Principles for the Management and Supervision of Interest Ra

7/28/2019 Principles for the Management and Supervision of Interest Ra

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Basel Committee

on Banking Supervision

Consultative Document

Principles for the

Management and Supervision

of Interest Rate Risk

Supporting Documentto the New Basel Capital Accord

Issued for comment by 31 May 2001

January 2001


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Table of contents

SUMMARY ..............................................................................................................................................1

I. SOURCES AND EFFECTS OF INTEREST RATE RISK ............................................................. 5

A. SOURCES OF INTEREST RATE RISK ........................................................................................5B. EFFECTS OF INTEREST RATE RISK..........................................................................................6

II. SOUND INTEREST RATE RISK MANAGEMENT PRACTICES .................................................8

III. BOARD AND SENIOR MANAGEMENT OVERSIGHT OF INTEREST RATE RISK...................9

A. BOARD OF DIRECTORS...........................................................................................................9B. SENIOR MANAGEMENT.........................................................................................................10C. LINES OF RESPONSIBILITY ANDAUTHORITY FOR MANAGING INTEREST RATE RISK ..................10

IV. ADEQUATE RISK MANAGEMENT POLICIES AND PROCEDURES ......................................12

V. RISK MEASUREMENT, MONITORING AND CONTROL FUNCTIONS ...................................14

A. INTEREST RATE RISK MEASUREMENT.....................................................................................14B. LIMITS.................................................................................................................................16C. STRESS TESTING.................................................................................................................17D. INTEREST RATE RISK MONITORING AND REPORTING .............................................................18

VI. INTERNAL CONTROLS .............................................................................................................19

VII. INFORMATION FOR SUPERVISORY AUTHORITIES..............................................................21

VIII. CAPITAL ADEQUACY................................................................................................................ 22

IX. DISCLOSURE OF INTEREST RATE RISK................................................................................ 23

X. SUPERVISORY TREATMENT OF INTEREST RATE RISK IN THE BANKING BOOK ...........24

ANNEX 1 INTEREST RATE RISK MEASUREMENT TECHNIQUES.............................................. 27

A. REPRICING SCHEDULES ................................................................................................... 27

B. SIMULATION APPROACHES ............................................................................................... 29

C. ADDITIONAL ISSUES......................................................................................................... 30

ANNEX 2 MONITORING OF INTEREST RATE RISK BY SUPERVISORY AUTHORITIES........... 32

A. TIME BANDS .................................................................................................................... 32

B. ITEMS ............................................................................................................................. 33C. SUPERVISORY ANALYSIS.................................................................................................. 33

ANNEX 3 THE STANDARDISED INTEREST RATE SHOCK.......................................................... 35

ANNEX 4 AN EXAMPLE OF A STANDARDISED FRAMEWORK ..................................................37

A. METHODOLOGY............................................................................................................... 37

B. CALCULATION PROCESS .................................................................................................. 38


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Principles for theManagement and Supervision of Interest Rate Risk

Summary1. As part of its on-going efforts to address international bank supervisory issues, theBasel Committee on Banking Supervision1 issued a paper on principles for the managementof interest rate risk in September 1997. In developing these principles, the Committee drewon supervisory guidance in member countries, on the comments of the banking industry onthe Committee's earlier paper, issued for consultation in April 1993,2 and on commentsreceived on the draft paper issued for consultation. In addition, the paper incorporated manyof the principles contained in the guidance issued by the Committee for derivatives activities,3

which are reflected in the qualitative parameters for model-users in the capital standards formarket risk4. This revised version of the 1997 paper is being issued to support the Pillar 2approach to interest rate risk in the banking book in The New Basel Capital Accord.5 The

revision is reflected especially in this Summary, in Principles 12 to 15, and in Annexes 3and 4.

2. Principles 1 to 13 in this paper are intended to be of general application for themanagement of interest rate risk, independent of whether the positions are part of the tradingbook or reflect banks' non-trading activities. They refer to an interest rate risk managementprocess, which includes the development of a business strategy, the assumption of assetsand liabilities in banking and trading activities, as well as a system of internal controls. Inparticular, they address the need for effective interest rate risk measurement, monitoring andcontrol functions within the interest rate risk management process. Principles 14 and 15, onthe other hand, specifically address the supervisory treatment of interest rate risk in thebanking book.

3. The principles are intended to be of general application, based as they are onpractices currently used by many international banks, even though their specific applicationwill depend to some extent on the complexity and range of activities undertaken by individualbanks. Under the New Basel Capital Accord, they form minimum standards expected ofinternationally active banks.

4. The exact approach chosen by individual supervisors to monitor and respond tointerest rate risk will depend upon a host of factors, including their on-site and off-sitesupervisory techniques and the degree to which external auditors are also used in thesupervisory function. All members of the Committee agree that the principles set outhere should be used in evaluating the adequacy and effectiveness of a bank's interest

1The Basel Committee on Banking Supervision is a Committee of banking supervisory authorities which was established bythe central-bank Governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisoryauthorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden,Switzerland, United Kingdom and the United States. It usually meets at the Bank for International Settlements in Basel,where its permanent Secretariat is located.

2Measurement of Banks' Exposure to Interest Rate Risk, Consultative proposal by the Committee, April 1993.

3Risk Management Guidelines for Derivatives, July 1994.

4Amendment to the Capital Accord to Incorporate Market Risk, January 1996.

5See Part 3: Pillar 2 - Supervisory Review Process, ofThe New Basel Capital Accord, January 2001.


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rate risk management, in assessing the extent of interest rate risk run by a bank in itsbanking book, and in developing the supervisory response to that risk.

5. In this, as in many other areas, sound controls are of crucial importance. It isessential that banks have a comprehensive risk management process in place thateffectively identifies, measures, monitors and controls interest rate risk exposures, and that issubject to appropriate board and senior management oversight. The paper describes each ofthese elements, drawing upon experience in member countries and principles established inearlier publications by the Committee.

6. The paper also outlines a number of principles for use by supervisory authoritieswhen evaluating banks' interest rate risk management. This paper strongly endorses theprinciple that banks internal measurement systems should, wherever possible, form thefoundation of the supervisory authorities measurement of and response to the level ofinterest rate risk. It provides guidance to help supervisors assess whether internalmeasurement systems are adequate for this purpose, and also provides an example of apossible framework for obtaining information on interest rate risk in the banking book in theevent that the internal measurement system is not judged to be adequate.

7. Even though the Committee is not currently proposing mandatory capital chargesspecifically for interest rate risk in the banking book, all banks must have enough capital tosupport the risks they incur, including those arising from interest rate risk. If supervisorsdetermine that a bank has insufficient capital to support its interest rate risk, they mustrequire either a reduction in the risk or an increase in the capital held to support it, or acombination of both. Supervisors should be particularly attentive to the capital sufficiency ofoutlier banks those whose interest rate risk in the banking book leads to an economicvalue decline of more than 20% of the sum of Tier 1 and Tier 2 capital following astandardised interest rate shock or its equivalent. Individual supervisors may also decide toapply additional capital charges to their banking system in general.

8. The Committee will keep the need for more standardised measures under reviewand may, at a later stage, revisit its approach in this area. In that context, the Committee isaware that industry techniques for measuring and managing interest rate risk are continuingto evolve, particularly for products with uncertain cash flows or repricing dates, such as manymortgage-related products and retail deposits.

9. The Committee is also distributing this paper to supervisory authorities worldwide inthe belief that the principles presented will provide a useful framework for prudentsupervision of interest rate risk. More generally, the Committee wishes to emphasise thatsound risk management practices are essential to the prudent operation of banks and topromoting stability in the financial system as a whole.

