Guidelines on Managing Interest Rate Risk in the Banking Book

G u i d e l i n e s o n

Managing Interest Rate Riskin the Banking Book

These guidelines were prepared by the Oesterreichische Nationalbank (OeNB)

in cooperation with the Financial Market Authority (FMA)

Publisher and editor:Oesterreichische Nationalbank (OeNB)Otto-Wagner-Platz 3, 1090 Vienna, Austria

Financial Market Authority (FMA)Praterstrae 23, 1020 Vienna, Austria

Produced by:Oesterreichische Nationalbank

Editors in chief:Gnther Thonabauer, Communications Division (OeNB)Barbara Nsslinger, Executive Board Affairs and Public Relations (FMA)

Coordinating editors:Gerhard Coosmann, Christian Doppler, Mario Plieschnig, Johannes Turner (all OeNB)Benedikt Hejda, Elisabeth Lehner, Elmar Mitterbuchner, Dagmar Urbanek, Ferdinand Wenzl (all FMA)

Translation:OeNB Language Services

Design:Peter Buchegger, Communications Division (OeNB)

Typesetting, printing and production:OeNB Printing Of ceOtto-Wagner-Platz 3, 1090 Vienna, Austria

Inquiries:Oesterreichische NationalbankCommunications DivisionPostal address: P.O. Box 61, 1011 Vienna, AustriaPhone: (+43-1) 404 20-6666Fax: (+43-1) 404 20-6698

E-Mail: [email protected]

Financial Market Authority (FMA)

Executive Board Affairs and Public RelationsPraterstrae 23, 1090 Vienna, Austria Phone: (+43-1) 249 59-5100

Orders:Oesterreichische NationalbankDocumentation Management and Communications ServicesPostal address: P.O. Box 61, 1011 Vienna, AustriaPhone: (+43-1) 404 20-2345Fax: (+43-1) 404 20-2398

E-Mail: [email protected]

Internet:www.oenb.atwww.fma.gv.at

Paper:Salzer Demeter, 100% woodpulp paper, bleached without chlorine, acid-free without optical whiteners

DVR 0031577

3The dynamic growth of nancial markets and the increased use of complex products have been fundamentally changing the conditions under which credit institutions do business. To be able to cope with these challenges, credit insti-tutions need to implement sound risk control and management systems. As a signi cant source of earnings, banks interest rate business is at the same time one of their major factors of risk, and therefore needs to be assessed reli-ably. Under the new regulatory capital requirements of Basel II, interest rate risk in the trading book continues to carry a minimum capital charge (Pillar 1 of Basel II). What is new is that interest rate risk in the banking book needs to be assessed in the review of capital adequacy (Pillar 2 of Basel II). To this effect, banks need to implement sound processes and systems to ensure that they are adequately capitalized at all times in view of all material risks. In other words, banks must correctly map and evaluate any positions that are subject to interest rate risk within the framework of integrated (bank-wide) risk management.These Guidelines on Managing Interest Rate Risk in the Banking Book are intended to provide guidance on designing the strategies and processes required for identifying, measuring, controlling and monitoring interest rate risks in the banking book. The processes described in these guidelines are provided as examples and should solely be seen as such. After all, the selection and suit-ability of individual approaches depend to a large extent on the complexity of each banks business. In accordance with the principle of proportionality, these guidelines therefore focus on the nature, scale and complexity of banking activities rather than on bank size alone.The aim of these guidelines is to develop a mutual understanding between credit institutions and banking supervisors in respect of the management of interest rate risk in the banking book. In this context, the Oesterreichische Nationalbank (OeNB) and the Financial Market Authority (FMA) consider themselves as partners of Austrias banks. We hope that these guidelines make for interesting and insightful reading.

Vienna, spring 2008

Preface

Univ. Doz. Mag. Dr. Josef ChristlMember of the Governing Board

of the Oesterreichischen Nationalbank

Dr. Kurt Pribil,Mag. Helmut Ettl

Management Board of FMA

41 Introduction 7 1.1 Motivation and Business Rationale 7 1.2 De nitions of Risk and Other De nitions 7 1.2.1 De nition of Interest Rate Risk 7 1.2.2 Earnings Perspective and Economic Value Perspective 8 1.2.3 Sources of Interest Rate Risk 8 1.2.4 Trading Book vs. Banking Book 9

2 International Regulations and Transposition into Austrian Legislation 11 2.1 Interest Rate Risks in the Banking Book from the Basel II Perspective 11 2.1.1 Pillar 2 Inclusion of Interest Rate Risks 12 2.1.2 Pillar 3 Disclosure Obligations Relating to Interest Rate Risk 12 2.1.3 Principles for Managing Interest Rate Risk The Basel Paper on Interest Rate Risk 13 2.2 EU Statutory Requirements for Transposition into Austrian Legislation 17 2.2.1 Basel II Guidelines 17 2.2.2 Further Speci cations by CEBS 18 2.3 Reporting Requirements for Interest Rate Statistics 19 2.3.1 Revised Reporting Regime 19 2.3.2 Statutory Reporting Requirements 19 2.3.3 Scope of Interest Rate Risk Reporting 20 2.3.4 Limitations of Interest Rate Risk Statistics and the Internal Model 20 2.4 Evaluation and Treatment of Interest Rate Statistics by Banking Supervisors 21 2.4.1 Re ections on Capital Adequacy 22 2.4.2 Standardized Interest Rate Shock 23 2.4.3 De nition and Treatment of Outlier Banks 23

3 Measuring and Managing Interest Rate Risk in the Banking Book 26 3.1 To Choose an Economic Value or an Earnings Perspective? 26 3.1.1 Managing Interest Rate Risk from an Earnings Perspective 27 3.1.2 Managing Interest Rate Risk from an Economic Value Perspective 27 3.1.3 Optimal Interest Rate Risk Management Strategies 28 3.2 Instruments for Quantifying Interest Rate Risks 31 3.2.1 Gap Analysis 32 3.2.2 Simulation Models 34 3.2.3 Elasticity Analysis 38

Table of Contents

4 Integrated (Dual) Management of the Interest Rate Book 41 4.1 De nition of the Risk Strategy 46 4.1.1 De nition of Benchmarks 46 4.1.2 De nition of Interest Rate Management Philosophy 47 4.1.3 Interest Rate Risk Limits 48 4.1.4 Product Innovation Process 49 4.2 Cash Flow Modeling 51 4.2.1 Retail Transactions 52 4.2.2 Proprietary Trading Activities Derivatives and Structured Products 71 4.2.3 Noninterest-Sensitive Positions with an Imputed Repricing Pro le 77 4.3 Yield/Risk Analysis 78 4.3.1 Yield Analysis 78 4.3.2 Risk Analysis 79 4.3.3 Risk-Adjusted Performance Measures 83 4.4 Putting Interest Rate Risk Management into Action 84 4.4.1 Establishing the Need for Action 84 4.4.2 Rollover (Earnings Perspective) 86 4.4.3 Inclusion of Stress Tests 87 4.5 Ex Post Analysis 92

References 93

Abbreviation Key 95

71.1 Motivation and Business RationaleOne of the key economic functions of credit institutions is to convert short-term deposits into long-term loans. Depending on the scale of this maturity transformation which essentially determines the risk arising from a banks balance sheet structure sharply uctuating market interest rates can have a considerable impact on banks earnings and on their capital base. The increas-ing complexity of markets makes effective processes for measuring and man-aging interest rate exposure an essential business requirement for credit insti-tutions. The rst challenge in this respect is to choose the right instruments from among the wide variety that is available to ef ciently manage maturity transformation in line with interest rate expectations.

The growing importance of interest rate risk in integrated risk manage-ment is also re ected in the relevant regulatory provisions. Following the latest amendment of the Austrian Banking Act, interest rate risk is now, for the rst time, explicitly cited among the due diligence obligations (under Article 39 paragraph 2b No 8 of the Austrian Banking Act).

1.2 De nitions of Risk and Other De nitions1.2.1 De nition of Interest Rate RiskInterest rate exposure is generally described as the risk of a reduction in a pro-jected or anticipated measure of net interest income (target measure) resulting from changes in market interest rates.1 Yet from a practical perspective such a de nition is somewhat awed, as the use of an anticipated (or projected) mea-sure of net interest income is fraught with risks. Any inappropriate assum ption in the projection phase will produce an inaccurate target measure and, conse-quently, result in an inaccurate assessment of interest rate risk.

