Financial Institutions

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1 Unofficial Translation This translation is for the convenience of those unfamiliar with the Thai language Please refer to Thai text for the official version Notification of the Bank of Thailand No. FPG. 42/2551 Re: Regulation on Supervision of Interest Rate Risk in the Banking Book of 1. Rationale Financial Institutions Market risk means the risk of losses to financial institutions positions in the trading book and banking book that may arise from market price volatility. Such positions include those related to interest rate, exchange rate, equity instrument, and commodity. Holding large amounts of instruments or market risk positions may cause adverse impact on financial institutions income and capital adequacy, especially when market price of such positions is highly volatile. In order to ensure that supervision of financial institutions market risk is in line with international standards and reflects the market risk efficiently, accurately, and comprehensively, and that financial institutions have appropriate market risk management, the Bank of Thailand has issued a Notification to prescribe the regulation on supervision of market risk of financial institutions to require financial institutions with a significant level of trading book transactions to maintain capital fund to support market risk from 1) positions related to interest rate and equity price in the trading book and 2) all positions related to exchange rate and commodity price. There are three capital calculation methods, namely, 1) Standardized Approach 2) Simulation Approach and 3) Mixed Approach In addition to trading book positions, financial institutions banking book positions may be affected from change in interest rate such as held to maturity debt security investments, loans, or deposits from the public, etc. When the interest rate fluctuates, financial institutions income and/or shareholders equity value may be affected as well. In order to oversee interest rate risk in the banking book efficiently and to ensure that financial institutions manage interest rate risk incurred from assets, liabilities and obligations in line with deposits, borrowings or money received from the public, the Bank of Thailand hereby issues a Notification regarding Regulation on Supervision of Interest Rate Risk in the Banking Book of Financial Institutions so that financial institutions can apply the regulation in managing their interest rate risk and maintaining appropriate capital fund in accordance with the risk level. This Notification is in accordance with the Financial Institution Business Act B.E (2008), whereas the essence of the guideline remains unchanged. 1/7

2 2. Statutory Power By virtue of Section 63 and Section 71 of the Financial Institution Business Act B.E (2008), the Bank of Thailand hereby issues the guideline on managing interest rate risk in the banking book and maintaining appropriate capital fund in accordance with the risk level of financial institutions, for financial institutions to comply with. 3. Scope of Application This Notification shall apply to all financial institutions according to the law on financial institution business. 4. Repealed Notification and Circular The Circular No. BOT.FPG. (21) C. 2141/2547 Re: Policy on Supervision of Interest Rate Risk in the Banking Book for Financial Institutions dated 27 December 2004 and Related Reports 5. Content 5.1 In this Notification Banking Book means positions of financial instruments or other transactions not intended for trading purpose, or financial instruments which were intended, at the onset, to be held for a long period of time or until maturity. Interest rate risk in the banking book means losses to earnings and/or economic value of financial institutions as a result of change in interest rate which may arise from both on- and off-balance sheet positions in the banking book. Details of types and interest rate risk impacts are in Attachment Guideline for effective interest rate risk management Effective interest rate risk management of financial institutions shall consist of 4 basic elements in managing assets, liabilities and off-balance-sheet items as follows: control; (1) Oversight by the board of directors and senior management; (2) Adequate risk management policies and procedures; (3) Appropriate risk measurement, monitoring, reporting, and (4) Effective internal controls related to risk management How financial institutions apply the 4 elements as mentioned in 2/7

3 5.2.1(1)-(4) when managing their interest rate risk may vary, depending on the scope, volume and complexity of the transactions, as well as the level of interest rate risk of each financial institution. Therefore, the interest rate risk management guideline may be diverse. For example, small financial institutions whose senior management closely monitors the day-to-day operations may use a less complex risk management process. Meanwhile, financial institutions with more complex and diverse transactions may need a more complex risk management process by reporting financial transactions to the senior management for daily monitoring, having adequate internal controls that include verification of information to be reported to the senior management in order to ensure that financial institutions operations comply with the specified policies and risk limits. Management 5.3 Roles and Responsibilities of the Board of Directors and Senior The board of directors is responsible for approving business strategies and risk management policies as well as ensures that the senior management take necessary actions to measure, control, monitor and report on interest rate risk in consistent with the scope, volume and complexity of the financial institutions transactions. over, the board of directors shall be informed with adequate and appropriate information in a timely manner in order to assess the senior management s ability to manage interest rate risk to be in line with the specified policies Senior management is responsible for monitoring the interest rate risk management systems to be in consistent with the risk level and transactions of the financial institutions as well as establishing risk limit, policies and procedures to control interest rate risk. over, senior management must allocate sufficient and appropriate resources and personnel for management of the financial institutions interest rate risk Financial institutions should have a sub-committee or individuals responsible for managing interest rate risk as well as ensuring segregation of duties, responsibilities, and operating procedures of risk management function, whose duties include risk measurement, controlling, monitoring, and reporting. Such risk management function shall be independent from position-taking function in order to avoid conflict of interests and shall directly report to the senior management and board of directors of the financial institutions. Details of roles and responsibilities of the board of directors and senior management are prescribed in Attachment Appropriate Risk Management Policies and Procedures Financial institutions must establish policies and procedures related to interest rate risk management in writing and inform relevant parties to 3/7

