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Trading and Capital-Markets Activities Manual

Trading Activities: Capital Adequacy (Continue)
Source: Federal Reserve System 
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ASSESSING CAPITAL ADEQUACY AT LARGE, COMPLEX BANKING ORGANIZATIONS 

Supervisors should place increasing emphasis on banking organizations' internal processes for assessing risks and for ensuring that capital, liquidity, and other financial resources are adequate in relation to the organization's overall risk profiles. This emphasis is necessary in part because of the greater scope and complexity of business activities, particularly those related to ongoing financial innovation, at many banking organizations. In this setting, one of the most challenging issues bankers and supervisors face is how to integrate the assessment of an institution's capital adequacy with a comprehensive view of the risks it faces. Simple ratios- including risk-based capital ratios-and traditional ''rules of thumb'' no longer suffice in assessing the overall capital adequacy of many banking organizations, especially large institutions and others with complex risk profiles, such as those that are significantly engaged in securitizations or other complex transfers of risk. 

Consequently, supervisors and examiners should evaluate internal capital-management processes to judge whether they meaningfully tie the identification, monitoring, and evaluation of risk to the determination of an institution's capital needs. The fundamental elements of a sound internal analysis of capital adequacy include measuring all material risks, relating capital to the level of risk, stating explicit capital adequacy goals with respect to risk, and assessing conformity to an institution's stated objectives. It is particularly important that large institutions and others with complex risk pro-files be able to assess their current capital adequacy and future capital needs systematically and comprehensively, in light of their risk profiles and business plans. For more information, see SR-99-18, ''Assessing Capital Adequacy in Relation to Risk at Large Banking Organizations and Others with Complex Risk Profiles.'' 

The practices described in this subsection extend beyond those currently followed by most large banking organizations to evaluate their capital adequacy. Therefore, supervisors and examiners should not expect these institutions to immediately have in place a comprehensive internal process for assessing capital adequacy. Rather, examiners should look for efforts to initiate such a process and thereafter make steady and meaningful progress toward a comprehensive assessment of capital adequacy. Examiners should evaluate an institution's progress at each examination or inspection, considering progress relative to both the institution's former practice and its peers, and record the results of this evaluation in the examination or inspection report. 

For those banking organizations actively involved in complex securitizations, other secondary-market credit activities, or other complex transfers of risk, examiners should expect a sound internal process for capital adequacy analysis to be in place immediately as a matter of safe and sound banking. Secondary-market credit activities generally include loan syndications, loan sales and participations, credit derivatives, and asset securitizations, as well as the provision of credit enhancements and liquidity facilities to such transactions. These activities are described further in SR-97-21, ''Risk Management and Capital Adequacy of Exposures Arising from Secondary-Market Credit Activities.'' 

Examiners should evaluate whether an organization is making adequate progress in assessing its capital needs on the basis of the risks arising from its business activities, rather than focusing its internal processes primarily on compliance with regulatory standards or comparisons with the capital ratios of peer institutions. In addition to evaluating an organization's current practices, supervisors and examiners should take account of plans and schedules to enhance existing capital-assessment processes and related risk-measurement systems, with appropriate sensitivity to transition timetables and implementation costs. Evaluation of adherence to schedules should be part of the examination and inspection process. Regardless of planned enhancements, supervisors should expect current internal processes for capital adequacy assessment to be appropriate to the nature, size, and complexity of an organization's activities, and to its process for determining the allowance for credit losses. 

The results of the evaluation of internal processes for assessing capital adequacy should currently be reflected in the institution's ratings for management. Examination and inspection reports should contain a brief description of the internal processes involved in internal analysis of the adequacy of capital in relation to risk, an assessment of whether these processes are adequate for the complexity of the institution and its risk profile, and an evaluation of the institution's efforts to develop and enhance these processes. Significant deficiencies and inadequate progress in developing and maintaining capital-assessment procedures should be noted in examination and inspection reports. As noted above, examiners should expect those institutions already engaged in complex activities involving the transfer of risk, such as securitization and related activities, to have sound internal processes for analyzing capital adequacy in place immediately as a fundamental component of safe and sound operation. As these processes develop and become fully implemented, supervisors and examiners should also increasingly rely on internal assessments of capital adequacy as an integral part of an institution's capital adequacy rating. If these internal assessments suggest that capital levels appear to be insufficient to support the risks taken by the institution, examiners should note this finding in examination and inspection reports, discuss plans for correcting this insufficiency with the institution's directors and management, and initiate supervisory actions, as appropriate. 