In a more useful way, interest rate exposure could be de ned as the risk that the amount of net interest income obtainable at unchanged interest rates may not be attained given an adverse change in market interest rates. Con-versely, banks stand to bene t from an interest rate opportunity should favorable changes in market interest rates drive up net interest income. Using a zero line2 thus makes it possible to rate the risks and opportunities that arise from changes in market interest rates. Another key factor in the equation is the target measure to be used for evaluating the a credit institutions perfor-mance. The Basel Committee on Banking Supervision, for instance, bases its de nition on the different effects of interest rate exposure: 3

Interest rate risk is the exposure of a banks nancial condition to adverse movements in interest rates. [] Changes in interest rates affect a banks earnings by changing its net interest income and the level of other interest sensitive income and operating expenses. Changes in interest rates also affect the underlying value of the banks assets, liabilities, and off-balance-sheet (OBS) instruments because the economic value of future cash ows (and in some cases, the cash ows themselves) change when interest rates change.

1 See Schwanitz (1996), p.5. 2 Also called a baseline scenario, indicating the measure of net interest income that can be generated

in the absence of any future changes in market interest rates.3 See Basel Committee on Banking Supervision (2004b) ref. 11.

1 Introduction

1 Introduction

8

1.2.2 Earnings Perspective and Economic Value PerspectiveChanges in interest rates affect a banks earnings and its risk situation in differ-ent ways. With regard to assessing a banks interest rate exposure, the two most common perspectives are the earnings perspective and the economic value perspective:

The earnings perspective focuses on the impact interest rate changes have on a banks near-term earnings. After all, changes in the yield curve have a direct impact on a banks future net interest income (including the estimated net income from asset securitization programs). Even noninter-est income components, particularly fee-based income, can indirectly depend on the future development of interest rates. Hence, interest rate risk analysis from an earnings perspective will focus on assessing the earn-ings effects that may arise from changes in market interest rates. The economic value perspective focuses on the impact interest rate changes may have on the economic value of future cash ows and thus on the economic value of both the interest rate book and capital. The present economic value is affected in two ways by changes in interest rates: by the change in future interest cash ows included in the calculation (= primary economic value perspective) and by the change in the discount rates of all future cash ows used for this calculation (= secondary economic value perspective).

1.2.3 Sources of Interest Rate Risk

As the Basel Committee on Banking Supervision has pointed out, it has become increasingly important to look beyond the traditional earnings and economic value effects and assess indirect interest rate effects as well. Taking a broader view of the potential earnings impact of changing interest rates, banks also need to take into consideration the growing share of (interest-sensitive) fee-based nancial services (loan servicing, asset securitization programs, pay-ments etc.). Further indirect effects stem from in the evolution of the balance sheet (structural effects) and from the downgrading of borrowers (credit rating effect). As a case in point, portfolio shifts from savings deposits to short-term xed deposits (structural effects), coupled with an inverse yield curve, resulted in a massive adverse effect on earnings in the early 1990s.

With a view to capturing interest rate risk appropriately, the Basel Com-mittee on Banking Supervision breaks down interest rate risk into four main types:4

repricing risk, which arises from mismatches in interest rate xation periods, yield curve risk, which is caused by changes in the slope and shape of the yield curve,basis risk, which arises from an imperfect correlation in the adjustment of the rates earned and paid on different products with otherwise similar repricing characteristics, and

4 See Basel Committee on Banking Supervision (2004b), ref. 13ff

1 Introduction

9

optionality risk, which arises primarily from options (gamma and vega effect) that are embedded in many banking book positions (e.g. early redemption rights in the case of loans).

1.2.4 Trading Book vs. Banking Book

To calculate the minimum regulatory capital requirements, banks must differ-entiate between interest rate risks in the trading book and interest rate risks in the banking book.

Under Article 22n paragraph 1 of the Austrian Banking Act, all positions in nancial instruments and commodities held for trading purposes are to be assigned to the trading book. Likewise, nancial instruments and commodi-ties used to hedge or re nance speci c risks in the trading book are also to be assigned to the trading book. To cover the market risks arising from the trading book, credit institutions must retain a minimum amount of capital, as was already laid down in the Basel paper on market risk entitled Amendment to the Capital Accord to Incorporate Market Risks of 1996.5 In the new regula-tory capital framework (Basel II), the requirement to adequately recognize interest rate risks in the trading book is now covered by Pillar 1.

The minimum capital requirements for different risk types in the trading book are determined either in accordance with the stipulated standardized approaches6 or with the credit institutions own risk model (VaR model)7 as approved by its banking supervisor. Credit institutions that do not exceed the thresholds foreseen by Article 22q of the Austrian Banking Act may calculate their minimum capital requirements for the corresponding risk types in the trading book in a simpli ed manner pursuant to Article 22 paragraph 1 No 1 of the Austrian Banking Act (8 % of risk-weighted assets).

The interest rate risk of all activities other than those identi ed in the trad-ing book8 i.e. interest rate risks in the banking book should be considered

5 A revised version was published in 1998.6 See Article 22o of the Austrian Banking Act and 195ff of the Solvency Regulation.7 See Article 22p of the Austrian Banking Act and 224ff of the Solvency Regulation.8 See Article 39 paragraph 2b of the Austrian Banking Act.

Chart 1

Source: OeNB.

interest rate risk in the trading book

PILLAR 1minimum regulatory capital requirements standardized approach,

Article 22o of the Austrian Banking Act internal VaR model,

Article 22p of the Austrian Banking Act

Article 22n paragraph1 of the Austrian Banking Act

PILLAR 2integrated risk management (ICAAP) Articles 39b paragraph 2b Nos 3 and 8

of the Austrian Banking Act Article 39a of the Austrian Banking Act

Recognition of Interest Rate Risk in the Trading and Banking Books

interest rate risk in the banking book

1 Introduction

10

under Pillar 2. Although current regulations do not stipulate standardized capital charges for interest rate risks in the banking book, Article 39a of the Austrian Banking Act compels credit institutions to include them in their internal capital adequacy assessment process (ICAAP) for assessing capital adequacy in relation to their risk pro le.

These guidelines focus on interest rate risks derived from transactions in the banking book. For guidance on interest rate risks in the trading book, please see the Guidelines on market risk9 published earlier by the OeNB.

9 See OeNB (2003).

11

2.1 Interest Rate Risks in the Banking Book from the Basel II Perspective

The Basel Committee on Banking Supervision, after an extensive consultation process, redrafted its recommendations for credit institutions regulatory capital requirements (Basel I) issued in 1988. The revision was motivated by the wish to adequately re ect current developments in banking and to strengthen the stability of the international nancial system. On Novem -ber 15, 2005, the Basel Committee on Banking Supervision presented the revised version of the Basel II Capital Accords framework agreement, ini-tially released under the title International Convergence of Capital Measure-ment and Capital Requirements on June 26, 2004. The major difference between this document and the Basel I framework, which merely imposed minimum capital requirements on credit institutions, is that Basel II forsees also a supervisory reviewing process (Pillar 2) and broader disclosure obliga-tions (Pillar 3).

The Basel Committee had originally planned to consider interest rate risks from the banking book under Pillar 1. However, given considerable differ-ences between banks in terms of both the nature of their underlying interest rate risk exposure and their monitoring and controlling processes, interest rate risks were eventually assigned to Pillar 2.10

10 See Basel Committee on Banking Supervision (2004a), ref. 762.

2 International Regulations and Trans position into Austrian Legislation

Chart 2

Source: OeNB.

PILLAR 1

minimum capital requirements

Three-Pillar Architecture of Basel II

capital requirement for:

credit risk standardized approach foundation IRB approach advanced IRB approach

market risk standardized approach internal VaR model

operational risk basic indicator approach (alternative) standardized approach

advanced management approaches (AMA)

PILLAR 2

supervisory review process

requirements for banks (ICAAP) capital control including risk management

recognition of interest riskin the banking book

requirements for banking supervisors(SREP) evaluation of banks internal systems assessment of risk profile monitoring compliance with

all requirements supervisory measures

PILLAR 3market disciplinecontrol by the market

disclosure obligations of banks

transparency for market participantsin respect of a banks risk situation(scope of application, risk management,comprehensive regulatory capital data)

enhanced comparability ofcredit institutions

Stability of the Financial System

Disclosure obligations forinterest rate risk in the banking book

2 International Regulations

and Transposition into Austrian Legislation

12

2.1.1 Pillar 2 Inclusion of Interest Rate RisksThe rst component of Pillar 2 is the internal capital adequacy assessment pro-cess (ICAAP). According to Article 39a paragraph 1 of the Austrian Banking Act, credit institutions must have effective systems and processes in place to determine the amount, composition and distribution of internal capital on an ongoing basis and to hold capital commensurate with the required level. The second component of Pillar 2 is the supervisory review and evaluation process (SREP). The purpose of SREP is to evaluate banks risk pro le, to assess qualitative aspects (management, strategy, internal processes), and to impose supervisory measures if necessary.

Basically, any risks that are not taken into account, or considered but not fully captured under Pillar 1 (minimum capital requirements), are treated under Pillar 2.

