is designed to limit the extent to which indirect hedges can reduce capital requirements given that they will not fully offset movements in a counterparty's credit spread. That is, with indirect hedges present, Khedged cannot reach zero. See paragraph 25 for its calculation. K hedged = ρ ⋅ ∑ C SCVA C - SNH C - IH 2 + 1 - ρ 2 ⋅ ∑ C SCVA C - SNH C 2 + ∑ C HMA C [Basel Framework, MAR 50.21] The formula for Khedged in the paragraph above comprises three main terms as below: The first term ρ ⋅ ∑ C SCVA C - SNH C - IH 2 aggregates the systematic components of CVA risk arising from the institution's counterparties, the single-name hedges and the index hedges. The second term 1 - ρ 2 ⋅ ∑ C SCVA C - SNH C 2 aggregates the idiosyncratic components of CVA risk arising from the institution's counterparties and the single-name hedges. The third term ∑ C HMA C aggregates the components of indirect hedges that are not aligned with counterparties' credit spreads. [Basel Framework, MAR 50.22] The quantity SNHc is calculated as follows (where the summation is across all single name hedges h that the institution has taken out to hedge the CVA risk of counterparty c), where: rhc is the supervisory prescribed correlation between the credit spread of counterparty c and the credit spread of a single-name hedge h of counterparty c. The value of rhc is set out in the Table 2 of paragraph 26. It is set at 100% if the hedge directly references the counterparty c, and set at lower values if it does not. M h S N is the remaining maturity of single-name hedge h. B h S N is the notional of single-name hedge h. For single-name contingent CDS, the notional is determined by the current market value of the reference portfolio or instrument. D F h S N is the supervisory discount factor calculated as 1 - e - 0.05 ⋅ M h S N 0.05 ⋅ M h S N RWh is the supervisory risk weight of single-name hedge h that reflects the volatility of the credit spread of the reference name of the hedging instrument. These risk weights are based on a combination of the sector and the credit quality of the reference name of the hedging instrument as prescribed in Table 1 of paragraph 16. SNH c = ∑ h ∈ c r h c ⋅ R W h ⋅ M h S N ⋅ B h S N ⋅ D F h S N [Basel Framework, MAR 50.23] The quantity IH is calculated as follows (where the summation is across all index hedges i that the institution has taken out to hedge CVA risk), where: M i ind is the remaining maturity of index hedge i. B i ind is the notional of the index hedge i. DF i ind is the supervisory discount factor calculated as 1 - e - 0.05 ⋅ M i i n d 0.05 ⋅ M i i n d RW i is the supervisory risk weight of the index hedge i. RW i is taken from the Table 1 of paragraph 16 based on the sector and the credit quality of the index constituents and adjusted as follows: For an index where all index constituents belong to the same sector and are of the same credit quality, the relevant value in the Table 1 of paragraph 16 is multiplied by 0.7 to account for diversification of idiosyncratic risk within the index. For an index spanning multiple sectors or with a mixture of investment grade constituents and other grade constituents, the name-weighted average of the risk weights from the Table 1 of paragraph 16 should be calculated and then multiplied by 0.7. IH = ∑ i RW i ⋅ M i ind ⋅ B i ind ⋅ DF i ind [Basel Framework, MAR 50.24] The quantity HMAC is calculated as follows (where the summation is across all single name hedges h that have been taken out to hedge the CVA risk of counterparty c), where r h c , M h SN , B h SN , DF h SN and RWh have the same definitions as set out in [MAR50.23]. HMA c = ∑ h ∈ c 1 - r h c 2 ⋅ RW h ⋅ M h SN ⋅ B h SN ⋅ DF h SN 2 [Basel Framework, MAR 50.25] The supervisory prescribed correlations rhc between the credit spread of counterparty c and the credit spread of its single-name hedge h are set in Table 2 as follows: Table 2 Correlations between credit spread of counterparty and single-name hedge Single-name hedge h of counterparty c Value of rhc References counterparty c directly 100% Has legal relation with counterparty c 80% Shares sector and region with counterparty c 50% [Basel Framework, MAR 50.26]

8.3 Standardized approach for credit valuation adjustment risk

The SA-CVA is an adaptation of the standardized approach for market risk set out in Chapter 9. The primary differences of the SA-CVA from the standardized approach for market risk are: the SA-CVA features a reduced granularity of market risk factors; and the SA-CVA does not include default risk and curvature risk. [Basel Framework, MAR 50.27] Under the SA-CVA, capital requirements must be calculated and reported to OSFI at a monthly frequency. In addition, institutions using the SA-CVA must have the ability to produce SA-CVA capital requirement calculations at the request of OSFI and must accordingly provide the calculations. [Basel Framework, MAR 50.28] The SA-CVA uses as inputs the sensitivities of regulatory CVA to counterparty credit spreads and market risk factors driving the values of covered transactions. Sensitivities must be computed by institutions in accordance with the prudent valuation standards set out in Chapter 9. [Basel Framework, MAR 50.29] For an institution to be considered eligible for the use of SA-CVA by OSFI as set out in paragraph 7, the institution must meet the following criteria at the minimum. An institution must be able to model exposure and calculate, on at least a monthly basis, CVA and CVA sensitivities to the market risk factors specified in paragraph 54 to paragraph 77. An institution must have a CVA desk (or a similar dedicated function) responsible for risk management and hedging of CVA. [Basel Framework, MAR 50.30]

8.3.1 Regulatory CVA calculations

An institution must calculate regulatory CVA for each counterparty with which it has at least one covered position for the purpose of the CVA risk capital requirements. [Basel Framework, MAR 50.31] Regulatory CVA at a counterparty level must be calculated according to the following principles. An institution must demonstrate its compliance to the principles to OSFI. Regulatory CVA must be calculated as the expectation of future losses resulting from default of the counterparty under the assumption that the institution itself is free from the default risk. In expressing the regulatory CVA, non-zero losses must have a positive sign. This is reflected in paragraph 52 where W S k h d g must be subtracted from WS k CVA . The calculation must be based on at least the following three sets of inputs: term structure of market-implied probability of default (PD); market-consensus expected loss-given-default (ELGD); simulated paths of discounted future exposure. The term structure of market-implied PD must be estimated from credit spreads observed in the markets. For counterparties whose credit is not actively traded (ie illiquid counterparties), the market-implied PD must be estimated from proxy credit spreads estimated for these counterparties according to the following requirements: An institution must estimate the credit spread curves of illiquid counterparties from credit spreads observed in the markets of the counterparty's liquid peers via an algorithm that discriminates on at least the following three variables: a measure of credit quality (e.g. rating), industry, and region. In certain cases, mapping an illiquid counterparty to a single liquid reference name can be allowed. A typical example would be mapping a municipality to its home country (i.e. setting the municipality credit spread equal to the sovereign credit spread plus a premium). An institution must justify to OSFI each case of mapping an illiquid counterparty to a single liquid reference name. When no credit spreads of any of the counterparty's peers is available due to the counterparty's specific type (e.g. project finance, funds), an institution is allowed to use a more fundamental analysis of credit risk to proxy the spread of an illiquid counterparty. However, where historical PDs are used as part of this assessment, the resulting spread cannot be based on historical PD only – it must relate to credit markets. The market-consensus ELGD value must be the same as the one used to calculate the risk-neutral PD from credit spreads unless the institution can demonstrate that the seniority of the exposure resulting from covered positions differs from the seniority of senior unsecured bonds.^{Footnote 6} Collateral provided by the counterparty does not change the seniority of the exposure. The simulated paths of discounted future exposure are produced by pricing all derivative transactions with the counterparty along simulated paths of relevant market risk factors and discounting the prices to today using risk-free interest rates along the path. All market risk factors material for the transactions with a counterparty must be simulated as stochastic processes for an appropriate number of paths defined on an appropriate set of future time points extending to the maturity of the longest transaction. For transactions with a significant level of dependence between exposure and the counterparty's credit quality, this dependence should be taken into account. For margined counterparties, collateral is permitted to be recognized as a risk mitigant under the following conditions: Collateral management requirements outlined in paragraph 56 and 57 of Chapter 7 are satisfied. All documentation used in collateralized transactions must be binding on all parties and legally enforceable in all relevant jurisdictions. Institutions must have conducted sufficient legal review to verify this and have a well founded legal basis to reach this conclusion, and undertake such further review as necessary to ensure continuing enforceability. For margined counterparties, the simulated paths of discounted future exposure must capture the effects of margining collateral that is recognized as a risk mitigant along each exposure path. All the relevant contractual features such as the nature of the margin agreement (unilateral vs bilateral), the frequency of margin calls, the type of collateral, thresholds, independent amounts, initial margins and minimum transfer amounts must be appropriately captured by the exposure model. To determine collateral available to an institution at a given exposure measurement time point, the exposure model must assume that the counterparty will not post or return any collateral within a certain time period immediately prior to that time point. The assumed value of this time period, known as the margin period of risk (MPoR), cannot be less than a supervisory floor. For SFTs and client cleared transactions as specified in paragraph 179 of Chapter 7 the supervisory floor for the MPoR is equal to 4+N business days, where N is the re-margining period specified in the margin agreement (in particular, for margin agreements with daily or intra-daily exchange of margin, the minimum MPoR is 5 business days). For all other transactions, the supervisory floor for the MPoR is equal to 9+N business days. [Basel Framework, MAR 50.32] The simulated paths of discounted future exposure are obtained via the exposure models used by an institution for calculating front office/accounting CVA, adjusted (if needed) to meet the requirements imposed for regulatory CVA calculation. Model calibration process (with the exception of the MPoR), market and transaction data used for regulatory CVA calculation must be the same as the ones used for accounting CVA calculation. [Basel Framework, MAR 50.33] The generation of market risk factor paths underlying the exposure models must satisfy and an institution must demonstrate to OSFI its compliance to the following requirements: Drifts of risk factors must be consistent with a risk-neutral probability measure. Historical calibration of drifts is not allowed. The volatilities and correlations of market risk factors must be calibrated to market data whenever sufficient data exist in a given market. Otherwise, historical calibration is permissible. The distribution of modelled risk factors must account for the possible non-normality of the distribution of exposures, including the existence of leptokurtosis ("fat tails"), where appropriate. [Basel Framework, MAR 50.34] Netting recognition is the same as in the accounting CVA calculations used by the institution. In particular, netting uncertainty can be modelled. [Basel Framework, MAR 50.35] An institution must satisfy and demonstrate to OSFI its compliance to the following requirements: Exposure models used for calculating regulatory CVA must be part of a CVA risk management framework that includes the identification, measurement, management, approval and internal reporting of CVA risk. An institution must have a credible track record in using these exposure models for calculating CVA and CVA sensitivities to market risk factors. Senior management should be actively involved in the risk control process and must regard CVA risk control as an essential aspect of the business to which significant resources need to be devoted. An institution must have a process in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operation of the exposure system used for accounting CVA calculations. An institution must have an independent control unit that is responsible for the effective initial and ongoing validation of the exposure models. This unit must be independent from business credit and trading units (including the CVA desk), must be adequately staffed and must report directly to senior management of the institution. An institution must document the process for initial and ongoing validation of its exposure models to a level of detail that would enable a third party to understand how the models operate, their limitations, and their key assumptions; and recreate the analysis. This documentation must set out the minimum frequency with which ongoing validation will be conducted as well as other circumstances (such as a sudden change in market behaviour) under which additional validation should be conducted. In addition, the documentation must describe how the validation is conducted with respect to data flows and portfolios, what analyses are used and how representative counterparty portfolios are constructed. The pricing models used to calculate exposure for a given path of market risk factors must be tested against appropriate independent benchmarks for a wide range of market states as part of the initial and ongoing model validation process. Pricing models for options must account for the non-linearity of option value with respect to market risk factors. An independent review of the overall CVA risk management process should be carried out regularly in the institution's own internal auditing process. This review should include both the activities of the CVA desk and of the independent risk control unit. An institution must define criteria on which to assess the exposure models and their inputs and have a written policy in place to describe the process to assess the performance of exposure models and remedy unacceptable performance. Exposure models must capture transaction-specific information in order to aggregate exposures at the level of the netting set. An institution must verify that transactions are assigned to the appropriate netting set within the model. Exposure models must reflect transaction terms and specifications in a timely, complete, and conservative fashion. The terms and specifications must reside in a secure database that is subject to formal and periodic audit. The transmission of transaction terms and specifications data to the exposure model must also be subject to internal audit, and formal reconciliation processes must be in place between the internal model and source data systems to verify on an ongoing basis that transaction terms and specifications are being reflected in the exposure system correctly or at least conservatively. The current and historical market data must be acquired independently of the lines of business and be compliant with accounting. They must be fed into the exposure models in a timely and complete fashion, and maintained in a secure database subject to formal and periodic audit. An institution must also have a well-developed data integrity process to handle the data of erroneous and/or anomalous observations. In the case where an exposure model relies on proxy market data, an institution must set internal policies to identify suitable proxies and the institution must demonstrate empirically on an ongoing basis that the proxy provides a conservative representation of the underlying risk under adverse market conditions. [Basel Framework, MAR 50.36]

8.3.2 Eligible hedges

Only whole transactions that are used for the purpose of mitigating CVA risk, and managed as such, can be eligible hedges. Transactions cannot be split into several effective transactions. [Basel Framework, MAR 50.37] Eligible hedges can include: instruments that hedge variability of the counterparty credit spread; and instruments that hedge variability of the exposure component of CVA risk. [Basel Framework, MAR 50.38] Instruments that are not eligible for the internal models approach for market risk under Chapter 9 (e.g. tranched credit derivatives) cannot be eligible CVA hedges. [Basel Framework, MAR 50.39]

8.3.3 Multiplier

Aggregated capital requirements can be scaled up by the multiplier mcva [Basel Framework, MAR 50.40] The multiplier mcva is set at 1. OSFI may require an institution to use a higher value of mcva if the supervisor determines that the institution's CVA model risk warrants it (e.g. if the level of model risk for the calculation of CVA sensitivities is too high or the dependence between the institution's exposure to a counterparty and the counterparty's credit quality is not appropriately taken into account in its CVA calculations). [Basel Framework, MAR 50.41]

8.3.4 Calculations

The SA-CVA capital requirements are calculated as the sum of the capital requirements for delta and vega risks calculated for the entire CVA portfolio (including eligible hedges). [Basel Framework, MAR 50.42] The capital requirements for delta risk are calculated as the simple sum of delta capital requirements calculated independently for the following six risk classes: interest rate risk; foreign exchange (FX) risk; counterparty credit spread risk; reference credit spread risk (i.e. credit spreads that drive the CVA exposure component); equity risk; and commodity risk. [Basel Framework, MAR 50.43] If an instrument is deemed as an eligible hedge for credit spread delta risk, it must be assigned in its entirety (see paragraph 37) either to the counterparty credit spread or to the reference credit spread risk class. Instruments must not be split between the two risk classes. [Basel Framework, MAR 50.44] The capital requirements for vega risk are calculated as the simple sum of vega capital requirements calculated independently for the following five risk classes. Note there here are no vega capital requirements for counterparty credit spread risk. interest rate risk; FX risk; reference credit spread risk; equity risk; and commodity risk. [Basel Framework, MAR 50.45] Delta and vega capital requirements are calculated in the same manner using the same procedures set out in paragraph 47 to paragraph 53. [Basel Framework, MAR 50.46] For each risk class, (i) the sensitivity of the aggregate CVA, s k C V A , and (ii) the sensitivity of the market value of all eligible hedging instruments in the CVA portfolio, s k H d g , to each risk factor k in the risk class are calculated. The sensitivities are defined as the ratio of the change of the value in question (i.e. (i) aggregate CVA or (ii) market value of all CVA hedges) caused by a small change of the risk factor's current value to the size of the change. Specific definitions for each risk class are set out in paragraph 54 to paragraph 77. These definitions include specific values of changes or shifts in risk factors. However, an institution may use smaller or larger values of risk factor shifts if doing so is consistent with internal risk management calculations. An institution may use algorithmic techniques, such as adjoint algorithmic differentiation to calculate CVA sensitivities under the SA-CVA if doing so is consistent with the institution's internal risk management calculations and the relevant validation standards described in the SA-CVA framework. [Basel Framework, MAR 50.47] CVA sensitivities for vega risk are always material and must be calculated regardless of whether or not the portfolio includes options. When CVA sensitivities for vega risk are calculated, the volatility shift must apply to both types of volatilities that appear in exposure models: volatilities used for generating risk factor paths; and volatilities used for pricing options. [Basel Framework, MAR 50.48] If a hedging instrument is an index, its sensitivities to all risk factors upon which the value of the index depends must be calculated. The index sensitivity to risk factor k must be calculated by applying the shift of risk factor k to all index constituents that depend on this risk factor and recalculating the changed value of the index. For example, to calculate delta sensitivity of S&P500 to large financial companies, an institution must apply the relevant shift to equity prices of all large financial companies that are constituents of S&P500 and re-compute the index. [Basel Framework, MAR 50.49] For the following risk classes, an institution may choose to introduce a set of additional risk factors that directly correspond to qualified credit and equity indices. For delta risks, a credit or equity index is qualified if it satisfies liquidity and diversification conditions specified in paragraph 143 of Chapter 9; for vega risks, any credit or equity index is qualified. Under this option, an institution must calculate sensitivities of CVA and the eligible CVA hedges to the qualified index risk factors in addition to sensitivities to the non-index risk factors. Under this option, for a covered transaction or an eligible hedging instrument whose underlying is a qualified index, its contribution to sensitivities to the index constituents is replaced with its contribution to a single sensitivity to the underlying index. For example, for a portfolio consisting only of equity derivatives referencing only qualified equity indices, no calculation of CVA sensitivities to non-index equity risk factors is necessary. If more than 75% of constituents of a qualified index (taking into account the weightings of the constituents) are mapped to the same sector, the entire index must be mapped to that sector and treated as a single-name sensitivity in that bucket. In all other cases, the sensitivity must be mapped to the applicable index bucket. counterparty credit spread risk; reference credit spread risk; and equity risk. [Basel Framework, MAR 50.50] The weighted sensitivities W S k C V A and W S k H d g for each risk factor k are calculated by multiplying the net sensitivities s k C V A and s k H d g , respectively, by the corresponding risk weight RWk (the risk weights applicable to each risk class are specified in paragraph 54 to paragraph 77). [Basel Framework, MAR 50.51] WS k CVA = RW k s k CVA WS k Hdg = RW k s k Hdg The net weighted sensitivity of the CVA portfolio sk to risk factor k is obtained by: WS k = WS K CVA - WS k Hdg Note that the formula in paragraph 52 is set out under the convention that the CVA is positive as specified in paragraph 32. It intends to recognize the risk reducing effect of hedging. For example, when hedging the counterparty credit spread component of CVA risk for a specific counterparty by buying credit protection on the counterparty: if the counterparty's credit spread widens, the CVA (expressed as a positive value) increases resulting in the positive CVA sensitivity to the counterparty credit spread. At the same time, as the value of the hedge from the institution's perspective increases as well (as credit protection becomes more valuable), the sensitivity of the hedge is also positive. The positive weighted sensitivities of the CVA and its hedge offset each other using the formula with the minus sign. If CVA loss had been expressed as a negative value, the minus sign in paragraph 52 would have been replaced by a plus sign. [Basel Framework, MAR 50.52] For each risk class, the net sensitivities are aggregated as follows: The weighted sensitivities must be aggregated into a capital requirement Kb within each bucket b (the buckets and correlation parameters ρkl applicable to each risk class are specified in paragraph 54 to paragraph 77), where R is the hedging disallowance parameter, set at 0.01, that prevents the possibility of recognizing perfect hedging of CVA risk. K b = ∑ k ∈ b WS k 2 + ∑ k ∈ b ∑ l ∈ b , l ≠ k ρ kl WS k WS l + R × ∑ k ∈ b WS k Hdg 2 Bucket-level capital requirements must then be aggregated across buckets within each risk class (the correlation parameters γbc applicable to each risk class are specified in paragraph 54 to paragraph 77). Note that this equation differs from the corresponding aggregation equation for market risk capital requirements in paragraph 116 of Chapter 9, including the multiplier mCVA. K = m CVA ∑ b K b 2 + ∑ b ∑ b≠c γ bc S b S c In calculating K in above (2), Sb is defined as the sum of the weighted sensitivities WSk for all risk factors k within bucket b, floored by -Kb and capped by Kb, and the Sc is defined in the same way for all risk factors k in bucket c: S b = max - K b ; min ∑ k ϵ b WS k ; K b S c = max - K c ; min ∑ k ϵ c WS k ; K c [Basel Framework, MAR 50.53]

8.3.5 Interest rate buckets, risk factors, sensitivities, risk weights and correlations

For interest rate delta and vega risks, buckets must be set per individual currencies. [Basel Framework, MAR 50.54] For interest rate delta and vega risks, cross-bucket correlation γbc is set at 0.5 for all currency pairs. [Basel Framework, MAR 50.55] The interest rate delta risk factors for an institution's reporting currency and for the following currencies USD, EUR, GBP, AUD, CAD, SEK or JPY: The interest rate delta risk factors are the absolute changes of the inflation rate and of the risk-free yields for the following five tenors: 1 year, 2 years, 5 years, 10 years and 30 years. The sensitivities to the abovementioned risk-free yields are measured by changing the risk-free yield for a given tenor for all curves in a given currency by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001. The sensitivity to the inflation rate is obtained by changing the inflation rate by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001. The risk weights RWk are set as follows: Table 3 Risk weight for interest rate risk factors (specified currencies) blank 1 year 2 years 5 years 10 years 30 years Inflation Risk weight 1.11% 0.93% 0.74% 0.74% 0.74% 1.11% The correlations between pairs of risk factors ρkl are set as follows: Table 4 Correlations for interest rate risk factors (specified currencies) Tenor Tenor 1 year 2 years 5 years 10 years 30 years Inflation 1 year 100% 91% 72% 55% 31% 40% 2 years n/a 100% 87% 72% 45% 40% 5 years n/a n/a 100% 91% 68% 40% 10 years n/a n/a n/a 100% 83% 40% 30 years n/a n/a n/a n/a 100% 40% Inflation n/a n/a n/a n/a n/a 100% [Basel Framework, MAR 50.56] The interest rate delta risk factors for other currencies not specified in paragraph above: The interest rate risk factors are the absolute change of the inflation rate and the parallel shift of the entire risk-free yield curve for a given currency. The sensitivity to the yield curve is measured by applying a parallel shift to all risk-free yield curves in a given currency by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001. The sensitivity to the inflation rate is obtained by changing the inflation rate by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001. The risk weights for both the risk-free yield curve and the inflation rate RWk are set at 1.58%. The correlations between the risk-free yield curve and the inflation rate ρkl are set at 40%. [Basel Framework, MAR 50.57] The interest rate vega risk factors for all currencies: The interest rate vega risk factors are a simultaneous relative change of all volatilities for the inflation rate and a simultaneous relative change of all interest rate volatilities for a given currency. The sensitivity to (i) the interest rate volatilities or (ii) inflation rate volatilities is measured by respectively applying a simultaneous shift to (i) all interest rate volatilities or (ii) inflation rate volatilities by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01. The risk weights for both the interest rate volatilities and the inflation rate volatilities RWk are set to 100%. Correlations between the interest rate volatilities and the inflation rate volatilities ρkl are set at 40%. [Basel Framework, MAR 50.58]

8.3.6 Foreign exchange buckets, risk factors, sensitivities, risk weights and correlations

For FX delta and vega risks, buckets must be set per individual currencies except for an institution's own reporting currency. [Basel Framework, MAR 50.59] For FX delta and vega risks, the cross-bucket correlation γbc is set at 0.6 for all currency pairs. [Basel Framework, MAR 50.60] The FX delta risk factors for all currencies: The single FX delta risk factor is defined as the relative change of the FX spot rate between a given currency and an institution's reporting currency, where the FX spot rate is the current market price of one unit of another currency expressed in the units of the institution's reporting currency. Sensitivities to FX spot rates are measured by shifting the exchange rate between the institution's reporting currency and another currency (i.e. the value of one unit of another currency expressed in units of the reporting currency) by 1% relative to its current value and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01. For transactions that reference an exchange rate between a pair of non-reporting currencies, the sensitivities to the FX spot rates between the institution's reporting currency and each of the referenced non-reporting currencies must be measured.^{Footnote 7} The risk weights for all exchange rates between the institution's reporting currency and another currency are set at 11%. [Basel Framework, MAR 50.61] The FX vega risk factors for all currencies: The single FX vega risk factor is a simultaneous relative change of all volatilities for an exchange rate between an institution's reporting currency and another given currency. The sensitivities to the FX volatilities are measured by simultaneously shifting all volatilities for a given foreign-domestic exchange rate between the institution's reporting or base currency and another currency by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01. For transactions that reference an exchange rate between a pair of non-reporting foreign-foreign currencies, the volatilities of the FX spot rates are shifted according to the representation of the foreign-foreign exchange rate volatility via two foreign-domestic (or base) exchange rate volatilities and the relevant implied correlation (the latter is assumed to be fixed). The risk weights for FX volatilities RWk are set to 100%. [Basel Framework, MAR 50.62]

8.3.7 Counterparty credit spread buckets, risk factors, sensitivities, risk weights and correlations

Counterparty credit spread risk is not subject to vega risk capital requirements. Buckets for delta risk are set as follows: Buckets 1 to 7 are defined for factors that are not qualified indices as set out in paragraph 50 ; Bucket 8 is set for the optional treatment of qualified indices. Under the optional treatment, only instruments that reference qualified indices can be assigned to bucket 8, while all single-name and all non-qualified index hedges must be assigned to buckets 1 to 7 for calculations of CVA sensitivities and sensitivities. For any instrument referencing an index assigned to buckets 1 to 7, the look-through approach must be used (i.e. sensitivity of the hedge to each index constituent must be calculated). Table 5 Buckets for counterparty credit spread delta risk Bucket number Sector 1 a) Sovereigns including central banks, multilateral development banks b) Local government, government-backed non-financials, education and public administration 2 Financials including government-backed financials 3 Basic materials, energy, industrials, agriculture, manufacturing, mining and quarrying 4 Consumer goods and services, transportation and storage, administrative and support service activities 5 Technology, telecommunications 6 Health care, utilities, professional and technical activities 7 Other sector 8 Qualified Indices [Basel Framework, MAR 50.63] For counterparty credit spread delta risk, the cross-bucket correlations γbc are set as follows: Table 6 Cross-bucket correlations for counterparty credit spread delta risk Bucket Bucket 1 2 3 4 5 6 7 8 1 100% 10% 20% 25% 20% 15% 0% 45% 2 n/a 100% 5% 15% 20% 5% 0% 45% 3 n/a n/a 100% 20% 25% 5% 0% 45% 4 n/a n/a n/a 100% 25% 5% 0% 45% 5 n/a n/a n/a n/a 100% 5% 0% 45% 6 n/a n/a n/a n/a n/a 100% 0% 45% 7 n/a n/a n/a n/a n/a n/a 100% 0% 8 n/a n/a n/a n/a n/a n/a n/a 100% [Basel Framework, MAR 50.64] The counterparty credit spread delta risk factors for a given bucket: The counterparty credit spread delta risk factors are absolute shifts of credit spreads of individual entities (counterparties and reference names for counterparty credit spread hedges) and qualified indices (if the optional treatment is chosen) for the following tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years. For each entity and each tenor point, the sensitivities are measured by shifting the relevant credit spread by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001. The risk weights RWk are set as follows depending on the entity's bucket, where IG, HY and NR represent "investment grade", "high yield" and "not rated" as specified for the BA-CVA in paragraph 16. The same risk weight for a given bucket and given credit quality applies to all tenors. Table 7 Risk weights for counterparty credit spread delta risk blank Bucket 1 a) 1 b) 2 3 4 5 6 7 8 IG names 0.5% 1.0% 5.0% 3.0% 3.0% 2.0% 1.5% 5.0% 1.5% HY and NR names 2.0% 4.0% 12.0% 7.0% 8.5% 5.5% 5.0% 12.0% 5.0% For buckets 1 to 7, the correlation parameter ρkl between two weighted sensitivities WSk and WSl is calculated as follows, where: ρtenor is equal to 100% if the two tenors are the same and 90% otherwise; ρname is equal to 100% if the two names are the same, 90% if the two names are distinct, but legally related and 50% otherwise; ρquality is equal to 100% if the credit quality of the two names is the same (ie IG and IG or HY/NR and HY/NR) and 80% otherwise. ρ kl = ρ tenor ⋅ ρ name ⋅ ρ quality For bucket 8, the correlation parameter ρkl between two weighted sensitivities WSk and WSl is calculated as follows, where ρtenor is equal to 100% if the two tenors are the same and 90% otherwise; ρname is equal to 100% if the two indices are the same and of the same series, 90% if the two indices are the same, but of distinct series, and 80% otherwise; ρquality is equal to 100% if the credit quality of the two indices is the same (ie IG and IG or HY and HY) and 80% otherwise. ρ kl = ρ tenor ⋅ ρ name ⋅ ρ quality [Basel Framework, MAR 50.65]

8.3.8 Reference credit spread buckets, risk factors, sensitivities, risk weights and correlations

Reference credit spread risk is subject to both delta and vega risk capital requirements. Buckets for delta and vega risks are set as follows, where IG, HY and NR represent "investment grade", "high yield" and "not rated" as specified for the BA-CVA in paragraph 16: Table 8 Buckets for reference credit spread risk Bucket number Credit quality Sector 1 IG Sovereigns including central banks, multilateral development banks 2 IG Local government, government-backed non-financials, education and public administration 3 IG Financials including government-backed financials 4 IG Basic materials, energy, industrials, agriculture, manufacturing, mining and quarrying 5 IG Consumer goods and services, transportation and storage, administrative and support service activities 6 IG Technology, telecommunications 7 IG Health care, utilities, professional and technical activities 8 HY and NR Sovereigns including central banks, multilateral development banks 9 HY and NR Local government, government-backed non-financials, education and public administration 10 HY and NR Financials including government-backed financials 11 HY and NR Basic materials, energy, industrials, agriculture, manufacturing, mining and quarrying 12 HY and NR Consumer goods and services, transportation and storage, administrative and support service activities 13 HY and NR Technology, telecommunications 14 HY and NR Health care, utilities, professional and technical activities 15 (Not applicable) Other sector 16 IG Qualified Indices 17 HY Qualified Indices [Basel Framework, MAR 50.66] For reference credit spread delta and vega risks, the cross-bucket correlations γbc are set as follows: The cross-bucket correlations γbc between buckets of the same credit quality (i.e. either IG or HY/NR) are set as follows: Table 9 Cross-bucket correlations for reference credit spread risk Bucket Bucket 1/8 2/9 3/10 4/11 5/12 6/13 7/14 15 16 17 1/8 100% 75% 10% 20% 25% 20% 15% 0% 45% 45% 2/9 n/a 100% 5% 15% 20% 15% 10% 0% 45% 45% 3/10 n/a n/a 100% 5% 15% 20% 5% 0% 45% 45% 4/11 n/a n/a n/a 100% 20% 25% 5% 0% 45% 45% 5/12 n/a n/a n/a n/a 100% 25% 5% 0% 45% 45% 6/13 n/a n/a n/a n/a n/a 100% 5% 0% 45% 45% 7/14 n/a n/a n/a n/a n/a n/a 100% 0% 45% 45% 15 n/a n/a n/a n/a n/a n/a n/a 100% 0% 0% 16 n/a n/a n/a n/a n/a n/a n/a n/a 100% 75% 17 n/a n/a n/a n/a n/a n/a n/a n/a n/a 100% For cross-bucket correlations γbc between buckets 1 to 14 of different credit quality (ie IG and HY/NR), the correlations γbc specified in subsection (1) are divided by 2. [Basel Framework, MAR 50.67] Reference credit spread delta risk factors for a given bucket: The single reference credit spread delta risk factor is a simultaneous absolute shift of the credit spreads of all tenors for all reference names in the bucket. The sensitivity to reference credit spread delta risk is measured by simultaneously shifting the credit spreads of all tenors for all reference names in the bucket by 1 basis point (0.0001 in absolute terms) and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.0001. The risk weights RWk are set as follows depending on the reference name's bucket: Table 10 Risk weights for reference credit spread delta risk Number Bucket Risk weight 1 IG 0.5% 2 IG 1.0% 3 IG 5.0% 4 IG 3.0% 5 IG 3.0% 6 IG 2.0% 7 IG 1.5% 8 IG 2.0% 9 IG 4.0% 10 HY/NR 12.0% 11 HY/NR 7.0% 12 HY/NR 8.5% 13 HY/NR 5.5% 14 HY/NR 5.0% 15 HY/NR 12.0% 16 HY/NR 1.5% 17 HY/NR 5.0% [Basel Framework, MAR 50.68] Reference credit spread vega risk factors for a given bucket: The single reference credit spread vega risk factor is a simultaneous relative shift of the volatilities of credit spreads of all tenors for all reference names in the bucket. The sensitivity to the reference credit spread vega risk factor is measured by simultaneously shifting the volatilities of credit spreads of all tenors for all reference names in the bucket by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01. Risk weights for reference credit spread volatilities RWk are set to 100%. [Basel Framework, MAR 50.69]

8.3.9 Equity buckets, risk factors, sensitivities, risk weights and correlations

For equity delta and vega risks, buckets are set as follows, where: Market capitalization ("market cap") is defined as the sum of the market capitalizations of the same legal entity or group of legal entities across all stock markets globally. The reference to "group of legal entities" covers cases where the listed entity is a parent company of a group of legal entities. Under no circumstances should the sum of the market capitalizations of multiple related listed entities be used to determine whether a listed entity is "large market cap" or "small market cap". "Large market cap" is defined as a market capitalization equal to or greater than CAD 2.5 billion and "small market cap" is defined as a market capitalization of less than CAD 2.5 billion. The advanced economies are Canada, the United States, Mexico, the euro area, the non-euro area western European countries (the United Kingdom, Norway, Sweden, Denmark and Switzerland), Japan, Oceania (Australia and New Zealand), Singapore and Hong Kong SAR. To assign a risk exposure to a sector, institutions must rely on a classification that is commonly used in the market for grouping issuers by industry sector. The institution must assign each issuer to one of the sector buckets in the table above and it must assign all issuers from the same industry to the same sector. Risk positions from any issuer that an institution cannot assign to a sector in this fashion must be assigned to the "other sector" (i.e. bucket 11). For multinational multi-sector equity issuers, the allocation to a particular bucket must be done according to the most material region and sector in which the issuer operates. Table 11 Buckets for equity risk Bucket number Size Region Sector 1 Large Emerging market economies Consumer goods and services, transportation and storage, administrative and support service activities, healthcare, utilities 2 Large Emerging market economies Telecommunications, industrials 3 Large Emerging market economies Basic materials, energy, agriculture, manufacturing, mining and quarrying 4 Large Emerging market economies Financials including government-backed financials, real estate activities, technology 5 Large Advanced economies Consumer goods and services, transportation and storage, administrative and support service activities, healthcare, utilities 6 Large Advanced economies Telecommunications, industrials 7 Large Advanced economies Basic materials, energy, agriculture, manufacturing, mining and quarrying 8 Large Advanced economies Financials including government-backed financials, real estate activities, technology 9 Small Emerging market economies All sectors described under bucket numbers 1, 2, 3, and 4 10 Small Advanced economies All sectors described under bucket numbers 5, 6, 7, and 8 11 (Not applicable) (Not applicable) Other sector 12 Large cap Advanced economies Qualified Indices 13 Other Other Qualified Indices [Basel Framework, MAR 50.70] For equity delta and vega risks, cross-bucket correlation γbc is set at 15% for all cross-bucket pairs that fall within bucket numbers 1 to 10. The cross-bucket correlation between buckets 12 and 13 is set at 75% and the cross-bucket correlation between buckets 12 or 13 and any of the buckets 1-10 is 45%. γbc is set at 0% for all cross-bucket pairs that include bucket 11. [Basel Framework, 50.71] Equity delta risk factors for a given bucket: The single equity delta risk factor is a simultaneous relative shift of equity spot prices for all reference names in the bucket. The sensitivity to the equity delta risk factor is measured by simultaneously shifting the equity spot prices for all reference names in the bucket by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01. Risk weights RWk are set as follows depending on the reference name's bucket: Table 12 Risk weights for equity delta risk Bucket number Risk weight 1 55% 2 60% 3 45% 4 55% 5 30% 6 35% 7 40% 8 50% 9 70% 10 50% 11 70% 12 15% 13 25% [Basel Framework, MAR 50.72] Equity vega risk factors for a given bucket: The single equity vega risk factor is a simultaneous relative shift of the volatilities for all reference names in the bucket. The sensitivity to the equity vega risk factor is measured by simultaneously shifting the volatilities for all reference names in the bucket by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01. The risk weights for equity volatilities RWk are set to 78% for large market capitalization buckets and to 100% for the other buckets. [Basel Framework, MAR 50.73]

8.3.10 Commodity buckets, risk factors, sensitivities, risk weights and correlations

For commodity delta and vega risks, buckets are set as follows: Table 13 Buckets for commodity risk Bucket number Commodity group Examples 1 Energy – Solid combustibles coal, charcoal, wood pellets, nuclear fuel (such as uranium) 2 Energy – Liquid combustibles crude oil (such as Light-sweet, heavy, West Texas Intermediate and Brent); biofuels (such as bioethanol and biodiesel); petrochemicals (such as propane, ethane, gasoline, methanol and butane); refined fuels (such as jet fuel, kerosene, gasoil, fuel oil, naphtha, heating oil and diesel) 3 Energy – Electricity and carbon trading electricity (such as spot, day-ahead, peak and off-peak); carbon emissions trading (such as certified emissions reductions, in-delivery month EU allowance, Regional Greenhouse Gas Initiative CO2 allowance and renewable energy certificates) 4 Freight dry-bulk route (such as Capesize, Panamax, Handysize and Supramax); liquid-bulk/gas shipping route (such as Suezmax, Aframax and very large crude carriers) 5 Metals – non-precious base metal (such as aluminium, copper, lead, nickel, tin and zinc); steel raw materials (such as steel billet, steel wire, steel coil, steel scrap and steel rebar, iron ore, tungsten, vanadium, titanium and tantalum); minor metals (such as cobalt, manganese, molybdenum) 6 Gaseous combustibles natural gas; liquefied natural gas 7 Precious metals (including gold) gold; silver; platinum; palladium 8 Grains & oilseed corn; wheat; soybean (such as soybean seed, soybean oil and soybean meal); oats; palm oil; canola; barley; rapeseed (such as rapeseed seed, rapeseed oil, and rapeseed meal); red bean, sorghum; coconut oil; olive oil; peanut oil; sunflower oil; rice 9 Livestock & dairy cattle (such live and feeder); hog; poultry; lamb; fish; shrimp; dairy (such as milk, whey, eggs, butter and cheese) 10 Softs and other agricultural cocoa; coffee (such as arabica and robusta); tea; citrus and orange juice; potatoes; sugar; cotton; wool; lumber and pulp; rubber 11 Other commodity industrial minerals (such as potash, fertilizer and phosphate rocks), rare earths; terephthalic acid; flat glass [Basel Framework, MAR 50.74] For commodity delta and vega risks, cross-bucket correlation γbc is set at 20% for all cross-bucket pairs that fall within bucket numbers 1 to 10. γbc is set at 0% for all cross-bucket pairs that include bucket 11. [Basel Framework, MAR 50.75] Commodity delta risk factors for a given bucket: The single commodity delta risk factor is a simultaneous relative shift of the commodity spot prices for all commodities in the bucket. The sensitivities to commodity delta risk factors are measured by simultaneously shifting the spot prices of all commodities in the bucket by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01. The risk weights RWk are set as follows depending on the reference name's bucket: Table 14 Risk weights for commodity delta risk blank Bucket number 1 2 3 4 5 6 7 8 9 10 11 RW 30% 35% 60% 80% 40% 45% 20% 35% 25% 35% 50% [Basel Framework, MAR 50.76] Commodity vega risk factors for a given bucket: The single commodity vega risk factor is a simultaneous relative shift of the volatilities for all commodities in the bucket. The sensitivity to the commodity vega risk factor is measured by simultaneously shifting the volatilities for all commodities in the bucket by 1% relative to their current values and dividing the resulting change in the aggregate CVA (or the value of CVA hedges) by 0.01. The risk weights for commodity volatilities RWk are set to 100%. [Basel Framework, MAR 50.77]

Footnotes

Footnote 1 Note that this is in contrast to the application of the market risk approaches set out in section 9.1.2 of Chapter 9, where institutions do not need OSFI's approval to use the standardized approach. Return to footnote 1 Footnote 2 One of the basic assumptions underlying the BA-CVA is that systematic credit spread risk is driven by a single factor. Under this assumption, ρ can be interpreted as the correlation between the credit spread of a counterparty and the single credit spread systematic factor. Return to footnote 2 Footnote 3 DF is the supervisory discount factor averaged over time between today and the netting set's effective maturity date. The interest rate used for discounting is set at 5%, hence 0.05 in the formula. The product of EAD and effective maturity ‎in the BA-CVA formula is a proxy for the area under the discounted expected exposure profile of the netting set. The IMM definition of effective maturity already includes this discount factor, hence DF is set to 1 for IMM institutions. Outside IMM, the netting set's effective maturity is defined as an average of actual trade maturities. This definition lacks discounting, so the supervisory discount factor is added to compensate for this. Return to footnote 3 Footnote 4 α is the multiplier used to convert Effective expected positive exposure (EEPE) to EAD in both SA-CCR and IMM. Its role in the calculation, therefore, is to convert the EAD of the netting set (EADNS) back to EEPE. Return to footnote 4 Footnote 5 If an institution has prior approval from OSFI to use the Advanced Internal Ratings-Based approach (AIRB) or Foundation Internal Ratings Based approach (FIRB) for credit risk and to use its internal ratings mappings for a particular reference, it does not need to seek OSFI approval in the context of BA-CVA. Return to footnote 5 Footnote 6 This would include non-CSA securities or other physical collateral which impacts the seniority in the recovery process including real estate, oil reserves or other inventories. Return to footnote 6 Footnote 7 For example, if a EUR-reporting bank holds an instrument that references the USD-GBP exchange rate, the bank must measure CVA sensitivity both to the EUR-GBP exchange rate and to the EUR-USD exchange rate. Return to footnote 7

Note

For institutions with a fiscal year ending October 31 or December 31, respectively. The Capital Adequacy Requirements (CAR) for banks, bank holding companies, and trust and loan companies, collectively referred to as ‘institutions’, are set out in nine chapters, each of which has been issued as a separate document. This document, Chapter 9 – Market Risk, should be read in conjunction with the other CAR chapters which include: Chapter 1 - Overview of Risk-based Capital Requirements Chapter 2 - Definition of Capital Chapter 3 - Operational Risk Chapter 4 - Credit Risk – Standardized Approach Chapter 5 - Credit Risk - Internal Ratings Based Approach Chapter 6 - Securitization Chapter 7 - Settlement and Counterparty Risk Chapter 8 - Credit Valuation Adjustment (CVA) Risk Chapter 9 - Market Risk Please refer to OSFI's Corporate Governance Guideline for OSFI's expectations of institution Boards of Directors in regards to the management of capital and liquidity.