4 comply with, as well as keep such documents for inspection by the Bank of Thailand s examiners. Such policies and procedures shall cover various aspects as prescribed in Attachment Financial institutions must review the interest rate risk management policies on a regular basis, including adjusting the policies to be consistent with the scope, volume and complexity of the financial institutions transactions and changing market conditions. 5.5 Guideline for Risk Measurement, Controlling and Monitoring Guideline for Risk Measurement (1) Financial institutions should establish systems that are able to measure all material interest rate risk and assess the effects from interest rate change on earnings 1 and/or economic value of the financial institutions in an adequate manner and in consistent with the scope, volume and complexity of the financial institutions transactions. The Bank of Thailand intends to encourage financial institutions to allocate staff and database systems in order to enhance or develop risk measurement systems which are able to measure the effects on both earnings and economic value of the financial institutions, as well as communicating key assumptions of risk measurement so that they are clearly understood by the financial institutions managment. (2) Financial institutions should have systems and tools to assess impacts from interest rate change in consistent with the scope, volume and complexity of the financial institutions transactions. Details of the systems and tools for interest rate risk assessment are prescribed in Attachment 4. (3) Financial institutions whose repricing risk is a major interest rate risk, with immaterial positions of embedded options 2 and complex activities may select the repricing gap method to assess the impact on earnings. Such method is the minimum requirement prescribed by the Bank of Thailand. Details of the interest rate risk measurement by the repricing gap method are prescribed in Attachment 5. (4) Financial institutions should consider the balance sheet structure and option risk exposure as elementary factors in the consideration to establish 1 Net interest income, at present and expected in the future, including the effects on net income in the case where the financial institution has materially significant proportion of non-interest income sensitive to interest rate changes. 2 Embedded options shall mean rights embedded in the financial instruments such as loans or instruments that allow one party to change the term or cash flow relevant to the contract or instrument. Examples are loan prepayment without any penalty fee or any other fees, caps, floors and callable bonds, etc. The embedded options make it difficult to estimate the returns and interest rate risk of such financial instruments since the probability of exercising such options changes as the interest rate changes. 4/7

5 the interest rate risk measurement systems that can measure interest rate risk effects on the economic value. For example, financial institutions with significant portion of embedded options or high proportion of fixed rate long-term assets, but with low proportion of long-term liabilities. (5) Financial institutions with material exposures in interest rate risk in foreign currency, as deemed by the financial institutions and are able to explain to the Bank of Thailand s examiners, must be able to measure the interest rate risk level of each currency as well since yield curve of interest rate in each currency may differ. (6) Financial institutions should develop various database systems in order to measure the interest rate risk for assets and liabilities with uncertain repricing period or uncertain remaining maturity in accordance with actual behavior of customers, especially financial institutions with significant level of exposures. For example, saving and current accounts deposits that depositors may choose to withdraw at any time (non-maturity deposits) or loans with the right to prepay with no cost since the position values and cash flow time band of these positions may change as market interest rate changes. Financial institutions that wish to adjust the data to be in line with customers behaviors shall comply with the stipulated guideline as prescribed in Attachment 6 (7) Financial institutions must conduct a stress test on interest rate risk, including the case of key assumption breakdowns. Financial institutions should also take into account those results when establishing and reviewing the interest rate risk policies and limits. The guideline on conducting stress testing is prescribed in Attachment Guideline for Risk Controlling Financial institutions must establish risk limit system and other related procedures as well as ensuring strict implementation and regular review in order to maintain risk within the level as specified by the financial institutions. Details of the guideline for risk controlling are prescribed in Attachment Guideline for Risk Monitoring (1) Financial institutions must obtain an information system that provides adequate and accurate information for measuring, controlling, monitoring and reporting interest rate risk. Such reports must be prepared regularly in a timely manner and presented to the board of directors, other committees, senior management and various business line managers as deemed appropriate. (2) Financial institutions must conduct validation testing of the measures and assumptions used in their interest rate risk measurement systems regularly to ensure that they can identify any possible shortcoming of the systems in order to improve efficiency and reliability of the risk meansurement systems. 5/7