Article 39 paragraph 2b of the Austrian Banking Act includes a set of exam-ples comprising the most important and frequent risks of banking transactions and operations including the interest rate risk arising from any transaction not covered yet by trading book risk types.

2.1.2 Pillar 3 Disclosure Obligations Relating to Interest Rate Risk

In addition to rede ning the calculation of capital requirements and establish-ing a supervisory review process under Pillars 1 and 2, Basel II imposes new and enhanced disclosure obligations on credit institutions under its third pillar. The purpose of Pillar 3 is to ensure greater transparency in terms of banks activities and risk strategies, as well as to enhance comparability across credit institutions which is all in the interests of market participants. At the same time, the provisions of Pillar 3 do not entail additional capital requirements but are limited to mandating the publication of key data, the disclosure of which neither weakens banks competitive positions nor violates banking secrecy.11

The range of data credit institutions in Austria are obliged to disclose in respect of their interest rate risk in the banking book is described in Article 14 of a corresponding Disclosure Regulation announced on October 9, 2006, in the Federal Law Gazette.12 According to this regulation, credit institutions must disclose the type of interest rate risks they are exposed to, the frequency with which they measure these risks, and the key assumptions they use for that purpose (including their assumptions relating to early loan repayment and investor behavior in respect of deposits with no xed maturity). Moreover, banks have to disclose changes in earnings, economic value or other target measures they use to measure interest rate risk. These data are to be published currency by currency.

11 See Article 26 paragraphs 5 and 6 of the Austrian Banking Act.12 Federal Law Gazette II No. 375/2006.



13

Within banking groups it is, as a rule, the responsibility of the highest con-solidation level to disclose all details that are relevant under Pillar 3.13 Unless speci ed otherwise, the minimum disclosure frequency is once a year.14 While it is up to each bank to decide what disclosure medium to use, all data must be published through the same channel, which must also be accessible to the public (e.g. the credit institutions annual report, website etc.). To avoid a duplication of efforts, credit institutions publishing the relevant data in conformity with accounting and stock exchange standards as well as with other regulations are deemed to have satis ed the requirements under Pillar 3.

2.1.3 Principles for Managing Interest Rate Risk The Basel Paper on Interest Rate Risk

The paper entitled International Convergence of Capital Measurement and Capital Requirements15 published by the Basel Committee on Banking Super-vision provides only general information on interest rate risk in the banking book. More speci c information is contained in an additional paper entitled Principles for the Management and Supervision of Interest Rate Risk (July 2004).16 This paper lists 15 principles that represent minimum requirements for the management of interest rate risk by credit institutions17 and that de ne the supervisory treatment of interest rate risk in the banking book. This paper is a revised and expanded version of the Principles for the Management of Interest Rate Risk published in September 1997. The revision primarily concerns Principle 12 (capital adequacy), Principle 13 (disclosure obligations relating to interest rate risk), Principles 14 and 15 (regulatory aspects) as well as Annexes 3 (standardized interest rate shock) and 4 (example of a master agreement).

Figure 3 presents an overview of the qualitative principles speci ed by the Basel paper on interest rate risk published in 2004. The following section brie y describes the individual principles and indicates the corresponding passages in the Austrian Banking Act through which they have been trans-posed into Austrian legislation.

13 There is an exception in respect of signi cant subsidiaries (Article 26a paragraph 4 Austrian Banking Act), which must disclose their capital structure (Article 4 Disclosure Regulation) and minimum capital requirements (Article 5 Disclosure Regulation). Credit institutions are classi ed as being signi cant subsidiaries by the FMA by way of an administrative ruling, subject to the criteria stipu-lated in Article 26a paragraph 5 of the Austrian Banking Act.

14 See Article 26 paragraph 3 of the Austrian Banking Act.15 Basel Committee on Banking Supervision (2004a), ref. 762764.16 The related consultation paper was published in January 2001. See Basel Committee on Banking

Supervision (2001).17 These principles concerning the minimum requirements for the management of credit institutions

interest rate risk apply to all risk positions (trading portfolio and other banking business).



14

2.1.3.1. Management Responsibility

The Basel paper on interest rate risk divides the responsibilities for interest rate risk management and oversight among the supreme management body and senior management. In the context of Austrian corporate law, the senior management would be the directors of a credit institution authorized to manage and legally represent it under Article 2 No 1 of the Austrian Banking Act. The supreme management body of Austrian corporations would be the supervisory board, whose core function is to oversee the directors in order to ensure that the latter are ful lling their responsibilities.

In Austrian companies, senior management is responsible for designing risk policy and for determining the principles and strategies for managing interest rate risk, as well as for ensuring that the necessary risk monitoring and control measures are in place.18 As a rule the policies or any adjustments thereof require supervisory board approval.19 Finally, reporting lines and obli-gations must be de ned accordingly to ensure adequate assessment of the credit institutions risk sensitivity as well as effective and ef cient monitoring and control of the existing risks.

Effective interest rate risk monitoring requires appropriate framework conditions in line with the nature, scale and complexity of a credit institutions banking activities. In this instance, the principle of proportionality is a major

18 For de nitions of the responsibility of senior managers/directors is inferable from Article 39 of the Austrian Banking Act on the basis of the current law applicable.

19 See Article 95 paragraph 5 no 8 of the Stock Corporation Act or Article 30j paragraph 5 no 8 of the Act on Limited Liability Companies.

Chart 3

Source: OeNB.

Qualitative Principles of Interest Rate Risk Outlined by the Basel Paper on Interest Rate Risk

guidelines forbanking supervisors14. Basel standardized market risk

scenarios15. sanction mechanisms

Qualitative Principlesof the Basel Paper

on Interest Rate Risk

management responsibility1. supreme management body2. senior management3. functional independence of units

risk strategy requirements1. principles/processes2. product innovation

integrated risk managementprocess, internal controls6. measurement, methodology2. risk limitation3. stress testing4. monitoring5. internal audit

11. information for banking supervisors

12. capital adequacy

1. disclosure



15

yardstick. Banks primarily undertaking low risk transactions can apply simpler methodologies than banks with complex transactions or a high business volume.

Responsibilities must be clearly assigned to individual persons and/or com-mittees. In addition, the relevant units must be functionally independent to avoid potential con icts of interests.20 Senior management should ensure that adequate interest rate risk management is in place for measuring, monitoring and controlling interest rate risks, and that all the relevant business units of the bank have been taken on board. Employees entrusted with interest rate risk management duties need to be aware of all types of interest rate risks across the bank, and they need to possess the necessary degree of indepen-dence vis--vis individuals who undertake risk positions.

Senior management is responsible, above all, for the existence of appropri-ate risk limits and of sound risk measurement and assessment systems and standards, as well as for the implementation of comprehensive processes for reporting interest rate risks, reviewing risk management and conducting effec-tive internal controls. Staff members, in turn, need to be suf ciently skilled and experienced to be able to cope with the nature, scale and complexity of banking activities.

2.1.3.2. Risk Strategy Requirements

As laid down by the Basel Committee on Banking Supervision, a key require-ment for the proper management of a banks interest rate risk is the de nition of the relevant principles and processes based on proportionality. More speci cally, it is important to clearly de ne responsibilities and accountability in taking risk management decisions as well as what kind of instruments are eligible. The purposes or goals for which eligible instruments may be used need to be speci ed as well. Qualitative points of this nature should be supple-mented with quantitative parameters determining the amount of interest rate risk acceptable to the credit institution. As a rule, principles should be reviewed periodically and adjusted where necessary.

In addition, sound processes and controls helping to identify interest rate exposures and incorporate them into risk management need to be in place to adequately cover product innovations and new activities. Credit institutions need to be aware of all risk characteristics when implementing new products.

In respect of the risk inherent in new transactions with which the bank has no experience yet, Article 39 paragraph 2c of the Austrian Banking Act speci- es that due consideration must be given to the safety of customers deposits and to the preservation of the banks own capital. For further details on the process relating to the introduction of new products, please see subsection 4.1.4, Product Innovation Process.

2.1.3.3. Requirements for Measuring, Monitoring and Managing Interest Rate Risk and for Internal Controls

Credit institutions should have measurement systems in place that capture all material interest rate risk positions and related sources of risk (e.g. repricing

20 See Article 39 paragraph 2 of the Austrian Banking Act.



16

risks, yield curve risks, basis risks and optionality risks) and that include all key maturity and repricing data. The effects on credit institutions earnings and economic value from potential changes in interest rates should be quanti- ed. The quality of data and model assumptions, on which the quality and reliability of credit institutions interest rate risk measurement system depend, are of particular importance. Employees entrusted with interest rate risk management duties need to be familiar with and understand the assumptions and parameters underlying the interest rate risk management system, and they need to review them at least on an annual basis.21 The assumptions should also be documented in a manner transparent to third parties.