Chapter 9 – Market Risk

Eligibility Requirements

This chapter is drawn from the Basel Committee on Banking Supervision (BCBS) market risk framework, which includes Minimum capital requirements for market risk (January 2019)^{Footnote 1}. For reference, the Basel text paragraph numbers that are associated with the text appearing in this chapter are indicated in square brackets at the end of each paragraph.^{Footnote 2} These requirements apply only to internationally active institutions. OSFI retains the right to apply the framework to other institutions, on a case by case basis. All institutions designated by OSFI as domestic systemically important banks (D-SIBs) shall meet the requirements of this chapter.

9.1. Market Risk Terminology, Definition and Application

9.1.1 Market Risk Terminology

This section provides a high-level description of terminologies used in the market risk frameworks. General Terminology Market risk: the risk of losses in on- and off-balance sheet risk positions arising from movements in market prices. [Basel Framework, MAR10.1] Notional value: the notional value of a derivative instrument is equal to the number of units underlying the instrument multiplied by the current market value of each unit of the underlying. [Basel Framework, MAR10.2] Trading desk: a group of traders or trading accounts in a business line within an institution that follows defined trading strategies with the goal of generating revenues or maintaining market presence from assuming and managing risk. [Basel Framework, MAR10.3] Pricing model: a model that is used to determine the value of an instrument (mark-to-market or mark-to-model) as a function of pricing parameters or to determine the change in the value of an instrument as a function of risk factors. A pricing model may be the combination of several calculations; e.g. a first valuation technique to compute a price, followed by valuation adjustments for risks that are not incorporated in the first step. [Basel Framework, MAR10.4] Rating Agencies: OSFI conducted a process to determine which of the major international rating agencies would be recognized as an eligible external credit assessment institution under this chapter. As a result of this process, OSFI will permit institutions to recognize credit ratings from the following rating agencies for market risk capital adequacy purposes: DBRS; Moody’s Investor Service; Standard and Poor’s (S&P); Fitch Rating Services and; Kroll Bond Rating Agency, Inc. Terminology for Financial Instruments Financial instrument: any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments include primary financial instruments (or cash instruments) and derivative financial instruments. [Basel Framework, MAR10.5] Instrument: the term used to describe financial instruments, instruments on foreign exchange (FX) and commodities. [Basel Framework, MAR10.6] Embedded derivative: a component of a financial instrument that includes a non-derivative host contract. For example, the conversion option in a convertible bond is an embedded derivative. [Basel Framework, MAR10.7] Look-through approach: an approach in which an institution determines the relevant capital requirements for a position that has underlyings (such as an index instrument, multi-underlying option, or an equity investment in a fund) as if the underlying positions were held directly by the institution. [Basel Framework, MAR10.8] Terminology for Market Risk Capital Requirement Calculations Risk factor: a principal determinant of the change in value of an instrument (e.g. an exchange rate or interest rate). [Basel Framework, MAR10.9] Risk position: the portion of the current value of an instrument that may be subject to losses due to movements in a risk factor. For example, a bond denominated in a currency different to an institution’s reporting currency has risk positions in general interest rate risk, credit spread risk (non-securitization) and FX risk, where the risk positions are the potential losses to the current value of the instrument that could occur due to a change in the relevant underlying risk factors (interest rates, credit spreads, or exchange rates). [Basel Framework, MAR10.10] Risk bucket: a defined group of risk factors with similar characteristics. [Basel Framework, MAR10.11] Risk class: a defined list of risks that are used as the basis for calculating market risk capital requirements: general interest rate risk, credit spread risk (non-securitization), credit spread risk (securitization: non-correlation trading portfolio), credit spread risk (securitization: correlation trading portfolio), FX risk, equity risk and commodity risk. [Basel Framework, MAR10.12] Terminology for Risk Metrics Sensitivity: an institution’s estimate of the change in value of an instrument due to a small change in one of its underlying risk factors. Delta and vega risks are sensitivities. [Basel Framework, MAR10.13] Delta risk: the linear estimate of the change in value of a financial instrument due to a movement in the value of a risk factor. The risk factor could be the price of an equity or commodity, or a change in an interest rate, credit spread or FX rate. [Basel Framework, MAR10.14] Vega risk: the potential loss resulting from the change in value of a derivative due to a change in the implied volatility of its underlying. [Basel Framework, MAR10.15] Curvature risk: the additional potential loss beyond delta risk due to a change in a risk factor for financial instruments with optionality. In the standardized approach in the market risk framework, it is based on two stress scenarios involving an upward shock and a downward shock to each regulatory risk factor. [Basel Framework, MAR10.16] Value at risk (VaR): a measure of the worst expected loss on a portfolio of instruments resulting from market movements over a given time horizon and a pre-defined confidence level. [Basel Framework, MAR10.17] Expected shortfall (ES): a measure of the average of all potential losses exceeding the VaR at a given confidence level. [Basel Framework, MAR10.18] Jump-to-default (JTD): the risk of a sudden default. JTD exposure refers to the loss that could be incurred from a JTD event. [Basel Framework, MAR10.19] Liquidity horizon: the time assumed to be required to exit or hedge a risk position without materially affecting market prices in stressed market conditions. [Basel Framework, MAR10.20] Terminology for Hedging and Diversification Basis risk: the risk that prices of financial instruments in a hedging strategy are imperfectly correlated, reducing the effectiveness of the hedging strategy. [Basel Framework, MAR10.21] Diversification: the reduction in risk at a portfolio level due to holding risk positions in different instruments that are not perfectly correlated with one another. [Basel Framework, MAR10.22] Hedge: the process of counterbalancing risks from exposures to long and short risk positions in correlated instruments. [Basel Framework, MAR10.23] Offset: the process of netting exposures to long and short risk positions in the same risk factor. [Basel Framework, MAR10.24] Standalone: being capitalised on a stand-alone basis means that risk positions are booked in a discrete, non-diversifiable trading book portfolio so that the risk associated with those risk positions cannot diversify, hedge or offset risk arising from other risk positions, nor be diversified, hedged or offset by them. [Basel Framework, MAR10.25] Terminology for Risk Factor Eligibility and Modellability Real prices: a term used for assessing whether risk factors pass the risk factor eligibility test. A price will be considered real if it is (i) a price from an actual transaction conducted by the institution, (ii) a price from an actual transaction between other arm’s length parties (e.g. at an exchange), or (iii) a price taken from a firm quote (i.e. a price at which the institution could transact with an arm’s length party). [Basel Framework, MAR10.26] Modellable risk factor: risk factors that are deemed modellable, based on the number of representative real price observations and additional qualitative principles related to the data used for the calibration of the ES model. Risk factors that do not meet the requirements for the risk factor eligibility test are deemed as non-modellable risk factors (NMRF). [Basel Framework, MAR10.27] Terminology for Internal Model Validation Backtesting: the process of comparing daily actual and hypothetical profits and losses with model-generated VaR measures to assess the conservatism of risk measurement systems. [Basel Framework, MAR10.28] Profit and loss (P&L) attribution (PLA): a method for assessing the robustness of institutions’ risk management models by comparing the risk-theoretical P&L predicted by trading desk risk management models with the hypothetical P&L. [Basel Framework, MAR10.29] Trading desk risk management model: the trading desk risk management model (pertaining to in-scope desks) includes all risk factors that are included in the institution’s ES model with OSFI parameters and any risk factors deemed not modellable, which are therefore not included in the ES model for calculating the respective regulatory capital requirement, but are included in NMRFs. [Basel Framework, MAR10.30] Actual P&L (APL): the actual P&L derived from the daily P&L process. It includes intraday trading as well as time effects and new and modified deals, but excludes fees and commissions as well as valuation adjustments for which separate regulatory capital approaches have been otherwise specified as part of the rules or which are deducted from Common Equity Tier 1 (CET1). Any other valuation adjustments that are market risk-related must be included in the APL. As is the case for the hypothetical P&L, the APL should include FX and commodity risks from positions held in the banking book. [Basel Framework, MAR10.31] Hypothetical P&L (HPL): the daily P&L produced by revaluing the positions held at the end of the previous day using the market data at the end of the current day. Commissions, fees, intraday trading and new/modified deals, valuation adjustments for which separate regulatory capital approaches have been otherwise specified as part of the rules and valuation adjustments which are deducted from CET1 are excluded from the HPL. Valuation adjustments updated daily should usually be included in the HPL. Time effects should be treated in a consistent manner in the HPL and risk-theoretical P&L. [Basel Framework, MAR10.32] Risk-theoretical P&L (RTPL): the daily desk-level P&L that is predicted by the valuation engines in the trading desk risk management model using all risk factors used in the trading desk risk management model (i.e. including the NMRFs). [Basel Framework, MAR10.33] Terminology for Credit Valuation Adjustment Risk Credit valuation adjustment (CVA): an adjustment to the valuation of a derivative transaction to account for the credit risk of contracting parties. [Basel Framework, MAR10.34] CVA risk: the risk of changes to CVA arising from changes in credit spreads of the contracting parties, compounded by changes to the value or variability in the value of the underlying of the derivative transaction. [Basel Framework, MAR10.35] 9.1.2 Definitions and Application of Market Risk This section defines the methods available for calculating and the scope of application of market risk capital requirements. Definition and Scope of Application Market risk is defined as the risk of losses arising from movements in market prices. The risks subject to market risk capital requirements include but are not limited to: default risk, interest rate risk, credit spread risk, equity risk, foreign exchange (FX) risk and commodities risk for trading book instruments; and FX risk and commodities risk for banking book instruments. [Basel Framework, MAR11.1] Derivative, repurchase/reverse repurchase, securities lending and other transactions booked in the trading book are subject to both the market risk and the counterparty credit risk capital requirements. This is because they face the risk of loss due to market fluctuations in the value of the underlying instrument and due to the failure of the counterparty to the contract. The counterparty risk weights used to calculate the credit risk capital requirements for these transactions are those used for calculating the capital requirements in the banking book. All transactions, including forward sales and purchases, shall be included in the calculation of capital requirements as of the date on which they were entered into. Although regular reporting will in principle take place only at intervals (quarterly in most countries), institutions are expected to manage their market risk in such a way that the capital requirements are being met on a continuous basis, including at the close of each business day. OSFI has at its disposal a number of effective measures to ensure that institutions do not window-dress by showing significantly lower market risk positions on reporting dates. Institutions will also be expected to maintain strict risk management systems to ensure that intraday exposures are not excessive. If an institution fails to meet the capital requirements at any time, OSFI shall ensure that the institution takes immediate measures to rectify the situation. [Basel Framework, MAR11.2] A matched currency risk position will protect an institution against loss from movements in exchange rates, but will not necessarily protect its capital adequacy ratio. If an institution has its capital denominated in its domestic currency and has a portfolio of foreign currency assets and liabilities that is completely matched, its capital/asset ratio will fall if the domestic currency depreciates. By running a short risk position in the domestic currency, the institution can protect its capital adequacy ratio, although the risk position would lead to a loss if the domestic currency were to appreciate. OSFI will allow institutions to protect their capital adequacy ratio in this way and exclude certain currency risk positions from the calculation of net open currency risk positions, subject to meeting each of the following conditions: The risk position is taken or maintained for the purpose of hedging partially or totally against the potential that changes in exchange rates could have an adverse effect on its capital ratio. The risk position is of a structural (i.e. non-dealing) nature such as positions stemming from: investments in affiliated but not consolidated entities denominated in foreign currencies; or investments in consolidated subsidiaries or branches denominated in foreign currencies. The exclusion is limited to the amount of the risk position that neutralizes the sensitivity of the capital ratio to movements in exchange rates. The exclusion from the calculation is made for at least six months. The establishment of a structural FX position and any changes in its position must follow the institution’s risk management policy for structural FX positions. This policy must be pre-approved by OSFI. Any exclusion of the risk position needs to be applied consistently, with the exclusionary treatment of the hedge remaining in place for the life of the assets or other items. The institution must document and have available for OSFI review the positions and amounts to be excluded from market risk capital requirements. [Basel Framework, MAR11.3] No FX risk capital requirement will apply to positions related to items that are deducted from an institution’s capital when calculating its capital base. [Basel Framework, MAR11.4] Holdings of capital instruments that are deducted from an institution’s capital or risk weighted at 1250% are not allowed to be included in the market risk framework. This includes: holdings of the institution’s own eligible regulatory capital instruments and, if applicable, own Other TLAC Instruments^{Footnote 3}; and holdings of other institutions’, securities firms’ and other financial entities’ eligible regulatory capital instruments and in G-SIBs’ or D-SIBs’ Other TLAC Instruments, as well as intangible assets, where OSFI requires that such assets are deducted from capital. Where an institution demonstrates that it is an active market-maker, OSFI may establish a dealer exception for holdings of other institutions’, securities firms’, and other financial entities’ capital instruments in the trading book. In order to qualify for the dealer exception, the institution must have adequate systems and controls surrounding the trading of financial institutions’ eligible regulatory capital instruments and Other TLAC Instruments. [Basel Framework, MAR11.5] This dealer exception applies only to positions in another institution’s regulatory capital instruments and/or Other TLAC Instruments that do not exceed the 10% threshold or the 5% threshold on non-significant investments described in Chapter 2 – Definition of Capital, section 2.3. For the capital treatment of significant investments in capital and Other TLAC Instruments of banks, financial and insurance entities refer to Chapter 2 – Definition of Capital, section 2.3. In the same way as for credit risk and operational risk, the capital requirements for market risk apply on a worldwide consolidated basis. OSFI may permit banking and financial entities in a group which is running a global consolidated trading book and whose capital is being assessed on a global basis to include just the net short and net long risk positions no matter where they are booked.^{Footnote 4} OSFI may grant this treatment only when the standardized approach in section 9.5 permits a full offset of the risk position (i.e. risk positions of the opposite sign do not attract a capital requirement). Nonetheless, there will be circumstances in which OSFI demands that the individual risk positions be taken into the measurement system without any offsetting or netting against risk positions in the remainder of the group. This may be needed, for example, where there are obstacles to the quick repatriation of profits from a foreign subsidiary or where there are legal and procedural difficulties in carrying out the timely management of risks on a consolidated basis. Moreover, OSFI will retain the right to continue to monitor the market risks of individual entities on a non-consolidated basis to ensure that significant imbalances within a group do not escape supervision. OSFI will be especially vigilant in ensuring that institutions do not conceal risk positions on reporting dates in such a way as to escape measurement. [Basel Framework, MAR11.6] Methods of Measuring Market Risk In determining its market risk for regulatory capital requirements, an institution may choose between two broad methodologies: the standardized approach and internal models approach (IMA) for market risk, described in section 9.5 and section 9.6, respectively, subject to the approval of OSFI. [Basel Framework, MAR11.7] All institutions must calculate the capital requirements using the standardized approach. Institutions that are approved by OSFI to use the IMA for market risk capital requirements must also calculate and report the capital requirement values calculated as set out below. An institution that uses the IMA for any of its trading desks must also calculate the capital requirement under the standardized approach for all instruments across all trading desks, regardless of whether those trading desks are eligible for the IMA. In addition, an institution that uses the IMA for any of its trading desks must calculate the standardized approach capital requirement for each trading desk that is eligible for the IMA as if that trading desk were a standalone regulatory portfolio (i.e. with no offsetting across trading desks). This will: serve as an indication of the fallback capital requirement for those desks that fail the eligibility criteria for inclusion in the institution’s internal model as outlined in section 9.6; generate information on the capital outcomes of the internal models relative to a consistent benchmark and facilitate comparison in implementation between institutions and/or across jurisdictions; monitor over time the relative calibration of standardized and modelled approaches, facilitating adjustments as needed; and provide macroprudential insight in an ex ante consistent format. [Basel Framework, MAR11.8] All institutions must calculate the market risk capital requirement using the standardized approach for the following: securitization exposures; and equity investments in funds that cannot be looked through but are assigned to the trading book in accordance to the conditions set out in paragraph 65(5)(b). [Basel Framework, MAR11.9] With respect to securitization exposures, asset backed securities that do not involve “at least two different stratified risk positions or tranches reflecting different degrees of credit risk” but might involve other sorts of tranching associated with pre-payment, as an example, are not considered products under this framework. As a consequence, such products can be treated as non-securitized positions for the purposes of credit spread risk capital requirements based on either the standardized framework or internal models. If in the standardized framework, these positions could also be subject to the residual risk add on if they are exposed to prepayment risk. Definitions of Trading Desk This section defines a trading desk, which is the level at which model approval is granted. For the purposes of market risk capital calculations, 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. [Basel Framework, MAR12.1] Trading desks are defined by the institution but subject to the regulatory approval of OSFI for capital purposes. An institution should be allowed to propose the trading desk structure per their organizational structure, consistent with the requirements set out in paragraph 55. An institution must prepare a policy document for each trading desk it defines, documenting how the institution satisfies the key elements in paragraph 55. OSFI will treat the definition of the trading desk as part of the initial model approval for the trading desk, as well as ongoing approval. OSFI may determine, based on the size of the institution’s overall trading operations, whether the proposed trading desk definitions are sufficiently granular. OSFI will check that the institution’s proposed definition of trading desk meets the criteria listed in key elements set out in paragraph 55. [Basel Framework, MAR12.2] Within this OSFI-approved trading desk structure, institutions may further define operational subdesks without the need for OSFI approval. These subdesks would be for internal operational purposes only and would not be used in the market risk capital framework. [Basel Framework, MAR12.3] The key attributes of a trading desk are as follows: A trading desk for the purposes of the regulatory capital charge is an unambiguously defined group of traders or trading accounts. A trading account is an indisputable and unambiguous unit of observation in accounting for trading activity. The trading desk must have one head trader and can have up to two head traders provided their roles, responsibilities and authorities are either clearly separated or one has ultimate oversight over the other. The head trader must have direct oversight of the group of traders or trading accounts. Each trader or each trading account in the trading desk must have a clearly defined specialty (or specialties). Each trading account must only be assigned to a single trading desk. The desk must have a clearly defined risk scope consistent with its pre-established objectives. The scope should include specification of the desk’s overall risk class and permitted risk factors. There is a presumption that traders (as well as head traders) are allocated to one trading desk. An institution can deviate from this presumption and may assign an individual trader to work across several trading desks provided it can be justified to OSFI on the basis of sound management, business and/or resource allocation reasons. Such assignments must not be made for the only purpose of avoiding other trading desk requirements (e.g. to optimize the likelihood of success in the backtesting and profit and loss attribution tests). The trading desk must have a clear reporting line to institution senior management, and should have a clear and formal compensation policy clearly linked to the pre-established objectives of the trading desk. A trading desk must have a well-defined and documented business strategy, including an annual budget and regular management information reports (including revenue, costs and risk-weighted assets). There must be a clear description of the economics of the business strategy for the trading desk, its primary activities and trading/hedging strategies. Economics: what is the economics behind the strategy (e.g. trading on the shape of the yield curve)? How much of the activities are customer driven? Does it entail trade origination and structuring, or execution services, or both? Primary activities: what is the list of permissible instruments and, out of this list, which are the instruments most frequently traded? Trading/hedging strategies: how would these instruments be hedged, what are the expected slippages and mismatches of hedges, and what is the expected holding period for positions? The management team at the trading desk (starting from the head trader) must have a clear annual plan for the budgeting and staffing of the trading desk. A trading desk’s documented business strategy must include regular Management Information reports, covering revenue, costs and risk-weighted assets for the trading desk. A trading desk must have a clear risk management structure. Risk management responsibilities: the institution must identify key groups and personnel responsible for overseeing the risk-taking activities at the trading desk. A trading desk must 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 at the institution. In setting limits, the trading desk must have: well-defined trading limits or directional exposures at the trading desk level that are based on the appropriate market risk metric (e.g. sensitivity of credit spread risk and/or jump-to-default for a credit trading desk), or just overall notional limits; and well-defined trader mandates. A trading desk under the internal model approach must produce, at least weekly, appropriate risk management reports. This would include, at a minimum: profit and loss reports, which would be periodically reviewed, validated and modified (if necessary) by Product Control; and internal and regulatory risk measure reports, including trading desk VaR / ES, trading desk VaR/ES sensitivities to risk factors, backtesting and p-value. [Basel Framework, MAR12.4] The institution must prepare, evaluate, and have available for OSFI the following for all trading desks: inventory ageing reports; daily limit reports including exposures, limit breaches, and follow-up action; reports on intraday limits and respective utilization and breaches for institutions with active intraday trading; and reports on the assessment of market liquidity. [Basel Framework, MAR12.5] Any foreign exchange or commodity positions held in the banking book must be included in the market risk capital requirement as set out in paragraph 40. For regulatory capital calculation purposes, these positions will be treated as if they were held on notional trading desks within the trading book. In the context of banking book FX and commodities positions, a “notional trading desk” does not necessarily have traders or trading accounts assigned to it, nor does it need to meet the qualitative trading desk requirements set out in this section. Institutions that wish to use the IMA to measure the FX or commodity risk of such notional trading desks must take at least one of the following actions: Transfer all or part of banking book FX and commodity risks to another trading desk via intra-trading book internal risk transfers (IRTs) (where trading desk requirements would continue to apply as appropriate for that desk); Apply for IMA approval for the notional trading desk. In this case, the notional desk only needs to meet the quantitative trading desk requirements. Subject to certain conditions, certain traders can have ownership and responsibilities in both trading book and banking book portfolios. [Basel Framework, MAR12.6]

9.2. Boundary between the Banking Book and the Trading Book

This section sets out the instruments to be included in the trading book (which are subject to market risk capital requirements) and those to be included in the banking book (which are subject to credit risk capital requirements).

Scope of the Trading Book

A trading book consists of all instruments that meet the specifications for trading book instruments set out in paragraphs 59 through 70. All other instruments must be included in the banking book. [Basel Framework, RBC25.1] Instruments comprise financial instruments, foreign exchange (FX), and commodities. A 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. Financial instruments include primary financial instruments (or cash instruments) and derivative financial instruments. 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. Commodities also include non-tangible (i.e. non-physical) goods such as electric power. The CSR capital requirement applies to money market instruments to the extent such instruments are covered instruments (i.e. they meet the definition of instruments to be included in the trading book as specified in paragraphs 59 through 70. [Basel Framework, RBC25.2] Institutions may only include a financial instrument, instruments on FX or commodity in the trading book when there is no legal impediment against selling or fully hedging it. [Basel Framework, RBC25.3] Institutions must fair value daily any trading book instrument and recognize any valuation change in the profit and loss (P&L) account. Instruments designated under the fair value option may be allocated to the trading book, but only if they comply with all the relevant requirements for trading book instruments set out in section 9.2. [Basel Framework, RBC25.4]

Standards for Assigning Instruments to the Regulatory Books

Any instrument an institution holds for one or more of the following purposes must, when it is first recognised on its books, be designated as a trading book instrument, unless specifically otherwise provided for in paragraph 60 or paragraph 64: short-term resale; profiting from short-term price movements; locking in arbitrage profits; or hedging risks that arise from instruments meeting (1), (2) or (3) above. Evidence of periodic sale activity is insufficient on its own to consider such position as being held for short-term resale and, as such, is insufficient to meet sub-bullet (1). [Basel Framework, RBC25.5] Any of the following instruments is seen as being held for at least one of the purposes listed in paragraph 62 and must therefore be included in the trading book, unless specifically otherwise provided for in paragraph 60 or paragraph 65: instruments in the correlation trading portfolio; instruments that would give rise to a net short credit or equity position in the banking book;^{Footnote 5} or instruments resulting from underwriting commitments, where underwriting commitments refer only to securities underwriting, and relate only to securities that are expected to be actually purchased by the institution on the settlement date^{Footnote 6}. Institutions should have processes in place to manage and monitor their banking book positions to ensure that any instrument that individually has the potential to create a net short credit or equity position in the banking book is not actually creating a non-negligible net short position at any point in time. Such processes should include clear limit structures and an appropriate monitoring frequency. Institutions should be proactive in identifying potential non-negligible net short positions and limiting their occurrence. As a general principle, instruments that give rise to a net short credit or equity position in the banking book must be assigned to the trading book unless a trading book treatment is explicitly excluded for the specific type of position. For example, if a credit default swap (CDS) that hedges loans in the banking book gives rise to a net short credit position, the net short position resulting from such instruments (i.e. the amount which cannot be offset against any long positions) must be treated as a trading book position and be subject to market risk capital requirements. [Basel Framework, RBC25.6] Any instrument which is not held for any of the purposes listed in paragraph 62 at inception, nor seen as being held for these purposes according to paragraph 63, must be assigned to the banking book. [Basel Framework, RBC25.7] The following instruments must be assigned to the banking book: unlisted equities; instruments designated for securitization warehousing; real estate holdings, where in the context of assigning instrument to the trading book, real estate holdings relate only to direct holdings of real estate as well as derivatives on direct holdings; retail and small or medium-sized enterprise (SME) credit, including commitments; equity investments in a fund, unless the institution meets at least one of the following conditions: the institution is able to look through the fund to its individual components at least on a quarterly basis, and there is sufficient and frequent information, verified by an independent third party, provided to the institution regarding the fund’s composition; or the institution obtains daily price quotes for the fund and it has access to the information contained in the fund’s mandate or in the national regulations governing such investment funds; hedge funds; derivative instruments and funds that have the above instrument types as underlying assets; and instruments held for the purpose of hedging a particular risk of a position in the types of instrument above. [Basel Framework, RBC25.8] There is a general presumption that any of the following instruments are being held for at least one of the purposes listed in paragraph 62 and therefore are trading book instruments, unless specifically otherwise provided for in paragraph 60 or paragraph 65: instruments held as accounting trading assets or liabilities;^{Footnote 7} instruments resulting from market-making activities; equity investments in a fund excluding those assigned to the banking book in accordance with paragraph 65(5); listed equities;^{Footnote 8} trading-related repo-style transactions, which comprise those entered into for the purposes of market-making, locking in arbitrage profits or creating short credit or equity positions. Repo-style transactions that are (i) entered for liquidity management or (ii) valued at accrual for accounting purpose are not part of the presumptive list of paragraph 66. Institutions must have documentation for the definition of liquidity management and internal control processes to monitor these transactions, which should be made available to OSFI upon request; or options including embedded derivatives^{Footnote 9} from instruments that the institution issued out of its own banking book and that relate to credit or equity risk. Liabilities issued out of the institution’s own banking book that contain embedded derivatives and thereby meet the criteria of paragraph 66(6) should be bifurcated. This means that institutions should split the liability into two components: (i) the embedded derivative, which is assigned to the trading book; and (ii) the residual liability, which is retained in the banking book. No internal risk transfers are necessary for this bifurcation. Likewise, where such a liability is unwound, or where an embedded option is exercised, both the trading and banking book components are conceptually unwound simultaneously and instantly retired; no transfers between trading and banking book are necessary. An option that manages FX risk in the banking book is covered by the presumptive list of trading book instruments included in paragraph 66(6). Only with explicit OSFI approval may an institution include in its banking book an option that manages banking book FX risk. A floor to an equity-linked bond is an embedded option with an equity as part of the underlying, and therefore the embedded option should be bifurcated and included in the trading book. [Basel Framework, RBC25.9] Institutions are allowed to deviate from the presumptive list specified in paragraph 66 according to the process set out below.^{Footnote 10} If an institution believes that it needs to deviate from the presumptive list established in paragraph 66 for an instrument, it must submit a request to OSFI and receive explicit approval. In its request, the institution must provide evidence that the instrument is not held for any of the purposes in paragraph 62. In cases where this approval is not given by OSFI, the instrument must be designated as a trading book instrument. Institutions must document any deviations from the presumptive list in detail on an on-going basis. Repo-style transactions not held for any of the purposes in paragraph 62 can be exempted from the list of presumptive trading book instruments in paragraph 66(5) and can be designated in the banking book for regulatory capital purposes. [Basel Framework, RBC25.10]

Supervisory Powers

Notwithstanding the process established in paragraph 67 for instruments on the presumptive list, OSFI may require the institution to provide evidence that an instrument in the trading book is held for at least one of the purposes of paragraph 62. If OSFI is of the view that an institution has not provided enough evidence or if OSFI believes the instrument customarily would belong in the banking book, it may require the institution to assign the instrument to the banking book, except if it is an instrument listed under paragraph 63. [Basel Framework, RBC25.11] OSFI may require the institution to provide evidence that an instrument in the banking book is not held for any of the purposes of paragraph 62. If OSFI is of the view that an institution has not provided enough evidence, or if OSFI believes such instruments would customarily belong in the trading book, it may require the institution to assign the instrument to the trading book, except if it is an instrument listed under paragraph 65. [Basel Framework, RBC25.12]

Documentation of Instrument Designation

An institution must have clearly defined policies, procedures and documented practices for determining which instruments to include in or to exclude from the trading book for the purposes of calculating their regulatory capital, ensuring compliance with the criteria set forth in this section, and taking into account the institution’s risk management capabilities and practices. An institution’s internal control functions must conduct an ongoing evaluation of instruments both in and out of the trading book to assess whether its instruments are being properly designated initially as trading or non-trading instruments in the context of the institution’s trading activities. Compliance with the policies and procedures must be fully documented and subject to periodic (at least yearly) internal audit and the results must be available for OSFI’s review. [Basel Framework, RBC25.13]

Restrictions on Moving Instruments between the Regulatory Books

Apart from moves required by paragraphs 62 to 67, there is a strict limit on the ability of institutions to move instruments between the trading book and the banking book by their own discretion after initial designation, which is subject to the process in paragraphs 72 and 73. Switching instruments for regulatory arbitrage is strictly prohibited. In practice, switching should be rare and will be allowed by OSFI only in extraordinary circumstances. Examples are a major publicly announced event, such as an institution restructuring that results in the permanent closure of trading desks, requiring termination of the business activity applicable to the instrument or portfolio or a change in accounting standards^{Footnote 11} that allows an item to be fair-valued through P&L. Market events, changes in the liquidity of a financial instrument, or a change of trading intent alone are not valid reasons for reassigning an instrument to a different book. When switching positions, institutions must ensure that the standards described in paragraphs 62 to 67 are always strictly observed. [Basel Framework, RBC25.14] Without exception, a capital benefit as a result of switching will not be allowed in any case or circumstance. This means that the institution must determine its total capital requirement (across the banking book and trading book) before and immediately after the switch. If this capital requirement is reduced as a result of this switch, the difference as measured at the time of the switch will be imposed on the institution as a disclosed Pillar 1 capital surcharge. This surcharge will be allowed to run off as the positions mature or expire, in a manner agreed with OSFI. To maintain operational simplicity, it is not envisaged that this additional capital requirement would be recalculated on an ongoing basis, although the positions would continue to also be subject to the ongoing capital requirements of the book into which they have been switched. The disallowance of capital benefits as a result of switching positions from one book to another applies without exception and in any case or circumstance. It is therefore independent of whether the switch has been made at the discretion of the institution or is beyond its control, e.g. in the case of the delisting of an equity. [Basel Framework, RBC25.15] Any reassignment between books must be approved by senior management and OSFI as follows. Any reallocation of securities between the trading book and banking book, including outright sales at arm’s length, should be considered a reassignment of securities and is governed by requirements of this paragraph. Any reassignment must be approved by senior management; thoroughly documented; determined by internal review to be in compliance with the institution’s policies; subject to prior approval by OSFI based on supporting documentation provided by the institution; and publicly disclosed. Unless required by changes in the characteristics of a position, any such reassignment is irrevocable. If an instrument is reclassified to be an accounting trading asset or liability there is a presumption that this instrument is in the trading book, as described in paragraph 66. Accordingly, in this case an automatic switch without approval of OSFI is acceptable. The treatment specified for internal risk transfers applies only to risk transfers done via internal derivatives trades. The reallocation of securities between trading and banking book should be considered a re-assignment of securities and is governed by this paragraph. Moving instruments between the trading book and the banking book should be rare. The movement of an instrument from the trading book to the banking book requires OSFI approval. Where an instrument is reclassified as an accounting trading asset or liability and per sub-bullet (3) above, and is switched to a trading book instrument for capital requirement purposes without OSFI approval, the disallowance of capital requirement benefits specified in paragraph 72 will apply. [Basel Framework, RBC25.16] An institution must adopt relevant policies that must be updated at least yearly. Updates should be based on an analysis of all extraordinary events identified during the previous year. Updated policies with changes highlighted must be sent to OSFI. Policies must include the following: The reassignment restriction requirements in paragraphs 71 through 73, especially the restriction that re-designation between the trading book and banking book may only be allowed in extraordinary circumstances, and a description of the circumstances or criteria where such a switch may be considered. The process for obtaining senior management and OSFI approval for such a transfer. How an institution identifies an extraordinary event. A requirement that re-assignments into or out of the trading book be publicly disclosed at the earliest reporting date. Institutions are permitted to exclude the following from the restrictions on moving instruments between regulatory books noted in paragraphs 71 to 73: CAD-denominated Level 1 and Level 2A High Quality Liquid Assets (HQLA); and non CAD-currency denominated Level 1 and Level 2A HQLA issued by Canadian entities^{Footnote 12}, as defined in Chapter 2 of OSFI’s Liquidity Adequacy Requirements Guideline. Where an institution’s Treasury purchases new issuances of the institution’s own stamped Bankers Acceptances from its dealer, such securities do not need to be included within the restrictions on moving instruments noted in paragraphs 71 to 73. [Basel Framework, RBC25.17]

Treatment of Internal Risk Transfers

An internal risk transfer is an internal written record of a transfer of risk within the banking book, between the banking and the trading book or within the trading book (between different desks). [Basel Framework, RBC25.18] There will be no regulatory capital recognition for internal risk transfers from the trading book to the banking book. Thus, if an institution engages in an internal risk transfer from the trading book to the banking book (e.g. for economic reasons) this internal risk transfer would not be taken into account when the regulatory capital requirements are determined. [Basel Framework, RBC25.19] For internal risk transfers from the banking book to the trading book, paragraphs 78 to 84 apply. [Basel Framework, RBC25.20] Internal risk transfer of credit and equity risk from banking book to trading book When an institution hedges a banking book credit risk exposure or equity risk exposure using a hedging instrument purchased through its trading book (i.e. using an internal risk transfer), The credit exposure in the banking book is deemed to be hedged for capital requirement purposes if and only if: the trading book enters into an external hedge with an eligible third-party protection provider that exactly matches the internal risk transfer; and the external hedge meets the requirements of paragraphs 265 to 270 of Chapter 4 vis-à-vis the banking book exposure.^{Footnote 13} The equity exposure in the banking book is deemed to be hedged for capital requirement purposes if and only if: the trading book enters into an external hedge from an eligible third-party protection provider that exactly matches the internal risk transfer; and the external hedge is recognized as a hedge of a banking book equity exposure. External hedges for the purposes of paragraph 78(1) and 78(2) can be made up of multiple transactions with multiple counterparties as long as the aggregate external hedge exactly matches the internal risk transfer, and the internal risk transfer exactly matches the aggregate external hedge. The term ‘exactly matches’ implies that the external hedge is considered to be effective if changes in fair value of the external hedge and the internal hedge are within a range of 90% to 110%. This assessment of effectiveness is to be done at inception and on a monthly basis thereafter, and the external hedge must be identified within five business days of the internal hedge. Institutions are expected to capture any residual risks add-on between the internal and external hedge with respect to instruments with exotic underlying and instruments bearing other residual risks, consistent with section 9.5.4. [Basel Framework, RBC25.21] Where the requirements in the paragraph above are fulfilled, the banking book exposure is deemed to be hedged by the banking book leg of the internal risk transfer for capital purposes in the banking book. Moreover both the trading book leg of the internal risk transfer and the external hedge must be included in the market risk capital requirements. [Basel Framework, RBC25.22] Where the requirements in paragraph 78 are not fulfilled, the banking book exposure is not deemed to be hedged by the banking book leg of the internal risk transfer for capital purposes in the banking book. Moreover, the third-party external hedge must be fully included in the market risk capital requirements and the trading book leg of the internal risk transfer must be fully excluded from the market risk capital requirements. [Basel Framework, RBC25.23] A banking book short credit position or a banking book short equity position created by an internal risk transfer^{Footnote 14} and not capitalised under banking book rules must be capitalised under the market risk rules together with the trading book exposure. [Basel Framework, RBC25.24] Internal risk transfer of general interest rate risk from banking book to trading book When an institution hedges a banking book interest rate risk exposure using an internal risk transfer with its trading book on or after the beginning of the institution’s fiscal Q1-2024, the trading book leg of the internal risk transfer is treated as a trading book instrument under the market risk framework if and only if: the internal risk transfer is documented with respect to the banking book interest rate risk being hedged and the sources of such risk; the internal risk transfer is conducted with a dedicated internal risk transfer trading desk which has been specifically approved by OSFI for this purpose; and the internal risk transfer must be subject to trading book capital requirements under the market risk framework on a stand-alone basis for the dedicated internal risk transfer desk, separate from any other GIRR or other market risks generated by activities in the trading book. Similar to the notional trading desk treatment set out in paragraph 57 for foreign exchange or commodities positions held in the banking book, general interest rate (GIRR) internal risk transfers (IRT) may be allocated to a trading desk that may not have traders or trading account assigned to it. For a GIRR IRT trading desk, only the quantitative requirements (i.e. PLA test and backtesting) set out in section 9.6.3 apply, while the qualitative criteria for trading desks as set out in paragraph 55 do not apply. A GIRR IRT desk must not have any trading book positions allocated to it, except GIRR IRTs between the trading book and the banking book as well as any external hedges that meet the conditions specified in paragraph 84. [Basel Framework, RBC25.25] Where the requirements in the paragraph above are fulfilled, the banking book leg of the internal risk transfer must be included in the banking book’s measure of interest rate risk exposures for regulatory capital purposes. [Basel Framework, RBC25.26] The OSFI-approved internal risk transfer desk may include instruments purchased from the market (i.e. external parties to the institution). Such transactions may be executed directly between the internal risk transfer desk and the market. Alternatively, the internal risk transfer desk may obtain the external hedge from the market via a separate non-internal risk transfer trading desk acting as an agent, if and only if the GIRR internal risk transfer entered into with the non-internal risk transfer trading desk exactly matches the external hedge from the market. In this latter case the respective legs of the GIRR internal risk transfer are included in the internal risk transfer desk and the non-internal risk transfer desk. External hedges for the purposes of this paragraph can be made up of multiple transactions with multiple counterparties as long as the aggregate external hedge exactly matches the internal risk transfer, and the internal risk transfer exactly matches the aggregate external hedge. The term ‘exactly matches’ implies that the external hedge is considered to be effective if changes in fair value of the external hedge and the internal hedge are within a range of 90% to 110%. This assessment of effectiveness is to be done at inception and on a monthly basis thereafter, and the external hedge must be identified within five business days of the internal hedge. Institutions are expected to capture any residual risks add-on between the internal and external hedge with respect to instruments with exotic underlying and instruments bearing other residual risks, consistent with section 9.5.4. [Basel Framework, RBC25.27] Internal risk transfers within the scope of application of the market risk capital requirement Internal risk transfers between trading desks within the scope of application of the market risk capital requirements (including FX risk and commodities risk in the banking book) will generally receive regulatory capital recognition. Internal risk transfers between the internal risk transfer desk and other trading desks will only receive regulatory capital recognition if the constraints in paragraphs 82 to 84 are fulfilled. There are no constraints on IRTs between trading desks that have internal model approval and trading desks that do not. In order to ensure a sufficiently conservative aggregation of risks, the aggregation of the capital requirements calculated using the standardized approach and the internal models approach does not recognize portfolio effects between trading desks that use either the standardized approach or the internal models approach. [Basel Framework, RBC25.28] The trading book leg of internal risk transfers must fulfil the same requirements under paragraph 82 as instruments in the trading book transacted with external counterparties. [Basel Framework, RBC25.29] Eligible hedges for the CVA capital requirement Eligible external hedges that are included in the credit valuation adjustment (CVA) capital requirement, and FX and commodity risk arising from CVA hedges that are eligible under the CVA standard, must be removed from the institution’s market risk capital requirement calculation. [Basel Framework, RBC25.30] Institutions may enter into internal risk transfers between the CVA portfolio and the trading book. Such an internal risk transfer consists of a CVA portfolio side and a non-CVA portfolio side. Where the CVA portfolio side of an internal risk transfer is recognised in the CVA risk capital requirement, the CVA portfolio side should be excluded from the market risk capital requirement, while the non-CVA portfolio side should be included in the market risk capital requirement. [Basel Framework, RBC25.31] In any case, such internal CVA risk transfers can only receive regulatory capital recognition if the internal risk transfer is documented with respect to the CVA risk being hedged and the sources of such risk. [Basel Framework, RBC25.32] Internal CVA risk transfers that are subject to curvature, default risk or residual risk add-on as set out in section 9.5 may be recognised in the CVA portfolio capital requirement and market risk capital requirement only if the trading book additionally enters into an external hedge with an eligible third-party protection provider that exactly matches the internal risk transfer. [Basel Framework, RBC25.33] Independent from the treatment in the CVA risk capital requirement and the market risk capital requirement, internal risk transfers between the CVA portfolio and the trading book can be used to hedge the counterparty credit risk exposure of a derivative instrument in the trading or banking book as long as the requirements of paragraph 78 are met. [Basel Framework, RBC25.34] The revised CVA framework (see Chapter 8) now captures both the risk and hedges of CVA (including both the credit risk and exposure components). As such, any other transactions related to the management of CVA risk will not be covered in the market risk framework. In addition, institutions are not permitted to include sensitivities to other valuation adjustment (commonly referred to as xVA) in the market risk framework. However, any market risk hedges of xVA risk must be included in the market risk framework with the following exceptions: Any market risk hedges of collateral valuation adjustments (ColVA sometimes referred to as overnight indexed swap or OIS discounting) that meet the conditions for eligibility listed in the paragraph below; and, Any market risk hedges of the exposure component of funding VA (FVA)^{Footnote 15}. Hedges of ColVA and hedges of the exposure component of FVA can be excluded from the market risk framework if all of the following conditions are met: Institutions have a well-defined and nominated trading desk that satisfies the organizational structure described in paragraph 55. That structure must include an independent risk control unit responsible for the design, documentation, and implementation of the measurement of FVA and ColVA risk. This unit should report directly to senior management of the institution. The excluded hedges are evidenced to be risk reducing at their inception according to the documented measure of FVA and/or ColVA risk through the use of: (i) risk factor identification processes, (ii) regular assessment of risk capture between unhedged- and hedged-P&L, (iii) P&L attribution assessment and stress testing programs as described in paragraph 272 and; (iv) an independent model validation process as per paragraph 273. The excluded hedges are initiated, tracked and managed as a hedge of either ColVA or the exposure component of FVA in accordance with internal protocols for compliance that are consistent with paragraph 278 and internal audit/validation functions in paragraph 281. Institutions must measure and monitor the effectiveness of the excluded hedges in normal conditions and in times of stress. Institutions should assess any material residual or basis risk as part of their stress testing programs (e.g., ICAAP, etc.) and account for this in Pillar 2 capital in excess of minimum requirements commensurate with their risk profile. OSFI will consider other regulatory frameworks as being adequate substitutes for meeting these requirements in order to mitigate duplication for institutions seeking these exemptions.