6 Details of risk reporting and validation testing of tools and assumptions are as prescribed in Attachment Internal Controls Related to Interest Rate Risk Management Financial institutions must obtain an appropriate internal controls for their interest rate risk management process and arrange to have a regular and independent review of the risk management systems in order to evaluate and improve efficiency of the interest rate risk management systems. Details of the guideline on internal control and review are prescribed in Attachment Guideline on Maintaining Capital Fund Financial institutions must consider and monitor their capital level to ensure adequacy and ability to cushion for potential losses from change in interest rate in their banking book positions The Bank of Thailand s examiners may provide opinions, on a case by case basis, to require financial institutions with high interest rate risk level and/or inadequate capital relative to the interest rate risk level to increase their capital and/or reduce the positions that incur interest rate risk or to undertake any actions to reduce the interest rate risk exposure. 5.8 Submission of Data and Relevant Reports Financial institutions shall prepare and submit the data for measuring interest rate risk in the banking book in accordance with the format and guideline prescribed by the Bank of Thailand in the Data Management System (DMS). The report shall be submitted within 21 days from the last day of each quarter. Guideline and explanation on data preparation are prescribed in Attachment Financial institutions with interest rate risk positions in any foreign currency at a significant level as deemed by the financial institutions must prepare and submit reports by each currency, in addition to the report in Thai baht. For immaterial foreign currency positions, financial institutions shall prepare and submit the aggregate report with other currencies Financial institutions that have adjusted data behaviors and already complied with the guideline on adjusting data behaviors shall submit the report by referring to the adjusted data behaviors together with the assumptions underlying the adjustments Financial institutions must retain documents and various details supporting data preparation as prescribed by the Bank of Thailand as well as details on 6/7

7 preparation of the reports internally used by the financial institutions for managing the interest rate risk and submit such information upon request by the Bank of Thailand. 6. Effective Date This Notification shall come into force the day following the date of its publication in the Government Gazette. Announced on 3 rd August 2008 (Mrs. Tarisa Watanagase) Governor Bank of Thailand 7/7

8 -1/1- Attachment 1 Types of Interest Rate Risk Types and Impacts of Interest Rate Risk 1. Repricing risk: arises from timing differences in the residual term (for the case of fixed rate) and the next repricing (for the case of floating rate) of assets, liabilities and off-balance-sheet items. Although timing differences may be the business fundamental of financial institutions, they may cause damages to the financial institutions. For example, a financial institution that uses short-term deposits to fund fixed rate long-term loans may encounter a decline in its net interest income when interest rate increases since the funding cost of deposit rates will increase while its earnings from loans remain fixed. 2. Yield curve risk: arises from change in the shape and slope of yield curve which negatively impact income and economic value of financial institutions. For example, the economic value of a financial institution having long position in a 10-year government bond and short position in a 5-year government bond will decline, when the yield curve becomes steeper (the increase in long-term interest rate is greater that in short-term interest rate) since the value of asset which is the 10-year bond declines more the value of liability which is the 5-year bond. 3. Basis risk: arises from change in market interest rate, making interest rates of assets, liabilities and off-balance-sheet items to change disproportionately even though the residual term or time to next repricing of assets, liabilities and off-balance-sheet items is the same. For example, when short-term interest rate in the market changes, the deposit rate, which is based on 1-month LIBOR, and the lending rate, which is based on 1-month US government bond, may change differently. 4. Option risk: arises from change in interest rate which causes the volume or period of cash flow from a financial instrument with embedded option to change in a way that adversely impacts earnings or economic value of financial institutions. For example, a financial institution purchasing a 30 year debenture whose issuer can redeem before maturity, with market interest rate at issuance of 10% and the face value interest rate of 10%. When market rate drops to 8%, the issuer may redeem the debenture, resulting in change in cash flow that the financial institution expects to receive. This will negatively affect the financial institution as its reinvestmen rate is lower. Or when a financial institution is funding through non-maturity deposits which allow the depositors to

9 -1/2- withdraw at any time, interest rate change may lead to change in cash flow of the financial institution and may adversely affect the financial institution. Effects of Interest Rate Risk Change in interest rates can have adverse effects on financial institutions both in the forms of earnings and economic value. Hence, the interest rate risk effects may be analysed in 2 perspectives as follows 1. Earnings Perspective means analysis of the effects of interest rate change on accrual or reported earnings of financial institutions. This is a short-term impact analysis which is generally used by many financial institutions as a decline in earnings resulting from change in interest rate may affect stability of the financial institutions. From the earnings perspective, most financial institutions mainly focus on the impact analysis on net interest income (the difference between interest income and interest expense) since they are directly affected by change in interest rate. Nonetheless, financial institutions with high proportion of non-interest income or fee income should consider the effects on net income as well (including the effects on net interest income, non-interest income and operating expense) since some types of fee income correlate with transaction volume of the financial institutions which may change when interest rate changes such as loan servicing fees, etc. 2. Economic Value Perspective means analysis of the effects of change in interest rate on the economic value of assets, liabilities and off-balance-sheet items of financial institutions. The economic value of all these items means the present value discounted by the market interest rate of expected cash inflow from assets, minus expected cash outflow from liabilities, plus the net expected cash flow of off-balance-sheet items. Therefore, the economic value perspective of financial institutions reflects sensitivity of the financial institutions s net worth to interest rate fluctuations which is a more comprehensive view the earnings perspective since it analyzes long-term effects on the financial institutions, whereas the earnings perspective considers short-term effects within 1-2 years.