To limit risks, credit institutions must establish and implement adequate limits in line with their business policy. The aim is to maintain interest rate risk within speci ed limits over a range of possible changes in interest rates. In addition to applying a ceiling to aggregate interest rate risk, limits are useful for individual portfolios, business units, instruments or departments. Subsec-tion 4.1.3, Interest Rate Risk Limits examines in greater depth the various types of limits as well as the structure of the limit system in asset-liability management.

Banks need to be able to make a sound judgment about the impact that adverse market conditions may have on their business. Appropriate stress tests simulating a range of developments should indicate which scenarios may generate extraordinary losses.22

Furthermore, it is essential to check if the underlying assumptions and model parameters remain valid under stress situations. The results of such stress simulations should be taken into account when the principles and limits for interest rate risk are determined and reviewed, and appropriate emergency plans should be in place.

Credit institutions should also have in place an adequate system of internal controls over their interest rate risk management process. For instance, credit institutions must ensure that competent employees are aware of and actually apply the de ned principles and processes, and that the de ned processes accomplish the intended objectives.

Article 39 paragraph 2 of the Austrian Banking Act speci es that the appro-priateness of the processes and their application should be reviewed by the banks internal audit unit at least once a year. The duties of the internal audit unit are speci ed in Article 42 of the Austrian Banking Act. These internal reviews should ensure that credit institutions interest rate risk measurement system is accurate enough to capture all the material components of interest rate risk and that any required amendments or improvements are made.

2.1.3.4. Capital Adequacy and Information for Banking Supervisors

Under Pillar 2, all banks must apply the internal capital adequacy assessment process (ICAAP) to ensure that the interest rate risk undertaken is commen-surate with the capital allocated.23 In Principle 12, the Basel Committee on

21 See Article 39a paragraph 2 Austrian Banking Act.22 See OeNB (1999), and subsection 4.4.3, Inclusion of Stress Testing.23 See subsection 2.1.1, Pillar 2 Inclusion of Interest Rate Risks.



17

Banking Supervision speci es that credit institutions undertaking signi cant interest rate risk in the banking book should also allocate a substantial amount of capital to support this risk.

Banking supervisors require timely data to undertake the review and evaluation processes considered under Pillar 2. In Austria, the relevant data are compiled through standardized supervisory reporting24 channels as well as through on-site examinations. In Principle 11, the Basel Committee on Bank-ing Supervision explains that banking supervisors should have enough infor-mation to identify and monitor banks that have repricing mismatches.

2.1.3.5. Disclosure

In Principle 13, the Basel Committee on Banking Supervision stipulates general disclosure requirements for the level of interest rate risk and the policies established for managing those risks. For further details on those policies in Austria, please see subsection 2.1.2, Pillar 3 Disclosure Obligations Relating to Interest Rate Risk.

2.1.3.6. Guidelines for Banking Supervisors

The Basel Committee on Banking Supervision requires banking supervisors to assess the soundness of credit institutions internal systems for measuring interest rate risk in the banking book and to check their risk-bearing capacity in relation to interest rate risks. Again, what is considered sound depends on the nature, scale and complexity of a banks business.25

Banking supervisors may set various measures should they conclude that the level of interest rate risk in the banking book is not commensurate with the capital available, or that the processes used are not suitable for the nature and volume of the exposures.26

2.2 EU Statutory Requirements for Transposition into Austrian Legislation

2.2.1 Basel II GuidelinesAt the European level, the recommendations of the Basel II Accord were trans-posed into EU legislation as Directives 2006/48/EC27 and 2006/49/EC28 and published in the Of cial Bulletin of the European Union on June 30, 2006. At the national level, these directives serve as a basis for transposition into national legislation and are applicable in Member States from January 1, 2007.

In respect of interest rate risk in the banking book, the following points of Directive 2006/48/EC (Capital Requirements Directive) are relevant, in particular:

Article 22 of the Capital Requirements Directive prescribes sound corpo-rate governance with clear organizational structures and lines of responsi-

24 See section 2.3, Supervisory Reporting on Interest Rate Risk.25 See notes on Article 39a paragraph 1 of the Austrian Banking Act (1558 d.B. XXII. GP).26 See subsection 2.4.3, De nition and Treatment of Outlier Banks. 27 Directive relating to the taking up and pursuit of the business of credit institutions (new version)

[previously: Directive 2000/12/EC]. 28 Directive on the capital adequacy of investment rms and credit institutions (new version) [previ-

ously: Directive 93/6/EEC].



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bility. Annex V, No 10 de nes the technical criteria relating to the organi-zation and treatment of interest rate risks in the banking book.Article 123 of the Capital Requirements Directive de nes the requirement for credit institutions to have in place comprehensive strategies and pro-cesses for ensuring on an ongoing basis the assessment of the amount, com-position and distribution of internal capital that they consider adequate to cover the nature and level of the risks to which they are exposed or might be exposed. With regard to the appropriateness of the rules, processes and mechanisms relative to the nature, scale and complexity of a credit institu-tions activities Article 123 of the Capital Requirements Directive speci -cally refers to the principle of proportionality.According to Article 124 No 5 of the Capital Requirements Directive, banking supervisors are responsible for monitoring and evaluating interest rate risk in the banking book. Article 136 of the Capital Requirements Directive outlines potential supervisory measures in the event a credit institution does not comply with the requirements of the directive.The disclosure requirements for interest rate risk are outlined in Annex XII, Part 2, point 12 of the Capital Requirements Directive.

Due to the wealth of detail in the directives, these provisions were trans-posed into Austrian legislation by way of an amendment to the Austrian Banking Act as well as by two FMA regulations (Solvency Regulation and Disclosure Regulation).

2.2.2 Further Speci cations by CEBS

In respect of interest rate risk in the banking book, the Committee of Euro-pean Banking Supervisors (CEBS) discussed the Basel II regulations in greater detail and issued a set of guidelines entitled Technical aspects of the manage-ment of interest rate risk arising from non-trading activities under the super-visory review process. This paper, published after of cial consultation on October 3, 2006, is conceived to serve as guidance for credit institutions and banking supervisors, and highlights additional technical aspects relating to this subject.

The CEBS paper basically speci ed the points already addressed in subsec-tion 2.1.3, Principles for Managing Interest Rate Risk the Basel Paper on Interest Rate Risk. The CEBS guidelines were not intended to provide a detailed framework for developing and applying quantitative analytical tech-niques, systems and processes after all, it is up to each bank how to imple-ment the system quantitatively.29 Basically, CEBS con rms the importance of the principle of proportionality as a yardstick for the complexity of methodol-ogies. Moreover, credit institutions are expected to show that their internal capital calculated is suf cient to cover the nature and level of all interest rate risks in the banking book.30

In particular, the CEBS document underlines the need for all credit insti-tutions to be able to calculate at the very least the effects of a standardized

29 See CEBS (2006a), p.1. 30 See Article 39a paragraph 1 of the Austrian Banking Act and also CEBS (2006b), p.9.



19

interest rate shock,31 which is de ned as a sudden and unexpected change in money market and/or capital market rates. The need for supervisory interven-tion by the Austrian FMA with regard to interest rate exposure is laid down in Article 69 paragraph 3 of the Austrian Banking Act and is treated in greater detail in section 2.4, Evaluation and Treatment of Interest Rate Risks by Banking Supervisors.

2.3 Reporting Requirements for Interest Rate Risk StatisticsTo enable banking supervisors to monitor interest rate risk positions, credit institutions must submit those positions in an appropriate format; in particu-lar, they must use the newly established risk-oriented supervisory reporting (ROSR) framework.

2.3.1 Revised Reporting Regime

In the run-up to the implementation of Basel II provisions in 2007, the OeNB and FMA completed the Risk-Oriented Supervisory Reporting (ROSR) project, which integrates the data requirements for Basel II, innovations in risk orientation and adjustments to international nancial reporting standards. The ROSR framework has also been informed by the international debate on pan-European harmonization of supervisory reporting (COREP and FINREP).32

The adjustment and restructuring of reporting requirements has wide-ranging importance for the reporting of interest rate risk. Previously, interest rate risk was reported only at an unconsolidated level and then only in respect of the banking book. Within the new ROSR framework, reports are to be led also at a consolidated level and also for foreign subsidiaries. Moreover, individual interest risk positions have to be reported separately for the banking book and trading book (if applicable).