9.3. Counterparty Credit Risk in the Trading Book

Institutions must calculate the counterparty credit risk charge for over-the-counter (OTC) derivatives, repo-style and other transactions booked in the trading book, separate from the capital requirement for market risk^{Footnote 16}. The risk weights to be used in this calculation must be consistent with those used for calculating the capital requirements in the banking book. Thus, institutions using the standardized approach in the banking book will use the standardized approach risk weights in the trading book and institutions using the internal ratings-based (IRB) approach in the banking book will use the IRB risk weights in the trading book in a manner consistent with the IRB roll-out situation in the banking book as described in section 5.2.3 of Chapter 5. For counterparties included in portfolios where the IRB approach is being used, the IRB risk weights will have to be applied. In the trading book, for repo-style transactions, all instruments, which are included in the trading book, may be used as eligible collateral. Those instruments which fall outside the banking book definition of eligible collateral shall be subject to a haircut at the level applicable to non-main index equities listed on recognized exchanges (as noted in paragraph 239 of Chapter 4). Where institutions are using a value-at-risk approach to measuring exposure for securities financing transactions, they also may apply this approach in the trading book in accordance with paragraph 125 to 128 of Chapter 5 and Chapter 7. The calculation of the counterparty credit risk charge for collateralized OTC derivative transactions is the same as the rules prescribed for such transactions booked in the banking book (see Chapter 7). The calculation of the counterparty charge for repo-style transactions will be conducted using the rules in Chapter 7 spelt out for such transactions booked in the banking book. The firm-size adjustment for small or medium-sized entities as set out in paragraph 69 of Chapter 5 shall also be applicable in the trading book. [Basel Framework, CRE55]

9.4. Prudent Valuation Guidance

Introduction

This section provides institutions with guidance on prudent valuation for positions that are accounted for at fair value, whether they are in the trading book or in the banking book. This guidance is especially important for positions without actual market prices or observable inputs to valuation, as well as less liquid positions which raise OSFI concerns about prudent valuation. The valuation guidance set forth below is not intended to require institutions to change valuation procedures for financial reporting purposes. OSFI will assess an institution’s valuation procedures for consistency with this guidance. One fact in OSFI’s assessment of whether an institution must take a valuation adjustment for regulatory purposes under paragraphs 104 to 107 should be the degree of consistency between the institution’s valuation procedures and these guidelines. [Basel Framework, CAP50.1] A framework for prudent valuation practices should at a minimum include the following. [Basel Framework, CAP50.2]

Systems and Controls

Institutions must establish and maintain adequate systems and controls sufficient to give management and OSFI the confidence that their valuation estimates are prudent and reliable. These systems must be integrated with other risk management systems within the organization (such as credit analysis). Such systems must include: 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 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, end of the month and ad-hoc verification procedures; and Clear and independent (i.e. independent of front office) reporting lines for the department accountable for the valuation process. The reporting line should ultimately be to a main member of senior management. [Basel Framework, CAP50.3]

Valuation Methodologies

Marking to market Marking-to-market is at least the daily valuation of positions at readily available close out prices that are sourced independently. Examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers. [Basel Framework, CAP50.4] Institutions must mark-to-market as much as possible. The more prudent side of bid/offer should be used unless the institution is a significant market maker in a particular position type and it can close out at mid-market. Institutions should maximise the use of relevant observable inputs and minimise the use of unobservable inputs when estimating fair value using a valuation technique. However, observable inputs or transactions may not be relevant, such as in a forced liquidation or distressed sale, or transactions may not be observable, such as when markets are inactive. In such cases, the observable data should be considered, but may not be determinative. [Basel Framework, CAP50.5] Marking to model Only where marking-to-market is not possible should institutions mark-to-model, but this must be demonstrated to be prudent. Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input. When marking to model, an extra degree of conservatism is appropriate. OSFI will consider the following in assessing whether a mark-to-model valuation is prudent: Senior management should be aware of the elements of the trading book or other fair-valued positions which are subject to mark to model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business. Market inputs should be sourced, to the extent possible, in line with market prices (as discussed above). The appropriateness of the market inputs for the particular position being valued should be reviewed regularly. Where available, generally accepted valuation methodologies for particular products should be used as far as possible. Where the model is developed by the institution itself, it should be based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. It should be independently tested. This includes validating the mathematics, the assumptions and the software implementation. There should be formal change control procedures in place and a secure copy of the model should be held and periodically used to check valuations. Risk management should be aware of the weaknesses of the models used and how best to reflect those in the valuation output. The model should be subject to periodic review to determine the accuracy of its performance (e.g. assessing continued appropriateness of the assumptions, analysis of profit and loss versus risk factors, comparison of actual close out values to model outputs). Valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation (see also valuation adjustments in paragraphs 102 to 107). [Basel Framework, CAP50.6] Independent price verification Independent price verification is distinct from daily mark-to-market. It is the process by which market prices or model inputs are regularly verified for accuracy. While daily marking-to-market may be performed by dealers, verification of market prices or model inputs should be performed by a unit independent of the dealing room, at least monthly (or, depending on the nature of the market/trading activity, more frequently). It need not be performed as frequently as daily mark-to-market, since the objective, i.e. independent, marking of positions, should reveal any error or bias in pricing, which should result in the elimination of inaccurate daily marks. [Basel Framework, CAP50.7] Independent price verification entails a higher standard of accuracy in that the market prices or model inputs are used to determine profit and loss figures, whereas daily marks are used primarily for management reporting in between reporting dates. For independent price verification, where pricing sources are more subjective, e.g. only one available broker quote, prudent measures such as valuation adjustments may be appropriate. [Basel Framework, CAP50.8]

Valuation Adjustments

As part of their procedures for marking to market, institutions must establish and maintain procedures for considering valuation adjustments. OSFI expects institutions using third-party valuations to consider whether valuation adjustments are necessary. Such considerations are also necessary when marking to model. [Basel Framework, CAP50.9] OSFI expects the following valuation adjustments/reserves to be formally considered at a minimum: unearned credit spreads, close-out costs, operational risks, early termination, investing and funding costs, and future administrative costs and, where appropriate, model risk. OSFI also expects that the valuation adjustment will be considered for positions individually (i.e. adjustments should be reflected in the valuation of the individual transactions) rather than on a portfolio level (i.e. adjustments are made in the form of a reserve for a portfolio of exposures and are not reflected in the valuation of the individual transactions). [Basel Framework, CAP50.10]

Adjustment to the Current Valuation of Less Liquid Positions for Regulatory Capital Purposes

Institutions must establish and maintain procedures for judging the necessity of and calculating an adjustment to the current valuation of less liquid positions for regulatory capital purposes. This adjustment may be in addition to any changes to the value of the position required for financial reporting purposes and should be designed to reflect the illiquidity of the position. OSFI expects institutions to consider the need for an adjustment to a position’s valuation to reflect current illiquidity whether the position is marked to market using market prices or observable inputs, third-party valuations or marked to model. [Basel Framework, CAP50.11] Bearing in mind that the assumptions made about liquidity in the market risk capital requirement may not be consistent with the institution’s ability to sell or hedge out less liquid positions, where appropriate, institutions must take an adjustment to the current valuation of these positions, and review their continued appropriateness on an on-going basis. Reduced liquidity may have arisen from market events. Additionally, close-out prices for concentrated positions and/or stale positions should be considered in establishing the adjustment. Institutions must consider all relevant factors when determining the appropriateness of the adjustment for less liquid positions. These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market makers), the average and volatility of trading volumes (including trading volumes during periods of market stress), market concentrations, the aging of positions, the extent to which valuation relies on marking-to-model, and the impact of other model risks not included in the paragraph above. [Basel Framework, CAP50.12] For complex products including, but not limited to, securitization exposures and n-th-to-default credit derivatives, institutions must explicitly assess the need for valuation adjustments to reflect two forms of model risk: the model risk associated with using a possibly incorrect valuation methodology; and the risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model. [Basel Framework, CAP50.13] The adjustment to the current valuation of less liquid positions made under paragraph 105 must impact Common Equity Tier 1 regulatory capital and may exceed those valuation adjustments made under financial reporting standards and paragraphs 102 and 103. [Basel Framework, CAP50.14]

9.5. Standardized Approach

9.5.1 General Provisions and Structure

This section sets out the general provisions and the structure of the standardized approach for calculating risk-weighted assets for market risk. General Provisions The risk-weighted assets for market risk under the standardized approach are determined by multiplying the capital requirements calculated as set out in this section by 12.5. [Basel Framework, MAR20.1] Capital requirements under the standardized approach must be calculated and reported to OSFI on a monthly basis. Subject to OSFI approval, capital requirements under the standardized approach for market risks arising from non-banking subsidiaries of an institution may be calculated and reported to OSFI on a quarterly basis. [Basel Framework, MAR20.2] An institution must also determine its regulatory capital requirements for market risk according to the standardized approach for market risk at the demand of OSFI. [Basel Framework, MAR20.3] Structure of the Standardized Approach The standardized approach capital requirement is the simple sum of three components: the capital requirement under the sensitivities-based method, the default risk capital (DRC) requirement and the residual risk add-on (RRAO). The capital requirement under the sensitivities-based method must be calculated by aggregating three risk measures – delta, vega and curvature, as set out in section 9.5.2: Delta: a risk measure based on sensitivities of an instrument to regulatory delta risk factors. Vega: a risk measure based on sensitivities to regulatory vega risk factors. Curvature: a risk measure which captures the incremental risk not captured by the delta risk measure for price changes in an option. Curvature risk is based on two stress scenarios involving an upward shock and a downward shock to each regulatory risk factor. The above three risk measures specify risk weights to be applied to the regulatory risk factor sensitivities. To calculate the overall capital requirement, the risk-weighted sensitivities are aggregated using specified correlation parameters to recognize diversification benefits between risk factors. In order to address the risk that correlations may increase or decrease in periods of financial stress, an institution must calculate three sensitivities-based method capital requirement values, based on three different scenarios on the specified values for the correlation parameters as set out in paragraphs 118 and 119. The DRC requirement captures the jump-to-default risk for instruments subject to credit risk as set out in paragraph 215. It is calibrated based on the credit risk treatment in the banking book in order to reduce the potential discrepancy in capital requirements for similar risk exposures across the institution. Some hedging recognition is allowed for similar types of exposures (corporates, sovereigns, and local governments/municipalities). Given recognition that not all market risks can be captured in the standardized approach so as to avoid an unduly complex regime, an RRAO ensures sufficient coverage of market risks for instruments specified in paragraph 259. The calculation method for the RRAO is set out in paragraph 265. [Basel Framework, MAR20.4] Definition of Correlation Trading Portfolio For the purpose of calculating the credit spread risk capital requirement under the sensitivities based method and the DRC requirement, the correlation trading portfolio is defined as the set of instruments that meet the requirements of (1) or (2) below. The instrument is a securitization position that meets the following requirements: The instrument is not a re-securitization position, nor a derivative of securitization exposures that does not provide a pro rata share in the proceeds of a securitization tranche, where the definition of securitization position is identical to that used in the credit risk framework. All reference entities are single-name products, including single-name credit derivatives, for which a liquid two-way market exists,^{Footnote 17} including traded indices on these reference entities. The instrument does not reference an underlying that is treated as a retail exposure, a residential mortgage exposure, or a commercial mortgage exposure under the standardized approach to credit risk. The instrument does not reference a claim on a special purpose entity. The instrument is a non-securitization hedge to a position described above. [Basel Framework, MAR20.5]

