RBS 2013 Annual Report Download - page 328
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Business review Risk and balance sheet management
326
Market risk continued
Traded market risk continued
VaR validation*
In addition to the independent VaR model reviews carried out by GRA
(discussed on page 323), a dedicated model-testing team within Market
Risk works with the risk managers to:
• Test the accuracy of the valuation methods used in the VaR model
on appropriately chosen test portfolios and trades.
• Apply in-house models to perform advanced internal back-testing to
complement the regulatory back-testing.
• Ensure that tests capture the effect of using external data proxies
where these are used.
• Identify risks not adequately captured in VaR, and ensure that such
risks are addressed via the RNIV framework (see page 328).
• Identify any model weaknesses or scope limitations and their
impact.
• Identify and give early warning of any market or portfolio weakness
that may become significant.
As well as being an important market risk measurement and control tool,
the VaR model is also used to determine a significant component of the
market risk capital requirement (see page 332 for more information on
calculation of capital requirements). Therefore, it is subject to not only
ongoing internal review and validation but also regulator-prescribed back-
testing.
VaR back-testing*
The main approach employed to assess the ongoing model performance
is back-testing, which counts the number of days when a loss exceeds
the corresponding daily VaR estimate, measured at a 99% confidence
level.
There are two types of profit and loss (P&L) used in back-testing
comparisons: Clean P&L and Hypothetical (Hypo) P&L.
The Clean P&L figure for a particular business day is the firm’s actual
P&L for that day in respect of the trading activities within the scope of the
firm’s regulatory VaR model, adjusted by stripping out:
• Fees and commissions;
• Brokerage;
• Additions to, and releases from, reserves that are not directly related
to market risk; and
• Any Day 1 P&L exceeding an amount of £500,000 (per transaction).
The Hypo P&L reflects the firm’s Clean P&L excluding any intra-day
activities.
A portfolio is said to produce a back-testing exception when the Clean or
Hypo P&L exceeds the VaR level on a given day. Such an event may be
caused by a large market movement or may highlight issues such as
missing risk factors or inappropriate time series. Any such issues
identified are analysed and addressed through taking appropriate
remediation or development action. The Group monitors both Clean and
Hypo back-testing exceptions.
Regulatory back-testing is performed and reported on a daily basis for
legal entities and major business portfolios. Divisional market risk teams
also perform back-testing at the lower levels as part of the internal
ongoing VaR model validation.
The back-testing described above primarily applies to Markets and Non-
Core models, which are approved by the regulators. However, where
appropriate, back-testing is also performed for other portfolios that are
not subject to regulatory approval.
The graph below presents 1-day 99% regulatory VaR vs. Hypo P&L for RBS plc, the Group's largest legal entity by market risk RWAs and positions.