Description
It is essential that banks' interest rate risk policies and procedures are clearly defined and consistent with the nature and complexity of their activities. These policies should be applied on a consolidated basis and, as appropriate, at the level of individual affiliates, especially when recognising legal distinctions and possible obstacles to cash movements among affiliates.
Basel Committee
on Banking Supervision
Principles for the
Management and
Supervision of Interest
Rate Risk
July 2004
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ISBN print: 92-9131-670-9
ISBN web: 92-9197-670-9
Table of Contents
Summary ..................................................................................................................................1
I. Sources and effects of interest rate risk ..........................................................................5
A. Sources of interest rate risk ...................................................................................5
B. 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...................................................................................................9
B. Senior management .............................................................................................10
C. Lines of responsibility and authority 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 ............................................................................14
B. Limits....................................................................................................................16
C. Stress testing .......................................................................................................17
D. 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...................................234
Annex 1: Interest rate risk measurement techniques .............................................................27
A. Repricing schedules.............................................................................................27
B. Simulation approaches.........................................................................................30
C. Additional issues ..................................................................................................31
Annex 2: Monitoring of interest rate risk by supervisory authorities .......................................33
A. Time bands ..........................................................................................................33
B. Items ....................................................................................................................34
C. Supervisory analysis ............................................................................................34
Annex 3: The standardised interest rate shock ......................................................................36
Annex 4: An example of a standardised framework ...............................................................38
A. Methodology.........................................................................................................38
B. Calculation process..............................................................................................39
Principles for the
Management and Supervision of Interest Rate Risk
Summary
1. As part of its ongoing efforts to address international bank supervisory issues, the
Basel Committee on Banking Supervision
1
(the Committee) issued a paper on principles for
the management of interest rate risk in September 1997. In developing these principles, the
Committee drew on supervisory guidance in member countries, on the comments of the
banking industry on the Committee's earlier paper, issued for consultation in April 1993,
2
and
on comments received on the draft paper issued for consultation. In addition, the paper
incorporated many of 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 for market risk (Market Risk Amendment).
4
This revised version of the 1997
paper was released for public consultation in January 2001 and September 2003, and is
being issued to support the Pillar 2 approach to interest rate risk in the banking book in the
new capital framework.
5
The revision is reflected especially in this Summary, in Principles 12
to 15, and in Annexes 3 and 4.
2. Principles 1 to 13 in this paper are intended to be of general application for the
management of interest rate risk, independent of whether the positions are part of the trading
book or reflect banks' non-trading activities. They refer to an interest rate risk management
process, which includes the development of a business strategy, the assumption of assets
and liabilities in banking and trading activities, as well as a system of internal controls. In
particular, they address the need for effective interest rate risk measurement, monitoring and
control functions within the interest rate risk management process. Principles 14 and 15, on
the other hand, specifically address the supervisory treatment of interest rate risk in the
banking book.
3. The principles are intended to be of general application, based as they are on
practices currently used by many international banks, even though their specific application
will depend to some extent on the complexity and range of activities undertaken by individual
banks. Under the new capital framework, they form minimum standards expected of
internationally active banks.
1
The Basel Committee on Banking Supervision is a Committee of banking supervisory authorities which was
established by the central bank Governors of the Group of Ten countries in 1975. It consists of senior
representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany,
Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States.
It usually meets at the Bank for International Settlements (BIS) in Basel, Switzerland, where its permanent
Secretariat is located.
2
Measurement of Banks' Exposure to Interest Rate Risk, consultative proposal by the Committee, April 1993
(available on the BIS website athttp://www.bis.org/publ/bcbs11.pdf).
3
Risk Management Guidelines for Derivatives, July 1994 (available on the BIS website athttp://www.bis.org/publ/bcbsc211.pdf).
4
Amendment to the Capital Accord to Incorporate Market Risk, January 1996 (available on the BIS website athttp://www.bis.org/publ/bcbs24.pdf).
5
See “Part 3: The Second Pillar - Supervisory Review Process”, International Convergence of Capital
Measurement and Capital Standards: A Revised Framework, June 2004 (available on the BIS website athttp://www.bis.org/publ/bcbs107.pdf).
1
4. The exact approach chosen by individual supervisors to monitor and respond to
interest rate risk will depend upon a host of factors, including their on-site and off-site
supervisory techniques and the degree to which external auditors are also used in the
supervisory function. All members of the Committee agree that the principles set out
here should be used in evaluating the adequacy and effectiveness of a bank's interest
rate risk management, in assessing the extent of interest rate risk run by a bank in its
banking 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 is
essential that banks have a comprehensive risk management process in place that
effectively identifies, measures, monitors and controls interest rate risk exposures, and that is
subject to appropriate board and senior management oversight. The paper describes each of
these elements, drawing upon experience in member countries and principles established in
earlier publications by the Committee.
6. The paper also outlines a number of principles for use by supervisory authorities
when evaluating banks' interest rate risk management. This paper strongly endorses the
principle that banks’ internal measurement systems should, wherever possible, form the
foundation of the supervisory authorities’ measurement of, and response to, the level of
interest rate risk. It provides guidance to help supervisors assess whether internal
measurement systems are adequate for this purpose, and also provides an example of a
possible framework for obtaining information on interest rate risk in the banking book in the
event that the internal measurement system is not judged to be adequate.
7. Even though the Committee is not currently proposing mandatory capital charges
specifically for interest rate risk in the banking book, all banks must have enough capital to
support the risks they incur, including those arising from interest rate risk. If supervisors
determine that a bank has insufficient capital to support its interest rate risk, they must
require either a reduction in the risk or an increase in the capital held to support it, or a
combination of both. Supervisors should be particularly attentive to the capital sufficiency of
“outlier banks” – those whose interest rate risk in the banking book leads to an economic
value decline of more than 20% of the sum of Tier 1 and Tier 2 capital following a
standardised interest rate shock or its equivalent. Individual supervisors may also decide to
apply additional capital charges to their banking system in general.
8. The Committee will continue to review the possible desirability of more standardised
measures and may, at a later stage, revisit its approach in this area. In that context, the
Committee is aware that industry techniques for measuring and managing interest rate risk
are continuing to evolve, particularly for products with uncertain cash flows or repricing dates,
such as many mortgage-related products and retail deposits.
9. The Committee is also making this paper available to supervisory authorities
worldwide in the belief that the principles presented will provide a useful framework for
prudent supervision of interest rate risk. More generally, the Committee wishes to emphasise
that sound risk management practices are essential to the prudent operation of banks and to
promoting stability in the financial system as a whole.
10. The Committee sets forth in Sections III to X of the paper the following fifteen
principles. These principles will be used by supervisory authorities in evaluating the
adequacy and effectiveness of a bank's interest rate risk management, assessing the extent
of interest rate risk run by a bank in its banking book, and developing the supervisory
response to that risk:
2
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 management
and ensure that senior management takes the steps necessary to monitor and control
these risks consistent with the approved strategies and policies. The board of
directors should be informed regularly of the interest rate risk exposure of the bank in
order to assess the monitoring and controlling of such risk against the board’s
guidance on the levels of risk that are acceptable to the bank.
Principle 2: Senior management must ensure that the structure of the bank's business
and the level of interest rate risk it assumes are effectively managed, that appropriate
policies 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 committees
responsible for managing interest rate risk and should ensure that there is adequate
separation of duties in key elements of the risk management process to avoid
potential conflicts of interest. Banks should have risk measurement, monitoring, and
control functions with clearly defined duties that are sufficiently independent from
position-taking functions of the bank and which report risk exposures directly to
senior management and the board of directors. Larger or more complex banks should
have a designated independent unit responsible for the design and administration of
the 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 are
clearly defined and consistent with the nature and complexity of their activities. These
policies should be applied on a consolidated basis and, as appropriate, at the level of
individual affiliates, especially when recognising legal distinctions and possible
obstacles to cash movements among affiliates.
Principle 5: It is important that banks identify the risks inherent in new products and
activities and ensure these are subject to adequate procedures and controls before
being introduced or undertaken. Major hedging or risk management initiatives should
be 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 that
capture all material sources of interest rate risk and that assess the effect of interest
rate changes in ways that are consistent with the scope of their activities. The
assumptions underlying the system should be clearly understood by risk managers
and bank management.
Principle 7: Banks must establish and enforce operating limits and other practices
that maintain exposures within levels consistent with their internal policies.
Principle 8: Banks should measure their vulnerability to loss under stressful market
conditions - including the breakdown of key assumptions - and consider those results
when establishing and reviewing their policies and limits for interest rate risk.
3
Principle 9: Banks must have adequate information systems for measuring,
monitoring, controlling, and reporting interest rate exposures. Reports must be
provided 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 their
interest rate risk management process. A fundamental component of the internal
control system involves regular independent reviews and evaluations of the
effectiveness of the system and, where necessary, ensuring that appropriate revisions
or enhancements to internal controls are made. The results of such reviews should be
available to the relevant supervisory authorities.
Information for supervisory authorities
Principle 11: Supervisory authorities should obtain from banks sufficient and timely
information with which to evaluate their level of interest rate risk. This information
should take appropriate account of the range of maturities and currencies in each
bank'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 risk
they undertake.
Disclosure of interest rate risk
Principle 13: Banks should release to the public information on the level of interest
rate 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 measurement
systems of banks adequately capture the interest rate risk in their banking book. If a
bank’s internal measurement system does not adequately capture the interest rate
risk, the bank must bring the system to the required standard. To facilitate
supervisors’ monitoring of interest rate risk exposures across institutions, banks
must provide the results of their internal measurement systems, expressed in terms of
the threat to economic value, using a standardised interest rate shock.
Principle 15: If supervisors determine that a bank is not holding capital commensurate
with the level of interest rate risk in the banking book, they should consider remedial
action, requiring the bank either to reduce its risk or hold a specific additional amount
of capital, or a combination of both.
4
I. Sources and effects of interest rate risk
11. Interest rate risk is the exposure of a bank's financial condition to adverse
movements in interest rates. Accepting this risk is a normal part of banking and can be an
important source of profitability and shareholder value. However, excessive interest rate risk
can pose a significant threat to a bank's earnings and capital base. Changes in interest rates
affect 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 the
underlying value of the bank's assets, liabilities, and off-balance-sheet (OBS) instruments
because the 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 that maintains interest rate risk within prudent levels is essential to the safety and
soundness of banks.
12. Before setting out some principles for interest rate risk management, a brief
introduction to the sources and effects of interest rate risk might be helpful. Thus, the
following 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 of
which is discussed in greater detail below. These sections also describe the two most
common perspectives for assessing a bank's interest rate risk exposure: the earnings
perspective and the economic value perspective. As the names suggest, the earnings
perspective 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 in
several 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 bank
assets, liabilities, and OBS positions. While such repricing mismatches are fundamental to
the business of banking, they can expose a bank's income and underlying 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 decline in both the future income arising
from the position and its underlying value if interest rates increase. 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 deposit matures.
14. Yield curve risk: Repricing mismatches can also expose a bank to changes in the
slope and shape of the yield curve. Yield curve risk arises when unanticipated shifts of the
yield curve have adverse effects on a bank's income or underlying economic value. For
instance, the underlying economic value of a long position in 10-year government bonds
hedged by a short position in 5-year government notes could decline sharply if the yield
curve 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 as
basis risk, arises from imperfect correlation in the adjustment of the rates earned and paid on
different instruments with otherwise similar repricing characteristics. When interest rates
change, these differences can give rise to unexpected changes in the cash flows and
earnings spread between assets, liabilities and OBS instruments of similar maturities or
repricing frequencies. For example, a strategy of funding a one-year loan that reprices
monthly based on the one-month US Treasury bill rate, with a one-year deposit that reprices
monthly based on one-month LIBOR, exposes the institution to the risk that the spread
between the two index rates may change unexpectedly.
5
16. Optionality: An additional and increasingly important source of interest rate risk
arises 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 in
some manner alter the cash flow of an instrument or financial contract. Options may be
stand-alone instruments such as exchange-traded options and over-the-counter (OTC)
contracts, or they may be embedded within otherwise standard instruments. While banks use
exchange-traded and OTC options in both trading and non-trading accounts, instruments
with embedded options are generally more important in non-trading activities. Examples of
instruments with embedded options include various types of bonds and notes with call or put
provisions, loans which give borrowers the right to prepay balances, and various types of
non-maturity deposit instruments which give depositors the right to withdraw funds at any
time, often without any penalties. If not adequately managed, the asymmetrical payoff
characteristics of instruments with optionality features 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 the disadvantage of the seller. Moreover, an
increasing array of options can involve significant leverage which can magnify the influences
(both negative and positive) of option positions on the financial condition of the firm.
B. Effects of interest rate risk
17. As the discussion above suggests, changes in interest rates can have adverse
effects both on a bank's earnings and its economic value. This has given rise to two
separate, but complementary, perspectives for assessing a bank's interest rate risk
exposure.
18. Earnings perspective: In the earnings perspective, the focus of analysis is the
impact of changes in interest rates on accrual or reported earnings. This is the traditional
approach 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 outright
losses can threaten the financial stability of an institution by undermining its capital adequacy
and by reducing market confidence.
19. In this regard, the component of earnings that has traditionally received the most
attention is net interest income (i.e. the difference between total interest income and total
interest 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 and
other non-interest income, a broader focus on overall net income - incorporating both interest
and non-interest income and expenses - has become more common. Non-interest income
arising from many activities, such as loan servicing and various asset securitisation
programs, can be highly sensitive to, and have complex relationships with, market interest
rates. For example, some banks provide the servicing and loan administration function for
mortgage loan pools in return for a fee based on the volume of assets it administers. When
interest rates fall, the servicing bank may 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 are becoming more interest rate sensitive. This
increased sensitivity has led both bank management and supervisors to take a broader view
of the potential effects of changes in market interest rates on bank earnings and to
increasingly factor these broader effects into their estimated 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 a
bank's economic value to fluctuations in interest rates is a particularly important
6
consideration of shareholders, management, and supervisors alike. The economic value of
an 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 be
viewed as the present value of the bank's expected net cash flows, defined as the expected
cash flows on assets minus the expected cash flows on liabilities plus the expected net cash
flows on OBS positions. In this sense, the economic value perspective reflects one view of
the sensitivity of the net worth of the bank to fluctuations in interest rates.
21. Since the economic value perspective considers the potential impact of interest rate
changes on the present value of all future cash flows, it provides a more comprehensive view
of the potential long-term effects of changes in interest rates than is offered by the earnings
perspective. This comprehensive view is important since changes in near-term earnings - the
typical focus of the earnings perspective - may not provide an accurate indication of the
impact of interest rate movements on the bank's overall positions.
22. Embedded losses: The earnings and economic value perspectives discussed thus
far 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 should
also consider the impact that past interest rates may have on future performance. In
particular, instruments that are not marked to market may already contain embedded gains
or losses due to past rate movements. These gains or losses may be reflected over time in
the bank's earnings. For example, a long-term, fixed-rate loan entered into when interest
rates were low and refunded more recently with liabilities bearing a higher rate of interest will,
over its remaining life, represent a drain on the bank's resources.
7
II. Sound interest rate risk management practices
23. Sound interest rate risk management involves the application of four basic elements
in the management of assets, liabilities, and OBS 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 interest
rate risk will depend upon the complexity and nature of its holdings and activities, as well as
on the level of interest rate risk exposure. What constitutes adequate interest rate risk
management practices can therefore vary considerably. For example, less complex banks
whose senior managers are actively involved in the details of day-to-day operations may be
able 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 more
elaborate and formal interest rate risk management processes to address their broad range
of financial activities and to provide senior management with the information they need to
monitor and direct day-to-day activities. Moreover, the more complex interest rate risk
management processes employed at such banks require adequate internal controls that
include audits or other appropriate oversight mechanisms to ensure the integrity of the
information used by senior officials in overseeing compliance with policies and limits. The
duties of the individuals involved in the risk measurement, monitoring, and control functions
must be sufficiently separate and independent from the business decision makers and
position takers to ensure the avoidance of conflicts of interest.
25. As with other risk factor categories, the Committee believes that interest rate risk
should be monitored on a consolidated, comprehensive basis, to include interest rate
exposures in subsidiaries. At the same time, however, institutions should fully recognise any
legal distinctions and possible obstacles to cash flow movements among affiliates and adjust
their risk management process accordingly. While consolidation may provide a
comprehensive measure in respect of interest rate risk, it may also underestimate risk when
positions in one affiliate are used to offset positions in another affiliate. This is because a
conventional accounting consolidation may allow theoretical offsets between such positions
from which a bank may not in practice be able to benefit because of legal or operational
constraints. Management should recognise the potential for consolidated measures to
understate risks in such circumstances.
8
III. Board and senior management oversight of interest rate risk
6
26. Effective oversight by a bank's board of directors and senior management is critical
to a sound interest rate risk management process. It is essential that these individuals are
aware of their responsibilities with regard to interest rate risk management and that they
adequately 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 bank
should approve strategies and policies with respect to interest rate risk management
and ensure that senior management takes the steps necessary to monitor and control
these risks consistent with the approved strategies and policies. The board of
directors should be informed regularly of the interest rate risk exposure of the bank in
order to assess the monitoring and controlling of such risk against the board’s
guidance on the levels of risk that are acceptable to the bank.
27. The board of directors has the ultimate responsibility for understanding the nature
and the level of interest rate risk taken by the bank. The board should approve broad
business strategies and policies that govern or influence the interest rate risk of the bank. It
should review the overall objectives of the bank with respect to interest rate risk and should
ensure the provision of clear guidance regarding the level of interest rate risk acceptable to
the bank. The board should also approve policies that identify lines of authority and
responsibility for managing interest rate risk exposures.
28. Accordingly, the board of directors is responsible for approving the overall policies of
the bank with respect to interest rate risk and for ensuring that management takes the steps
necessary to identify, measure, monitor, and control these risks. The board or a specific
committee 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 in
monitoring 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 the
bank holds significant positions in complex instruments. In addition, the board or one of its
committees should periodically re-evaluate significant interest rate risk management policies
as 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 and
senior management - as well as between senior management and others in the bank -
regarding the bank's interest rate risk exposures and management process. Board members
need not have detailed technical knowledge of complex financial instruments, legal issues, or
of sophisticated risk management techniques. They have the responsibility, however, to
ensure that senior management has a full understanding of the risks incurred by the bank
6
This section refers to a management structure composed of a board of directors and senior management. The
Committee is aware that there are significant differences in legislative and regulatory frameworks across
countries as regards the functions 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 fulfils its tasks. For this reason, in some cases, it is known as a
supervisory board. This means that the board has no executive functions. In other countries, by contrast, the
board has a broader competence in that it lays down the general framework for the management of the bank.