10 - 2/1 - Attachment 2 Roles and Responsibilities of the Board of Directors and Senior Management of Financial Institutions The board of directors of financial institutions 3 has the roles and responsibilities to manage interest rate risk as follows: 1. Obtain the knowledge and understand the sources of interest rate risk, risk exposures and interest rate risk management of the financial institutions; 2. Approve the lines of authority related to interest rate risk management to ensure balance of power and independence between business unit and risk management unit which is responsible for identifying, measuring, monitoring and controlling risk; 3. Approve the business strategies related to interest rate risk, interest rate risk management policies and internal controls including new transaction or product approval policies; 4. Delegate and oversee that the senior management identify, measure, monitor and control interest rate risk of the financial institutions in commensuration with the scope, volume and complexity of the transactions and products as well as allocate resources that are adequate and appropriate for interest rate risk management of the financial institutions; 5. Approve the interest rate risk limit or risk level that is acceptable to the financial institutions; 6. Have sufficient, appropriate and timely information in order to evaluate the interest rate risk management capacity of the senior management to be in line with the approved policies; 7. Periodically review the interest rate risk management policies of the financial institutions as well as the business strategies that affect their interest rate risk exposure to be in consistent with changing circumstances. 3 Or any designated committee in the case of foreign bank branch.

11 -2/2- Senior management has the roles and responsibilities to manage interest rate risk as follows: 1. Oversee the preparation of business strategies and interest rate risk management policies for approval by the financial institutions board of directors and to apply the approved policies strictly and comprehensively within the financial institutions as well as review the said policies to ensure that they are in consistent with changing circumstances; 2. Establish appropriate lines of authority that are related to interest rate risk management as well as clearly define the responsibilities of each subordinating unit; 3. Ensure that there are appropriate interest rate risk management systems that include setting of procedures and methods to identify, measure, monitor, control and report interest rate risk; 4. Oversee compliance of the interest rate risk management policies and internal controls as well as effectively review the interest rate risk management systems; 5. Establish risk limit for approval by the board of directors of financial institutions; 6. Have sufficient, appropriate and timely information in order to assess any potential losses to the financial institutions caused by change in market risk factors and other key risk factors both under a normal and crisis situation; 7. Approve new transactions or products of financial institutions as well as set the objectives and procedures of the transactions to comply with the policies approved by the financial institutions board of directors; 8. Regularly meet or consult with the financial institutions board of directors and risk management staff regarding the risk management procedures and processes; 9. Ensure that staff acquire technical and financial knowledge and understand related businesses, sufficiently for interest rate risk management and internal controls.

12 -3/1- Attachment 3 Appropriate Interest Risk Management Policies and Operating Procedures Appropriate interest rate risk management policies should have the characteristics and details covering various aspects as follows: 1. Clarity and consistency with the scope, volume and complexity of the financial institutions transactions; 2. Specifying risk limits, operating procedures and approval process of various transactions as well as practical guidance and approval for a transaction that exceeds the risk limit; 3. Designating lines of authority in each unit with clear segregation from each other by defining duties and responsibilities of risk-taking business units and risk management unit as well as guideline and operating procedures that prevent conflict of interest; 4. Setting clear operating procedures as well as strategies to generate profits and prevent related risks, types of financial instruments that financial institutions are permitted to hold and clear objectives for holding such financial instruments; 5. Establishing internal control processes for interest rate risk management including authority, duties, and responsibilities of the units responsible for reviewing the interest rate risk management; 6. Identifying a new transaction or product related to interest rate risk with details covering the following aspects: 6.1 Product description and strategy for undertaking the transaction; 6.2 Resource allocation interest rate risk management of the new product and transaction; 6.3 Risk analysis of the new product or transaction; 6.4 Procedure to measure, monitor and control risk of the new product or transaction; 6.5 Consultation result among units related to the new product such as legal unit, accounting unit, risk management unit and other units prior to commencing the new product or transaction; 6.6 Monitoring and evaluating result after commencing the new transaction for use in development of new product and risk management in the future;

13 -3/2-7. Financial institutions must conduct regular review of the interest rate risk management policies as well as appropriately revise the policies to be in consistent with the scope, volume and complexity of the transaction and changing market conditions.