10. The Committee stipulates in the eight sections III to X of the paper the followingfifteen principles. These will be used by supervisory authorities in evaluating the adequacyand effectiveness of a bank's interest rate risk management, in assessing the extent ofinterest rate risk run by a bank in its banking book, and in developing the supervisoryresponse to that risk:

Board and senior management oversight of interest rate risk

Principle 1: In order to carry out its responsibilities, the board of directors in a bank

should approve strategies and policies with respect to interest rate risk managementand ensure that senior management takes the steps necessary to monitor and controlthese risks. The board of directors should be informed regularly of the interest rate


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risk exposure of the bank in order to assess the monitoring and controlling of suchrisk.

Principle 2: Senior management must ensure that the structure of the bank's businessand the level of interest rate risk it assumes are effectively managed, that appropriatepolicies and procedures are established to control and limit these risks, and that

resources are available for evaluating and controlling interest rate risk.Principle 3: Banks should clearly define the individuals and/or committeesresponsible for managing interest rate risk and should ensure that there is adequateseparation of duties in key elements of the risk management process to avoidpotential conflicts of interest. Banks should have risk measurement, monitoring andcontrol functions with clearly defined duties that are sufficiently independent fromposition-taking functions of the bank and which report risk exposures directly tosenior management and the board of directors. Larger or more complex banks shouldhave a designated independent unit responsible for the design and administration ofthe bank's interest rate risk measurement, monitoring and control functions.

Adequate risk management policies and procedures

Principle 4: It is essential that banks' interest rate risk policies and procedures areclearly defined and consistent with the nature and complexity of their activities. Thesepolicies should be applied on a consolidated basisand, as appropriate, at the level ofindividual affiliates, especially when recognising legal distinctions and possibleobstacles to cash movements among affiliates.

Principle 5: It is important that banks identify the risks inherent in new products andactivities and ensure these are subject to adequate procedures and controls beforebeing introduced or undertaken. Major hedging or risk management initiatives shouldbe approved in advance by the board or its appropriate delegated committee.

Risk measurement, monitoring and control functions

Principle 6: It is essential that banks have interest rate risk measurement systems thatcapture all material sources of interest rate risk and that assess the effect of interestrate changes in ways that are consistent with the scope of their activities. Theassumptions underlying the system should be clearly understood by risk managersand bank management.

Principle 7: Banks must establish and enforce operating limits and other practicesthat maintain exposures within levels consistent with their internal policies.

Principle 8: Banks should measure their vulnerability to loss under stressful marketconditions - including the breakdown of key assumptions - and consider those resultswhen establishing and reviewing their policies and limits for interest rate risk.

Principle 9: Banks must have adequate information systems for measuring,monitoring, controlling and reporting interest rate exposures. Reports must beprovided on a timely basis to the bank's board of directors, senior management and,where appropriate, individual business line managers.

Internal controls

Principle 10: Banks must have an adequate system of internal controls over theirinterest rate risk management process. A fundamental component of the internal


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control system involves regular independent reviews and evaluations of theeffectiveness of the system and, where necessary, ensuring that appropriate revisionsor enhancements to internal controls are made. The results of such reviews should beavailable to the relevant supervisory authorities.

Information for supervisory authorities

Principle 11: Supervisory authorities should obtain from banks sufficient and timelyinformation with which to evaluate their level of interest rate risk. This informationshould take appropriate account of the range of maturities and currencies in eachbank's portfolio, including off-balance sheet items, as well as other relevant factors,such as the distinction between trading and non-trading activities.

Capital adequacy

Principle 12: Banks must hold capital commensurate with the level of interest rate riskthey undertake.

Disclosure of interest rate risk

Principle 13: Banks should release to the public information on the level of interestrate risk and their policies for its management.

Supervisory treatment of interest rate risk in the banking book

Principle 14: Supervisory authorities must assess whether the internal measurementsystems of banks adequately capture the interest rate risk in their banking book. If abanks internal measurement system does not adequately capture the interest raterisk, banks must bring the system to the required standard. To facilitate supervisorsmonitoring of interest rate risk exposures across institutions, banks must provide theresults of their internal measurement systems, expressed in terms of the threat toeconomic value, using a standardised interest rate shock.

Principle 15: If supervisors determine that a bank is not holding capital commensuratewith the level of interest rate risk in the banking book, they should consider remedialaction, requiring the bank either to reduce its risk, to hold a specific additional amountof capital, or a combination of both.


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I. Sources and effects of interest rate risk

11. Interest rate risk is the exposure of a bank's financial condition to adversemovements in interest rates. Accepting this risk is a normal part of banking and can be animportant source of profitability and shareholder value. However, excessive interest rate riskcan pose a significant threat to a bank's earnings and capital base. Changes in interest ratesaffect a bank's earnings by changing its net interest income and the level of other interest-sensitive income and operating expenses. Changes in interest rates also affect theunderlying value of the bank's assets, liabilities and off-balance sheet instruments becausethe present value of future cash flows (and in some cases, the cash flows themselves)change when interest rates change. Accordingly, an effective risk management process thatmaintains interest rate risk within prudent levels is essential to the safety and soundness ofbanks.

12. Before setting out some principles for interest rate risk management, a briefintroduction to the sources and effects of interest rate risk might be helpful. Thus, thefollowing sections describe the primary forms of interest rate risk to which banks are typically

exposed. These include repricing risk, yield curve risk, basis risk and optionality, each ofwhich is discussed in greater detail below. These sections also describe the two mostcommon perspectives for assessing a bank's interest rate risk exposure: the earningsperspective and the economic value perspective. As the names suggest, the earningsperspective focuses on the impact of interest rate changes on a bank's near-term earnings,while the economic value perspective focuses on the value of a bank's net cash flows.

A. Sources of Interest Rate Risk

13. Repricing risk: As financial intermediaries, banks encounter interest rate risk inseveral ways. The primary and most often discussed form of interest rate risk arises from

timing differences in the maturity (for fixed rate) and repricing (for floating rate) of bankassets, liabilities and off-balance-sheet (OBS) positions. While such repricing mismatchesare fundamental to the business of banking, they can expose a bank's income andunderlying economic value to unanticipated fluctuations as interest rates vary. For instance,a bank that funded a long-term fixed rate loan with a short-term deposit could face a declinein both the future income arising from the position and its underlying value if interest ratesincrease. These declines arise because the cash flows on the loan are fixed over its lifetime,while the interest paid on the funding is variable, and increases after the short-term depositmatures.

14. Yield curve risk: Repricing mismatches can also expose a bank to changes in theslope and shape of the yield curve. Yield curve risk arises when unanticipated shifts of theyield curve have adverse effects on a bank's income or underlying economic value. Forinstance, the underlying economic value of a long position in 10-year government bondshedged by a short position in 5-year government notes could decline sharply if the yieldcurve steepens, even if the position is hedged against parallel movements in the yield curve.

15. Basis risk: Another important source of interest rate risk (commonly referred to asbasis risk) arises from imperfect correlation in the adjustment of the rates earned and paid ondifferent instruments with otherwise similar repricing characteristics. When interest rateschange, these differences can give rise to unexpected changes in the cash flows andearnings spread between assets, liabilities and OBS instruments of similar maturities orrepricing frequencies. For example, a strategy of funding a one year loan that reprices

monthly based on the one month U.S. Treasury Bill rate, with a one-year deposit thatreprices monthly based on one month Libor, exposes the institution to the risk that thespread between the two index rates may change unexpectedly.