Owing to these differences, the notions of the board of directors and the senior management are used in this
paper not to identify legal constructs but rather to label two decision-making functions within a bank.
9
and that the bank has personnel available who have the necessary technical skills to
evaluate and control these risks.
B. Senior management
Principle 2: Senior management must ensure that the structure of the bank's business
and the level of interest rate risk it assumes are effectively managed, that appropriate
policies and procedures are established to control and limit these risks, and that
resources are available for evaluating and controlling interest rate risk.
30. Senior management is responsible for ensuring that the bank has adequate policies
and procedures for managing interest rate risk on both a long-term and day-to-day basis and
that it maintains clear lines of authority and responsibility for managing and controlling this
risk. 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 aggregate
information as well as sufficient supporting detail to enable management to assess the
sensitivity of the institution to changes in market conditions and other important risk factors.
Senior management should also review periodically the organisation's interest rate risk
management policies and procedures to ensure that they remain appropriate and sound.
Senior management should also encourage and participate in discussions with members of
the board and, where appropriate to the size and complexity of the bank, with risk
management staff regarding risk measurement, reporting, and management procedures.
32. Management should ensure that analysis and risk management activities related to
interest rate risk are conducted by competent staff with technical knowledge and experience
consistent with the nature and scope of the bank's activities. There should be sufficient depth
in staff resources to manage these activities and to accommodate the temporary absence of
key personnel.
C. Lines of responsibility and authority for managing interest rate risk
Principle 3: Banks should clearly define the individuals and/or committees
responsible for managing interest rate risk and should ensure that there is adequate
separation of duties in key elements of the risk management process to avoid
potential conflicts of interest. Banks should have risk measurement, monitoring, and
control functions with clearly defined duties that are sufficiently independent from
position-taking functions of the bank and which report risk exposures directly to
senior management and the board of directors. Larger or more complex banks should
have a designated independent unit responsible for the design and administration of
the bank's interest rate risk measurement, monitoring, and control functions.
33. Banks should clearly identify the individuals and/or committees responsible for
conducting all of the various elements of interest rate risk management. Senior management
should define lines of authority and responsibility for developing strategies, implementing
10
tactics, and conducting the risk measurement and reporting functions of the interest rate risk
management process. Senior management should also provide reasonable assurance that
all activities and all aspects of interest rate risk are covered by a bank's risk management
process.
34. Care should be taken to ensure that there is adequate separation of duties in key
elements of the risk management process to avoid potential conflicts of interest.
Management should ensure that sufficient safeguards exist to minimise the potential that
individuals initiating risk-taking positions may inappropriately influence key control functions
of the risk management process such as the development and enforcement of policies and
procedures, the reporting of risks to senior management, and the conduct of back-office
functions. The nature and scope of such safeguards should be in accordance with the size
and structure of the bank. They should also be commensurate with the volume and
complexity of interest rate risk incurred by the bank and the complexity of its transactions and
commitments. Larger or more complex banks should have a designated independent unit
responsible for the design and administration of the bank's interest rate risk measurement,
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 risk
should have a well-founded understanding of all types of interest rate risk faced throughout
the bank.
11
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. These
policies should be applied on a consolidated basis and, as appropriate, at the level of
individual affiliates, especially when recognising legal distinctions and possible
obstacles to cash movements among affiliates.
36. Banks should have clearly defined policies and procedures for limiting and
controlling interest rate risk. These policies should be applied on a consolidated basis and,
as appropriate, at specific affiliates or other units of the bank. Such policies and procedures
should delineate lines of responsibility and accountability over interest rate risk management
decisions and should clearly define authorised instruments, hedging strategies, and position-
taking opportunities. Interest rate risk policies should also identify quantitative parameters
that define the acceptable level of interest rate risk for the bank. Where appropriate, limits
should be further specified for certain types of instruments, portfolios, and activities. All
interest rate risk policies should be reviewed periodically and revised as needed.
Management should define the specific procedures and approvals necessary for exceptions
to policies, limits, and authorisations.
37. A policy statement identifying the types of instruments and activities that the bank
may employ or conduct is one means whereby management can communicate their
tolerance of risk on a consolidated basis and at different legal entities. If such a statement is
prepared, it should clearly identify permissible instruments, either specifically or by their
characteristics, and should also describe the purposes or objectives for which they may be
used. The statement should also delineate a clear set of institutional procedures for acquiring
specific 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 new
products and activities and ensure these are subject to adequate procedures and
controls before being introduced or undertaken. Major hedging or risk management
initiatives should be approved in advance by the board or its appropriate delegated
committee.
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 characteristics
and can incorporate them into its risk management process. When analysing whether or not
a product or activity introduces a new element of interest rate risk exposure, the bank should
be aware that changes to an instrument's maturity, repricing, or repayment terms can
materially affect the product's interest rate risk characteristics. To take a simple example, a
decision to buy and hold a 30-year Treasury bond would represent a significantly different
interest rate risk strategy for a bank that had previously limited its investment maturities to
less than 3 years. Similarly, a bank specialising in fixed-rate, short-term commercial loans
that then engages in residential fixed-rate mortgage lending should be aware of the
optionality features of the risk embedded in many mortgage products that allow the borrower
to 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 major
hedging or risk management initiatives in advance of their implementation. Proposals to
undertake new instruments or new strategies should contain these features:
• Description of the relevant product or strategy;
12
• Identification of the resources required to establish sound and effective interest rate
risk management of the product or activity;
• Analysis of the reasonableness of the proposed activities in relation to the bank's
overall financial condition and capital levels; and
• Procedures to be used to measure, monitor, and control the risks of the proposed
product or activity.
13
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 that
capture all material sources of interest rate risk and that assess the effect of interest
rate changes in ways that are consistent with the scope of their activities. The
assumptions underlying the system should be clearly understood by risk managers
and bank management.
40. In general, but depending on the complexity and range of activities of the individual
bank, banks should have interest rate risk measurement systems that assess the effects of
rate changes on both earnings and economic value. These systems should provide
meaningful measures of a bank's current levels of interest rate risk exposure, and should be
capable 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, and
OBS 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 interest
rate risk exposures arising from the full scope of a bank's activities, including both trading
and non-trading sources. This does not preclude different measurement systems and risk
management approaches being used for different activities; however, management should
have 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 sources
of interest rate risk including repricing, yield curve, basis, and option risk exposures. In many
cases, the interest rate characteristics of a bank's largest holdings will dominate its
aggregate risk profile. While all of a bank's holdings should receive appropriate treatment,
measurement systems should evaluate such concentrations with particular rigour. Interest
rate risk measurement systems should also provide rigorous treatment of those instruments
which might significantly affect a bank's aggregate position, even if they do not represent a
major concentration. Instruments with significant embedded or explicit option characteristics
should 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 to
static simulations using current holdings to highly sophisticated dynamic modelling
techniques that reflect potential future business activities.
45. 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
OBS positions into “time bands” according to their maturity (if fixed-rate) or time remaining to
their next repricing (if floating-rate). These schedules can be used to generate simple
indicators of the interest rate risk sensitivity of both earnings and economic value to changing
interest 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.
14
46. A maturity/repricing schedule can also be used to evaluate the effects of changing
interest 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 liabilities
that fall into each time band, where duration is a measure of the percentage change in the
economic 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 to
provide a rough approximation of the change in a bank's economic value that would occur
given a particular set of changes in market interest rates.
47. Many banks (especially those using complex financial instruments or otherwise
having complex risk profiles) employ more sophisticated interest rate risk measurement
systems than those based on simple maturity/repricing schedules. These simulation
techniques typically involve detailed assessments of the potential effects of changes in
interest rates on earnings and economic value by simulating the future path of interest rates
and their impact on cash flows. In static simulations, the cash flows arising solely from the
bank's current on- and off-balance sheet positions are assessed. In a dynamic simulation
approach, 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 more
sophisticated techniques allow for dynamic interaction of payments streams and interest
rates, and better capture the effect of embedded or explicit options.
48. Regardless of the measurement system, the usefulness of each technique depends
on the validity of the underlying assumptions and the accuracy of the basic methodologies
used to model interest rate risk exposure. In designing interest rate risk measurement
systems, 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 in
part on the number of time bands into which positions are aggregated. Clearly, aggregation
of 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 extent
of aggregation and simplification to be built into the measurement approach.
49. Estimates of interest rate risk exposure, whether linked to earnings or economic
value, utilise, in some form, forecasts of the potential course of future interest rates. For risk
management purposes, banks should incorporate a change in interest rates that is
sufficiently large to encompass the risks attendant to their holdings. Banks should consider
the use of multiple scenarios, including potential effects in changes in the relationships
among interest rates (ie, yield curve risk and basis risk) as well as changes in the general
level of interest rates. For determining probable changes in interest rates, simulation
techniques could, for example, be used. Statistical analysis can also play an important role in
evaluating 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 of
the risk measurement process. A bank should ensure that all material positions and cash
flows, whether stemming from on- or off-balance-sheet positions, are incorporated into the
measurement system on a timely basis. Where applicable, these data should include
information on the coupon rates or cash flows of associated instruments and contracts. Any
manual adjustments to underlying data should be clearly documented, and the nature and
reasons for the adjustments should be clearly understood. In particular, any adjustments to
expected cash flows for expected prepayments or early redemptions should be well
reasoned 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 and
bank management. In particular, techniques using sophisticated simulations should be used
15
carefully so that they do not become “black boxes”, producing numbers that have the
appearance of precision, but that in fact are opaque and may not be very accurate when their
specific assumptions and parameters are revealed. Key assumptions should be recognised
by senior management and risk managers and should be re-evaluated at least annually.
These assumptions should also be clearly documented and their significance understood.
Assumptions used in assessing the interest rate sensitivity of complex instruments and
instruments with uncertain maturities should be subject to particularly rigorous
documentation and review.
52. When measuring interest rate risk exposure, two further aspects merit close
attention: the treatment of those positions where behavioural maturity differs from contractual
maturity and the treatment of positions denominated in different currencies. Positions such
as savings and sight deposits may have contractual maturities or may be open-ended, but in
either case, depositors generally have the option to make withdrawals at any time. In
addition, banks often choose not to move rates paid on these deposits in line with changes in
market rates. These factors complicate the measurement of interest rate risk exposure, since
not only the value of the positions but also the timing of their cash flows can change when
interest rates vary. With respect to banks' assets, prepayment features of mortgages and
mortgage-related instruments also introduce uncertainty about the timing of cash flows on
these positions. These issues are described in more detail in Annex 1, which forms an
integral part of this text.
53. Banks with positions denominated in different currencies can expose themselves to
interest rate risk in each of these currencies. Since yield curves vary from currency to
currency, banks generally need to assess exposures in each. Banks with the necessary skills
and sophistication, and with material multi-currency exposures, may choose to include in
their risk measurement process methods to aggregate their exposures in different currencies
using assumptions about the correlation between interest rates in different currencies. A
bank that uses correlation assumptions to aggregate its risk exposures should periodically
review 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 practices
that 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 risk
exposure 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 for
achieving 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 to
individual portfolios, activities, or business units. Limit systems should also ensure that
positions that exceed certain predetermined levels receive prompt management attention. An
appropriate limit system should enable management to control interest rate risk exposures,
initiate discussion about opportunities and risks, and monitor actual risk taking against
predetermined risk tolerances.
55. A bank's limits should be consistent with its overall approach to measuring interest
rate risk. Aggregate interest rate risk limits clearly articulating the amount of interest rate risk
acceptable to the bank should be approved by the board of directors and re-evaluated
periodically. Such limits should be appropriate to the size, complexity and capital adequacy
of the bank as well as its ability to measure and manage its risk. Depending on the nature of
a bank's holdings and its general sophistication, limits can also be identified for individual
16
business units, portfolios, instrument types, or specific instruments. The level of detail of risk
limits should reflect the characteristics of the bank's holdings, including the various sources
of interest rate risk to which the bank is exposed.
56. Limit exceptions should be made known to appropriate senior management without
delay. There should be a clear policy as to how senior management will be informed and
what action should be taken by management in such cases. Particularly important is whether
limits are absolute in the sense that they should never be exceeded or whether, under
specific circumstances which should be clearly described, breaches of limits can be tolerated
for a short period of time. In that context, the relative conservatism of the chosen limits may
be an important factor.
57. Regardless of their level of aggregation, limits should be consistent with the bank's
overall approach to measuring interest rate risk and should address the potential impact of
changes in market interest rates on reported earnings and the bank's economic value of
equity. From an earnings perspective, banks should explore limits on the variability of net
income as well as net interest income in order to fully assess the contribution of non-interest
income to the interest rate risk exposure of the bank. Such limits usually specify acceptable
levels 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 of
equity should be appropriate for the size and complexity of its underlying positions. For
banks engaged in traditional banking activities and with few holdings of long-term
instruments, options, instruments with embedded options, or other instruments whose value
may be substantially altered given changes in market rates, relatively simple limits on the
extent of such holdings may suffice. For more complex banks, however, more detailed limit
systems on acceptable changes in the estimated economic value of equity of the bank may
be 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 rate
movements used in developing these limits should represent meaningful stress situations
taking into account historic rate volatility and the time required for management to address
exposures. Limits may also be based on measures derived from the underlying statistical
distribution 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 of
interest rate risk to the bank including mismatch, yield curve, basis, and option risks. Simple
scenarios 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 market
conditions - including the breakdown of key assumptions - and consider those results
when establishing and reviewing their policies and limits for interest rate risk.
60. The risk measurement system should also support a meaningful evaluation of the
effect of stressful market conditions on the bank. Stress testing should be designed to
provide information on the kinds of conditions under which the bank's strategies or positions
would 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 slope
and the shape of the yield curve (i.e. yield curve risk), changes in the liquidity of key financial
markets, or changes in the volatility of market rates. In addition, stress scenarios should
include conditions under which key business assumptions and parameters break down. The
17
stress testing of assumptions used for illiquid instruments and instruments with uncertain
contractual maturities is particularly critical to achieving an understanding of the bank's risk
profile. In conducting stress tests, special consideration should be given to instruments or
markets where concentrations exist, as such positions may be more difficult to liquidate or
offset in stressful situations. Banks should consider “worst case” scenarios in addition to
more probable events. Management and the board of directors should periodically review
both the design and the results of such stress tests, and ensure that appropriate contingency
plans 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 be
provided 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 for
managing interest rate risk exposure, both to inform management and to support compliance
with board policy. Reporting of risk measures should be done regularly and should clearly
compare current exposure to policy limits. In addition, past forecasts or risk estimates should
be compared with actual results to identify any modelling shortcomings.
62. Reports detailing the interest rate risk exposure of the bank should be reviewed by
the board on a regular basis. While the types of reports prepared for the board and for
various levels of management will vary based on the bank's interest rate risk profile, they
should at a minimum include the following:
• Summaries of the bank's aggregate exposures;
• Reports demonstrating the bank's compliance with policies and limits;
• Key assumptions, for example, non-maturity deposit behaviour and prepayment
information;
• Results of stress tests, including those assessing breakdowns in key assumptions
and parameters; and
• Summaries of the findings of reviews of interest rate risk policies, procedures, and
the adequacy of the interest rate risk measurement systems, including any findings
of internal and external auditors and retained consultants.
18
VI. Internal controls
Principle 10: Banks must have an adequate system of internal controls over their
interest rate risk management process. A fundamental component of the internal
control system involves regular independent reviews and evaluations of the
effectiveness of the system and, where necessary, ensuring that appropriate revisions
or enhancements to internal controls are made. The results of such reviews should be
available to relevant supervisory authorities.
63. Banks should have adequate internal controls to ensure the integrity of their interest
rate risk management process. These internal controls should be an integral part of the
institution's overall system of internal control. They should promote effective and efficient
operations, reliable financial and regulatory reporting, and compliance with relevant laws,
regulations, and institutional policies. An effective system of internal control for interest rate
risk includes:
• A strong control environment;
• An adequate process for identifying and evaluating risk;
• The establishment of control activities such as policies, procedures, and
methodologies;
• 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 to
appropriate approval processes, exposure limits, reconciliations, reviews, and other
mechanisms designed to provide a reasonable assurance that the institution's interest rate
risk management objectives are achieved. Many attributes of a sound risk management
process, including risk measurement, monitoring, and control functions, are key aspects of
an effective system of internal control. Banks should ensure that all aspects of the internal
control system are effective, including those aspects that are not directly part of the risk
management process.
65. In addition, an important element of a bank's internal control system over its interest
rate risk management process is regular evaluation and review. This includes ensuring that
personnel are following established policies and procedures, as well as ensuring that the
procedures that were established actually accomplish the intended objectives. Such reviews
and evaluations should also address any significant change that may impact the
effectiveness of controls, such as changes in market conditions, personnel, technology, and
structures of compliance with interest rate risk exposure limits, and should ensure that
appropriate follow-up with management has occurred for any limits that were exceeded.
Management should ensure that all such reviews and evaluations are conducted regularly by
individuals who are independent of the function they are assigned to review. When revisions
or enhancements to internal controls are warranted, there should be a mechanism in place to
ensure that these are implemented in a timely manner.
66. Reviews of the interest rate risk measurement system should include assessments
of the assumptions, parameters, and methodologies used. Such reviews should seek to
understand, test, and document the current measurement process, evaluate the system's
accuracy, and recommend solutions to any identified weaknesses. If the measurement
system incorporates one or more subsidiary systems or processes, the review should include
testing aimed at ensuring that the subsidiary systems are well-integrated and consistent with
each other in all critical respects. The results of this review, along with any recommendations
19
for improvement, should be reported to senior management and/or the board and acted upon
in a timely manner.
67. The frequency and extent to which a bank should re-evaluate its risk measurement
methodologies and models depend, in part, on the particular interest rate risk exposures
created by holdings and activities, the pace and nature of market interest rate changes, and
the pace and complexity of innovation with respect to measuring and managing interest rate
risk.
