BCBS Standard for Interest Rate Risk in the Banking Book – Objectives, Approaches and Disclosure

Meeting on IRRBB and the Revised Standardised Approach for Credit RiskSao Paulo, Brazil27-28 April 2016

Jeff MillerFSI Connect Relationship ManagerFinancial Stability InstituteThe views expressed in this presentation are those of the presenter and not necessarily those of the BIS/BCBS

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Outline

Background Overview of new IRRBB standard Disclosure

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Outline

Background Overview of new IRRBB standard Disclosure

Background – what is IRRBB?

“The current or prospective risk to a bank’s capital and earningsarising from adverse movements in interest rates that affect the

bank’s banking book positions.”

Changes in interest rates affect a bank’s: Economic value (EV) – by changing the present value

and timing of future cash flows, which changes the underlying value of assets, liabilities and off-balance sheet positions

Net interest income (NII) – by altering interest-sensitive income and expenses

Inherent to the business of banking

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IRRBB – why do we care?

High levels of exposure to the IRRBB can pose a significant threat to a bank’s capital and/or future earnings

Banking book instruments are generally intended to be held to maturity But changes in market value not necessarily reflected in

financial accounts

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Basel Committee guidance – a bit of history

1993 – consultative paper on ‘measuring banks’ exposure to interest rate risk’

1997 – principles for interest rate risk management in both banking and trading books

2004 – Principles for the management and supervision of interest rate risk Element of Basel II’s Pillar 2 / supervisory review Emphasises risk management Includes ‘possible’ supervisory measurement framework Introduced ‘outlier approach’: after standardised shock,

decline in EV > 20% of Tier 1 plus Tier 2 Broad, non-prescriptive disclosure requirements

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Current approaches to IRRBB – supervisors and banks

Majority of Basel Committee members follow Pillar 2 approach based on EV measure, some of which: Include any resulting add-on in minimum requirement Also consider earnings impact

Two Basel Committee jurisdictions follow Pillar 1 APRA has required Pillar 1 capital for IRRBB since 2008

- Applies only to banks also using IRB and AMA- EV-based, with NII offset for negative change in EV

Banks primarily use earnings-based measures

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IRRBB consultative proposal (June 2015)

Motivation included: Help ensure banks have sufficient capital sufficient to

cover potential losses from exposures to changes in interest rates

Limit incentives for capital arbitrage between (i) trading and banking books, and (ii) different accounting treatments

Recognition of need to update 2004 principles to reflect changes in market and supervisory practices

Included Pillar 1 and enhanced Pillar 2 options (with elements of Pillar 3)

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Why Pillar 1?

Promotes greater consistency, transparency and comparability – and hence, market confidence and a more level playing field

But … the usual complications from implementing a standardised approach across heterogenous markets, banks … Breadth of sub-types of IRRBB to be captured Whether, and how, to incorporate both EV and NII Extent to which IRRBB should be compatible with trading

book capital requirements Appropriateness of standardising the treatment of all on-

and off-balance sheet positions

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Proposed Pillar 1 framework – main elements

Capital requirement per standardised EV-based approach Possible earnings overlay to address EV / NII trade-offs

Some (‘constrained’) reliance on banks’ internal assessments Standardised parameters for treatment of positions ‘less

amenable’ to standardisation ‘Credible fallback’ provided for modelled inputs

Six prescribed interest rate shock scenarios, by currency Minimum requirement = scenario producing worst outcome

Updated principles for risk management, supervision (Pillar 2) Significantly enhanced public disclosure requirements (Pillar 3)

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Pillar 2 – what does ‘enhanced’ mean?

Similar to Pillar 2 for other risks, combining ICAAP and SREP

But with the addition of: Well-defined methodology for assessing capital

adequacy (~ proposed Pillar 1 methodology) Strong presumption for capital consequences for banks

with undue risk relative to capital or earnings (‘outlier approach’)

Mandatory disclosure – supervisory and public Peer review process – ensure consistent implementation

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Outline

Background Overview of new IRRBB standard Disclosure

IRRBB standard (April 2016) – essential elements

Enhanced Pillar 2 (vs Pillar 1) – more appropriate for heterogenous nature of IRRBB

Updated principles for IRRBB risk management, supervision Expanded guidance on expectations for management Elaboration on aspects of supervisory review process Enhanced risk capture of standardised framework Stronger presumption for capital consequences Enhanced outlier approach More extensive disclosure requirements

Scope: large internationally active banks, consolidated Implementation: by 2018

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Updated principles for IRRBB

Updated IRRBB principles replace those from 2004 Principles 1-7: expectations for banks’ management

(identification, measurement, monitoring, control) Principle 8: disclosure Principle 9: internal assessment of capital adequacy Principles 10-12: expectations for supervisory approach

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Principles for banks

Management of IRRRBB – specific areas updated include: Development of interest rate shock scenarios Consideration of impact on both EV and earnings Key behavioural and modelling assumptions Internal validation process for models

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Principles for supervisors – outlier approach

Supervisors can have multiple outlier tests, but must publish criteria for identifying outliers

Every supervisor must use: ∆EVE > 15% of Tier 1 capital under any of the six

prescribed scenarios Threshold in any other test to be at least as stringent

Outliers could also include bank where shocked ∆NII raises doubt about ability to continue normal business operations