9.5.2 Sensitivities-Based Method

This section sets out the calculation of the sensitivities-based method under the standardized approach for market risk. Main Concepts of the Sensitivities-Based Method The sensitivities of financial instruments to a prescribed list of risk factors are used to calculate the delta, vega and curvature risk capital requirements. These sensitivities are risk-weighted and then aggregated, first within risk buckets (risk factors with common characteristics) and then across buckets within the same risk class as set out in paragraphs 120 to 127. The following terminology is used in the sensitivities-based method: Risk class: seven risk classes are defined in paragraphs 151 to 201. General interest rate risk (GIRR) Credit spread risk (CSR): non-securitizations CSR: securitizations (non-correlation trading portfolio, or non-CTP) CSR: securitizations (correlation trading portfolio, or CTP) Equity risk Commodity risk Foreign exchange (FX) risk Risk factor: variables (e.g. an equity price or a tenor of an interest rate curve) that affect the value of an instrument as defined in paragraphs 121 to 127. Bucket: a set of risk factors that are grouped together by common characteristics (e.g. all tenors of interest rate curves for the same currency), as defined in paragraphs 151 to 201. Risk position: the portion of the risk of an instrument that relates to a risk factor. Methodologies to calculate risk positions for delta, vega and curvature risks are set out in paragraph 115 to 117 and paragraphs 127 to 138. For delta and vega risks, the risk position is a sensitivity to a risk factor. For curvature risk, the risk position is based on losses from two stress scenarios. Risk capital requirement: the amount of capital that an institution should hold as a consequence of the risks it takes; it is computed as an aggregation of risk positions first at the bucket level, and then across buckets within a risk class defined for the sensitivities-based method as set out in paragraphs 115 to 119. [Basel Framework, MAR21.1] Instruments Subject to Each Component of the Sensitivities-Based Method In applying the sensitivities-based method, all instruments held in trading desks as set out in paragraph 52 to 57 and subject to the sensitivities-based method (i.e. excluding instruments where the value at any point in time is purely driven by an exotic underlying as set out in paragraph 260), are subject to delta risk capital requirements. Additionally, the instruments specified in (1) to (4) are subject to vega and curvature risk capital requirements: Any instrument with optionality^{Footnote 18}. Any instrument with an embedded prepayment option^{Footnote 19} – this is considered an instrument with optionality according to above (1). The embedded option is subject to vega and curvature risk with respect to interest rate risk and CSR (non-securitization and securitization) risk classes. When the prepayment option is a behavioural option the instrument may also be subject to the residual risk add-on (RRAO) as per section 9.5.4. The pricing model of the institution must reflect such behavioural patterns where relevant. For securitization tranches, instruments in the securitized portfolio may have embedded prepayment options as well. In this case the securitization tranche may be subject to the RRAO. Instruments whose cash flows cannot be written as a linear function of underlying notional. For example, the cash flows generated by a plain-vanilla option cannot be written as a linear function (as they are the maximum of the spot and the strike). Therefore, all options are subject to vega risk and curvature risk. Instruments whose cash flows can be written as a linear function of underlying notional are instruments without optionality (e.g. cash flows generated by a coupon bearing bond can be written as a linear function) and are not subject to vega risk nor curvature risk capital requirements. Curvature risks may be calculated for all instruments subject to delta risk, not limited to those subject to vega risk as specified in (1) to (3) above. For example, where an institution manages the non-linear risk of instruments with optionality and other instruments holistically, the institution may choose to include instruments without optionality in the calculation of curvature risk. This treatment is allowed subject to all of the following restrictions: Use of this approach shall be applied consistently through time. Curvature risk must be calculated for all instruments subject to the sensitivities-based method. [Basel Framework, MAR21.2] Process to Calculate the Capital Requirement under the Sensitivities-Based Method As set out in paragraph 113, the capital requirement under the sensitivities-based method is calculated by aggregating delta, vega and curvature capital requirements. The relevant paragraphs that describe this process are as follows: The risk factors for delta, vega and curvature risks for each risk class are defined in paragraphs 120 to 126. The methods to risk weight sensitivities to risk factors and aggregate them to calculate delta and vega risk positions for each risk class are set out in paragraph 116 and paragraphs 127 to 207, which include the definition of delta and vega sensitivities, definition of buckets, risk weights to apply to risk factors, and correlation parameters. The methods to calculate curvature risk are set out in paragraph 117 and paragraphs 208 to 213, which include the definition of buckets, risk weights and correlation parameters. The risk class level capital requirement calculated above must be aggregated to obtain the capital requirement at the entire portfolio level as set out in paragraphs 118 and 119. [Basel Framework, MAR21.3] Calculation of the delta and vega risk capital requirement for each risk class For each risk class, an institution must determine its instruments’ sensitivity to a set of prescribed risk factors, risk weight those sensitivities, and aggregate the resulting risk-weighted sensitivities separately for delta and vega risk using the following step-by-step approach: For each risk factor as defined in paragraphs 120 to 126, a sensitivity is determined as set out in paragraphs 127 to 150. Sensitivities to the same risk factor must be netted to give a net sensitivity sk across all instruments in the portfolio to each risk factor k. In calculating the net sensitivity, all sensitivities to the same given risk factor (e.g. all sensitivities to the one-year tenor point of the three-month Euribor swap curve) from instruments of opposite direction should offset, irrespective of the instrument from which they derive. For instance, if an institution’s portfolio is made of two interest rate swaps on three-month Euribor with the same fixed rate and same notional but of opposite direction, the GIRR on that portfolio would be zero. The weighted sensitivity WSk is the product of the net sensitivity sk and the corresponding risk weight RWk as defined in paragraphs 151 to 207. W S k = R W k s k Within bucket aggregation: the risk position for delta (respectively vega) bucket b, Kb, must be determined by aggregating the weighted sensitivities to risk factors within the same bucket using the prescribed correlation ρkl set out in the following formula, where the quantity within the square root function is floored at zero: K b = max ⁡ ( 0 , ∑ k WS k 2 + ∑ k ∑ k ≠ l ρ kl WS k WS l ) Across bucket aggregation: The delta (respectively vega) risk capital requirement is calculated by aggregating the risk positions across the delta (respectively vega) buckets within each risk class, using the corresponding prescribed correlations ϒbc as set out in the following formula, where: S b = ∑ k WS k for all risk factors in bucket b, and S c = ∑ k WS k in bucket c. If these values for Sb and Sc described in above sub paragraph 116(a) produce a negative number for the overall sum of ∑ b K b 2 + ∑ b ∑ c ≠ b ϒ bc S b S c , the institution is to calculate the delta (respectively vega) risk capital requirement using an alternative specification whereby: S b = max ⁡ min ⁡ ∑ k WS k , K b , − K b for all risk factors in bucket b; and S c = max ⁡ min ⁡ ∑ k WS k , K c , - K c for all risk factors in bucket c. Delta (respectively vega) = ∑ b K b 2 + ∑ b ∑ c ≠ b ϒ bc S b S c [Basel Framework, MAR21.4] Calculation of the curvature risk capital requirement for each risk class For each risk class, to calculate curvature risk capital requirements an institution must apply an upward shock and a downward shock to each prescribed risk factor and calculate the incremental loss for instruments sensitive to that risk factor above that already captured by the delta risk capital requirement using the following step-by-step approach: For each instrument sensitive to curvature risk factor k, an upward shock and a downward shock must be applied to k. The size of shock (i.e. risk weight) is set out in paragraphs 210 and 211. For example for GIRR, all tenors of all the risk free interest rate curves within a given currency (e.g. three-month Euribor, six-month Euribor, one year Euribor, etc. for the euro) must be shifted upward applying the risk weight as set out in paragraph 211. The resulting potential loss for each instrument, after the deduction of the delta risk positions, is the outcome of the upward scenario. The same approach must be followed on a downward scenario. If the price of an instrument depends on several risk factors, the curvature risk must be determined separately for each risk factor. The net curvature risk capital requirement, determined by the values CVRk⁺ and CVRk^- for an institution’s portfolio for risk factor k described in the above paragraph is calculated by the formula below. It calculates the aggregate incremental loss beyond the delta capital requirement for the prescribed shocks, where i is an instrument subject to curvature risks associated with risk factor k; xk is the current level of risk factor k; Vi (xk) is the price of instrument i at the current level of risk factor k; Vi (xk^{(RW^(curvature)+)}) and Vi (xk^{(RW^(curvature)−)}) denote the price of instrument i after xk is shifted (i.e. “shocked”) upward and downward respectively; RWk^(curvature) is the risk weight for curvature risk factor k for instrument i; and sik is the delta sensitivity of instrument i with respect to the delta risk factor that corresponds to curvature risk factor k, where: for the FX and equity risk classes, sik is the delta sensitivity of instrument i; and for the GIRR, CSR and commodity risk classes, sik is the sum of delta sensitivities to all tenors of the relevant curve of instrument i with respect to curvature risk factor k. CVR k + = - ∑ i V i ( x k RW Curvature + ) − V x k - R W k Curvature × s ik CVR k - = - ∑ i V i ( x k RW Curvature - ) − V x k + R W k Curvature × s ik Within bucket aggregation: the curvature risk exposure must be aggregated within each bucket using the corresponding prescribed correlation ρkl as set out in the following formula, where: The bucket level capital requirement (Kb) is determined as the greater of the capital requirement under the upward scenario (Kb⁺) and the capital requirement under the downward scenario (Kb⁻). Notably, the selection of upward and downward scenarios is not necessarily the same across the high, medium and low correlations scenarios specified in the paragraph below. Where K b = K b + , this shall be termed “selecting the upward scenario”. Where K b = K b - , this shall be termed “selecting the downward scenario”. In the specific case where K b + = K b - , if ∑ k CVR k + > ∑ k CVR k - , it is deemed that the upward scenario is selected; otherwise the downward scenario is selected. ψ(CVRk,CVRl) takes the value 0 if CVRk and CVRl both have negative signs and the value 1 otherwise. K b = max ⁡ K b + , K b - , where K b + = max ⁡ 0 , ∑ k max ⁡ C V R k + , 0 2 + ∑ l ≠ k ∑ k ρ kl C V R k + CVR l + ψ CVR k + , CVR l + K b - = max ⁡ 0 , ∑ k max ⁡ CVR k - , 0 2 + ∑ l ≠ k ∑ k ρ kl CVR k - CVR l - ψ CVR k - , CVR l - Across bucket aggregation: curvature risk positions must then be aggregated across buckets within each risk class, using the corresponding prescribed correlations ϒbc, where: S b = ∑ k CVR k + for all risk factors in bucket b, when the upward scenario has been selected for bucket b in above (3)(a). S b = ∑ k CVR k - otherwise; and ψ(Sb, Sc) takes the value 0 if Sb and Sc both have negative signs and 1 otherwise. Curvature risk = max ⁡ 0 , ∑ b K b 2 + ∑ c ≠ b ∑ b ϒ bc S b S c ψ S b , S c The delta used for the calculation of the curvature risk capital requirement should be the same as that used for calculating the delta risk capital requirement. The assumptions that are used for the calculation of the delta (i.e. sticky delta for normal or log-normal volatilities) should also be used for calculating the shifted or shocked price of the instrument. [Basel Framework, MAR21.5] Calculation of aggregate sensitivities-based method capital requirement In order to address the risk that correlations increase or decrease in periods of financial stress, the aggregation of bucket level capital requirements and risk class level capital requirements per each risk class for delta, vega, and curvature risks as specified in paragraphs 116 to 117 must be repeated, corresponding to three different scenarios on the specified values for the correlation parameter ρkl (correlation between risk factors within a bucket) and ϒbc (correlation across buckets within a risk class). Under the “medium correlations” scenario, the correlation parameters ρkl and ϒbc as specified in paragraphs 151 to 213 apply. Under the “high correlations” scenario, the correlation parameters ρkl and ϒbc that are specified in paragraphs 151 to 213 are uniformly multiplied by 1.25, with ρkl and ϒbc subject to a cap at 100%. Under the “low correlations” scenario, the correlation parameters ρkl and ϒbc that are specified in paragraphs 151 to 213 are replaced by ρ kl low = max ⁡ 2 × ρ kl - 100 % ; 75 % × ρ kl and ϒ bc low = max ⁡ 2 × ϒ bc - 100 % ; 75 % × ϒ bc . [Basel Framework, MAR21.6] The total capital requirement under the sensitivities-based method is aggregated as follows: For each of three correlation scenarios, the institution must simply sum up the separately calculated delta, vega and curvature capital requirements for all risk classes to determine the overall capital requirement for that scenario. The sensitivities-based method capital requirement is the largest capital requirement from the three scenarios. For the calculation of capital requirements for all instruments in all trading desks using the standardized approach as set out in paragraph 49(1), paragraph 109 and paragraph 400, the capital requirement is calculated for all instruments in all trading desks. For the calculation of capital requirements for each trading desk using the standardized approach as if that desk were a standalone regulatory portfolio as set out in paragraph 49(2), the capital requirements under each correlation scenario are calculated and compared at each trading desk level, and the maximum for each trading desk is taken as the capital requirement. [Basel Framework, MAR21.7] Sensitivities-Based Method: Risk Factor and Sensitivity Definitions Risk factor definitions for delta, vega and curvature risks GIRR factors Delta GIRR: the GIRR delta risk factors are defined along two dimensions: (i) a risk-free yield curve for each currency in which interest rate-sensitive instruments are denominated and (ii) the following tenors: 0.25 years, 0.5 years, 1 year, 2 years, 3 years, 5 years, 10 years, 15 years, 20 years and 30 years, to which delta risk factors are assigned.^{Footnote 20} The risk-free yield curve per currency should be constructed using money market instruments held in the trading book that have the lowest credit risk, such as overnight index swaps (OIS). Alternatively, the risk-free yield curve should be based on one or more market-implied swap curves used by the institution to mark positions to market. For example, interbank offered rate (BOR) swap curves. When data on market-implied swap curves described in above (1)(a) are insufficient, the risk-free yield curve may be derived from the most appropriate sovereign bond curve for a given currency. In such cases the sensitivities related to sovereign bonds are not exempt from the CSR capital requirement: when an institution cannot perform the decomposition y=r+cs, any sensitivity to y is allocated both to the GIRR and to CSR classes as appropriate with the risk factor and sensitivity definitions in the standardized approach. Applying swap curves to bond-derived sensitivities for GIRR will not change the requirement for basis risk to be captured between bond and credit default swap (CDS) curves in the CSR class. For the purpose of constructing the risk-free yield curve per currency, an OIS curve (such as Eonia or a new benchmark rate) and a BOR swap curve (such as three-month Euribor or other benchmark rates) must be considered two different curves. Two BOR curves at different maturities (e.g. three-month Euribor and six-month Euribor) must be considered two different curves. An onshore and an offshore currency curve (e.g. onshore Indian rupee and offshore Indian rupee) must be considered two different curves. The GIRR delta risk factors also include a flat curve of market-implied inflation rates for each currency with term structure not recognized as a risk factor. The sensitivity to the inflation rate from the exposure to implied coupons in an inflation instrument gives rise to a specific capital requirement. All inflation risks for a currency must be aggregated to one number via simple sum. This risk factor is only relevant for an instrument when a cash flow is functionally dependent on a measure of inflation (e.g. the notional amount or an interest payment depending on a consumer price index). GIRR risk factors other than for inflation risk will apply to such an instrument notwithstanding. Inflation rate risk is considered in addition to the sensitivity to interest rates from the same instrument, which must be allocated, according to the GIRR framework, in the term structure of the relevant risk-free yield curve in the same currency. Inflation is included in the GIRR vega risk capital requirement. As no maturity dimension is specified for the delta capital requirement for inflation (i.e. the possible underlying of the option), the vega risk for inflation should be considered only along the single dimension of the maturity of the option. The GIRR delta risk factors also include one of two possible cross-currency basis risk factors^{Footnote 21} for each currency (i.e. each GIRR bucket) with the term structure not recognized as a risk factor (i.e. both cross-currency basis curves are flat). The two cross-currency basis risk factors are basis of each currency over USD or basis of each currency over EUR. For instance, an AUD-denominated institution trading a JPY/USD cross-currency basis swap would have a sensitivity to the JPY/USD basis but not to the JPY/EUR basis. Cross-currency bases that do not relate to either basis over USD or basis over EUR must be computed either on “basis over USD” or “basis over EUR” but not both. GIRR risk factors other than for cross-currency basis risk will apply to such an instrument notwithstanding. Cross-currency basis risk is considered in addition to the sensitivity to interest rates from the same instrument, which must be allocated, according to the GIRR framework, in the term structure of the relevant risk-free yield curve in the same currency. When calculating the cross-currency basis spread (CCBS) capital requirement, institutions may use a term structure-based CCBS curve and aggregate sensitivities to individual tenors by simple sum. Cross-currency bases are included in the GIRR vega risk capital requirement. As no maturity dimension is specified for the delta capital requirement for cross-currency bases (i.e. the possible underlying of the option), the vega risk for cross-currency bases should be considered only along the single dimension of the maturity of the option. Vega GIRR: within each currency, the GIRR vega risk factors are the implied volatilities of options that reference GIRR-sensitive underlyings; as defined along two dimensions:^{Footnote 22} The maturity of the option: the implied volatility of the option as mapped to one or several of the following maturity tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years. The residual maturity of the underlying of the option at the expiry date of the option: the implied volatility of the option as mapped to two (or one) of the following residual maturity tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years. Curvature GIRR: The GIRR curvature risk factors are defined along only one dimension: the constructed risk-free yield curve per currency with no term structure decomposition. For example, the euro, Eonia, three-month Euribor and six-month Euribor curves must be shifted at the same time in order to compute the euro-relevant risk-free yield curve curvature risk capital requirement. For the calculation of sensitivities, all tenors (as defined for delta GIRR) are to be shifted in parallel. There is no curvature risk capital requirement for inflation and cross-currency basis risks. The treatment described in above (1)(b) for delta GIRR also applies to vega GIRR and curvature GIRR risk factors. (7) Institutions are not permitted to perform capital computations based on internally used tenors. Risk factors and sensitivities must be assigned to the prescribed tenors. As stated in footnote 22 to paragraph 120 and footnote 27 to paragraph 137, the assignment of risk factors and sensitivities to the specified tenors should be performed by linear interpolation or a method that is most consistent with the pricing functions used by the independent risk control function of the institution to report market risks or profits and losses to senior management. For the specified instruments (e.g. callable bonds, options on sovereign bond futures and bond options), delta, vega and curvature capital requirements must be computed for GIRR. Repo rate risk factors for fixed income funding instruments are subject to the GIRR capital requirement. A relevant repo curve should be considered by currency. Risk weights may not be floored for interest rate and credit instruments when applying the risk weights for GIRR. [Basel Framework, MAR21.8] CSR non-securitization risk factors Delta CSR non-securitization: the CSR non-securitization delta risk factors are defined along two dimensions: the relevant issuer credit spread curves (bond and CDS); and the following tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years. Vega CSR non-securitization: the vega risk factors are the implied volatilities of options that reference the relevant credit issuer names as underlyings (bond and CDS); further defined along one dimension - the maturity of the option. This is defined as the implied volatility of the option as mapped to one or several of the following maturity tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years. Curvature CSR non-securitization: the CSR non-securitization curvature risk factors are defined along one dimension: the relevant issuer credit spread curves (bond and CDS). For instance, the bond-inferred spread curve of an issuer and the CDS-inferred spread curve of that same issuer should be considered a single spread curve. For the calculation of sensitivities, all tenors (as defined for CSR) are to be shifted in parallel. Institutions are not permitted to perform capital computations based on internally used tenors. Risk factors and sensitivities must be assigned to the prescribed tenors. As stated in footnote 22 to paragraph 120 and footnote 27 to paragraph 137, the assignment of risk factors and sensitivities to the specified tenors should be performed by linear interpolation or a method that is most consistent with the pricing functions used by the independent risk control function of the institution to report market risks or profits and losses to senior management. For the specified instruments, delta, vega and curvature capital requirements must be computed for CSR. Bond and CDS credit spreads are considered distinct risk factors under paragraph 131(1), and ρkl^(basis) referenced in paragraphs 166 and 167 is meant to capture only the bond-CDS basis. Risk weights are not allowed to be floored for interest rate and credit instruments when applying the risk weights for CSR, even with a possibility of the interest rates being negative. [Basel Framework, MAR21.9] CSR securitization: non-CTP risk factors For securitization instruments that do not meet the definition of CTP as set out in paragraph 112 (i.e., non-CTP), the sensitivities of delta risk factors (i.e. CS01) must be calculated with respect to the spread of the tranche rather than the spread of the underlying of the instruments. Delta CSR securitization (non-CTP): the CSR securitization delta risk factors are defined along two dimensions: Tranche credit spread curves; and The following tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years to which delta risk factors are assigned. Vega CSR securitization (non-CTP): Vega risk factors are the implied volatilities of options that reference non-CTP credit spreads as underlyings (bond and CDS); further defined along one dimension - the maturity of the option. This is defined as the implied volatility of the option as mapped to one or several of the following maturity tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years. Curvature CSR securitization (non-CTP): the CSR securitization curvature risk factors are defined along one dimension, the relevant tranche credit spread curves (bond and CDS). For instance, the bond-inferred spread curve of a given Spanish residential mortgage-backed security (RMBS) tranche and the CDS-inferred spread curve of that given Spanish RMBS tranche would be considered a single spread curve. For the calculation of sensitivities, all the tenors are to be shifted in parallel. [Basel Framework, MAR21.10] CSR securitization: CTP risk factors For securitization instruments that meet the definition of a CTP as set out in paragraph 112, the sensitivities of delta risk factors (i.e. CS01) must be computed with respect to the names underlying the securitization or nth-to-default instrument. Delta CSR securitization (CTP): the CSR correlation trading delta risk factors are defined along two dimensions: the relevant underlying credit spread curves (bond and CDS); and the following tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years, to which delta risk factors are assigned. Vega CSR securitization (CTP): the vega risk factors are the implied volatilities of options that reference CTP credit spreads as underlyings (bond and CDS), as defined along one dimension, the maturity of the option. This is defined as the implied volatility of the option as mapped to one or several of the following maturity tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years. Curvature CSR securitization (CTP): the CSR correlation trading curvature risk factors are defined along one dimension, the relevant underlying credit spread curves (bond and CDS). For instance, the bond-inferred spread curve of a given name within an iTraxx series and the CDS-inferred spread curve of that given underlying would be considered a single spread curve. For the calculation of sensitivities, all the tenors are to be shifted in parallel. [Basel Framework, MAR21.11] Equity risk factors Delta equity: the equity delta risk factors are: all the equity spot prices; and all the equity repurchase agreement rates (equity repo rates). Vega equity: The equity vega risk factors are the implied volatilities of options that reference the equity spot prices as underlyings as defined along one dimension, the maturity of the option. This is defined as the implied volatility of the option as mapped to one or several of the following maturity tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years. There is no vega risk capital requirement for equity repo rates. Curvature equity: The equity curvature risk factors are all the equity spot prices. There is no curvature risk capital requirement for equity repo rates. [Basel Framework, MAR21.12] Commodity risk factors Delta commodity: the commodity delta risk factors are all the commodity spot prices. However for some commodities such as electricity (which is defined to fall within bucket 3 (energy – electricity and carbon trading) in paragraph 194 the relevant risk factor can either be the spot or the forward price, as transactions relating to commodities such as electricity are more frequent on the forward price than transactions on the spot price. Commodity delta risk factors are defined along two dimensions: legal terms with respect to the delivery location^{Footnote 23} of the commodity; and time to maturity of the traded instrument at the following tenors: 0 years, 0.25 years, 0.5 years, 1 year, 2 years, 3 years, 5 years, 10 years, 15 years, 20 years and 30 years. The current prices for futures and forward contracts should be used to compute the commodity delta risk factors. Commodity delta should be allocated to the relevant tenor based on the tenor of the futures and forward contract and given that spot commodity price positions should be slotted into the first tenor (0 years). Vega commodity: the commodity vega risk factors are the implied volatilities of options that reference commodity spot prices as underlyings. No differentiation between commodity spot prices by the maturity of the underlying or delivery location is required. The commodity vega risk factors are further defined along one dimension, the maturity of the option. This is defined as the implied volatility of the option as mapped to one or several of the following maturity tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years. Curvature commodity: the commodity curvature risk factors are defined along only one dimension, the constructed curve (i.e. no term structure decomposition) per commodity spot prices. For the calculation of sensitivities, all tenors (as defined for delta commodity) are to be shifted in parallel. For precious metals capital calculations, institutions have the option to decompose future and forward contracts into spot and lease rate exposures subject to pricing availability. Lease rates can be included as a GIRR risk factor according to paragraph 120. [Basel Framework, MAR21.13] FX risk factors Delta FX: the FX delta risk factors are defined below. The FX delta risk factors are all the exchange rates between the currency in which an instrument is denominated and the reporting currency. For transactions that reference an exchange rate between a pair of non-reporting currencies, the FX delta risk factors are all the exchange rates between: the reporting currency; and both the currency in which an instrument is denominated and any other currencies referenced by the instrument.^{Footnote 24} Subject to OSFI’s approval, FX risk may alternatively be calculated relative to a base currency instead of the reporting currency. In such case the institution must account for not only: the FX risk against the base currency; but also the FX risk between the reporting currency and the base currency (i.e. translation risk). The resulting FX risk calculated relative to the base currency as set out in (b) is converted to the capital requirements in the reporting currency using the spot reporting/base exchange rate reflecting the FX risk between the base currency and the reporting currency. The FX base currency approach may be allowed under the following conditions: To use this alternative, an institution may only consider a single currency as its base currency; and The institution shall demonstrate to OSFI that calculating FX risk relative to their proposed base currency provides an appropriate risk representation for their portfolio (for example, by demonstrating that it does not inappropriately reduce capital requirements relative to those that would be calculated without the base currency approach) and that the translation risk between the base currency and the reporting currency is taken into account. Vega FX: the FX vega risk factors are the implied volatilities of options that reference exchange rates between currency pairs; as defined along one dimension, the maturity of the option. This is defined as the implied volatility of the option as mapped to one or several of the following maturity tenors: 0.5 years, 1 year, 3 years, 5 years and 10 years. Curvature FX: the FX curvature risk factors are defined below. The FX curvature risk factors are all the exchange rates between the currency in which an instrument is denominated and the reporting currency. For transactions that reference an exchange rate between a pair of non-reporting currencies, the FX risk factors are all the exchange rates between: the reporting currency; and both the currency in which an instrument is denominated and any other currencies referenced by the instrument. Where OSFI’s approval for the base currency approach has been granted for delta risks, FX curvature risks shall also be calculated relative to a base currency instead of the reporting currency, and then converted to the capital requirements in the reporting currency using the spot reporting/base exchange rate. No distinction is required between onshore and offshore variants of a currency for all FX delta, vega and curvature risk factors. In addition, no distinction is required between deliverable and non-deliverable variants of a currency. [Basel Framework, MAR21.14] Sensitivities-based method: definition of sensitivities Sensitivities for each risk class must be expressed in the reporting currency of the institution. [Basel Framework, MAR21.15] For each risk factor defined in paragraphs 120 to 126, sensitivities are calculated as the change in the market value of the instrument as a result of applying a specified shift to each risk factor, assuming all the other relevant risk factors are held at the current level as defined in paragraph 129 to 150. In the context of delta sensitivity calculations, as per paragraph 129, an institution may make use of alternative formulations of sensitivities based on pricing models that the institution’s independent risk control unit uses to report market risks or actual profits and losses to senior management. In doing so, the institution should demonstrate to OSFI that the alternative formulations of sensitivities yield results very close to the prescribed formulations. [Basel Framework, MAR21.16] Requirements on instrument price or pricing models for sensitivity calculation In calculating the risk capital requirement under the sensitivities-based method in section 9.5.2, the institution must determine each delta and vega sensitivity and curvature scenario based on instrument prices or pricing models that an independent risk control unit within an institution uses to report market risks or actual profits and losses to senior management. Institutions should use zero rate or market rate sensitivities consistent with the pricing models referenced in that paragraph. [Basel Framework, MAR21.17] A key assumption of the standardized approach for market risk is that an institution’s pricing models used in actual profit and loss reporting provide an appropriate basis for the determination of regulatory capital requirements for all market risks. To ensure such adequacy, institutions must at a minimum establish a framework for prudent valuation practices that include the requirements described in section 9.4. [Basel Framework, MAR21.18] Sensitivity definitions for delta risk Delta GIRR: the sensitivity is defined as the PV01. PV01 is measured by changing the interest rate r at tenor t (rt) of the risk-free yield curve in a given currency by 1 basis point (i.e. 0.0001 in absolute terms) and dividing the resulting change in the market value of the instrument (Vi) by 0.0001 (i.e. 0.01%) as follows, where: rt is the risk-free yield curve at tenor t; cst is the credit spread curve at tenor t; and Vi is the market value of the instrument i as a function of the risk-free interest rate curve and credit spread curve: s k , r t = V i r t + 0.0001 , cs t - V i r t , cs t 0.0001 In cases where the institution does not have counterparty-specific money market curves, proxying PV01 is permitted. [Basel Framework, MAR21.19] Delta CSR non-securitization, securitization (non-CTP) and securitization (CTP): the sensitivity is defined as CS01. The CS01 (sensitivity) of an instrument i is measured by changing a credit spread cs at tenor t (cst) by 1 basis point (i.e. 0.0001 in absolute terms) and dividing the resulting change in the market value of the instrument (Vi) by 0.0001 (i.e. 0.01%) as follows: s k , cs t = V i r t , cs t + 0.0001 - V i r t , cs t 0.0001 In cases where the institution does not have counterparty-specific money market curves, proxying CS01 is permitted. [Basel Framework, MAR21.20] Delta equity spot: the sensitivity is measured by changing the equity spot price by 1 percentage point (i.e. 0.01 in relative terms) and dividing the resulting change in the market value of the instrument (Vi) by 0.01 (i.e. 1%) as follows, where: k is a given equity; EQk is the market value of equity k; and Vi is the market value of instrument i as a function of the price of equity k. s k = V i 1.01 EQ k - V i EQ k 0.01 [Basel Framework, MAR21.21] Delta equity repo rates: the sensitivity is measured by applying a parallel shift to the equity repo rate term structure by 1 basis point (i.e. 0.0001 in absolute terms) and dividing the resulting change in the market value of the instrument Vi by 0.0001 (i.e. 0.01%) as follows, where: k is a given equity; RTSk is the repo term structure of equity k; and Vi is the market value of instrument i as a function of the repo term structure of equity k. s k = V i RTS k + 0.0001 - V i RTS k 0.0001 [Basel Framework, MAR21.22] Delta commodity: the sensitivity is measured by changing the commodity spot price by 1 percentage point (i.e. 0.01 in relative terms) and dividing the resulting change in the market value of the instrument Vi by 0.01 (i.e. 1%) as follows, where: k is a given commodity; CTYk is the market value of commodity k; and Vi is the market value of instrument i as a function of the spot price of commodity k: s k = V i 1.01 CTY k - V i CTY k 0.01 [Basel Framework, MAR21.23] Delta FX: the sensitivity is measured by changing the exchange rate by 1 percentage point (i.e. 0.01 in relative terms) and dividing the resulting change in the market value of the instrument Vi by 0.01 (i.e. 1%), where: k is a given currency; FXk is the exchange rate between a given currency and an institution’s reporting currency or base currency, where the FX spot rate is the current market price of one unit of another currency expressed in the units of the institution’s reporting currency or base currency; and Vi is the market value of instrument i as a function of the exchange rate k: s k = V i 1.01 FX k - V i FX k 0.01 [Basel Framework, MAR21.24] Sensitivity definitions for vega risk The option-level vega risk sensitivity to a given risk factor^{Footnote 25} is measured by multiplying vega by the implied volatility of the option as follows, where: vega, ∂V i ∂σ i , is defined as the change in the market value of the option Vi as a result of a small amount of change to the implied volatility σi; and the instrument’s vega and implied volatility used in the calculation of vega sensitivities must be sourced from pricing models used by the independent risk control unit of the institution. s k = vega × implied volatility [Basel Framework, MAR21.25] The following sets out how to derive vega risk sensitivities in specific cases: Options that do not have a maturity, are assigned to the longest prescribed maturity tenor, and these options are also assigned to the RRAO. Options that do not have a strike or barrier and options that have multiple strikes or barriers, are mapped to strikes and maturity used internally to price the option, and these options are also assigned to the RRAO. CTP securitization tranches that do not have an implied volatility, are not subject to vega risk capital requirement. Such instruments may not, however, be exempt from delta and curvature risk capital requirements. In the case where options do not have a specified maturity (e.g. cancellable swaps), the institution must assign those options to the longest prescribed maturity tenor for vega risk sensitivities and also assign such options to the RRAO. In the case of the institution viewing the optionality of the cancellable swap as a swaption, the institution must assign the swaption to the longest prescribed maturity tenor for vega risk sensitivities (as it does not have a specified maturity) and derive the residual maturity of the underlying of the option accordingly. [Basel Framework, MAR21.26] Requirements on sensitivity computations When computing a first-order sensitivity for instruments subject to optionality, institutions should assume that the implied volatility either: remains constant, consistent with a “sticky strike” approach; or follows a “sticky delta” approach, such that implied volatility does not vary with respect to a given level of delta. [Basel Framework, MAR21.27] For the calculation of vega sensitivities, the distribution assumptions (i.e. log-normal assumptions or normal assumptions) for pricing models are applied as follows: For the computation of a vega GIRR sensitivity, institutions may use either the log-normal or normal assumptions. Institutions may also choose a mix of log-normal and normal assumptions for different currencies. For the computation of a vega CSR sensitivity, institutions may use either the log-normal or normal assumptions. For the computation of a vega equity, commodity or FX sensitivity, institutions must use the log-normal assumption.^{Footnote 26} [Basel Framework, MAR21.28] If, for internal risk management, an institution computes vega sensitivities using different definitions than the definitions set out in this standard, the institution may transform the sensitivities computed for internal risk management purposes to deduce the sensitivities to be used for the calculation of the vega risk measure. [Basel Framework, MAR21.29] All vega sensitivities must be computed ignoring the impact of credit valuation adjustments (CVA). [Basel Framework, MAR21.30] Treatment of index instruments and multi-underlying options In the delta and curvature risk context: for index instruments and multi-underlying options, a look-through approach should be used. However, an institution may opt not to apply the look-through approach for instruments referencing any listed and widely recognised and accepted equity or credit index, where: it is possible to look-through the index (i.e. the constituents and their respective weightings are known); the index contains at least 20 constituents; no single constituent contained within the index represents more than 25% of the total index; the largest 10% of constituents represents less than 60% of the total index; and for equity indices, the total market capitalization of all the constituents of the index is no less than CAD $50 billion. The no look-through approach for equity and credit indices cannot be applied to funds that do not track a listed and widely recognized index even if their holdings meet the criteria set out above. [Basel Framework, MAR21.31] For a given instrument, irrespective of whether a look-through approach is adopted or not, the sensitivity inputs used for the delta and curvature risk calculation must be consistent. [Basel Framework, MAR21.32] Where an institution opts not to apply the look-through approach in accordance with paragraph 143, a single sensitivity shall be calculated to each widely recognised and accepted index that an instrument references. The sensitivity to the index should be assigned to the relevant delta risk bucket defined in paragraphs 165 and 184 as follows: Where more than 75% of constituents in that index (taking into account the weightings of that index) would be mapped to a specific sector bucket (i.e. bucket 1 to bucket 11 for equity risk, or bucket 1 to bucket 16 for CSR), the sensitivity to the index shall be mapped to that single specific sector bucket and treated like any other single-name sensitivity in that bucket. In all other cases, the sensitivity may be mapped to an “index” bucket (i.e. bucket 12 or bucket 13 for equity risk; or bucket 17 or bucket 18 for CSR). The same principle as above (1) applies when allocating sensitivities to a specific index bucket. For equity risk, an equity index should be mapped to the large market cap and advanced economy indices bucket (i.e. bucket 12) if at least 75% of the constituents in that index (taking into account the weightings of that index) are both large cap and advanced economy equities. Otherwise, it should be mapped to the other equity indices bucket (i.e. bucket 13). For CSR, a credit index should be mapped to the investment grade indices bucket (i.e. bucket 17) if at least 75% of the constituents in that index (taking into account the weightings of that index) are investment grade. Otherwise, it should be mapped to the high yield indices bucket (i.e. bucket 18). [Basel Framework, MAR21.33] A look-through approach should be used for indices that do not meet the criteria set out in paragraph 143(2) to (5), and for any multi-underlying instruments that reference a bespoke set of equities or credit positions. Where a look-through approach is adopted, for index instruments and multi-underlying options other than the CTP, the sensitivities to constituent risk factors from those instruments or options are allowed to net with sensitivities to single-name instruments without restriction. Index CTP instruments cannot be broken down into its constituents (i.e. the index CTP should be considered a risk factor as a whole) and the above-mentioned netting at the issuer level does not apply either. Where a look-through approach is adopted, it shall be applied consistently through time,^{Footnote 27} at least at the desk level, and shall be used for all identical instruments that reference the same index. Where a look-through approach for such indices is not possible, institutions may treat these indices in the same manner as prescribed for equity investments in funds in paragraph 148(2), 148(3) and 220 for default risk charge purposes. This treatment is permitted where institutions have the ability to obtain daily price quotes and have knowledge of the mandate of the indices. [Basel Framework, MAR21.34] Treatment of equity investments in funds For equity investments in funds that can be looked through as set out in paragraph 65(5)(a), institutions must apply a look-through approach and treat the underlying positions of the fund as if the positions were held directly by the institution (taking into account the institution’s share of the equity of the fund, and any leverage in the fund structure), except for the funds that meet the following conditions: For funds that hold an index instrument that meets the criteria set out under paragraph 143, institutions must still apply a look-through and treat the underlying positions of the fund as if the positions were held directly by the institution, but the institution may then choose to apply the “no look-through” approach for the index holdings of the fund as set out in paragraph 145. For funds that track an index benchmark, an institution may opt not to apply the look-through approach and opt to measure the risk assuming the fund is a position in the tracked index only where: the fund has an absolute value of a tracking difference (ignoring fees and commissions) of less than 1%; and the tracking difference is checked at least annually and is defined as the annualized return difference between the fund and its tracked benchmark over the last 12 months of available data (or a shorter period in the absence of a full 12 months of data). Subject to the criteria in this paragraph, equity investment funds that invest purely in either equity or debt instruments to replicate a listed and widely-recognized index may be treated as if they were investments in those equities or credit indices and institutions may apply the no look-through approach available for credit and equity indices on those funds if those investments in funds meet the requirements set out in paragraphs 143 to 146. [Basel Framework, MAR21.35] For equity investments in funds that cannot be looked through (i.e. do not meet the criterion set out in paragraph 65(5)(a), but that the institution has access to daily price quotes and knowledge of the mandate of the fund (i.e. meet both the criteria set out in paragraph 65(5)(b), institutions may calculate capital requirements for the fund in one of three ways: If the fund tracks an index benchmark and meets the requirement set out in paragraph 147(2)(a) and (b), the institution may assume that the fund is a position in the tracked index, and may assign the sensitivity to the fund to relevant sector specific buckets or index buckets as set out in paragraph 145. Subject to OSFI’s approval, the institution may consider the fund as a hypothetical portfolio in which the fund invests to the maximum extent allowed under the fund’s mandate in those assets attracting the highest capital requirements under the sensitivities-based method, and then progressively in those other assets implying lower capital requirements. If more than one risk weight can be applied to a given exposure under the sensitivities-based method, the maximum risk weight applicable must be used. This hypothetical portfolio must be subject to market risk capital requirements on a stand-alone basis for all positions in that fund, separate from any other positions subject to market risk capital requirements. The counterparty credit and CVA risks of the derivatives of this hypothetical portfolio must be calculated using the simplified methodology set out in paragraph 153(c) of Chapter 4 of OSFI’s CAR Guideline pertaining to the banking book equity investment in funds treatment. An institution may treat their equity investment in the fund as an unrated equity exposure to be allocated to the “other sector” bucket (bucket 11). In applying this treatment, institutions must also consider whether, given the mandate of the fund, the default risk capital (DRC) requirement risk weight prescribed to the fund is sufficiently prudent (as set out in paragraph 220), and whether the RRAO should apply (as set out in paragraph 263). [Basel Framework, MAR21.36] Equity investments in a given fund that do not meet the requirements of paragraph 65(5) must be assigned to the banking book. Notwithstanding paragraph 63(2), net short positions in funds that do not meet the requirements of paragraph 65(5) should be placed in the banking book and are subject to a 100% capital requirement. [Basel Framework, MAR21.37] Treatment of vega risk for multi-underlying instruments In the vega risk context: Multi-underlying options (including index options) are usually priced based on the implied volatility of the option, rather than the implied volatility of its underlying constituents and a look-through approach may not need to be applied, regardless of the approach applied to the delta and curvature risk calculation as set out in paragraphs 143 to 147.^{Footnote 28} For indices, the vega risk with respect to the implied volatility of the multi-underlying options will be calculated using a sector specific bucket or an index bucket defined in paragraphs 165 and 184 as follows: Where more than 75% of constituents in that index (taking into account the weightings of that index) would be mapped to a single specific sector bucket (i.e. bucket 1 to bucket 11 for equity risk; or bucket 1 to bucket 16 for CSR), the sensitivity to the index shall be mapped to that single specific sector bucket and treated like any other single-name sensitivity in that bucket. In all other cases, the sensitivity may be mapped to an “index” bucket (i.e. bucket 12 or bucket 13 for equity risk or bucket 17 or bucket 18 for CSR). [Basel Framework, MAR21.38] Sensitivities-Based Method: Definition of Delta Risk Buckets, Risk Weights and Correlations Paragraphs 153 to 201 set out buckets, risk weights and correlation parameters for each risk class to calculate delta risk capital requirement as set out in paragraph 116. [Basel Framework, MAR21.39] The prescribed risk weights and correlations in paragraphs 153 to 201 have been calibrated to the liquidity adjusted time horizon related to each risk class. [Basel Framework, MAR21.40] Delta GIRR buckets, risk weights and correlations Each currency is a separate delta GIRR bucket, so all risk factors in risk-free yield curves for the same currency in which interest rate-sensitive instruments are denominated are grouped into the same bucket. [Basel Framework, MAR21.41] For calculating weighted sensitivities, the risk weights for each tenor in risk-free yield curves are set in Table 1 as follows: Table 1 – Delta GIRR buckets and risk weights Tenor Risk weight (percentage points) 0.25 years 1.7% 0.5 years 1.7% 1 years 1.6% 2 years 1.3% 3 years 1.2% 5 years 1.1% 10 years 1.1% 15 years 1.1% 20 years 1.1% 30 years 1.1% [Basel Framework, MAR21.42] The risk weight for the inflation risk factor and the cross-currency basis risk factors, respectively, is set at 1.6%. [Basel Framework, MAR21.43] For EUR, USD, GBP, AUD, JPY, SEK, CAD as well as the domestic reporting currency of an institution, the above risk weights may, at the discretion of the institution, be divided by the square root of 2. [Basel Framework, MAR21.44] For aggregating GIRR risk positions within a bucket, the correlation parameter ρkl between weighted sensitivities WSk and WSl within the same bucket (i.e. same currency), same assigned tenor, but different curves is set at 99.90%. In aggregating delta risk positions for cross-currency basis risk for onshore and offshore curves, which must be considered two different curves as set out in paragraph 120, an institution may choose to aggregate all cross-currency basis risk for a currency (i.e. “Curr/USD” or “Curr/EUR”) for both onshore and offshore curves by a simple sum of weighted sensitivities. [Basel Framework, MAR21.45] The delta risk correlation ρkl between weighted sensitivities WSk and WSl within the same bucket with different tenor and same curve is set in the following Table 2:^{Footnote 29} Table 2 – Delta GIRR correlations (ρkl) within the same bucket, with different tenor and same curve Tenor Tenor 0.25 year 0.5 year 1 year 2 year 3 year 5 year 10 year 15 year 20 year 30 year 0.25 year 100.0% 97.0% 91.4% 81.1% 71.9% 56.6% 40.0% 40.0% 40.0% 40.0% 0.5 year 97.0% 100.0% 97.0% 91.4% 86.1% 76.3% 56.6% 41.9% 40.0% 40.0% 1 year 91.4% 97.0% 100.0% 97.0% 94.2% 88.7% 76.3% 65.7% 56.6% 41.9% 2 year 81.1% 91.4% 97.0% 100.0% 98.5% 95.6% 88.7% 82.3% 76.3% 65.7% 3 year 71.9% 86.1% 94.2% 98.5% 100.0% 98.0% 93.2% 88.7% 84.4% 76.3% 5 year 56.6% 76.3% 88.7% 95.6% 98.0% 100.0% 97.0% 94.2% 91.4% 86.1% 10 year 40.0% 56.6% 76.3% 88.7% 93.2% 97.0% 100.0% 98.5% 97.0% 94.2% 15 year 40.0% 41.9% 65.7% 82.3% 88.7% 94.2% 98.5% 100.0% 99.0% 97.0% 20 year 40.0% 40.0% 56.6% 76.3% 84.4% 91.4% 97.0% 99.0% 100.0% 98.5% 30 year 40.0% 40.0% 41.9% 65.7% 76.3% 86.1% 94.2% 97.0% 98.5% 100.0% [Basel Framework, MAR21.46] Between two weighted sensitivities WSk and WSl within the same bucket with different tenor and different curves, the correlation ρkl is equal to the correlation parameter specified in paragraph 158 multiplied by 99.90%.^{Footnote 30} The 99.90% correlation also applies to different inflation curves in the same currency for GIRR. [Basel Framework, MAR21.47] The delta risk correlation ρkl between a weighted sensitivity WSk to the inflation curve and a weighted sensitivity WSl to a given tenor of the relevant yield curve is 40%. [Basel Framework, MAR21.48] The delta risk correlation ρkl between a weighted sensitivity WSk to a cross-currency basis curve and a weighted sensitivity WSl to each of the following curves is 0%: a given tenor of the relevant yield curve; the inflation curve; or another cross-currency basis curve (if relevant). [Basel Framework, MAR21.49] For aggregating GIRR risk positions across different buckets (i.e. different currencies), the parameter ϒbc is set at 50%. [Basel Framework, MAR21.50] Delta CSR non-securitizations buckets, risk weights and correlations For delta CSR non-securitizations, buckets are set along two dimensions – credit quality and sector – as set out in Table 3. The CSR non-securitization sensitivities or risk exposures should first be assigned to a bucket defined before calculating weighted sensitivities by applying a risk weight. Table 3 – Buckets for delta CSR non-securitizations Bucket number Credit quality Sector 1 Investment grade (IG) Sovereigns including central banks, multilateral development institutions 2 Investment grade (IG) Local government, government-backed non-financials, education, public administration 3 Investment grade (IG) Financials including government-backed financials 4 Investment grade (IG) Basic materials, energy, industrials, agriculture, manufacturing, mining and quarrying 5 Investment grade (IG) Consumer goods and services, transportation and storage, administrative and support service activities 6 Investment grade (IG) Technology, telecommunications 7 Investment grade (IG) Health care, utilities, professional and technical activities 8 Investment grade (IG) Covered bonds^{Footnote 31} 9 High yield (HY) & non-rated (NR) Sovereigns including central banks, multilateral development institutions 10 High yield (HY) & non-rated (NR) Local government, government-backed non-financials, education, public administration 11 High yield (HY) & non-rated (NR) Financials including government-backed financials 12 High yield (HY) & non-rated (NR) Basic materials, energy, industrials, agriculture, manufacturing, mining and quarrying 13 High yield (HY) & non-rated (NR) Consumer goods and services, transportation and storage, administrative and support service activities 14 High yield (HY) & non-rated (NR) Technology, telecommunications 15 High yield (HY) & non-rated (NR) Health care, utilities, professional and technical activities 16 (Not applicable) Other sector^{Footnote 32} 17 IG Qualified Indices 18 HY Qualified Indices When external ratings are assigned by credit rating agencies, risk weights should be consistent with the treatment of external ratings under paragraphs 178 and 179 of Chapter 4, if there are two ratings which map into different risk weights, the higher risk weight should be applied. If there are three or more ratings with different risk weights, the ratings corresponding to the two lowest risk weights should be referred to and the higher of those two risk weights will be applied. Consistent with section 4.1 of Chapter 4, instruments issued by the following entities shall receive the same treatment as instruments issued by the Government of Canada: all provincial and territorial governments and agents of the federal, provincial or territorial government whose debts are, by virtue of their enabling legislation, obligations of the parent government. Where there are no external ratings under paragraph 16 of the revised CVA risk framework (Chapter 8), where there are no external ratings or where external ratings are not recognised within a jurisdiction, institutions may, subject to OSFI’s approval: for the purpose of assigning delta CSR non-securitization risk weights, map the internal rating to an external rating, and assign a risk weight corresponding to either “investment grade” or “high yield” in paragraph 163; for the purpose of assigning default risk weights under the DRC requirement, map the internal rating to an external rating, and assign a risk weight corresponding to one of the seven external ratings in the table included paragraph 236; or apply the risk weights specified in paragraph 163 and 236 for unrated/non-rated categories. Non-tranched MBS issued by government sponsored-entities (GSEs), such as Fannie and Freddie, are assigned to bucket 2 (local government, government-backed non-financials, education, public administration) for CSR with a risk weight of 1.0%. In accordance with paragraph 224, the LGD for non-tranched MBS issued by GSEs is 75% (i.e. the LGD assigned to senior debt instruments) unless the GSE security satisfies the requirements of footnote 33 for treatment of the security as a covered bond. [Basel Framework, MAR21.51] To assign a risk exposure to a sector, institutions must rely on a classification that is commonly used in the market for grouping issuers by industry sector. The institution must assign each issuer to one and only one of the sector buckets in the table under paragraph 163. Risk positions from any issuer that an institution cannot assign to a sector in this fashion must be assigned to the other sector (i.e. bucket 16). [Basel Framework, MAR21.52] For calculating weighted sensitivities, the risk weights for buckets 1 to 18 are set out in Table 4. Risk weights are the same for all tenors (i.e. 0.5 years, 1 year, 3 years, 5 years, 10 years) within each bucket: Table 4 – Risk weights for buckets for delta CSR non-securitizations Bucket number Risk weight 1 0.5% 2 1.0% 3 5.0% 4 3.0% 5 3.0% 6 2.0% 7 1.5% 8 2.5%^{Footnote 33} 9 2.0% 10 4.0% 11 12.0% 12 7.0% 13 8.5% 14 5.5% 15 5.0% 16 12.0% 17 1.5% 18 5.0% [Basel Framework, MAR21.53] For buckets 1 to 15, for aggregating delta CSR non-securitizations risk positions within a bucket, the correlation parameter ρkl between two weighted sensitivities WSk and WSl within the same bucket, is set as follows, where: ρkl^(name) is equal to 1 where the two names of sensitivities k and l are identical, and 35% otherwise; ρkl^(tenor) is equal to 1 if the two tenors of the sensitivities k and l are identical, and to 65% otherwise; and ρkl^(basis) is equal to 1 if the two sensitivities are related to same curves, and 99.90% otherwise. ρ kl = ρ kl name ⋅ ρ kl tenor ⋅ ρ kl basis ^{Footnote 34} Bond and CDS credit spreads are considered distinct risk factors under paragraph 121(1), and ρkl^(basis) referenced in this paragraph and below is meant to capture only the bond-CDS basis. [Basel Framework, MAR21.54] For buckets 17 and 18, for aggregating delta CSR non-securitizations risk positions within a bucket, the correlation parameter ρkl between two weighted sensitivities WSk and WSl within the same bucket is set as follows, where: ρkl^(name) is equal to 1 where the two names of sensitivities k and l are identical, and 80% otherwise; ρkl^(tenor) is equal to 1 if the two tenors of the sensitivities k and l are identical, and to 65% otherwise; and ρkl^(basis) is equal to 1 if the two sensitivities are related to same curves, and 99.90% otherwise. ρ kl = ρ kl name ⋅ ρ kl tenor ⋅ ρ kl basis [Basel Framework, MAR21.55] The correlations above do not apply to the other sector bucket (i.e. bucket 16). The aggregation of delta CSR non-securitization risk positions within the other sector bucket (i.e. bucket 16) would be equal to the simple sum of the absolute values of the net weighted sensitivities allocated to this bucket. The same method applies to the aggregation of vega risk positions. K b(other bucket) = ∑ k WS k The aggregation of curvature CSR non-securitization risk positions within the other sector bucket (i.e. bucket 16) would be calculated by the formula below. K b(other bucket) = max ⁡ ∑ k max ⁡ CVR k + , 0 , ∑ k max ⁡ CVR k - , 0 [Basel Framework, MAR21.56] For aggregating delta CSR non-securitization risk positions across buckets 1 to 18, the correlation parameter ϒbc is set as follows, where: ϒbc^(rating) is equal to 50% where the two buckets b and c are both in buckets 1 to 15 and have a different rating category (either IG or HY/NR). ϒbc^(rating) is equal to 1 otherwise; and ϒbc^(sector) is equal to 1 if the two buckets belong to the same sector, and to the specified numbers in Table 5 otherwise. ϒ bc = ϒ bc (rating) ⋅ ϒ bc (sector) Table 5 – Values of ϒbc^(sector) where the buckets do not belong to the same sector Bucket Bucket 1 / 9 2 / 10 3 / 11 4 / 12 5 / 13 6 / 14 7 / 15 8 16 17 18 1 / 9 75% 10% 20% 25% 20% 15% 10% 0% 45% 45% 2 / 10 5% 15% 20% 15% 10% 10% 0% 45% 45% 3 / 11 5% 15% 20% 5% 20% 0% 45% 45% 4 / 12 20% 25% 5% 5% 0% 45% 45% 5 / 13 25% 5% 15% 0% 45% 45% 6 / 14 5% 20% 0% 45% 45% 7 / 15 5% 0% 45% 45% 8 0% 45% 45% 16 0% 0% 17 75% 18 [Basel Framework, MAR21.57] Delta CSR securitization (CTP) buckets, risk weights and correlations Sensitivities to CSR arising from the CTP and its hedges are treated as a separate risk class as set out in paragraph 113. The buckets, risk weights and correlations for the CSR securitizations (CTP) apply as follows: The same bucket structure and correlation structure apply to the CSR securitizations (CTP) as those for the CSR non-securitization framework as set out in paragraphs 163 to 169 with an exception of index buckets (i.e. buckets 17 and 18). The risk weights and correlation parameters of the delta CSR non-securitizations are modified to reflect longer liquidity horizons and larger basis risk as specified in paragraph 171 to 173. [Basel Framework, MAR21.58] For calculating weighted sensitivities, the risk weights for buckets 1 to 16 are set out in Table 6. Risk weights are the same for all tenors (i.e. 0.5 years, 1 year, 3 years, 5 years, 10 years) within each bucket: Table 6 – Risk weights for sensitivities to CSR arising from the CTP Bucket number Risk weight 1 4.0% 2 4.0% 3 8.0% 4 5.0% 5 4.0% 6 3.0% 7 2.0% 8 6.0% 9 13.0% 10 13.0% 11 16.0% 12 10.0% 13 12.0% 14 12.0% 15 12.0% 16 13.0% [Basel Framework, MAR21.59] For aggregating delta CSR securitizations (CTP) risk positions within a bucket, the delta risk correlation ρkl is derived the same way as in paragraph 166 and 167, except that the correlation parameter applying when the sensitivities are not related to same curves, ρkl^(basis), is modified. ρkl^(basis) is now equal to 1 if the two sensitivities are related to same curves, and 99.00% otherwise. The identical correlation parameters for ρkl^(name) and ρkl^(tenor) to CSR non-securitization as set out in paragraph 166 and 167 apply. [Basel Framework, MAR21.60] For aggregating delta CSR securitizations (CTP) risk positions across buckets, the correlation parameters for ϒbc are identical to CSR non-securitization as set out in paragraph 169. [Basel Framework, MAR21.61] Delta CSR securitization (non-CTP) buckets, risk weights and correlations For delta CSR securitizations not in the CTP, buckets are set along two dimensions – credit quality and sector – as set out in Table 7. The delta CSR securitization (non-CTP) sensitivities or risk exposures must first be assigned to a bucket before calculating weighted sensitivities by applying a risk weight. Table 7 – Buckets for delta CSR securitizations (non-CTP) Bucket number Credit quality Sector 1 Senior investment grade (IG) RMBS – Prime 2 Senior investment grade (IG) RMBS – Mid-prime 3 Senior investment grade (IG) RMBS – Sub-prime 4 Senior investment grade (IG) CMBS 5 Senior investment grade (IG) Asset-backed securities (ABS) – Student loans 6 Senior investment grade (IG) ABS – Credit cards 7 Senior investment grade (IG) ABS – Auto 8 Senior investment grade (IG) Collateralised loan obligation (CLO) non-CTP 9 Non-senior IG RMBS – Prime 10 Non-senior IG RMBS – Mid-prime 11 Non-senior IG RMBS – Sub-prime 12 Non-senior IG Commercial mortgage-backed securities (CMBS) 13 Non-senior IG ABS – Student loans 14 Non-senior IG ABS – Credit cards 15 Non-senior IG ABS – Auto 16 Non-senior IG CLO non-CTP 17 High yield & non-rated RMBS – Prime 18 High yield & non-rated RMBS – Mid-prime 19 High yield & non-rated RMBS – Sub-prime 20 High yield & non-rated CMBS 21 High yield & non-rated ABS – Student loans 22 High yield & non-rated ABS – Credit cards 23 High yield & non-rated ABS – Auto 24 High yield & non-rated CLO non-CTP 25 (Not applicable) Other sector^{Footnote 35} [Basel Framework, MAR21.62] To assign a risk exposure to a sector, institutions must rely on a classification that is commonly used in the market for grouping tranches by type. The institution must assign each tranche to one of the sector buckets in above Table 7. Risk positions from any tranche that an institution cannot assign to a sector in this fashion must be assigned to the other sector (i.e. bucket 25). [Basel Framework, MAR21.63] For calculating weighted sensitivities, the risk weights for buckets 1 to 8 (senior IG) are set out in Table 8: Table 8 – Risk weights for buckets 1 to 8 for delta CSR securitizations (non-CTP) Bucket number Risk weight (in percentage points) 1 0.9% 2 1.5% 3 2.0% 4 2.0% 5 0.8% 6 1.2% 7 1.2% 8 1.4% [Basel Framework, MAR21.64] The risk weights for buckets 9 to 16 (non-senior investment grade) are then equal to the corresponding risk weights for buckets 1 to 8 scaled up by a multiplication by 1.25. For instance, the risk weight for bucket 9 is equal to 1.25 × 0.9% = 1.125%. [Basel Framework, MAR21.65] The risk weights for buckets 17 to 24 (high yield and non-rated) are then equal to the corresponding risk weights for buckets 1 to 8 scaled up by a multiplication by 1.75. For instance, the risk weight for bucket 17 is equal to 1.75 × 0.9% = 1.575%. [Basel Framework, MAR21.66] The risk weight for bucket 25 is set at 3.5%. [Basel Framework, MAR21.67] For aggregating delta CSR securitizations (non-CTP) risk positions within a bucket, the correlation parameter ρkl between two sensitivities WSk and WSl within the same bucket, is set as follows, where: ρkl^(tranche) is equal to 1 where the two names of sensitivities k and l are within the same bucket and related to the same securitization tranche (more than 80% overlap in notional terms), and 40% otherwise; ρkl^(tenor) is equal to 1 if the two tenors of the sensitivities k and l are identical, and to 80% otherwise; and ρkl^(basis) is equal to 1 if the two sensitivities are related to same curves, and 99.90% otherwise. ρ kl = ρ kl tranche ⋅ ρ kl tenor ⋅ ρ kl basis There is no granularity for issuers in the delta CSR securitization part as set out in paragraph 122. Where two tranches have exactly the same issuer, same tenor and same basis, but different tranches (i.e. different credit quality), the correlation must be 40%. [Basel Framework, MAR21.68] The correlations above do not apply to the other sector bucket (i.e. bucket 25). The aggregation of delta CSR securitizations (non-CTP) risk positions within the other sector bucket would be equal to the simple sum of the absolute values of the net weighted sensitivities allocated to this bucket. The same method applies to the aggregation of vega risk positions. K b(other bucket) = ∑ k WS k The aggregation of curvature CSR risk positions within the other sector bucket (i.e. bucket 16) would be calculated by the formula below. K b(otherwise bucket) = max ⁡ ∑ k max ⁡ CVR k + , 0 , ∑ k max ⁡ CVR k - , 0 [Basel Framework, MAR21.69] For aggregating delta CSR securitizations (non-CTP) risk positions across buckets 1 to 24, the correlation parameter ϒbc is set as 0%. [Basel Framework, MAR21.70] For aggregating delta CSR securitizations (non-CTP) risk positions between the other sector bucket (i.e. bucket 25) and buckets 1 to 24, (i) the capital requirements for bucket 25 and (ii) the aggregated capital requirements for buckets 1 to 24 will be simply summed up to the overall risk class level capital requirements. There should be no diversification or hedging effects recognised in aggregating the capital requirements for the other sector bucket (i.e. bucket 25) with those for buckets 1 to 24. [Basel Framework, MAR21.71] Equity risk buckets, risk weights and correlations For delta equity risk, buckets are set along three dimensions – market capitalization, economy and sector – as set out in Table 9. The equity risk sensitivities or exposures must first be assigned to a bucket before calculating weighted sensitivities by applying a risk weight. Table 9 – Buckets for delta sensitivities to equity risk Bucket number Market cap Economy Sector 1 Large Emerging market economy Consumer goods and services, transportation and storage, administrative and support service activities, healthcare, utilities 2 Large Emerging market economy Telecommunications, industrials 3 Large Emerging market economy Basic materials, energy, agriculture, manufacturing, mining and quarrying 4 Large Emerging market economy Financials including government-backed financials, real estate activities, technology 5 Large Advanced economy Consumer goods and services, transportation and storage, administrative and support service activities, healthcare, utilities 6 Large Advanced economy Telecommunications, industrials 7 Large Advanced economy Basic materials, energy, agriculture, manufacturing, mining and quarrying 8 Large Advanced economy Financials including government-backed financials, real estate activities, technology 9 Small Emerging market economy All sectors described under bucket numbers 1, 2, 3 and 4 10 Small Advanced economy All sectors described under bucket numbers 5, 6, 7 and 8 11 (Not applicable) (Not applicable) Other sector^{Footnote 36} 12 Large Advanced economy Equity indices (non-sector specific) 13 (Not applicable) (Not applicable) Other equity indices (non-sector specific) [Basel Framework, MAR21.72] Market capitalization (market cap) is defined as the sum of the market capitalizations based on the market value of the total outstanding shares issued by the same listed legal entity or a group of legal entities across all stock markets globally, where the total outstanding shares issued by the group of legal entities refer to cases where the listed entity is a parent company of a group of legal entities. Under no circumstances should the sum of the market capitalizations of multiple related listed entities be used to determine whether a listed entity is “large market cap” or “small market cap”. [Basel Framework, MAR21.73] Large market cap is defined as a market capitalization equal to or greater than CAD 2.5 billion and small market cap is defined as a market capitalization of less than CAD 2.5 billion. [Basel Framework, MAR21.74] The advanced economies are Canada, the United States, Mexico, the euro area, the non-euro area western European countries (the United Kingdom, Norway, Sweden, Denmark and Switzerland), Japan, Oceania (Australia and New Zealand), Singapore and Hong Kong SAR. An equity issuer must be allocated to a particular bucket according to the most material country or region in which the issuer operates. As stated in paragraph 188: “For multinational multi-sector equity issuers, the allocation to a particular bucket must be done according to the most material region and sector in which the issuer operates.” [Basel Framework, MAR21.75] To assign a risk exposure to a sector, institutions must rely on a classification that is commonly used in the market for grouping issuers by industry sector. The institution must assign each issuer to one of the sector buckets in the table under paragraph 184 and it must assign all issuers from the same industry to the same sector. Risk positions from any issuer that an institution cannot assign to a sector in this fashion must be assigned to the other sector (i.e. bucket 11). For multinational multi-sector equity issuers, the allocation to a particular bucket must be done according to the most material region and sector in which the issuer operates. [Basel Framework, MAR21.76] For calculating weighted sensitivities, the risk weights for the sensitivities to each of equity spot price and equity repo rates for buckets 1 to 13 are set out in Table 10: Table 10 – Risk weights for buckets 1 to 13 for sensitivities to equity risk Bucket number Risk weight for equity spot price Risk weight for equity repo rate 1 55% 0.55% 2 60% 0.60% 3 45% 0.45% 4 55% 0.55% 5 30% 0.30% 6 35% 0.35% 7 40% 0.40% 8 50% 0.50% 9 70% 0.70% 10 50% 0.50% 11 70% 0.70% 12 15% 0.15% 13 25% 0.25% [Basel Framework, MAR21.77] For aggregating delta equity risk positions within a bucket, the correlation parameter ρkl between two sensitivities WSk and WSl within the same bucket is set at as follows The correlation parameter ρkl is set at 99.90%, where: one is a sensitivity to an equity spot price and the other a sensitivity to an equity repo rates; and both are related to the same equity issuer name. The correlation parameter ρkl is set out in (a) to (e) below, where both sensitivities are to equity spot price, and where: 15% between two sensitivities within the same bucket that fall under large market cap, emerging market economy (bucket number 1, 2, 3 or 4). 25% between two sensitivities within the same bucket that fall under large market cap, advanced economy (bucket number 5, 6, 7 or 8). 7.5% between two sensitivities within the same bucket that fall under small market cap, emerging market economy (bucket number 9). 12.5% between two sensitivities within the same bucket that fall under small market cap, advanced economy (bucket number 10). 80% between two sensitivities within the same bucket that fall under either index bucket (bucket number 12 or 13) The same correlation parameter ρkl as set out in above (2)(a) to (e) apply, where both sensitivities are to equity repo rates. The correlation parameter ρkl is set as each parameter specified in above (2)(a) to (e) multiplied by 99.90%, where: One is a sensitivity to an equity spot price and the other a sensitivity to an equity repo rate; and Each sensitivity is related to a different equity issuer name. [Basel Framework, MAR21.78] The correlations set out above do not apply to the other sector bucket (i.e. bucket 11). The aggregation of equity risk positions within the other sector bucket capital requirement would be equal to the simple sum of the absolute values of the net weighted sensitivities allocated to this bucket. The same method applies to the aggregation of vega risk positions. K b(other bucket) = ∑ k WS k The aggregation of curvature equity risk positions within the other sector bucket (i.e. bucket 11) would be calculated by the formula: K b(other bucket) = max ⁡ ∑ k max ⁡ CVR k + , 0 , ∑ k max ⁡ CVR k - , 0 [Basel Framework, MAR21.79] For aggregating delta equity risk positions across buckets 1 to 13, the correlation parameter ϒbc is set at: 15% if bucket b and bucket c fall within bucket numbers 1 to 10; 0% if either of bucket b and bucket c is bucket 11; 75% if bucket b and bucket c are bucket numbers 12 and 13 (i.e. one is bucket 12, one is bucket 13); and 45% otherwise. [Basel Framework, MAR21.80] Commodity risk buckets, risk weights and correlations For delta commodity risk, 11 buckets that group commodities by common characteristics are set out in Table 11. [Basel Framework, MAR21.81] For calculating weighted sensitivities, the risk weights for each bucket are set out in Table 11: Table 11 – Delta commodity buckets and risk weights Bucket number Commodity bucket Examples of commodities allocated to each commodity bucket (non-exhaustive) Risk weight 1 Energy – solid combustibles Coal, charcoal, wood pellets, uranium 30% 2 Energy – liquid combustibles Light-sweet crude oil; heavy crude oil; West Texas Intermediate (WTI) crude; Brent crude; etc. (i.e. various types of crude oil) Bioethanol; biodiesel; etc. (i.e. various biofuels) Propane; ethane; gasoline; methanol; butane; etc. (i.e. various petrochemicals) Jet fuel; kerosene; gasoil; fuel oil; naphtha; heating oil; diesel etc. (i.e. various refined fuels) 35% 3 Energy – electricity and carbon trading Spot electricity; day-ahead electricity; peak electricity; off-peak electricity (i.e. various electricity types) Certified emissions reductions; in-delivery month EU allowance; Regional Greenhouse Gas Initiative CO2 allowance; renewable energy certificates; etc. (i.e. various carbon trading emissions) 60% 4 Freight Capesize; Panamax; Handysize; Supramax (i.e. various types of dry-bulk route) Suezmax; Aframax; very large crude carriers (i.e. various liquid-bulk/gas shipping route) 80% 5 Metals – non-precious Aluminium; copper; lead; nickel; tin; zinc (i.e. various base metals) Steel billet; steel wire; steel coil; steel scrap; steel rebar; iron ore; tungsten; vanadium; titanium; tantalum (i.e. steel raw materials) Cobalt; manganese; molybdenum (i.e. various minor metals) 40% 6 Gaseous combustibles Natural gas; liquefied natural gas 45% 7 Precious metals (including gold) Gold; silver; platinum; palladium 20% 8 Grains and oilseed Corn; wheat; soybean seed; soybean oil; soybean meal; oats; palm oil; canola; barley; rapeseed seed; rapeseed oil; rapeseed meal; red bean; sorghum; coconut oil; olive oil; peanut oil; sunflower oil; rice 35% 9 Livestock and dairy Live cattle; feeder cattle; hog; poultry; lamb; fish; shrimp; milk; whey; eggs; butter; cheese 25% 10 Softs and other agriculturals Cocoa; arabica coffee; robusta coffee; tea; citrus juice; orange juice; potatoes; sugar; cotton; wool; lumber; pulp; rubber 35% 11 Other commodity Potash; fertilizer; phosphate rocks (i.e. various industrial materials) Rare earths; terephthalic acid; flat glass 50% [Basel Framework, MAR21.82] For the purpose of aggregating commodity risk positions within a bucket using a correlation parameter, the correlation parameter ρkl between two sensitivities WSk and WSl within the same bucket, is set as follows, where: ρkl^(cty) is equal to 1 where the two commodities of sensitivities k and l are identical, and to the intra-bucket correlations in Table 12 otherwise, where, any two commodities are considered distinct commodities if in the market two contracts are considered distinct when the only difference between each other is the underlying commodity to be delivered. For example, WTI and Brent in bucket 2 (i.e. energy – liquid combustibles) would typically be treated as distinct commodities; Instruments with a spread as their underlying are considered sensitive to different risk factors. In the example cited, the swap will be sensitive to both WTI and Brent, each of which require a capital charge at the risk factor level (i.e. delta of WTI and delta of Brent). ρkl^(tenor) is equal to 1 if the two tenors of the sensitivities k and l are identical, and to 99.00% otherwise; and ρkl^(basis) is equal to 1 if the two sensitivities are identical in the delivery location of a commodity, and 99.90% otherwise. ρ kl = ρ kl cty ⋅ ρ kl tenor ⋅ ρ kl basis ^{Footnote 37} Table 12 – Values of ρkl^(cty) for intra-bucket correlations Bucket number Commodity bucket Correlation (ρkl^(cty)) 1 Energy – Solid combustibles 55% 2 Energy – Liquid combustibles 95% 3 Energy – Electricity and carbon trading 40% 4 Freight 80% 5 Metals – non-precious 60% 6 Gaseous combustibles 65% 7 Precious metals (including gold) 55% 8 Grains and oilseed 45% 9 Livestock and dairy 15% 10 Softs and other agriculturals 40% 11 Other commodity 15% [Basel Framework, MAR21.83] For determining whether the commodity correlation parameter (ρkl^(cty)) as set out in Table 12 in paragraph 195 should apply, this paragraph provides non-exhaustive examples of further definitions of distinct commodities as follows: For bucket 3 (energy – electricity and carbon trading): Each time interval (i) at which the electricity can be delivered and (ii) that is specified in a contract that is made on a financial market is considered a distinct electricity commodity (e.g. peak and off-peak). Electricity produced in a specific region (e.g. Electricity NE, Electricity SE or Electricity North) is considered a distinct electricity commodity. For bucket 4 (freight): Each combination of freight type and route is considered a distinct commodity. Each week at which a good has to be delivered is considered a distinct commodity. Instruments with a spread as their underlying are considered sensitive to different risk factors. For example, if there is a swap on the spread between WTI and the Brent, the swap will be sensitive to both WTI and Brent, each of which require a capital charge at the risk factor level (i.e. delta of WTI and delta of Brent). The correlation to aggregate capital charges is specified in paragraph 195. [Basel Framework, MAR21.84] For aggregating delta commodity risk positions across buckets, the correlation parameter ϒbc is set as follows: 20% if bucket b and bucket c fall within bucket numbers 1 to 10; and 0% if either bucket b or bucket c is bucket number 11. [Basel Framework, MAR21.85] Foreign exchange risk buckets, risk weights and correlations An FX risk bucket is set for each exchange rate between the currency in which an instrument is denominated and the reporting currency. [Basel Framework, MAR21.86] A unique relative risk weight equal to 15% applies to all the FX sensitivities. [Basel Framework, MAR21.87] For the specified currency pairs USD/EUR, USD/JPY, USD/GBP, USD/AUD, USD/CAD, USD/CHF, USD/MXN, USD/CNY, USD/NZD, USD/RUB, USD/HKD, USD/SGD, USD/TRY, USD/KRW, USD/SEK, USD/ZAR, USD/INR, USD/NOK, USD/BRL, and for currency pairs forming first-order crosses across these specified currency pairs, the above risk weight may at the discretion of the institution be divided by the square root of 2. [Basel Framework, MAR21.88] For aggregating delta FX risk positions across buckets, the correlation parameter ϒbc is uniformly set to 60%. [Basel Framework, MAR21.89] Sensitivities-Based Method: Definition of Vega Risk Buckets, Risk Weights and Correlations Paragraphs 203 to 207 set out buckets, risk weights and correlation parameters to calculate vega risk capital requirement as set out in paragraph 116. [Basel Framework, MAR21.90] The same bucket definitions for each risk class are used for vega risk as for delta risk. [Basel Framework, MAR21.91] For calculating weighted sensitivities for vega risk, the risk of market illiquidity is incorporated into the determination of vega risk, by assigning different liquidity horizons for each risk class as set out in Table 13. The risk weight for each risk class^{Footnote 38} is also set out in Table 13. Table 13 – Regulatory liquidity horizon, LHrisk class and risk weights per risk class Risk class LHrisk class Risk weights GIRR 60 100% CSR non-securitizations 120 100% CSR securitizations (CTP) 120 100% CSR securitizations (non-CTP) 120 100% Equity (large cap and indices) 20 77.78% Equity (small cap and other sector) 60 100% Commodity 120 100% FX 40 100% The 20-day liquidity horizon applies to vega risk factors that would be allocated to large market cap buckets (i.e. buckets 1 to 8) or to index buckets (i.e. buckets 12 and 13) as set out in paragraph 184. The 60-day liquidity horizon applies to vega risk factors that would be allocated to small market cap buckets (i.e. buckets 9 and 10) or to the other sector bucket (i.e. bucket 11) as set out in paragraph 184. [Basel Framework, MAR21.92] For aggregating vega GIRR risk positions within a bucket, the correlation parameter ρkl is set as follows, where: ρkl^{(option maturity)} is equal to e - α ⋅ T k - T l min ⁡ T k ; T l , where: α is set at 1%; Tk (respectively Tl) is the maturity of the option from which the vega sensitivity VRk (VRl) is derived, expressed as a number of years; and ρkl^{(underlying maturity)} is equal to e - α ⋅ T k U - T l U min ⁡ T k U ; T l U , where: α is set at 1%; and Tk^U (respectively Tl^U) is the maturity of the underlying of the option from which the sensitivity VRk (VRl) is derived, expressed as a number of years after the maturity of the option. ρ kl = min ⁡ ρ kl (option maturity) ⋅ ρ kl (underlying maturity) ; 1 [Basel Framework, MAR21.93] For aggregating vega risk positions within a bucket of the other risk classes (i.e. non-GIRR), the correlation parameter ρkl is set as follows, where: ρkl^(DELTA) is equal to the correlation that applies between the delta risk factors that correspond to vega risk factors k and l. For instance, if k is the vega risk factor from equity option X and l is the vega risk factor from equity option Y then ρkl^(DELTA) is the delta correlation applicable between X and Y; and ρkl^{(option maturity)} is defined as in the above paragraph ρ kl = min ⁡ ρ kl (DELTA) ⋅ ρ kl (option maturity) ; 1 For determining the delta risk factors that correspond to vega risk factors k and l, for CSR and commodity risks in paragraphs 121 to 123 and paragraph 125, if the vega risk factors are defined for a smaller number of dimensions than are defined for delta risk factors, only the dimensions that are defined both as a vega risk factor dimension and as a delta risk factor dimension for the relevant risk class need to be considered as a correlation based on delta risk factors (ρkl^((DELTA)) in the calculation of vega risk for purposes of the requirements in this paragraph. This means that the following dimensions are considered: for CSR non-securitisation risk: option maturity (ρkl^{(option maturity)}) and underlying name (ρkl^(name)); for CSR securitisations (CTP) risk: option maturity (ρkl^{(option maturity)}) and underlying name (ρkl^(name)); for CSR securitisation (non-CTP): option maturity (ρkl^{(option maturity)}) and securitisation tranche (ρkl^(tranche)); and for commodity risk: option maturity (ρkl^{(option maturity)}) and commodity (ρkl^(cty)). [Basel Framework, MAR21.94] For aggregating vega risk positions across different buckets within a risk class (GIRR and non-GIRR), the same correlation parameters for ϒbc, as specified for delta correlations for each risk class in paragraphs 151 to 201 are to be used for the aggregation of vega risk (e.g. ϒbc = 50% is to be used for the aggregation of vega risk sensitivities across different GIRR buckets). [Basel Framework, MAR21.95] Sensitivities-Based Method: Definition of Curvature Risk Buckets, Risk Weights and Correlations Paragraphs 209 to 213 set out buckets, risk weights and correlation parameters to calculate curvature risk capital requirement as set out in paragraph 117. [Basel Framework, MAR21.96] The delta buckets are replicated for the calculation of curvature risk capital requirement, unless specified otherwise in the preceding paragraphs within paragraphs 120 to 201. [Basel Framework, MAR21.97] For calculating the net curvature risk capital requirement CVRk for risk factor k for FX and equity risk classes, the curvature risk weight, which is the size of a shock to the given risk factor, is a relative shift equal to the respective delta risk weight. For FX curvature, for options that do not reference an institution’s reporting currency (or base currency as set out in paragraph 126(b) as an underlying, net curvature risk charges (CVRk⁺ and CVRk⁻) may be divided by a scalar of 1.5. Alternatively, and subject to OSFI’s approval, an institution may apply the scalar of 1.5 consistently to all FX instruments provided curvature sensitivities are calculated for all currencies, including sensitivities determined by shocking the reporting currency (or base currency where used) relative to all other currencies. [Basel Framework, MAR21.98] For calculating the net curvature risk capital requirement CVRk for curvature risk factor k for GIRR, CSR and commodity risk classes, the curvature risk weight is the parallel shift of all the tenors for each curve based on the highest prescribed delta risk weight for each bucket. For example, in the case of GIRR for a given currency (i.e. bucket), the risk weight assigned to 0.25-year tenor (i.e. the most punitive tenor risk weight) is applied to all the tenors simultaneously for each risk-free yield curve (consistent with a “translation”, or “parallel shift” risk calculation). [Basel Framework, MAR21.99]. For aggregating curvature risk positions within a bucket, the curvature risk correlations ρkl are determined by squaring the corresponding delta correlation parameters ρkl. In a case where a curvature risk factor is defined differently than the corresponding delta risk factor for a given risk class (i.e. for CSR non-securitisations, CSR securitisations (CTP), CSR securitisations (non-CTP) and commodities as defined in paragraph 121 to paragraph 123 and paragraph 125), institutions do not need to consider this delta risk factor dimension. For example, for CSR non-securitisations and CSR securitisations (CTP), consistent with paragraph 121 which defines a bucket along one dimension (i.e. the relevant credit spread curve), the correlation parameter ρkl as defined in paragraph 166 and paragraph 167 is not applicable to the curvature risk capital requirement calculation. Thus, the correlation parameter is determined by whether the two names of weighted sensitivities are the same. In the formula in paragraph 166 and paragraph 167, the correlation parameters ρkl^(basis) and ρkl^(tenor) need not apply and only correlation parameter ρkl^(name) applies between two weighted sensitivities within the same bucket. This correlation parameter should be squared. In applying the high and low correlations scenario set out in paragraph 118, the curvature risk capital requirements are calculated by applying curvature correlation parameters ρkl determined in this paragraph. [Basel Framework, MAR21.100] For aggregating curvature risk positions across buckets, the curvature risk correlations ϒbc are determined by squaring the corresponding delta correlation parameters ϒbc. For instance, when aggregating CVREUR and CVRUSD for the GIRR, the correlation should be 50%² = 25%. In applying the high and low correlations scenario set out in paragraph 118, the curvature risk capital requirements are calculated by applying the curvature correlation parameters ϒbc, (i.e. the square of the corresponding delta correlation parameter). [Basel Framework, MAR21.101]

