Interest Rate Risk Management for the Banking Book: Macro Hedging

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1 Interest Rate Risk Management for the Banking Book: Macro Hedging Giuseppe Loforese Head of ALM - Intesa Sanpaolo Chair of ALM Hedge Accounting WG EBF Co-Chairman IRRBB WG - EBF

2 AGENDA IRRBB: Macro Hedging Overview Models Representing Hedging Activity

3 OVERVIEW IRR for the banking book: regulatory framework As pointed out in Basel Committee July 2004 Chapter X, Principle 14: All material interest rate risk associated with the banking book must be assessed. To do this, internal systems must accurately incorporate all of a bank s interest rate sensitive on- and off-balance sheet holdings; internal systems must be capable of measuring risk using both an earnings and economic/sensitivity approach. In this respect, best practice should at least comprise: A. A methodology to identify the different risk components, with particular focus on those affecting the IRR (slide 11) B. A set of instruments to deal with the management of IRR: 1. Standard measures for IRR sensitivity (PV01, bucketing, etc.) & limits. Slide Models for optionalities (prepayment option & sight depos) & for Equity. Slides Standard measures for refixing and basis risk. Slide 12 3

4 OVERVIEW trading vs banking book, objective of IRR management Trading book vs Banking book: as for the management of interest rate risk, the trading book exposure is usually treated separately from the one arising from the banking book. IRR management activity relates to the pure interest rate component of the larger Net Interest Margin (NIM), which includes both credit & liquidity spreads. The main objective of IRR management of a bank with an originate and hold business model is to reduce the volatility of the pure interest margin and to produce a stable stream of pure interest income. 4

5 OVERVIEW IRR for the banking book: ALM s compromise ALM should strive for a compromise between the stream of future NIMs and current NIM: they are two sides of the very same coin. This is typically achieved via a framework of limits consistent with the size of the existing banking book. ALM adopts the trading and treasury tools to its own needs (PV01 (1), bucket sensitivity, vega, stress scenario) to: spot sources of IR risk; assess the impact of interest changes on the current & future interest margin stream. (1) Present value of 1 bp shift Future interest margins perspective - economic value/sensitivity approach: potential impact of interest rate changes on the present value of all future cash flows related to the existing banking book long-term effects of changes in interest rates Current interest margin perspective: effects of IR changes on net interest income near-term perspective, not providing indication of the impact of IR changes on the bank's overall position 5

6 OVERVIEW Repricing risk Repricing risk (also known as refinancing risk) appears whenever the duration of assets differs from the duration of liabilities. If assets' duration > liabilities' duration: Asset: fixed rate loan 10Y 5% Liability: fixed rate bond 5Y 4% GAP Interest margin fixed (5% - 4%) uncertain (5% - x) t 0 t 5 t 10 If Interest rate If interest rate, the future liability would cost more., the future liability would cost less. 6

7 OVERVIEW Repricing risk A better understanding of IRR exposure could be assessed by bucketing cash flows and theirs sensitivities. Let s assume the following banking book: Not prepayable ASSETS Fixed rate mortgages 15 /bn 20y amort. 4.00% LIABILITIES Notional Maturity Rate Notional Maturity Rate Fixed rate liabilities 15 /bn 10y bullet 3.50% Interest rate swap 10 /bn 10y bullet Rec 3.50% Pay EUR1M 7

8 OVERVIEW Repricing risk: bucket sensitivity & limits 15.0 Cash flows ( /bn) 10.0 Fixed rate liabilities 5.0 Interest rate swap (fixed y 2y 3y 4y 5y 6y 7y 8y 9y 10y 11y 12y 13y 14y 15y 16y 17y 18y Fixed 19y rate 20y mortgages Fixed rate mortgages Fixed rate liabilities Net Cash Flows Fixed rate liabilities Interest Interest rate swap rate swap (fixed (fixed leg) leg) Net Cash Flows 1y 2y 3y 4y 5y 6y 7y Shift 8y sensitivity 9y 10y 11y (PV01 12y /mln) 13y 14y 15y 16y 17y 18y 19y 20y Fixed rate mortgages Net Cash Flows Upper limit Fixed rate liabilities 5.00 Fixed rate mortgages Fixed rate liabilities Interest rate swap - - Interest rate swap Fixed rate mortgages y 1.5-3y 1.5-3y 3-5y 3-5y 5-7y 5-7y7-10y 7-10y 10-15y 10-15y 15-20y Net position Net position Lower limit y 2y 3y 4y 5y 6y 7y 8y 9y 10y 11y 12y 13y 14y 15y