Fundamental Elements of a Sound Internal Analysis of Capital Adequacy 

Because risk-measurement and -management issues are evolving rapidly, it is currently neither possible nor desirable for supervisors to prescribe in detail the precise contents and structure of a sound and effective internal capital-assessment process for large and complex institutions. Indeed, the attributes of sound practice will evolve over time as methodologies and capabilities change, and will depend significantly on the individual circumstances of each institution. Nevertheless, a sound process for assessing capital adequacy should include four fundamental elements: 

1. Identifying and measuring all material risks. A disciplined risk-measurement program promotes consistency and thoroughness in assessing current and prospective risk pro-files, while recognizing that risks often cannot be precisely measured. The detail and sophistication of risk measurement should be appropriate to the characteristics of an institution's activities and to the size and nature of the risks that each activity presents. At a minimum, risk-measurement systems should be sufficiently comprehensive and rigorous to capture the nature and magnitude of risks faced by the institution, while differentiating risk exposures consistently among risk categories and levels. Controls should be in place to ensure objectivity and consistency and that all material risks, both on- and off-balance-sheet, are adequately addressed. 

Banking organizations should conduct detailed analyses to support the accuracy or appropriateness of the risk-measurement techniques used. Similarly, inputs used in risk measurement should be of good quality. Those risks not easily quantified should be evaluated through more subjective, qualitative techniques or through stress testing. Changes in an institution's risk profile should be incorporated into risk measures on a timely basis, whether the changes are due to new products, increased volumes or changes in concentrations, the quality of the bank's portfolio, or the overall economic environment. Thus, measurement should not be oriented to the current treatment of these transactions under risk-based capital regulations. When measuring risks, institutions should perform comprehensive and rigorous stress tests to identify possible events or changes in markets that could have serious adverse effects in the future. Institutions should also give adequate consideration to contingent exposures arising from loan commitments, securitization programs, and other transactions or activities that may create these exposures for the bank. 

2. Relating capital to the level of risk. The amount of capital held should reflect not only the measured amount of risk, but also an adequate ''cushion'' above that amount to take account of potential uncertainties in risk measurement. A banking organization's capital should reflect the perceived level of precision in the risk measures used, the potential volatility of exposures, and the relative importance to the institution of the activities producing the risk. Capital levels should also reflect that historical correlations among exposures can rapidly change. Institutions should be able to demonstrate that their approach to relating capital to risk is conceptually sound and that outputs and results are reasonable. An institution could use sensitivity analysis of key inputs and peer analysis in assessing its approach. One credible method for assessing capital adequacy is for an institution to consider itself adequately capitalized if it meets a reasonable and objectively determined standard of financial health, tempered by sound judgment-for example, a target public-agency debt rating or even a statistically measured maximum probability of becoming insolvent over a given time horizon. In effect, this latter method is the foundation of the Basel Accord's treatment of capital requirements for market foreign exchange risk. 

3. Stating explicit capital adequacy goals with respect to risk. Institutions need to establish explicit goals for capitalization as a standard for evaluating their capital adequacy with respect to risk. These target capital levels might reflect the desired level of risk coverage or, alternatively, a desired credit rating for the institution that reflects a desired degree of creditworthiness and, thus, access to funding sources. These goals should be reviewed and approved by the board of directors. Because risk profiles and goals may differ across institutions, the chosen target levels of capital may differ significantly as well. Moreover, institutions should evaluate whether their long-run capital targets might differ from short-run goals, based on current and planned changes in risk pro-files and the recognition that accommodating new capital needs can require significant lead time. 

In addition, capital goals and the monitoring of performance against those goals should be integrated with the methodology used to identify the adequacy of the allowance for credit losses (the allowance). Although both the allowance and capital represent the ability to absorb losses, insufficiently clear distinction of their respective roles in absorbing losses can distort analysis of their adequacy. For example, an institution's internal standard of capital adequacy for credit risk could reflect the desire that capital absorb ''unexpected losses,'' that is, some level of potential losses in excess of that level already estimated as being inherent in the current portfolio and reflected in the allowance.20 In this setting, an institution that does not maintain its allowance at the high end of the range of estimated credit losses would require more capital than would otherwise be necessary to maintain its overall desired capacity to absorb potential losses. Failure to recognize this relationship could lead an institution to overestimate the strength of its capital position. 