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16. Optionality: An additional and increasingly important source of interest rate riskarises from the options embedded in many bank assets, liabilities and OBS portfolios.Formally, an option provides the holder the right, but not the obligation, to buy, sell, or insome manner alter the cash flow of an instrument or financial contract. Options may be standalone instruments such as exchange-traded options and over-the-counter (OTC) contracts,or they may be embedded within otherwise standard instruments. While banks useexchange-traded and OTC-options in both trading and non-trading accounts, instrumentswith embedded options are generally most important in non-trading activities. They includevarious types of bonds and notes with call or put provisions, loans which give borrowers theright to prepay balances, and various types of non-maturity deposit instruments which givedepositors the right to withdraw funds at any time, often without any penalties. If notadequately managed, the asymmetrical payoff characteristics of instruments with optionalityfeatures can pose significant risk particularly to those who sell them, since the options held,both explicit and embedded, are generally exercised to the advantage of the holder and thedisadvantage of the seller. Moreover, an increasing array of options can involve significantleverage which can magnify the influences (both negative and positive) of option positions onthe financial condition of the firm.

B. Effects of Interest Rate Risk

17. As the discussion above suggests, changes in interest rates can have adverseeffects both on a bank's earnings and its economic value. This has given rise to twoseparate, but complementary, perspectives for assessing a bank's interest rate riskexposure.

18. Earnings perspective: In the earnings perspective, the focus of analysis is theimpact of changes in interest rates on accrual or reported earnings. This is the traditionalapproach to interest rate risk assessment taken by many banks. Variation in earnings is an

important focal point for interest rate risk analysis because reduced earnings or outrightlosses can threaten the financial stability of an institution by undermining its capital adequacyand by reducing market confidence.

19. In this regard, the component of earnings that has traditionally received the mostattention is net interest income (i.e. the difference between total interest income and totalinterest expense). This focus reflects both the importance of net interest income in banks'overall earnings and its direct and easily understood link to changes in interest rates.However, as banks have expanded increasingly into activities that generate fee-based andother non-interest income, a broader focus on overall net income - incorporating both interestand non-interest income and expenses - has become more common. The non-interestincome arising from many activities, such as loan servicing and various asset securitisationprograms, can be highly sensitive to market interest rates. For example, some banks providethe servicing and loan administration function for mortgage loan pools in return for a feebased on the volume of assets it administers. When interest rates fall, the servicing bankmay experience a decline in its fee income as the underlying mortgages prepay. In addition,even traditional sources of non-interest income such as transaction processing fees arebecoming more interest rate sensitive. This increased sensitivity has led both bankmanagement and supervisors to take a broader view of the potential effects of changes inmarket interest rates on bank earnings and to factor these broader effects into theirestimated earnings under different interest rate environments.

20. Economic value perspective: Variation in market interest rates can also affect the

economic value of a bank's assets, liabilities and OBS positions. Thus, the sensitivity of abank's economic value to fluctuations in interest rates is a particularly importantconsideration of shareholders, management and supervisors alike. The economic value of an


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instrument represents an assessment of the present value of its expected net cash flows,discounted to reflect market rates. By extension, the economic value of a bank can beviewed as the present value of bank's expected net cash flows, defined as the expected cashflows on assets minus the expected cash flows on liabilities plus the expected net cash flowson OBS positions. In this sense, the economic value perspective reflects one view of thesensitivity of the net worth of the bank to fluctuations in interest rates.

21. Since the economic value perspective considers the potential impact of interest ratechanges on the present value of all future cash flows, it provides a more comprehensive viewof the potential long-term effects of changes in interest rates than is offered by the earningsperspective. This comprehensive view is important since changes in near-term earnings - thetypical focus of the earnings perspective - may not provide an accurate indication of theimpact of interest rate movements on the bank's overall positions.

22. Embedded losses: The earnings and economic value perspectives discussed thusfar focus on how future changes in interest rates may affect a bank's financial performance.When evaluating the level of interest rate risk it is willing and able to assume, a bank shouldalso consider the impact that past interest rates may have on future performance. Inparticular, instruments that are not marked to market may already contain embedded gainsor losses due to past rate movements. These gains or losses may be reflected over time inthe bank's earnings. For example, a long term fixed rate loan entered into when interest rateswere low and refunded more recently with liabilities bearing a higher rate of interest will, overits remaining life, represent a drain on the bank's resources.


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II. Sound interest rate risk management practices

23. Sound interest rate risk management involves the application of four basic elementsin the management of assets, liabilities and off-balance-sheet instruments:

Appropriate board and senior management oversight;

Adequate risk management policies and procedures;

Appropriate risk measurement, monitoring and control functions; and

Comprehensive internal controls and independent audits.

24. The specific manner in which a bank applies these elements in managing its interestrate risk will depend upon the complexity and nature of its holdings and activities as well ason the level of interest rate risk exposure. What constitutes adequate interest rate riskmanagement practices can therefore vary considerably. For example, less complex bankswhose senior managers are actively involved in the details of day-to-day operations may beable to rely on relatively basic interest rate risk management processes. However, other

organisations that have more complex and wide-ranging activities are likely to require moreelaborate and formal interest rate risk management processes, to address their broad rangeof financial activities and to provide senior management with the information they need tomonitor and direct day-to-day activities. Moreover, the more complex interest rate riskmanagement processes employed at such banks require adequate internal controls thatinclude audits or other appropriate oversight mechanisms to ensure the integrity of theinformation used by senior officials in overseeing compliance with policies and limits. Theduties of the individuals involved in the risk measurement, monitoring and control functionsmust be sufficiently separate and independent from the business decision makers andposition takers to ensure the avoidance of conflicts of interest.

25. As with other risk factor categories, the Committee believes that interest rate riskshould be monitored on a consolidated, comprehensive basis, to include interest rateexposures in subsidiaries. At the same time, however, institutions should fully recognise anylegal distinctions and possible obstacles to cash flow movements among affiliates and adjusttheir risk management process accordingly. While consolidation may provide acomprehensive measure in respect of interest rate risk , it may also underestimate risk whenpositions in one affiliate are used to offset positions in another affiliate. This is because aconventional accounting consolidation may allow theoretical offsets between such positionsfrom which a bank may not in practice be able to benefit because of legal or operationalconstraints. Management should recognise the potential for consolidated measures tounderstate risks in such circumstances.


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III. Board and senior management oversight of interest rate risk6

26. Effective oversight by a bank's board of directors and senior management is criticalto a sound interest rate risk management process. It is essential that these individuals areaware of their responsibilities with regard to interest rate risk management and that theyadequately perform their roles in overseeing and managing interest rate risk.

A. Board of directors

Principle 1: In order to carry out its responsibilities, the board of directors in a bankshould approve strategies and policies with respect to interest rate risk managementand ensure that senior management takes the steps necessary to monitor and controlthese risks. The board of directors should be informed regularly of the interest raterisk exposure of the bank in order to assess the monitoring and controlling of suchrisk.

27. The board of directors has the ultimate responsibility for understanding the natureand the level of interest rate risk taken by the bank. The board should approve broadbusiness strategies and policies that govern or influence the interest rate risk of the bank. Itshould review the overall objectives of the bank with respect to interest rate risk and shouldensure the provision of clear guidance regarding the level of interest rate risk acceptable tothe bank. The board should also approve policies that identify lines of authority andresponsibility for managing interest rate risk exposures.

28. Accordingly, the board of directors is responsible for approving the overall policies ofthe bank with respect to interest rate risk and for ensuring that management takes the stepsnecessary to identify, measure, monitor, and control these risks. The board or a specificcommittee of the board should periodically review information that is sufficient in detail and

timeliness to allow it to understand and assess the performance of senior management inmonitoring and controlling these risks in compliance with the bank's board-approved policies.Such reviews should be conducted regularly, being carried out more frequently where thebank holds significant positions in complex instruments. In addition, the board or one of itscommittees should periodically re-evaluate significant interest rate risk management policiesas well as overall business strategies that affect the interest rate risk exposure of the bank.

29. The board of directors should encourage discussions between its members andsenior management - as well as between senior management and others in the bank -regarding the bank's interest rate risk exposures and management process. Board membersneed not have detailed technical knowledge of complex financial instruments, legal issues, orof sophisticated risk management techniques. They have the responsibility, however, toensure that senior management has a full understanding of the risks incurred by the bankand that the bank has personnel available who have the necessary technical skills toevaluate and control these risks.