68. Banks, particularly those with complex risk exposures, should have their
measurement, monitoring, and control functions reviewed on a regular basis by an
independent party (such as an internal or external auditor). In such cases, reports written by
external auditors or other outside parties should be available to relevant supervisory
authorities. It is essential that any independent reviewer ensures that the bank's risk
measurement 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 the
following factors in making the risk assessment:
• The quantity of interest rate risk, for example:
- Volume and price sensitivity of various products;
- Vulnerability of earnings and capital under differing rate changes, including
yield curve twists; and
- Exposure of earnings and economic value to various other forms of interest
rate risk, including basis and optionality risk.
• The quality of interest rate risk management, for example whether:
- The bank's internal measurement system is appropriate to the nature, scope,
and complexities of the bank and its activities;
- The bank has an independent risk control unit responsible for the design and
administration of the risk measurement, monitoring, and control functions;
- The board of directors and senior management are actively involved in the risk
control process;
- Internal policies, controls, and procedures concerning interest rate risk are
well documented and complied with;
- The assumptions of the risk measurement system are well documented, data
is accurately processed, and data aggregation is proper and reliable; and
- The organisation has adequate staffing to conduct a sound risk management
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 functions
periodically reviewed by external auditors. This does not have to involve a full replication of
the internal audit process.
20
VII. Information for supervisory authorities
Principle 11: Supervisory authorities should obtain from banks sufficient and timely
information with which to evaluate their level of interest rate risk. This information
should take appropriate account of the range of maturities and currencies in each
bank'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 to
assess individual banks' interest rate risk exposures. In order to minimise reporting burden,
internal management reports are the preferred method for obtaining this information, but it
could also be obtained through standardised reports that are submitted by banks, through
on-site examinations, or by other means. The precise information obtained could differ
among supervisors, but must include the results of the standardised rate shock applied under
Principle 14. At a minimum, supervisors should have enough information to identify and
monitor banks that have significant repricing mismatches. Information contained in internal
management 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 the
behavioural maturity is different from the contractual maturity. Reviewing the results of a
bank's internal model, perhaps under a variety of different assumptions, scenarios, and
stress tests, can also be highly informative.
72. Banks operating in different currencies can expose themselves to interest rate risk in
each of these currencies. Supervisory authorities, therefore, will want banks to analyse their
exposures in different currencies separately, at least when exposures in different currencies
are material.
73. Another question is the extent to which interest rate risk should be viewed on a
whole-bank basis or whether the trading book, which is marked to market, and the banking
book, which is often not, should be treated separately. As a general rule, it is desirable for
any measurement system to incorporate interest rate risk exposures arising from the full
scope of a bank's activities, including both trading and non-trading sources. This does not
preclude different measurement systems and risk management approaches being used for
different activities; however, management should have an integrated view of interest rate risk
across products and business lines. Supervisors may want to obtain more specific
information on how trading and non-trading activities are measured and incorporated into a
single measurement system. They should also ensure that interest rate risk in both trading
and non-trading activities is properly managed and controlled.
74. A meaningful analysis of interest rate risk is only possible if the supervisor receives
the relevant information regularly and on a timely basis. Since the risk profile in the traditional
banking business changes less rapidly than in the trading business, quarterly or semi-annual
reporting of the former may be sufficient for many banks. Some of the factors that
supervisors may wish to consider when designing a specific reporting framework are
described in greater detail in Annex 2, which forms an integral part of this text.
21
VIII. Capital adequacy
Principle 12: Banks must hold capital commensurate with the level of interest rate risk
they undertake.
75. Changes in interest rates expose banks to the risk of loss, which may, in extreme
cases, 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 sound
management, banks translate the level of interest rate risk they undertake, whether as part of
their 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. In
cases where banks undertake significant interest rate risk in the course of their business
strategies, a substantial amount of capital should be allocated specifically to support this risk.
76. Where interest rate risk is undertaken as part of a bank’s trading activities, the
supervisory capital treatment of that risk is set out in the Market Risk Amendment. Where it is
undertaken as part of a bank’s non-trading activities, the supervisory treatment, covering
both capital and other tools of supervision, is set out in Principles 14 and 15 of this
document.
22
IX. Disclosure of interest rate risk
Principle 13: Banks should release to the public information on the level of interest
rate risk and their policies for its management.
77. The core objective of public disclosure is to facilitate market participants’
assessment of banks’ interest rate risk profiles in both the banking and trading books. The
Committee has set forth requirements for the public disclosure of information on interest rate
risk as part of the overall review of the capital framework.
7
7
See “Part 4: The Third Pillar - Market Discipline”, International Convergence of Capital Measurement and
Capital Standards: A Revised Framework, June 2004 (available on the BIS website athttp://www.bis.org/publ/bcbs107.pdf).
23
X. Supervisory treatment of interest rate risk in the banking book
Principle 14: Supervisory authorities must assess whether the internal measurement
systems of banks adequately capture the interest rate risk in their banking book. If a
bank’s internal measurement system does not adequately capture the interest rate
risk, the bank must bring the system to the required standard. To facilitate
supervisors’ monitoring of interest rate risk exposures across institutions, banks
must provide the results of their internal measurement systems, expressed in terms of
the threat to economic value, using a standardised interest rate shock.
78. Supervisors should evaluate whether internal measurement systems for banking
book interest rate risk are adequate for managing risk in a safe and sound manner that is
adequate for use in supervisory evaluations of capital adequacy. Depending on the nature
and scale of a bank’s business, a wide variety of methodologies could be employed in
internal measurement systems. Such evaluations could be performed through a review of
internal and external audit findings or through on-site supervisory reviews.
79. A bank’s internal systems must meet the following criteria, which amplify the key
points set out in Principle 6:
(a) All material interest rate risk associated with a bank’s assets, liabilities, and OBS
positions in the banking book must be assessed. To do this, internal systems must
accurately incorporate all of a bank’s interest rate sensitive on- and off-balance-
sheet holdings.
(b) Generally accepted financial concepts and risk measurement techniques must be
utilised. In particular, internal systems must be capable of measuring risk using both
an earnings and economic value approach. The monitoring of interest rate risk in the
banking book for supervisory purposes should be based on risk as measured by the
economic value approach.
8
(c) Data inputs are adequately specified (commensurate with the nature and complexity
of a bank’s holdings) with regard to rates, maturities, re-pricing, embedded options,
and other details to provide a reasonably accurate portrayal of changes in economic
value or earnings.
(d) The system’s assumptions (used to transform positions into cash flows) are
reasonable, properly documented, and stable over time. This is especially important
for assets and liabilities whose behaviour differs markedly from contractual maturity
or repricing, and for new products. Material changes to assumptions should be
documented, justified, and approved by management.
(e) Interest rate risk measurement systems must be integrated into the bank’s daily risk
management practices. The output of the systems should be used in characterising
the level of interest rate risk to senior management and boards of directors.
(f) The interest rate shock
9
(or equivalent parameters) as determined in paragraph 81
below has been properly incorporated into the systems.
8
The 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.
9
See Annex 3 for the background on selection of the standardised interest rate shock.
24
80. If supervisors determine that a bank’s internal measurement system does not
adequately capture interest rate risk in the banking book, the first and most immediate
course of action is to require the bank to bring its system to the required standard. In the
interim, the bank must supply its supervisor with information on the interest rate risk in its
banking book in a form specified by the supervisor. Supervisors may wish to use this
information in making their own estimates of risk using a standardised framework applying
the same standardised rate shock.
10
81. This standardised rate shock should in principle be determined by banks, 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.
11
• For exposures in non-G10 currencies, either:
(a) A parallel rate shock substantially consistent with 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 the particular non-G10
currency; 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 such
cases, banks should carry out a similar analysis for each currency accounting for 5% or more
of either their banking book assets or liabilities, using an interest rate shock calculated
according to the preceding paragraph. To ensure complete coverage of the banking book,
remaining exposures should be aggregated and subjected to a 200 basis point shock.
83. The relative simplicity of the 200 basis point parallel rate shock has the
disadvantage of ignoring exposures that might be revealed through scenarios that include
yield curve twists, inversions, and other relevant scenarios.
12
As has already been noted,
such alternative scenarios are a necessary component of the overall management of interest
rate risk. Supervisors will continue to expect institutions to consider multiple scenarios in
evaluating their interest rate risk as appropriate to the level and nature of risk they are taking.
Principle 15: If supervisors determine that a bank is not holding capital commensurate
with the level of interest rate risk in the banking book, they should consider remedial
action, requiring the bank either to reduce its risk or hold a specific additional amount
of 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 an economic value decline of more than
10
An example of a possible standardised framework is set out in Annex 4.
11
This approach may be useful, for example, in circumstances where interest rates are very low.
12
The appropriateness of the proposed shock will also need to be monitored on an ongoing basis, and
recalibrated should the rate environment shift materially.
25
20% of the sum of Tier 1 and Tier 2 capital following the standardised interest rate shock or
its equivalent (as determined under Principle 14).
85. The response in cases where supervisors determine that there is insufficient capital
will depend on a variety of factors. However, the response must result in the bank either
holding additional capital or reducing the measured risk (through, for example, hedging or a
restructuring of the banking book), or a combination of both, depending on the
circumstances.
26
Annex 1
Interest rate risk measurement techniques
1. This annex provides a brief overview of the various techniques used by banks to
measure the exposure of earnings and of economic value to changes in interest rates. The
variety of techniques ranges from calculations that rely on simple maturity and repricing
tables, to static simulations based on current on- and off-balance-sheet positions, to highly
sophisticated dynamic modelling techniques that incorporate assumptions about the
behaviour of the bank and its customers in response to changes in the interest rate
environment. Some of these general approaches can be used to measure interest rate risk
exposure from both an earnings and an economic value perspective, while others are more
typically associated with only one of these two perspectives. In addition, the methods vary in
their 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, while
the more sophisticated methods can more easily capture the full range of risk exposures.
2. As this discussion suggests, the various measurement approaches described below
have their strengths and weaknesses in terms of providing accurate and reasonable
measures of interest rate risk exposure. Ideally, a bank's interest rate risk measurement
system would take into account the specific characteristics of each individual interest-
sensitive position, and would capture in detail the full range of potential movements in
interest rates. In practice, however, measurement systems embody simplifications that move
away from this ideal. For instance, in some approaches, positions may be aggregated into
broad categories, rather than modelled separately, introducing a degree of measurement
error 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 a
parallel shift of the yield curve may be assumed or less than perfect correlations between
interest rates may not be taken into account. Finally, the various approaches differ in their
ability to capture the optionality inherent in many positions and instruments. The discussion
in the following sections will highlight the areas of simplification that typically characterise
each 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
OBS positions into a certain number of predefined time bands according to their maturity (if
fixed-rate) or time remaining to their next repricing (if floating-rate). Those assets and
liabilities lacking definitive repricing intervals (e.g. sight deposits or savings accounts) or
actual maturities that could vary from contractual maturities (e.g. mortgages with an option
for early repayment) are assigned to repricing time bands according to the judgement and
past experience of the bank.
1. Gap analysis
4. Simple maturity/repricing schedules can be used to generate simple indicators of the
interest rate risk sensitivity of both earnings and economic value to changing interest rates.
27
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 used by banks. To evaluate
earnings exposure, interest rate-sensitive liabilities in each time band 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 rates to yield an approximation
of the change in net interest income that would result from such an interest rate movement.
The size of the interest rate movement used in the analysis can be based on a variety of
factors, including historical experience, simulation of potential future interest rate
movements, and the judgement of bank management.
5. A negative, or liability-sensitive, gap occurs when liabilities exceed assets (including
OBS positions) in a given time band. This means that an increase in market interest 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 a decrease in the level
of interest rates.
6. These simple gap calculations can be augmented by information on the average
coupon on assets and liabilities in each time band. This information can be used to place the
results of the gap calculations in context. For instance, information on the average coupon
rate could be used to calculate estimates of the level of net interest income arising from
positions 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 rate
risk exposure, it has a number of shortcomings. First, gap analysis does not take account of
variation in the characteristics of different positions within a time band. In particular, all
positions within a given time band are assumed to mature or reprice simultaneously, a
simplification that is likely to have greater impact on the precision of the estimates as the
degree of aggregation within a time band increases. Moreover, gap analysis ignores
differences in spreads between interest rates that could arise as the level of market interest
rates changes (basis risk). In addition, it does not take into account any changes in the timing
of 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-related
positions. For these reasons, gap analysis provides only a rough approximation of the actual
change in net interest income which would result from the chosen change in the pattern of
interest rates. Finally, most gap analyses fail to capture variability in non-interest revenue
and expenses, a potentially important source of risk to current income.
2. Duration
8. A maturity/repricing schedule can also be used to evaluate the effects of changing
interest 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 liabilities
that fall into each time band. Duration is a measure of the percentage change in the
economic value of a position that will occur given a small change in the level of interest
rates.
13
It reflects the timing and size of cash flows that occur before the instrument's
13
In its simplest form, duration measures changes in economic value resulting from a percentage change of
interest rates under the simplifying assumptions that changes in value are proportional to changes in the level
of interest rates and that the timing of payments is fixed. Two important modifications of simple duration are
commonly used that relax one or both of these assumptions. The first case is so-called modified duration.
28
contractual maturity. Generally, the longer the maturity or next repricing date of the
instrument and the smaller the payments that occur before maturity (e.g. coupon payments),
the higher the duration (in absolute value). Higher duration implies that a given change in the
level of interest rates will have a larger impact on economic value.
9. Duration-based weights can be used in combination with a maturity/repricing
schedule to provide a rough approximation of the change in a bank's economic value that
would occur given a particular change in the level of market interest rates. Specifically, an
“average” duration is assumed for the positions that fall into each time band. The average
durations are then multiplied by an assumed change in interest rates to construct a weight for
each time band. In some cases, different weights are used for different positions that fall
within a time band, reflecting broad differences in the coupon rates and maturities (for
instance, one weight for assets, and another for liabilities). In addition, different interest rate
changes are sometimes used for different time bands, generally to reflect differences in the
volatility of interest rates along the yield curve. The weighted gaps are aggregated across
time bands to produce an estimate of the change in economic value of the bank that would
result from the assumed changes in interest rates.
10. Alternatively, an institution could estimate the effect of changing market rates by
calculating the precise duration of each asset, liability, and OBS position and then deriving
the net position for the bank based on these more accurate measures, rather than by
applying an estimated average duration weight to all positions in a given time band. This
would eliminate potential errors occurring when aggregating positions/cash flows. As another
variation, risk weights could also be designed for each time band on the basis of actual
percentage changes in market values of hypothetical instruments that would result from a
specific scenario of changing market rates. That approach - which is sometimes referred to
as effective duration - would better capture the non-linearity of price movements arising from
significant changes in market interest rates and, thereby, would avoid an important limitation
of duration.
11. Estimates derived from a standard duration approach may provide an acceptable
approximation of a bank's exposure to changes in economic value for relatively non-complex
banks. Such estimates, however, generally focus on just one form of interest rate risk
exposure - repricing risk. As a result, they may not reflect interest rate risk arising, for
instance, from changes in the relationship among interest rates within a time band (basis
risk). In addition, because such approaches typically use an average duration for each time
band, the estimates will not reflect differences in the actual sensitivity of positions that can
arise from differences in coupon rates and the timing of payments. Finally, the simplifying
assumptions that underlie the calculation of standard duration means that the risk of options
may not be adequately captured.
Modified duration - which is standard duration divided by 1 + r, where r is the level of market interest rates - is
an elasticity. As such, it reflects the percentage change in the economic value of the instrument for a given
percentage change in 1 + r. As with simple duration, it assumes a linear relationship between percentage
changes in value and percentage changes in interest rates. The second form of duration relaxes this
assumption, as well as the assumption that the timing of payments is fixed. Effective duration is the
percentage change in the price of the relevant instrument for a basis point change in yield.
29
B. Simulation approaches
12. Many banks (especially those using complex financial instruments or otherwise
having complex risk profiles) employ more sophisticated interest rate risk measurement
systems than those based on simple maturity/repricing schedules. These simulation
techniques typically involve detailed assessments of the potential effects of changes in
interest rates on earnings and economic value by simulating the future path of interest rates
and their impact on cash flows.
13. In some sense, simulation techniques can be seen as an extension and refinement
of the simple analysis based on maturity/repricing schedules. However, simulation
approaches typically involve a more detailed breakdown of various categories of on- and off-
balance-sheet positions, so that specific assumptions about the interest and principal
payments and non-interest income and expense arising from each type of position can be
incorporated. In addition, simulation techniques can incorporate more varied and refined
changes in the interest rate environment, ranging from changes in the slope and shape of the
yield curve to interest rate scenarios derived from Monte Carlo simulations.
1. Static simulation
14. In static simulations, the cash flows arising solely from the bank's current on- and
off-balance-sheet positions are assessed. For assessing the exposure of earnings,
simulations estimating the cash flows and resulting earnings streams over a specific period
are conducted based on one or more assumed interest rate scenarios. Typically, although
not always, these simulations entail relatively straightforward shifts or tilts of the yield curve,
or changes of spreads between different interest rates. When the resulting cash flows are
simulated over the entire expected lives of the bank's holdings and discounted back to their
present values, an estimate of the change in the bank's economic value can be calculated.
14
2. Dynamic simulation
15. In a dynamic simulation approach, the simulation builds in more detailed
assumptions about the future course of interest rates and the expected changes in a bank's
business activity over that time. For instance, the simulation could involve assumptions about
a bank's strategy for changing administered interest rates (on savings deposits, for example),
about the behaviour of the bank's customers (e.g. withdrawals from sight and savings
deposits), and/or about the future stream of business (new loans or other transactions) that
the bank will encounter. Such simulations use these assumptions about future activities and
reinvestment strategies to project expected cash flows and estimate dynamic earnings and
economic value outcomes. These more sophisticated techniques allow for dynamic
interaction of payments streams and interest rates, and better capture the effect of
embedded or explicit options.
16. As with other approaches, the usefulness of simulation-based interest rate risk
measurement techniques depends on the validity of the underlying assumptions and the
accuracy of the basic methodology. The output of sophisticated simulations must be
assessed largely in the light of the validity of the simulation's assumptions about future
14
The duration analysis described in the previous section can be viewed as a very simple form of static
simulation.