2.3.2 Statutory Reporting Requirements

Following consultation with the OeNB, the Financial Market Authority, with the consent of the Austrian Federal Finance Minister, issued a regulation on the report of condition and income (RRCI) under Article 74 paragraphs 1 and 7 of the Austrian Banking Act. Under Article 74 paragraph 1 of the Austrian Banking Act, credit institutions and superordinate credit institutions must send quarterly reports of condition and income to the FMA using the prescribed RRCI format.33

Under Article 74 paragraph 1 No 2 of the Austrian Banking Act, interest rate risk statistics must contain information that facilitates the assessment and monitoring of compliance with risk-speci c due diligence obligations (Articles 39 and 39a of the Austrian Banking Act). Furthermore, Article 74 paragraph 1 nal sentence of the Austrian Banking Act requires superordinate credit insti-

31 See CEBS (2006a), pp. 9 and 11.32 COREP = Common European Reporting for Solvency; FINREP = Financial Reporting (for corpo-

rate nancial statements under IFRS).33 Under Article 16 of RRCI, the FMA made use of the option cited in Article 74 paragraph 7 Austrian

Banking Act pursuant to which credit institutions must forward reports of condition and income to the OeNB only.



20

tutions to prepare the report of condition and income also for fully consoli-dated foreign subsidiaries (Articles 59 and 59a of the Austrian Banking Act).

2.3.3 Scope of Interest Rate Risk Reporting

Under the aforementioned new reporting framework, credit institutions, banking groups and their foreign banking subsidiaries must include interest rate risk statistics in their (consolidated and unconsolidated) reports of condition and income. To provide guidance, the OeNB has published detailed guidelines for compiling interest rate risk statistics (as well as guidelines for the whole reporting framework); these guidelines are also available online at www.oenb.at.34

For the sake of simplicity, this paper will refer only to the unconsolidated version of the guidelines for reporting interest rate risk statistics. For more details, see the reporting guidelines for banking groups and foreign subsidiar-ies.

As mentioned above, the scope of the interest rate statistics was extended to cover the trading book and the consolidated group accounts (including foreign bank subsidiaries). At the same time, the scope of reporting has been considerably reduced for banks foreign subsidiaries.

Trading book reports are to be submitted only by credit institutions which exceed the thresholds de ned in Article 22q paragraph 1 of the Austrian Banking Act. Credit institutions which use complex processes (models pursu-ant to Article 22p of the Austrian Banking Act) for calculating their capital in the trading book may with the OeNBs consent use individual reporting solutions to compile their interest rate risk statistics.

Like many other risk statement items, consolidated interest rate risk items may be presented in a simpli ed form. For instance, credit institutions need not include subsidiaries with no signi cant interest rate risk activity, and they may use traditional aggregation methods based on eliminating individual items instead of traditional consolidation methods.

2.3.4 Limitations of Interest Rate Risk Statistics and the Internal Model

For the sake of comparability and broad consistency in reporting within the banking sector, a number of simpli cations have been agreed for the interest rate risk statistics, which of course also give rise to data weaknesses.

In other words, given the underlying assumptions (interest cash ows dis-regarded, book value reporting, at yield curve, etc.) these statistics provide merely a broad-brush picture, i.e. only an approximate estimation of interest rate risk. Above all, credit institutions which maintain complex products in the banking book must, at any rate, be able to map and evaluate the interest rate risk of these products appropriately. Complex products call for more sophisticated methodologies.

The aforementioned shortcomings can largely be avoided by using internal models. Banks applying such models are therefore supposed to report two

34 www.oenb.at/de/stat_melders/melderservice/bankenstatistik/aufsichtsstatistik/vera_neu/vera_uebersicht.jsp (German only).



21

separate sets of interest rate data (III. Standardized Approach, IV. Internal Risk Management):

In their reports of condition and income, credit institutions are, as a rule, required to indicate the aggregated change in economic value triggered by the assumed change in interest rates (currently speci ed at 200 basis points in the reporting guidelines on the risk statement). Credit institutions with an inter-nal risk measurement system in place that differs from the selected standard-ized approach35 must also forward the results in accordance with the internal models approach under IV. Internal Risk Management.36 In principle, credit institutions are free to select the process for measuring internal interest rate risk provided this process is considered to be appropriate within the meaning of Article 39 paragraph 2 of the Austrian Banking Act.

2.4 Evaluation and Treatment of Interest Rate Risks by Banking Supervisors

As already outlined in subsection 2.1.1 (Pillar 2 Inclusion of Interest Rate Risks) credit institutions are not required to back interest rate risk in the banking book with capital under Pillar 1. Yet they need to monitor interest rate risk in the banking book under Pillar 2 within the integrated risk manage-ment framework. Speci cally, credit institutions must establish an internal capital adequacy assessment process (ICAAP) for assessing capital adequacy in relation to their risk pro le.

Moreover, Pillar 2 requires banking supervisors to subject all credit insti-tutions to a supervisory review and evaluation process (SREP). SREP includes the evaluation of a credit institutions own internal processes, systems, mecha-nisms and strategies, as well as the evaluation of its risk pro le.37 Banking supervisors must lay down the frequency and intensity of the reviews to be performed at each bank, and actually conduct such reviews at least on an annual basis, having regard to systemic importance as well as to the nature,

35 Repricing method or duration method 36 See Reporting guidelines on the risk statement.37 In this respect, SREP should check whether the interest rate risk in the banking book was also

included in the internal capital adequacy assessment process.

Table 1

Presentation of Interest Rate Risk in Interest Rate Risk Statistics

III. Standardized approach IV. Internal risk management

change in economic value triggered by the assumed change in interest rates

change in economic value triggered by the assumed change in interest rates

% of eligible capital % of eligible capital



22

scale and risk inherent in bank activities (proportionality principle).38 If neces-sary, supervisory measures can be imposed in the event of noncompliance.

2.4.1 Re ections on Capital Adequacy

Credit institutions undertake risks as part of their business activities and bear the nancial damage resulting from a materialization of risk.39

In this respect, a key supervisory duty is to ensure that credit institutions are aware of the nature, scale and complexity of the risks undertaken, that they measure these risks, and that they control and limit them accordingly.40

Within the framework of integrated risk management, the interest rate risk identi ed in the banking book must be measured by sound systems, com-mensurate with risk-bearing capacity and covered by adequate capital. A credit institutions risk-bearing capacity can only be guaranteed in the long term if the capital it holds is adequately suf cient to support the level of undertaken risks.41 The more complex the interest rate products used, the higher the need under Pillar 2 to put in place sophisticated and appropriate models of risk assessment.

In principle, credit institutions are free to choose the process for measur-ing interest risk in the banking book, provided this process and its application as a management, accounting and control tool is appropriate for capturing interest rate risk within the meaning of Article 39 paragraph 2 of the Austrian Banking Act.42

Integrating interest rate risk management into bank-wide risk management activities is essential for maintaining risk-bearing capacity. In addition to mon-itoring earnings, best practice is to react to increases (changes) in the eco-nomic value of all interest-sensitive positions (interest rate book).43

Adequate interest rate risk management is based on an integrated economic value perspective of performance and risk. The integrated risk management framework covers all available data, all products, all systems applied, and the underlying methods and models. Based on this framework, banks will de ne the three key measures to be managed (earnings, economic value and risk), thus aligning these three perspectives in a management triangle.44

Article 39 paragraph 2 of the Austrian Banking Act requires credit institu-tions to identify, assess control and monitor interest rate risks in the banking book: All credit institutions must have precise knowledge of the interest rate risks they have undertaken. On a consolidated basis, the superordinate credit institution pursuant to Article 30 paragraph 5 of the Austrian Banking Act is

38 Article 124 paragraph 4 of the Capital Requirements Directive: Competent authorities shall estab-lish the frequency and intensity of the review and evaluation having regard to the size, systemic importance, nature, scale and complexity of the activities of the credit institution concerned and taking into account the principle of proportionality. The review and evaluation shall be updated at least on an annual basis.

39 See Bschgen/Brner (2003), p. 18ff. 40 See Basel Committee on Banking Supervision (2004b), ref. 719ff.41 See OeNB/FMA (2006), p. 69.42 See Reporting guidelines on the risk statement.43 See Eller/Schwaiger/Federa (2001), p. 3ff.44 See Eller/Schwaiger/Federa (2001), p. 2.



23

responsible for the adequate treatment of interest rate risks in the banking book.

Under Article 39a of the Austrian Banking Act, credit institutions must have effective systems and processes in place in order to assess their capital adequacy. Within banking groups, capital adequacy may be assessed at differ-ent levels.45 To estimate the impact of potential sudden and unexpected inter-est rate changes on capital,46 the methods and models used for calculating interest rate risk must be supplemented by the simulation of appropriate (stress) scenarios.

