Regulatory requirements

The Basel Committee on Banking Supervision sets out its requirements for backtesting
in the document Supervisory framework for the use of ‘backtesting’ in conjunction
with the internal models approach to market risk capital requirements (1996b). The
key points of the requirements can be summarized as follows:
Ω Risk figures for backtesting are based on a 1-day holding period and a 99%
confidence interval.
Ω A 1-year observation period is used for counting the number of exceptions.
Ω The number of exceptions is formally tested quarterly.
The committee also urges banks to develop the ability to use synthetic P&L as well
as dirty P&L for backtesting.
The result of the backtesting exercise is a number of exceptions. This number is
used to adjust the multiplier used for calculating the bank’s capital requirement for
market risk. The multiplier is the factor by which the market risk measurement is
multiplied to arrive at a capital requirement figure. The multiplier can have a
minimum value of 3, but under unsatisfactory backtesting results can have a value
up to 4. Note that the value of the multiplier set by a bank’s local regulator may also
be increased for other reasons. Table 9.1 (Table 2 from Basel Committee on Banking
Supervision (1996b)) provides guidelines for setting the multiplier.
The numbers of exceptions are grouped into zones. A result in the green zone is
taken to indicate that the backtesting result shows no problems in the risk measurement
method. A result in the yellow zone is taken to show possible problems. The
bank is asked to provide explanations for each exception, the multiplier will probably
be increased, and risk measurement methods kept under review. A result in the red
zone is taken to mean that there are severe problems with the bank’s risk measurement
model or system. Under some circumstances, the local regulator may decide that there is an acceptable reason for an exception (e.g. a sudden increase in market
volatilities). Some exceptions may then be disregarded, as they do not indicate
problems with risk measurement.
Local regulations are based on the international regulations given in Basel Committee
on Banking Supervision (1996b) but may be more strict in some areas.