6This section refers to a management structure composed of a board of directors and senior management. The Committee isaware that there are significant differences in legislative and regulatory frameworks across countries as regards thefunctions of the board of directors and senior management. In some countries, the board has the main, if not exclusive,function of supervising the executive body (senior management, general management) so as to ensure that the latter fulfilsits tasks. For this reason, in some cases, it is known as a supervisory board. This means that the board has no executivefunctions. In other countries, by contrast, the board has a broader competence in that it lays down the general framework forthe management of the bank. Owing to these differences, the notions of the board of directors and the senior managementare used in this paper not to identify legal constructs but rather to label two decision-making functions within a bank.


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B. Senior Management

Principle 2: Senior management must ensure that the structure of the bank's businessand the level of interest rate risk it assumes are effectively managed, that appropriatepolicies and procedures are established to control and limit these risks, and thatresources are available for evaluating and controlling interest rate risk.

30. Senior management is responsible for ensuring that the bank has adequate policiesand procedures for managing interest rate risk on both a long-term and day-to-day basis andthat it maintains clear lines of authority and responsibility for managing and controlling thisrisk. Management is also responsible for maintaining:

appropriate limits on risk taking;

adequate systems and standards for measuring risk;

standards for valuing positions and measuring performance;

a comprehensive interest rate risk reporting and interest rate risk management

review process; and

effective internal controls.

31. Interest rate risk reports to senior management should provide aggregateinformation as well as sufficient supporting detail to enable management to assess thesensitivity of the institution to changes in market conditions and other important risk factors.Senior management should also review periodically the organisation's interest rate riskmanagement policies and procedures to ensure that they remain appropriate and sound.Senior management should also encourage and participate in discussions with members ofthe board and, where appropriate to the size and complexity of the bank, with riskmanagement staff regarding risk measurement, reporting and management procedures.

32. Management should ensure that analysis and risk management activities related tointerest rate risk are conducted by competent staff with technical knowledge and experienceconsistent with the nature and scope of the bank's activities. There should be sufficient depthin staff resources to manage these activities and to accommodate the temporary absence ofkey personnel.

C. Lines of Responsibility and Authority for Managing Interest Rate Risk

Principle 3: Banks should clearly define the individuals and/or committeesresponsible for managing interest rate risk and should ensure that there is adequate

separation of duties in key elements of the risk management process to avoidpotential conflicts of interest. Banks should have risk measurement, monitoring andcontrol functions with clearly defined duties that are sufficiently independent fromposition-taking functions of the bank and which report risk exposures directly tosenior management and the board of directors. Larger or more complex banks shouldhave a designated independent unit responsible for the design and administration ofthe bank's interest rate risk measurement, monitoring and control functions.

33. Banks should clearly identify the individuals and/or committees responsible forconducting all of the various elements of interest rate risk management. Senior managementshould define lines of authority and responsibility for developing strategies, implementingtactics and conducting the risk measurement and reporting functions of the interest rate risk

management process. Senior management should also provide reasonable assurance that


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all activities and all aspects of interest rate risk are covered by a bank's risk managementprocess.

34. Care should be taken to ensure that there is adequate separation of duties in keyelements of the risk management process to avoid potential conflicts of interest.Management should ensure that sufficient safeguards exist to minimise the potential thatindividuals initiating risk-taking positions may inappropriately influence key control functionsof the risk management process such as the development and enforcement of policies andprocedures, the reporting of risks to senior management, and the conduct of back-officefunctions. The nature and scope of such safeguards should be in accordance with the sizeand structure of the bank. They should also be commensurate with the volume andcomplexity of interest rate risk incurred by the banks and the complexity of its transactionsand commitments. Larger or more complex banks should have a designated independentunit responsible for the design and administration of the bank's interest rate riskmeasurement, monitoring and control functions.The control functions carried out by this unit,such as administering the risk limits, are part of the overall internal control system.

35. The personnel charged with measuring, monitoring and controlling interest rate riskshould have a well-founded understanding of all types of interest rate risk faced throughoutthe bank.


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IV. Adequate risk management policies and procedures

Principle 4: It is essential that banks' interest rate risk policies and procedures are

clearly defined and consistent with the nature and complexity of their activities. Thesepolicies should be applied on a consolidated basis and, as appropriate, at the level ofindividual affiliates, especially when recognising legal distinctions and possibleobstacles to cash movements among affiliates.

36. Banks should have clearly defined policies and procedures for limiting andcontrolling interest rate risk. These policies should be appliedon a consolidated basis and,as appropriate, at specific affiliates or other units of the bank. Such policies and proceduresshould delineate lines of responsibility and accountability over interest rate risk managementdecisions and should clearly define authorised instruments, hedging strategies and position-taking opportunities. Interest rate risk policies should also identify quantitative parametersthat define the level of interest rate risk acceptable for the bank. Where appropriate, such

limits should be further specified for certain types of instruments, portfolios, and activities. Allinterest rate risk policies should be reviewed periodically and revised as needed.Management should define the specific procedures and approvals necessary for exceptionsto policies, limits and authorisations.

37. A policy statement identifying the types of instruments and activities that the bankmay employ or conduct is one means whereby management can communicate theirtolerance of risk on a consolidated basis and at different legal entities. If such a statement isprepared, it should clearly identify permissible instruments, either specifically or by theircharacteristics, and should also describe the purposes or objectives for which they may beused. The statement should also delineate a clear set of institutional procedures for acquiringspecific instruments, managing portfolios, and controlling the bank's aggregate interest rate

risk exposure.

Principle 5: It is important that banks identify the interest rate risks inherent in newproducts and activities and ensure these are subject to adequate procedures andcontrols before being introduced or undertaken. Major hedging or risk managementinitiatives should be approved in advance by the board or its appropriate delegatedcommittee.

38. Products and activities that are new to the bank should undergo a careful pre-acquisition review to ensure that the bank understands their interest rate risk characteristicsand can incorporate them into its risk management process. When analysing whether or nota product or activity introduces a new element of interest rate risk exposure, the bank shouldbe aware that changes to an instrument's maturity, repricing or repayment terms canmaterially affect the product's interest rate risk characteristics. To take a simple example, adecision to buy and hold a 30 year treasury bond would represent a significantly differentinterest rate risk strategy for a bank that had previously limited its investment maturities toless than 3 years. Similarly, a bank specialising in fixed-rate short-term commercial loansthat then engages in residential fixed-rate mortgage lending should be aware of theoptionality features of the risk embedded in many mortgage products that allow the borrowerto prepay the loan at any time with little, if any, penalty.

39. Prior to introducing a new product, hedging, or position-taking strategy,management should ensure that adequate operational procedures and risk control systems

are in place. The board or its appropriate delegated committee should also approve majorhedging or risk management initiatives in advance of their implementation. Proposals toundertake new instruments or new strategies should contain these features:


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a description of the relevant product or strategy;

an identification of the resources required to establish sound and effective interestrate risk management of the product or activity;

an analysis of the reasonableness of the proposed activities in relation to the bank'soverall financial condition and capital levels; and

the procedures to be used to measure, monitor and control the risks of the proposedproduct or activity.


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V. Risk measurement, monitoring and control functions

A. Interest rate risk measurement

Principle 6: It is essential that banks have interest rate risk measurement systems thatcapture all material sources of interest rate risk and that assess the effect of interestrate changes in ways that are consistent with the scope of their activities. Theassumptions underlying the system should be clearly understood by risk managersand bank management.

40. In general, but depending on the complexity and range of activities of the individualbank, banks should have interest rate risk measurement systems that assess the effects ofrate changes on both earnings and economic value. These systems should providemeaningful measures of a bank's current levels of interest rate risk exposure, and should becapable of identifying any excessive exposures that might arise.