2.4.2 Standardized Interest Rate Shock

Under the reporting requirements for interest rate risk, Austrian credit insti-tutions must communicate the impact of a standardized interest rate shock on their eligible capital. This report is used by banking supervisors to identify, among other things, outlier banks (i.e. banks with an increased interest rate risk in the banking book) and to introduce appropriate measures. The applica-tion of an interest rate shock that is standardized for all credit institutions ensures a uniform assessment of credit institutions risk and enables banking supervisors to compare risk across credit institutions.47

In the Basel paper on interest rate risk, the Basel Committee for Banking Supervision sets forth the general requirements for an appropriate standard-ized interest rate shock. An interest rate shock is presumed to trigger a sudden and unexpected change in money market and/or capital market rates. The scenario must be designed to reveal the effects of embedded options and of convexity within bank products.48

Article 69 paragraph 3 of the Austrian Banking Act currently de nes the standardized interest rate shock as a parallel upward or downward interest rate shift by 200 basis points. Supervisors are considering additional scenarios (1st or 99th percentile of one-year interest rate changes over an observation period of at least 5 years). Based on their ndings, the standardized interest rate risk shock may be adjusted in the future.

2.4.3 De nition and Treatment of Outlier Banks

Outlier banks are identi ed based on the impact the standardized interest rate shock has on their capital base. Credit institutions must disclose the corre-sponding ratio (% of eligible capital) in their reports.49

A credit institution is designated an outlier, i.e. found to carry excessive interest rate risk, if the given interest rate shock causes its capital base to

45 See Articles 39a paras 3 and 4 of the Austrian Banking Act; for further information on ICAAP application levels, please consult the guidelines on bank-wide risk management already published by the OeNB and FMA see OeNB/FMA (2006), p. 20ff.

46 In this instance, capital is de ned by Article 23 paragraph 14 Nos 1-6, and No 8, Austrian Banking Act (tier 1 capital plus tier II capital, less deduction items for equity interests pursuant to Arti-cle 23 paragraph 13 No 3/4 of the Austrian Banking Act). Pro t brought forward can be counted toward eligible capital.

47 See Grundke (2006), p. 288.48 See Basel Committee on Banking Supervision (2004b), Annex 3.49 See Reporting guidelines on the risk statement.



24

decline by more than 20%. In this event, the FMA must take measures pursu-ant to Article 69 paragraph 3 of the Austrian Banking Act.

It should be noted here that supervisors generally take a broader perspec-tive than that. In other words, a more than 20% decline in capital following an interest rate shock is not the sole criterion for introducing supervisory mea-sures. The interest rate shock test basically produces an indication of excessive interest rate risk that alerts supervisors to the necessity of monitoring a given bank more closely. For instance, supervisors will check whether banks have paid due attention to interest rate risk in their integrated risk management activities and ICAAP reviews.50 Such reviews may, in fact, call for FMA action even if the capital base shrinks by less than 20%. However, each individual case will be assessed separately.

If, in respect of outlier banks, it should subsequently emerge that the risks undertaken were not suf ciently covered by capital or that the ICAAP pro-cesses were inadequate, the banking supervisors will introduce appropriate countermeasures.

Article 136 of Directive 2006/48/EC lists a number of measures super-visors may take rapidly in the event of noncompliance with the directive (and, consequently, Pillar 2). These measures were transposed into Austrian legisla-tion in Articles 70 paras 4 and 4a of the Austrian Banking Act.

Essentially, the FMA has been empowered to impose speci c capital charges if other measures provided for by the Banking Act do not appear ade-quate (Article 70 paragraph 4a of the Austrian Banking Act) especially if extra charges appear appropriate in view of the overall risk situation of a given credit institution. Likewise, the supervisors may require additional capital if other supervisory measures can only be implemented in the medium term. However, Article 70 paragraph 4a of the Austrian Banking Act may be invoked only if milder measures,51 speci cally instructions to remedy the situation (Article 70 paragraph 4 No 1 of the Austrian Banking Act), are not appropri-ate or remain ineffective.52

Basically, the FMA may take the following measures against outlier banks:The FMA will subject outlier banks to special supervisory monitoring. As a possible milder measure, the FMA can request outliers to explain their outlier status and to describe the remedial measures they intend to take (Article 70 paragraph 1 No 1 of the Austrian Banking Act). In particular, outliers must describe how they accounted for interest rate risk when calculating capital adequacy (ICAAP).The FMA can require credit institutions to enhance their interest rate risk management framework (regulations, processes, mechanisms and strategies).Credit institutions internal processes for assessing capital adequacy must capture and limit risks appropriately. If noncompliance with the Austrian Banking Act (Articles 39 and 39a) results in an inadequate limitation of a

50 Adequate risk allocation must be validated to the banking supervisor within the framework of supervisory monitoring especially if capital should decline by more than 20% owing to simulated unexpected uctuations in interest rates.

51 See Article 2 paragraph 1 of the Administrative Enforcement Act.52 See explanatory notes on Article 70 paragraph 4a of the Austrian Banking Act (1558 d.B.XXII. GP).



25

banks or banking groups operational risks, the FMA may instruct the credit institution under Article 70 paragraph 4 No 1 of the Austrian Bank-ing Act to restore statutory compliance within an adequate period of time on pain of penalties (e.g. a ne53).If statutory compliance is not restored within the stipulated period, the FMA will impose a penalty, or renew the instruction to remedy the situa-tion subject to higher penalties.If the renewed instruction to remedy also remains ineffective, the FMA will request the given credit institution to reduce the risk.If the prescribed measures fail to reestablish adequate coverage and limita-tion of risks and to restore statutory compliance, the FMA may require the bank to hold more capital.54 However, this will only occur if other mea-sures laid down in the Austrian Banking Act do not appear satisfactory and if the FMAs previous instructions remain ineffective. When imposing speci c capital charges, the FMA must take into account quantitative and qualitative as well as time factors.55The FMA may request banks to reduce their risks and hold more capital at the same time. Furthermore, the FMA may restrict credit institutions and banking groups in their scope of activity.

The FMA is not obligated to impose the supervisory measures speci ed in Article 70 paragraphs 4 and 4a of the Austrian Banking Act in the order in which they are cited therein since, otherwise, it would need to limit or pro-hibit business operations before imposing additional capital requirements. The FMA will generally adopt the milder of available measures in order to ensure the restoration of statutory compliance.

At any rate, banking supervisors may carry out an on-site inspection pur-suant to Article 70 paragraph 1 No 3 of the Austrian Banking Act, for instance to determine the correct presentation of transactions or to monitor progress on the restoration of statutory compliance.

53 See Article 5 of the Administrative Enforcement Act. 54 Up to a maximum of 150% of the total minimum capital requirements pursuant to Article 22

paragraph 1 of the Austrian Banking Act55 See explanatory notes on Article 70 paragraph 4a of the Austrian Banking Act (1558 d.B.XXII.

GP).

26

3.1 To Choose an Economic Value Perspective or an Earnings Perspective?

Interest rate risk management involves a tradeoff between maximizing the interest rate books economic value, optimizing the yield/risk ratio and real-izing the desired earnings. Moreover, interest rate risk is perceived differently under economic value considerations than when viewed from an earnings per-spective. From an economic value perspective, for example, the coupon amount of an asset with a given maturity is not a relevant factor as adjustments are made on the basis of market value; hence the economic value would not differ in the nal analysis.56 Yet annual net interest income and thus the earn-ings result depend heavily on the level of the nominal interest rate.57 Figure 4 below illustrates the different perspectives by plotting the cash ow structure against the market performance for straight bonds and for oating rate notes.

56 See Schierenbeck (2003a), p. 194. 57 Adjustment is made partly via net income from the valuation of the securities portfolio.

Cash Flow and Market Performance of Straight Bonds and Floating Rate NotesChart 4

cash flow (left-hand side)market value (right-hand side)

Source: OeNB.

1

20

16

12

8

4

0

years

102

100

98

96

942 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1

20

16

12

8

4

0

years

102

100

98

96

942 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

floating rate notes

straight bondsEUR

EUR

3 Measuring and Managing Interest Rate Risk in the Banking Book

3 Measuring and Managing Interest Rate Risk

in the Banking Book

27

Since, apart from valuation effects for marketable securities, economic value uctuations in the interest rate book do not have a direct and immediate effect on earnings from the perspective of commercial law, it is generally dif- cult in practice to establish economic value-based measures as the key inter-est rate risk management measures, at the neglect of earnings-based measures. The following sections examine the speci c pros and cons of earnings-based and economic value-based instruments and ultimately present a modern yield/risk-oriented management approach (integrated interest rate book manage-ment).58

3.1.1 Managing Interest Rate Risk from an Earnings Perspective

Given the high visibility of income gures, many credit institutions are guided by short-term earnings considerations in managing their interest rate book. A key difference between economic value analyses and income statements con-sists in how earnings effects are distributed over time. Unlike economic value calculations, income statements re ect earnings accrued up to the underlying balance sheet date while providing only incomplete pro t or loss reports of sorts, as effects beyond the balance sheet date are ignored. Due to the short observation period, however, there is a risk that while improving current earn-ings with relevant measures, credit institutions ignore the related economic value effects. Such an approach ultimately implies but that current earnings are managed to the detriment of earnings generated in subsequent periods.