9.5.3 Default Risk Capital Requirement

Main Concepts of Default Risk Capital Requirements The default risk capital (DRC) requirement is intended to capture jump-to-default (JTD) risk that may not be captured by credit spread shocks under the sensitivities-based method. DRC requirements provide some limited hedging recognition. In this section offsetting refers to the netting of exposures to the same obligor (where a short exposure may be subtracted in full from a long exposure) and hedging refers to the application of a partial hedge benefit from the short exposures (where the risk of long and short exposures in distinct obligors do not fully offset due to basis or correlation risks). [Basel Framework, MAR22.1] Instruments Subject To the Default Risk Capital Requirement The DRC requirement must be calculated for instruments subject to default risk: Non-securitization portfolios (including equities) Securitization portfolio (non-correlation trading portfolio, or non-CTP) Securitization (correlation trading portfolio, or CTP). [Basel Framework, MAR22.2] Overview of DRC Requirement Calculation The following step-by-step approach must be followed for each risk class subject to default risk. The specific definition of gross JTD risk, net JTD risk, bucket, risk weight and the method for aggregation of DRC requirement across buckets are separately set out per each risk class in subsections in paragraphs 221 to 238. The gross JTD risk of each exposure is computed separately. With respect to the same obligator, the JTD amounts of long and short exposures are offset (where permissible) to produce net long and/or net short exposure amounts per distinct obligor. Net JTD risk positions are then allocated to buckets. Within a bucket, a hedge benefit ratio is calculated using net long and short JTD risk positions. This acts as a discount factor that reduces the amount of net short positions to be netted against net long positions within a bucket. A prescribed risk weight is applied to the net positions which are then aggregated. Bucket level DRC requirements are aggregated as a simple sum across buckets to give the overall DRC requirement. [Basel Framework, MAR22.3] No diversification benefit is recognised between the DRC requirements for: non-securitizations; securitizations (non-CTP); and securitizations (CTP). [Basel Framework, MAR22.4] For traded non-securitization credit and equity derivatives, JTD risk positions by individual constituent issuer legal entity should be determined by applying a look-through approach. When decomposing multiple underlying positions of a single security or product (e.g. index options), the JTD equivalent is defined as the difference between the value of the security or product assuming that each single name referenced by the security or product, separately from the others, defaults (with zero recovery) and the value of the security or product assuming that none of the names referenced by the security or product default. [Basel Framework, MAR22.5] For the CTP, the capital requirement calculation includes the default risk for non-securitization hedges. These hedges must be removed from the calculation of default risk non-securitization. [Basel Framework, MAR22.6] For claims on an equity investment in a fund that is subject to the treatment specified in paragraph 148(3) (i.e. treated as an unrated “other sector” equity), the equity investment in the fund shall be treated as an unrated equity instrument. Where the mandate of that fund allows the fund to invest in primarily high-yield or distressed names, institutions shall apply the maximum risk weight per Table 15 in paragraph 236 that is achievable under the fund’s mandate (by calculating the effective average risk weight of the fund when assuming that the fund invests first in defaulted instruments to the maximum possible extent allowed under its mandate, and then in CCC-rated names to the maximum possible extent, and then B-rated, and then BB-rated). Neither offsetting nor diversification between these generated exposures and other exposures is allowed. For equity investments in funds for which the sensitivities-based method capital requirements are calculated according to paragraph 148(3) (i.e. the “other sector” equity treatment), the mandate of the fund may not be used to determine to jump-to-default (JTD) of the fund for default risk. In such cases, the LGD should be 100%, consistent with the requirement in this paragraph to treat the equity investment as a position in an unrated equity instrument. [Basel Framework, MAR22.8] Default Risk Capital Requirement for Non-Securitizations Gross jump-to-default risk positions (gross JTD) The gross JTD risk position is computed exposure by exposure. For instance, if an institution has a long position on a bond issued by Apple, and another short position on a bond issued by Apple, it must compute two separate JTD exposures. [Basel Framework, MAR22.9] For the purpose of DRC requirements, the determination of the long/short direction of positions must be on the basis of long or short with respect to whether the credit exposure results in a loss or gain in the case of a default. Specifically, a long exposure is defined as a credit exposure that results in a loss in the case of a default. For derivative contracts, the long/short direction is also determined by whether the contract will result in a loss in the case of a default (i.e. long or short position is not determined by whether the option or credit default swap (CDS), is bought or sold). Thus, for the purpose of DRC requirements, a sold put option on a bond is a long credit exposure, since a default results in a loss to the seller of the option. [Basel Framework, MAR22.10] The gross JTD is a function of the loss given default (LGD), notional amount (or face value) and the cumulative profit and loss (P&L) already realised on the position, where: notional is the bond-equivalent notional amount (or face value) of the position; and P&L is the cumulative mark-to-market loss (or gain) already taken on the exposure. P&L is equal to the market value minus the notional amount, where the market value is the current market value of the position. JTD (long) = max (LGD × notional + P&L, 0) JTD (short) = min (LGD × notional + P&L, 0) [Basel Framework, MAR22.11] For calculating the gross JTD, LGD is set as follows: Equity instruments and non-senior debt instruments are assigned an LGD of 100%. Senior debt instruments are assigned an LGD of 75%. Covered bonds, as defined within paragraph 163, are assigned an LGD of 25%. When the price of the instrument is not linked to the recovery rate of the defaulter (e.g. a foreign exchange-credit hybrid option where the cash flows are swap of cash flows, long EUR coupons and short USD coupons with a knockout feature that ends cash flows on an event of default of a particular obligor), there should be no multiplication of the notional by the LGD. Non-tranched MBS issued by government sponsored-entities (GSEs), such as Fannie and Freddie, are assigned to bucket 2 (local government, government-backed non-financials, education, public administration) for credit spread risk with a risk weight of 1.0%. The LGD for non-tranched MBS issued by GSEs is 75% (i.e. the LGD assigned to senior debt instruments) unless the GSE security satisfies the requirements of footnote 33 to paragraph 163 for treatment of the security as a covered bond. [Basel Framework, MAR22.12] In calculating the JTD as set out in paragraph 223, the notional amount of an instrument that gives rise to a long (short) exposure is recorded as a positive (negative) value, while the P&L loss (gain) is recorded as a negative (positive) value. If the contractual or legal terms of the derivative allow for the unwinding of the instrument with no exposure to default risk, then the JTD is equal to zero. [Basel Framework, MAR22.13] The notional amount is used to determine the loss of principal at default, and the mark-to-market loss is used to determine the net loss so as to not double-count the mark-to-market loss already recorded in the market value of the position. For all instruments, the notional amount is the notional amount of the instrument relative to which the loss of principal is determined. Examples are as follows: For a bond, the notional amount is the face value. For credit derivatives, the notional amount of a CDS contract or a put option on a bond is the notional amount of the derivative contract. In the case of a call option on a bond, the notional amount to be used in the JTD calculation is zero (since, in the event of default, the call option will not be exercised). In this case, a JTD would extinguish the call option’s value and this loss would be captured through the mark-to-market P&L term in the JTD calculation. Table 14 illustrates examples of the notional amounts and market values for a long credit position with a mark-to-market loss to be used in the JTD calculation, where: the bond-equivalent market value is an intermediate step in determining the P&L for derivative instruments; the mark-to-market value of CDS or an option takes an absolute value; and the strike amount of the bond option is expressed in terms of the bond price (not the yield). Table 14 – Examples of components for a long credit position in the JTD calculation Instrument Notional Bond-equivalent market value P&L Bond Face value of bond Market value of bond Market value – face value CDS Notional of CDS Notional of CDS + mark-to-market (MtM) value of CDS - MtM value of CDS Sold put option on a bond Notional of option Strike amount – | MtM value of option | (Strike – | MtM value of option | ) – Notional Bought call option on a bond 0 MtM value of option MtM value of option P&L = bond-equivalent market value – notional. With this representation of the P&L for a sold put option, a lower strike results in a lower JTD loss. The JTD equivalent for a single security or product with multiple underlying positions (e.g. index options) is defined as the difference between the value of the security or product assuming that each single name referenced by the security or product, separately from the others, defaults (with zero recovery) and the value of the security or product assuming that none of the names referenced by the security or product default. When computing the DRC requirement for a convertible bond, institutions should consider the P&L of the equity optionality embedded within the convertible bond, as a convertible bond can be decomposed into a vanilla bond and a long equity option. This avoids situations where the JTD risk of the instrument is potentially underestimated. [Basel Framework, MAR22.14] To account for defaults within the one-year capital horizon, the JTD for all exposures of maturity less than one year and their hedges are scaled by a fraction of a year. No scaling is applied to the JTD for exposures of one year or greater.^{Footnote 39} For example, the JTD for a position with a six month maturity would be weighted by one-half, while the JTD for a position with a one year maturity would have no scaling applied to the JTD. As required by the paragraph below, cash equity positions are assigned a maturity of either more than one year or three months. There is no discretion permitted to assign cash equity positions to any maturity between three months and one year. In determining the offsetting criterion, paragraph 229 specifies that the maturity of the derivatives contract be considered, not the maturity of the underlying instrument. Paragraph 230 further states that the maturity weighting applied to the JTD for any product with a maturity of less than three months is floored at three months. To illustrate how the standardized approach DRC requirement should be calculated with a simple hypothetical portfolio, consider equity index futures with one month to maturity and a negative market value of EUR 10 million (–EUR 10 million, maturity 1M), hedged with the underlying equity positions with a positive market value of EUR 10 million (+EUR 10 million). Both positions in the example should be considered having a three-month maturity. Based on paragraph 227, which requires maturity scaling, defined as a fraction of the year, of positions and their hedge, the JTD for the above trading portfolio would be calculated as follows: 1/4 × 10 − 1/4 × 10 = 0. [Basel Framework, MAR22.15] Cash equity positions (i.e. stocks) are assigned to a maturity of either more than one year or three months, at institutions’ discretion. [Basel Framework, MAR22.16] For derivative exposures, the maturity of the derivative contract is considered in determining the offsetting criterion, not the maturity of the underlying instrument. [Basel Framework, MAR22.17] The maturity weighting applied to the JTD for any sort of product with a maturity of less than three months (such as short term lending) is floored at a weighting factor of one-fourth or, equivalently, three months (that means that the positions having shorter-than-three months remaining maturity would be regarded as having a remaining maturity of three months for the purpose of the DRC requirement). In the case where a total return swap (TRS) with a maturity of one month is hedged by the underlying equity, the net JTD for such a position would be zero. If the contractual/legal terms of the derivative allow for the unwinding of both legs of the position at the time of expiry of the first to mature with no exposure to default risk of the underlying credit beyond that point, then the JTD for the maturity-mismatched position is equal to zero. [Basel Framework, MAR22.18] Net jump-to-default risk positions (net JTD) Exposures to the same obligator may be offset as follows: The gross JTD risk positions of long and short exposures to the same obligor may be offset where the short exposure has the same or lower seniority relative to the long exposure. For example, a short exposure in an equity may offset a long exposure in a bond, but a short exposure in a bond cannot offset a long exposure in the equity. For the purposes of determining whether a guaranteed bond is an exposure to the underlying obligor or an exposure to the guarantor, the credit risk mitigation requirements set out in paragraphs 260 and 262 of Chapter 4 apply. Exposures of different maturities that meet this offsetting criterion may be offset as follows. Exposures with maturities longer than the capital horizon (one year) may be fully offset. An exposure to an obligor comprising a mix of long and short exposures with a maturity less than the capital horizon (equal to one year) must be weighted by the ratio of the exposure’s maturity relative to the capital horizon. For example, with the one-year capital horizon, a three-month short exposure would be weighted so that its benefit against long exposures of longer-than-one-year maturity would be reduced to one quarter of the exposure size.^{Footnote 40} [Basel Framework, MAR22.19] In the case of long and short offsetting exposures where both have a maturity under one year, the scaling can be applied to both the long and short exposures. In the case of either i) an investment grade bond^{Footnote 41} or a large cap equity^{Footnote 42} that is hedging a TRS or ii) a bond forward that is hedging a Level 1 High Quality Liquid Asset as defined in Chapter 2 of OSFI’s Liquidity Adequacy Requirements Guideline, the mismatch applied between long and short position mismatches is capped at 40 days. The institution must be able to demonstrate to OSFI the governance capacity to unwind such cash positions within this timeframe. Such recognition is only admissible if the institution: chooses to make use of the rebalancing/liquidation of the hedge consistently over the relevant set of trading book risk positions, demonstrates that the inclusion of rebalancing/liquidation results in better risk measurement, demonstrates that the markets for the security serving as a hedge are liquid enough to allow for this kind of rebalancing/liquidation, even during periods of stress, and establishes a limit system based on instrument exposure relative to average daily traded volume of the cash position. [Basel Framework, MAR22.20] Finally, the offsetting may result in net long JTD risk positions and net short JTD risk positions. The net long and net short JTD risk positions are aggregated separately as described below. [Basel Framework, MAR22.21] Calculation of default risk capital requirement for non-securitization For the default risk of non-securitizations, three buckets are defined as: corporates; sovereigns; and local governments and municipalities. [Basel Framework, MAR22.22] In order to recognise hedging relationship between net long and net short positions within a bucket, a hedge benefit ratio is computed as follows. A simple sum of the net long JTD risk positions (not risk-weighted) must be calculated, where the summation is across the credit quality categories (i.e. rating bands). The aggregated amount is used in the numerator and denominator of the expression of the hedge benefit ratio (HBR) below. A simple sum of the net (not risk-weighted) short JTD risk positions must be calculated, where the summation is across the credit quality categories (i.e. rating bands). The aggregated amount is used in the denominator of the expression of the HBR below. The HBR is the ratio of net long JTD risk positions to the sum of net long JTD and absolute value of net short JTD risk positions: HBR = ∑ net JTD long ∑ net JTD long + ∑ net JTD short [Basel Framework, MAR22.23] For calculating the weighted net JTD, default risk weights are set depending on the credit quality categories (i.e. rating bands) for all three buckets (i.e. irrespective of the type of counterparty), as set out in Table 15 Table 15 – Default risk weights for non-securitizations by credit quality category Credit quality category Default risk weight AAA 0.5% AA 2% A 3% BBB 6% BB 15% B 30% CCC 50% Unrated 15% Defaulted 100% [Basel Framework, MAR22.24] The capital requirement for each bucket is to be calculated as the combination of the sum of the risk-weighted long net JTD, the HBR, and the sum of the risk-weighted short net JTD, where the summation for each long net JTD and short net JTD is across the credit quality categories (i.e. rating bands). In the following formula, DRC stands for DRC requirement; and i refers to an instrument belonging to bucket b. DRC b = max ⁡ ∑ i ∈ Long RW i ⋅ net JTD i - HBR ⋅ ∑ i ∈ Short RW i ⋅ |net JTD i | ; 0 [Basel Framework, MAR22.25] No hedging is recognised between different buckets – the total DRC requirement for non-securitizations must be calculated as a simple sum of the bucket level capital requirements. [Basel Framework, MAR22.26] Default Risk Capital Requirement for Securitizations (Non-CTP) Gross jump-to-default risk positions (gross JTD) For the computation of gross JTD on securitizations, the same approach must be followed as for default risk (non-securitizations), except that an LGD ratio is not applied to the exposure. Because the LGD is already included in the default risk weights for securitizations to be applied to the securitization exposure (see below), to avoid double counting of LGD the JTD for securitizations is simply the market value of the securitization exposure (i.e. the JTD for tranche positions is their market value). [Basel Framework, MAR22.27] For the purposes of offsetting and hedging recognition for securitizations (non-CTP), positions in underlying names or a non-tranched index position may be decomposed proportionately into the equivalent replicating tranches that span the entire tranche structure. When underlying names are treated in this way, they must be removed from the non-securitization default risk treatment. [Basel Framework, MAR22.28] Net jump-to-default risk positions (net JTD) For default risk of securitizations (non-CTP), offsetting is limited to a specific securitization exposure (i.e. tranches with the same underlying asset pool). This means that: no offsetting is permitted between securitization exposures with different underlying securitized portfolio (i.e. underlying asset pools), even if the attachment and detachment points are the same; and no offsetting is permitted between securitization exposures arising from different tranches with the same securitized portfolio. [Basel Framework, MAR22.29] Securitization exposures that are otherwise identical except for maturity may be offset. The same offsetting rules for non-securitizations including scaling down positions of less than one year as set out in paragraphs 227 through 230 apply to JTD risk positions for securitizations (non-CTP). Offsetting within a specific securitization exposure is allowed as follows. Securitization exposures that can be perfectly replicated through decomposition may be offset. Specifically, if a collection of long securitization exposures can be replicated by a collection of short securitization exposures, then the securitization exposures may be offset. Furthermore, when a long securitization exposure can be replicated by a collection of short securitization exposures with different securitized portfolios, then the securitization exposure with the “mixed” securitization portfolio may be offset by the combination of replicating securitization exposures. After the decomposition, the offsetting rules would apply as in any other case. As in the case of default risk (non-securitizations), long and short securitization exposures should be determined from the perspective of long or short the underlying credit, e.g. the institution making losses on a long securitization exposure in the event of a default in the securitized portfolio. [Basel Framework, MAR22.30] Calculation of default risk capital requirement for securitizations (non-CTP) For default risk of securitizations (non-CTP), the buckets are defined as follows: Corporates (excluding small and medium enterprises) – this bucket takes into account all regions. Other buckets – these are defined along two dimensions: Asset classes: the 11 asset classes are defined as asset-backed commercial paper; auto Loans/Leases; residential mortgage-backed securities (MBS); credit cards; commercial MBS; collateralized loan obligations; collateralized debt obligation (CDO)-squared; small and medium enterprises; student loans, other retail; and other wholesale. Regions: the four regions are defined as Asia, Europe, North America and all other. [Basel Framework, MAR22.31] To assign a securitization exposure to a bucket, institutions must rely on a classification that is commonly used in the market for grouping securitization exposures by type and region of underlying. The institution must assign each securitization exposure to one and only one of the buckets above and it must assign all securitizations with the same type and region of underlying to the same bucket. Any securitization exposure that an institution cannot assign to a type or region of underlying in this fashion must be assigned to the “other bucket”. [Basel Framework, MAR22.32] The capital requirement for default risk of securitizations (non-CTP) is determined using a similar approach to that for non-securitizations. The DRC requirement within a bucket is calculated as follows: The hedge benefit discount HBR, as defined in paragraph 235, is applied to net short securitization exposures in that bucket. The capital requirement is calculated as in paragraph 237. [Basel Framework, MAR22.33] For calculating the weighted net JTD, the risk weights of securitization exposures are defined by the tranche instead of the credit quality. The risk weight for securitizations (non-CTP) is applied as follows: The default risk weights for securitization exposures are based on the corresponding risk weights for banking book instruments, which is defined in Chapter 6. Transactions that are assessed as simple, transparent and comparable-compliant for capital purposes are subject to alternative capital treatment requirements outlined in the Chapter 6 with the following modification: the maturity component in the banking book securitization framework is set to zero (i.e. a one-year maturity is assumed) to avoid double-counting of risks in the maturity adjustment (of the banking book approach) since migration risk in the trading book will be captured in the credit spread capital requirement. Following the corresponding treatment in the banking book, the hierarchy of approaches in determining the risk weights should be applied at the underlying pool level. The capital requirement under the standardized approach for an individual cash securitization position can be capped at the fair value of the transaction. [Basel Framework, MAR22.34] No hedging is recognised between different buckets. Therefore, the total DRC requirement for securitizations (non-CTP) must be calculated as a simple sum of the bucket-level capital requirements. [Basel Framework, MAR22.35] Default Risk Capital Requirement for Securitizations (CTP) Gross jump-to-default risk positions (gross JTD) For the computation of gross JTD on securitizations (CTP), the same approach must be followed as for default risk-securitizations (non-CTP) as described in paragraph 239. [Basel Framework, MAR22.36] The gross JTD for non-securitizations (CTP) (i.e. single-name and index hedges) positions is defined as their market value. [Basel Framework, MAR22.37] Nth-to-default products should be treated as tranched products with attachment and detachment points defined below, where “Total names” is the total number of names in the underlying basket or pool: Attachment point = (N − 1) / Total names Detachment point = N / Total names [Basel Framework, MAR22.38] Net jump-to-default risk positions (net JTD) Exposures that are otherwise identical except for maturity may be offset. The same concept of long and short positions from a perspective of loss or gain in the event of a default as set out in paragraph 222 and offsetting rules for non-securitizations including scaling down positions of less than one year as set out in paragraphs 227 to 230 apply to JTD risk positions for securitizations (non-CTP). For index products, for the exact same index family (e.g. CDX.NA.IG), series (e.g. series 18) and tranche (e.g. 0–3%), securitization exposures should be offset (netted) across maturities (subject to the offsetting allowance as described above). Long and short exposures that are perfect replications through decomposition may be offset as follows. When the offsetting involves decomposing single name equivalent exposures, decomposition using a valuation model would be allowed in certain cases as follows. Such decomposition is the sensitivity of the security’s value to the default of the underlying single name obligor. Decomposition with a valuation model is defined as follows: a single name equivalent constituent of a securitization (e.g. tranched position) is the difference between the unconditional value of the securitization and the conditional value of the securitization assuming that the single name defaults, with zero recovery, where the value is determined by a valuation model. In such cases, the decomposition into single-name equivalent exposures must account for the effect of marginal defaults of the single names in the securitization, where in particular the sum of the decomposed single name amounts must be consistent with the undecomposed value of the securitization. Further, such decomposition is restricted to vanilla securitizations (e.g. vanilla CDOs, index tranches or bespokes); while the decomposition of exotic securitizations (e.g. CDO squared) is prohibited. Moreover, for long and short positions in index tranches, and indices (non-tranched), if the exposures are to the exact same series of the index, then offsetting is allowed by replication and decomposition. For instance, a long securitization exposure in a 10–15% tranche vs combined short securitization exposures in 10–12% and 12–15% tranches on the same index/series can be offset against each other. Similarly, long securitization exposures in the various tranches that, when combined perfectly, replicate a position in the index series (non-tranched) can be offset against a short securitization exposure in the index series if all the positions are to the exact same index and series (e.g. CDX.NA.IG series 18). Long and short positions in indices and single-name constituents in the index may also be offset by decomposition. For instance, single-name long securitization exposures that perfectly replicate an index may be offset against a short securitization exposure in the index. When a perfect replication is not possible, then offsetting is not allowed except as indicated in the next sentence. Where the long and short securitization exposures are otherwise equivalent except for a residual component, the net amount must show the residual exposure. For instance, a long securitization exposure in an index of 125 names, and short securitization exposures of the appropriate replicating amounts in 124 of the names, would result in a net long securitization exposure in the missing 125^th name of the index. Different tranches of the same index or series may not be offset (netted), different series of the same index may not be offset, and different index families may not be offset. [Basel Framework, MAR22.39] Calculation of default risk capital requirement for securitizations (CTP) For default risk of securitizations (CTP), each index is defined as a bucket of its own. A non-exhaustive list of indices include: CDX North America IG, iTraxx Europe IG, CDX HY, iTraxx XO, LCDX (loan index), iTraxx LevX (loan index), Asia Corp, Latin America Corp, Other Regions Corp, Major Sovereign (G7 and Western Europe) and Other Sovereign. [Basel Framework, MAR22.40] Bespoke securitization exposures should be allocated to the index bucket of the index they are a bespoke tranche of. For instance, the bespoke tranche 5% - 8% of a given index should be allocated to the bucket of that index. [Basel Framework, MAR22.41] The default risk weights for securitizations applied to tranches are based on the corresponding risk weights for the banking book instruments, which is defined in Chapter 6 with the following modification: the maturity component in the banking book securitization framework is set to zero, i.e. a one-year maturity is assumed to avoid double-counting of risks in the maturity adjustment (of the banking book approach) since migration risk in the trading book will be captured in the credit spread capital requirement. [Basel Framework, MAR22.42] For the non-tranched products, the same risk weights for non-securitizations as set out in paragraph 236 apply. For the tranched products, institutions must derive the risk weight using the banking book treatment as set out in the paragraph above. [Basel Framework, MAR22.43] Within a bucket (i.e. for each index) at an index level, the capital requirement for default risk of securitizations (CTP) is determined in a similar approach to that for non-securitizations. The hedge benefit ratio (HBR), as defined in paragraph 235, is modified and applied to net short positions in that bucket as in the formula below, where the subscript ctp for the term HBRctp indicates that the HBR is determined using the combined long and short positions across all indices in the CTP (i.e. not only the long and short positions of the bucket by itself). The summation of risk-weighted amounts in the formula spans all exposures relating to the index (i.e. index tranche, bespoke, non-tranche index or single name). A deviation from the approach for non-securitizations is that no floor at zero applies at the bucket level, and consequently, the DRC requirement at the index level (DRCb) can be negative. DRC b = ∑ i ∈ Long RW i ⋅ net JTD i - HBR ctp ⋅ ∑ i ∈ Short RW i ⋅ |net JTD i | [Basel Framework, MAR22.44] The total DRC requirement for securitizations (CTP) is calculated by aggregating bucket level capital amounts as follows. For instance, if the DRC requirement for the index CDX North America IG is +100 and the DRC requirement for the index Major Sovereign (G7 and Western Europe) is -100, the total DRC requirement for the CTP is 100 − 0.5 × 100 = 50.^{Footnote 43} DRC CTP = max ⁡ ∑ b max ⁡ DRC b , 0 + 0.5 × min ⁡ DRC b , 0 , 0 [Basel Framework, MAR22.45]