9 OVERVIEW managing open portfolios As mentioned, the Banking Book is what is not managed in the Trading Book All single items belonging to a specific category (mortgages, bonds, sight depos, equity, etc.) flow undiscretionally into the banking book under management. With the exception of net equity, noninterest bearing items are excluded. The resulting portfolio is tautologically an open portfolio/a sum of open portfolios managed as a single unit by the Treasury/ALM via an open portfolio of hedging instruments EUR Mortgages Loans Bonds CPs and CDs Sight depos Net Equity Trading securities USD Mortgages Loans Bonds CPs and CDs Sight depos Equity Trading book Treasury ALM banking book under management & hedging instruments IRS OIS Swaption Cap/Floor Basis swap 9

10 OVERVIEW transfer pricing and internal deals Bank s treasury department gathers pure interest rate risk exposure stemming from the business units at the relevant benchmark rate (i.e. IRS or Euribor) via Transfer Price Process; The treasury manages its net risk position by dealing with: Investment Bank/ Trading desk Treasury ALM Market the group s investment bank and/or the internal trading desk and/or market counterparties Business Unit Business Unit Business Unit Business Unit Business Unit 10

11 OVERVIEW Segregation of risk components Basic example of IRR components segmentation Assets Overall risk exposure Liabilities Floating rate loan with 4% Fixed Rate Prepayable Mortgage Fixed Rate Bond (sub-libor: bond's rate < IRS) Subordinated Bond Liquidity + Credit spread Prep. Premium Optionality risk 1.00% Euribor 3M 1.00% 0.60% Euribor 3M 0.50% 3.00% 2.50% 3.00% Euribor 3M Cap Premium Euribor 1M Base rate Interest rate risk Interest rate risk management 0.50% 0.60% Euribor 3M 3.00% 3.00% Euribor 3M Euribor 3m Liquidity + Credit Spread All residual components: commercial margins, liquidity spread, etc. Base rate: Fixed rate equivalent to Euribor/Libor Prepayment Premium: margin component related to the cost of hedging the prepayment risk 3.00% Cap Premium: margin component related to the cost of hedging the IR cap 1.00% 1.00% -0.50% 11

12 OVERVIEW Refixing & basis risk Before the 2008 liquidity crisis, basis risk on the same currency was not an issue (i.e. Euribor 6m was quasi equivalent to Euribor 3m refinanced on forward rate for 3 months) and banks managed the refixing risk via OIS (2) : It was sufficient to wait for the fixing day and enter into an OIS to hedge this risk perfectly. As a consequence of the crisis, Euribor/Libor vs OIS rates started to diverge significantly (2) Overnight Index Swap 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% Both repricing and basis mismatch requires now different hedging mechanics. The cost of the basis is also a component to be included in the interest risk management and transfer price process. See slide % Euribor 6m OIS 6M 12

13 AGENDA IRRBB: Macro Hedging Overview Models Representing Hedging Activity 13

14 MODELS Any IRR measure is based on the various assets' and liabilities' cash flows. In some cases, these cash flows are not fully determined. In these cases, one has to use expected cash flows, i.e. a model. The three most important areas where this is true are loans with prepayment options, sight deposits, and non-financial assets and liabilities. 14

15 MODELS Prepayment Risk In many countries, debtors have a contractual or legal right to prepay all or a portion of their fixed-rate mortgage. If the prepaid loan has carried a relatively high interest rate, the bank incurs an economic loss. In many cases, the customer does not have to pay a prepayment penalty that (fully) compensates the bank for this loss. In risk management, this prepayment right is considered an option. It has to be taken into account as, on average, it will shorten the loans' cash flow profile and therefore, by implication, change the bank's IRR. Prepayment risk is necessarily modelled at an aggregate, i.e. portfolio, level. A "law of large numbers" effect usually reduces the uncertainty sorrounding the question, To what extent will any one customer actually exercise his option? 15