4. Assessing conformity to the institution's stated objectives. Both the target level and composition of capital, along with the process for setting and monitoring such targets, should be reviewed and approved periodically by the institution's board of directors. 

20. In March 1999, the banking agencies and the Securities and Exchange Commission issued a joint interagency letter to financial institutions stressing that depository institutions should have prudent and conservative allowances that fall within an acceptable range of estimated losses. The Federal Reserve has issued additional guidance on credit-loss allowances to supervisors and bankers in SR-99-13, ''Recent Developments Regarding Loan-Loss Allowances.''

Risks Addressed in a Sound Internal Analysis of Capital Adequacy 

Sound internal risk-measurement and capital assessment processes should address the full range of risks faced by an institution. The four risks listed below do not represent an exhaustive list of potential issues that should be addressed. The capital regulations of the Federal Reserve and other U.S. banking agencies refer to many specific factors and other risks that institutions should consider in assessing capital adequacy. 

  Credit risk. Internal credit-risk-rating systems are vital to measuring and managing credit risk at large banking organizations. Accordingly, a large institution's internal ratings system should be adequate to support the identification and measurement of risk for its lending activities and adequately integrated into the institution's overall analysis of capital adequacy. Well-structured credit-risk-rating systems should reflect implicit, if not explicit, judgments of loss probabilities or expected loss, and should be supported where possible by quantitative analyses. Definitions of risk ratings should be sufficiently detailed and descriptive, applied consistently, and regularly reviewed for consistency throughout the institution. SR-98-25, ''Sound Credit-Risk Management and the Use of Internal Credit-Risk Ratings at Large Banking Organizations,'' discusses the need for banks to have sufficiently detailed, consistent, and accurate risk ratings for all loans, not only for criticized or problem credits. It describes an emerging sound practice of incorporating such ratings information into internal capital frameworks, recognizing that riskier assets require higher capital levels. 

Banking organizations should also take full account of credit risk arising from securitization and other secondary-market credit activities, including credit derivatives. Maintaining detailed and comprehensive credit-risk measures is most necessary at institutions that conduct asset securitization programs, due to the potential of these activities to greatly change-and reduce the transparency of-the risk profile of credit portfolios. SR-97-21, ''Risk Management and Capital Adequacy of Exposures Arising from Secondary-Market Credit Activities,'' states that such changes have the effect of distorting portfolios that were previously ''balanced'' in terms of credit risk. As used here, the term ''balanced'' refers to the overall weighted mix of risks assumed in a loan portfolio by the current regulatory risk-based capital standard. This standard, for example, effectively treats the commercial loan portfolios of all banks as having ''typical'' levels of risk. The current capital standard treats most loans alike; consequently, banks have an incentive to reduce their regulatory capital requirements by securitizing or otherwise selling lower-risk assets, while increasing the average level of remaining credit risk through devices like first-loss positions and contingent exposures. It is important, therefore, that these institutions have the ability to assess their remaining risks and hold levels of capital and allowances for credit losses. These institutions are at the frontier of financial innovation, and they should also be at the frontier of risk measurement and internal capital allocation. 

  Market risk. The current regulatory capital standard for market risk (see ''Market-Risk Measure,'' below) is based largely on a bank's own measure of value-at-risk (VAR). This approach was intended to produce a more accurate measure of risk and one that is also compatible with the management practices of banks. The market-risk standard also emphasizes the importance of stress testing as a critical complement to a mechanical VAR based calculation in evaluating the adequacy of capital to support the trading function. 

  Interest-rate risk. Interest-rate risk within the banking book (that is, in non-trading activities) should also be closely monitored. The banking agencies have emphasized that banks should carefully assess the risk to the economic value of their capital from adverse changes in interest rates. The ''Joint Policy Statement on Interest-Rate Risk,'' SR-96-13, provides guidance in this matter that includes the importance of assessing interest-rate risk to the economic value of a banking organization's capital and, in particular, sound practice in selecting appropriate interest-rate scenarios to be applied for capital adequacy purposes. 

  Operational and other risks. Many banking organizations see operational risk-often viewed as any risk not categorized as credit or market risk-as second in significance only to credit risk. This view has become more widely held in the wake of recent, highly visible breakdowns in internal controls and corporate governance by internationally active institutions. Although operational risk does not easily lend itself to quantitative measurement, it can have substantial costs to banking organizations through error, fraud, or other performance problems. The great dependence of banking organizations on information technology systems highlights only one aspect of the growing need to identify and control this operational risk. 