Since the effects of past maturity transformation decisions tend to span across several reporting periods, it is not possible to assess such decisions on a cost-causative basis in income statements. It should also be mentioned that the income statement may mask accounting effects such as the release of hidden reserves (or formation of hidden charges) as a result of which economic losses may be covered up temporarily or for good. Thus, a purely earnings-based perspective cannot fully satisfy the requirements of interest rate book manage-ment subject to yield/risk considerations.

Pros and cons of earnings perspectives:Target measures re ect the accrual of earnings effects over time and are compatible with the income statement.Transparency and acceptance of target measures is high; earnings measures have a strong signaling effect for external users.Potential effects beyond the projection horizon are not taken into account. Moreover, the income statement is highly malleable.Earnings performance can only be assessed to a limited extent from a yield/risk-related perspective.

3.1.2 Managing Interest Rate Risk from an Economic Value Perspective

Interest rate book management from an economic value perspective supple-ments the traditional earnings perspective with performance and risk target measures that may prompt management action. The economic value re ects the aggregated effects of a change in market interest rates by discounting (inde-

58 See chapter 4, Integrated (Dual) Interest Rate Book Management.


in the Banking Book

28

pendent of accounting rules) all future cash ows. Thus, changes in relevant risk parameters are re ected in the interest rate books economic value imme-diately. The risk exposure from an economic value perspective can be inter-preted as a potential lead indicator for future earnings and may prompt management to change the cash ow structure accordingly. The economic value concept facilitates ef cient interest rate risk management by making the earnings and risk situation more transparent.

However, managing interest rate risk solely from an economic value perspective ignores the relevant accounting rules, which means that it does not re ect the accrual of economic value effects over time in the income state-ment. From an economic value perspective, it is not relevant how the risk situ-ation appears in individual periods: the earnings effects are disclosed in the form of aggregate risk gures and analyzed on the basis of those gures. Since in banking practice going concern analysis (within the framework of SREP) is based on balance sheet measures, the distribution of earnings effects over time is of great importance, however. Furthermore, it should be mentioned that the implementation of economic value perspectives requires the development of expertise in the competent organizational units.

Pros and cons of economic value perspectives:Economic value perspectives facilitate integrated risk analysis. Perfor-mance is presented in an aggregated form. The ability to determine the interest rate books risk status at all times facilitates the management of the interest rate book on a yield/risk basis. Economic values provide a transparent view of the long-term effects of changes in market rates. The risk exposure from an economic value perspective can be considered as a potential lead indicator for negative earnings effects.Economic values can be rolled over into earnings measures to a limited extent only, as the economic value perspective ignores subperiods.The implementation of interest rate book management based on economic value considerations gives rise to a number of conceptual questions that can be answered only if adequate staff and technical resources are avail-able.

3.1.3 Optimal Interest Rate Risk Management Strategies

In many credit institutions, the practice of interest rate book management is still focused on monitoring changes in earnings over time whereas calculating economic values, which re ect the aggregate future effects of market interest rate changes, is frequently given short shrift. Obviously, the prevailing nan-cial reporting regime under the Austrian Commercial Code under which changes in economic value (unlike changes in net interest income) remain largely undisclosed because marking to market is rarely used provides a strong incentive for conducting earnings-based analyses.59 Yet over time, the increased use of international accounting standards (IFRS, U.S. GAAP) will

59 Market values (and economic values) only become relevant if a credit institution nds itself in a valuation situation, e.g. capital increase, disposal process.


in the Banking Book

29

strengthen the fair value approach (particularly via the exercise of fair value options60) as a risk analysis tool and thus further enhance the need for ef cient and meaningful economic value analysis.

Despite the economic superiority of the economic value concept, the earn-ings perspective should not be ignored, as a number of questions can only be answered when the earnings perspective is taken into consideration as well:

How does the accrual of economic value effects appear in the earnings statement?What is the interplay between the two perspectives? What are the deter-minants for earnings performance?Which business strategies permit optimizing the yield/risk ratio, given speci c earnings measures?How high are earnings when the net positions are liquidated?What is the earnings potential in a benchmark strategy selected on the basis of the economic value perspective?

In banking practice, economic value and the earnings considerations often prompt fairly divergent paths of action. The following example is meant to highlight the differences over time:

Data Situation in the Base Period

60 Pursuant to IAS 39.

Comparison of Pointers for Interest Rate Risk ManagementChart 5

1

5

4

3

2

1

0year2 3

maturity spread1.58%

4.47%

2.89%

3.97%

%

Comparison of Pointers forInterest Rate Risk Managementcurrent yield curve

t0

t1

1st year 2.89% 5.50%2st year 3.97% 6.50%3st year 4.47% 7.50%

transformation strategy

3-year retail loan at 4.47%1-year re nancing (1st year : 2.89%)amount: EUR 100,000


in the Banking Book

30

A normal yield curve is assumed in the base period. In the example above, the credit institution transforms funds borrowed for one year into a three-year retail loan. The aim of this maturity transformation strategy is to earn a posi-tive maturity premium. Table 2 shows the cash ow structure based on the underlying trend in interest rates:

An analysis of the earnings effect of activities in table 3 shows that increas-ing re nancing costs offset the positive transformation amount observed in the rst period (earnings effect in t

1: +1.580) in the following periods (t

2: 1.807;

t3: 1.906). Whereas economic value calculations reveal the earnings effects

of changes in market interest rates without a time lag (income from an eco-nomic value perspective in t

1: 2.133), earnings-based reporting does not

allow to assign future transformation losses on a cost-causative basis to the rst period although the negative earnings effects in successive periods were evidently triggered by transactions in the rst period. This example shows that earnings-based analysis on an annual basis can result in the mismanagement of interest rate risk. Only economic value-based analysis can ensure an integrated risk perspective that reveals the big picture.

Although earnings-based analyses and economic value calculations gener-ate identical results on balance, the results may prompt different paths of action at interim points (pro t from an earnings perspective in t

1: +1.580; loss from

an economic value in t1: 2.133). Potential tradeoffs between the two perspec-

tives can largely be resolved through integrated management approaches. Without doubt the optimal interest rate management strategy should include a combined analysis of performance measures from both an earn-ings and an economic value perspective.61 After all, the two approaches are

61 See Basel Committee on Banking Supervision (2004b), ref. 40.

Table 2

Performance Measured from an Economic Value Perspective transactions

cash ow of transactions t = 0 t = 1 t = 2 t = 3

3-year retail loan at 4.47% 100,000 +4,470 + 4,470 +104,4701-year re nancing at 2.89% +100,000 102,8901-year investment in t

1 at an underlying rate of 5.50% 1,807 +1,906

2-year re nancing in t1 at an underlying rate of 6.50% 0 +98,094 6,376 104,470

income from an economic value perspective 0 2,133 0 0

Table 3

Performance Measured from an Earnings Perspective

earnings effect of activities t = 1 t = 2 t = 3 Total

3-year retail loan at 4.47% +4,470 +4,470 +4,4701-year re nancing at 2.89% 2,8901-year investment in t

1 at an underlying rate of 5.50% +99

2-year re nancing in t1 at an underlying rate of 6.50% 6,376 6,376

income from an earnings perspective +1,580 1,807 1,906 2,133


in the Banking Book

31

not mutually exclusive but complement each other. Integrated interest rate book management can be considered as an essential cornerstone of successful interest rate risk management.62

3.2 Instruments for Quantifying Interest Rate RisksAs for measuring interest rate risk in the banking book, there are many tech-niques and processes available that differ from each other in terms of complex-ity and accuracy. In this respect, the following principle applies: the larger and more complex interest rate risks in the banking book are, the more advanced the risk measurement and management processes of the credit institution con-cerned should be. Both earnings measures re ecting net interest income earned in the given reporting period (earnings perspective) and net interest income measures for a given point in time such as the economic value of capital (or of the interest rate book)63 (economic value perspective) can be used as target measures for risk analysis. Whereas interest rate risk measurement from an earnings perspective focuses on analyzing changes in earnings in the current period that are induced by interest rate uctuations, economic value analyses re ect all the effects of interest rate changes in an aggregated form.

The instruments and methods for analyzing interest rate risk can basically be divided into two categories: instruments based on accounting-related earn-ings measures (elasticity analysis, earnings simulation) and economic value-related tools (economic value simulation, value at risk). A further differentia-tion can be made in terms of the nature and scale of the transactions covered. Whereas static simulations solely assess the cash ows from the banks current interest-sensitive positions, dynamic simulations also include the evolution of the balance sheet (through new business, customer behavior etc.).

Using gap analysis and elasticity analysis to quantify the earnings effect produces broad-brush results which would need to be cross-checked with other methods. In practice, these techniques have already largely been replaced by simulation models.