30
interest rates and the behaviour of the bank and its customers. One of the primary concerns
that arises is that such simulations do not become “black boxes” that lead to false confidence
in the precision of the estimates.
C. Additional issues
17. One of the most difficult tasks when measuring interest rate risk is how to deal with
those positions where behavioural maturity differs from contractual maturity (or where there
is no stated contractual maturity). On the asset side of the balance sheet, such positions may
include mortgages and mortgage-related securities, which can be subject to prepayment. In
some countries, borrowers have the discretion to prepay their mortgages with little or no
penalty, which creates uncertainty about the timing of the cash flows associated with these
instruments. Although there is always some volatility in prepayments resulting from
demographic factors (such as death, divorce, or job transfers) and macroeconomic
conditions, most of the uncertainty surrounding prepayments arises from the response of
borrowers to movements in interest rates. In general, declines in interest rates result in
increasing levels of prepayments as borrowers refinance their loans at lower yields. In
contrast, when interest rates rise unexpectedly, prepayment rates tend to slow, leaving the
bank with a larger than anticipated volume of mortgages paying below current market rates.
18. On the liability side, such positions include so-called non-maturity deposits such as
sight deposits and savings deposits, which can be withdrawn, often without penalty, at the
discretion of the depositor. The treatment of such deposits is further complicated by the fact
that the rates received by depositors tend not to move in close correlation with changes in
the general level of market interest rates. In fact, banks can and do administer the rates on
the accounts with the specific intention of managing the volume of deposits retained.
19. The treatment of positions with embedded options is an issue of special concern in
measuring the exposure of both current earnings and economic value to interest rate
changes. In addition, the issue arises across the full spectrum of approaches to interest rate
measurement, from simple gap analysis to the most sophisticated simulation techniques. In
the maturity/repricing schedule framework, banks typically make assumptions about the likely
timing of payments and withdrawals on these positions and “spread” the balances across
time bands accordingly. For instance, it might be assumed that certain percentages of a pool
of 30-year mortgages prepay in given years during the life of the mortgages. As a result, a
large share of the mortgage balances that would have been assigned to the time band
containing 30-year instruments would be spread among nearer-term time bands. In a
simulation framework, more sophisticated behavioural assumptions could be employed, such
as the use of option-adjusted pricing models to better estimate the timing and magnitude of
cash flows under different interest rate environments. In addition, simulations can incorporate
the bank's assumptions about its likely future treatment of administered interest rates on non-
maturity deposits.
20. As with other elements of interest rate risk measurement, the quality of the
estimates of interest rate risk exposure depends on the quality of the assumptions about the
future cash flows on the positions with uncertain maturities. Banks typically look to the past
behaviour of such positions for guidance about these assumptions. For instance,
econometric or statistical analysis can be used to analyse the behaviour of a bank's holdings
in response to past interest rate movements. Such analysis is particularly useful to assess
the likely behaviour of non-maturity deposits, which can be influenced by bank-specific
factors such as the nature of the bank's customers and local or regional market conditions. In
the same vein, banks may use statistical prepayment models - either models developed
internally by the bank or models purchased from outside developers - to generate
31
expectations about mortgage-related cash flows. Finally, input from managerial and business
units within the bank could have an important influence, since these areas may be aware of
planned changes to business or repricing strategies that could affect the behaviour of the
future cash flows of positions with uncertain maturities.
32
Annex 2
Monitoring of interest rate risk by supervisory authorities
1. This annex provides a brief overview of some of the factors that supervisory
authorities might consider in obtaining and analysing information on individual banks'
exposures to interest rate risk. As discussed in Section VII, supervisory authorities should
obtain information sufficient to assess banks' exposures to interest rate risk in a timely
fashion. Such information may be obtained through on-site examinations, through reports
that are submitted by banks on a regular basis, or through other means.
2. While the precise information that is obtained will differ across supervisory
authorities, one approach that some may adopt is a reporting framework that collects
information on a bank's positions by remaining maturity or time to next repricing. Under such
an approach, a bank would categorise its interest-sensitive assets, liabilities, and OBS
positions into a series of repricing time bands or maturity categories. The two sections that
follow discuss the considerations that a supervisor should take into account in specifying the
number of time bands and the grouping of positions in the reporting framework. The final
section of this annex describes some general approaches that supervisory authorities may
wish to consider in analysing the information that is obtained through such a reporting
framework.
A. Time bands
3. If a reporting framework is used in which information is collected by time to next
repricing, the number and specific categories of time bands chosen should be sufficient to
provide supervisors with a reasonable basis for identifying potentially significant repricing
mismatches. The bands, however, could vary materially across countries, both in number
and in range, depending on the lending and investing practices and experiences of banks in
individual markets.
4. The usefulness of supervisory analysis crucially depends on the precision with
which maturities of the positions and cash flows are recorded in the system. In analysing
interest rate sensitivities, it is not enough to know when an instrument matures. Rather, the
critical factor is when the instrument reprices. Therefore, the emphasis of this section is on
repricing rather than maturity. For cash flows whose repricing is unambiguous, the most
precise approach is to use the exact repricing date. Any aggregation of positions/cash flows
in time bands or zones necessarily implies a loss of information and a lower degree of
precision. For this reason, the number of time bands in a repricing ladder framework always
reflects a decision regarding the necessary level of precision and the cost of pursuing greater
accuracy. Supervisory authorities could use the repricing ladder in the standardised
approach of the Market Risk Amendment as a starting point when developing a reporting
framework that meets their particular needs. The breakdown can, of course, be modified by
supervisors either in a general way or in a specific way for banks where the nature of
business activities warrants or justifies a different reporting form.
33
B. Items
5. As with the time bands, the breakdown of assets and liabilities could differ among
supervisors. A reporting system should include information for all rate-sensitive assets,
liabilities, and OBS positions, and should also identify balances, by specific types of
instruments, when those instruments have or may have materially different cash flow
characteristics. Specific attention should be given to items whose behavioural repricings
differ from contractual maturities, such as savings deposits and, in some countries,
mortgage-related instruments. Further information on these issues is provided in Annex 1. If
the volume of these positions is significant, they should be reported separately so as to
facilitate an assessment of the underlying options risk in the bank’s balance sheet structure.
6. The analysis of interest rate risk may be more difficult if a bank is engaged in trading
activities. As a general rule, it is desirable for any measurement system to incorporate
interest rate risk exposures arising from the full scope of a bank's activities, including both
trading and non-trading sources. This does not preclude different measurement systems and
risk management approaches being used for different activities; however, management
should have an integrated view of interest rate risk across products and business lines.
Supervisors may wish to permit banks that manage their interest rate risk exposures on an
integrated basis to aggregate trading and non-trading positions in the overall reporting
framework. However, it is important to recognise that in many countries different accounting
rules may apply to the trading book and the traditional banking book. Under these accounting
rules, losses in the trading book may not always be offset by profits in the banking book if the
latter are unrealised. Furthermore, unlike the banking book, the composition of the trading
portfolio changes significantly from week to week or even day to day because it is managed
separately and according to a different (shorter) risk horizon than the banking book. This
means that a hedge that is present on a given day may disappear a few days later.
Supervisors should, therefore, review the risk management practices and information
systems of banks that conduct material trading activities and should obtain the information
necessary to ensure that interest rate risk in both trading and non-trading activities is
properly managed and controlled.
C. Supervisory analysis
7. A reporting framework designed along these lines may provide supervisors with a
flexible tool for analysing interest rate risk. Supervisors can use this basic information to
perform their own assessments of a bank's exposure and risk profile.
8. Such assessments may provide insights regarding an institution's exposure to
parallel shifts, or to a flattening, steepening, or inversion of the yield curve with rate changes
of different magnitude based on either statistical probabilities or a worst-case analysis. For
banks with important exposures in foreign currencies, analysis investigating different
assumptions regarding correlations between interest rates in different currencies can be
useful. With respect to instruments with behavioural maturities, supervisors may wish to
assess assumptions that differ from those used by the institution.
9. The focus of supervisors' quantitative analysis can be the impact of interest rate
changes on either current earnings or the economic value of the bank’s portfolio. In
conducting their analysis, information about average yields on assets and liabilities in each
time band may be useful and supervisors may wish to collect such information in addition to
pure position data.
34
10. Depending on their overall approach, supervisors may conduct their analysis of
interest rate risk either on a case-by-case basis or as part of a broader system designed to
identify outliers with apparently excessive risk-taking.
11. By conducting an assessment of interest rate risk using the proposed framework,
supervisors may gain more insight into an institution's risk profile than with a reporting
system that reduces the complexity of interest rate risk to a single number. In doing so,
supervisors can become more familiar with the sensitivity of risk measures to changes in the
underlying assumptions, and the evaluation process may produce as many insights as the
quantitative result itself.
12. Regardless of the extent of a supervisor's own independent quantitative analysis, a
bank's own interest rate risk measure, whether reported as part of a basic supervisory
reporting system or reviewed as part of an individual assessment of a bank's risk
management, is an important consideration in the supervisory process. Reviewing the results
of a bank's internal model can be highly informative, but can also be a difficult process
because of the multitude of important assumptions and modelling techniques which need to
be made transparent to supervisors. To be most useful, the information received should
indicate the contribution of principal elements of a bank's portfolio to the risk profile under
different assumptions with respect to interest rate changes and the market response. Finally,
any quantitative analysis should be supplemented by a review of internal management
reports in order to gain greater insights into management's evaluation and management of
risks, its methods for measuring exposures, and factors not reflected in the information
available in the limited reporting to supervisors.
35
Annex 3
The standardised interest rate shock
1. To facilitate supervisors’ monitoring of interest rate risk exposures across
institutions, banks would have to provide the results of their internal measurement systems,
expressed in terms of the change in economic value relative to capital, using a standardised
interest rate shock. This annex gives the technical background to the selection of the
standardised rate shock. In selecting the shock, the following guiding principles were
followed:
• The rate shock should reflect a fairly uncommon and stressful rate environment;
• The magnitude of the rate shock should be significant enough to capture the effects
of embedded options and convexity within bank assets and liabilities so that
underlying risk may be revealed;
• The rate shock should be straightforward and practical to implement, and should be
able to accommodate the diverse approaches inherent in single-rate-path simulation
models and statistically driven value-at-risk models for banking book positions;
• The underlying methodology should provide relevant shocks for both G10 and
material non-G10 currency exposures; and
• The underlying methodology should be adaptable for those non-G10 supervisors
who wish to implement this approach in their own countries.
2. With these principles in mind, the proposed rate shock should in principle be
determined by banks, 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 1
st
and 99
th
percentile of
observed interest rate changes using a one-year (240 working days) holding
period and a minimum five years of observations for the particular non-G10
currency; 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.
3. In considering potential rate shocks, historical rate changes among a number of G10
countries were analysed. A one-year holding period (240 business days) was selected both
for practical purposes and in recognition that within a one-year period most institutions have
the ability to restructure or hedge their positions to mitigate further losses in economic value
should rates appear to be exceptionally volatile. Five years worth of rate change
observations require a minimum of six years of historical data to calculate rate differences for
a one-year holding period on a rolling basis. For example, the first observation from five
years ago must look back to the rate environment six years ago to calculate the first rate
change.
36
4. A five-year historical observation period (six years of data) was thought to be long
enough to capture more recent and relevant interest rate cycles. That time period also
appears to offer a reasonably manageable set of data for institutions that wish to incorporate
such data into their statistically driven value-at-risk models or in their own evaluations of a
suitable parallel rate shock for non-G10 currencies. In defining uncommon and stressful
scenarios, rate shocks of a magnitude that would not be expected to be exceeded with a 99
percent confidence interval were considered adequate.
5. In evaluating the data for G10 shocks, rate moves at the 1st and 99th percentile
were roughly comparable across most currencies, especially for longer maturities. A 200
basis point up and down rate shock appears to adequately cover volatilities across G10
currencies. The appropriateness of the proposed shock will need to be monitored on an
ongoing basis, and recalibrated should the rate environment shift materially. Importantly, by
calibrating the parallel shock to be roughly consistent with shocks that would be implemented
through more sophisticated, statistically driven approaches using standard parameters (99
percent confidence interval, one-year holding period, five years of observations), this
approach does not foreclose the use of more innovative risk measurement systems. It also
allows institutions to use these parameters for calculating appropriate shocks themselves
when they have material exposures outside G10 countries and for supervisors in emerging
market and other non-G10 countries to derive simple shocks that are appropriate for their
own countries.
6. The analysis so far has implicitly assumed that banks only carry interest rate risk in
their home currency. However, many banks will be exposed to interest rate risk in more than
one currency. In such cases, banks should carry out a similar analysis for each currency
accounting for 5% or more of either their banking book assets or liabilities, using an interest
rate shock calculated according to one of the methodologies set out above. To ensure
complete coverage of the banking book, remaining exposures should be aggregated and
subjected to a 200 basis point shock.
7. The relative simplicity of a 200 basis point parallel rate shock has the disadvantage
of ignoring exposures that might be revealed through scenarios that include yield curve
twists, inversions, and other relevant scenarios. Such alternative scenarios are a necessary
component of the overall management of interest rate risk as noted elsewhere in this paper.
Supervisors will continue to expect institutions to perform multiple scenarios in evaluating
their interest rate risk as appropriate to the level and nature of risk they are taking.
8. While more nuanced rate scenarios might tease out certain underlying risk
characteristics, for the more modest objectives of supervisors in detecting institutions with
significant levels of interest rate risk, a simple parallel shock is adequate. Such an approach
also recognises the potential for spurious precision that occurs when undue attention to fine
detail is placed on one aspect of a measurement system without recognition that
assumptions employed for certain asset and liability categories, such as core deposits, are
by necessity blunt and judgmental. Such judgmental aspects of an interest rate risk model
often drive the resulting risk measure and conclusion, regardless of the detailed attention
paid to other aspects of the risk measure.
37
Annex 4
An example of a standardised framework
1. This annex contains an example setting out the methodology and calculation
process in one version of a standardised framework. Other methodologies and calculation
processes could be equally applicable in this context, depending on the circumstances of the
bank concerned. Such a framework is intended for supervisory reporting purposes only, and
is not intended to represent an adequate framework for internal risk management purposes.
A. Methodology
2. Positions on the bank’s balance sheet would be slotted into the maturity approach
according to the following principles:
(a) All assets and liabilities belonging to the banking book and all OBS items belonging
to the banking book which are sensitive to changes in interest rates (including all
interest rate derivatives) are slotted into a maturity ladder comprising a number of
time bands large enough to capture the nature of interest rate risk in a national
banking market. Annex 2 discusses issues relating to the selection of appropriate
time bands. Separate maturity ladders are to be used for each currency accounting
for more than 5% of either banking book assets or liabilities.
(b) On-balance-sheet items are treated at book value.
(c) Fixed-rate instruments are allocated according to the residual term to maturity and
floating-rate instruments according to the residual term to the next repricing date.
(d) Exposures which create practical processing problems because of their large
number and relatively small individual amount (e.g. instalment or mortgage loans)
may be allocated on the basis of statistically supported assessment methods.
(e) Core deposits are slotted according to an assumed maturity of no longer than five
years.
(f) National supervisors will provide guidance on how other items with a behavioural
maturity or repricing that differ from contractual maturity or repricing are to be slotted
into the time band structure.
(g) Derivatives are converted into positions in the relevant underlying. The amounts
considered are the principal amount of the underlying or of the notional underlying.
(h) Futures and forward contracts, including forward rate agreements (FRA), are treated
as a combination of a long and a short position. The maturity of a future or a FRA
will be the period until delivery or exercise of the contract, plus - where applicable -
the life of the underlying instrument. For example, a long position in a June three-
month interest rate future (taken in April) is to be reported as a long position with a
maturity of five months and a short position with a maturity of two months.
(i) Swaps are treated as two notional positions with relevant maturities. For example,
an interest rate swap under which a bank is receiving floating-rate interest and
paying fixed-rate interest will be treated as a long floating-rate position of maturity
equivalent to the period until the next interest fixing and a short fixed-rate position of
38
maturity equivalent to the residual life of the swap. The separate legs of cross-
currency swaps are to be treated in the relevant maturity ladders for the currencies
concerned.
(j) Options are considered according to the delta equivalent amount of the underlying
or of the notional underlying.
B. Calculation process
3. The calculation process consists of five steps.
(a) The first step is to offset the longs and shorts in each time band, resulting in a single
short or long position in each time band.
(b) The second step is to weight these resulting short and long positions by a factor that
is designed to reflect the sensitivity of the positions in the different time bands to an
assumed change in interest rates. The set of weighting factors for each time band is
set out in Table 1 below. These factors are based on an assumed parallel shift of
200 basis points throughout the time spectrum, and on a proxy of modified duration
of positions situated at the middle of each time band and yielding 5%.
(c) The third step is to sum these resulting weighted positions, offsetting longs and
shorts, leading to the net short- or long-weighted position of the banking book in the
given currency.
(d) The fourth step is to calculate the weighted position of the whole banking book by
summing the net short- and long-weighted positions calculated for different
currencies.
(e) The fifth step is to relate the weighted position of the whole banking book to capital.
39
Table 1
Weighting factors per time band (second step in the calculation process)
Time band
Middle of
time band
Proxy of modified
duration
Assumed
change in
yield
Weighting
factor
Up to 1 month
1 to 3 months
3 to 6 months
6 to 12 months
1 to 2 years
2 to 3 years
3 to 4 years
4 to 5 years
5 to 7 years
7 to 10 years
10 to 15 years
15 to 20 years
Over 20 years
0.5 months
2 months
4.5 months
9 months
1.5 years
2.5 years
3.5 years
4.5 years
6 years
8.5 years
12.5 years
17.5 years
22.5 years
0.04 years
0.16 years
0.36 years
0.71 years
1.38 years
2.25 years
3.07 years
3.85 years
5.08 years
6.63 years
8.92 years
11.21 years
13.01 years
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
0.08%
0.32%
0.72%
1.43%
2.77%
4.49%
6.14%
7.71%
10.15%
13.26%
17.84%
22.43%
26.03%
40
doc_490441262.pdf
It is essential that banks' interest rate risk policies and procedures are clearly defined and consistent with the nature and complexity of their activities. These policies should be applied on a consolidated basis and, as appropriate, at the level of individual affiliates, especially when recognising legal distinctions and possible obstacles to cash movements among affiliates.