Examiner Review of Internal Analysis of Capital Adequacy 

Supervisors and examiners should review internal processes for capital assessment at large and complex banking organizations, as well as the adequacy of their capital and their compliance with regulatory standards, as part of the regular supervisory process. In general, this review should assess the degree to which an institution has in place, or is making progress toward implementing, a sound internal process to assess capital adequacy as described above. Examiners should briefly describe in the examination or inspection report the approach and internal processes used by an institution to assess its capital adequacy with respect to the risks it takes. Examiners should then document their evaluation of the adequacy and appropriateness of these processes for the size and complexity of the institution, along with their assessment of the quality and timing of the institution's plans to develop and enhance its processes for evaluating capital adequacy with respect to risk. In all cases, the findings of this review should be considered in determining the institution's supervisory rating for management. Over time, this review should also become an integral element of assessing and assigning a supervisory rating for capital adequacy as the institution develops appropriate processes for establishing capital targets and analyzing its capital adequacy as described above. If an institution's internal assessments suggest that capital levels appear to be insufficient to support its risk positions, examiners should note this finding in examination and inspection reports, discuss plans for correcting this insufficiency with the institution's directors and management, and, as appropriate, initiate follow-up supervisory actions. 

Supervisors and examiners should assess the degree to which internal targets and processes incorporate the full range of material risks faced by a banking organization. Examiners should also assess the adequacy of risk measures used in assessing internal capital adequacy for this purpose, and the extent to which these risk measures are also used operationally in setting limits, evaluating business-line performance, and evaluating and controlling risk more generally. Measurement systems that are in place but are not integral to an institution's risk management should be viewed with some scepticism. Supervisors and examiners should review whether an institution treats similar risks across products and/or business lines consistently, and whether changes in the institution's risk profile are fully reflected in a timely manner. Finally, supervisors and examiners should consider the results of sensitivity analyses and stress tests conducted by the institution, and how these results relate to capital plans. 

In addition to being in compliance with regulatory capital ratios, banking organizations should be able to demonstrate through internal analysis that their capital levels and composition are adequate to support the risks they face, and that these levels are properly monitored and reviewed by directors. Supervisors and examiners should review this analysis, including the target levels of capital chosen, to determine whether it is sufficiently comprehensive and relevant to the current operating environment. Supervisors and examiners should also consider the extent to which an institution has provided for unexpected events in setting its capital levels. In this connection, the analysis should cover a sufficiently wide range of external conditions and scenarios, and the sophistication of techniques and stress tests used should be commensurate with the institution's activities. Consideration of such conditions and scenarios should take appropriate account of the possibility that adverse events may have disproportionate effects on overall capital levels, such as the effect of tier 1 limitations, adverse capital-market responses, and other such magnification effects. Finally, supervisors should consider the quality of the institution's management information reporting and systems, the manner in which business risks and activities are aggregated, and management's record in responding to emerging or changing risks. 

In performing this review, supervisors and examiners should be careful to distinguish between (1) a comprehensive process that seeks to identify an institution's capital requirements on the basis of measured economic risk, and (2) one that focuses only narrowly on the calculation and use of allocated capital (also known as ''economic value added'' or EVA) for individual products or business lines for internal profitability analysis. The latter approach, which measures the amount by which operations or projects return more or less than their cost of capital, can be important to an organization in targeting activities for future growth or cutbacks. However, it requires that the organization first determine by some method the amount of capital necessary for each activity or business line. Moreover, an EVA approach often is unable to meaningfully aggregate the allocated capital across business lines and risk types as a tool for evaluating the institution's overall capital adequacy. Supervisors and examiners should therefore focus on the first process above and should not be confused with related efforts of management to measure relative returns of the firm or of individual business lines, given an amount of capital already invested or allocated. 