14 -4/1- Attachment 4 Systems and Tools for Measuring Interest Rate Risk 1. Risk measurement systems of financial institutions should have the following characteristics: 1.1 Capable of capturing all materially significant types of interest rate risk of assets, liabilities and other off-balance-sheet items. 1.2 Consistent with the generally accepted financial concepts and/or techniques for measuring risks. 1.3 Having clear and written details of assumptions, variables, as well as methodologies or operating procedures of the systems. 2. Financial institutions may use different systems to measure or manage risks for different transactions. For example, a financial institution may use the value at risk method for the trading book positions and repricing gap method or simulation for the banking book positions, etc. Nonetheless, the financial institution s management must understand the integrated view of interest rate risk arising from its various products and business lines. 3. Tools used for assessing the effects of interest rate change are numerous, ranging from a static repricing gap method which is a simple calculation and static simulations which assess the effects of interest rate change from various scenarios using information of existing positions of the financial institutions, to highly complicated techniques such as dynamic modeling that is able to reflect the effects of new transaction and product, possible changing behaviors of consumers in the future, change in business strategies, and various decision making of the financial institutions as well as being able to reflect the effects from embedded and explicit options. In this regard, various tools for measuring interest rate risk are prescribed in Attachment 4.1

15 -4/2- Attachment 4.1 Interest Rate Risk Measurement Tools and Techniques Static Repricing Gap Approach 1. The simplest technique for assessing interest rate risk of financial institution is static repricing gap which may be used to measure the effects of interest rate change on earnings and economic value of the financial institutions. When it is used for assessing the interest rate risk effects on earnings, it is called repricing gap analysis. This is the first technique developed to assess interest rate risk of financial institutions and is widely adopted by many financial institutions. Nonetheless, some financial institutions may develop the said technique to be more accurate by applying the duration principle with the repricing gap table in order to assess the effects of interest rate change on the economic value. Such technique is called duration-based gap. 2. Static repricing gap technique is prepared by recording assets, liabilities and off-balance-sheet items which are sensitive to interest rate in a time band table by the time remaining before maturity (for fixed rate case) or by the time remaining before next repricing (for floating rate case). In general, this may be called gap analysis, where the gap size in each time band is calculated from assets deducted by liabilities, added to offbalance-sheet items within that time band. Then the gap in each time band is multiplied by the assumed change in interest rate in order to estimate change in earnings resulting from change in interest rate, which is an indicator of repricing risk exposure. The size of interest rate change used in the analysis can be based on various factors e.g. historical data, trend of interest rate change in the future and the decision making of the financial institutions management, etc. 3. In designing the interest rate risk assessment systems, financial institutions should ensure that details of rate-sensitive positions are commensurate with complexity of the tools since accuracy of each type of interest rate risk assessment tool, for example, as repricing gap partly depends on the number of time bands, aggregation of positions or cash flows within a too-wide time band will reduce assessment accuracy. In practice, financial institutions must also evaluate the materiality of reduced accuracy resulting from setting a time-band width in comparison with the assessment effort.

16 -4/3-4. For assets or liabilities with uncertain repricing period e.g. current account and saving deposits as well as items whose actual residual term differs from the contractual term e.g. housing loans which allow prepayment without any penalty fee, interest or other additional fees to the financial institutions, etc. Shall be recorded in the time band corresponding with actual behaviors as much as possible. Such recording should depend on the judgment, historical experience and statistical data of each financial institution 5. Negative repricing gap or liability-sensitive gap in each time band will occur when the difference of interest rate-sensitive assets and liabilities plus the net position of off-balance sheet items during each time band has a negative value, which implies that increase in market interest rate tends to reduce net interest income of financial institutions. Conversely, positive repricing gap or asset-sensitive gap implies that increase in market interest rate tends to increase net interest income of financial institutions. 6. Although repricing gap analysis is a widely used approach to assess interest rate risk exposure since it is simple, this general technique has limitations as follows. 6.1 It does not take into account the difference of remaining time before next repricing of each position in a particular time band. That is, every position in each time band is assumed to mature or to be repriced simultaneously. Hence, if financial institutions use too wide time band, the caculated risk level is likely to deviate. The remedy is to set the time band of positions more finely. 6.2 It does not consider the difference of change in each type of interest rate which may arise as market interest rate changes (basis risk). 6.3 It does not take into account the effects on earnings arising from option risk e.g. the repayment period may differ from the contractual term as interest rate changes, etc. 6.4 It does not reflect the effects of interest rate change on non-interest income and expense which may be significant component of net income of financial institutions. 6.5 The technique using repricing gap analysis is a crude approach in assessing the effects on net interest income of financial institutions that may arise from assumed interest rate changes.