41. Measurement systems should:

assess all material interest rate risk associated with a bank's assets, liabilities, andOBS positions;

utilise generally accepted financial concepts and risk measurement techniques; and

have well documented assumptions and parameters.

42. As a general rule, it is desirable for any measurement system to incorporate interestrate risk exposures arising from the full scope of a bank's activities, including both tradingand non-trading sources. This does not preclude different measurement systems and riskmanagement approaches being used for different activities; however, management shouldhave an integrated view of interest rate risk across products and business lines.

43. A bank's interest rate risk measurement system should address all material sourcesof interest rate risk including repricing, yield curve, basis and option risk exposures. In manycases, the interest rate characteristics of a bank's largest holdings will dominate itsaggregate risk profile. While all of a bank's holdings should receive appropriate treatment,measurement systems should evaluate such concentrations with particular rigour. Interestrate risk measurement systems should also provide rigorous treatment of those instrumentswhich might significantly affect a bank's aggregate position, even if they do not represent amajor concentration. Instruments with significant embedded or explicit option characteristicsshould receive special attention.

44. A number of techniques are available for measuring the interest rate risk exposure

of both earnings and economic value. Their complexity ranges from simple calculations tostatic simulations using current holdings to highly sophisticated dynamic modellingtechniques that reflect potential future business and business decisions.

45. The simplest techniques for measuring a bank's interest rate risk exposure beginwith a maturity/repricing schedule that distributes interest-sensitive assets, liabilities andOBS positions into "time bands" according to their maturity (if fixed rate) or time remaining totheir next repricing (if floating rate). These schedules can be used to generate simpleindicators of the interest rate risk sensitivity of both earnings and economic value to changinginterest rates. When this approach is used to assess the interest rate risk of current earnings,it is typically referred to as gap analysis. The size of the gap for a given time band - that is,assets minus liabilities plus OBS exposures that reprice or mature within that time band -

gives an indication of the bank's repricing risk exposure.


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46. A maturity/repricing schedule can also be used to evaluate the effects of changinginterest rates on a bank's economic value by applying sensitivity weights to each time band.Typically, such weights are based on estimates of the duration of the assets and liabilitiesthat fall into each time-band, where duration is a measure of the percent change in theeconomic value of a position that will occur given a small change in the level of interest rates.Duration-based weights can be used in combination with a maturity/repricing schedule toprovide a rough approximation of the change in a bank's economic value that would occurgiven a particular set of changes in market interest rates.

47. Many banks (especially those using complex financial instruments or otherwisehaving complex risk profiles) employ more sophisticated interest rate risk measurementsystems than those based on simple maturity/repricing schedules. These simulationtechniques typically involve detailed assessments of the potential effects of changes ininterest rates on earnings and economic value by simulating the future path of interest ratesand their impact on cash flows. In static simulations, the cash flows arising solely from thebank's current on- and off-balance sheet positions are assessed. In a dynamic simulationapproach, the simulation builds in more detailed assumptions about the future course of

interest rates and expected changes in a bank's business activity over that time. These moresophisticated techniques allow for dynamic interaction of payments streams and interestrates, and better capture the effect of embedded or explicit options.

48. Regardless of the measurement system, the usefulness of each technique dependson the validity of the underlying assumptions and the accuracy of the basic methodologiesused to model interest rate risk exposure. In designing interest rate risk measurementsystems, banks should ensure that the degree of detail about the nature of their interest-sensitive positions is commensurate with the complexity and risk inherent in those positions.For instance, using gap analysis, the precision of interest rate risk measurement depends inpart on the number of time bands into which positions are aggregated. Clearly, aggregationof positions/cash flows into broad time bands implies some loss of precision. In practice, the

bank must assess the significance of the potential loss of precision in determining the extentof aggregation and simplification to be built into the measurement approach.

49. Estimates of interest rate risk exposure, whether linked to earnings or economicvalue, utilise, in some form, forecasts of the potential course of future interest rates. For riskmanagement purposes, banks should incorporate a change in interest rates that issufficiently large to encompass the risks attendant to their holdings. Banks should considerthe use of multiple scenarios, including potential effects in changes in the relationshipsamong interest rates (i.e. yield curve risk and basis risk) as well as changes in the generallevel of interest rates. For determining probable changes in interest rates, simulationtechniques could, for example, be used. Statistical analysis can also play an important role inevaluating correlation assumptions with respect to basis or yield curve risk.

50. The integrity and timeliness of data on current positions is also a key component ofthe risk measurement process. A bank should ensure that all material positions and cashflows, whether stemming from on- or off-balance-sheet positions, are incorporated into themeasurement system on a timely basis. Where applicable, these data should includeinformation on the coupon rates or cash flows of associated instruments and contracts. Anymanual adjustments to underlying data should be clearly documented, and the nature andreasons for the adjustments should be clearly understood. In particular, any adjustments toexpected cash flows for expected prepayments or early redemptions should be wellreasoned and such adjustments should be available for review.

51. In assessing the results of interest rate risk measurement systems, it is important

that the assumptions underlying the system are clearly understood by risk managers andbank management. In particular, techniques using sophisticated simulations should be used


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carefully so that they do not become "black boxes", producing numbers that have theappearance of precision, but that in fact are not very accurate when their specificassumptions and parameters are revealed. Key assumptions should be recognised by seniormanagement and risk managers and should be re-evaluated at least annually. They shouldalso be clearly documented and their significance understood. Assumptions used inassessing the interest rate sensitivity of complex instruments and instruments with uncertainmaturities should be subject to particularly rigorous documentation and review.

52. When measuring interest rate risk exposure, two further aspects call for morespecific comment: the treatment of those positions where behavioural maturity differs fromcontractual maturity and the treatment of positions denominated in different currencies.Positions such as savings and sight deposits may have contractual maturities or may beopen-ended, but in either case, depositors generally have the option to make withdrawals atany time. In addition, banks often choose not to move rates paid on these deposits in linewith changes in market rates. These factors complicate the measurement of interest rate riskexposure, since not only the value of the positions but also the timing of their cash flows canchange when interest rates vary. With respect to banks' assets, prepayment features of

mortgages and mortgage related instruments also introduce uncertainty about the timing ofcash flows on these positions. These issues are described in more detail in Annex 1, whichforms an integral part of this text.

53. Banks with positions denominated in different currencies can expose themselves tointerest rate risk in each of these currencies. Since yield curves vary from currency tocurrency, banks generally need to assess exposures in each. Banks with the necessary skillsand sophistication, and with material multi-currency exposures, may choose to include intheir risk measurement process methods to aggregate their exposures in different currenciesusing assumptions about the correlation between interest rates in different currencies. Abank that uses correlation assumptions to aggregate its risk exposures should periodicallyreview the stability and accuracy of those assumptions. The bank also should evaluate what

its potential risk exposure would be in the event that such correlations break down.

B. Limits

Principle 7: Banks must establish and enforce operating limits and other practicesthat maintain exposures within levels consistent with their internal policies.

54. The goal of interest rate risk management is to maintain a bank's interest rate riskexposure within self-imposed parameters over a range of possible changes in interest rates.A system of interest rate risk limits and risk taking guidelines provides the means forachieving that goal. Such a system should set boundaries for the level of interest rate risk for

the bank and, where appropriate, should also provide the capability to allocate limits toindividual portfolios, activities or business units. Limit systems should also ensure thatpositions that exceed certain predetermined levels receive prompt management attention. Anappropriate limit system should enable management to control interest rate risk exposures,initiate discussion about opportunities and risks, and monitor actual risk taking againstpredetermined risk tolerances.

