Interest Rate Risk in the Banking Book

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1 Sidney Leever, Frank Pardoel, Pim Poppe. March 2016 Interest Rate Risk in the Banking Book

2 White paper: Interest Rate Risk in the Banking Book March 2016 Interest Rate Risk in the Banking Book In 2015, two documents were published that will have a significant impact on the risk management framework of banking institutions. In May 2015, the European Banking Authority (EBA) published an update to the guidelines for managing Interest Rate Risk in the Banking Book (IRRBB). These guidelines provide technical guidance on how banks should account for IRRBB in their Internal Capital Adequacy Assessment Process (ICAAP) and furthermore provide guidance on policies, risk measurement, reporting requirements, corporate planning, systems and governance. In June 2015, the Bank for International Settlements (BIS) also published a consultative document regarding IRRBB. Similarly to the EBA guidelines, this document requires banks to appropriately estimate their capital levels for IRRBB. Moreover, the document consults whether these capital estimates should be captured under Pillar I or Pillar II, provides high level principles for the management of IRRBB and addresses the interdependence between interest rate risk in trading book and the banking book. 2 Both papers combined will have a significant impact on how banks measure, monitor, hedge and manage their interest rate risk. The papers will affect the bank s organization: its governance, its risk models, its systems and its policies. In this white paper RiskQuest provides an overview of the impact on the different roles within a financial institutions focusing on European commercial banks. Main takeaways: EBA and BIS papers provide transparent guidelines for IRRBB risk management in the near future. Supervisors receive guidance to establish a transparent and uniform European supervisory framework. The degrees of freedom in the IRRBB risk management framework will decrease in the future. Convergence of IRRBB risk management will increase, providing benchmark opportunities; analysts, supervisors and rating agencies will use these benchmark opportunities. The capital markets for equity and debt will demand more disclosure in terms of IRRBB. Differing levels of complexity and size will determine each bank s level of IRRBB sophistication. Fulfilling the IRRBB guidelines will require a significant investment from a governance, policies, measurement and IT perspective. The IRRBB guidelines will require a significant combined effort between board, ALM, risk management, finance, modelling and IT. RiskQuest advises a readiness check and the set-up of a guidelines implementation program. RiskQuest has extensive knowledge both in modelling, risk governance and capital assessment; with a special attention to the field of ALM.

3 White paper series RiskQuest Introduction Regulators felt that that a renewed focus on IRRBB was necessary since in contrast to credit risk, market risk and operational risk IRRBB is not captured in Pillar I of the Basel accord. As a consequence, it was found that IRRBB practices diverge widely across banks. Moreover, as the savings and loans crisis in the 1980s has shown, IRRBB is a significant risk within the banking industry. The current exceptionally low interest rate regime is all the more reason to pay proper attention to this risk. IRRBB relates to both the asset and liability side of the balance sheet, e.g. mortgages and savings, but also to off-balance sheet exposures, e.g. mortgage offers, new business. Four sources of interest rate risk can be discerned: Repricing risk arises from timing differences between rate changes (or cash flows) from on- and off-balance sheet instruments. Yield curve risk arises from (non-parallel) changes in the shape of the curves. Option risk arises from the risk of having embedded options. Basis risk arises since different curves and indices do not move in a uniform manner. 3 Each of the risk components impact the asset and liability positions of the bank both on-balance and off-balance. Being aware of the quantitative and qualitative aspects is necessary. Therefore, per sub-risk component, an illustrative example is provided in Table 1. Repricing risk Suppose a bank finances a 20-year mortgage using short term deposits. If the deposit rate rises, the spread on the contract and profit decreases. Yield Curve Risk Flattening of the yield curve forces the shortterm rate to rise more significantly than longterm rates. A borrow short, lend long strategy becomes less profitable. (Embedded) Option risk A decrease in interest rates increases the incentive of prepaying on a (mortgage) loan. The loan is replaced by one with a lower interest rate. Thereby, future interest rate profits diminish. Basis Risk Whenever a strategy profits from the spread between the LIBOR and US T-bills and a different shock is observed, basis risk arises. Table 1: Per IRRBB risk component, one finds an illustrative example 1. 1 Note that there is not one unique interest rate curve. Various curves impact the capital and earnings of a bank depending on its positions, geographical location and type of business. Examples of interest rate curves are EURIBOR, LIBOR, AAA swap curve and BB swap curve -