16 mln EUR MODELS Prepayment Risk Banks use different models to capture prepayment risk. To illustrate, we present one popular approach, called a Constant Prepayment Rate (CPR) model. Depending on the assumed CPR, the cash flow profile changes significantly: Cash flows of a 20-year amortizing loan with and without prepayments CPR 0% CPR 25% Years 16

17 MODELS Prepayment Risk One important input when calibrating such a CPR model are historical data of actual prepayment rates: Max CPR Core CPR 17

18 apr-11 apr-13 apr-15 apr-17 apr-19 apr-21 apr-23 apr-25 apr-27 apr-29 apr-31 Mln MODELS Prepayment Risk In practice, a pool of mortgages might be separated into different layers that represent different degrees of prepayment risk: EXPECTED AMORTIZATION The core CPR layer (dark grey area) reflects the portion of mortgages which are highly likely to be prepaid. The max CPR layer (light grey area) reflects the portion of mortgages which are assumed not to be prepaid CONTRACTUAL DEBT DEBT CPR 3% DEBT CPR 15% The uncertain CPR layer (red area) represents the portion of mortgages which might be prepaid and which could be hedged using options. 18

19 EUR bn MODELS Sight Deposits From a contractual view point, sight deposits have an overnight maturity. However, historical data show that, in aggregate, sight deposits are a relatively stable source of funding. Moreover, the average customer rate is rather sticky: % 6% average customer rate 1m Euribor 10y average of 10y swap 10 4% 5 2% %

20 mln EUR '000 EUR per bp MODELS Sight Deposits Thus, under an IRR perspective, a material portion of sight deposits represents not overnight money but rather a sticky-rate long-term liability. The widely used core volume models aim to incorporate this insight into ALM's risk management by adjusting the relevant cash flow profile: 35 Cash flow profile and interest rate sensitivity of portfolio of modelled vs contractual sight deposits contractual maturity: overnight core volume: rolling 10y-tranches buffer volume: overnight o/n 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y maturity bucket 0.0 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y maturity bucket 20

21 MODELS Non-Financial Assets and Liabilities The third area where modelling is used in IRR are non-financial assets and liabilities. They are often modelled as "net equity" (i.e. equity less assets such as property or equipment plus liabilities such as pension reserves). In a recent survey by PwC, 58% of the banks said they incorporated a target duration for their net equity/assets into the IRR management. The majority of them used a duration of between 1 and 5 years. financial assets financial liabilities Many banks use a so-called replication model for this purpose (i.e. they model a bottom layer of their equity as a number of staggered fixed-rate tranches which are rolled over at regular intervals). non-financial assets non-financial liabilities equity net equity/ net assets 21

22 AGENDA IRRBB: Macro Hedging Overview Models Representing Hedging Activity 22

23 Hedging IRR Let s consider the following simplified Balance Sheet: Assets Balance Sheet Liabilities Loan EUR 100mln Fixed rate 5% Funding EUR 100mln Floating rate Eur1M The Bank has an interest risk exposure of EUR 100 at 10 year. The Treasurer/ALM reduces the risk by hedging EUR 80 via derivatives 23

24 1. Hedging IRR through FVH derivatives The Bank hedges EUR 80mln of the Loan through IRS A (Pay 5% Rec Eur1M) accounted as a FVH derivative. Let s assume interest rates falling, B/S and P/L will be as follows: Assets Balance Sheet Liabilities Income Statement Loan EUR 100mln Fixed rate 5% ΔFV (Hedged portion) = +10 as interest rates have decreased Funding EUR 100mln Floating rate Eur1M IRS A (Not. EUR 80mln) Pay 5% Rec Eur1M Negative FV = -10 as interest rates have decreased Loan EUR 100mln 5 Funding EUR 100mln -100 x Eur1M IRS A fixed leg -4 IRS A floating leg 80 x Eur1M Interst income/expense 1-20 x Eur1M Hedged Loan EUR 80mln 10 IRS A -10 FV adjustments 0 24