17 -4/4- Duration-based Gap Approach 1. Static repricing gap table may also be used to evaluate the effects on economic value by defining sensitivity weights (duration-based weight) for each time band to multiply with the gap and interest rate change in each time band to obtain duration weighted gap. The sum of all time bands gives a rough estimate of change in economic value of financial institutions that may arise from the assumed change in interest rate. 2. In general, the sensitivity weights in each time band can be estimated from multiplying the average duration 4 (which reflects the percentage change of economic value of the position to small change in interest rate) of various positions within the same time band with change in interest rate in each time band. In some cases, the weights may differ for positions on the asset side and liability side within the same time band in order to reflect the different coupon rates and remaining terms to maturity of those positions. over, the assumptions on interest rate changes for each time band may differ in order to reflect differences in interest rate volatility along the yield curve. 3. Financial institutions may calculate a more refine and accurate sensitivity weight by calculating duration of each asset, liability and off-balance-sheet item. Such approach will correct potential errors arising from aggregating positions or cash flows of each time band when calculating average duration. Furthermore, financial institutions may consider using effective duration instead of modified duration to better reflect non-linear relationship between economic value change and change in interest rate. Simulation Approaches 1. Financial institutions holding significant proportion of positions with complex financial instruments or risk sources other repricing risk should use more sophisticated risk measurement tools rather the static repricing gap, such as simulations, etc. Such techniques assess potential effects of interest rate change on earnings and economic value in detail by simulating future trend and size of interest rate change and the effects on cash flows. 4 Duration approach has been applied in 2 forms, namely, 1) Modified Duration is elasticity value which is equal to normal duration divided by 1+r, where r is the level of market interest rate. Therefore such value will represent the percentage change on economic value of a position to percentage change in interest rate under the assumptions that a) change in such value has a linear relationship with change in interest rate and b) timing of payments is fixed; and, 2) Effective Duration reflects relaxation of such assumptions, therefore it is an estimated sensitivity of a position to change in interest rate in case there is an embedded options.

18 -4/5-2. Static simulations 5 are techniques to assess the effects on interest rate risk solely on cash flows of financial institutions existing positions. For assessing effects on earnings, these techniques will estimate cash flows and earnings over a specific period under simulation of more one case of interest rate change. Generally, they include changes of the slope and shape of yield curve, and changes in spread of various interest rates. Assessing the effects on economic value under these techniques can be done by estimating expected cash flows over the entire life of all positions held by the financial institutions and discounted back to their present values. 3. Some types of static simulation may be enhanced further from the simple analysis based on static repricing gap table by separating details of different positions, both on- and off-balance sheet so that specific assumptions about interest and principal payments as well as effects on non-interest income and expense can be incorporated in the assessment. 4. Dynamic simulation is a more complex technique the static simulation method. The impact analysis on earnings and economic value is similar to the static simulation method but with more detailed assumptions on future trends in interest rate and changes in business activities of financial institutions from the present positions. Therefore, it can better reflect dynamic interaction of cash flows and and interest rates. The simulation may include the following assumptions. 4.1 Financial institutions strategies for changing future administered interest rates such as savings interest rates, etc.; 4.2 Behavior of customers from positions with embedded options and/or various explicit options such as withdrawal behavior of savings and current account with unclear remaining time to maturity, loan prepayment, changes of cash flows from embedded options, etc.; and 4.3 New transactions or products such as new loans or new types of transactions, etc. 5. Financial institutions having material positions in many foreign currencies and being prepared in terms of personnel with expertise as well as having sufficiently sophisticated interest rate risk measurement systems may choose to consolidate positions of several currencies together under the risk assessment systems by making assumptions on correlations between interest rates of different currencies. Financial institutions which 5 Duration gap described previously can be viewed as a very simple form of static EVE simulation.

19 -4/6- apply assumptions of correlations in aggregating the risk positions must regularly review the validity of such assumptions as well as assess potential risk exposures in case where the correlations diverge from the assumptions.

