FSA regulations

The Financial Services Authority (FSA) is the UK banking regulator. Its requirements
for backtesting are given in section 10 of the document Use of Internal Models to
Measure Market Risks (1998). The key points of these regulations that clarify or go
beyond the requirements of the Basel Committee are now discussed.
Ω When a bank is first seeking model recognition (i.e. approval to use its internal
market risk measurement model to set its market risk capital requirement), it
must supply 3 months of backtesting data.
Ω When an exception occurs, the bank must notify its supervisor orally by close of
business two working days after the loss is incurred.
Ω The bank must supply a written explanation of exceptions monthly.
Ω A result in the red zone may lead to an increase in the multiplication factor greater
than 1, and may lead to withdrawal of model recognition.
The FSA also explains in detail how exceptions may be allowed to be deemed
‘unrecorded’ when they do not result from deficiencies in the risk measurement
model. The main cases when this may be allowed are:
Ω Final P&L figures show that the exception did not actually occur.
Ω A sudden increase in market volatility led to exceptions that nearly all models
would fail to predict.
Ω The exception resulted from a risk that is not captured within the model, but for
which regulatory capital is already held.
Other capabilities that the bank ‘should’ rather than ‘must’ have are the ability to
analyse P&L (e.g. by option greeks), and to split down backtesting to the trading book
level. The bank should also be able to do backtesting based on hypothetical P&L
(although not necessarily on a daily basis), and should use clean P&L for its daily
backtesting.