62 See chapter 4, Integrated (Dual) Interest Rate Book Management.63 All interest-sensitive on and off balance positions in the banking book are included.

Instruments/Methods for Quantifying Risk in the Banking BookChart 6

Source: OeNB.

performance measuredfrom an earnings perspective

performance measuredfrom an economic value perspective

gap analysis

simulation models

earnings simulation economic value simulation value at risk

elasticity analysis


in the Banking Book

32

The basis for reliable interest rate risk measurement is the completeness, accuracy and timeliness of the underlying data. Data must re ect the relevant characteristics of interest-sensitive positions as well as the cash ow structures of individual products such as the amount and frequency of interest cash ows, repricing pro les, repayment modalities and embedded options (rights to accelerate repayment and to early redemption, interest rate ceilings and oors etc.). In banking practice, gap analysis data (net asset and liability positions per time band) are frequently used as input for further interest rate risk analysis (economic value simulation, value at risk).

3.2.1 Gap Analysis

Gap analysis refers to the allocation of interest-sensitive assets and liabilities, including off balance sheet (OBS) positions, to a number of prede ned time bands64 according to maturity ( xed rate assets) or according to the remaining time to repricing ( oating rate assets). To simplify the process, allocation is based on par or book values.65 Since numerous banks use gap analysis as a rst step in analyzing interest risk (from an economic value perspective), it is important that they model the cash ows arising from their transactions as accurately as possible66 to produce a meaningful breakdown of their interest-sensitive positions by maturity/repricing dates. Accuracy is increased by augmenting the number of time bands (i.e. reducing the band-width). The number of time bands should be adjusted to the type of transaction (e.g. differ-ent currencies) and its complexity as well as to the resulting inherent risk. For instance, a credit institution with a high share of money market transactions will have to narrowly space its near-term time bands. By contrast, a credit institution with commitments primarily in medium- to long-term time bucket will put the main emphasis on medium- to long-term time bands when depict-ing maturities.

3.2.1.1. Calculation of Earnings Effects

Traditional gap analysis is one of the oldest instruments used to measure banks near-term risk exposure from an earnings perspective. As a rule, gap analysis reports are restricted to a one-year horizon. To calculate the earnings effects, liabilities are subtracted from the corresponding assets in each time band to produce an interest rate gap for that band. This gap is used to estimate the effects on earnings. In the case of a short net position (total assets > total liabilities), for instance, a decrease in market interest rates implies a decrease in net interest income. Conversely, rising interest rates would drive up earn-ings in such case. The intensity of the change in net interest income as a result of changes in market interest rates depends on the net position. For every time band, the expected change in net interest income the earnings effect is cal-culated by multiplying the gap by the de ned interest rate scenario. Gap analy-

64 Noninterest rate sensitive positions can also be included using cash ow assumptions. See subsection 4.2.3, Noninterest Rate Sensitive Positions.

65 Within the framework of interest rate statistics, simpli ed gap analysis (reporting transactions at book values) is used to depict interest rate risk.

66 See section 4.2, Cash Flow Modeling.


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sis, however, can only roughly capture interest rate risk, assuming a simple parallel shift in the yield curve (based on the current balance sheet structure).

The following points of criticism relating to gap analysis are relevant:67

If oating positions do not react to changes in market interest rates in the way assumed,68 the assessment of the interest rate risk position will be incorrect. Risk can be quanti ed properly only if the average oating rate of risk positions is subject to the same uctuations as the market interest rate. Moreover, average interest rates of oating assets and liabilities are assumed to react in synch to changes in market interest rates. These assumptions are in sharp contradiction to reality, as the interest rate sensi-tivities of different oating balance sheet positions have a considerable impact on a credit institutions risk pro le in practice. A further weakness lies in the static approach, i.e. the fact that gap analysis does not take account of the evolution of the balance sheet (through chang-ing customer behavior, new business activities, etc). Earnings effects aris-ing from the imperfect correlation of earned and paid interest rates (basis risk) and embedded options are depicted and quanti ed inappropriately. The static approach assumes that xed positions are not subject to interest rate risk outside the observation period. Indirect earnings effects that arise from changes in portfolio market values are not included because valuation rules are not taken into account in risk analysis.

3.2.1.2. Calculation of Economic Value Effects

Gap analysis also facilitates the analysis of the effects of interest rate changes on the economic value of the interest rate book (and the economic value of capital). Analysis from an economic value perspective is based on the determi-nation of the cash ow structure of individual transactions and the subsequent mapping of cash ows onto the gap analysis time bands. The accuracy of this calculation can be improved by augmenting the number of time bands. Sensi-tivity factors assigned to each time band (modi ed duration, key rates, basis

67 The aforementioned points of criticism do not relate to gap analysis in general but to the method of calculating earnings effects based on gap analysis.

68 All positions in this section are understood as having oating rates or as being locked into inde nite periods of the rate.

Net Positions and their Earnings ProfileChart 7

Source: OeNB.

rising interest rates

net asset positions

net liability positions

opportunity

falling interest rates

risk

risk opportunity


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point value) are used to estimate value effects.69 Zero bond discounting factors can also be used for a more accurate estimation of economic value effects.70

3.2.2 Simulation Models

Simulation approaches are used to map balance sheet and income statement developments based on various external and corporate scenarios. Simulation processes help analyze the potential effects of interest rate changes on current earnings (earnings perspective) and on the economic value of a credit insti-tution (economic value perspective). The main difference between the two methods is that economic value-based simulation includes all future cash ows that are currently known whereas earnings-based simulation re ects only cash ows within the observation period. Simulation models facilitate risk expo-sure calculations with a very high degree of accuracy and exibility, even for very complex portfolios.

There are static and dynamic simulations. The latter also re ect the poten-tial (likely) evolution of the balance sheet (changes in banks business activity, customer behavior etc.), capturing the dynamic character of the bank balance sheet. Simulation methods lend themselves particularly well to earnings-based analyses, given the near-term horizon of the latter. An essential prerequisite for the implementation of dynamic simulation models is to have mastered static analysis. The future bank balance sheet depends on a number of factors that are both intrinsic to credit institutions (future pricing policy, expiry effects etc.) and extrinsic to them (competitive situation, macroeconomic develop-ment, customer-related factors, changes in market interest rates etc). One asset of dynamic simulation is that it strengthens banks decision-making basis for managing interest rate risk by opening up new perspectives. Through dynamic simulation, credit institutions decision-makers obtain a comprehen-sive picture of the expected earnings and risks arising from cash ows from the banks on and off balance sheet positions.

69 The aforementioned sensitivity measures are subjected to a brief SWOT analysis in subsection 4.3.2.2. 70 This approach basically corresponds to a simulation of net economic value; see subsection 3.2.2.2

Simulation of Economic value.

How Simulation Models WorkChart 8

Source: OeNB.

targetmeasures

market data scenarios

balance sheet evolution scenarios

Chance

sim

ulat

ion

retail behavior models

control measures

economic valueof interestrate book

losses

currentvalue

target measures

derivation of control measuresrisk

Return


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3.2.2.1. Dynamic Simulation of EarningsThe development of net interest income depends on two key factors: the inter-est rate component as such (average return on portfolios, interest rate sensi-tivity of oating rate transactions, changes in the yield curve etc.) and the so-called structural component71 (evolution of the balance sheet structure, pricing policy for new and renewed business activities etc.).72 To map these components, banks need to design dynamic, forward-looking earnings simula-tion models.

To specify expected (likely) external and corporate scenarios, credit insti-tutions can use empirically estimated regularities, balance sheet evolution forecasts, target de nitions or other behavioral assumptions. The basic pre-requisite for risk analysis to yield meaningful results is a sound cause-effect relationship between the outcomes of individual scenarios and the underlying assumptions.73 (Dynamic) simulation models basically help analyze the effects of economic decisions and derive speci c recommendations for action by way of what-if analyses. Essentially, dynamic earnings simulation extrapolates the balance sheet over the future projection horizon using different scenarios, namely:

market data scenariosbalance sheet evolution scenariosretail behavior modelsMarket data scenarios: Market data scenarios may refer to interest rate

scenarios for speci c reference dates or to entire probability distributions of future yield curve scenarios, which are statistically generated by a forecasting model (e.g. Monte Carlo simulation). As a rule, this exercise should entail a manageable and diversi ed selection of scenarios.

Balance sheet evolution scenarios: With regard to the evolution of the balance sheet, credit institutions translate strategic management goals into volume forecasts for each individual balance sheet position. Speci cally, they de ne the characteristics of new activities/products (e.g. volumes, repricing pro le, type of coupon etc.) including the rules governing pricing adjustments (interest rate elasticities, maturity margins etc.). Volume forecasts (and fore-casts of selected bala

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Guidelines on Managing Interest Rate Risk in the Banking Book