4 White paper: Interest Rate Risk in the Banking Book March The EBA and BIS IRRBB documents The consultative document on IRRBB proposes twelve principles for banks as guidance for development of their risk management process, including models for asset liabilities management, internal process management, business strategy and monitoring. By publishing the principles, the supervisory authority reveals the points of attention in case the IRRBB risk management framework is under supervisory review. Some interesting considerations from the consultative paper in light of IRRBB are: Senior management should carefully formulate the risk appetite for IRRBB both from an earnings perspective and from economic value perspective. The risk should be measured, monitored and managed accordingly (earnings perspective and economic value perspective). Stress testing and scenario analysis are powerful tools for measuring and monitor IRRBB. Models used for IRRBB will heavily depend on behavioral assumptions. Therefore, behavioral assumptions should be understood, thoroughly analyzed, documented properly and supported by sufficient and high-quality data. Senior management should be informed about IRRBB levels and hedging strategies. Moreover, they are in charge of IRRBB capital allocation decisions. A consideration, which is often overlooked, is the trade-off between the short-term IR- RBB effects finding its origin in the earnings of a bank versus the long-term IRRBB effects finding its origin in the economic value, i.e. capital position. Therefore, IRRBB can also be described form the perspective of two components: economic value volatility and earning volatility. The types of trades, risk profile and balance sheet composition will determine the strategy of how to manage these IRRBB components. A take-away is that monitoring both metrics will be crucial. The decision to stabilize one or the other will differ per bank. Nevertheless the IRRBB framework needs to cover both components. Both the EBA guidelines and the BIS consultative paper, introduce the link between size and complexity of the bank and the sophistication level of the risk management framework 2. Four levels of sophistication are introduced. The more complex and larger the bank, the more sophisticated the risk management framework should be. The first instance of where the level of sophistication enters into the risk management framework is the risk measures. In Figure 1, one finds an illustration of the level of sophistication and the implications for the risk measures. 2 Similar to the distinction between standardized, foundations IRB or advanced IRB approaches defined for credit risk management.

5 White paper series RiskQuest As an example, consider the Earnings-at-Risk (EaR) risk measure where the sophistication levels differ as follows: Level 1: apply the standard shock, i.e. 200bps, to earnings on a constant balance sheet. Level 2: apply the standard shock and other yield curve shocks, on scenarios and stress tests. Level 3: apply yield curve, basis risk and option stress tests on scenarios and stress tests. Level 4: add behavioral assumptions to reforecast business volumes and earnings. A bank will determine its own level of ambition. The larger Dutch banks will probably opt for level 4. The level of sophistication will automatically provide insight in the magnitude of the risk management framework. IRRBB: Pillar I or Pillar II IRRBB is currently part of Pillar II of the Basel framework. Being part of the second pillar allows banks to differentiate and not being forced into a uniform capital calculation framework. The main reasoning behind the Pillar II classification was that IRRBB was not to be harmonized and differences in IRRBB could arise due to geographical location or type of business. The risk would have been too heterogeneous. One example is prepayment risk. In for example the Netherlands, clients are allowed to prepay an annual fixed percentage (usually 10%) without being charged a penalty and for the rest of the loan a penalty applies (with exception of relocation) 3. In other countries different terms and conditions apply and prepayment risk constitutes of walking away from the loan. Both risks are part of the IRRBB, however allow for a different approach, modelling and governance wise. Another consideration is that harmonizing the risk management framework may increase systemic risk, since all banks will use the same tools and approaches. 5 Pillar system in a nutshell The three pillar system in the Basel accords is intended to introduce standards for capital, risk management and supervision. The level of required capital depends on the risk profile and business profile of the individual banks. The first pillar addresses the regulatory capital and identifies the three major risk components, i.e. credit, market and operational risk. The second pillar relates to the ICAAP. Under this assessment, the bank should evaluate the major sources of risk from a capital perspective. Hereto stress testing and scenario analysis are helpful tools. The third pillar focuses on disclosures. The business terminology reads: minimum capital requirement for the first pillar, supervisory review for the second pillar and market discipline for the third pillar. 3 Refer to the RiskQuest white paper named ALM Risk Penalty Methodology.

6 White paper: Interest Rate Risk in the Banking Book March 2016 Figure 1: Overview of the key metrics from the banking book effected by interest rate movements. 6 On the other hand, a standardized methodology for IRRBB, i.e. capturing IRRBB under Pillar I, will introduce a larger consistency in the risk management framework. Thereby, banks will be more uniform in their IRRBB approach. At the same time, the importance of IRRBB will be highlighted. One could argue that the risk of IRRBB has a comparable magnitude as for example credit, market and operational risk. The argument of difficulty in harmonization also applies for the other Pillar I risk classes. The pillar structure immediately relates to the most important consideration of the consultative document of the BIS: treating IRRBB as an element of the first pillar or letting IRRBB be part of the second pillar. RiskQuest believes that capturing IRRBB under Pillar I emphasizes the importance of IRRBB. Nevertheless a standardized approach for IRRBB may overlook individual risk components. Therefore, IRRBB and certain bank specific or country specific elements (e.g. the Dutch prepayment option mentioned before) should also be captured under Pillar II. This way an increase in systemic risk is prevented, banks are still allowed to deal with the heterogeneous nature of IRRBB and at the same time IRRBB is given same priority as credit, market and operational risk.

