Measurement of IRRBB Sao Paulo 27 April 2016 Zdenka van Schaik ASBA/FSI meeting
Agenda o IRRBB exposure EVE approach Treatment of equity Treatment of margins IR R B B r NII approach Treatment behavioural risk Treatment non-maturity deposits Treatment prepayment risk 2
Scope of IRRBB IRRBB risk types GAP risk repricing risk and yield curve risk Basis risk tenor risk and reference risk Option risk automatic option risk and customer behavior risk Related risks CSRBB Inflation risk Additional concerns P&L effect of hedge accounting
Composition of IRRBB position Banking book Assets Funding Mismatch position Assets Equity Investment position
-8'000 GAP profile 6'000 4'000 2'000 0-2'000-4'000 1 m 3 m 6 m 1 Y 2 Y 3 Y 4 Y 5 Y 7 Y 10 Y 15 Y 20 Y 30 Y Consumer credit Mortgages Investment portfolio Current accounts Savings Term deposits Bonds -6'000
Net GAP profile = equity exposure 6'000 4'000 2'000 0-2'000 1 m 3 m 6 m 1 Y 2 Y 3 Y 4 Y 5 Y 7 Y 10 Y 15 Y 20 Y 30 Y GAPs before swaps GAPs after swaps -4'000-6'000-8'000
GAP risk EVE approach Gonne concern perspective Preserving value of a bank for resolution No real P&L effect Long term effect and all exposures included Disincentive to stabilize earnings NII approach Going concern perspective Preserving earnings level Real P&L effect Short term effect Can include effects of new production
EVE approach Banking book Δ Economic value of equity as a result of interest rate shock Duration assets Duration funding Duration of equity Duration assets Avg duration assets = Duration equity = residual item Avg duration liabilities and eq.
Modified duration Price sensitivity of an instrument to changes in interest rate Δ Market value instrument = - ModD x MV instrument x Δr ModD = MMMMMMMM (1+rr) PV CF 1 PV CF 2 PV CF 3 PV CF 4 PV CF 5 t i =1 t i =2 t i =3 t i =4 t i =5 MacD=4,3
Composition of IRRBB position Banking book Mismatch position ΔEVE = ΣΔNII Assets Funding High duration = high volatility EVE and NII Position fully hedgable r MV NII Assets Equity Investment position ΔEVE = opportunity cost of capital High duration = high vol EVE and low vol NII Trade-off volatility EVE and NII R MV NII
GAP profile replicating portfolio Duration 1 GAP profile replication portfolio Duration 5 High mismatch - Duration 15 1 2 3 4 5 6 7 8 9 10152030 Year 1 2 3 4 5 6 7 8 9 10 15 20 30 Year 1 2 3 4 5 6 7 8 9 10 15 20 30 Year 12000 10000 8000 6000 4000 2000 0 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 Replicating D 1 Replicating D 2 Replicating D 5 Interest rate 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 12000 10000 8000 6000 4000 2000 0 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 Replicating D 15 Mismatch D 15 Interest rate
Problem EVE measure Sole focus on EVE can lead to earnings destabilization underestimation of the effect of declining and remaining low interest rates on NII Possible solutions: Allow assumption on interest rate sensitivity of equity to offset the exposure Introduce focus on NII Introduce a threshold for the exposure when assessing undue risk (BCBS)
Computation EVE exposure: treatment of equity 1. Matched positions 3. Equity exposure 2. Mismatch position 4. Equity exposure in EVE computation BCBS sets assumption of equity in O/N
IRRBB treatment and undue risk BCBS Outlier banks potentially undue IRRBB when supervisory review confirms inadequate management or excessive risk supervisors must require mitigation actions and/or additional capital. BCBS Outlier criterion ΔEVE =15% of T1; ΔEVE as defined in principle 8 for disclosure purposes Open to interpretation: The exact scope and computation of the IRRBB exposure The exact definition of excessive risk for supervisory review
Treatment of spreads and margins R = risk free rate + credit and liquidity spread + commercial margin Commercial margin = coverage expenses + profit margin What constitutets IRRBB? BCBS: risk of changes in risk free rate Inclusion of spreads and margins into cash flows overestimates the duration bias towards earnings destabilization Shocks calibrated to risk free rate Banks are allowed to filter out the spreads and margins from cash flows
Computation EVE exposure: treatment of spreads and margins Matched positions Equity exposure Commercial margin Mismatch position Commercial margin Carry (result position) Composition Equity exposure Nominal amount Risk free rate Credit spread Carry Commercial margin The effect of the problem of EVE approach giving disincentive to earnings stabilization is magnified by inclusion of commercial margin.
Risk from NII perspective Total equity 40,000 Yearly repricing 10,000 IR up + 100 bp 100 Effect IR up 100 bp on profit 2013 +25% Effect IR up 100 bp on profit 2012 +5% 2013 2012 NII 9,000 9,200 Commissions 2,000 2,200 Other income 2,000 2,200 Total operating income 13,000 13,600 Operating expenses 9,000 9,200 Other expenses 3,600 2,400 Operating profit before taxation 400 2,000
Challenges of NII measure Prognosis about future production, margins, pricing What does constitute NII risk? How to treat profit margin buffers? BCBS: National discretion to define an Outlier criterion in terms of NII
Prepayment fixed rate mortgages Prepayment rate % of properties sold x % of prepayment options in the money IR Prepayment rate Market value equity NII 19
Challenges modelling prepayment Statistically sound models Data quality BCBS standardized methodology: scalars applied to internal estimate in interest rate shock scenarios (1.2 for scenario down and 0.8 for up)
Challenges modelling prepayment Statistically sound models Data quality BCBS standardized methodology: scalars applied to internal estimate in interest rate shock scenarios (1.2 for scenario down and 0.8 for up)
Treatment non-maturity deposits Different to liquidity treatment Separation core and non-core deposits BCBS treatment in standardized methodology Table 2. Caps on core deposits and average maturity by category Cap on proportion of core deposits Cap on average maturity (years) Retail/transactional 90 5 Retail/non-transactional 70 4.5 Wholesale 50 4
Principle 8: Public disclosure ΔEVE for six scenarios: Exclude equity assumption Disclose the treatment of spread and margins in the cash flows Disclose discount rate Run-off balance sheet ΔNII for scenario parallel shock up and down: Include all cash flows including spreads and commercial margin Constant balance sheet Rolling 10 month period Disclose average duration non-maturity deposits Disclose modelling choices for prepayment
Discussion 1: EVE vs NII in supervisory review What should be the primary focus of the supervisory review when measuring exposure for purposes of identification of excessive risk? Primary focus on EVE Primary focus on NII; if yes how long horizon? Combination of EVE and NII; if yes how to combine?
Discussion 2: computation EVE for supervisory review How should the EVE be measured for purposes of identification of excessive risk? Disallow any assumption on equity? How to treat spreads and margins in the computation of EVE in the nominator and denominator? What should the EVE measure be set against in the process of identification of excessive risk? T1 CET1 Excess capital
Questions?