9.5.4 Residual Risk Add-On

This section sets out the calculation of residual risk add-on under the standardized approach for market risk. Introduction The residual risk add-on (RRAO) is to be calculated for all instruments bearing residual risk separately in addition to other components of the capital requirement under the standardized approach. [Basel Framework, MAR23.1] Instruments Subject To the Residual Risk Add-On Instruments with an exotic underlying and instruments bearing other residual risks are subject to the RRAO. [Basel Framework, MAR23.2] Instruments with an exotic underlying are trading book instruments with an underlying^{Footnote 44} exposure that is not within the scope of delta, vega or curvature risk treatment in any risk class under the sensitivities-based method or default risk capital (DRC) requirements in the standardized approach.^{Footnote 45} [Basel Framework, MAR23.3] Instruments bearing other residual risks are those that meet any of the three criteria below: Instruments subject to vega or curvature risk capital requirements in the trading book and with pay-offs that cannot be written or perfectly replicated as a finite linear combination of vanilla options with a single underlying equity price, commodity price, exchange rate, bond price, credit default swap price or interest rate swap; Instruments which fall under the definition of the correlation trading portfolio (CTP) in paragraph 112, except for those instruments that are recognized in the market risk framework as eligible hedges of risks within the CTP; Transactions executed by the internal risk transfer desk giving rise to residual risk between the internal hedge and the external hedge, as specified in paragraph 84. Bonds with multiple call dates would be considered as instruments bearing other residual risks, as they are path-dependent options. [Basel Framework, MAR23.4] A non-exhaustive list of other residual risks types and instruments that may fall within the criteria set out in the paragraph above include: Gap risk: risk of a significant change in vega parameters in options due to small movements in the underlying, which results in hedge slippage. Relevant instruments subject to gap risk include all path dependent options, such as barrier options, and Asian options as well as all digital options. Correlation risk: risk of a change in a correlation parameter necessary for determining the value of an instrument with multiple underlyings. Relevant instruments subject to correlation risk include all basket options, best-of-options, spread options, basis options, Bermudan options and quanto options. Behavioural risk: risk of a change in exercise/prepayment outcomes such as those that arise in fixed rate mortgage products where retail clients may make decisions motivated by factors other than pure financial gain (such as demographical features and/or and other social factors). A callable bond may only be seen as possibly having behavioural risk if the right to call lies with a retail client. [Basel Framework, MAR23.5] When an instrument is subject to one or more of the following risk types, this by itself will not cause the instrument to be subject to the RRAO: Risk from a cheapest-to-deliver option; Smile risk: the risk of a change in an implied volatility parameter necessary for determining the value of an instrument with optionality relative to the implied volatility of other instruments optionality with the same underlying and maturity, but different moneyness; Correlation risk arising from multi-underlying European or American plain vanilla options, and from any options that can be written as a linear combination of such options. This exemption applies in particular to the relevant index options; Dividend risk arising from a derivative instrument whose underlying does not consist solely of dividend payments; and (5) Index instruments and multi-underlying options of which treatment for delta, vega or curvature risk are set out in paragraphs 143 and 144. These are subject to the RRAO if they fall within the definitions set out in this section. For funds that are subject to the treatment specified in paragraph 148(3) (i.e. treated as an unrated “other sector” equity), institutions shall assume the fund is exposed to exotic underlying exposures, and to other residual risks, to the maximum possible extent allowed under the fund’s mandate. [Basel Framework, MAR23.6] In cases where a transaction exactly matches with a third-party transaction (i.e. a back-to-back transaction), the instruments used in both transactions must be excluded from the RRAO capital requirement. Any instrument that is listed and/or eligible for central clearing must be excluded from the RRAO for other residual risks as defined in paragraph 261. Any instrument that is listed and/or eligible for central clearing with an exotic underlying must be included in the RRAO. Hedges may be excluded from the RRAO only if the hedge exactly matches the trade (i.e. via a back-to-back transaction). For the example, when dividend swaps hedging dividend risks, dividend swaps should remain within the RRAO. A TRS on an underlying product may be excluded from the RRAO capital requirement if there is an equal and opposite exposure in the same TRS. If no exactly matching transaction exists, the entire notional of the TRS would be allocated to the RRAO. [Basel Framework, MAR23.7] Calculation of the Residual Risk Add-On The residual risk add-on must be calculated in addition to any other capital requirements within the standardized approach. The residual risk add-on is to be calculated as follows. The scope of instruments that are subject to the RRAO must not have an impact in terms of increasing or decreasing the scope of risk factors subject to the delta, vega, curvature or DRC treatments in the standardized approach. The RRAO is the simple sum of gross notional amounts of the instruments bearing residual risks, multiplied by a risk weight. The risk weight for instruments with an exotic underlying specified in paragraph 260 is 1.0%. The risk weight for instruments bearing other residual risks specified in paragraph 261 is 0.1%.^{Footnote 46} [Basel Framework, MAR23.8]

9.6 Internal Models Approach

9.6.1 General Provisions

This section sets out the general criteria for institutions’ use of the internal models approach. General Criteria The use of internal models for the purposes of determining market risk capital requirements is conditional upon the explicit approval of OSFI. [Basel Framework, MAR30.1] OSFI will only approve an institution’s use of internal models to determine market risk capital requirements if, at a minimum: OSFI is satisfied that the institution’s risk management system is conceptually sound and is implemented with integrity; the institution has, in OSFI’s view, a sufficient number of staff skilled in the use of sophisticated models not only in the trading area but also in the risk control, audit and, if necessary, back office areas; the institution’s trading desk risk management model has, in OSFI’s judgement, a proven track record of reasonable accuracy in measuring risk; the institution regularly conducts stress tests along the lines set out in paragraphs 284 to 288; and the positions included in the institution’s internal trading desk risk management models for determining minimum market risk capital requirements are held in trading desks that have been approved for the use of those models and that have passed the required tests described in paragraph 282. Institutions applying to use internal models to determine market risk capital requirements are required to meet an internal models coverage threshold of 50% at all times. This coverage ratio is calculated as the ratio of the standardized market risk capital requirements of internal model approved in-scope desks divided by the standardized market risk capital requirement of all desks (including out of scope desks but excluding those portfolios captured in paragraph 50). For clarity, only instruments for which the standardized approach must be used by all institutions, as specified in paragraph 50, and their capital contribution should be excluded from the numerator and the denominator, along with their respective hedges. Once an institution has received the approval to use internal models, OSFI will monitor the institution’s compliance with the 50% threshold. Coverage Ratio = SA IMA SA all desks ^{Footnote 47} [Basel Framework, MAR30.2] OSFI may insist on a period of initial monitoring and live testing of an institution’s internal trading desk risk management model before it is used for the purposes of determining the institution’s market risk capital requirements. [Basel Framework, MAR30.3] The scope of trading portfolios that are eligible to use internal models to determine market risk capital requirements is determined based on a three-prong approach as follows: The institution must satisfy OSFI that both the institution’s organizational infrastructure (including the definition and structure of trading desks) and its institution-wide^{Footnote 48} internal risk management model meet qualitative evaluation criteria, as set out in paragraphs 270 to 281. The institution must nominate individual trading desks, as defined in paragraphs 52 to 57, for which the institution seeks model approval in order to use the internal models approach (IMA). The institution must nominate trading desks that it intends to be in-scope for model approval and trading desks that are out-of-scope for the use of the IMA. The institution must specify in writing the basis for these nominations. The institution must not nominate trading desks to be out-of-scope for model approval due to capital requirements for a particular trading desk determined using the standardized approach being lower than those determined using the IMA. The institution must use the standardized approach to determine the market risk capital requirements for trading desks that are out-of-scope for model approval. The positions in these out-of-scope trading desks are to be combined with all other positions that are subject to the standardized approach in order to determine the institution’s standardized approach capital requirements. Trading desks that the institution does not nominate for model approval at the time of model approval will be ineligible to use the IMA for a period of at least one year from the date of the latest internal model approval. The institution must receive OSFI’s approval to use the IMA on individual trading desks. Following the identification of eligible trading desks, this step determines which trading desks will be in-scope to use the IMA and which risk factors within in-scope trading desks are eligible to be included in the institution’s internal expected shortfall (ES) models to determine market risk capital requirements as set out in section 9.6.4. Each trading desk must satisfy profit and loss (P&L) attribution (PLA) tests on an ongoing basis to be eligible to use the IMA to determine market risk capital requirements. In order to conduct the PLA test, the institution must identify the set of risk factors to be used to determine its market risk capital requirements. Each trading desk also must satisfy backtesting requirements on an ongoing basis to be eligible to use the IMA to determine market risk capital requirements as set out in paragraphs 319 to 334. Institutions must conduct PLA tests and backtesting on a quarterly basis to update the eligibility and trading desk classification in PLA for trading desks in-scope to use the IMA. The market risk capital requirements for risk factors that satisfy the risk factor eligibility test as set out in paragraphs 327 to 339 must be determined using ES models as specified in paragraphs 361 to 375. The market risk capital requirements for risk factors that do not satisfy the risk factor eligibility test must be determined using stressed expected shortfall (SES) models as specified in paragraphs 376 to 377. Securitization positions are out of scope for IMA regulatory capital treatment, and as a result they are not taken into account for the model eligibility tests. This implies that institutions are not allowed to include securitizations in trading desks for which they determine market risk capital requirements using the IMA. Securitizations must be included in trading desks for which capital requirements are determined using the standardized approach. Institutions are allowed to also include hedging instruments in trading desks which include securitizations and are capitalised using the standardized approach. [Basel Framework, MAR30.4] Qualitative Standards In order to use the IMA to determine market risk capital requirements, the institution must have market risk management systems that are conceptually sound and implemented with integrity. Accordingly, the institution must meet the qualitative criteria set out below on an ongoing basis. OSFI will assess that the institution has met the criteria before the institution is permitted to use the IMA. [Basel Framework, MAR30.5] The institution must have an independent risk control unit that is responsible for the design and implementation of the institution’s market risk management system. The risk control unit should produce and analyse daily reports on the output of the trading desk’s risk management model, including an evaluation of the relationship between measures of risk exposure and trading limits. This risk control unit must be independent of business trading units and should report directly to senior management of the institution. [Basel Framework, MAR30.6] The institution’s risk control unit must conduct regular backtesting and PLA assessments at the trading desk level. The institution must also conduct regular backtesting of its institution-wide internal models used for determining market risk capital requirements. [Basel Framework, MAR30.7] A distinct unit of the institution that is separate from the unit that designs and implements the internal models must conduct the initial and ongoing validation of all internal models used to determine market risk capital requirements. The model validation unit must validate all internal models used for purposes of the IMA on at least an annual basis. [Basel Framework, MAR30.8] The senior management of the institution must be actively involved in the risk control process and must devote appropriate resources to risk control as an essential aspect of the business. In this regard, the daily reports prepared by the independent risk control unit must be reviewed by a level of management with sufficient seniority and authority to enforce both reductions of positions taken by individual traders and reductions in the institution’s overall risk exposure. [Basel Framework, MAR30.9] Internal models used to determine market risk capital requirements are likely to differ from those used by an institution in its day-to-day internal risk management functions. Nevertheless, the core design elements of both the market risk capital requirement model and the internal risk management model should be the same. Valuation models that are a feature of both models should be similar. These valuation models must be an integral part of the internal identification, measurement, management and internal reporting of price risks within the institution’s trading desks. Internal risk management models should, at a minimum, be used to assess the risk of the positions that are subject to market risk capital requirements, although they may assess a broader set of positions. The construction of a trading desk risk management model must be based on the methodologies used in the institution’s internal risk management model with regard to risk factor identification, parameter estimation and proxy concepts and deviate only if this is appropriate due to regulatory requirements. An institution’s market risk capital requirement model and its internal risk management model should address an identical set of risk factors. [Basel Framework, MAR30.10] A routine and rigorous programme of stress testing is required. The results of stress testing must be: reviewed at least monthly by senior management; used in the institution’s internal assessment of capital adequacy; and reflected in the policies and limits set by the institution’s senior management. [Basel Framework, MAR30.11] Where stress tests reveal particular vulnerability to a given set of circumstances, the institution must take prompt action to mitigate those risks appropriately (e.g. by hedging against that outcome, reducing the size of the institution’s exposures or increasing capital). [Basel Framework, MAR30.12] The institution must maintain a protocol for compliance with a documented set of internal manuals, policies, controls and procedures concerning the operation of the internal market risk management model. The institution’s risk management model must be well documented. Such documentation may include a comprehensive risk management manual that describes the basic principles of the risk management model and that provides a detailed explanation of the empirical techniques used to measure market risk. [Basel Framework, MAR30.13] The institution must receive approval from OSFI prior to implementing any significant changes to its internal models used to determine market risk capital requirements. [Basel Framework, MAR30.14] The institution’s internal models for determining market risk capital requirements must address the full set of positions that are in the scope of application of the model. All models’ measurements of risk must be based on a sound theoretical basis, calculated correctly, and reported accurately. [Basel Framework, MAR30.15] The institution’s internal audit and validation functions or external auditor must conduct an independent review of the market risk measurement system on at least an annual basis. The scope of the independent review must include both the activities of the business trading units and the activities of the independent risk control unit. The independent review must be sufficiently detailed to determine which trading desks are impacted by any failings. At a minimum, the scope of the independent review must include the following: the organization of the risk control unit; the adequacy of the documentation of the risk management model and process; the accuracy and appropriateness of market risk management models (including any significant changes); the verification of the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources; the approval process for risk pricing models and valuation systems used by the institution’s front- and back-office personnel; the scope of market risks reflected in the trading desk risk management models; the integrity of the management information system; the accuracy and completeness of position data; the accuracy and appropriateness of volatility and correlation assumptions; the accuracy of valuation and risk transformation calculations; the verification of trading desk risk management model accuracy through frequent backtesting and PLA assessments; and the general alignment between the model to determine market risk capital requirements and the model the institution uses in its day-to-day internal management functions. [Basel Framework, MAR30.16] Model Validation Standards Institutions must maintain a process to ensure that their internal models have been adequately validated by suitably qualified parties independent of the model development process to ensure that each model is conceptually sound and adequately reflects all material risks. Model validation must be conducted both when the model is initially developed and when any significant changes are made to the model. The institution must revalidate its models periodically, particularly when there have been significant structural changes in the market or changes to the composition of the institution’s portfolio that might lead to the models no longer being adequate. Model validation must include PLA and backtesting, and must, at a minimum, also include the following: Tests to demonstrate that any assumptions made within internal models are appropriate and do not underestimate risk. This may include reviewing the appropriateness of assumptions of normal distributions and any pricing models. Further to the regulatory backtesting programmes, model validation must assess the hypothetical P&L (HPL) calculation methodology. The institution must use hypothetical portfolios to ensure that internal models are able to account for particular structural features that may arise. For example, where the data history for a particular instrument does not meet the quantitative standards in paragraphs 361 to 372 and the institution maps these positions to proxies, the institution must ensure that the proxies produce conservative results under relevant market scenarios, with sufficient consideration given to ensuring: that material basis risks are adequately reflected (including mismatches between long and short positions by maturity or by issuer); and that the models reflect concentration risk that may arise in an undiversified portfolio. [Basel Framework, MAR30.17] External Validation The model validation conducted by external auditors and/or OSFI of an institution’s internal model to determine market risk capital requirements should, at a minimum, include the following steps: Verification that the internal validation processes described in the paragraph above are operating in a satisfactory manner; Confirmation that the formulae used in the calculation process, as well as for the pricing of options and other complex instruments, are validated by a qualified unit, which in all cases should be independent from the institution’s trading area; Confirmation that the structure of internal models is adequate with respect to the institution’s activities and geographical coverage; Review of the results of both the institution’s backtesting of its internal models (i.e. comparison of value-at-risk with actual P&L and HPL) and its PLA process to ensure that the models provide a reliable measure of potential losses over time. On request, an institution should make available to OSFI and/or to its external auditors the results as well as the underlying inputs to ES calculations and details of the PLA exercise; and Confirmation that data flows and processes associated with the risk measurement system are transparent and accessible. On request and in accordance with procedures, the institution should provide OSFI and its external auditors access to the models’ specifications and parameters. [Basel Framework, MAR30.18] Stress Testing Institutions that use the IMA for determining market risk capital requirements must have in place a rigorous and comprehensive stress testing programme both at the trading desk level and at the institution-wide level. [Basel Framework, MAR30.19] Institutions’ stress scenarios must cover a range of factors that (i) can create extraordinary losses or gains in trading portfolios, or (ii) make the control of risk in those portfolios very difficult. These factors include low-probability events in all major types of risk, including the various components of market, credit and operational risks. An institution must design stress scenarios to assess the impact of such factors on positions that feature both linear and non-linear price characteristics (i.e. options and instruments that have option-like characteristics). [Basel Framework, MAR30.20] Institutions’ stress tests should be of a quantitative and qualitative nature, incorporating both market risk and liquidity risk aspects of market disturbances. Quantitative elements should identify plausible stress scenarios to which institutions could be exposed. Qualitatively, an institution’s stress testing program should evaluate the capacity of the institution’s capital to absorb potential significant losses and identify steps the institution can take to reduce its risk and conserve capital. [Basel Framework, MAR30.21] Institutions should routinely communicate results of stress testing to senior management. [Basel Framework, MAR30.22] Institutions should combine the use of OSFI’s stress scenarios with stress tests developed by the institution itself to reflect its specific risk characteristics. Stress scenarios may include the following: OSFI’s scenarios requiring no simulations by the institution. An institution should have information on the largest losses experienced during the reporting period and may be required to make this available for OSFI’s review. OSFI may compare this loss information to the level of capital requirements that would result from an institution’s internal measurement system. For example, the institution may be required to provide OSFI with an assessment of how many days of peak day losses would have been covered by a given ES estimate. Scenarios requiring a simulation by the institution. Institutions should subject their portfolios to a series of simulated stress scenarios and provide OSFI with the results. These scenarios could include testing the current portfolio against past periods of significant disturbance (e.g. the 1987 equity crash, the Exchange Rate Mechanism crises of 1992 and 1993, the increase in interest rates in the first quarter of 1994, the 1998 Russian financial crisis, the 2000 bursting of the technology stock bubble, the 2007–08 subprime mortgage crisis, or the 2011–12 Euro zone crisis) incorporating both the significant price movements and the sharp reduction in liquidity associated with these events. A second type of scenario would evaluate the sensitivity of the institution’s market risk exposure to changes in the assumptions about volatilities and correlations. Applying this test would require an evaluation of the historical range of variation for volatilities and correlations and evaluation of the institution’s current positions against the extreme values of the historical range. Due consideration should be given to the sharp variation that at times has occurred in a matter of days in periods of significant market disturbance. For example, the above-mentioned situations involved correlations within risk factors approaching the extreme values of 1 or –1 for several days at the height of the disturbance. Institution-developed stress scenarios. In addition to the scenarios prescribed by OSFI under paragraph 288(1), an institution should also develop its own stress tests that it identifies as most adverse based on the characteristics of its portfolio (e.g. problems in a key region of the world combined with a sharp move in oil prices). An institution should provide OSFI with a description of the methodology used to identify and carry out the scenarios as well as with a description of the results derived from these scenarios. [Basel Framework, MAR30.23]

9.6.2 Model Requirements

This section sets out specification and model eligibility for risk factors per the internal models approach. Specification of Market Risk Factors An important part of an institution’s trading desk internal risk management model is the specification of an appropriate set of market risk factors. Risk factors are the market rates and prices that affect the value of the institution’s trading positions. The risk factors contained in a trading desk risk management model must be sufficient to represent the risks inherent in the institution’s portfolio of on- and off-balance sheet trading positions. Although institutions will have some discretion in specifying the risk factors for their internal models, the following requirements must be fulfilled. [Basel Framework, MAR31.1] An institution’s market risk capital requirement models should include all risk factors that are used for pricing. In the event a risk factor is incorporated in a pricing model but not in the trading desk risk management model, the institution must support this omission to the satisfaction of OSFI. [Basel Framework, MAR31.2] An institution’s market risk capital requirement model must include all risk factors that are specified in the standardized approach for the corresponding risk class, as set out in sections 9.5.1 to 9.5.3. In the event a standardized approach risk factor is not included in the market risk capital requirement model, the institution must support this omission to the satisfaction of OSFI. For securitized products, institutions are prohibited from using internal models to determine market risk capital requirements. Institutions must use the standardized approach to determine the market risk capital requirements for securitized products as set out in paragraph 51. Accordingly, an institution’s market risk capital requirement model should not specify risk factors for securitizations as defined in paragraphs 122 to 123. [Basel Framework, MAR31.3] An institution’s market risk capital requirement model and any stress scenarios calculated for non-modellable risk factors must address non-linearities for options and other relevant products (e.g. mortgage-backed securities), as well as correlation risk and relevant basis risks (e.g. basis risks between credit default swaps and bonds). [Basel Framework, MAR31.4] An institution may use proxies for which there is an appropriate track record for their representation of a position (e.g. an equity index used as a proxy for a position in an individual stock). In the event an institution uses proxies, the institution must support their use to the satisfaction of OSFI. [Basel Framework, MAR31.5] An institution is expected to develop an internal process that describes minimum conditions under which a proxy has a good track record; a methodology for assessing proxies against those conditions (including independent validations); and steps to address the use of proxies that fail to meet that standard. For general interest rate risk, an institution must use a set of risk factors that corresponds to the interest rates associated with each currency in which the institution has interest rate sensitive on- or off-balance sheet trading positions. The trading desk risk management model must model the yield curve using one of a number of generally accepted approaches (e.g. estimating forward rates of zero coupon yields). The yield curve must be divided into maturity segments in order to capture variation in the volatility of rates along the yield curve. For material exposures to interest rate movements in the major currencies and markets, institutions must model the yield curve using a minimum of six risk factors. The number of risk factors used ultimately should be driven by the nature of the institution’s trading strategies. An institution with a portfolio of various types of securities across many points of the yield curve and that engages in complex arbitrage strategies would require the use of a greater number of risk factors than an institution with less complex portfolios. [Basel Framework, MAR31.6] The trading desk risk management model must incorporate separate risk factors to capture credit spread risk (e.g. between bonds and swaps). A variety of approaches may be used to reflect the credit spread risk arising from less-than-perfectly correlated movements between government and other fixed income instruments, such as specifying a completely separate yield curve for non-government fixed income instruments (e.g. swaps or municipal securities) or estimating the spread over government rates at various points along the yield curve. [Basel Framework, MAR31.7] For exchange rate risk, the trading desk risk management model must incorporate risk factors that correspond to the individual foreign currencies in which the institution’s positions are denominated. Because the output of an institution’s risk measurement system will be expressed in the institution’s reporting currency, any net position denominated in a foreign currency will introduce foreign exchange risk. An institution must utilise risk factors that correspond to the exchange rate between the institution’s reporting currency and each foreign currency in which the institution has a significant exposure. [Basel Framework, MAR31.8] For equity risk, an institution must utilise risk factors that correspond to each of the equity markets in which the institution holds significant positions. At a minimum, an institution must utilize risk factors that reflect market-wide movements in equity prices (e.g. a market index). Positions in individual securities or in sector indices may be expressed in beta-equivalents relative to a market-wide index. An institution may utilize risk factors that correspond to various sectors of the overall equity market (e.g. industry sectors or cyclical and non-cyclical sectors). Positions in individual securities within each sector may be expressed in beta-equivalents relative to a sector index. An institution may also utilize risk factors that correspond to the volatility of individual equities. The sophistication and nature of the modelling technique for a given market should correspond to the institution’s exposure to the overall market as well as the institution’s concentration in individual equities in that market. [Basel Framework, MAR31.9] For commodity risk, institutions must utilise risk factors that correspond to each of the commodity markets in which the institution holds significant positions. For institutions with relatively limited positions in commodity-based instruments, the institution may utilize a straightforward specification of risk factors. Such a specification could entail utilizing one risk factor for each commodity price to which the institution is exposed (including different risk factors for different geographies where relevant). For an institution with active trading in commodities, the institution’s model must account for variation in the convenience yield^{Footnote 49} between derivatives positions such as forwards and swaps and cash positions in the commodity. [Basel Framework, MAR31.10] For the risks associated with equity investments in funds (EIFs): For funds that meet the criterion set out in paragraph 65(5)(a) (i.e. funds with look-through possibility), institutions must consider the risks of the fund, and of any associated hedges, as if the fund’s positions were held directly by the institution (taking into account the institution’s share of the equity of the fund, and any leverage in the fund structure). The institution must assign these positions to the trading desk to which the fund is assigned. Institutions must make reasonable efforts to gather the latest information related to these structures. OSFI may require, as needed, that institutions increase the frequency of their look through, and/or incorporate additional controls and oversight in order to monitor the EIFs during intra-quarterly periods. Such measures could consist of and depend on these factors: Historical divergences by tracking and comparing the funds’ daily price (based on Net Asset Value) versus the price if the fund were to hold the same portfolio as of the last look through date. If a threshold for tolerable deviations were breached, the institution would need to conduct more frequent look through than quarterly if data is available. The level and frequency of the turnover of the fund. The threshold and significance of such line of business versus other trading portfolios. For funds that do not meet the criterion set out in paragraph 65(5)(a), but meet both the criteria set out in paragraph 65(5)(b) (i.e. daily prices and knowledge of the mandate of the fund), institutions must use the standardized approach to calculate capital requirements for the fund. [Basel Framework, MAR31.11] Model Eligibility of Risk Factors An institution must determine which risk factors within its trading desks that have received approval to use the internal models approach as set out in section 9.6.3 are eligible to be included in the institution’s internal expected shortfall (ES) model for regulatory capital requirements as set out in section 9.6.4. For a risk factor to be classified as modellable by an institution, a necessary condition is that it passes the risk factor eligibility test (RFET). This test requires identification of a sufficient number of real prices that are representative of the risk factor. Collateral reconciliations or valuations cannot be considered real prices to meet the RFET. A price will be considered real if it meets at least one of the following criteria: It is a price at which the institution has conducted a transaction; It is a verifiable price for an actual transaction between other arms-length parties; It is a price obtained from a committed quote^{Footnote 50} made by (i) the institution itself or (ii) another party. The committed quote must be collected and verified through a third-party vendor, a trading platform or an exchange; or It is a price that is obtained from a third-party vendor, where: the transaction or committed quote has been processed through the vendor; the vendor agrees to provide evidence of the transaction or committed quote to OSFI upon request; or the price meets any of the three criteria immediately listed in paragraph 301(1) to (3). Orderly transactions and eligible committed quotes with a non-negligible volume, as compared to usual transaction sizes for the institution, reflective of normal market conditions can be generally accepted as valid. [Basel Framework, MAR31.12] To pass the RFET, a risk factor that an institution uses in an internal model must meet either of the following criteria on a quarterly basis. Any real price that is observed for a transaction should be counted as an observation for all of the risk factors for which it is representative. The institution must identify for the risk factor at least 24 real price observations per year (measured over the period used to calibrate the current ES model, with no more than one real price observation per day to be included in this count).^{Footnote 51}^, ^{Footnote 52} Moreover, over the previous 12 months there must be no 90-day period in which fewer than four real price observations are identified for the risk factor (with no more than one real price observation per day to be included in this count). The above criteria must be monitored on a monthly basis; or The institution must identify for the risk factor at least 100 “real” price observations over the previous 12 months (with no more than one “real” price observation per day to be included in this count). Regarding the reform of benchmark rate reference rates, risk factors must have sufficient market liquidity, evidenced by records of trades, to be eligible for modelling. The replacement of risk factors due to benchmark rate reform could raise particular challenges for the count of real price observations for the RFET. Hence, when conducting the RFET for a new benchmark rate, institutions can count both: (i) real price observations of the old benchmark rate (that has been replaced by the new benchmark rate) from before the discontinuation of this rate and until one year after the discontinuation; and (ii) real price observations of the new benchmark rate. In this context, discontinuation includes cessation of the old benchmark rate or an event whereby the old benchmark rate is deemed by OSFI to no longer be representative of the underlying market. [Basel Framework, MAR31.13] In order for a risk factor to pass the RFET, an institution may also count real price observations based on information collected from a third-party vendor provided all of the following criteria are met: The vendor communicates to the institution the number of corresponding real prices observed and the dates at which they have been observed. The vendor provides, individually, a minimum necessary set of identifier information to enable institutions to map real prices observed to risk factors. The vendor is subject to an audit regarding the validity of its pricing information. The results and reports of this audit must be made available on request to OSFI and to institutions as a precondition for the institution to be allowed to use real price observations collected by the third-party vendor. If the audit of a third-party vendor is not satisfactory, OSFI may decide to prevent the institution from using data from this vendor.^{Footnote 53} [Basel Framework, MAR31.14] A real price is representative for a risk factor of an institution where the institution is able to extract the value of the risk factor from the value of the real price. The institution must have policies and procedures that describe its mapping of real price observations to risk factors. The institution must provide sufficient information to OSFI in order to determine if the methodologies the institution uses are appropriate. [Basel Framework, MAR31.15] Bucketing approach for the RFET Where a risk factor is a point on a curve or a surface (and other higher dimensional objects such as cubes), in order to count real price observations for the RFET, institutions may choose from the following bucketing approaches: The own bucketing approach. Under this approach, the institution must define the buckets it will use and meet the following requirements: Each bucket must include only one risk factor, and all risk factors must correspond to the risk factors that are part of the risk-theoretical profit and loss (RTPL) of the institution for the purpose of the profit and loss (P&L) attribution (PLA) test.^{Footnote 54} The buckets must be non-overlapping. The regulatory bucketing approach. Under this approach, the institution must use the following set of standard buckets as set out in Table 16. For interest rate, foreign exchange and commodity risk factors with one maturity dimension (excluding implied volatilities) (t, where t is measured in years), the buckets in row (A) below must be used. For interest rate, foreign exchange and commodity risk factors with several maturity dimensions (excluding implied volatilities) (t, where t is measured in years), the buckets in row (B) below must be used. Credit spread and equity risk factors with one or several maturity dimensions (excluding implied volatilities) (t, where t is measured in years), the buckets in row (C) below must be used. For any risk factors with one or several strike dimensions (delta, δ; i.e. the probability that an option is “in the money” at maturity), the buckets in row (D) below must be used.^{Footnote 55} For expiry and strike dimensions of implied volatility risk factors (excluding those of interest rate swaptions), only the buckets in rows (C) and (D) below must be used. For maturity, expiry and strike dimensions of implied volatility risk factors from interest rate swaptions, only the buckets in row (B), (C) and (D) below must be used. Table 16 – Standard buckets for the regulatory bucketing approach Row Bucket 1 2 3 4 5 6 7 8 9 (A) 0≤t<0.75 0.75≤t<1.5 1.5≤t<4 4≤t<7 7≤t<12 12≤t<18 18≤t<25 25≤t<35 35≤t<∞ (B) 0≤t<0.75 0.75≤t<4 4≤t<10 10≤t<18 18≤t<30 30≤t<∞ (C) 0≤t<1.5 1.5≤t<3.5 3.5≤t<7.5 7.5≤t<15 15≤t<∞ (D) 0≤δ<0.05 0.05≤δ<0.3 0.3≤δ<0.7 0.7≤δ<0.95 0.95≤δ<1.00 [Basel Framework, MAR31.16] Institutions may count all real price observations allocated to a bucket to assess whether it passes the RFET for any risk factors that belong to the bucket. A real price observation must be allocated to a bucket for which it is representative of any risk factors that belong to the bucket. [Basel Framework, MAR31.17] As debt and commodity instruments mature, real price observations for those products that have been identified within the prior 12 months are usually still counted in the maturity bucket to which they were initially allocated per paragraph 306. When institutions no longer need to model a credit spread risk or commodity risk factor belonging to a given maturity bucket, institutions are allowed to re-allocate the real price observations of this bucket to the adjacent (shorter) maturity bucket.^{Footnote 56} A real price observation may only be counted in a single maturity bucket for the purposes of the RFET. [Basel Framework, MAR31.18] Where an institution uses a parametric function to represent a curve/surface and defines the function’s parameters as the risk factors in its risk measurement system, the RFET must be passed at the level of the market data used to calibrate the function’s parameters and not be passed directly at the level of these risk factor parameters (due to the fact that real price observations may not exist that are directly representative of these risk factors). [Basel Framework, MAR31.19] An institution may use systematic credit or equity risk factors within its models that are designed to capture market-wide movements for a given economy, region or sector, but not the idiosyncratic risk of a specific issuer (the idiosyncratic risk of a specific issuer would be a non-modellable risk factor (NMRF) unless there are sufficient real price observations of that issuer). Real price observations of market indices or instruments of individual issuers may be considered representative for a systematic risk factor as long as they share the same attributes as the systematic risk factor. [Basel Framework, MAR31.20] In addition to the approach set out in the above paragraph, where systematic risk factors of credit or equity risk factors include a maturity dimension (e.g. a credit spread curve), one of the bucketing approaches set out above must be used for this maturity dimension to count “real” price observations for the RFET. [Basel Framework, MAR31.21] Once a risk factor has passed the RFET, the institution should choose the most appropriate data to calibrate its model. The data used for calibration of the model does not need to be the same data used to pass the RFET. [Basel Framework, MAR31.22] Once a risk factor has passed the RFET, the institution must demonstrate that the data used to calibrate its ES model are appropriate based on the principles contained in paragraphs 314 to 315. Where an institution has not met these principles to the satisfaction OSFI for a particular risk factor, OSFI may choose to deem the data unsuitable for use to calibrate the model and, in such case, the risk factor must be excluded from the ES model and subject to capital requirements as an NMRF. [Basel Framework, MAR31.23] There may, on very rare occasions, be a valid reason why a significant number of modellable risk factors across different institutions may become non-modellable due to a widespread reduction in trading activities (for instance, during periods of significant cross-border financial market stress affecting several institutions or when financial markets are subjected to a major regime shift). One possible OSFI’s response in this instance could be to consider as modellable a risk factor that no longer passes the RFET. However, such a response should not facilitate a decrease in capital requirements. OSFI will only pursue such a response under the most extraordinary, systemic circumstances. [Basel Framework, MAR31.24] Principles for the modellability of risk factors that pass the RFET Institutions use many different types of models to determine the risks resulting from trading positions. The data requirements for each model may be different. For any given model, institutions may use different sources or types of data for the model’s risk factors. Institutions must not rely solely on the number of observations of real prices to determine whether a risk factor is modellable. The accuracy of the source of the risk factor real price observation must also be considered. [Basel Framework, MAR31.25] In addition to the requirements specified in paragraphs 301 to 312, institutions must apply the principles below to determine whether a risk factor that passed the RFET can be modelled using the ES model or should be subject to capital requirements as an NMRF. Institutions are required to demonstrate to OSFI that these principles are being followed. OSFI may determine risk factors to be non-modellable in the event these principles are not applied. Principle one. The data used may include combinations of modellable risk factors. Institutions often price instruments as a combination of risk factors. Generally, risk factors derived solely from a combination of modellable risk factors are modellable. For example, risk factors derived through multifactor beta models for which inputs and calibrations are based solely on modellable risk factors, can be classified as modellable and can be included within the ES model. A risk factor derived from a combination of modellable risk factors that are mapped to distinct buckets of a given curve/surface is modellable only if this risk factor also passes the RFET. Interpolation based on combinations of modellable risk factors should be consistent with mappings used for PLA testing (to determine the RTPL) and should not be based on alternative, and potentially broader, bucketing approaches. Likewise, institutions may compress risk factors into a smaller dimension of orthogonal risk factors (e.g. principal components) and/or derive parameters from observations of modellable risk factors, such as in models of stochastic implied volatility, without the parameters being directly observable in the market. Subject to the approval of OSFI, institutions may extrapolate up to a reasonable distance from the closest modellable risk factor. The extrapolation should not rely solely on the closest modellable risk factor but on more than one modellable risk factor. In the event that an institution uses extrapolation, the extrapolation must be considered in the determination of the RTPL. Principle two. The data used must allow the model to pick up both idiosyncratic and general market risk. General market risk is the tendency of an instrument’s value to change with the change in the value of the broader market, as represented by an appropriate index or indices. Idiosyncratic risk is the risk associated with a particular issuance, including default provisions, maturity and seniority. The data must allow both components of market risk to be captured in any market risk model used to determine capital requirements. If the data used in the model do not reflect either idiosyncratic or general market risk, the institution must apply an NMRF charge for those aspects that are not adequately captured in its model. Principle three. The data used must allow the model to reflect volatility and correlation of the risk positions. Institutions must ensure that they do not understate the volatility of an asset (e.g. by using inappropriate averaging of data or proxies). Further, institutions must ensure that they accurately reflect the correlation of asset prices, rates across yield curves and/or volatilities within volatility surfaces. Different data sources can provide dramatically different volatility and correlation estimates for asset prices. The institution should choose data sources so as to ensure that (i) the data are representative of real price observations; (ii) price volatility is not understated by the choice of data; and (iii) correlations are reasonable approximations of correlations among real price observations. Furthermore, any transformations must not understate the volatility arising from risk factors and must accurately reflect the correlations arising from risk factors used in the institution’s ES model. Principle four. The data used must be reflective of prices observed and/or quoted in the market. Where data used are not derived from real price observations, the institution must demonstrate that the data used are reasonably representative of real price observations. To that end, the institution must periodically reconcile price data used in a risk model with front office and back office prices. Just as the back office serves to check the validity of the front office price, risk model prices should be included in the comparison. The comparison of front or back office prices with risk prices should consist of comparisons of risk prices with real price observations, but front office and back office prices can be used where real price observations are not widely available. Institutions must document their approaches to deriving risk factors from market prices. Principle five. The data used must be updated at a sufficient frequency. A market risk model may require large amounts of data, and it can be challenging to update such large data sets frequently. Institutions should strive to update their model data as often as possible to account for frequent turnover of positions in the trading portfolio and changing market conditions. Institutions should update data at a minimum on a monthly basis, but preferably daily. Additionally, institutions should have a workflow process for updating the sources of data. Furthermore, where the institution uses regressions to estimate risk factor parameters, these must be re-estimated on a regular basis, generally no less frequently than every two weeks. Calibration of pricing models to current market prices must also be sufficiently frequent, ideally no less frequent than the calibration of front office pricing models. Where appropriate, institutions should have clear policies for backfilling and/or gap-filling missing data. Principle six. The data used to determine stressed expected shortfall (ESR,S) must be reflective of market prices observed and/or quoted in the period of stress. The data for the ESR,S model should be sourced directly from the historical period whenever possible. There are cases where the characteristics of current instruments in the market differ from those in the stress period. Nevertheless, institutions must empirically justify any instances where the market prices used for the stress period are different from the market prices actually observed during that period. Further, in cases where instruments that are currently traded did not exist during a period of significant financial stress, institutions must demonstrate that the prices used match changes in prices or spreads of similar instruments during the stress period. In cases where institutions do not sufficiently justify the use of current market data for products whose characteristics have changed since the stress period, the institution must omit the risk factor for the stressed period and meet the requirement of paragraph 365(2)(b) that the reduced set of risk factors explain 75% of the fully specified ES model. Moreover, if name-specific risk factors are used to calculate the ES in the actual period and these names were not available in the stressed period, there is a presumption that the idiosyncratic part of these risk factors are not in the reduced set of risk factors. Exposures for risk factors that are included in the current set but not in the reduced set need to be mapped to the most suitable risk factor of the reduced set for the purposes of calculating ES measures in the stressed period. Principle seven. The use of proxies must be limited, and proxies must have sufficiently similar characteristics to the transactions they represent. Proxies must be appropriate for the region, quality and type of instrument they are intended to represent. OSFI will assess whether methods for combining risk factors are conceptually and empirically sound. For example, the use of indices in a multifactor model must capture the correlated risk of the assets represented by the indices, and the remaining idiosyncratic risk must be demonstrably uncorrelated across different issuers. A multifactor model must have significant explanatory power for the price movements of assets and must provide an assessment of the uncertainty in the final outcome due to the use of a proxy. The coefficients (betas) of a multifactor model must be empirically based and must not be determined based on judgment. Instances where coefficients are set by judgment generally should be considered as NMRFs. If risk factors are represented by proxy data in the current period ES model, the proxy data representation of the risk factor – not the risk factor itself – must be used in the RTPL unless the institution has identified the basis between the proxy and the actual risk factor and properly capitalised the basis either by including the basis in the ES model (if the risk factor is a modellable) or capturing the basis as a NMRF. If the capital requirement for the basis is properly determined, then the institution can choose to include in the RTPL either: the proxy risk factor and the basis; or the actual risk factor itself. [Basel Framework, MAR31.26]