20 -5/1- Attachment 5 Guidelines for Measuring Interest Rate Risk by Repricing Gap Approach Financial institutions that assess interest rate risk by the repricing gap method shall comply with following minimum guidelines specified by the Bank of Thailand. There is no behavioral adjustment of items whose remaining maturity or terms to the next repricing differ from the contractual terms such as loan prepayments, non-maturity deposits and non-performing loans, etc. Procedures for Measuring Interest Rate Risk Measuring interest rate risk impact on earnings by the repricing gap method can be organized into 6 steps as follows: 1. Record assets, liabilities and off-balance-sheet positions in the banking book, for which there is no behavioral adjustment of items without definite contractual maturity and loan prepayments, in the repricing gap table where time bands must be divided into quarters for the first 1-2 year at the minimum in accordance with the guidelines specified by the Bank of Thailand below. 2. Calculate gap for each time band by netting positions of assets, liabilities and net off-balance-sheet positions in each time band. 3. Calculate cumulative gap for each time band by adding gap of each time band to gap of the previous time bands. 4. Assess impact on earnings from interest rate change under assumptions of interest rate change such as 100-basis-point increase equally throughout the yield curve(parallel shift in the yield curve) with in 1 year by multiplying 1) gap for each time band and 2) interest rate change assumption e.g (100 basis points) and 3) proportion of 1 year time remaining in effect (the midpoint of each time band to 1 year that continues to be effected by interest rate risk) e.g. for 0-1 month time band, the midpoint is 0.5 month; thus the proportion of 1 year that the gap in the 0-1 month band will be effected by interest rate change is equal to (12-0.5)/12 or Assess the level of all interest rate risk in banking book, which is equal to the sum of impacts on earnings arising from interest rate change during 1 year as derived from Step 4 for all currencies.

21 6. Compare the overall interest rate risk level in the banking book derived from Step 5 with the projected future net interest income of financial institutions within the next 1 year. Financial institutions may consider assessing interest rate risk in the form of impact on economic value by using the duration-based gap method applying risk weights according to the BIS 6 guidelines during the initial period by following the procedures below. 1. Record assets, liabilities and off-balance-sheet items in the repricing gap table by time bankds as specified by the Bank of Thailand s guidelines below. 2. Calculate gap for each time band by netting the positions of assets, liabilities and net off-balance-sheet position in each time band. 3. Multiply the gap in each time band with duration-based weight of each time band (Table 1) which reflects sensitivity of the position in each time band to change in interest rate e.g. 100 basis point increase equally throughout the yield curve (parallel shift in the yield curve). 4. Sum the results derived from netting impacts on economic value in each time band to yield total impacts on economic value in all time bands for each currency. 5. Sum the impacts on economic value from the table by each currency to yield aggregate impacts on economic value for all currencies. 6. Compare the aggregate net value of interest rate risk in the banking book with capital fund of the financial institutions to evaluate the level of interest rate risk in the banking book. -5/2-6 Refer to Principles for the Management and Supervision of Interest Rate, July 2004 of Bank for International Settlements (BIS)

22 -5/3- Weighted Gap in Each Time Band Time Band Table 1 Weighted Gap Midpoint of the Time Band Proxy of Modified Duration 1/ Interest Rate Change Risk Weight 0-1 month 0.5 month 0.04 year 100 bps 0.04% more 1-3 months 2 months 0.16 year 100 bps 0.16% more 3-6 months 4.5 months 0.36 year 100 bps 0.36% more 6-12 months 9 months 0.71 year 100 bps 0.71% more 1-2 years 1.5 years 1.38 years 100 bps 1.38% more 2-3 years 2.5 years 2.25 years 100 bps 2.25 % more 3-4 years 3.5 years 3.07 years 100 bps 3.07 % more 4-5 years 4.5 years 3.85 years 100 bps 3.85 % more 5-7 years 6 years 5.08 years 100 bps 5.08 % more 7-10 years 8.5 years 6.63 years 100 bps 6.63 % more years 12.5 years 8.92 years 100 bps 8.92 % more years 17.5 years years 100 bps % more 20 years 22.5 years years 100 bps % 1/ Modified duration of the gap in each time band is approximated from the midpoint of each time band under the assumption that the rate of return is 5% according to the BIS guideline.