MARKET-RISK MEASURE 

In August 1996, the Federal Reserve amended its risk-based capital framework to incorporate a measure for market risk. (See 12 CFR 208, appendix E, for state member banks and 12 CFR 225, appendix E, for bank holding companies.) As described more fully below, certain institutions with significant exposure to market risk must measure that risk using their internal value-at-risk (VAR) measurement model and, subject to parameters contained in the market-risk rules, hold sufficient levels of capital to cover the exposure. The market-risk amendment is a supplement to the credit risk-based capital rules: An institution applying the market-risk rules remains subject to the requirements of the credit-risk rules, but must adjust its risk-based capital ratio to reflect market risk.21 

21. An institution adjusts its risk-based capital ratio by removing certain assets from its credit-risk weight categories and, instead, including those assets (and others) in the measure for market risk. 

Covered Banking Organizations 

The market-risk rules apply to any insured state member bank or bank holding company whose trading activity (on a worldwide consolidated basis) equals (1) 10 percent or more of its total assets or (2) $1 billion or more. For purposes of these criteria, a banking organization's trading activity is defined as the sum of its trading assets and trading liabilities as reported in its most recent Consolidated Report of Condition and Income (call report) for a bank or in its most recent Y-9C report for a bank holding company. Total assets means quarter-end total assets as most recently reported by the institution. When addressing this capital requirement, bank holding companies should include any section 20 subsidiary as well as any other subsidiaries consolidated in their FR Y-9 reports. 

In addition, on a case-by-case basis, the Federal Reserve may require an institution that does not meet the applicability criteria to comply with the market-risk rules if it deems it necessary for safety-and-soundness reasons, or may exclude an institution that meets the applicability criteria if its recent or current exposure is not reflected by the level of its ongoing trading activity. Institutions most likely to be exempted from this capital requirement are small banks whose reported trading activities exceed the 10 percent criterion but whose management of trading risks does not raise supervisory concerns. Such banks may be those whose trading activities focus on maintaining a market in local municipal securities, but who are not otherwise actively engaged in trading or position-taking activities. However, before making any exceptions to the criteria, Reserve Banks should consult with Board staff. An institution that does not meet the applicability criteria may, subject to supervisory approval, comply voluntarily with the market-risk rules. An institution applying the market-risk rules must have its internal-model and risk-management procedures evaluated by the Federal Reserve to ensure compliance with the rules. 

Covered Positions 

For supervisory purposes, a covered banking organization must hold capital to support its exposure to general market risk arising from fluctuations in interest rates, equity prices, foreign-exchange rates, and commodity prices, including risk associated with all derivative positions. In addition, capital must support its exposure to specific risk arising from changes in the market value of debt and equity positions in the trading account due to factors other than broad market movements, including the credit risk of an instrument's issuer. An institution's covered positions include all of its trading-account positions as well as all foreign-exchange and commodity positions, whether or not they are in the trading account. 

For market-risk capital purposes, an institution's trading account is defined in the instructions to the banking agencies' call report. In general, the trading account includes on- and off-balance-sheet positions in financial instruments acquired with the intent to resell in order to profit from short-term price or rate movements (or other price or rate variations). All positions in the trading account must be marked to market and reflected in an institution's earnings statement. Debt positions in the trading account include instruments such as fixed or floating-rate debt securities, nonconvertible preferred stock, certain convertible bonds, or derivative contracts of debt instruments. Equity positions in the trading account include instruments such as common stock, certain convertible bonds, commitments to buy or sell equities, or derivative contracts of equity instruments. An institution may include in its measure for general market risk certain non-trading account instruments that it deliberately uses to hedge trading activities. Those instruments are not subject to a specific-risk capital charge, but instead continue to be included in risk-weighted assets under the credit-risk framework. 

The market-risk capital charge applies to all of an institution's foreign-exchange and commodities positions. An institution's foreign exchange positions include, for each currency, items such as its net spot position (including ordinary assets and liabilities denominated in a foreign currency), forward positions, guarantees that are certain to be called and likely to be unrecoverable, and any other items that react primarily to changes in exchange rates. An institution may, subject to examiner approval, exclude from the market-risk measure any structural positions in foreign currencies. For this purpose, structural positions include transactions designed to hedge an institution's capital ratios against the effect of adverse exchange-rate movements on (1) subordinated debt, equity, or minority interests in consolidated subsidiaries and capital assigned to foreign branches that are denominated in foreign currencies, and (2) any positions related to unconsolidated subsidiaries and other items that are deducted from an institution's capital when calculating its capital base. An institution's commodity positions include all positions, including derivatives, that react primarily to changes in commodity prices. 

