RBI/2012-13/
DBOD.No.BP.BC.     /21.06.001/2012-13

September 17, 2012

The Chairman and Managing Director/
Chief Executive Officer
All Scheduled Commercial Banks
(Excluding RRBs and LABs)

Dear Sir,

Draft Supplementary Guidance on Treatment of Illiquid Positions

Please refer to para 8.8 in the guidelines on treatment of illiquid positions contained in our Master Circular DBOD.No.BP.BC.16/21.06.001/2010-11 dated July 2, 2012 on the New Capital Adequacy Framework. The prudent valuation adjustment for illiquid positions has assumed greater importance in the wake of the recent financial crisis. Basel Committee on Banking Supervision (BCBS) has sought to address the issue in two ways. First, the Prudent Valuation Guidance contained in the Basel II Market Risk Framework was substantially revised in July 2009 to address the deficiencies and challenges in valuation of illiquid positions observed during the crisis. These changes were duly reflected in the circular DBOD.No.BP.BC.73/21.06.001/2009-10 dated February 8, 2010 on Enhancements to Basel II Framework. Secondly, the BCBS has issued guidance on computing capital for Incremental Risk Charge in the Trading Book (IRC) under the Internal Models Approach (IMA) extending the liquidity horizon to a minimum of 3 months for measurement of capital charge for default and migration risk in the credit- related assets held in the Trading Book. This guidance reflected the inability of banks to dispose of such assets within the 10-day horizon assumed for the VaR models under Internal Models Approach for Market Risk. In addition, Credit Valuation Adjustments (CVA) to the mark-to market values of derivatives transactions to reflect the differences in credit worthiness of the counterparties and the capitalization of CVA losses have also been the focus of the measures to improve the capital adequacy framework for counterparty risk taken under Basel III.

2. Inappropriate valuation of illiquid positions raises additional supervisory concerns during stressed periods when the processes and controls surrounding the valuation practices are more likely to become weak. Therefore, it becomes necessary to ensure that the valuation practices are improved substantially during benign periods and are embedded in the risk management culture of banks. Further, Indian banks are still following the Standardised Measurement Method (SMM) for computing capital charge for market risk and even the RBI’s guidelines on Internal Models Approach (IMA) for market risk have not extended the VaR-based methodologies to specific risk. Therefore, the capitalization of unexpected losses due to illiquidity of positions as envisaged under IMA and IRC by Indian banks is likely to take some time. Many banks are going to continue to follow the Standardized Measurement Method for a long time. It is, therefore, considered very crucial for Indian banks to make concerted efforts to implement the Prudent Valuation Guidance issued by RBI to capture at least the expected losses due to illiquidity.

3. In order to ensure that a consistent methodology is adopted by banks for the purpose, a Working Group on valuation adjustments and treatment of illiquid positions was constituted by the Reserve Bank of India in June 2010 in pursuance to the announcement made in the Annual Policy Statement for the year 2010-11. Based on the recommendations of the Working Group and other relevant inputs, a draft supplementary guidance prepared in this regard is furnished in Annex to enable the banks to begin implementation thereof in a standardised manner. Banks/other interested parties may offer their comments / suggestions on the various proposals enumerated therein latest by October 19, 2012 by mail to the Chief General Manager-in-Charge, Reserve Bank of India, Department of Banking Operations and Development, Central Office, 12th floor, Central Office Building, Shahid Bhagat Singh Marg, Mumbai-400001 or through e-mail.

Yours faithfully,

(Deepak Singhal)
Chief General Manager-in-Charge

Encls: as above