55. A bank's limits should be consistent with its overall approach to measuring interestrate risk. Aggregate interest rate risk limits clearly articulating the amount of interest rate riskacceptable to the bank should be approved by the board of directors and re-evaluatedperiodically. Such limits should be appropriate to the size, complexity and capital adequacyof the bank as well as its ability to measure and manage its risk. Depending on the nature ofa bank's holdings and its general sophistication, limits can also be identified with individualbusiness units, portfolios, instrument types or specific instruments. The level of detail of risk


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limits should reflect the characteristics of the bank's holdings including the various sources ofinterest rate risk to which the bank is exposed.

56. Limit exceptions should be made known to appropriate senior management withoutdelay. There should be a clear policy as to how senior management will be informed andwhat action should be taken by management in such cases. Particularly important is whetherlimits are absolute in the sense that they should never be exceeded or whether, underspecific circumstances, which should be clearly described, breaches of limits can betolerated for a short period of time. In that context, the relative conservatism of the chosenlimits may be an important factor.

57. Regardless of their level of aggregation, limits should be consistent with the bank'soverall approach to measuring interest rate risk and should address the potential impact ofchanges in market interest rates on reported earnings and the bank's economic value ofequity. From an earnings perspective, banks should explore limits on the variability of netincome as well as net interest income in order to fully assess the contribution of non-interestincome to the interest rate risk exposure of the bank. Such limits usually specify acceptablelevels of earnings volatility under specified interest rate scenarios.

58. The form of limits for addressing the effect of rates on a bank's economic value ofequity should be appropriate for the size and complexity of its underlying positions. Forbanks engaged in traditional banking activities and with few holdings of long-terminstruments, options, instruments with embedded options, or other instruments whose valuemay be substantially altered given changes in market rates, relatively simple limits on theextent of such holdings may suffice. For more complex banks, however, more detailed limitsystems on acceptable changes in the estimated economic value of equity of the bank maybe needed.

59. Interest rate risk limits may be keyed to specific scenarios of movements in market

interest rates such as an increase or decrease of a particular magnitude. The ratemovements used in developing these limits should represent meaningful stress situationstaking into account historic rate volatility and the time required for management to addressexposures. Limits may also be based on measures derived from the underlying statisticaldistribution of interest rates, such as earnings at risk or economic value at risk techniques.Moreover, specified scenarios should take account of the full range of possible sources ofinterest rate risk to the bank including mismatch, yield curve, basis and option risks. Simplescenarios using parallel shifts in interest rates may be insufficient to identify such risks.

C. Stress Testing

Principle 8: Banks should measure their vulnerability to loss under stressful marketconditions - including the breakdown of key assumptions - and consider those resultswhen establishing and reviewing their policies and limits for interest rate risk.

60. The risk measurement system should also support a meaningful evaluation of theeffect of stressful market conditions on the bank. Stress testing should be designed toprovide information on the kinds of conditions under which the bank's strategies or positionswould be most vulnerable, and thus may be tailored to the risk characteristics of the bank.Possible stress scenarios might include abrupt changes in the general level of interest rates,changes in the relationships among key market rates (i.e. basis risk), changes in the slopeand the shape of the yield curve (i.e. yield curve risk), changes in the liquidity of key financialmarkets or changes in the volatility of market rates. In addition, stress scenarios shouldinclude conditions under which key business assumptions and parameters break down. Thestress testing of assumptions used for illiquid instruments and instruments with uncertain


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contractual maturities is particularly critical to achieving an understanding of the bank's riskprofile. In conducting stress tests, special consideration should be given to instruments ormarkets where concentrations exist as such positions may be more difficult to liquidate oroffset in stressful situations. Banks should consider "worst case" scenarios in addition tomore probable events. Management and the board of directors should periodically reviewboth the design and the results of such stress tests, and ensure that appropriate contingencyplans are in place.

D. Interest Rate Risk Monitoring and Reporting

Principle 9: Banks must have adequate information systems for measuring,monitoring, controlling and reporting interest rate exposures. Reports must beprovided on a timely basis to the bank's board of directors, senior management and,where appropriate, individual business line managers.

61. An accurate, informative, and timely management information system is essential formanaging interest rate risk exposure, both to inform management and to support compliancewith board policy. Reporting of risk measures should be regular and should clearly comparecurrent exposure to policy limits. In addition, past forecasts or risk estimates should becompared with actual results to identify any modelling shortcomings.

62. Reports detailing the interest rate risk exposure of the bank should be reviewed bythe board on a regular basis. While the types of reports prepared for the board and forvarious levels of management will vary based on the bank's interest rate risk profile, theyshould, at a minimum include the following:

summaries of the bank's aggregate exposures;

reports demonstrating the bank's compliance with policies and limits;

results of stress tests including those assessing breakdowns in key assumptionsand parameters; and

summaries of the findings of reviews of interest rate risk policies, procedures, andthe adequacy of the interest rate risk measurement systems, including any findingsof internal and external auditors and retained consultants.


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VI. Internal controls

Principle 10: Banks must have anadequate system ofinternal controls over theirinterest rate risk management process. A fundamental component of the internalcontrol system involves regular independent reviews and evaluations of theeffectiveness of the system and, where necessary, ensuring that appropriate revisionsor enhancements to internal controls are made. The results of such reviews should beavailable to relevant supervisory authorities.

63. Banks should have adequate internal controls to ensure the integrity of their interestrate risk management process. These internal controls should be an integral part of theinstitution's overall system of internal control. They should promote effective and efficientoperations, reliable financial and regulatory reporting, and compliance with relevant laws,regulations and institutional policies. An effective system of internal control for interest raterisk includes:

a strong control environment;

an adequate process for identifying and evaluating risk;

the establishment of control activities such as policies, procedures andmethodologies;

adequate information systems; and,

continual review of adherence to established policies and procedures.

64. With regard to control policies and procedures, attention should be given toappropriate approval processes, exposure limits, reconciliations, reviews and othermechanisms designed to provide a reasonable assurance that the institution's interest raterisk management objectives are achieved. Many attributes of a sound risk management

process, including risk measurement, monitoring and control functions, are key aspects of aneffective system of internal control. Banks should ensure that all aspects of the internalcontrol system are effective, including those aspects that are not directly part of the riskmanagement process.

65. In addition, an important element of a bank's internal control system over its interestrate risk management process is regular evaluation and review. This includes ensuring thatpersonnel are following established policies and procedures, as well as ensuring that theprocedures that were established actually accomplish the intended objectives. Such reviewsand evaluations should also address any significant change that may impact theeffectiveness of controls, such as changes in market conditions, personnel, technology, andstructures of compliance with interest rate risk exposure limits, and ensure that appropriate

follow-up with management has occurred for any limits that were exceeded. Managementshould ensure that all such reviews and evaluations are conducted regularly by individualswho are independent of the function they are assigned to review. When revisions orenhancements to internal controls are warranted, there should be a mechanism in place toensure that these are implemented in a timely manner.

66. Reviews of the interest rate risk measurement system should include assessmentsof the assumptions, parameters, and methodologies used. Such reviews should seek tounderstand, test, and document the current measurement process, evaluate the system'saccuracy, and recommend solutions to any identified weaknesses. If the measurementsystem incorporates one or more subsidiary systems or processes, the review should includetesting aimed at ensuring that the subsidiary systems are well-integrated and consistent witheach other in all critical respects. The results of this review, along with any recommendations


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for improvement, should be reported to senior management and/or the board and acted uponin a timely manner.

67. The frequency and extent to which a bank should re-evaluate its risk measurementmethodologies and models depend, in part, on the particular interest rate risk exposurescreated by holdings and activities, the pace and nature of market interest rate changes, andthe pace and complexity of innovation with respect to measuring and managing interest raterisk.