Adjustment to the Risk-Based Capital Calculation 

An institution applying the market-risk rules must measure its market risk and, on a daily basis, hold capital to maintain an overall minimum 8.0 percent ratio of total qualifying capital to risk-weighted assets adjusted for market risk. 

An institution's risk-based capital ratio denominator is its adjusted credit-risk-weighted assets plus its market-risk-equivalent assets. Adjusted risk-weighted assets are risk-weighted assets, as determined under the credit-risk-based capital standards, less the risk-weighted amounts of all covered positions other than foreign exchange positions outside the trading account and over-the-counter (OTC) derivatives. (In other words, an institution should not risk weight (or could risk weight at zero percent) any non-derivative debt, equity, or foreign-exchange positions in its trading account and any non-derivative commodity positions whether in or out of the trading account. These positions are no longer subject to a credit-risk capital charge.) An institution's market-risk-equivalent assets is its measure for market risk (determined as discussed in the following sections) multiplied by 12.5 (the reciprocal of the minimum 8.0 percent capital ratio). 

An institution's measure for market risk is a VAR-based capital charge plus an add-on capital charge for specific risk. The VAR-based capital charge is the larger of either (1) the average VAR measure for the last 60 business days, calculated under the regulatory criteria and increased by a multiplication factor ranging from three to four, or (2) the previous day's VAR calculated under the regulatory criteria, but without the multiplication factor. An institution's multiplication factor is three unless its back-testing 22 results or supervisory judgment indicate that a higher factor or other action is appropriate. 

An institution's risk-based capital ratio numerator consists of a combination of core (tier 1) capital; supplemental (tier 2) capital; and a third tier of capital (tier 3), which may only be used to meet market-risk capital requirements. To qualify as capital, instruments must be unsecured and may not contain or be covered by any covenants, terms, or restrictions that are inconsistent with safe and sound banking practices. Tier 3 capital is subordinated debt with an original maturity of at least two years. It must be fully paid up and subject to a lock-in clause that prevents the issuer from repaying the debt even at maturity if the issuer's capital ratio is, or with repayment would become, less than the minimum 8.0 percent risk-based capital ratio. 

An institution must satisfy the overall conditions that at least 50 percent of its total qualifying capital must be tier 1 capital and term subordinated debt (excluding mandatory convertible debt), and intermediate term preferred stock (and related surplus) may not exceed 50 percent of tier 1 capital. In addition, an institution's tier 3 capital must not exceed 250 percent of its tier 1 capital allocated for market risk (that is, tier 3 capital is limited to 71.4 percent of the institution's measure for market risk).23 

22. Beginning one year after an institution begins to apply the market-risk rules, it must begin ''back-testing'' its VAR measures generated for internal risk-management purposes against actual trading results to assist in evaluating the accuracy of its internal model. 
23. The market-risk rules (12 CFR 208 appendix E, section 3(b)(2)) discuss ''allocating'' capital to cover credit risk and market risk. The allocation terminology is only relevant for the limit on tier 3 capital. Otherwise, as long as the 50 percent tier 1 and tier 2/tier 3 condition is satisfied, there is no requirement that an institution must allocate or identify its capital for credit or market risk.

Internal Models 

An institution applying the market-risk rules must use its internal model to measure its daily VAR in accordance with the rule's requirements. However, institutions can and will use different assumptions and modeling techniques when determining their VAR measures for internal  risk-management purposes. These differences often reflect distinct business strategies and approaches to risk management. For example, an institution may calculate VAR using an internal model based on variance-covariance matrices, historical simulations, Monte Carlo simulations, or other statistical approaches. In all cases, however, the model must cover the institution's material risks.24 Where shortcomings exist, the use of the model for the calculation of general market risk may be allowed, subject to certain conditions designed to correct deficiencies in the model within a given timeframe. 

The market-risk rules do not specify modeling parameters for an institution's internal risk-management purposes. However, the rules do include minimum qualitative requirements for internal risk-management processes, as well as certain quantitative requirements for the parameters and assumptions for internal models used to measure market-risk exposure for regulatory capital purposes. Examiners should verify that an institution's risk-measurement model and risk-management system conform to the minimum qualitative and quantitative requirements discussed below. 

24. For institutions using an externally developed or outsourced risk-measurement model, the model may be used for risk-based capital purposes provided it complies with the requirements of the market-risk rules, management fully understands the model, the model is integrated into the institution's daily risk management, and the institution's overall risk-management process is sound.

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