Basel Committee
on Banking Supervision
Principles for the
Management and
Supervision of Interest
Rate Risk
July 2004
Requests for copies of publications, or for additions/changes to the mailing list, should be sent to:
Bank for International Settlements
Press & Communications
CH-4002 Basel, Switzerland
E-mail: [email protected]
Fax: +41 61 280 9100 and +41 61 280 8100
© Bank for International Settlements 2004. All rights reserved. Brief excerpts may be reproduced or translated
provided the source is stated.
ISBN print: 92-9131-670-9
ISBN web: 92-9197-670-9
Table of Contents
Summary ..................................................................................................................................1
I. Sources and effects of interest rate risk ..........................................................................5
A. Sources of interest rate risk ...................................................................................5
B. 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...................................................................................................9
B. Senior management .............................................................................................10
C. Lines of responsibility and authority 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 ............................................................................14
B. Limits....................................................................................................................16
C. Stress testing .......................................................................................................17
D. 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...................................234
Annex 1: Interest rate risk measurement techniques .............................................................27
A. Repricing schedules.............................................................................................27
B. Simulation approaches.........................................................................................30
C. Additional issues ..................................................................................................31
Annex 2: Monitoring of interest rate risk by supervisory authorities .......................................33
A. Time bands ..........................................................................................................33
B. Items ....................................................................................................................34
C. Supervisory analysis ............................................................................................34
Annex 3: The standardised interest rate shock ......................................................................36
Annex 4: An example of a standardised framework ...............................................................38
A. Methodology.........................................................................................................38
B. Calculation process..............................................................................................39
Principles for the
Management and Supervision of Interest Rate Risk
Summary
1. As part of its ongoing efforts to address international bank supervisory issues, the
Basel Committee on Banking Supervision
1
(the Committee) issued a paper on principles for
the management of interest rate risk in September 1997. In developing these principles, the
Committee drew on supervisory guidance in member countries, on the comments of the
banking industry on the Committee's earlier paper, issued for consultation in April 1993,
2
and
on comments received on the draft paper issued for consultation. In addition, the paper
incorporated many of 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 for market risk (Market Risk Amendment).
4
This revised version of the 1997
paper was released for public consultation in January 2001 and September 2003, and is
being issued to support the Pillar 2 approach to interest rate risk in the banking book in the
new capital framework.
5
The revision is reflected especially in this Summary, in Principles 12
to 15, and in Annexes 3 and 4.
2. Principles 1 to 13 in this paper are intended to be of general application for the
management of interest rate risk, independent of whether the positions are part of the trading
book or reflect banks' non-trading activities. They refer to an interest rate risk management
process, which includes the development of a business strategy, the assumption of assets
and liabilities in banking and trading activities, as well as a system of internal controls. In
particular, they address the need for effective interest rate risk measurement, monitoring and
control functions within the interest rate risk management process. Principles 14 and 15, on
the other hand, specifically address the supervisory treatment of interest rate risk in the
banking book.
3. The principles are intended to be of general application, based as they are on
practices currently used by many international banks, even though their specific application
will depend to some extent on the complexity and range of activities undertaken by individual
banks. Under the new capital framework, they form minimum standards expected of
internationally active banks.
1
The Basel Committee on Banking Supervision is a Committee of banking supervisory authorities which was
established by the central bank Governors of the Group of Ten countries in 1975. It consists of senior
representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany,
Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States.
It usually meets at the Bank for International Settlements (BIS) in Basel, Switzerland, where its permanent
Secretariat is located.
2
Measurement of Banks' Exposure to Interest Rate Risk, consultative proposal by the Committee, April 1993
(available on the BIS website athttp://www.bis.org/publ/bcbs11.pdf).
3
Risk Management Guidelines for Derivatives, July 1994 (available on the BIS website athttp://www.bis.org/publ/bcbsc211.pdf).
4
Amendment to the Capital Accord to Incorporate Market Risk, January 1996 (available on the BIS website athttp://www.bis.org/publ/bcbs24.pdf).
5
See “Part 3: The Second Pillar - Supervisory Review Process”, International Convergence of Capital
Measurement and Capital Standards: A Revised Framework, June 2004 (available on the BIS website athttp://www.bis.org/publ/bcbs107.pdf).
1
4. The exact approach chosen by individual supervisors to monitor and respond to
interest rate risk will depend upon a host of factors, including their on-site and off-site
supervisory techniques and the degree to which external auditors are also used in the
supervisory function. All members of the Committee agree that the principles set out
here should be used in evaluating the adequacy and effectiveness of a bank's interest
rate risk management, in assessing the extent of interest rate risk run by a bank in its
banking 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 is
essential that banks have a comprehensive risk management process in place that
effectively identifies, measures, monitors and controls interest rate risk exposures, and that is
subject to appropriate board and senior management oversight. The paper describes each of
these elements, drawing upon experience in member countries and principles established in
earlier publications by the Committee.
6. The paper also outlines a number of principles for use by supervisory authorities
when evaluating banks' interest rate risk management. This paper strongly endorses the
principle that banks’ internal measurement systems should, wherever possible, form the
foundation of the supervisory authorities’ measurement of, and response to, the level of
interest rate risk. It provides guidance to help supervisors assess whether internal
measurement systems are adequate for this purpose, and also provides an example of a
possible framework for obtaining information on interest rate risk in the banking book in the
event that the internal measurement system is not judged to be adequate.
7. Even though the Committee is not currently proposing mandatory capital charges
specifically for interest rate risk in the banking book, all banks must have enough capital to
support the risks they incur, including those arising from interest rate risk. If supervisors
determine that a bank has insufficient capital to support its interest rate risk, they must
require either a reduction in the risk or an increase in the capital held to support it, or a
combination of both. Supervisors should be particularly attentive to the capital sufficiency of
“outlier banks” – those whose interest rate risk in the banking book leads to an economic
value decline of more than 20% of the sum of Tier 1 and Tier 2 capital following a
standardised interest rate shock or its equivalent. Individual supervisors may also decide to
apply additional capital charges to their banking system in general.
8. The Committee will continue to review the possible desirability of more standardised
measures and may, at a later stage, revisit its approach in this area. In that context, the
Committee is aware that industry techniques for measuring and managing interest rate risk
are continuing to evolve, particularly for products with uncertain cash flows or repricing dates,
such as many mortgage-related products and retail deposits.
9. The Committee is also making this paper available to supervisory authorities
worldwide in the belief that the principles presented will provide a useful framework for
prudent supervision of interest rate risk. More generally, the Committee wishes to emphasise
that sound risk management practices are essential to the prudent operation of banks and to
promoting stability in the financial system as a whole.
10. The Committee sets forth in Sections III to X of the paper the following fifteen
principles. These principles will be used by supervisory authorities in evaluating the
adequacy and effectiveness of a bank's interest rate risk management, assessing the extent
of interest rate risk run by a bank in its banking book, and developing the supervisory
response to that risk:
2
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 management
and ensure that senior management takes the steps necessary to monitor and control
these risks consistent with the approved strategies and policies. The board of
directors should be informed regularly of the interest rate risk exposure of the bank in
order to assess the monitoring and controlling of such risk against the board’s
guidance on the levels of risk that are acceptable to the bank.
Principle 2: Senior management must ensure that the structure of the bank's business
and the level of interest rate risk it assumes are effectively managed, that appropriate
policies 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 committees
responsible for managing interest rate risk and should ensure that there is adequate
separation of duties in key elements of the risk management process to avoid
potential conflicts of interest. Banks should have risk measurement, monitoring, and
control functions with clearly defined duties that are sufficiently independent from
position-taking functions of the bank and which report risk exposures directly to
senior management and the board of directors. Larger or more complex banks should
have a designated independent unit responsible for the design and administration of
the 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 are
clearly defined and consistent with the nature and complexity of their activities. These
policies should be applied on a consolidated basis and, as appropriate, at the level of
individual affiliates, especially when recognising legal distinctions and possible
obstacles to cash movements among affiliates.
Principle 5: It is important that banks identify the risks inherent in new products and
activities and ensure these are subject to adequate procedures and controls before
being introduced or undertaken. Major hedging or risk management initiatives should
be 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 that
capture all material sources of interest rate risk and that assess the effect of interest
rate changes in ways that are consistent with the scope of their activities. The
assumptions underlying the system should be clearly understood by risk managers
and bank management.
Principle 7: Banks must establish and enforce operating limits and other practices
that maintain exposures within levels consistent with their internal policies.
Principle 8: Banks should measure their vulnerability to loss under stressful market
conditions - including the breakdown of key assumptions - and consider those results
when establishing and reviewing their policies and limits for interest rate risk.
3
Principle 9: Banks must have adequate information systems for measuring,
monitoring, controlling, and reporting interest rate exposures. Reports must be
provided 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 their
interest rate risk management process. A fundamental component of the internal
control system involves regular independent reviews and evaluations of the
effectiveness of the system and, where necessary, ensuring that appropriate revisions
or enhancements to internal controls are made. The results of such reviews should be
available to the relevant supervisory authorities.
Information for supervisory authorities
Principle 11: Supervisory authorities should obtain from banks sufficient and timely
information with which to evaluate their level of interest rate risk. This information
should take appropriate account of the range of maturities and currencies in each
bank'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 risk
they undertake.
Disclosure of interest rate risk
Principle 13: Banks should release to the public information on the level of interest
rate 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 measurement
systems of banks adequately capture the interest rate risk in their banking book. If a
bank’s internal measurement system does not adequately capture the interest rate
risk, the bank must bring the system to the required standard. To facilitate
supervisors’ monitoring of interest rate risk exposures across institutions, banks
must provide the results of their internal measurement systems, expressed in terms of
the threat to economic value, using a standardised interest rate shock.
Principle 15: If supervisors determine that a bank is not holding capital commensurate
with the level of interest rate risk in the banking book, they should consider remedial
action, requiring the bank either to reduce its risk or hold a specific additional amount
of capital, or a combination of both.
4
I. Sources and effects of interest rate risk
11. Interest rate risk is the exposure of a bank's financial condition to adverse
movements in interest rates. Accepting this risk is a normal part of banking and can be an
important source of profitability and shareholder value. However, excessive interest rate risk
can pose a significant threat to a bank's earnings and capital base. Changes in interest rates
affect 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 the
underlying value of the bank's assets, liabilities, and off-balance-sheet (OBS) instruments
because the 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 that maintains interest rate risk within prudent levels is essential to the safety and
soundness of banks.
12. Before setting out some principles for interest rate risk management, a brief
introduction to the sources and effects of interest rate risk might be helpful. Thus, the
following 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 of
which is discussed in greater detail below. These sections also describe the two most
common perspectives for assessing a bank's interest rate risk exposure: the earnings
perspective and the economic value perspective. As the names suggest, the earnings
perspective 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 in
several 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 bank
assets, liabilities, and OBS positions. While such repricing mismatches are fundamental to
the business of banking, they can expose a bank's income and underlying 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 decline in both the future income arising
from the position and its underlying value if interest rates increase. 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 deposit matures.
14. Yield curve risk: Repricing mismatches can also expose a bank to changes in the
slope and shape of the yield curve. Yield curve risk arises when unanticipated shifts of the
yield curve have adverse effects on a bank's income or underlying economic value. For
instance, the underlying economic value of a long position in 10-year government bonds
hedged by a short position in 5-year government notes could decline sharply if the yield
curve 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 as
basis risk, arises from imperfect correlation in the adjustment of the rates earned and paid on
different instruments with otherwise similar repricing characteristics. When interest rates
change, these differences can give rise to unexpected changes in the cash flows and
earnings spread between assets, liabilities and OBS instruments of similar maturities or
repricing frequencies. For example, a strategy of funding a one-year loan that reprices
monthly based on the one-month US Treasury bill rate, with a one-year deposit that reprices
monthly based on one-month LIBOR, exposes the institution to the risk that the spread
between the two index rates may change unexpectedly.
5
16. Optionality: An additional and increasingly important source of interest rate risk
arises 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 in
some manner alter the cash flow of an instrument or financial contract. Options may be
stand-alone instruments such as exchange-traded options and over-the-counter (OTC)
contracts, or they may be embedded within otherwise standard instruments. While banks use
exchange-traded and OTC options in both trading and non-trading accounts, instruments
with embedded options are generally more important in non-trading activities. Examples of
instruments with embedded options include various types of bonds and notes with call or put
provisions, loans which give borrowers the right to prepay balances, and various types of
non-maturity deposit instruments which give depositors the right to withdraw funds at any
time, often without any penalties. If not adequately managed, the asymmetrical payoff
characteristics of instruments with optionality features 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 the disadvantage of the seller. Moreover, an
increasing array of options can involve significant leverage which can magnify the influences
(both negative and positive) of option positions on the financial condition of the firm.
B. Effects of interest rate risk
17. As the discussion above suggests, changes in interest rates can have adverse
effects both on a bank's earnings and its economic value. This has given rise to two
separate, but complementary, perspectives for assessing a bank's interest rate risk
exposure.
18. Earnings perspective: In the earnings perspective, the focus of analysis is the
impact of changes in interest rates on accrual or reported earnings. This is the traditional
approach 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 outright
losses can threaten the financial stability of an institution by undermining its capital adequacy
and by reducing market confidence.
19. In this regard, the component of earnings that has traditionally received the most
attention is net interest income (i.e. the difference between total interest income and total
interest 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 and
other non-interest income, a broader focus on overall net income - incorporating both interest
and non-interest income and expenses - has become more common. Non-interest income
arising from many activities, such as loan servicing and various asset securitisation
programs, can be highly sensitive to, and have complex relationships with, market interest
rates. For example, some banks provide the servicing and loan administration function for
mortgage loan pools in return for a fee based on the volume of assets it administers. When
interest rates fall, the servicing bank may 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 are becoming more interest rate sensitive. This
increased sensitivity has led both bank management and supervisors to take a broader view
of the potential effects of changes in market interest rates on bank earnings and to
increasingly factor these broader effects into their estimated 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 a
bank's economic value to fluctuations in interest rates is a particularly important
6
consideration of shareholders, management, and supervisors alike. The economic value of
an 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 be
viewed as the present value of the bank's expected net cash flows, defined as the expected
cash flows on assets minus the expected cash flows on liabilities plus the expected net cash
flows on OBS positions. In this sense, the economic value perspective reflects one view of
the sensitivity of the net worth of the bank to fluctuations in interest rates.
21. Since the economic value perspective considers the potential impact of interest rate
changes on the present value of all future cash flows, it provides a more comprehensive view
of the potential long-term effects of changes in interest rates than is offered by the earnings
perspective. This comprehensive view is important since changes in near-term earnings - the
typical focus of the earnings perspective - may not provide an accurate indication of the
impact of interest rate movements on the bank's overall positions.
22. Embedded losses: The earnings and economic value perspectives discussed thus
far 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 should
also consider the impact that past interest rates may have on future performance. In
particular, instruments that are not marked to market may already contain embedded gains
or losses due to past rate movements. These gains or losses may be reflected over time in
the bank's earnings. For example, a long-term, fixed-rate loan entered into when interest
rates were low and refunded more recently with liabilities bearing a higher rate of interest will,
over its remaining life, represent a drain on the bank's resources.
7
II. Sound interest rate risk management practices
23. Sound interest rate risk management involves the application of four basic elements
in the management of assets, liabilities, and OBS 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 interest
rate risk will depend upon the complexity and nature of its holdings and activities, as well as
on the level of interest rate risk exposure. What constitutes adequate interest rate risk
management practices can therefore vary considerably. For example, less complex banks
whose senior managers are actively involved in the details of day-to-day operations may be
able 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 more
elaborate and formal interest rate risk management processes to address their broad range
of financial activities and to provide senior management with the information they need to
monitor and direct day-to-day activities. Moreover, the more complex interest rate risk
management processes employed at such banks require adequate internal controls that
include audits or other appropriate oversight mechanisms to ensure the integrity of the
information used by senior officials in overseeing compliance with policies and limits. The
duties of the individuals involved in the risk measurement, monitoring, and control functions
must be sufficiently separate and independent from the business decision makers and
position takers to ensure the avoidance of conflicts of interest.
25. As with other risk factor categories, the Committee believes that interest rate risk
should be monitored on a consolidated, comprehensive basis, to include interest rate
exposures in subsidiaries. At the same time, however, institutions should fully recognise any
legal distinctions and possible obstacles to cash flow movements among affiliates and adjust
their risk management process accordingly. While consolidation may provide a
comprehensive measure in respect of interest rate risk, it may also underestimate risk when
positions in one affiliate are used to offset positions in another affiliate. This is because a
conventional accounting consolidation may allow theoretical offsets between such positions
from which a bank may not in practice be able to benefit because of legal or operational
constraints. Management should recognise the potential for consolidated measures to
understate risks in such circumstances.
8
III. Board and senior management oversight of interest rate risk
6
26. Effective oversight by a bank's board of directors and senior management is critical
to a sound interest rate risk management process. It is essential that these individuals are
aware of their responsibilities with regard to interest rate risk management and that they
adequately 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 bank
should approve strategies and policies with respect to interest rate risk management
and ensure that senior management takes the steps necessary to monitor and control
these risks consistent with the approved strategies and policies. The board of
directors should be informed regularly of the interest rate risk exposure of the bank in
order to assess the monitoring and controlling of such risk against the board’s
guidance on the levels of risk that are acceptable to the bank.
27. The board of directors has the ultimate responsibility for understanding the nature
and the level of interest rate risk taken by the bank. The board should approve broad
business strategies and policies that govern or influence the interest rate risk of the bank. It
should review the overall objectives of the bank with respect to interest rate risk and should
ensure the provision of clear guidance regarding the level of interest rate risk acceptable to
the bank. The board should also approve policies that identify lines of authority and
responsibility for managing interest rate risk exposures.