7 White paper series RiskQuest Governance and organizational impact The IRRBB guidelines may also have impact on the organization or governance of risk. The impact is summarized in matrix form. The matrix in Table 2, shows on the horizontal dimension the different roles within a bank. On the vertical dimension, the matrix shows the different themes of the IRRBB risk management framework. The board s main tasks will be to approve the overall IRRBB risk management framework and define the risk appetite. Understanding the risks and the magnitude will be fundamental tasks. Given the risk management framework, e.g. limits, ALM conducts business and implements and monitors appropriate hedge strategies. Finance deals with the accounting consequences of an updated IRRBB risk management framework. The risk models itself used for risk management and hedging will be developed by modelling. As mentioned before, the behavioral assumptions and data quality will be important topics. IT plays a significant role in setting-up, maintaining and controlling the appropriate systems including infrastructure and data warehouses. As can be observed, IRRBB risk management will be a joint effort of all roles. 7

8 White paper: Interest Rate Risk in the Banking Book March 2016 Board ALM (1st line) Risk (2nd line) Finance (2nd line) Modelling (1st and 2nd line) IT (1st and 2nd line) Internal Capital Determines risk appetite for IRRBB through a risk appetite statement Understand IRRBB capital impact of business decisions Takes into account capital restrictions in its overall IRRBB strategy Reports on internal capital (internal stakeholders) Reports outlier test of standard shock (external stakeholders) Reports on internal capital (external stakeholders Reports outlier test of standard shock (external stakeholders) Development of method to translate IRRBB risk measures into internal capital requirements 8 Measurement Acting on reported limited excesses Understanding fundamentals of IRRBB measurement Understanding of the bank s overall IRRBB risk. Understanding of strengths and weaknesses in the bank s IRRBB approach Takes risks and hedge risks within approved limits Makes corporate planning assumptions (e.g. business growth) Limit monitoring Reporting on limit excesses Monitors risk metrics from both earnings perspective and economic value perspective Validates corporate planning assumptions Monitoring of impact of supervisory standard shock Accounting treatment of fair valued instruments in banking book Hedge accounting Proposes methodology for measuring IRRBB (e.g. valuation principles and risk metrics) Designs relevant and portfolio specific interest rate scenarios (incl. basis risk) Models customer behavior (e.g. savings and mortgage prepayments) Value embedded options (e.g. prepayment assumption) Recording of all transactions taking into account interest rate characteristics. Allows for aggregation and disaggregation (e.g. to transaction level Governance Approves overall IRRBB strategy Understanding of interest rate derivatives Understanding of the bank s products and client behavior Proposes IRRBB strategy on the basis of the risk appetite statement Expertise and knowledge of interest rate derivatives Expertise and knowledge of the bank s products and client behavior Proposes limits given risk appetite statement and approved strategy Expertise and knowledge of interest rate derivatives Expertise and knowledge of the bank s products and client behavior Ensures IRRBB approach is implemented in an appropriate and robust system Policies Approves policies Be aware of design and operating effectiveness of IRRBB processes and controls Sets policy for distinction between banking book and trading book Sets IRRBB policy Sets accounting policy Sets modelling policy Establishes controls around data quality Establishes controls to prevent and handle systems failure and disruptions Table 2: The IRRBB risk management framework considered per role in a bank.

9 White paper series RiskQuest Conclusion The change process of the risk management framework related to IRRBB was initiated by the recent BIS consultative paper and the updated EBA guidelines. Understanding the trade-off between economic value and earnings volatility, defining and explaining the behavioral assumptions, sufficient and high-quality data, stress testing and scenario analysis, connection between complexity of the IRRBB risk management framework and sophistication level of the bank, governance and internal control will be important elements for IRRBB in the coming years. References Basel Committee on Banking Supervision, Interest rate risk in the banking book, Consultative Document, June Basel Committee on Banking Supervision, Principles for the Management and Supervision of Interest Rate Risk, Consultative Document, June European Banking Authority, Guidelines on the management of interest rate risk arising from nontrading activities, May

10 White paper: Interest Rate Risk in the Banking Book March 2016 RiskQuest is an Amsterdam based consultancy firm specialised in risk models for the financial sector. The importance of these models in measuring risk has strongly increased, supported by external regulations such as Basel II/III and Solvency II. Advanced risk models form the basis of our service offer. These models may be employed in a frontoffice environment (acceptance, valuation & pricing) or in a mid-office context (risk management and measurement). The business areas that we cover are lending, financial markets and insurance. In relation to the models, we provide advice on: Strategic issues; Model development; Model validation; Model use. Weesperzijde 33, Amsterdam This report is prepared by RiskQuest for general guidance on matters of interest only, and is not intended to provide specific advice on any matter, nor is it intended to be comprehensive. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, RiskQuest does not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. If specific advice is required, or if you wish to receive further information on any matters referred to in this paper, please speak directly with your contact at RiskQuest or those listed in this publication. Our general conditions apply to services rendered from us, to our quotations, offers, propositions and calculations RiskQuest. All rights reserved.

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