9.6.3 Backtesting and P&L Attribution Test Requirements

This section sets out the profit and loss attribution test and backtesting requirements for institutions that use the internal models approach. As set out in paragraph 269, an institution that intends to use the internal models approach (IMA) to determine market risk capital requirements for a trading desk must conduct and successfully pass backtesting at the institution-wide level and both the backtesting and profit and loss (P&L) attribution (PLA) test at the trading desk level as identified in paragraph 269(2). [Basel Framework, MAR32.1] Paragraph 267 describes the criteria that an institution must meet in order to remain eligible to use the IMA to determine market risk capital requirements. The institution’s aggregated market risk capital requirement must be based on positions held in trading desks that qualify for use of the institution’s internal models for market risk capital requirements by satisfying the backtesting and PLA test as set out in this section. This criterion must be assessed by the institution on a quarterly basis when calculating the aggregate capital requirement for market risk according to paragraph 403. [Basel Framework, MAR32.2] The implementation of the backtesting programme and the PLA test must begin on the date that the internal models capital requirement becomes effective. For OSFI’s approval of a model, the institution must provide a one-year backtesting and PLA test report to confirm the quality of the model. OSFI may require backtesting and PLA test results prior to that date. OSFI will determine any necessary response to backtesting results based on the number of exceptions over the course of 12 months (i.e. 250 trading days) generated by the institution’s model. Based on the assessment on the significance of exceptions, OSFI may initiate a dialogue with the institution to determine if there is a problem with an institution’s model. In the most serious cases, OSFI will impose an additional increase in an institution’s capital requirement or disallow use of the model. [Basel Framework, MAR32.3] Backtesting Requirements Backtesting requirements compare the value-at-risk (VaR) measure calibrated to a one-day holding period against each of the actual P&L (APL) and hypothetical P&L (HPL) over the prior 12 months. Specific requirements to be applied at the institution-wide level and trading desk level are set out below. [Basel Framework, MAR32.4] Backtesting of the institution-wide risk model must be based on a VaR measure calibrated at a 99^th percentile confidence level. An exception or an outlier occurs when either the actual loss or the hypothetical loss of the institution-wide trading book registered in a day of the backtesting period exceeds the corresponding daily VaR measure given by the model. As per paragraph 414, exceptions for actual losses are counted separately from exceptions for hypothetical losses; the overall number of exceptions is the greater of these two amounts. In the event either the P&L or the daily VaR measure is not available or impossible to compute, it will count as an outlier. [Basel Framework, MAR32.5] In the event an outlier can be shown by the institution to relate to a non-modellable risk factor, and the capital requirement for that non-modellable risk factor exceeds the actual or hypothetical loss for that day, it may be disregarded for the purpose of the overall backtesting process if OSFI is notified accordingly and does not object to this treatment. In these cases, an institution must document the history of the movement of the value of the relevant non-modellable risk factor and have supporting evidence that the non-modellable risk factor has caused the relevant loss. If the backtesting exception at a desk-level test is being driven by a non-modellable risk factor that receives an SES capital requirement that is in excess of the maximum of the APL loss or HPL loss for that day, it is permitted to be disregarded for the purposes of the desk-level backtesting. The institution must be able to calculate a non-modellable risk factor capital requirement for the specific desk and not only for the respective risk factor across all desks. For example, if the P&L for a desk is EUR –1.5 million and VaR is EUR 1 million, a non-modellable risk factor capital requirement (at desk level) of EUR 0.8 million would not be sufficient to disregard an exception for the purpose of desk-level backtesting. The non-modellable risk factor capital requirement attributed to the standalone desk level (without VaR) must be greater than the loss of EUR 1.5 million in order to disregard an exception for the purpose of desk-level backtesting. [Basel Framework, MAR32.6] The scope of the portfolio subject to institution-wide backtesting should be updated quarterly based on the results of the latest trading desk-level backtesting, risk factor eligibility test and PLA tests. [Basel Framework, MAR32.7] The framework for OSFI’s interpretation of backtesting results for the institution-wide capital model encompasses a range of possible responses, depending on the strength of the signal generated from the backtesting. These responses are classified into three backtesting zones, distinguished by colours into a hierarchy of responses. Green zone. This corresponds to results that do not themselves suggest a problem with the quality or accuracy of an institution’s model. Amber zone. This encompasses results that do raise questions in this regard, for which such a conclusion is not definitive. Red zone. This indicates a result that almost certainly indicates a problem with an institution’s risk model. [Basel Framework, MAR32.8] These zones are defined according to the number of exceptions generated in the backtesting programme considering statistical errors as explained in paragraphs 415 to 427. Table 17 sets out boundaries for these zones and the presumptive supervisory response for each backtesting outcome, based on a sample of 250 observations. [Basel Framework, MAR32.9] Table 17 – Backtesting zones Backtesting zone Number of exceptions Backtesting dependent multiplier (to be added to any qualitative add-on per paragraph 403) Green 0 1.50 Green 1 1.50 Green 2 1.50 Green 3 1.50 Green 4 1.50 Amber 5 1.70 Amber 6 1.76 Amber 7 1.83 Amber 8 1.88 Amber 9 1.92 Red 10 or more 2.00 The backtesting green zone generally would not initiate OSFI’s increase in capital requirements for backtesting (i.e. no backtesting add-on would apply). [Basel Framework, MAR32.10] Outcomes in the backtesting amber zone could result from either accurate or inaccurate models. However, they are generally deemed more likely for inaccurate models than for accurate models. Within the backtesting amber zone, OSFI will impose a higher capital requirement in the form of a backtesting add-on. The number of exceptions should generally inform the size of any backtesting add-on, as set out in Table 17 of paragraph 324. [Basel Framework, MAR32.11] An institution must also document all of the exceptions generated from its ongoing backtesting programme, including an explanation for each exception. [Basel Framework, MAR32.12] An institution may also implement backtesting for confidence intervals other than the 99^th percentile, or may perform other statistical tests not set out in this standard. [Basel Framework, MAR32.13] Besides a higher capital requirement for any outcomes that place the institution in the backtesting amber zone, in the case of severe problems with the basic integrity of the model, OSFI may consider whether to disallow the institution’s use of the model for market risk capital requirement purposes altogether. [Basel Framework, MAR32.14] If an institution’s model falls into the backtesting red zone, OSFI will automatically increase the multiplication factor applicable to the institution’s model or may disallow use of the model. [Basel Framework, MAR32.15] Backtesting at the trading desk level The performance of a trading desk’s risk management model will be tested through daily backtesting. [Basel Framework, MAR32.16] The backtesting assessment is considered to be complementary to the PLA assessment when determining the eligibility of a trading desk for the IMA. [Basel Framework, MAR32.17] At the trading desk level, backtesting must compare each desk’s one-day VaR measure (calibrated to the most recent 12 months’ data, equally weighted) at both the 97.5^th percentile and the 99^th percentile, using at least one year of current observations of the desk’s one-day P&L. An exception or an outlier occurs when either the actual or hypothetical loss of the trading desk registered in a day of the backtesting period exceeds the corresponding daily VaR measure determined by the institution’s model. Exceptions for actual losses are counted separately from exceptions for hypothetical losses; the overall number of exceptions is the greater of these two amounts. In the event either the P&L or the risk measure is not available or impossible to compute, it will count as an outlier. Volatility scaling of returns for VaR calculation at the discretion of the institution that results in a shorter observation period being used is not allowed. An institution may scale up the volatility of all observations for a selected (group of) risk factor(s) to reflect a recent stress period. The institution may use this scaled data to calculate future VaR and expected shortfall estimates only after ex ante notification of such a scaling to OSFI. [Basel Framework, MAR32.18] If any given trading desk experiences either more than 12 exceptions at the 99^th percentile or 30 exceptions at the 97.5^th percentile in the most recent 12-month period, the capital requirement for all of the positions in the trading desk must be determined using the standardized approach.^{Footnote 57} [Basel Framework, MAR32.19] PLA Test Requirements The PLA test compares daily risk-theoretical P&L (RTPL) with the daily HPL for each trading desk. It intends to: measure the materiality of simplifications in a institutions’ internal models used for determining market risk capital requirements driven by missing risk factors and differences in the way positions are valued compared with their front office systems; and prevent institutions from using their internal models for the purposes of capital requirements when such simplifications are considered material. [Basel Framework, MAR32.20] The PLA test must be performed on a standalone basis for each trading desk in scope for use of the IMA. [Basel Framework, MAR32.21] Definition of profits and losses used for the PLA test and backtesting The RTPL is the daily trading desk-level P&L that is produced by the valuation engine of the trading desk’s risk management model. The trading desk’s risk management model must include all risk factors that are included in the institution’s expected shortfall (ES) model with OSFI’s parameters and any risk factors deemed not modellable by OSFI, and which are therefore not included in the ES model for calculating the respective regulatory capital requirement, but are included in non-modellable risk factors. The RTPL must not take into account any risk factors that the institution does not include in its trading desk’s risk management model. [Basel Framework, MAR32.22] Movements in all risk factors contained in the trading desk’s risk management model should be included, even if the forecasting component of the internal model uses data that incorporates additional residual risk. For example, an institution using a multifactor beta-based index model to capture event risk might include alternative data in the calibration of the residual component to reflect potential events not observed in the name-specific historical time series. The fact that the name is a risk factor in the model, albeit modelled in a multifactor model environment, means that, for the purposes of the PLA test, the institution would include the actual return of the name in the RTPL (and in the HPL) and receive recognition for the risk factor coverage of the model. [Basel Framework, MAR32.23] The PLA test compares a trading desk’s RTPL with its HPL. The HPL used for the PLA test should be identical to the HPL used for backtesting purposes. This comparison is performed to determine whether the risk factors included and the valuation engines used in the trading desk’s risk management model capture the material drivers of the institution’s P&L by determining if there is a significant degree of association between the two P&L measures observed over a suitable time period. The RTPL can differ from the HPL for a number of reasons. However, a trading desk risk management model should provide a reasonably accurate assessment of the risks of a trading desk to be deemed eligible for the internal models-based approach. [Basel Framework, MAR32.24] The HPL must be calculated by revaluing the positions held at the end of the previous day using the market data of the present day (i.e. using static positions). As HPL measures changes in portfolio value that would occur when end-of-day positions remain unchanged, it must not take into account intraday trading nor new or modified deals, in contrast to the APL. Both APL and HPL include foreign denominated positions and commodities included in the banking book. [Basel Framework, MAR32.25] Fees and commissions must be excluded from both APL and HPL as well as valuation adjustments for which separate regulatory capital approaches have been otherwise specified as part of the rules (e.g. credit valuation adjustment and its associated eligible hedges) and valuation adjustments that are deducted from Common Equity Tier 1 (e.g. the impact on the debt valuation adjustment component of the fair value of financial instruments must be excluded from these P&Ls). [Basel Framework, MAR32.26] Any other market risk-related valuation adjustments, irrespective of the frequency by which they are updated, must be included in the APL while only valuation adjustments updated daily must be included in the HPL, unless the institution has received specific agreement to exclude them from OSFI. Smoothing of valuation adjustments that are not calculated daily is not allowed. P&L due to the passage of time should be included in the APL and should be treated consistently in both HPL and RTPL.^{Footnote 58} [Basel Framework, MAR32.27] Valuation adjustments that the institution is unable to calculate at the trading desk level (e.g. because they are assessed in terms of the institution’s overall positions/risks or because of other constraints around the assessment process) are not required to be included in the HPL and APL for backtesting at the trading desk level, but should be included for institution-wide backtesting. To the satisfaction of OSFI, the institution must provide support for valuation adjustments that are not computed at a trading desk level. [Basel Framework, MAR32.28] Both APL and HPL must be computed based on the same pricing models (e.g. same pricing functions, pricing configurations, model parametrisation, market data and systems) as the ones used to produce the reported daily P&L. [Basel Framework, MAR32.29] PLA test data input alignment For the sole purpose of the PLA assessment, institutions are allowed to align RTPL input data for its risk factors with the data used in HPL if these alignments are documented, justified to OSFI and the requirements set out below are fulfilled: Institutions must demonstrate that HPL input data can be appropriately used for RTPL purposes, and that no risk factor differences or valuation engine differences are omitted when transforming HPL input data into a format which can be applied to the risk factors used in RTPL calculation. Any adjustment of RTPL input data must be properly documented, validated and justified to OSFI. Institutions must have procedures in place to identify changes with regard to the adjustments of RTPL input data. Institutions must notify OSFI of any such changes. Institutions must provide assessments on the effect these input data alignments would have on the RTPL and the PLA test. To do so, institutions must compare RTPL based on HPL-aligned market data with the RTPL based on market data without alignment. This comparison must be performed when designing or changing the input data alignment process and upon the request of OSFI. [Basel Framework, MAR32.30] Adjustments to RTPL input data will be allowed when the input data for a given risk factor that is included in both the RTPL and the HPL differs due to different providers of market data sources or time fixing of market data sources, or transformations of market data into input data suitable for the risk factors of the underlying pricing models. These adjustments can be done either: by direct replacement of the RTPL input data (e.g. par rate tenor x, provider a) with the HPL input data (e.g. par rate tenor x, provider b); or by using the HPL input data (e.g. par rate tenor x, provider b) as a basis to calculate the risk factor data needed in the RTPL/ES model (e.g. zero rate tenor x). In the event trading desks of an institution operate in different time zones compared to the location of the institution’s risk control department, the institution is permitted to align the snapshot time used for the calculation of the RTPL of a desk to the snapshot time used for the derivation of its HPL. [Basel Framework, MAR32.31] If the HPL uses market data in a different manner to RTPL to calculate risk parameters that are essential to the valuation engine, these differences must be reflected in the PLA test and as a result in the calculation of HPL and RTPL. In this regard, HPL and RTPL are allowed to use the same market data only as a basis, but must use their respective methods (which can differ) to calculate the respective valuation engine parameters. This would be the case, for example, where market data are transformed as part of the valuation process used to calculate RTPL. In that instance, institutions may align market data between RTPL and HPL pre-transformation but not post-transformation. [Basel Framework, MAR32.32] Institutions are not permitted to align HPL input data for risk factors with input data used in RTPL. Adjustments to RTPL or HPL to address residual operational noise are not permitted. Residual operational noise arises from computing HPL and RTPL in two different systems at two different points in time. It may originate from transitioning large portions of data across systems, and potential data aggregations may result in minor reconciliation gaps below tolerance levels for intervention; or from small differences in static/reference data and configuration. [Basel Framework, MAR32.33] PLA test metrics The PLA requirements are based on two test metrics: the Spearman correlation metric to assess the correlation between RTPL and HPL; and the Kolmogorov-Smirnov (KS) test metric to assess similarity of the distributions of RTPL and HPL. [Basel Framework, MAR32.34] To calculate each test metric for a trading desk, the institution must use the time series of the most recent 250 trading days of observations of RTPL and HPL. [Basel Framework, MAR32.35] Process for determining the Spearman correlation metric For a time series of HPL, institutions must produce a corresponding time series of ranks based on the size of the P&L (RHPL). That is, the lowest value in the HPL time series receives a rank of 1, the next lowest value receives a rank of 2 and so on. [Basel Framework, MAR32.36] Similarly, for a time series of RTPL, institutions must produce a corresponding time series of ranks based on size (RRTPL). [Basel Framework, MAR32.37] Institutions must calculate the Spearman correlation coefficient of the two time series of rank values of RRTPL and RHPL based on size using the following formula, where sRHPL and σRRTPL are the standard deviations of RRTPL and RHPL. r S = cov R HPL , R RTPL σ R HPL × σ R RTPL [Basel Framework, MAR32.38] Process for determining Kolmogorov-Smirnov test metrics The institution must calculate the empirical cumulative distribution function of RTPL. For any value of RTPL, the empirical cumulative distribution is the product of 0.004 and the number of RTPL observations that are less than or equal to the specified RTPL. [Basel Framework, MAR32.39] The institution must calculate the empirical cumulative distribution function of HPL. For any value of HPL, the empirical cumulative distribution is the product of 0.004 and number of HPL observations that are less than or equal to the specified HPL. [Basel Framework, MAR32.40] The KS test metric is the largest absolute difference observed between these two empirical cumulative distribution functions at any P&L value. [Basel Framework, MAR32.41] PLA test metrics evaluation Based on the outcome of the metrics, upon an initial approval for a trading desk to use internal models, the trading desk may be allocated to the PLA test green zone for one year. After one year, a trading desk is allocated to a PLA test red zone, an amber zone or a green zone as set out in Table 18. A trading desk is in the PLA test green zone if both the correlation metric is above 0.80; and the KS distributional test metric is below 0.09 (p-value = 0.264). A trading desk is in the PLA test red zone if the correlation metric is less than 0.7 or if the KS distributional test metric is above 0.12 (p-value = 0.055). A trading desk is in the PLA amber zone if it is allocated neither to the green zone nor to the red zone. Table 18 – PLA test thresholds Zone Spearman correlation KS test Amber zone thresholds 0.80 0.09 (p-value = 0.264) Red zone thresholds 0.70 0.12 (p-value = 0.055) [Basel Framework, MAR32.42] If a trading desk is in the PLA test red zone, it is ineligible to use the IMA to determine market risk capital requirements and must be use the standardized approach. Risk exposures held by these ineligible trading desks must be included with the out-of-scope trading desks for purposes of determining capital requirement per the standardized approach. A trading desk deemed ineligible to use the IMA must remain out-of-scope to use the IMA until: the trading desk produces outcomes in the PLA test green zone; and the trading desk has satisfied the backtesting exceptions requirements over the past 12 months. [Basel Framework, MAR32.43] If a trading desk is in the PLA test amber zone, it is not considered an out-of-scope trading desk for use of the IMA. If a trading desk is in the PLA test amber zone, it cannot return to the PLA test green zone until: the trading desk produces outcomes in the PLA test green zone; and the trading desk has satisfied its backtesting exceptions requirements over the prior 12 months. Trading desks in the PLA test amber zone are subject to a capital surcharge as specified in paragraph 403. [Basel Framework, MAR32.44] Treatment for Exceptional Situations There may, on very rare occasions, be a valid reason why a series of accurate trading desk level-models across different institutions will produce many backtesting exceptions or inadequately track the P&L produced by the front office pricing model (for instance, during periods of significant cross-border financial market stress affecting several institutions or when financial markets are subjected to a major regime shift). One possible OSFI’s response in this instance would be to permit the relevant trading desks to continue to use the IMA but require each trading desk’s model to take account of the regime shift or significant market stress as quickly as practicable while maintaining the integrity of its procedures for updating the model. OSFI will only pursue such a response under the most extraordinary, systemic circumstances. [Basel Framework, MAR32.45]

9.6.4 Capital Requirements Calculation

This section sets out the process by which capital requirements are calculated per the internal models approach. Calculation of Expected Shortfall Institutions will have flexibility in devising the precise nature of their expected shortfall (ES) models, but the following minimum standards will apply for the purpose of calculating market risk capital requirements. OSFI will have discretion to apply stricter standards. The IMA does not require all products to be simulated on full revaluation. Simplifications (e.g. sensitivities-based valuation) may be used provided that OSFI agrees that the method used is adequate for the instruments covered. [Basel Framework, MAR33.1] ES must be computed on a daily basis for the institution-wide internal models to determine market risk capital requirements. ES must also be computed on a daily basis for each trading desk that uses the internal models approach (IMA). [Basel Framework, MAR33.2] In calculating ES, an institution must use a 97.5^th percentile, one-tailed confidence level. [Basel Framework, MAR33.3] In calculating ES, the liquidity horizons described in paragraph 372 must be reflected by scaling an ES calculated on a base horizon. The ES for a liquidity horizon must be calculated from an ES at a base liquidity horizon of 10 days with scaling applied to this base horizon result as expressed below, where: ES is the regulatory liquidity-adjusted ES; T is the length of the base horizon, i.e. 10 days; EST(P) is the ES at horizon T of a portfolio with positions P = (pi) with respect to shocks to all risk factors that the positions P are exposed to; EST(P, j) is the ES at horizon T of a portfolio with positions P = (pi) with respect to shocks for each position pi in the subset of risk factors Q(pi, j), with all other risk factors held constant; the ES at horizon T, EST(P) must be calculated for changes in the risk factors, and EST(P, j) must be calculated for changes in the relevant subset Q(pi, j) of risk factors, over the time interval T without scaling from a shorter horizon; Q(pi, j)j is the subset of risk factors for which liquidity horizons, as specified in paragraph 372, for the desk where pi is booked are at least as long as LHj according to the table below. For example, Q(pi,4) is the set of risk factors with a 60-day horizon and a 120-day liquidity horizon. Note that Q(pi, j) is a subset of Q(pi, j−1); the time series of changes in risk factors over the base time interval T may be determined by overlapping observations; and LHj is the liquidity horizon j, with lengths in the following table: Table 19 – Liquidity horizons, j J LHj 1 10 2 20 3 40 4 60 5 120 ES = ES P 2 + ∑ j ≥ 2 ES T P , j LH j - LH j - 1 T 2 [Basel Framework, MAR33.4] The ES measure must be calibrated to a period of stress. Specifically, the ES measure must replicate an ES outcome that would be generated on the institution’s current portfolio if the relevant risk factors were experiencing a period of stress. This is a joint assessment across all relevant risk factors, which will capture stressed correlation measures. This calibration is to be based on an indirect approach using a reduced set of risk factors. Institutions must specify a reduced set of risk factors that are relevant for their portfolio and for which there is a sufficiently long history of observations. This reduced set of risk factors is subject to OSFI’s approval and must meet the data quality requirements for a modellable risk factor as outlined in paragraph 301 to 313. The identified reduced set of risk factors must be able to explain a minimum of 75% of the variation of the full ES model (i.e. the ES of the reduced set of risk factors should be at least equal to 75% of the fully specified ES model on average measured over the preceding 12-week period). In terms of indicator for the identification of the stress period, the aggregate capital requirement for modellable risk factors (IMCC) as per paragraph 375 has to be maximised for the modellable risk factors. The reduced set of risk factors must be able to explain a minimum of 75% of the variation of the full ES model at the group level for the aggregate of all desks with IMA model approval. This may be done by demonstrating that the average of the measurements of the ratio (ES using reduced set of risk factors and current period (ESR,C) to ES using full set of risk factors and current period (ESF,C)) over the preceding 12-week period is at least 75%. Regarding the reform of benchmark reference rates, if the new benchmark rate is currently eligible for modelling according to section 9.6.2 but was not available during the stress period, it may pose a challenge to institutions calculating the expected shortfall (ES) for the current and stress period per section 9.6.4. To address this, if the new benchmark rate is eligible for modelling according to 9.6.2 but was not available during the stress period, institutions may use: (i) for the current period, the new benchmark rate in the full set of risk factors ESF,C and in the reduced set of risk factors ESR,C; and (ii) for the stress period, the old benchmark rate in the reduced set of risk factors ESR,S. This interpretation does not annul the specification in the above paragraph that the reduced set is subject to OSFI approval and must meet the data quality requirements. [Basel Framework, MAR33.5] The ES for market risk capital purposes is therefore expressed as follows, where: The ES for the portfolio using the above reduced set of risk factors (ESR,S), is calculated based on the most severe 12-month period of stress available over the observation horizon. ESR,S is then scaled up by the ratio of (i) the current ES using the full set of risk factors to (ii) the current ES measure using the reduced set of factors. For the purpose of this calculation, this ratio is floored at 1. ESF,C is the ES measure based on the current (most recent) 12-month observation period with the full set of risk factors; and ESR,C is the ES measure based on the current period with a reduced set of risk factors. ES = ES R , S × ES F , C ES R , C [Basel Framework, MAR33.6] For measures based on stressed observations (ESR,S), institutions must identify the 12-month period of stress over the observation horizon in which the portfolio experiences the largest loss. The observation horizon for determining the most stressful 12 months must, at a minimum, include the 2007-09 period^{Footnote 59}. Observations within this period must be equally weighted. Institutions must update their 12-month stressed periods at least quarterly, or whenever there are material changes in the risk factors in the portfolio. Whenever an institution updates its 12-month stressed periods it must also update the reduced set of risk factors (as the basis for the calculations of ER,C and ER,S) accordingly. [Basel Framework, MAR33.7] For measures based on current observations (ESF,C), institutions must update their data sets no less frequently than once every three months and must also reassess data sets whenever market prices are subject to material changes. This updating process must be flexible enough to allow for more frequent updates. OSFI may also require an institution to calculate its ES using a shorter observation period if, in OSFI’s judgement, this is justified by a significant upsurge in price volatility. In this case, however, the period should be no shorter than six months. [Basel Framework, MAR33.8] No particular type of ES model is prescribed. Provided that each model used captures all the material risks run by the institution, as confirmed through profit and loss (P&L) attribution (PLA) tests and backtesting, and conforms to each of the requirements set out above and below, OSFI may permit institutions to use models based on either historical simulation, Monte Carlo simulation, or other appropriate analytical methods. [Basel Framework, MAR33.9] Institutions will have discretion to recognise empirical correlations within broad regulatory risk factor classes (interest rate risk, equity risk, foreign exchange risk, commodity risk and credit risk, including related options volatilities in each risk factor category). Empirical correlations across broad risk factor categories will be constrained by the supervisory aggregation scheme, as described in paragraphs 374 to 375, and must be calculated and used in a manner consistent with the applicable liquidity horizons, clearly documented and able to be explained to OSFI on request. [Basel Framework, MAR33.10] Institutions’ models must accurately capture the risks associated with options within each of the broad risk categories. The following criteria apply to the measurement of options risk: Institutions’ models must capture the non-linear price characteristics of options positions. Institutions’ risk measurement systems must have a set of risk factors that captures the volatilities of the rates and prices underlying option positions, i.e. vega risk. Institutions with relatively large and/or complex options portfolios must have detailed specifications of the relevant volatilities. Institutions must model the volatility surface across both strike price and vertex (i.e. tenor). [Basel Framework, MAR33.11] As set out in paragraph 364, a scaled ES must be calculated based on the liquidity horizon n defined below. n is calculated per the following conditions: Institutions must map each risk factor on to one of the risk factor categories shown below using consistent and clearly documented procedures. The mapping of risk factors must be: set out in writing; validated by the institution’s risk management; made available to OSFI; and subject to internal audit. n is determined for each broad category of risk factor as set out in Table 20. However, on a desk-by-desk basis, n can be increased relative to the values in the table below (i.e. the liquidity horizon specified below can be treated as a floor). Where n is increased, the increased horizon must be 20, 40, 60 or 120 days and the rationale must be documented and be subject to OSFI approval. Furthermore, liquidity horizons should be capped at the maturity of the related instrument if the maturity of the instrument is longer than the respective liquidity horizon of the risk factor as prescribed in this paragraph. Table 20 – Liquidity horizon n by risk factor Risk factor category n Risk factor category n Interest rate: specified currencies - EUR, USD, GBP, AUD, JPY, SEK, CAD and domestic currency of an institution 10 Equity price (small cap): volatility 60 Interest rate: unspecified currencies 20 Equity: other types 60 Interest rate: volatility 60 Foreign exchange (FX) rate: specified currency pairs^{Footnote 60} 10 Interest rate: other types 60 FX rate: currency pairs 20 Credit spread: sovereign (investment grade, or IG) 20 FX: volatility 40 Credit spread: sovereign (high yield, or HY) 40 FX: other types 40 Credit spread: corporate (IG) 40 Energy and carbon emissions trading price 20 Credit spread: corporate (HY) 60 Precious metals and non-ferrous metals price 20 Credit spread: volatility 120 Other commodities price 60 Credit spread: other types 120 Energy and carbon emissions trading price: volatility 60 Equity price (large cap) 10 Precious metals and non-ferrous metals price: volatility 60 Equity price (small cap) 20 Other commodities price: volatility 120 Equity price (large cap): volatility 20 Commodity: other types 120 The liquidity horizon for equity large cap repo and dividend risk factors is 20 days. All other equity repo and dividend risk factors are subject to a liquidity horizon of 60 days. For mono-currency and cross-currency basis risk, liquidity horizons of 10 days and 20 days for interest rate-specified currencies and unspecified currencies, respectively, should be applied. The liquidity horizon for inflation risk factors should be consistent with the liquidity horizons for interest rate risk factors for a given currency. If the maturity of the instrument is shorter than the respective liquidity horizon of the risk factor as prescribed in paragraph 372, the next longer liquidity horizon length (out of the lengths of 10, 20, 40, 60 or 120 days as set out in the paragraph) compared with the maturity of the instrument itself must be used. For example, although the liquidity horizon for interest rate volatility is prescribed as 60 days, if an instrument matures in 30 days, a 40-day liquidity horizon would apply for the instrument’s interest rate volatility. To determine the liquidity horizon of multi-sector credit and equity indices, the respective liquidity horizons of the underlying instruments must be used. A weighted average of liquidity horizons of the instruments contained in the index must be determined by multiplying the liquidity horizon of each individual instrument by its weight in the index (i.e. the weight used to construct the index) and summing across all instruments. The liquidity horizon of the index is the shortest liquidity horizon (out of 10, 20, 40, 60 and 120 days) that is equal to or longer than the weighted average liquidity horizon. For example, if the weighted average liquidity horizon is 12 days, the liquidity horizon of the index would be 20 days. [Basel Framework, MAR33.12] Calculation of Capital Requirement for Modellable Risk Factors For those trading desks that are permitted to use the IMA, all risk factors that are deemed to be modellable must be included in the institution’s internal, institution-wide ES model. The institution must calculate its internally modelled capital requirement at the institution-wide level using this model, with no supervisory constraints on cross-risk class correlations (IMCC(C)). Institutions design their own models for use under the IMA. As a result, they may exclude risk factors from IMA models as long as OSFI does not conclude that the risk factor must be capitalised by either ES or SES. Moreover, at a minimum, the risk factors defined in paragraphs 289 to 300 need to be covered in the IMA. If a risk factor is capitalised by neither ES nor SES, it is to be excluded from the calculation of risk-theoretical P&L. [Basel Framework, MAR33.13] The institution must calculate a series of partial ES capital requirements (i.e. all other risk factors must be held constant) for the range of broad regulatory risk classes (interest rate risk, equity risk, foreign exchange risk, commodity risk and credit spread risk). These partial, non-diversifiable (constrained) ES values (IMCC(Ci)) will then be summed to provide an aggregated risk class ES capital requirement. [Basel Framework, MAR33.14] The aggregate capital requirement for modellable risk factors (IMCC) is based on the weighted average of the constrained and unconstrained ES capital requirements, where: The stress period used in the risk class level ESR,S,i should be the same as that used to calculate the portfolio-wide ESR,S. Rho (ρ) is the relative weight assigned to the institution’s internal model. The value of ρ is 0.5. B stands for broad regulatory risk classes as set out in paragraph 374. IMCC = ρ IMCC C + 1 - ρ ∑ i = 1 B IMCC C i where IMCC C = ES R , S ES F , C ES R , C and IMCC C i = ES R , S , i ES F , C , i ES R , C , i To calculate the aggregate capital requirement for modellable risk factors (internally modelled capital charge, IMCC) up to 63 daily ES calculations would be necessary if each ES measure were required to be calculated daily. The formula specified in this paragraph, IMCC = ρ IMCC C + 1 - ρ ∑ i = 1 B IMCC C i , can be rewritten as IMCC = ρ IMCC C + 1 - ρ ∑ i = 1 B IMCC C i IMCC C IMCC C with IMCC C = ES R , S ES F , C ES R , C . While ESR,S , ESF,C and ESR,C must be calculated daily, it is generally acceptable that the ratio of undiversified IMCC(C) to diversified IMCC(C), ∑ i = 1 B IMCC C i IMCC C , may be calculated on a weekly basis. By defining ω as ω = ρ + 1 - ρ ⋅ ∑ i = 1 B IMCC C i IMCC C the formula for the calculation of IMCC can be rearranged, leading to the following expression of IMCC: IMCC = ω ⋅ IMCC C . Hence, IMCC can be calculated as a multiple of IMCC(C), where IMCC(C) is calculated daily and the multiplier ω is updated weekly. Institutions must have procedures and controls in place to ensure that the weekly calculation of the “undiversified IMCC(C) to diversified IMCC(C)” ratio does not lead to a systematic underestimation of risks relative to daily calculation. Institutions must be in a position to switch to daily calculation upon OSFI’s direction. [Basel Framework, MAR33.15] Calculation of Capital Requirement for Non-Modellable Risk Factors Capital requirements for each non-modellable risk factor (NMRF) are to be determined using a stress scenario that is calibrated to be at least as prudent as the ES calibration used for modelled risks (i.e. a loss calibrated to a 97.5% confidence threshold over a period of stress). In determining that period of stress, an institution must determine a common 12-month period of stress across all NMRFs in the same risk class. Subject to OSFI’s approval, an institution may be permitted to calculate stress scenario capital requirements at the bucket level (using the same buckets that the institution uses to disprove modellability, per paragraph 305) for risk factors that belong to curves, surfaces or cubes (i.e. a single stress scenario capital requirement for all the NMRFs that belong to the same bucket). For each NMRF, the liquidity horizon of the stress scenario must be the greater of the liquidity horizon assigned to the risk factor in paragraph 372 and 20 days. OSFI may require a higher liquidity horizon. For NMRFs arising from idiosyncratic credit spread risk, institutions may apply a common 12-month stress period. Likewise, for NMRFs arising from idiosyncratic equity risk arising from spot, futures and forward prices, equity repo rates, dividends and volatilities, institutions may apply a common 12-month stress scenario. Additionally, a zero correlation assumption may be used when aggregating gains and losses provided the institution conducts analysis to demonstrate to OSFI that this is appropriate.^{Footnote 61} Correlation or diversification effects between other non-idiosyncratic NMRFs are recognized through the formula set out in the paragraph below. In the event that an institution cannot provide a stress scenario which is acceptable for OSFI, the institution will have to use the maximum possible loss as the stress scenario. [Basel Framework, MAR33.16] The aggregate regulatory capital measure for I (non-modellable idiosyncratic credit spread risk factors that have been demonstrated to be appropriate to aggregate with zero correlation), J (non-modellable idiosyncratic equity risk factors that have been demonstrated to be appropriate to aggregate with zero correlation) and the remaining K (risk factors in model-eligible trading desks that are non-modellable (SES)) is calculated as follows, where: ISESNM,i is the stress scenario capital requirement for idiosyncratic credit spread non-modellable risk i from the I risk factors aggregated with zero correlation; ISESNM,j is the stress scenario capital requirement for idiosyncratic equity non-modellable risk j from the J risk factors aggregated with zero correlation; SESNM,k is the stress scenario capital requirement for non-modellable risk k from K risk factors; and Rho (ρ) is equal to 0.6. SES = ∑ i = 1 I ISES NM , i 2 + ∑ j = 1 J ISES NM , j 2 + ρ ⋅ ∑ k = 1 K SES NM , k 2 + 1 - ρ 2 ⋅ ∑ k = 1 K SES NM , k 2 [Basel Framework, MAR33.17] Calculation of Default Risk Capital Requirement Institutions must have a separate internal model to measure the default risk of trading book positions. The general criteria in paragraphs 266 to 269 and the qualitative standards in paragraphs 270 to 281 also apply to the default risk model. [Basel Framework, MAR33.18] Default risk is the risk of direct loss due to an obligor’s default as well as the potential for indirect losses that may arise from a default event. [Basel Framework, MAR33.19] Default risk must be measured using a value-at-risk (VaR) model. Institutions must use a default simulation model with two types of systematic risk factors. The model should always have two random variables that correspond to the systematic risk factors. Systematic risk in a DRC requirement model must be accounted for via multiple systematic factors of two different types. The random variable that determines whether an obligor defaults must be an obligor-specific function of the systematic factors of both types and of an idiosyncratic factor. For example, in a Merton-type model, obligor i defaults when its asset return Xi falls below an obligor-specific threshold that determines the obligor’s probability of default. Systematic risk can be described via M systematic regional factors Yj^region (j = 1, ⋯, M) and N systematic industry factors Yj^industry (j = 1, ⋯, N). For each obligor i, region factor loadings βi,j^region and industry factor loadings βi,j^industry that describe the sensitivity of the obligor’s asset return to each systematic factor need to be chosen. There must be at least one non-zero factor loading for the region type and at least one non-zero factor loading for the industry type. The asset return of obligor i can be represented as X i = ∑ j = 1 M β i , j region ⋅ Y j region + ∑ j = 1 N β i , j industry ⋅ Y j industry + ϒ i ⋅ ε i , where εi is the idiosyncratic risk factor and ϒi is the idiosyncratic factor loading. Default correlations must be based on credit spreads or on listed equity prices. Correlations must be based on data covering a period of 10 years that includes a period of stress as defined in paragraph 365 and based on a one-year liquidity horizon. Only credit spreads or listed equity prices are permitted. No additional data sources (e.g. rating time series) are permitted. Institutions must have clear policies and procedures that describe the correlation calibration process, documenting in particular in which cases credit spreads or equity prices are used. Institutions have the discretion to apply a minimum liquidity horizon of 60 days to the determination of default risk capital (DRC) requirement for equity sub-portfolios. Institutions are permitted to calibrate correlations to liquidity horizons of 60 days in the case that a separate calculation is performed for equity sub-portfolios and these desks deal predominately in equity exposures. In the case of a desk with both equity and bond exposures, for which a joint calculation for default risk of equities and bonds needs to be performed, the correlations need to be calibrated to a liquidity horizon of one year. In this case, an institution is permitted to consistently use a 60-day probability of default (PD) for equities and a one-year PD for bonds. Institutions are permitted to use a 60-day liquidity horizon for all equity positions but are permitted to use a longer liquidity horizon where appropriate, e.g. where equity is held to hedge hybrid positions (such as convertibles). The VaR calculation must be conducted weekly and be based on a one-year time horizon at a one-tail, 99.9 percentile confidence level. [Basel Framework, MAR33.20] All positions subject to market risk capital requirements that have default risk as defined in paragraph 379, with the exception of those positions subject to the standardized approach, are subject to the DRC requirement model. Sovereign exposures (including those denominated in the sovereign’s domestic currency), equity positions and defaulted debt positions must be included in the model. For equity positions, the default of an issuer must be modelled as resulting in the equity price dropping to zero. [Basel Framework, MAR33.21] The DRC requirement model capital requirement is the greater of: the average of the DRC requirement model measures over the previous 12 weeks; or the most recent DRC requirement model measure. [Basel Framework, MAR33.22] An institution must assume constant positions over the one-year horizon, or 60 days in the context of designated equity sub-portfolios. An institution must have constant positions over the chosen liquidity horizon. The concept of constant positions has changed in the market risk framework because the capital horizon is now meant to always be synonymous with the new definition of liquidity horizon and no new positions are added when positions expire during the capital horizon. For securities with a maturity under one year, a constant position can be maintained within the liquidity horizon but, much like under the Basel II.5 incremental risk charge, any maturity of a long or short position must be accounted for when the ability to maintain a constant position within the liquidity horizon cannot be contractually assured. [Basel Framework, MAR33.23] Default risk must be measured for each obligor. Probabilities of default (PDs) implied from market prices are not acceptable unless they are corrected to obtain an objective probability of default. PDs are subject to floors of: 0.01% for claims on or directly guaranteed by the Government of Canada, the Bank of Canada, and a Canadian provincial or territorial government; and 0.03% for all other claims. [Basel Framework, MAR33.24] An institution’s model may reflect netting of long and short exposures to the same obligor. If such exposures span different instruments with exposure to the same obligor, the effect of the netting must account for different losses in the different instruments (e.g. differences in seniority). [Basel Framework, MAR33.25] The basis risk between long and short exposures of different obligors must be modelled explicitly. The potential for offsetting default risk among long and short exposures across different obligors must be included through the modelling of defaults. The pre-netting of positions before input into the model other than as described in the above paragraph is not allowed. [Basel Framework, MAR33.26] The DRC requirement model must recognise the impact of correlations between defaults among obligors, including the effect on correlations of periods of stress as described below. These correlations must be based on objective data and not chosen in an opportunistic way where a higher correlation is used for portfolios with a mix of long and short positions and a low correlation used for portfolios with long only exposures. An institution must validate that its modelling approach for these correlations is appropriate for its portfolio, including the choice and weights of its systematic risk factors. An institution must document its modelling approach and the period of time used to calibrate the model. These correlations must be measured over a liquidity horizon of one year. These correlations must be calibrated over a period of at least 10 years. Institutions must reflect all significant basis risks in recognizing these correlations, including, for example, maturity mismatches, internal or external ratings, vintage etc. Paragraph 383 states that an institution must have constant positions over the chosen liquidity horizon, however, an institution must capture material mismatches between the position and its hedge. [Basel Framework, MAR33.27] The institution’s model must capture any material mismatch between a position and its hedge. With respect to default risk within the one-year capital horizon, the model must account for the risk in the timing of defaults to capture the relative risk from the maturity mismatch of long and short positions of less than one-year maturity. In case of either i) an investment grade bond^{Footnote 62} or a large-cap^{Footnote 63} equity that is hedging a TRS or ii) a bond forward that is hedging a Level 1 High Quality Liquid Asset as defined in Chapter 2 of OSFI’s Liquidity Adequacy Requirements Guideline, the institution can cap its maturity mismatch at 40 days. To apply this cap, the institution must be able to demonstrate to OSFI the governance capacity to unwind such cash positions within this timeframe. Such recognition is only admissible if the institution: chooses to make use of the rebalancing/liquidation of the hedge consistently over the relevant set of trading book risk positions; demonstrates that the inclusion of rebalancing/liquidation results in a better risk measurement; demonstrates that the markets for the security serving as hedge are liquid enough to allow for this kind of rebalancing/liquidation, even during periods of stress; and establishes a limit system based on instrument exposure relative to average daily traded volume of the cash position. [Basel Framework, MAR33.28] The institution’s model must reflect the effect of issuer and market concentrations, as well as concentrations that can arise within and across product classes during stressed conditions. [Basel Framework, MAR33.29] As part of this DRC requirement model, the institution must calculate, for each and every position subjected to the model, an incremental loss amount relative to the current valuation that the institution would incur in the event that the obligor of the position defaults. [Basel Framework, MAR33.30] Loss estimates must reflect the economic cycle; for example, the model must incorporate the dependence of the recovery on the systemic risk factors. [Basel Framework, MAR33.31] The institution’s model must reflect the non-linear impact of options and other positions with material non-linear behaviour with respect to default. In the case of equity derivatives positions with multiple underlyings, simplified modelling approaches (for example modelling approaches that rely solely on individual jump-to-default sensitivities to estimate losses when multiple underlyings default) may be applied (subject to OSFI approval). [Basel Framework, MAR33.32] Default risk must be assessed from the perspective of the incremental loss from default in excess of the mark-to-market losses already taken into account in the current valuation. [Basel Framework, MAR33.33] Owing to the high confidence standard and long capital horizon of the DRC requirement, robust direct validation of the DRC model through standard backtesting methods at the 99.9%/one-year soundness standard will not be possible. Accordingly, validation of a DRC model necessarily must rely more heavily on indirect methods including but not limited to stress tests, sensitivity analyses and scenario analyses, to assess its qualitative and quantitative reasonableness, particularly with regard to the model’s treatment of concentrations. Given the nature of the DRC soundness standard, such tests must not be limited to the range of events experienced historically. The validation of a DRC model represents an ongoing process in which OSFI and institutions jointly determine the exact set of validation procedures to be employed. [Basel Framework, MAR33.34] Institutions should strive to develop relevant internal modelling benchmarks to assess the overall accuracy of their DRC models. [Basel Framework, MAR33.35] Due to the unique relationship between credit spread and default risk, institutions must seek approval for each trading desk with exposure to these risks, both for credit spread risk and default risk. Trading desks which do not receive approval will be deemed ineligible for internal modelling standards and be subject to the standardized capital framework. [Basel Framework, MAR33.36] Where an institution has approved PD estimates as part of the internal ratings-based (IRB) approach, this data must be used. Where such estimates do not exist, or OSFI determines that they are not sufficiently robust, PDs must be computed using a methodology consistent with the IRB methodology and satisfy the following conditions. Risk-neutral PDs should not be used as estimates of observed (historical) PDs. PDs must be measured based on historical default data including both formal default events and price declines equivalent to default losses. Where possible, this data should be based on publicly traded securities over a complete economic cycle. The minimum historical observation period for calibration purposes is five years. PDs must be estimated based on historical data of default frequency over a one-year period. The PD may also be calculated on a theoretical basis (e.g. geometric scaling) provided that the institution is able to demonstrate that such theoretical derivations are in line with historical default experience. PDs provided by external sources may also be used by institutions, provided they can be shown to be relevant for the institution’s portfolio. [Basel Framework, MAR33.37] Where an institution has approved loss-given-default (LGD)^{Footnote 64} estimates as part of the IRB approach, this data must be used. Where such estimates do not exist, or OSFI determines that they are not sufficiently robust, LGDs must be computed using a methodology consistent with the IRB methodology and satisfy the following conditions. LGDs must be determined from a market perspective, based on a position’s current market value less the position’s expected market value subsequent to default. The LGD should reflect the type and seniority of the position and cannot be less than zero. LGDs must be based on an amount of historical data that is sufficient to derive robust, accurate estimates. LGDs provided by external sources may also be used by institutions, provided they can be shown to be relevant for the institution’s portfolio. [Basel Framework, MAR33.38] Institutions must establish a hierarchy ranking their preferred sources for PDs and LGDs, in order to avoid the cherry-picking of parameters. [Basel Framework, MAR33.39] Calculation of Capital Requirement for Model-Ineligible Trading Desks The regulatory capital requirement associated with trading desks that are either out-of-scope for model approval or that have been deemed ineligible to use an internal model (Cu) is to be calculated by aggregating all such risks and applying the standardized approach. [Basel Framework, MAR33.40] Aggregation of Capital Requirements The aggregate (non-DRC) capital requirement for those trading desks approved and eligible for the IMA (i.e. trading desks that pass the backtesting requirements and that have been assigned to the PLA test green zone or amber zone (CA) in paragraphs 358 to 360) is equal to the maximum of the most recent observation and a weighted average of the previous 60 days scaled by a multiplier and is calculated as follows where SES is the aggregate regulatory capital measure for the risk factors in model-eligible trading desks that are non-modellable. C A = max ⁡ IMCC t - 1 + SES t - 1 ; m c ⋅ IMCC avg + SES avg [Basel Framework, MAR33.41] The multiplication factor mc is fixed at 1.5 unless it is set at a higher level by OSFI to reflect the addition of a qualitative add on and/or a backtesting add-on per the following considerations. Institutions must add to this factor a “plus” directly related to the ex-post performance of the model, thereby introducing a built-in positive incentive to maintain the predictive quality of the model. For the backtesting add-on, the plus will range from 0 to 0.5 based on the outcome of the backtesting of the institution’s daily VaR at the 99^th percentile based on current observations on the full set of risk factors (VaRFC). If the backtesting results are satisfactory and the institution meets all of the qualitative standards set out in paragraphs 270 to 281, the plus factor could be zero. Section 9.6.3 presents in detail the approach to be applied for backtesting and the plus factor. The backtesting add-on factor is determined based on the maximum of the exceptions generated by the backtesting results against actual P&L (APL) and hypothetical P&L (HPL) as described section 9.6.3. [Basel Framework, MAR33.42] The aggregate capital requirement for market risk (ACRtotal) is equal to the aggregate capital requirement for approved and eligible trading desks (IMAG,A = CA + DRC) plus the standardized approach capital requirement for trading desks that are either out-of-scope for model approval or that have been deemed ineligible to use the internal models approach (Cu). If at least one eligible trading desk is in the PLA test amber zone, a capital surcharge is added. The impact of the capital surcharge is limited by the formula: ACR total = min ⁡ IMA G , A + Capital surcharge + C U ; SA all desk + max ⁡ 0 ; IMA G , A − SA G , A [Basel Framework, MAR33.43] For the purposes of calculating the capital requirement, the risk factor eligibility test, the PLA test and the trading desk-level backtesting are applied on a quarterly basis to update the modellability of risk factors and desk classification to the PLA test green zone, amber zone, or red zone. In addition, the stressed period and the reduced set of risk factors (ER,C and ER,S) must be updated on a quarterly basis. The reference dates to perform the tests and to update the stress period and selection of the reduced set of risk factors should be consistent. Institutions must reflect updates to the stressed period and to the reduced set of risk factors as well as the test results in calculating capital requirements in a timely manner. The averages of the previous 60 days (IMCC, SES) and or respectively 12 weeks (DRC) have only to be calculated at the end of the quarter for the purpose of calculating the capital requirement. [Basel Framework, MAR33.44] The capital surcharge is calculated as the difference between the aggregated standardized capital charges (SAG,A) and the aggregated internal models-based capital charges (IMAG,A = CA + DRC) multiplied by a factor k. To determine the aggregated capital charges, positions in all of the trading desks in the PLA green zone or amber zone are taken into account. The capital surcharge is floored at zero. In the formula below: k = 0.5 × ∑ i ∈ A S A i ∑ i ∈ G , A S A i ; SAi denotes the standardized capital requirement for all the positions of trading desk “i”; i ∈ A denotes the indices of all the approved trading desks in the amber zone; and i ∈ G,A denotes the indices of all the approved trading desks in the green zone or amber zone. Capital surcharge = k ⋅ max ⁡ 0 , SA G , A - IMA G , A [Basel Framework, MAR33.45] The risk-weighted assets for market risk under the IMA are determined by multiplying the capital requirements calculated as set out in this section by 12.5. [Basel Framework, MAR33.46]