Outliers must be considered to possibly have undue IRRBB and be subject to review

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Principles for supervisors – capital consequences

Where management is inadequate OR risk excessive relative to capital, earnings or general risk profile, supervisor mustrequire bank to do one or more of the following: Reduce IRRBB exposure Raise capital Introduce constraints on internal risk parameters Improve risk management

Supervisors can mandate bank to follow the standardised framework (eg if they find that the bank’s IMS does not adequately capture IRRBB)

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Standardised framework for IRRBB

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Stage 5

Stage 4

Stage 3

Stage 2

Stage 1Not amenable Amenable

Non-maturity deposits Behavioural options

Slotting of notional repricing cash flows (19 time buckets)

Compute ∆EVE per currency(6 shock scenarios)

Add-on for options

IRRBB EVE calculation(maximum of worst aggregated reductions to EVE across six prescribed interest rate shocks)

Less amenable

Interest-rate sensitive banking book positions – standardisation

Standardised framework – cash flow slotting

Approach captures all future notional repricing cash flows arising from interest rate-sensitive: Assets Liabilities Off-balance sheet items

Instruments must first be allocated to one of three categories based on their ‘amenability to standardisation’ (amenable, less amendable, not amenable)

Corresponding cash flows are then slotted into 19 pre-defined time buckets (by currency)

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Positions not amenable – NMDs

Segment non-maturity deposits into retail (transactional and non-transactional) and wholesale categories

Identify core and non-core components (subject to cap) based on observed volume changes over 10 years1. Identify stable part of each category – that portion that is highly likely to remain undrawn2. Core is the proportion of stable that is unlikely to reprice even under significant interest rate shock

Slot NMDs into appropriate time bucket (non-core treated as overnight) – cap on average maturity

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NMDs – caps

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Positions not amenable – behavioural options

Applies to fixed-rate loans subject to prepayment (eg mortgages) and term deposits subject to early redemption risk Customer’s exercise of option influenced by interest rate

Two-step approach to estimate optionality1. Baseline estimates calculated by bank (subject to supervisory approval) or prescribed by national supervisor2. Baseline estimates multiplied by prescribed scalars Scalars vary by scenario and reflect likely behavioural

change in the exercise of the options

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Standardised framework – interest rate shock scenarios

Six prescribed scenarios for EVE

Two prescribed for NII – parallel up and parallel down Standard specifies absolute shocks by currency to

accommodate different environments across jurisdictions

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1. Parallel up2. Parallel down

3. Steepener4. Flattener

5. Short up6. Short down

Calculation of standardised EVE risk measure

Loss in economic value of equity (∆EVE) is calculated for: Each of the six prescribed interest rate scenarios, and in Every currency with material exposures (>5% of banking book

assets or liabilities) Across all scenario-currency pairs:

Net notional repricing cash flow is calculated for each time bucket

All cash flows are discounted to present value and summed to determine the ‘shocked’ EVE in that pair

∆EVE in a scenario-currency pair = ‘shocked’ EVE less EVE under current interest rate term structure

EVE risk measure = maximum of worst aggregated reductions to EVE across six prescribed scenarios

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Outline

Background Overview of new IRRBB standard Disclosure

Disclosure – previous requirement (Basel II, Pillar 3)

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Disclosure – new IRRBB standard

Disclosure requirements significantly strengthened: Must disclose ∆EVE and ∆NII per prescribed scenarios Own IMS, unless instructed otherwise by national

supervisor (eg standardised framework) Prescribed format for qualitative and quantitative

disclosures Sufficient qualitative info to enable market to:

Monitor sensitivity of EV and earnings to interest rates Understand primary assumptions underlying IMS Gain insight into overall IRRBB objectives, management

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Disclosure – basis for improved comparability

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• Exclude own equity• Include all cash flows from all interest-rate sensitive

assets, liabilities and off-balance sheet items• Discount using risk-free rate or risk-free rate

including commercial margins and other spread components

• Assume run-off balance sheet (no new business)

∆EVE

• Include expected cash flows (including commercial margins) from all interest-rate sensitive assets, …

• Assume constant balance sheet (maturing or repricing cash flows are replaced by identical cash flows)

• Disclose as difference in future interest income over rolling 12-month period

∆NII

Disclosure – qualitative

Bank’s definition of IRRBB for risk control and measurement Description of IRRBB management and mitigation strategies Periodicity of calculation of IRRBB measures Description of interest rate shock scenarios used for EV and

earnings-based measures Where significant modelling assumptions for IMS are different

from those for disclosure, description and rationale High-level hedging strategies High-level description of key modelling, parametric assumptions

eg, methodology for estimating loan prepayment rates NMDs – average and longest repricing maturities

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Disclosure – quantitative

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BCBS Standard for Interest Rate Risk in the Banking Book – Objectives, Approaches and Disclosure

Meeting on IRRBB and the Revised Standardised Approach for Credit RiskSao Paulo, Brazil27-28 April 2016

Jeff MillerFSI Connect Relationship ManagerFinancial Stability InstituteThe views expressed in this presentation are those of the presenters and not necessarily those of the BIS/BCBS