68. Banks, particularly those with complex risk exposures, should have theirmeasurement, monitoring and control functions reviewed on a regular basis by anindependent party (such as an internal or external auditor). In such cases, reports written byexternal auditors or other outside parties should be available to relevant supervisoryauthorities. It is essential that any independent reviewer ensures that the bank's riskmeasurement system is sufficient to capture all material elements of interest rate risk,whether arising from on- or off-balance sheet activities. Such a reviewer should consider thefollowing factors in making the risk assessment:

the quantity of interest rate risk, e.g.

- the volume and price sensitivity of various products;

- the vulnerability of earnings and capital under differing rate changes includingyield curve twists;

- the exposure of earnings and economic value to various other forms ofinterest rate risk, including basis and optionality risk.

the quality of interest rate risk management, e.g.

-whether the bank's internal measurement system is appropriate to the nature,scope, and complexities of the bank and its activities;

- whether the bank has an independent risk control unit responsible for thedesign and administration of the risk measurement, monitoring and controlfunctions;

- whether the board of directors and senior management are actively involved inthe risk control process;

- whether internal policies, controls and procedures concerning interest rate riskare well documented and complied with;

- whether the assumptions of the risk measurement system are well

documented, data accurately processed, and data aggregation is proper andreliable; and

- whether the organisation has adequate staffing to conduct a sound riskmanagement process.

69. In those instances where the independent review is conducted by internal auditors,banks are encouraged to have the risk measurement, monitoring and control functionsperiodically reviewed by external auditors.


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VII. Information for supervisory authorities

Principle 11: Supervisory authorities should obtain from banks sufficient and timelyinformation with which to evaluate their level of interest rate risk. This informationshould take appropriate account of the range of maturities and currencies in eachbank's portfolio, including off-balance-sheet items, as well as other relevant factors,such as the distinction between trading and non-trading activities.

70. Supervisory authorities should, on a regular basis, obtain sufficient information toassess individual banks' interest rate risk exposures. In order to minimise reporting burden,internal management reports are the preferred method for obtaining this information, but itcould also be obtained through standardised reports that are submitted by banks, throughon-site examinations, or by other means. The precise information obtained could differamong supervisors, but must include the results of the standardised rate shock applied underPrinciple 14. As a minimum, supervisors should have enough information to identify andmonitor banks that have significant repricing mismatches. Information contained in internalmanagement reports, such as maturity/repricing gaps, earnings and economic value

simulation estimates, and the results of stress tests can be particularly useful in this regard.

71. Supervisors may want to collect additional information on those positions where thebehavioural maturity is different from the contractual maturity. Reviewing the results of abank's internal model, perhaps under a variety of different assumptions, scenarios and stresstests, can also be highly informative.

72. Banks operating in different currencies can expose themselves to interest rate risk ineach of these currencies. Supervisory authorities, therefore, will want banks to analyse theirexposures in different currencies separately, at least when exposures in different currenciesare material.

73. Another question is the extent to which interest rate risk should be viewed on awhole bank basis or whether the trading book, which is marked to market, and the bankingbook, which is often not, should be treated separately. As a general rule, it is desirable forany measurement system to incorporate interest rate risk exposures arising from the fullscope of a bank's activities, including both trading and non-trading sources. This does notpreclude different measurement systems and risk management approaches being used fordifferent activities; however, management should have an integrated view of interest rate riskacross products and business lines. Supervisors may want to obtain more specificinformation on how trading and non-trading activities are measured and incorporated into asingle measurement system. They should also ensure that interest rate risk in both tradingand non-trading activities is properly managed and controlled.

74. A meaningful analysis of interest rate risk is only possible if the supervisor receivesthe relevant information regularly and on a timely basis. Since the risk profile in the traditionalbanking business changes less rapidly than in the trading business, quarterly or semi-annualreporting of the former may be sufficient for many banks. Some of the factors thatsupervisors may wish to consider when designing a specific reporting framework aredescribed in greater detail in Annex 2, which forms an integral part of this text.


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VIII. Capital adequacy

Principle 12: Banks must hold capital commensurate with the level of interest rate riskthey undertake.

75. Changes in interest rates expose banks to the risk of loss, which may, in extremecases, threaten the survival of the institution. In addition to adequate systems and controls,capital has an important role to play in mitigating and supporting this risk. As part of soundmanagement, banks translate the level of interest rate risk they undertake, whether as part oftheir trading or non-trading activities, into their overall evaluation of capital adequacy,although there is no general agreement on the methodologies to be used in this process. Incases where banks undertake significant interest rate risk in the course of their businessstrategy, a substantial amount of capital should be allocated specifically to support this risk.

76. Where interest rate risk is undertaken as part of a banks trading activities, thesupervisory capital treatment of that risk is set out in the Market Risk Amendment. Where it isundertaken as part of a banks non-trading activities, the supervisory treatment, covering

both capital and other tools of supervision, is set out in Principles 14 and 15 of thisdocument.


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IX. Disclosure of interest rate risk

Principle 13: Banks should release to the public information on the level of interestrate risk and their policies for its management.

77. The core objective of public disclosure is to facilitate market participantsassessment of banks interest rate risk profiles in both the banking and trading books. TheCommittee has laid down recommendations for the public disclosure of information oninterest rate risk as part of the overall review of the Accord7. These include information aboutthe banks risk management processes, the characteristics of any models used, the ratescenarios used and key assumptions on judgmental aspects of assets and liability portfoliosthat drive the resulting risk measure.

7See Part 4: Pillar 3 - Market Discipline, ofThe New Basel Capital Accord, January 2001.


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X. Supervisory treatment of interest rate risk in the banking book

Principle 14: Supervisory authorities must assess whether the internal measurementsystems of banks adequately capture the interest rate risk in their banking book. If abanks internal measurement system does not adequately capture the interest raterisk, banks must bring the system to the required standard. To facilitate supervisorsmonitoring of interest rate risk exposures across institutions, banks must provide theresults of their internal measurement systems, expressed in terms of the threat toeconomic value, using a standardised interest rate shock.

78. Supervisors should evaluate whether internal measurement systems for bankingbook interest rate risk are adequate for managing risk in a safe and sound manner andadequate for use in supervisory evaluations of capital adequacy. Depending on the natureand scale of a banks business, a wide variety of methodologies could be employed ininternal measurement systems. Such evaluations could be performed through a review ofinternal and external audit findings or through on-site supervisory reviews.

79. A banks internal systems must meet the following criteria, which amplify the keypoints set out in Principle 6.

(a) They must assess all material interest rate risk associated with a banks assets,liabilities and off-balance-sheet positions in the banking book. To do this, they mustaccurately incorporate all a banks interest rate sensitive on and off-balance sheetholdings.

(b) They must utilise generally accepted financial concepts and risk measurementtechniques. In particular, they must be capable of measuring risk on both anearnings and economic value approach. The monitoring of interest rate risk in thebanking book for supervisory purposes would be based on risk as measured by theeconomic value approach8.

(c) Their data inputs are adequately specified (commensurate with the nature andcomplexity of a banks holdings) with regard to rates, maturities, re-pricing,embedded options and other details to provide a reasonably accurate portrayal ofchanges in economic value or earnings.

(d) The systems assumptions (used to transform positions into cash flows) arereasonable, properly documented and stable over time. This is especially importantfor assets and liabilities whose behaviour differs markedly from contractual maturityor repricing, and for new products. Material changes to assumptions should bedocumented, justified and approved by management. In particular, supervisorswould not normally expect core deposits - those deposits which can be withdrawn

without notice but which in practice tend to remain with the bank - to be given anassumed maturity or repricing frequency of longer than three to five years withoutadditional empirical analysis.

(e) Interest rate risk measurement systems must be integrated into the banks daily riskmanagement practices. The output of the systems should be used in characterisingthe level of interest rate risk to senior management and boards of directors.

8The use of the economic value perspective is one area where the application of this approach to banks outside the G10

internationally active population might be varied.


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(f) The interest rate shock (or the equivalent parameters) as determined in paragraph819 below has been properly incorporated into the systems.