23 -5/4- General Guidelines for Making Entries 1. Items to be recorded in various time bands in the Repricing Gap Table are assets, liabilities and off-balance-sheet items which are rate-sensitive, including both interest rate bearing items and non- interest bearing items that are rate sensitive, namely, financial instruments sold at a discount such as zero coupon bonds, etc. Non-rate sensitive assets, liabilities and off-balance-sheet items shall be recorded under Non-rate sensitive column. 2. On-balance-sheet items shall be recorded in the Repricing Gap Table using their book values in baht as at the month end. 3. Off-balance-sheet derivatives shall be recorded by the two-leg approach, namely, long and short positions, where the derivatives transactions are splitted to positions of the underlying instruments first. Entries are then made by using 1) principal value of the underlying in case there is underlying instrument (except option, see 21) or 2) principal amount of the notional underlying in case there is no underlying instrument such as interest rate swap, FX forward/swap, cross currency swap, etc. Foreign exchange contracts and interest rate swap contracts between two currencies shall be recorded separately, one in each respective currency. Interest rate swaps in one currency shall be recorded as 2 legs : long and short position in the same currency. 4. Financial institutions having material proportion of foreign interest rate positions as deemed by the financial institutions and are able to justify and have supporting documents to be presented to the Bank of Thailand s examiners, shall prepare the repricing gap table by each currency and record the equivalent amounts in baht using the contractual exchange rates or, if not specified, the exchange rates on the reporting date. 5. Interest bearing assets and liabilities shall be recorded in the repricing gap table by interest rate type. They can be categorized into 2 types as follows. 5.1 Fixed rate items mean assets and liabilities with fixed interest rates. Items with constant fixed rate throughout the contract such as fixed rate bonds, fixed deposits, etc. shall be recorded in the time band according to the remaining time to maturity. For cases where rates are fixed for a period and float in the next period, the entry shall be in the time bands where floating rates will be in effect. For example, housing loans with fixed interest rate during the first 3 years, after which the rate will be floating equal to MLR shall be recorded in the 2-3 year time band.

24 -5/5-5.2 Floating rate items mean assets, liabilities whose interest rates can change. They can be categorized into 2 types as follows: (1) Variable rate items mean assets, liabilities whose interest rates change at the discretion of the counterparty or with reference rates such as LIBOR. For example, floating rate notes whose rates change with LIBOR, loans whose rates are based on LIBOR, etc. These items shall be recorded in the time bands according to the time to next repricing, assuming that the reference interest rate will be adjusted immediately after the reporting date. If remaining maturity of the assets or liabilities is less the time to last repricing, the items shall be recorded by the remaining maturity. (2) Managed rate items mean assets and liabilities with floating interest rates and no definite repricing dates, but interest rates are adjusted at the discretion and strategy of each financial institution. For example, loans with interest rates of MLR + spread, etc. These items shall be recorded in the time band according to the remaining time until next projected repricing after changes in market rates or reference rates, assuming that market rates or reference rates will be adjusted immediately after the reporting date. In this respect, financial institutions should be able to justify the assumptions related to the repricing period so that the Bank of Thailand can examine. For example, if a financial institution historically adjusts its interest rates every 3 months, then the item shall be recorded in the 1-3 month time band. Alternatively, if the financial institution adjusts its rates 1 month following the market interest rate movement, the item shall be recorded in the 0-1 month time band, assuming that market interest rates will change immediately after the reporting date. 6. Non-interest bearing assets and liabilities such as zero coupon bond shall be recorded in the time band by the time remaining to maturity. 7. Assets and liabilities with installed payments (installment items) as opposed to single payments at maturity should be recorded separately for each amount in the appropriate time band in response to the period before next repricing of each amount. For example, a loan with book value of 2 million baht will be repriced in the next 2 months while there will be a repayment of 100,000 baht in the next 10 days; the entries will be 100,000 baht in the 0-1 month time band and THB 1,900,000 in the 1-2 month time band. 8. Internal deals shall not be recorded in the repricing gap table.

25 -5/6- Details for Recording Assets, Liabilities and Off-Balance-Sheet Items Assets 1. Cash shall be recorded in the Non-rate sensitive column. 2. Interbank items e.g. interbank loans shall be recorded in the time band according to the time remaining until next repricing for floating rate items and time remaining until maturity for fixed rate items. 3. Purchase with resale agreements shall be recorded under the heading prescribed in the Notification of Bank of Thailand Re: Preparation and Announcement of Financial Statement of Financial Institutions in the time band according to the time remaining until contractual maturity since they have fixed interest rates. 4. Investments 4.1 Debt securities with floating rates shall be recorded in the time band according to the time remaining until next repricing and debt securities with fixed interest rates shall be recorded in the time band according to time remaining until contractual maturity. 4.2 Common shares and other equity instruments whose attributes are similar to equity securities shall be recorded in the Non-rate sensitive column. Preferred shares whose attributes are similar to debt instruments with variable or fixed interest rates shall be recorded in the time band according to the time remaining until contractual maturity or next repricing dates, respectively. 4.3 Other securities such as: Callable bond with clear information regarding redemption period shall be recorded in the time band which the issuer is expected to redeem such instrument, by considerting the reference to maturity, call price and current price which the issuer will call when the price of the instrument is higher or equal to the call price. For instance, a 10-year bond whose issuer may call after 5 years, with market price that reflects interest rate in the next 6 years is equivalent to 102 baht and call price is 101 baht. It is then highly probable that this bond will be called in the 6th year; hence, it shall be recorded in the 5-7 year time band. In case where there is uncertainty of call period, it shall be recorded in the time band according to the time remaining until contractual maturity.

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