28. Accordingly, the board of directors is responsible for approving the overall policies of
the bank with respect to interest rate risk and for ensuring that management takes the steps
necessary to identify, measure, monitor, and control these risks. The board or a specific
committee 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 in
monitoring 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 the
bank holds significant positions in complex instruments. In addition, the board or one of its
committees should periodically re-evaluate significant interest rate risk management policies
as 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 and
senior management - as well as between senior management and others in the bank -
regarding the bank's interest rate risk exposures and management process. Board members
need not have detailed technical knowledge of complex financial instruments, legal issues, or
of sophisticated risk management techniques. They have the responsibility, however, to
ensure that senior management has a full understanding of the risks incurred by the bank
6
This section refers to a management structure composed of a board of directors and senior management. The
Committee is aware that there are significant differences in legislative and regulatory frameworks across
countries as regards the functions 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 fulfils its tasks. For this reason, in some cases, it is known as a
supervisory board. This means that the board has no executive functions. In other countries, by contrast, the
board has a broader competence in that it lays down the general framework for the management of the bank.
Owing to these differences, the notions of the board of directors and the senior management are used in this
paper not to identify legal constructs but rather to label two decision-making functions within a bank.
9
and that the bank has personnel available who have the necessary technical skills to
evaluate and control these risks.
B. Senior management
Principle 2: Senior management must ensure that the structure of the bank's business
and the level of interest rate risk it assumes are effectively managed, that appropriate
policies and procedures are established to control and limit these risks, and that
resources are available for evaluating and controlling interest rate risk.
30. Senior management is responsible for ensuring that the bank has adequate policies
and procedures for managing interest rate risk on both a long-term and day-to-day basis and
that it maintains clear lines of authority and responsibility for managing and controlling this
risk. 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 aggregate
information as well as sufficient supporting detail to enable management to assess the
sensitivity of the institution to changes in market conditions and other important risk factors.
Senior management should also review periodically the organisation's interest rate risk
management policies and procedures to ensure that they remain appropriate and sound.
Senior management should also encourage and participate in discussions with members of
the board and, where appropriate to the size and complexity of the bank, with risk
management staff regarding risk measurement, reporting, and management procedures.
32. Management should ensure that analysis and risk management activities related to
interest rate risk are conducted by competent staff with technical knowledge and experience
consistent with the nature and scope of the bank's activities. There should be sufficient depth
in staff resources to manage these activities and to accommodate the temporary absence of
key personnel.
C. Lines of responsibility and authority for managing interest rate risk
Principle 3: Banks should clearly define the individuals and/or committees
responsible for managing interest rate risk and should ensure that there is adequate
separation of duties in key elements of the risk management process to avoid
potential conflicts of interest. Banks should have risk measurement, monitoring, and
control functions with clearly defined duties that are sufficiently independent from
position-taking functions of the bank and which report risk exposures directly to
senior management and the board of directors. Larger or more complex banks should
have a designated independent unit responsible for the design and administration of
the bank's interest rate risk measurement, monitoring, and control functions.
33. Banks should clearly identify the individuals and/or committees responsible for
conducting all of the various elements of interest rate risk management. Senior management
should define lines of authority and responsibility for developing strategies, implementing
10
tactics, and conducting the risk measurement and reporting functions of the interest rate risk
management process. Senior management should also provide reasonable assurance that
all activities and all aspects of interest rate risk are covered by a bank's risk management
process.
34. Care should be taken to ensure that there is adequate separation of duties in key
elements of the risk management process to avoid potential conflicts of interest.
Management should ensure that sufficient safeguards exist to minimise the potential that
individuals initiating risk-taking positions may inappropriately influence key control functions
of the risk management process such as the development and enforcement of policies and
procedures, the reporting of risks to senior management, and the conduct of back-office
functions. The nature and scope of such safeguards should be in accordance with the size
and structure of the bank. They should also be commensurate with the volume and
complexity of interest rate risk incurred by the bank and the complexity of its transactions and
commitments. Larger or more complex banks should have a designated independent unit
responsible for the design and administration of the bank's interest rate risk measurement,
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 risk
should have a well-founded understanding of all types of interest rate risk faced throughout
the bank.
11
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. These
policies should be applied on a consolidated basis and, as appropriate, at the level of
individual affiliates, especially when recognising legal distinctions and possible
obstacles to cash movements among affiliates.
36. Banks should have clearly defined policies and procedures for limiting and
controlling interest rate risk. These policies should be applied on a consolidated basis and,
as appropriate, at specific affiliates or other units of the bank. Such policies and procedures
should delineate lines of responsibility and accountability over interest rate risk management
decisions and should clearly define authorised instruments, hedging strategies, and position-
taking opportunities. Interest rate risk policies should also identify quantitative parameters
that define the acceptable level of interest rate risk for the bank. Where appropriate, limits
should be further specified for certain types of instruments, portfolios, and activities. All
interest rate risk policies should be reviewed periodically and revised as needed.
Management should define the specific procedures and approvals necessary for exceptions
to policies, limits, and authorisations.
37. A policy statement identifying the types of instruments and activities that the bank
may employ or conduct is one means whereby management can communicate their
tolerance of risk on a consolidated basis and at different legal entities. If such a statement is
prepared, it should clearly identify permissible instruments, either specifically or by their
characteristics, and should also describe the purposes or objectives for which they may be
used. The statement should also delineate a clear set of institutional procedures for acquiring
specific 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 new
products and activities and ensure these are subject to adequate procedures and
controls before being introduced or undertaken. Major hedging or risk management
initiatives should be approved in advance by the board or its appropriate delegated
committee.
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 characteristics
and can incorporate them into its risk management process. When analysing whether or not
a product or activity introduces a new element of interest rate risk exposure, the bank should
be aware that changes to an instrument's maturity, repricing, or repayment terms can
materially affect the product's interest rate risk characteristics. To take a simple example, a
decision to buy and hold a 30-year Treasury bond would represent a significantly different
interest rate risk strategy for a bank that had previously limited its investment maturities to
less than 3 years. Similarly, a bank specialising in fixed-rate, short-term commercial loans
that then engages in residential fixed-rate mortgage lending should be aware of the
optionality features of the risk embedded in many mortgage products that allow the borrower
to 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 major
hedging or risk management initiatives in advance of their implementation. Proposals to
undertake new instruments or new strategies should contain these features:
• Description of the relevant product or strategy;
12
• Identification of the resources required to establish sound and effective interest rate
risk management of the product or activity;
• Analysis of the reasonableness of the proposed activities in relation to the bank's
overall financial condition and capital levels; and
• Procedures to be used to measure, monitor, and control the risks of the proposed
product or activity.
13
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 that
capture all material sources of interest rate risk and that assess the effect of interest
rate changes in ways that are consistent with the scope of their activities. The
assumptions underlying the system should be clearly understood by risk managers
and bank management.
40. In general, but depending on the complexity and range of activities of the individual
bank, banks should have interest rate risk measurement systems that assess the effects of
rate changes on both earnings and economic value. These systems should provide
meaningful measures of a bank's current levels of interest rate risk exposure, and should be
capable 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, and
OBS 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 interest
rate risk exposures arising from the full scope of a bank's activities, including both trading
and non-trading sources. This does not preclude different measurement systems and risk
management approaches being used for different activities; however, management should
have 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 sources
of interest rate risk including repricing, yield curve, basis, and option risk exposures. In many
cases, the interest rate characteristics of a bank's largest holdings will dominate its
aggregate risk profile. While all of a bank's holdings should receive appropriate treatment,
measurement systems should evaluate such concentrations with particular rigour. Interest
rate risk measurement systems should also provide rigorous treatment of those instruments
which might significantly affect a bank's aggregate position, even if they do not represent a
major concentration. Instruments with significant embedded or explicit option characteristics
should 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 to
static simulations using current holdings to highly sophisticated dynamic modelling
techniques that reflect potential future business activities.
45. 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
OBS positions into “time bands” according to their maturity (if fixed-rate) or time remaining to
their next repricing (if floating-rate). These schedules can be used to generate simple
indicators of the interest rate risk sensitivity of both earnings and economic value to changing
interest 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.
14
46. A maturity/repricing schedule can also be used to evaluate the effects of changing
interest 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 liabilities
that fall into each time band, where duration is a measure of the percentage change in the
economic 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 to
provide a rough approximation of the change in a bank's economic value that would occur
given a particular set of changes in market interest rates.
47. Many banks (especially those using complex financial instruments or otherwise
having complex risk profiles) employ more sophisticated interest rate risk measurement
systems than those based on simple maturity/repricing schedules. These simulation
techniques typically involve detailed assessments of the potential effects of changes in
interest rates on earnings and economic value by simulating the future path of interest rates
and their impact on cash flows. In static simulations, the cash flows arising solely from the
bank's current on- and off-balance sheet positions are assessed. In a dynamic simulation
approach, 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 more
sophisticated techniques allow for dynamic interaction of payments streams and interest
rates, and better capture the effect of embedded or explicit options.
48. Regardless of the measurement system, the usefulness of each technique depends
on the validity of the underlying assumptions and the accuracy of the basic methodologies
used to model interest rate risk exposure. In designing interest rate risk measurement
systems, 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 in
part on the number of time bands into which positions are aggregated. Clearly, aggregation
of 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 extent
of aggregation and simplification to be built into the measurement approach.
49. Estimates of interest rate risk exposure, whether linked to earnings or economic
value, utilise, in some form, forecasts of the potential course of future interest rates. For risk
management purposes, banks should incorporate a change in interest rates that is
sufficiently large to encompass the risks attendant to their holdings. Banks should consider
the use of multiple scenarios, including potential effects in changes in the relationships
among interest rates (ie, yield curve risk and basis risk) as well as changes in the general
level of interest rates. For determining probable changes in interest rates, simulation
techniques could, for example, be used. Statistical analysis can also play an important role in
evaluating 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 of
the risk measurement process. A bank should ensure that all material positions and cash
flows, whether stemming from on- or off-balance-sheet positions, are incorporated into the
measurement system on a timely basis. Where applicable, these data should include
information on the coupon rates or cash flows of associated instruments and contracts. Any
manual adjustments to underlying data should be clearly documented, and the nature and
reasons for the adjustments should be clearly understood. In particular, any adjustments to
expected cash flows for expected prepayments or early redemptions should be well
reasoned 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 and
bank management. In particular, techniques using sophisticated simulations should be used
15
carefully so that they do not become “black boxes”, producing numbers that have the
appearance of precision, but that in fact are opaque and may not be very accurate when their
specific assumptions and parameters are revealed. Key assumptions should be recognised
by senior management and risk managers and should be re-evaluated at least annually.
These assumptions should also be clearly documented and their significance understood.
Assumptions used in assessing the interest rate sensitivity of complex instruments and
instruments with uncertain maturities should be subject to particularly rigorous
documentation and review.
52. When measuring interest rate risk exposure, two further aspects merit close
attention: the treatment of those positions where behavioural maturity differs from contractual
maturity and the treatment of positions denominated in different currencies. Positions such
as savings and sight deposits may have contractual maturities or may be open-ended, but in
either case, depositors generally have the option to make withdrawals at any time. In
addition, banks often choose not to move rates paid on these deposits in line with changes in
market rates. These factors complicate the measurement of interest rate risk exposure, since
not only the value of the positions but also the timing of their cash flows can change when
interest rates vary. With respect to banks' assets, prepayment features of mortgages and
mortgage-related instruments also introduce uncertainty about the timing of cash flows on
these positions. These issues are described in more detail in Annex 1, which forms an
integral part of this text.
53. Banks with positions denominated in different currencies can expose themselves to
interest rate risk in each of these currencies. Since yield curves vary from currency to
currency, banks generally need to assess exposures in each. Banks with the necessary skills
and sophistication, and with material multi-currency exposures, may choose to include in
their risk measurement process methods to aggregate their exposures in different currencies
using assumptions about the correlation between interest rates in different currencies. A
bank that uses correlation assumptions to aggregate its risk exposures should periodically
review 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 practices
that 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 risk
exposure 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 for
achieving 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 to
individual portfolios, activities, or business units. Limit systems should also ensure that
positions that exceed certain predetermined levels receive prompt management attention. An
appropriate limit system should enable management to control interest rate risk exposures,
initiate discussion about opportunities and risks, and monitor actual risk taking against
predetermined risk tolerances.
55. A bank's limits should be consistent with its overall approach to measuring interest
rate risk. Aggregate interest rate risk limits clearly articulating the amount of interest rate risk
acceptable to the bank should be approved by the board of directors and re-evaluated
periodically. Such limits should be appropriate to the size, complexity and capital adequacy
of the bank as well as its ability to measure and manage its risk. Depending on the nature of
a bank's holdings and its general sophistication, limits can also be identified for individual
16
business units, portfolios, instrument types, or specific instruments. The level of detail of risk
limits should reflect the characteristics of the bank's holdings, including the various sources
of interest rate risk to which the bank is exposed.
56. Limit exceptions should be made known to appropriate senior management without
delay. There should be a clear policy as to how senior management will be informed and
what action should be taken by management in such cases. Particularly important is whether
limits are absolute in the sense that they should never be exceeded or whether, under
specific circumstances which should be clearly described, breaches of limits can be tolerated
for a short period of time. In that context, the relative conservatism of the chosen limits may
be an important factor.
57. Regardless of their level of aggregation, limits should be consistent with the bank's
overall approach to measuring interest rate risk and should address the potential impact of
changes in market interest rates on reported earnings and the bank's economic value of
equity. From an earnings perspective, banks should explore limits on the variability of net
income as well as net interest income in order to fully assess the contribution of non-interest
income to the interest rate risk exposure of the bank. Such limits usually specify acceptable
levels 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 of
equity should be appropriate for the size and complexity of its underlying positions. For
banks engaged in traditional banking activities and with few holdings of long-term
instruments, options, instruments with embedded options, or other instruments whose value
may be substantially altered given changes in market rates, relatively simple limits on the
extent of such holdings may suffice. For more complex banks, however, more detailed limit
systems on acceptable changes in the estimated economic value of equity of the bank may
be 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 rate
movements used in developing these limits should represent meaningful stress situations
taking into account historic rate volatility and the time required for management to address
exposures. Limits may also be based on measures derived from the underlying statistical
distribution 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 of
interest rate risk to the bank including mismatch, yield curve, basis, and option risks. Simple
scenarios 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 market
conditions - including the breakdown of key assumptions - and consider those results
when establishing and reviewing their policies and limits for interest rate risk.
60. The risk measurement system should also support a meaningful evaluation of the
effect of stressful market conditions on the bank. Stress testing should be designed to
provide information on the kinds of conditions under which the bank's strategies or positions
would 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 slope
and the shape of the yield curve (i.e. yield curve risk), changes in the liquidity of key financial
markets, or changes in the volatility of market rates. In addition, stress scenarios should
include conditions under which key business assumptions and parameters break down. The
17
stress testing of assumptions used for illiquid instruments and instruments with uncertain
contractual maturities is particularly critical to achieving an understanding of the bank's risk
profile. In conducting stress tests, special consideration should be given to instruments or
markets where concentrations exist, as such positions may be more difficult to liquidate or
offset in stressful situations. Banks should consider “worst case” scenarios in addition to
more probable events. Management and the board of directors should periodically review
both the design and the results of such stress tests, and ensure that appropriate contingency
plans 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 be
provided 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 for
managing interest rate risk exposure, both to inform management and to support compliance
with board policy. Reporting of risk measures should be done regularly and should clearly
compare current exposure to policy limits. In addition, past forecasts or risk estimates should
be compared with actual results to identify any modelling shortcomings.
62. Reports detailing the interest rate risk exposure of the bank should be reviewed by
the board on a regular basis. While the types of reports prepared for the board and for
various levels of management will vary based on the bank's interest rate risk profile, they
should at a minimum include the following:
• Summaries of the bank's aggregate exposures;
• Reports demonstrating the bank's compliance with policies and limits;
• Key assumptions, for example, non-maturity deposit behaviour and prepayment
information;
• Results of stress tests, including those assessing breakdowns in key assumptions
and parameters; and
• Summaries of the findings of reviews of interest rate risk policies, procedures, and
the adequacy of the interest rate risk measurement systems, including any findings
of internal and external auditors and retained consultants.
18
VI. Internal controls
Principle 10: Banks must have an adequate system of internal controls over their
interest rate risk management process. A fundamental component of the internal
control system involves regular independent reviews and evaluations of the
effectiveness of the system and, where necessary, ensuring that appropriate revisions
or enhancements to internal controls are made. The results of such reviews should be
available to relevant supervisory authorities.
63. Banks should have adequate internal controls to ensure the integrity of their interest
rate risk management process. These internal controls should be an integral part of the
institution's overall system of internal control. They should promote effective and efficient
operations, reliable financial and regulatory reporting, and compliance with relevant laws,
regulations, and institutional policies. An effective system of internal control for interest rate
risk includes:
• A strong control environment;
• An adequate process for identifying and evaluating risk;
• The establishment of control activities such as policies, procedures, and
methodologies;
• 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 to
appropriate approval processes, exposure limits, reconciliations, reviews, and other
mechanisms designed to provide a reasonable assurance that the institution's interest rate
risk management objectives are achieved. Many attributes of a sound risk management
process, including risk measurement, monitoring, and control functions, are key aspects of
an effective system of internal control. Banks should ensure that all aspects of the internal
control system are effective, including those aspects that are not directly part of the risk
management process.
65. In addition, an important element of a bank's internal control system over its interest
rate risk management process is regular evaluation and review. This includes ensuring that
personnel are following established policies and procedures, as well as ensuring that the
procedures that were established actually accomplish the intended objectives. Such reviews
and evaluations should also address any significant change that may impact the
effectiveness of controls, such as changes in market conditions, personnel, technology, and
structures of compliance with interest rate risk exposure limits, and should ensure that
appropriate follow-up with management has occurred for any limits that were exceeded.
Management should ensure that all such reviews and evaluations are conducted regularly by
individuals who are independent of the function they are assigned to review. When revisions
or enhancements to internal controls are warranted, there should be a mechanism in place to
ensure that these are implemented in a timely manner.
66. Reviews of the interest rate risk measurement system should include assessments
of the assumptions, parameters, and methodologies used. Such reviews should seek to
understand, test, and document the current measurement process, evaluate the system's
accuracy, and recommend solutions to any identified weaknesses. If the measurement
system incorporates one or more subsidiary systems or processes, the review should include
testing aimed at ensuring that the subsidiary systems are well-integrated and consistent with
each other in all critical respects. The results of this review, along with any recommendations
19
for improvement, should be reported to senior management and/or the board and acted upon
in a timely manner.