25 2. Hedging IRR through CFH derivatives The Bank hedges EUR 80mln of the Funding through IRS B (Pay 5% Rec Eur1M) accounted as a CFH derivative. Let s assume interest rates falling, B/S and P/L will be as follows: Assets Balance Sheet Liabilities Income Statement Loan EUR 100mln Fixed rate 5% Funding EUR 100mln Floating rate Eur1M IRS B (Not. EUR 80mln) Pay 5% Rec Eur1M CFH Valutation Reserve EUR -10mln Loan EUR 100mln 5 Funding EUR 100mln -100 x Eur1M IRS B fixed leg -4 IRS B floating leg 80 x Eur1M Interst income/expense 1-20 x Eur1M Negative FV = -10 as interest rates have decreased 25

26 3. Hedging IRR a mix of FVH and CFH derivatives The Bank hedges EUR 40mln of the Loan through IRS A (Pay 5% Rec Eur1M) accounted as a CFH derivative and EUR 40mln of the Funding through IRS B (Pay 5% Rec Eur1M). Let s assume interest rates falling, B/S and P/L will be as follows: Assets Balance Sheet Liabilities Income Statement Loan EUR 100mln Fixed rate 5% ΔFV (Hedged portion) = +5 as interest rates have decreased Negative FV = -5 as interest rates have decreased Funding EUR 100mln Floating rate Eur1M IRS A (Not. EUR 40mln) Pay 5% Rec Eur1M IRS B (Not. EUR 40mln) Pay 5% Rec Eur1M CFH Valutation Reserve EUR -5mln Loan EUR 100mln 5 Funding EUR 100mln -100 x Eur1M IRS A fixed leg -2 IRS A floating leg 40 x Eur1M IRS B fixed leg -2 IRS B floating leg 40 x Eur1M Interst income/expense 1-20 x Eur1M Hedged Loan EUR 40mln 5 IRS A -5 FV adjustments 0 26

27 4. Hedging risk through derivatives under PRA The Bank hedges EUR 80mln of the Loan through IRS A (Pay 5% Rec Eur1M) under Portfolio Revaluation Approach. Let s assume interest rates falling, B/S and P/L will be as follows: Assets Balance Sheet Liabilities Income Statement Loan EUR 100mln Fixed rate 5% ΔFV (whole revaluation) = +12,5 as interest rates have decreased Negative FV = -10 as interest rates have decreased Funding EUR 100mln Floating rate Eur1M IRS A (Not. EUR 80mln) Pay 5% Rec Eur1M Loan EUR 100mln 5 Funding EUR 100mln -100 x Eur1M IRS A fixed leg -4 IRS A floating leg 80 x Eur1M Interst income/expense 1-20 x Eur1M Loan EUR 100mln 12.5 Funding EUR 100mln 0 IRS A -10 FV adjustments

28 5. Hedging risk through derivatives under PRA without whole portfolio revaluation The Bank hedges EUR 80mln of the Loan through IRS A (Pay 5% Rec Eur1M) under Portfolio Revaluation Approach without whole portfolio revaluation. Let s assume interest rates falling, B/S and P/L will be as follows: Assets Balance Sheet Liabilities Income Statement Loan EUR 100mln Fixed rate 5% Synthetic Item Funding EUR 100mln Floating rate Eur1M IRS A (Not. EUR 80mln) Pay 5% Rec Eur1M Loan EUR 100mln 5 Funding EUR 100mln -100 x Eur1M IRS A fixed leg -4 IRS A floating leg 80 x Eur1M Interst income/expense 1-20 x Eur1M Hedged Loan EUR 80mln 10 IRS A -10 FV adjustments 0 Since IRS A represents a hedge which mitigates IRR, no FV revaluation shall occur. FV valuation of IRS A is therefore offset through a synthetic item in both B/S and P/L 28

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