80. If supervisors determine that a banks internal measurement system does notadequately capture interest rate risk in the banking book, the first, most immediate course ofaction is to require the bank to bring its system to the required standard. In the interim, thebank must supply its supervisor with information on the interest rate risk in its banking bookin a form specified by the supervisor. Supervisors may wish to use this information in makingtheir own estimates of risk using a standardised framework applying the same standardisedrate shock10.

81. This standardised rate shock should be based on the following:

For exposures in G10 currencies, either:

(a) an upward and downward 200 basis point parallel rate shock, or

(b) 1st and 99th percentile of observed interest rate changes using a one year

(240 working days) holding period and a minimum five years of observations.

For exposures in non-G10 currencies, either:

(a) a parallel rate shock substantially consistent with 1st and 99th percentile ofobserved interest rate changes using a one year (240 working days) holdingperiod and a minimum five years of observations for the particular non-G10currency, or

(b) 1st and 99th percentile of observed interest rate changes using a one year(240 working days) holding period and a minimum five years of observations.

82. Many banks will be exposed to interest rate risk in more than one currency. In suchcases, banks should carry out a similar analysis for each currency accounting for 5% or moreof their banking book assets, using an interest rate shock calculated according to the rulesset out above. To ensure complete coverage of the banking book, any remaining exposuresshould be subject to a 200 basis point shock.

83. The relative simplicity of the 200 basis point parallel rate shock has thedisadvantage of ignoring exposures that might be revealed through scenarios that includeyield curve twists, inversions and other relevant scenarios. As has already been noted, suchalternative scenarios are a necessary component of the overall management of interest raterisk. Supervisors will continue to expect institutions to perform multiple scenarios inevaluation of their interest rate risk as appropriate to the level and nature of risk they are

taking.

9See Annex 3 for the background to selection of the standardised interest rate shock.

10An example of a possible standardised framework is set out in Annex 4.


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Principle 15: If supervisors determine that a bank is not holding capital commensuratewith the level of interest rate risk in the banking book, they should consider remedialaction, requiring the bank either to reduce its risk, to hold a specific additional amountof capital, or a combination of both.

84. Banks must hold capital to support the level of interest rate risk they undertake.Supervisors should be particularly attentive to the capital sufficiency of outlier banks those whose interest rate risk in the banking book leads to a economic value decline of morethan 20% of the sum of Tier 1 and Tier 2 capital following the standardised interest rateshock or its equivalent (as determined under Principle 14).

85. The response in cases where supervisors determine that there is insufficient capitalwill depend on a variety of factors. However, the response must result in the bank eitherholding additional capital or reducing the measured risk (through, for example, hedging or arestructuring of the banking book), or a combination of both, depending on the circumstancesof the case.


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Annex 1

Interest rate risk measurement techniques

1. This annex provides a brief overview of the various techniques used by banks tomeasure the exposure of earnings and of economic value to changes in interest rates. Thevariety of the techniques ranges from calculations that rely on simple maturity and repricingtables, to static simulations based on current on- and off-balance sheet positions, to highlysophisticated dynamic modelling techniques that incorporate assumptions about thebehaviour of the bank and its customers in response to changes in the interest rateenvironment. Some of these general approaches can be used to measure interest rate riskexposure from both an earnings and an economic value perspective, while others are moretypically associated with only one of these two perspectives. In addition, the methods vary intheir ability to capture the different forms of interest rate exposure: the simplest methods are

intended primarily to capture the risks arising from maturity and repricing mismatches, whilethe more sophisticated methods can more easily capture the full range of risk exposures.

2. As this discussion suggests, the various measurement approaches described belowhave their strengths and weaknesses in terms of providing accurate and reasonablemeasures of interest rate risk exposure. Ideally, a bank's interest rate risk measurementsystem would take into account the specific characteristics of each individual interest-sensitive position, and would capture in detail the full range of potential movements ininterest rates. In practice, however, measurement systems embody simplifications that moveaway from this ideal. For instance, in some approaches, positions may be aggregated intobroad categories, rather than modelled separately, introducing a degree of measurementerror into the estimation of their interest rate sensitivity. Similarly, the nature of interest rate

movements that each approach can incorporate may be limited: in some cases, only aparallel shift of the yield curve may be assumed or less than perfect correlations betweeninterest rates may not be taken into account. Finally, the various approaches differ in theirability to capture the optionality inherent in many positions and instruments. The discussionin the following sections will highlight the areas of simplification that typically characteriseeach of the major interest rate risk measurement techniques.

A. Repricing Schedules

3. The simplest techniques for measuring a bank's interest rate risk exposure begin

with a maturity/repricing schedule that distributes interest-sensitive assets, liabilities and off-balance sheet positions into a certain number of predefined time bands according to theirmaturity (if fixed rate) or time remaining to their next repricing (if floating rate). Those assetsand liabilities lacking definitive repricing intervals (e.g. sight deposits or savings accounts) oractual maturities that could vary from contractual maturities (e.g. mortgages with an optionfor early repayment) are assigned to repricing time bands according to the judgement andpast experience of the bank.

4. Gap analysis: Simple maturity/repricing schedules can be used to generate simpleindicators of the interest rate risk sensitivity of both earnings and economic value to changinginterest rates. When this approach is used to assess the interest rate risk of current earnings,it is typically referred to as gap analysis. Gap analysis was one of the first methods

developed to measure a bank's interest rate risk exposure, and continues to be widely usedby banks. To evaluate earnings exposure, interest rate sensitive liabilities in each time band


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are subtracted from the corresponding interest rate sensitive assets to produce a repricing"gap" for that time band. This gap can be multiplied by an assumed change in interest ratesto yield an approximation of the change in net interest income that would result from such aninterest rate movement. The size of the interest rate movement used in the analysis can bebased on a variety of factors, including historical experience, simulation of potential futureinterest rate movements, and the judgement of bank management.

5. A negative, or liability-sensitive, gap occurs when liabilities exceed assets (includingoff-balance sheet positions) in a given time band. This means that an increase in marketinterest rates could cause a decline in net interest income. Conversely, a positive, or asset-sensitive, gap implies that the bank's net interest income could decline as a result of adecrease in the level of interest rates.

6. These simple gap calculations can be augmented by information on the averagecoupon on assets and liabilities in each time band. This information can be used to place theresults of the gap calculations in context. For instance, information on the average couponrate could be used to calculate estimates of the level of net interest income arising frompositions maturing or repricing within a given time band, which would then provide a "scale"to assess the changes in income implied by the gap analysis.

7. Although gap analysis is a very commonly used approach to assessing interest raterisk exposure, it has a number of shortcomings. First, gap analysis does not take account ofvariation in the characteristics of different positions within a time band. In particular, allpositions within a given time band are assumed to mature or reprice simultaneously, asimplification that is likely to have greater impact on the precision of the estimates as thedegree of aggregation within a time band increases. Moreover, gap analysis ignoresdifferences in spreads between interest rates that could arise as the level of market interestrates changes (basis risk). In addition, it does not take into account any changes in the timingof payments that might occur as a result of changes in the interest rate environment. Thus, it

fails to account for differences in the sensitivity of income that may arise from option-relatedpositions. For these reasons, gap analysis provides only a rough approximation to the actualchange in net interest income which would result from the chosen change in the pattern ofinterest rates. Finally, most gap analyses fail to capture variability in non-interest revenueand expenses, a potentially important source of risk to current income.

8. Duration: A maturity/repricing schedule can also be used to evaluate the effects ofchanging interest rates on a bank's economic value by applying sensitivity weights to eachtime band. Typically, such weights are based on estimates of the duration of the assets andliabilities that fall into each time band. Duration is a measure of the percent change in theeconomic value of a position that will occur given a small change in the level of interestrates.11 It re

Documents

Principles for the Management and Supervision of Interest Ra