67. The frequency and extent to which a bank should re-evaluate its risk measurement
methodologies and models depend, in part, on the particular interest rate risk exposures
created by holdings and activities, the pace and nature of market interest rate changes, and
the pace and complexity of innovation with respect to measuring and managing interest rate
risk.
68. Banks, particularly those with complex risk exposures, should have their
measurement, monitoring, and control functions reviewed on a regular basis by an
independent party (such as an internal or external auditor). In such cases, reports written by
external auditors or other outside parties should be available to relevant supervisory
authorities. It is essential that any independent reviewer ensures that the bank's risk
measurement 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 the
following factors in making the risk assessment:
• The quantity of interest rate risk, for example:
- Volume and price sensitivity of various products;
- Vulnerability of earnings and capital under differing rate changes, including
yield curve twists; and
- Exposure of earnings and economic value to various other forms of interest
rate risk, including basis and optionality risk.
• The quality of interest rate risk management, for example whether:
- The bank's internal measurement system is appropriate to the nature, scope,
and complexities of the bank and its activities;
- The bank has an independent risk control unit responsible for the design and
administration of the risk measurement, monitoring, and control functions;
- The board of directors and senior management are actively involved in the risk
control process;
- Internal policies, controls, and procedures concerning interest rate risk are
well documented and complied with;
- The assumptions of the risk measurement system are well documented, data
is accurately processed, and data aggregation is proper and reliable; and
- The organisation has adequate staffing to conduct a sound risk management
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 functions
periodically reviewed by external auditors. This does not have to involve a full replication of
the internal audit process.
20
VII. Information for supervisory authorities
Principle 11: Supervisory authorities should obtain from banks sufficient and timely
information with which to evaluate their level of interest rate risk. This information
should take appropriate account of the range of maturities and currencies in each
bank'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 to
assess individual banks' interest rate risk exposures. In order to minimise reporting burden,
internal management reports are the preferred method for obtaining this information, but it
could also be obtained through standardised reports that are submitted by banks, through
on-site examinations, or by other means. The precise information obtained could differ
among supervisors, but must include the results of the standardised rate shock applied under
Principle 14. At a minimum, supervisors should have enough information to identify and
monitor banks that have significant repricing mismatches. Information contained in internal
management 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 the
behavioural maturity is different from the contractual maturity. Reviewing the results of a
bank's internal model, perhaps under a variety of different assumptions, scenarios, and
stress tests, can also be highly informative.
72. Banks operating in different currencies can expose themselves to interest rate risk in
each of these currencies. Supervisory authorities, therefore, will want banks to analyse their
exposures in different currencies separately, at least when exposures in different currencies
are material.
73. Another question is the extent to which interest rate risk should be viewed on a
whole-bank basis or whether the trading book, which is marked to market, and the banking
book, which is often not, should be treated separately. As a general rule, it is desirable for
any measurement system to incorporate interest rate risk exposures arising from the full
scope of a bank's activities, including both trading and non-trading sources. This does not
preclude different measurement systems and risk management approaches being used for
different activities; however, management should have an integrated view of interest rate risk
across products and business lines. Supervisors may want to obtain more specific
information on how trading and non-trading activities are measured and incorporated into a
single measurement system. They should also ensure that interest rate risk in both trading
and non-trading activities is properly managed and controlled.
74. A meaningful analysis of interest rate risk is only possible if the supervisor receives
the relevant information regularly and on a timely basis. Since the risk profile in the traditional
banking business changes less rapidly than in the trading business, quarterly or semi-annual
reporting of the former may be sufficient for many banks. Some of the factors that
supervisors may wish to consider when designing a specific reporting framework are
described in greater detail in Annex 2, which forms an integral part of this text.
21
VIII. Capital adequacy
Principle 12: Banks must hold capital commensurate with the level of interest rate risk
they undertake.
75. Changes in interest rates expose banks to the risk of loss, which may, in extreme
cases, 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 sound
management, banks translate the level of interest rate risk they undertake, whether as part of
their 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. In
cases where banks undertake significant interest rate risk in the course of their business
strategies, a substantial amount of capital should be allocated specifically to support this risk.
76. Where interest rate risk is undertaken as part of a bank’s trading activities, the
supervisory capital treatment of that risk is set out in the Market Risk Amendment. Where it is
undertaken as part of a bank’s non-trading activities, the supervisory treatment, covering
both capital and other tools of supervision, is set out in Principles 14 and 15 of this
document.
22
IX. Disclosure of interest rate risk
Principle 13: Banks should release to the public information on the level of interest
rate risk and their policies for its management.
77. The core objective of public disclosure is to facilitate market participants’
assessment of banks’ interest rate risk profiles in both the banking and trading books. The
Committee has set forth requirements for the public disclosure of information on interest rate
risk as part of the overall review of the capital framework.
7
7
See “Part 4: The Third Pillar - Market Discipline”, International Convergence of Capital Measurement and
Capital Standards: A Revised Framework, June 2004 (available on the BIS website athttp://www.bis.org/publ/bcbs107.pdf).
23
X. Supervisory treatment of interest rate risk in the banking book
Principle 14: Supervisory authorities must assess whether the internal measurement
systems of banks adequately capture the interest rate risk in their banking book. If a
bank’s internal measurement system does not adequately capture the interest rate
risk, the bank must bring the system to the required standard. To facilitate
supervisors’ monitoring of interest rate risk exposures across institutions, banks
must provide the results of their internal measurement systems, expressed in terms of
the threat to economic value, using a standardised interest rate shock.
78. Supervisors should evaluate whether internal measurement systems for banking
book interest rate risk are adequate for managing risk in a safe and sound manner that is
adequate for use in supervisory evaluations of capital adequacy. Depending on the nature
and scale of a bank’s business, a wide variety of methodologies could be employed in
internal measurement systems. Such evaluations could be performed through a review of
internal and external audit findings or through on-site supervisory reviews.
79. A bank’s internal systems must meet the following criteria, which amplify the key
points set out in Principle 6:
(a) All material interest rate risk associated with a bank’s assets, liabilities, and OBS
positions in the banking book must be assessed. To do this, internal systems must
accurately incorporate all of a bank’s interest rate sensitive on- and off-balance-
sheet holdings.
(b) Generally accepted financial concepts and risk measurement techniques must be
utilised. In particular, internal systems must be capable of measuring risk using both
an earnings and economic value approach. The monitoring of interest rate risk in the
banking book for supervisory purposes should be based on risk as measured by the
economic value approach.
8
(c) Data inputs are adequately specified (commensurate with the nature and complexity
of a bank’s holdings) with regard to rates, maturities, re-pricing, embedded options,
and other details to provide a reasonably accurate portrayal of changes in economic
value or earnings.
(d) The system’s assumptions (used to transform positions into cash flows) are
reasonable, properly documented, and stable over time. This is especially important
for assets and liabilities whose behaviour differs markedly from contractual maturity
or repricing, and for new products. Material changes to assumptions should be
documented, justified, and approved by management.
(e) Interest rate risk measurement systems must be integrated into the bank’s daily risk
management practices. The output of the systems should be used in characterising
the level of interest rate risk to senior management and boards of directors.
(f) The interest rate shock
9
(or equivalent parameters) as determined in paragraph 81
below has been properly incorporated into the systems.
8
The 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.
9
See Annex 3 for the background on selection of the standardised interest rate shock.
24
80. If supervisors determine that a bank’s internal measurement system does not
adequately capture interest rate risk in the banking book, the first and most immediate
course of action is to require the bank to bring its system to the required standard. In the
interim, the bank must supply its supervisor with information on the interest rate risk in its
banking book in a form specified by the supervisor. Supervisors may wish to use this
information in making their own estimates of risk using a standardised framework applying
the same standardised rate shock.
10
81. This standardised rate shock should in principle be determined by banks, 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.
11
• For exposures in non-G10 currencies, either:
(a) A parallel rate shock substantially consistent with 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 the particular non-G10
currency; 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 such
cases, banks should carry out a similar analysis for each currency accounting for 5% or more
of either their banking book assets or liabilities, using an interest rate shock calculated
according to the preceding paragraph. To ensure complete coverage of the banking book,
remaining exposures should be aggregated and subjected to a 200 basis point shock.
83. The relative simplicity of the 200 basis point parallel rate shock has the
disadvantage of ignoring exposures that might be revealed through scenarios that include
yield curve twists, inversions, and other relevant scenarios.
12
As has already been noted,
such alternative scenarios are a necessary component of the overall management of interest
rate risk. Supervisors will continue to expect institutions to consider multiple scenarios in
evaluating their interest rate risk as appropriate to the level and nature of risk they are taking.
Principle 15: If supervisors determine that a bank is not holding capital commensurate
with the level of interest rate risk in the banking book, they should consider remedial
action, requiring the bank either to reduce its risk or hold a specific additional amount
of 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 an economic value decline of more than
10
An example of a possible standardised framework is set out in Annex 4.
11
This approach may be useful, for example, in circumstances where interest rates are very low.
12
The appropriateness of the proposed shock will also need to be monitored on an ongoing basis, and
recalibrated should the rate environment shift materially.
25
20% of the sum of Tier 1 and Tier 2 capital following the standardised interest rate shock or
its equivalent (as determined under Principle 14).
85. The response in cases where supervisors determine that there is insufficient capital
will depend on a variety of factors. However, the response must result in the bank either
holding additional capital or reducing the measured risk (through, for example, hedging or a
restructuring of the banking book), or a combination of both, depending on the
circumstances.
26
Annex 1
Interest rate risk measurement techniques
1. This annex provides a brief overview of the various techniques used by banks to
measure the exposure of earnings and of economic value to changes in interest rates. The
variety of techniques ranges from calculations that rely on simple maturity and repricing
tables, to static simulations based on current on- and off-balance-sheet positions, to highly
sophisticated dynamic modelling techniques that incorporate assumptions about the
behaviour of the bank and its customers in response to changes in the interest rate
environment. Some of these general approaches can be used to measure interest rate risk
exposure from both an earnings and an economic value perspective, while others are more
typically associated with only one of these two perspectives. In addition, the methods vary in
their 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, while
the more sophisticated methods can more easily capture the full range of risk exposures.
2. As this discussion suggests, the various measurement approaches described below
have their strengths and weaknesses in terms of providing accurate and reasonable
measures of interest rate risk exposure. Ideally, a bank's interest rate risk measurement
system would take into account the specific characteristics of each individual interest-
sensitive position, and would capture in detail the full range of potential movements in
interest rates. In practice, however, measurement systems embody simplifications that move
away from this ideal. For instance, in some approaches, positions may be aggregated into
broad categories, rather than modelled separately, introducing a degree of measurement
error 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 a
parallel shift of the yield curve may be assumed or less than perfect correlations between
interest rates may not be taken into account. Finally, the various approaches differ in their
ability to capture the optionality inherent in many positions and instruments. The discussion
in the following sections will highlight the areas of simplification that typically characterise
each 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
OBS positions into a certain number of predefined time bands according to their maturity (if
fixed-rate) or time remaining to their next repricing (if floating-rate). Those assets and
liabilities lacking definitive repricing intervals (e.g. sight deposits or savings accounts) or
actual maturities that could vary from contractual maturities (e.g. mortgages with an option
for early repayment) are assigned to repricing time bands according to the judgement and
past experience of the bank.
1. Gap analysis
4. Simple maturity/repricing schedules can be used to generate simple indicators of the
interest rate risk sensitivity of both earnings and economic value to changing interest rates.
27
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 used by banks. To evaluate
earnings exposure, interest rate-sensitive liabilities in each time band 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 rates to yield an approximation
of the change in net interest income that would result from such an interest rate movement.
The size of the interest rate movement used in the analysis can be based on a variety of
factors, including historical experience, simulation of potential future interest rate
movements, and the judgement of bank management.
5. A negative, or liability-sensitive, gap occurs when liabilities exceed assets (including
OBS positions) in a given time band. This means that an increase in market interest 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 a decrease in the level
of interest rates.
6. These simple gap calculations can be augmented by information on the average
coupon on assets and liabilities in each time band. This information can be used to place the
results of the gap calculations in context. For instance, information on the average coupon
rate could be used to calculate estimates of the level of net interest income arising from
positions 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 rate
risk exposure, it has a number of shortcomings. First, gap analysis does not take account of
variation in the characteristics of different positions within a time band. In particular, all
positions within a given time band are assumed to mature or reprice simultaneously, a
simplification that is likely to have greater impact on the precision of the estimates as the
degree of aggregation within a time band increases. Moreover, gap analysis ignores
differences in spreads between interest rates that could arise as the level of market interest
rates changes (basis risk). In addition, it does not take into account any changes in the timing
of 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-related
positions. For these reasons, gap analysis provides only a rough approximation of the actual
change in net interest income which would result from the chosen change in the pattern of
interest rates. Finally, most gap analyses fail to capture variability in non-interest revenue
and expenses, a potentially important source of risk to current income.
2. Duration
8. A maturity/repricing schedule can also be used to evaluate the effects of changing
interest 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 liabilities
that fall into each time band. Duration is a measure of the percentage change in the
economic value of a position that will occur given a small change in the level of interest
rates.
13
It reflects the timing and size of cash flows that occur before the instrument's
13
In its simplest form, duration measures changes in economic value resulting from a percentage change of
interest rates under the simplifying assumptions that changes in value are proportional to changes in the level
of interest rates and that the timing of payments is fixed. Two important modifications of simple duration are
commonly used that relax one or both of these assumptions. The first case is so-called modified duration.
28
contractual maturity. Generally, the longer the maturity or next repricing date of the
instrument and the smaller the payments that occur before maturity (e.g. coupon payments),
the higher the duration (in absolute value). Higher duration implies that a given change in the
level of interest rates will have a larger impact on economic value.
9. Duration-based weights can be used in combination with a maturity/repricing
schedule to provide a rough approximation of the change in a bank's economic value that
would occur given a particular change in the level of market interest rates. Specifically, an
“average” duration is assumed for the positions that fall into each time band. The average
durations are then multiplied by an assumed change in interest rates to construct a weight for
each time band. In some cases, different weights are used for different positions that fall
within a time band, reflecting broad differences in the coupon rates and maturities (for
instance, one weight for assets, and another for liabilities). In addition, different interest rate
changes are sometimes used for different time bands, generally to reflect differences in the
volatility of interest rates along the yield curve. The weighted gaps are aggregated across
time bands to produce an estimate of the change in economic value of the bank that would
result from the assumed changes in interest rates.
10. Alternatively, an institution could estimate the effect of changing market rates by
calculating the precise duration of each asset, liability, and OBS position and then deriving
the net position for the bank based on these more accurate measures, rather than by
applying an estimated average duration weight to all positions in a given time band. This
would eliminate potential errors occurring when aggregating positions/cash flows. As another
variation, risk weights could also be designed for each time band on the basis of actual
percentage changes in market values of hypothetical instruments that would result from a
specific scenario of changing market rates. That approach - which is sometimes referred to
as effective duration - would better capture the non-linearity of price movements arising from
significant changes in market interest rates and, thereby, would avoid an important limitation
of duration.
11. Estimates derived from a standard duration approach may provide an acceptable
approximation of a bank's exposure to changes in economic value for relatively non-complex
banks. Such estimates, however, generally focus on just one form of interest rate risk
exposure - repricing risk. As a result, they may not reflect interest rate risk arising, for
instance, from changes in the relationship among interest rates within a time band (basis
risk). In addition, because such approaches typically use an average duration for each time
band, the estimates will not reflect differences in the actual sensitivity of positions that can
arise from differences in coupon rates and the timing of payments. Finally, the simplifying
assumptions that underlie the calculation of standard duration means that the risk of options
may not be adequately captured.
Modified duration - which is standard duration divided by 1 + r, where r is the level of market interest rates - is
an elasticity. As such, it reflects the percentage change in the economic value of the instrument for a given
percentage change in 1 + r. As with simple duration, it assumes a linear relationship between percentage
changes in value and percentage changes in interest rates. The second form of duration relaxes this
assumption, as well as the assumption that the timing of payments is fixed. Effective duration is the
percentage change in the price of the relevant instrument for a basis point change in yield.
29
B. Simulation approaches
12. Many banks (especially those using complex financial instruments or otherwise
having complex risk profiles) employ more sophisticated interest rate risk measurement
systems than those based on simple maturity/repricing schedules. These simulation
techniques typically involve detailed assessments of the potential effects of changes in
interest rates on earnings and economic value by simulating the future path of interest rates
and their impact on cash flows.
13. In some sense, simulation techniques can be seen as an extension and refinement
of the simple analysis based on maturity/repricing schedules. However, simulation
approaches typically involve a more detailed breakdown of various categories of on- and off-
balance-sheet positions, so that specific assumptions about the interest and principal
payments and non-interest income and expense arising from each type of position can be
incorporated. In addition, simulation techniques can incorporate more varied and refined
changes in the interest rate environment, ranging from changes in the slope and shape of the
yield curve to interest rate scenarios derived from Monte Carlo simulations.
1. Static simulation
14. In static simulations, the cash flows arising solely from the bank's current on- and
off-balance-sheet positions are assessed. For assessing the exposure of earnings,
simulations estimating the cash flows and resulting earnings streams over a specific period
are conducted based on one or more assumed interest rate scenarios. Typically, although
not always, these simulations entail relatively straightforward shifts or tilts of the yield curve,
or changes of spreads between different interest rates. When the resulting cash flows are
simulated over the entire expected lives of the bank's holdings and discounted back to their
present values, an estimate of the change in the bank's economic value can be calculated.
14
2. Dynamic simulation
15. In a dynamic simulation approach, the simulation builds in more detailed
assumptions about the future course of interest rates and the expected changes in a bank's
business activity over that time. For instance, the simulation could involve assumptions about
a bank's strategy for changing administered interest rates (on savings deposits, for example),
about the behaviour of the bank's customers (e.g. withdrawals from sight and savings
deposits), and/or about the future stream of business (new loans or other transactions) that
the bank will encounter. Such simulations use these assumptions about future activities and
reinvestment strategies to project expected cash flows and estimate dynamic earnings and
economic value outcomes. These more sophisticated techniques allow for dynamic
interaction of payments streams and interest rates, and better capture the effect of
embedded or explicit options.