9.6.5 Guidance on use of the Internal Models Approach

This section sets out application guidance for backtesting requirements and principles for risk factor modellability under the internal models approach. Trading Desk-Level Backtesting An additional consideration in specifying the appropriate risk measures and trading outcomes for profit and loss (P&L) attribution test and backtesting arises because the internally modelled risk measurement is generally based on the sensitivity of a static portfolio to instantaneous price shocks. That is, end-of-day trading positions are input into the risk measurement model, which assesses the possible change in the value of this static portfolio due to price and rate movements over the assumed holding period. [Basel Framework, MAR99.1] While this is straightforward in theory, in practice it complicates the issue of backtesting. For instance, it is often argued that neither expected shortfall nor value-at-risk measures can be compared against actual trading outcomes, since the actual outcomes will reflect changes in portfolio composition during the holding period. According to this view, the inclusion of fee income together with trading gains and losses resulting from changes in the composition of the portfolio should not be included in the definition of the trading outcome because they do not relate to the risk inherent in the static portfolio that was assumed in constructing the value-at-risk measure. [Basel Framework, MAR99.2] This argument is persuasive with regard to the use of risk measures based on price shocks calibrated to longer holding periods. That is, comparing the liquidity-adjusted time horizon 99^th percentile risk measures from the internal models capital requirement with actual liquidity-adjusted time horizon trading outcomes would probably not be a meaningful exercise. In particular, in any given multi-day period, significant changes in portfolio composition relative to the initial positions are common at major trading institutions. For this reason, the backtesting framework described here involves the use of risk measures calibrated to a one-day holding period. Other than the restrictions mentioned in this paper, the test would be based on how institutions model risk internally. [Basel Framework, MAR99.3] Given the use of one-day risk measures, it is appropriate to employ one-day trading outcomes as the benchmark to use in the backtesting programme. The same concerns about “contamination” of the trading outcomes discussed above continue to be relevant, however, even for one-day trading outcomes. That is, there is a concern that the overall one-day trading outcome is not a suitable point of comparison, because it reflects the effects of intraday trading, possibly including fee income that is booked in connection with the sale of new products. [Basel Framework, MAR99.4] On the one hand, intraday trading will tend to increase the volatility of trading outcomes and may result in cases where the overall trading outcome exceeds the risk measure. This event clearly does not imply a problem with the methods used to calculate the risk measure; rather, it is simply outside the scope of what the measure is intended to capture. On the other hand, including fee income may similarly distort the backtest, but in the other direction, since fee income often has annuity-like characteristics. Since this fee income is not typically included in the calculation of the risk measure, problems with the risk measurement model could be masked by including fee income in the definition of the trading outcome used for backtesting purposes. [Basel Framework, MAR99.5] To the extent that backtesting programmes are viewed purely as a statistical test of the integrity of the calculation of the risk measures, it is appropriate to employ a definition of daily trading outcome that allows for an uncontaminated test. To meet this standard, institutions must have the capability to perform the tests based on the hypothetical changes in portfolio value that would occur were end-of-day positions to remain unchanged. [Basel Framework, MAR99.6] Backtesting using actual daily P&Ls is also a useful exercise since it can uncover cases where the risk measures are not accurately capturing trading volatility in spite of being calculated with integrity. [Basel Framework, MAR99.7] For these reasons, OSFI requires institutions to develop the capability to perform these tests using both hypothetical and actual trading outcomes. In combination, the two approaches are likely to provide a strong understanding of the relation between calculated risk measures and trading outcomes. The total number of backtesting exceptions for the purpose of the thresholds in paragraph 324 must be calculated as the maximum of the exceptions generated under hypothetical or actual trading outcomes. [Basel Framework, MAR99.8] Institution-Wide Backtesting Statistical considerations in defining the backtesting zones To place the definitions of three zones of the institution-wide backtesting in proper perspective, however, it is useful to examine the probabilities of obtaining various numbers of exceptions under different assumptions about the accuracy of an institution’s risk measurement model. [Basel Framework, MAR99.9] Three zones have been delineated and their boundaries chosen in order to balance two types of statistical error: the possibility that an accurate risk model would be classified as inaccurate on the basis of its backtesting result, and the possibility that an inaccurate model would not be classified that way based on its backtesting result. [Basel Framework, MAR99.10] Table 21 reports the probabilities of obtaining a particular number of exceptions from a sample of 250 independent observations under several assumptions about the actual percentage of outcomes that the model captures (i.e. these are binomial probabilities). For example, the left-hand portion of Table 21 sets out probabilities associated with an accurate model (that is, a true coverage level of 99%). Under these assumptions, the column labelled “exact” reports that exactly five exceptions can be expected in 6.7% of the samples. Table 21 – Probabilities of exceptions from 250 independent observations Exception Model is accurate Model is inaccurate: possible alternative levels of coverage Coverage = 99% Coverage = 98% Coverage = 97% Coverage = 96% Coverage = 95% Exact Type 1 Exact Type 2 Exact Type 2 Exact Type 2 Exact Type 2 0 8.1% 100.0% 0.6% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 1 20.5% 91.9% 3.3% 0.6% 0.4% 0.0% 0.0% 0.0% 0.0% 0.0% 2 25.7% 71.4% 8.3% 3.9% 1.5% 0.4% 0.2% 0.0% 0.0% 0.0% 3 21.5% 45.7% 14.0% 12.2% 3.8% 1.9% 0.7% 0.2% 0.1% 0.0% 4 13.4% 24.2% 17.7% 26.2% 7.2% 5.7% 1.8% 0.9% 0.3% 0.1% 5 6.7% 10.8% 17.7% 43.9% 10.9% 12.8% 3.6% 2.7% 0.9% 0.5% 6 2.7% 4.1% 14.8% 61.6% 13.8% 23.7% 6.2% 6.3% 1.8% 1.3% 7 1.0% 1.4% 10.5% 76.4% 14.9% 37.5% 9.0% 12.5% 3.4% 3.1% 8 0.3% 0.4% 6.5% 86.9% 14.0% 52.4% 11.3% 21.5% 5.4% 6.5% 9 0.1% 0.1% 3.6% 93.4% 11.6% 66.3% 12.7% 32.8% 7.6% 11.9% 10 0.0% 0.0% 1.8% 97.0% 8.6% 77.9% 12.8% 45.5% 9.6% 19.5% 11 0.0% 0.0% 0.8% 98.7% 5.8% 86.6% 11.6% 58.3% 11.1% 29.1% 12 0.0% 0.0% 0.3% 99.5% 3.6% 92.4% 9.6% 69.9% 11.6% 40.2% 13 0.0% 0.0% 0.1% 99.8% 2.0% 96.0% 7.3% 79.5% 11.2% 51.8% 14 0.0% 0.0% 0.0% 99.9% 1.1% 98.0% 5.2% 86.9% 10.0% 62.9% 15 0.0% 0.0% 0.0% 100.0% 0.5% 99.1% 3.4% 92.1% 8.2% 72.9% This table reports both exact probabilities of obtaining a certain number of exceptions from a sample of 250 independent observations under several assumptions about the true level of coverage, as well as type 1 or type 2 error probabilities derived from these exact probabilities. The left-hand portion of the table pertains to the case where the model is accurate and its true level of coverage is 99%. Thus, the probability of any given observation being an exception is 1% (100% − 99% = 1%). The column labelled "exact" reports the probability of obtaining exactly the number of exceptions shown under this assumption in a sample of 250 independent observations. The column labelled "type 1" reports the probability that using a given number of exceptions as the cut-off for rejecting a model will imply erroneous rejection of an accurate model using a sample of 250 independent observations. For example, if the cut-off level is set at five or more exceptions, the type 1 column reports the probability of falsely rejecting an accurate model with 250 independent observations is 10.8%. The right-hand portion of the table pertains to models that are inaccurate. In particular, the table concentrates of four specific inaccurate models, namely models whose true levels of coverage are 98%, 97%, 96% and 95% respectively. For each inaccurate model, the exact column reports the probability of obtaining exactly the number of exceptions shown under this assumption in a sample of 250 independent observations. The type 2 columns report the probability that using a given number of exceptions as the cut-off for rejecting a model will imply erroneous acceptance of an inaccurate model with the assumed level of coverage using a sample of 250 independent observations. For example, if the cut-off level is set at five or more exceptions, the type 2 column for an assumed coverage level of 97% reports the probability of falsely accepting a model with only 97% coverage with 250 independent observations is 12.8%. [Basel Framework, MAR99.11] The right-hand portion of the table reports probabilities associated with several possible inaccurate models, namely models whose true levels of coverage are 98%, 97%, 96%, and 95%, respectively. Thus, the column labelled “exact” under an assumed coverage level of 97% shows that five exceptions would then be expected in 10.9% of the samples. [Basel Framework, MAR99.12] Table 21 also reports several important error probabilities. For the assumption that the model covers 99% of outcomes (the desired level of coverage), the table reports the probability that selecting a given number of exceptions as a threshold for rejecting the accuracy of the model will result in an erroneous rejection of an accurate model (type 1 error). For example, if the threshold is set as low as one exception, then accurate models will be rejected fully 91.9% of the time, because they will escape rejection only in the 8.1% of cases where they generate zero exceptions. As the threshold number of exceptions is increased, the probability of making this type of error declines. [Basel Framework, MAR99.13] Under the assumptions that the model’s true level of coverage is not 99%, the table reports the probability that selecting a given number of exceptions as a threshold for rejecting the accuracy of the model will result in an erroneous acceptance of a model with the assumed (inaccurate) level of coverage (type 2 error). For example, if the model’s actual level of coverage is 97%, and the threshold for rejection is set at seven or more exceptions, the table indicates that this model would be erroneously accepted 37.5% of the time. [Basel Framework, MAR99.14] The results in Table 21 also demonstrate some of the statistical limitations of backtesting. In particular, there is no threshold number of exceptions that yields both a low probability of erroneously rejecting an accurate model and a low probability of erroneously accepting all of the relevant inaccurate models. It is for this reason that OSFI has rejected an approach that contains only a single threshold. [Basel Framework, MAR99.15] Given these limitations, OSFI has classified outcomes for the backtesting of the institution-wide model into three categories. In the first category, the test results are consistent with an accurate model, and the possibility of erroneously accepting an inaccurate model is low (i.e. backtesting “green zone”). At the other extreme, the test results are extremely unlikely to have resulted from an accurate model, and the probability of erroneously rejecting an accurate model on this basis is remote (i.e. backtesting “red zone”). In between these two cases, however, is a zone where the backtesting results could be consistent with either accurate or inaccurate models, and OSFI will encourage an institution to present additional information about its model before taking action (i.e. backtesting ”amber zone”). [Basel Framework, MAR99.16] Table 22 sets out the OSFI’s agreed boundaries for these zones and the presumptive OSFI response for each backtesting outcome, based on a sample of 250 observations. For other sample sizes, the boundaries should be deduced by calculating the binomial probabilities associated with true coverage of 99%, as in Table 21. The backtesting amber zone begins at the point such that the probability of obtaining that number or fewer exceptions equals or exceeds 95%. Table 22 reports these cumulative probabilities for each number of exceptions. For 250 observations, it can be seen that five or fewer exceptions will be obtained 95.88% of the time when the true level of coverage is 99%. Thus, the backtesting amber zone begins at five exceptions. Similarly, the beginning of the backtesting red zone is defined as the point such that the probability of obtaining that number or fewer exceptions equals or exceeds 99.99%. Table 22 shows that for a sample of 250 observations and a true coverage level of 99%, this occurs with 10 exceptions. Table 22 – Backtesting zone boundaries Backtesting zone Number of exceptions Backtesting-dependent multiplier (to be added to any qualitative add-on per paragraph 404) Cumulative probability Green 0 1.50 8.11% Green 1 1.50 28.58% Green 2 1.50 54.32% Green 3 1.50 75.81% Green 4 1.50 89.22% Amber 5 1.70 95.88% Amber 6 1.76 98.63% Amber 7 1.83 99.60% Amber 8 1.88 99.89% Amber 9 1.92 99.97% Red 10 or more 2.00 99.99% This table defines the backtesting green, amber and red zones that OSFI will use to assess backtesting results in conjunction with the internal models approach to market risk capital requirements. The boundaries shown in the table are based on a sample of 250 observations. For other sample sizes, the amber zone begins at the point where the cumulative probability equals or exceeds 95%, and the red zone begins at the point where the cumulative probability equals or exceeds 99.99%. The cumulative probability is simply the probability of obtaining a given number or fewer exceptions in a sample of 250 observations when the true coverage level is 99%. For example, the cumulative probability shown for four exceptions is the probability of obtaining between zero and four exceptions. Note that these cumulative probabilities and the type 1 error probabilities reported in Table 21 do not sum to one because the cumulative probability for a given number of exceptions includes the possibility of obtaining exactly that number of exceptions, as does the type 1 error probability. Thus, the sum of these two probabilities exceeds one by the amount of the probability of obtaining exactly that number of exceptions. [Basel Framework, MAR99.17] The backtesting green zone needs little explanation. Since a model that truly provides 99% coverage would be quite likely to produce as many as four exceptions in a sample of 250 outcomes, there is little reason for concern raised by backtesting results that fall in this range. This is reinforced by the results in Table 21, which indicate that accepting outcomes in this range leads to only a small chance of erroneously accepting an inaccurate model. [Basel Framework, MAR99.18] The range from five to nine exceptions constitutes the backtesting amber zone. Outcomes in this range are plausible for both accurate and inaccurate models, although Table 21 suggests that they are generally more likely for inaccurate models than for accurate models. Moreover, the results in Table 21 indicate that the presumption that the model is inaccurate should grow as the number of exceptions increases in the range from five to nine. [Basel Framework, MAR99.19] Table 22 sets out the OSFI’s agreed guidelines for increases in the multiplication factor applicable to the internal models capital requirement, resulting from backtesting results in the backtesting amber zone. [Basel Framework, MAR99.20] These particular values reflect the general idea that the increase in the multiplication factor should be sufficient to return the model to a 99^th percentile standard. For example, five exceptions in a sample of 250 imply only 98% coverage. Thus, the increase in the multiplication factor should be sufficient to transform a model with 98% coverage into one with 99% coverage. Needless to say, precise calculations of this sort require additional statistical assumptions that are not likely to hold in all cases. For example, if the distribution of trading outcomes is assumed to be normal, then the ratio of the 99^th percentile to the 98^th percentile is approximately 1.14, and the increase needed in the multiplication factor is therefore approximately 1.13 for a multiplier of 1. If the actual distribution is not normal, but instead has “fat tails”, then larger increases may be required to reach the 99^th percentile standard. The concern about fat tails was also an important factor in the choice of the specific increments set out in Table 22. [Basel Framework, MAR99.21] Examples of the Application of the Principles for Risk Factor Modellability Although OSFI may use discretion regarding the types of evidence required of institutions to provide risk factor modellability, the following are examples of the types of evidence that institutions may be required to provide. Regression diagnostics for multi-factor beta models. In addition to showing that indices or other regressors are appropriate for the region, asset class and credit quality (if applicable) of an instrument, institutions must be prepared to demonstrate that the coefficients used in multi-factor models are adequate to capture both general market risk and idiosyncratic risk. If the institution assumes that the residuals from the multi-factor model are uncorrelated with each other, the institution should be prepared to demonstrate that the modellable residuals are uncorrelated. Further, the factors in the multi-factor model must be appropriate for the region and asset class of the instrument and must explain the general market risk of the instrument. This must be demonstrated through goodness-of-fit statistics (e.g. an adjusted-R² coefficient) and other diagnostics on the coefficients. Most importantly, where the estimated coefficients are not used (i.e. the parameters are judgment-based), the institution must describe how the coefficients are chosen and why they cannot be estimated, and demonstrate that the choice does not underestimate risk. In general, risk factors are not considered modellable in cases where parameters are set by judgment. Recovery of price from risk factors. The institution must periodically demonstrate and document that the risk factors used in its risk model can be fed into front office pricing models and recover the actual prices of the assets. If the recovered prices substantially deviate from the actual prices, this can indicate a problem with prices used to derive the risk factors and call into question the validity of data inputs for risk purposes. In such cases, OSFI may determine that the risk factor is non-modellable. Risk pricing is periodically reconciled with front office and back office prices. While institutions are free to use price data from external sources, these external prices should periodically be reconciled with internal prices (from both front office and back office) to ensure they do not deviate substantially, and that they are not consistently biased in any fashion. Results of these reconciliations should be made available to OSFI, including statistics on the differences of the risk price from front office and back office prices. It is standard practice for institutions to conduct reconciliation of front office and back office prices; the risk prices must be included as part of the reconciliation of the front office and whenever there is a potential for discrepancy. If the discrepancy is large, OSFI may determine that the risk factor is non-modellable. Risk factors generated from parameterised models. For options, implied volatility surfaces are often built using a parameterised model based on single-name underlyings and/or option index RPOs and/or market quotes. Liquid options at moneyness, tenor and option expiry points may be used to calibrate level, volatility, drift and correlation parameters for a single-name or benchmark volatility surface. Once these parameters are set, they are derived risk factors in their own right that must be updated and recalibrated periodically as new data arrive and trades occur. In the event that these risk factors are used to proxy for other single-name option surface points, there must be an additional-basis non-modellable risk factor overlay for any potential deviations. [Basel Framework, MAR99.22]

Footnotes

Footnote 1 Minimum capital requirements for market risk which includes previously published frequently asked questions (FAQs). Return to footnote 1 referrer Footnote 2 Following the format: [Basel Framework, XXX yy.zz]. Return to footnote 2 referrer Footnote 3 ‘Other TLAC Instruments’ are defined under CAR Chapter 2, paragraph 53. Return to footnote 3 referrer Footnote 4 The positions of less than wholly owned subsidiaries would be subject to the generally accepted accounting principles in the country where the parent company is supervised. Return to footnote 5 referrer Footnote 5 An institution will have a net short risk position for equity risk or credit risk in the banking book if the present value of the banking book increases when an equity price decreases or when a credit spread on an issuer or group of issuers of debt increases Return to footnote 5 referrer Footnote 6 Within the context of positions that remain unsold after the underwriting period. Return to footnote 6 referrer Footnote 7 Under IFRS (IAS 39) and US GAAP, these instruments would be designated as held for trading. Under IFRS 9, these instruments would be held within a trading business model. These instruments would be fair valued through the P&L account. Return to footnote 7 referrer Footnote 8 Subject to OSFI’s review, certain listed equities may be excluded from the market risk framework. Examples of equities that may be excluded include, but are not limited to, equity positions arising from deferred compensation plans, convertible debt securities, loan products with interest paid in the form of “equity kickers”, equities taken as a debt previously contracted, institution-owned life insurance products, and legislated programmes. The set of listed equities that the institution wishes to exclude from the market risk framework should be made available to, and discussed with OSFI and should be managed by a desk that is separate from desks for proprietary or short-term buy/sell instruments. Return to footnote 8 referrer Footnote 9 An embedded derivative is a component of a hybrid contract that includes a non-derivative host such as liabilities issued out of the institution’s own banking book that contain embedded derivatives. The embedded derivative associated with the issued instrument (i.e. host) should be bifurcated and separately recognised on the institution’s balance sheet for accounting purposes. Return to footnote 9 referrer Footnote 10 The presumptions for the designation of an instrument to the trading book or banking book set out in this text will be used where a designation of an instrument to the trading book or banking book is not otherwise specified in this text. Return to footnote 10 referrer Footnote 11 A change in accounting standards refers to the accounting standards themselves changing, rather than the accounting classification of an instrument changing. Return to footnote 11 referrer Footnote 12 Canadian entities include the Government of Canada, the government of a province or territory within Canada, and an agent of any of those governments whose debts are, by virtue of the agent’s governing legislation, guaranteed by the applicable government. Canadian entities also include any body corporate, trust, partnership, fund, and unincorporated association or organization formed under the laws of Canada, including under the laws of a province or territory within Canada. Return to footnote 12 referrer Footnote 13 With respect to paragraphs 262 to 267 under Chapter 4, the cap of 60% on a credit derivative without a restructuring obligation only applies with regard to recognition of credit risk mitigation of the banking book instrument for regulatory capital purposes and not with regard to the amount of the internal risk transfer. Return to footnote 13 referrer Footnote 14 Banking book instruments that are over-hedged by their respective documented internal risk transfer create a short (risk) position in the banking book. Return to footnote 14 referrer Footnote 15 FVA can be split into a funding (or cost of funds) component and an exposure component. Hedges of the cost of funds component must be included in the market risk framework. Return to footnote 15 referrer Footnote 16 The treatment for unsettled foreign exchange and securities trades is set forth in Chapter 7. Return to footnote 16 referrer Footnote 17 A two-way market is deemed to exist where there are independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid-ask quotes can be determined within one day and the transaction settled at such price within a relatively short time frame in conformity with trade custom. Return to footnote 17 referrer Footnote 18 For example, each instrument that is an option or that includes an option (e.g. an embedded option such as convertibility or rate dependent prepayment and that is subject to the capital requirements for market risk). A non-exhaustive list of example instruments with optionality includes: calls, puts, caps, floors, swaptions, barrier options and exotic options. Return to footnote 18 referrer Footnote 19 An instrument with a prepayment option is a debt instrument which grants the debtor the right to repay part of or the entire principal amount before the contractual maturity without having to compensate for any foregone interest. The debtor can exercise this option with a financial gain to obtain funding over the remaining maturity of the instrument at a lower rate in other ways in the market. Return to footnote 19 referrer Footnote 20 The assignment of risk factors to the specified tenors should be performed by linear interpolation or a method that is most consistent with the pricing functions used by the independent risk control function of an institution to report market risks or P&L to senior management. Return to footnote 20 referrer Footnote 21 Cross-currency basis are basis added to a yield curve in order to evaluate a swap for which the two legs are paid in two different currencies. They are in particular used by market participants to price cross-currency interest rate swaps paying a fixed or a floating leg in one currency, receiving a fixed or a floating leg in a second currency, and including an exchange of the notional in the two currencies at the start date and at the end date of the swap. Return to footnote 21 referrer Footnote 22 For example, an option with a forward starting cap, lasting 12 months, consists of four consecutive caplets on USD three-month Libor. There are four (independent) options, with option expiry dates in 12, 15, 18 and 21 months. These options are all on underlying USD three-month Libor; the underlying always matures three months after the option expiry date (its residual maturity being three months). Therefore, the implied volatilities for a regular forward starting cap, which would start in one year and last for 12 months should be defined along the following two dimensions: (i) the maturity of the option’s individual components (caplets) – 12, 15, 18 and 21 months; and (ii) the residual maturity of the underlying of the option – three months. Return to footnote 22 referrer Footnote 23 For example, a contract that can be delivered in five ports can be considered having the same delivery location as another contract if and only if it can be delivered in the same five ports. However, it cannot be considered having the same delivery location as another contract that can be delivered in only four (or less) of those five ports. Return to footnote 23 referrer Footnote 24 For example, for an FX forward referencing USD/JPY, the relevant risk factors for a CAD-reporting institution to consider are the exchange rates USD/CAD and JPY/CAD. If that CAD-reporting institution calculates FX risk relative to a USD base currency, it would consider separate deltas for the exchange rate JPY/USD risk and CAD/USD FX translation risk and then translate the resulting capital requirement to CAD at the USD/CAD spot exchange rate. Return to footnote 24 referrer Footnote 25 As specified in the vega risk factor definitions in paragraphs 120 to 126, the implied volatility of the option must be mapped to one or more maturity tenors. Return to footnote 25 referrer Footnote 26 Since vega ∂V ∂σ i of an instrument is multiplied by its implied volatility (σi), the vega risk sensitivity for that instrument will be the same under the log-normal assumption and the normal assumption. As a consequence, institutions may use a log-normal or normal assumption for GIRR and CSR (in recognition of the trade-offs between constrained specification and computational burden for a standardized approach). For the other risk classes, institutions must only use a log-normal assumption (in recognition that this is aligned with common practices across jurisdictions). Return to footnote 26 referrer Footnote 27 In other words, an institution can initially not apply a look-through approach, and later decide to apply it. However once applied (for a certain type of instrument referencing a particular index), the institution will require OSFI approval to revert to a “no look-through” approach. Return to footnote 27 referrer Footnote 28 As specified in the vega risk factor definitions in paragraphs 120 to 126, the implied volatility of an option must be mapped to one or more maturity tenors. Return to footnote 28 referrer Footnote 29 The delta GIRR correlation parameters (ρkl) set out in Table 2 is determined by max ⁡ e - θ ⋅ T k - T l min ⁡ T k ; T l ; 40 % , where Tk (respectively Tl) is the tenor that relates to WSk (respectively WSl); and θ is set at 3%. For example, the correlation between a sensitivity to the one-year tenor of the Eonia swap curve and the a sensitivity to the five-year tenor of the Eonia swap curve in the same currency is max ⁡ e - 3 % ⋅ 1 - 5 min ⁡ 1 ; 5 ; 40 % = 88.69 % . Return to footnote 29 referrer Footnote 30 For example, the correlation between a sensitivity to the one-year tenor of the Eonia swap curve and a sensitivity to the five-year tenor of the three-month Euribor swap curve in the same currency is (88.69%) ⋅ (0.999) = 88.60%. Return to footnote 30 referrer Footnote 31 Covered bonds must meet the definition provided in paragraphs 26, 27 and 28 in OSFI’s Guideline B-2 – Large Exposure Limits for Domestic Systemically Important Banks Return to footnote 31 referrer Footnote 32 Credit quality is not a differentiating consideration for this bucket. Return to footnote 32 referrer Footnote 33 For covered bonds that are rated AA- or higher, the applicable risk weight may at the discretion of the institution be 1.5%. Return to footnote 33 referrer Footnote 34 For example, a sensitivity to the five-year Apple bond curve and a sensitivity to the 10-year Google CDS curve would be 35% ⋅ 65% ⋅ 99.90% = 22.73%. Return to footnote 34 referrer Footnote 35 Credit quality is not a differentiating consideration for this bucket. Return to footnote 35 referrer Footnote 36 Market capitalization or economy (i.e. advanced or emerging market) is not a differentiating consideration for this bucket. Return to footnote 36 referrer Footnote 37 For example, the correlation between the sensitivity to Brent, one-year tenor, for delivery in Le Havre and the sensitivity to WTI, five-year tenor, for delivery in Oklahoma is 95% ⋅ 99.00% ⋅ 99.90% = 93.96%. Return to footnote 37 referrer Footnote 38 The risk weight for a given vega risk factor k (RWk) is determined by RW k = min ⁡ RW σ ⋅ LH risk class 10 ; 100 % , where RWσ is set at 55%; and LHrisk class is specified per risk class in Table 13. Return to footnote 38 referrer Footnote 39 Note that this paragraph refers to the scaling of gross JTD (i.e. not net JTD). Return to footnote 39 referrer Footnote 40 Basel Committee on Banking Supervision, Revisions to the securitization framework, December 2014, 2016 and 2018. Return to footnote 40 referrer Footnote 41 Investment grade refers to a rating of Baa3 or better by Moody’s; a rating of BBB- or better by S&P; and the equivalent investment grade credit rating from any additional rating agency selected by the institution. Return to footnote 41 referrer Footnote 42 Large cap refers to the shares of a company with a market capitalization higher than CAD $6.25 billion. Return to footnote 42 referrer Footnote 43 The procedure for the DRCb and DRCCTP terms accounts for the basis risk in cross index hedges, as the hedge benefit from cross-index short positions is discounted twice, first by the hedge benefit ratio HBR in DRCb, and again by the term 0.5 in the DRCCTP equation. Return to footnote 43 referrer Footnote 44 Future realised volatility is considered an exotic underlying for the purpose of the RRAO. Return to footnote 44 referrer Footnote 45 Examples of exotic underlying exposures include: longevity risk, weather, natural disasters, future realised volatility (as an underlying exposure for a swap). Return to footnote 45 referrer Footnote 46 Where the institution cannot satisfy OSFI that the RRAO provides a sufficiently prudent capital charge, OSFI will address any potentially under-capitalised risks by imposing a conservative additional capital charge under Pillar 2. Return to footnote 46 referrer Footnote 47 SAIMA refers to the standardized capital requirements across all IMA in-scope desks. SAall desks* refers to the standardized capital requirements across all desks aside from desks with paragraph 50 instruments. Return to footnote 47 referrer Footnote 48 The term “institution-wide” is defined as pertaining to the group of trading desks that the institution nominates as in-scope in their application for the IMA. Return to footnote 48 referrer Footnote 49 The convenience yield reflects the benefits from direct ownership of the physical commodity (e.g. the ability to profit from temporary market shortages). The convenience yield is affected both by market conditions and by factors such as physical storage costs. Return to footnote 49 referrer Footnote 50 A committed quote is a price from an arm’s length provider at which the provider of the quote must buy or sell the financial instrument. Return to footnote 50 referrer Footnote 51 When an institution uses data for real price observations from an external or an internal source, and those observations are provided with a time lag (e.g. data provided for a particular day is only made available a number of weeks later), the period used for the RFET may differ from the period used to calibrate the current ES model. The difference in periods used for the RFET and calibration of the ES model should not be greater than one month, i.e. an institution could use, for each risk factor, a one-year time period finishing up to one month before the RFET assessment instead of the period used to calibrate the current ES model. Return to footnote 51 referrer Footnote 52 In particular, an institution may add modellable risk factors, and replace non-modellable risk factors by a basis between these additional modellable risk factors and these non-modellable risk factors. This basis will then be considered a non-modellable risk factor. A combination between modellable and non-modellable risk factors will be a non-modellable risk factor. Return to footnote 52 referrer Footnote 53 In this case, the institution may be permitted to use real price observations from this vendor for other risk factors. Return to footnote 53 referrer Footnote 54 The requirement to use the same buckets or segmentation of risk factors for the PLA test and the RFET recognises that there is a trade-off in determining buckets for an ES model. The use of more granular buckets may facilitate a trading desk’s success in meeting the requirements of the PLA test, but additional granularity may challenge an institution’s ability to source a sufficient number of real observed prices per bucket to satisfy the RFET. Institutions should consider this trade-off when designing their ES models. Return to footnote 54 referrer Footnote 55 For options markets where alternative definitions of moneyness are standard, institutions shall convert the regulatory delta buckets to the market-standard convention using their own approved pricing models. Return to footnote 55 referrer Footnote 56 For example, if a bond with an original maturity of four years, had a real price observation on its issuance date eight months ago, institutions can opt to allocate the real price observation to the bucket associated with a maturity between 1.5 and 3.5 years instead of to the bucket associated with a maturity between 3.5 and 7.5 years to which it would normally be allocated. Return to footnote 56 referrer Footnote 57 Desks with exposure to issuer default risk must pass a two-stage approval process. First, the market risk model must pass backtesting and PLA. Conditional on approval of the market risk model, the desk may then apply for approval to model default risk. Desks that fail either test must be capitalised under the standardized approach. Return to footnote 57 referrer Footnote 58 Time effects can include various elements such as: the sensitivity to time, or theta effect (i.e. using mathematical terminology, the first-order derivative of the price relative to the time) and carry or costs of funding. Return to footnote 58 referrer Footnote 59 OSFI’s approval is required if an institution would like to remove the observation horizon related to the 2007-09 Great Financial Crisis (GFC) period. Return to footnote 59 referrer Footnote 60 USD/EUR, USD/JPY, USD/GBP, USD/AUD, USD/CAD, USD/CHF, USD/MXN, USD/CNY, USD/NZD, USD/RUB, USD/HKD, USD/SGD, USD/TRY, USD/KRW, USD/SEK, USD/ZAR, USD/INR, USD/NOK, USD/BRL, EUR/JPY, EUR/GBP, EUR/CHF and JPY/AUD. Currency pairs forming first-order crosses across these specified currency pairs are also subject to the same liquidity horizon. Return to footnote 60 referrer Footnote 61 The tests are generally done on the residuals of panel regressions where the dependent variable is the change in issuer spread while the independent variables can be either a change in a market factor or a dummy variable for sector and/or region. The assumption is that the data on the names used to estimate the model suitably proxies the names in the portfolio and the idiosyncratic residual component captures the multifactor-name basis. If the model is missing systematic explanatory factors or the data suffers from measurement error, then the residuals would exhibit heteroscedasticity (which can be tested via White, Breuche Pagan tests etc.) and/or serial correlation (which can be tested with Durbin Watson, Lagrange multiplier (LM) tests etc.) and/or cross-sectional correlation (clustering). Return to footnote 61 referrer Footnote 62 Investment grade refers to a rating of Baa3 or better by Moody’s; a rating of BBB- or better by S&P; and the equivalent investment grade credit rating from any additional rating agency selected by the institution. Return to footnote 62 Footnote 63 Large cap refers to the shares of a company with a market capitalization higher than CAD $6.25 billion. Return to footnote 63 Footnote 64 LGD should be interpreted in this context as 1 - recovery rate. Return to footnote 64 referrer

Date modified:: 2023-10-20