16. As with other approaches, the usefulness of simulation-based interest rate risk
measurement techniques depends on the validity of the underlying assumptions and the
accuracy of the basic methodology. The output of sophisticated simulations must be
assessed largely in the light of the validity of the simulation's assumptions about future
14
The duration analysis described in the previous section can be viewed as a very simple form of static
simulation.
30
interest rates and the behaviour of the bank and its customers. One of the primary concerns
that arises is that such simulations do not become “black boxes” that lead to false confidence
in the precision of the estimates.
C. Additional issues
17. One of the most difficult tasks when measuring interest rate risk is how to deal with
those positions where behavioural maturity differs from contractual maturity (or where there
is no stated contractual maturity). On the asset side of the balance sheet, such positions may
include mortgages and mortgage-related securities, which can be subject to prepayment. In
some countries, borrowers have the discretion to prepay their mortgages with little or no
penalty, which creates uncertainty about the timing of the cash flows associated with these
instruments. Although there is always some volatility in prepayments resulting from
demographic factors (such as death, divorce, or job transfers) and macroeconomic
conditions, most of the uncertainty surrounding prepayments arises from the response of
borrowers to movements in interest rates. In general, declines in interest rates result in
increasing levels of prepayments as borrowers refinance their loans at lower yields. In
contrast, when interest rates rise unexpectedly, prepayment rates tend to slow, leaving the
bank with a larger than anticipated volume of mortgages paying below current market rates.
18. On the liability side, such positions include so-called non-maturity deposits such as
sight deposits and savings deposits, which can be withdrawn, often without penalty, at the
discretion of the depositor. The treatment of such deposits is further complicated by the fact
that the rates received by depositors tend not to move in close correlation with changes in
the general level of market interest rates. In fact, banks can and do administer the rates on
the accounts with the specific intention of managing the volume of deposits retained.
19. The treatment of positions with embedded options is an issue of special concern in
measuring the exposure of both current earnings and economic value to interest rate
changes. In addition, the issue arises across the full spectrum of approaches to interest rate
measurement, from simple gap analysis to the most sophisticated simulation techniques. In
the maturity/repricing schedule framework, banks typically make assumptions about the likely
timing of payments and withdrawals on these positions and “spread” the balances across
time bands accordingly. For instance, it might be assumed that certain percentages of a pool
of 30-year mortgages prepay in given years during the life of the mortgages. As a result, a
large share of the mortgage balances that would have been assigned to the time band
containing 30-year instruments would be spread among nearer-term time bands. In a
simulation framework, more sophisticated behavioural assumptions could be employed, such
as the use of option-adjusted pricing models to better estimate the timing and magnitude of
cash flows under different interest rate environments. In addition, simulations can incorporate
the bank's assumptions about its likely future treatment of administered interest rates on non-
maturity deposits.
20. As with other elements of interest rate risk measurement, the quality of the
estimates of interest rate risk exposure depends on the quality of the assumptions about the
future cash flows on the positions with uncertain maturities. Banks typically look to the past
behaviour of such positions for guidance about these assumptions. For instance,
econometric or statistical analysis can be used to analyse the behaviour of a bank's holdings
in response to past interest rate movements. Such analysis is particularly useful to assess
the likely behaviour of non-maturity deposits, which can be influenced by bank-specific
factors such as the nature of the bank's customers and local or regional market conditions. In
the same vein, banks may use statistical prepayment models - either models developed
internally by the bank or models purchased from outside developers - to generate
31
expectations about mortgage-related cash flows. Finally, input from managerial and business
units within the bank could have an important influence, since these areas may be aware of
planned changes to business or repricing strategies that could affect the behaviour of the
future cash flows of positions with uncertain maturities.
32
Annex 2
Monitoring of interest rate risk by supervisory authorities
1. This annex provides a brief overview of some of the factors that supervisory
authorities might consider in obtaining and analysing information on individual banks'
exposures to interest rate risk. As discussed in Section VII, supervisory authorities should
obtain information sufficient to assess banks' exposures to interest rate risk in a timely
fashion. Such information may be obtained through on-site examinations, through reports
that are submitted by banks on a regular basis, or through other means.
2. While the precise information that is obtained will differ across supervisory
authorities, one approach that some may adopt is a reporting framework that collects
information on a bank's positions by remaining maturity or time to next repricing. Under such
an approach, a bank would categorise its interest-sensitive assets, liabilities, and OBS
positions into a series of repricing time bands or maturity categories. The two sections that
follow discuss the considerations that a supervisor should take into account in specifying the
number of time bands and the grouping of positions in the reporting framework. The final
section of this annex describes some general approaches that supervisory authorities may
wish to consider in analysing the information that is obtained through such a reporting
framework.
A. Time bands
3. If a reporting framework is used in which information is collected by time to next
repricing, the number and specific categories of time bands chosen should be sufficient to
provide supervisors with a reasonable basis for identifying potentially significant repricing
mismatches. The bands, however, could vary materially across countries, both in number
and in range, depending on the lending and investing practices and experiences of banks in
individual markets.
4. The usefulness of supervisory analysis crucially depends on the precision with
which maturities of the positions and cash flows are recorded in the system. In analysing
interest rate sensitivities, it is not enough to know when an instrument matures. Rather, the
critical factor is when the instrument reprices. Therefore, the emphasis of this section is on
repricing rather than maturity. For cash flows whose repricing is unambiguous, the most
precise approach is to use the exact repricing date. Any aggregation of positions/cash flows
in time bands or zones necessarily implies a loss of information and a lower degree of
precision. For this reason, the number of time bands in a repricing ladder framework always
reflects a decision regarding the necessary level of precision and the cost of pursuing greater
accuracy. Supervisory authorities could use the repricing ladder in the standardised
approach of the Market Risk Amendment as a starting point when developing a reporting
framework that meets their particular needs. The breakdown can, of course, be modified by
supervisors either in a general way or in a specific way for banks where the nature of
business activities warrants or justifies a different reporting form.
33
B. Items
5. As with the time bands, the breakdown of assets and liabilities could differ among
supervisors. A reporting system should include information for all rate-sensitive assets,
liabilities, and OBS positions, and should also identify balances, by specific types of
instruments, when those instruments have or may have materially different cash flow
characteristics. Specific attention should be given to items whose behavioural repricings
differ from contractual maturities, such as savings deposits and, in some countries,
mortgage-related instruments. Further information on these issues is provided in Annex 1. If
the volume of these positions is significant, they should be reported separately so as to
facilitate an assessment of the underlying options risk in the bank’s balance sheet structure.
6. The analysis of interest rate risk may be more difficult if a bank is engaged in trading
activities. As a general rule, it is desirable for any measurement system to incorporate
interest rate risk exposures arising from the full scope of a bank's activities, including both
trading and non-trading sources. This does not preclude different measurement systems and
risk management approaches being used for different activities; however, management
should have an integrated view of interest rate risk across products and business lines.
Supervisors may wish to permit banks that manage their interest rate risk exposures on an
integrated basis to aggregate trading and non-trading positions in the overall reporting
framework. However, it is important to recognise that in many countries different accounting
rules may apply to the trading book and the traditional banking book. Under these accounting
rules, losses in the trading book may not always be offset by profits in the banking book if the
latter are unrealised. Furthermore, unlike the banking book, the composition of the trading
portfolio changes significantly from week to week or even day to day because it is managed
separately and according to a different (shorter) risk horizon than the banking book. This
means that a hedge that is present on a given day may disappear a few days later.
Supervisors should, therefore, review the risk management practices and information
systems of banks that conduct material trading activities and should obtain the information
necessary to ensure that interest rate risk in both trading and non-trading activities is
properly managed and controlled.
C. Supervisory analysis
7. A reporting framework designed along these lines may provide supervisors with a
flexible tool for analysing interest rate risk. Supervisors can use this basic information to
perform their own assessments of a bank's exposure and risk profile.
8. Such assessments may provide insights regarding an institution's exposure to
parallel shifts, or to a flattening, steepening, or inversion of the yield curve with rate changes
of different magnitude based on either statistical probabilities or a worst-case analysis. For
banks with important exposures in foreign currencies, analysis investigating different
assumptions regarding correlations between interest rates in different currencies can be
useful. With respect to instruments with behavioural maturities, supervisors may wish to
assess assumptions that differ from those used by the institution.
9. The focus of supervisors' quantitative analysis can be the impact of interest rate
changes on either current earnings or the economic value of the bank’s portfolio. In
conducting their analysis, information about average yields on assets and liabilities in each
time band may be useful and supervisors may wish to collect such information in addition to
pure position data.
34
10. Depending on their overall approach, supervisors may conduct their analysis of
interest rate risk either on a case-by-case basis or as part of a broader system designed to
identify outliers with apparently excessive risk-taking.
11. By conducting an assessment of interest rate risk using the proposed framework,
supervisors may gain more insight into an institution's risk profile than with a reporting
system that reduces the complexity of interest rate risk to a single number. In doing so,
supervisors can become more familiar with the sensitivity of risk measures to changes in the
underlying assumptions, and the evaluation process may produce as many insights as the
quantitative result itself.
12. Regardless of the extent of a supervisor's own independent quantitative analysis, a
bank's own interest rate risk measure, whether reported as part of a basic supervisory
reporting system or reviewed as part of an individual assessment of a bank's risk
management, is an important consideration in the supervisory process. Reviewing the results
of a bank's internal model can be highly informative, but can also be a difficult process
because of the multitude of important assumptions and modelling techniques which need to
be made transparent to supervisors. To be most useful, the information received should
indicate the contribution of principal elements of a bank's portfolio to the risk profile under
different assumptions with respect to interest rate changes and the market response. Finally,
any quantitative analysis should be supplemented by a review of internal management
reports in order to gain greater insights into management's evaluation and management of
risks, its methods for measuring exposures, and factors not reflected in the information
available in the limited reporting to supervisors.
35
Annex 3
The standardised interest rate shock
1. To facilitate supervisors’ monitoring of interest rate risk exposures across
institutions, banks would have to provide the results of their internal measurement systems,
expressed in terms of the change in economic value relative to capital, using a standardised
interest rate shock. This annex gives the technical background to the selection of the
standardised rate shock. In selecting the shock, the following guiding principles were
followed:
• The rate shock should reflect a fairly uncommon and stressful rate environment;
• The magnitude of the rate shock should be significant enough to capture the effects
of embedded options and convexity within bank assets and liabilities so that
underlying risk may be revealed;
• The rate shock should be straightforward and practical to implement, and should be
able to accommodate the diverse approaches inherent in single-rate-path simulation
models and statistically driven value-at-risk models for banking book positions;
• The underlying methodology should provide relevant shocks for both G10 and
material non-G10 currency exposures; and
• The underlying methodology should be adaptable for those non-G10 supervisors
who wish to implement this approach in their own countries.
2. With these principles in mind, the proposed rate shock should in principle be
determined by banks, 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 1
st
and 99
th
percentile of
observed interest rate changes using a one-year (240 working days) holding
period and a minimum five years of observations for the particular non-G10
currency; 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.
3. In considering potential rate shocks, historical rate changes among a number of G10
countries were analysed. A one-year holding period (240 business days) was selected both
for practical purposes and in recognition that within a one-year period most institutions have
the ability to restructure or hedge their positions to mitigate further losses in economic value
should rates appear to be exceptionally volatile. Five years worth of rate change
observations require a minimum of six years of historical data to calculate rate differences for
a one-year holding period on a rolling basis. For example, the first observation from five
years ago must look back to the rate environment six years ago to calculate the first rate
change.
36
4. A five-year historical observation period (six years of data) was thought to be long
enough to capture more recent and relevant interest rate cycles. That time period also
appears to offer a reasonably manageable set of data for institutions that wish to incorporate
such data into their statistically driven value-at-risk models or in their own evaluations of a
suitable parallel rate shock for non-G10 currencies. In defining uncommon and stressful
scenarios, rate shocks of a magnitude that would not be expected to be exceeded with a 99
percent confidence interval were considered adequate.
5. In evaluating the data for G10 shocks, rate moves at the 1st and 99th percentile
were roughly comparable across most currencies, especially for longer maturities. A 200
basis point up and down rate shock appears to adequately cover volatilities across G10
currencies. The appropriateness of the proposed shock will need to be monitored on an
ongoing basis, and recalibrated should the rate environment shift materially. Importantly, by
calibrating the parallel shock to be roughly consistent with shocks that would be implemented
through more sophisticated, statistically driven approaches using standard parameters (99
percent confidence interval, one-year holding period, five years of observations), this
approach does not foreclose the use of more innovative risk measurement systems. It also
allows institutions to use these parameters for calculating appropriate shocks themselves
when they have material exposures outside G10 countries and for supervisors in emerging
market and other non-G10 countries to derive simple shocks that are appropriate for their
own countries.
6. The analysis so far has implicitly assumed that banks only carry interest rate risk in
their home currency. However, many banks will be exposed to interest rate risk in more than
one currency. In such cases, banks should carry out a similar analysis for each currency
accounting for 5% or more of either their banking book assets or liabilities, using an interest
rate shock calculated according to one of the methodologies set out above. To ensure
complete coverage of the banking book, remaining exposures should be aggregated and
subjected to a 200 basis point shock.
7. The relative simplicity of a 200 basis point parallel rate shock has the disadvantage
of ignoring exposures that might be revealed through scenarios that include yield curve
twists, inversions, and other relevant scenarios. Such alternative scenarios are a necessary
component of the overall management of interest rate risk as noted elsewhere in this paper.
Supervisors will continue to expect institutions to perform multiple scenarios in evaluating
their interest rate risk as appropriate to the level and nature of risk they are taking.
8. While more nuanced rate scenarios might tease out certain underlying risk
characteristics, for the more modest objectives of supervisors in detecting institutions with
significant levels of interest rate risk, a simple parallel shock is adequate. Such an approach
also recognises the potential for spurious precision that occurs when undue attention to fine
detail is placed on one aspect of a measurement system without recognition that
assumptions employed for certain asset and liability categories, such as core deposits, are
by necessity blunt and judgmental. Such judgmental aspects of an interest rate risk model
often drive the resulting risk measure and conclusion, regardless of the detailed attention
paid to other aspects of the risk measure.
37
Annex 4
An example of a standardised framework
1. This annex contains an example setting out the methodology and calculation
process in one version of a standardised framework. Other methodologies and calculation
processes could be equally applicable in this context, depending on the circumstances of the
bank concerned. Such a framework is intended for supervisory reporting purposes only, and
is not intended to represent an adequate framework for internal risk management purposes.
A. Methodology
2. Positions on the bank’s balance sheet would be slotted into the maturity approach
according to the following principles:
(a) All assets and liabilities belonging to the banking book and all OBS items belonging
to the banking book which are sensitive to changes in interest rates (including all
interest rate derivatives) are slotted into a maturity ladder comprising a number of
time bands large enough to capture the nature of interest rate risk in a national
banking market. Annex 2 discusses issues relating to the selection of appropriate
time bands. Separate maturity ladders are to be used for each currency accounting
for more than 5% of either banking book assets or liabilities.
(b) On-balance-sheet items are treated at book value.
(c) Fixed-rate instruments are allocated according to the residual term to maturity and
floating-rate instruments according to the residual term to the next repricing date.
(d) Exposures which create practical processing problems because of their large
number and relatively small individual amount (e.g. instalment or mortgage loans)
may be allocated on the basis of statistically supported assessment methods.
(e) Core deposits are slotted according to an assumed maturity of no longer than five
years.
(f) National supervisors will provide guidance on how other items with a behavioural
maturity or repricing that differ from contractual maturity or repricing are to be slotted
into the time band structure.
(g) Derivatives are converted into positions in the relevant underlying. The amounts
considered are the principal amount of the underlying or of the notional underlying.
(h) Futures and forward contracts, including forward rate agreements (FRA), are treated
as a combination of a long and a short position. The maturity of a future or a FRA
will be the period until delivery or exercise of the contract, plus - where applicable -
the life of the underlying instrument. For example, a long position in a June three-
month interest rate future (taken in April) is to be reported as a long position with a
maturity of five months and a short position with a maturity of two months.
(i) Swaps are treated as two notional positions with relevant maturities. For example,
an interest rate swap under which a bank is receiving floating-rate interest and
paying fixed-rate interest will be treated as a long floating-rate position of maturity
equivalent to the period until the next interest fixing and a short fixed-rate position of
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maturity equivalent to the residual life of the swap. The separate legs of cross-
currency swaps are to be treated in the relevant maturity ladders for the currencies
concerned.
(j) Options are considered according to the delta equivalent amount of the underlying
or of the notional underlying.
B. Calculation process
3. The calculation process consists of five steps.
(a) The first step is to offset the longs and shorts in each time band, resulting in a single
short or long position in each time band.
(b) The second step is to weight these resulting short and long positions by a factor that
is designed to reflect the sensitivity of the positions in the different time bands to an
assumed change in interest rates. The set of weighting factors for each time band is
set out in Table 1 below. These factors are based on an assumed parallel shift of
200 basis points throughout the time spectrum, and on a proxy of modified duration
of positions situated at the middle of each time band and yielding 5%.
(c) The third step is to sum these resulting weighted positions, offsetting longs and
shorts, leading to the net short- or long-weighted position of the banking book in the
given currency.
(d) The fourth step is to calculate the weighted position of the whole banking book by
summing the net short- and long-weighted positions calculated for different
currencies.
(e) The fifth step is to relate the weighted position of the whole banking book to capital.
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Table 1
Weighting factors per time band (second step in the calculation process)
Time band
Middle of
time band
Proxy of modified
duration
Assumed
change in
yield
Weighting
factor
Up to 1 month
1 to 3 months
3 to 6 months
6 to 12 months
1 to 2 years
2 to 3 years
3 to 4 years
4 to 5 years
5 to 7 years
7 to 10 years
10 to 15 years
15 to 20 years
Over 20 years
0.5 months
2 months
4.5 months
9 months
1.5 years
2.5 years
3.5 years
4.5 years
6 years
8.5 years
12.5 years
17.5 years
22.5 years
0.04 years
0.16 years
0.36 years
0.71 years
1.38 years
2.25 years
3.07 years
3.85 years
5.08 years
6.63 years
8.92 years
11.21 years
13.01 years
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
200 bp
0.08%
0.32%
0.72%
1.43%
2.77%
4.49%
6.14%
7.71%
10.15%
13.26%
17.84%
22.43%
26.03%
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