BCBS Standard for Interest Rate Risk in the Banking Book Objectives, Approaches and Disclosure

BCBS Standard for Interest Rate Risk in the Banking Book Objectives, Approaches and Disclosure Meeting on IRRBB and the Revised Standardised Approach for Credit Risk Sao Paulo, Brazil 27-28 April 2016 Jeff Miller FSI Connect Relationship Manager Financial Stability Institute The views expressed in this presentation are those of the presenter and not necessarily those of the BIS/BCBS

Outline Background Overview of new IRRBB standard Disclosure 2

Outline Background Overview of new IRRBB standard Disclosure 3

Background what is IRRBB? The current or prospective risk to a bank s capital and earnings arising from adverse movements in interest rates that affect the bank s banking book positions. Changes in interest rates affect a bank s: Economic value (EV) by changing the present value and timing of future cash flows, which changes the underlying value of assets, liabilities and off-balance sheet positions Net interest income (NII) by altering interest-sensitive income and expenses Inherent to the business of banking 4

IRRBB why do we care? High levels of exposure to the IRRBB can pose a significant threat to a bank s capital and/or future earnings Banking book instruments are generally intended to be held to maturity But changes in market value not necessarily reflected in financial accounts 5

Basel Committee guidance a bit of history 1993 consultative paper on measuring banks exposure to interest rate risk 1997 principles for interest rate risk management in both banking and trading books 2004 Principles for the management and supervision of interest rate risk Element of Basel II s Pillar 2 / supervisory review Emphasises risk management Includes possible supervisory measurement framework Introduced outlier approach : after standardised shock, decline in EV > 20% of Tier 1 plus Tier 2 Broad, non-prescriptive disclosure requirements 6

Current approaches to IRRBB supervisors and banks Majority of Basel Committee members follow Pillar 2 approach based on EV measure, some of which: Include any resulting add-on in minimum requirement Also consider earnings impact Two Basel Committee jurisdictions follow Pillar 1 APRA has required Pillar 1 capital for IRRBB since 2008 - Applies only to banks also using IRB and AMA - EV-based, with NII offset for negative change in EV Banks primarily use earnings-based measures 7

IRRBB consultative proposal (June 2015) Motivation included: Help ensure banks have sufficient capital sufficient to cover potential losses from exposures to changes in interest rates Limit incentives for capital arbitrage between (i) trading and banking books, and (ii) different accounting treatments Recognition of need to update 2004 principles to reflect changes in market and supervisory practices Included Pillar 1 and enhanced Pillar 2 options (with elements of Pillar 3) 8

Why Pillar 1? Promotes greater consistency, transparency and comparability and hence, market confidence and a more level playing field But the usual complications from implementing a standardised approach across heterogenous markets, banks Breadth of sub-types of IRRBB to be captured Whether, and how, to incorporate both EV and NII Extent to which IRRBB should be compatible with trading book capital requirements Appropriateness of standardising the treatment of all onand off-balance sheet positions 9

Proposed Pillar 1 framework main elements Capital requirement per standardised EV-based approach Possible earnings overlay to address EV / NII trade-offs Some ( constrained ) reliance on banks internal assessments Standardised parameters for treatment of positions less amenable to standardisation Credible fallback provided for modelled inputs Six prescribed interest rate shock scenarios, by currency Minimum requirement = scenario producing worst outcome Updated principles for risk management, supervision (Pillar 2) Significantly enhanced public disclosure requirements (Pillar 3) 10

Pillar 2 what does enhanced mean? Similar to Pillar 2 for other risks, combining ICAAP and SREP But with the addition of: Well-defined methodology for assessing capital adequacy (~ proposed Pillar 1 methodology) Strong presumption for capital consequences for banks with undue risk relative to capital or earnings ( outlier approach ) Mandatory disclosure supervisory and public Peer review process ensure consistent implementation 11

Outline Background Overview of new IRRBB standard Disclosure 12

IRRBB standard (April 2016) essential elements Enhanced Pillar 2 (vs Pillar 1) more appropriate for heterogenous nature of IRRBB Updated principles for IRRBB risk management, supervision Expanded guidance on expectations for management Elaboration on aspects of supervisory review process Enhanced risk capture of standardised framework Stronger presumption for capital consequences Enhanced outlier approach More extensive disclosure requirements Scope: large internationally active banks, consolidated Implementation: by 2018 13

Updated principles for IRRBB Updated IRRBB principles replace those from 2004 Principles 1-7: expectations for banks management (identification, measurement, monitoring, control) Principle 8: disclosure Principle 9: internal assessment of capital adequacy Principles 10-12: expectations for supervisory approach 14

Principles for banks Management of IRRRBB specific areas updated include: Development of interest rate shock scenarios Consideration of impact on both EV and earnings Key behavioural and modelling assumptions Internal validation process for models 15

Principles for supervisors outlier approach Supervisors can have multiple outlier tests, but must publish criteria for identifying outliers Every supervisor must use: EVE > 15% of Tier 1 capital under any of the six prescribed scenarios Threshold in any other test to be at least as stringent Outliers could also include bank where shocked NII raises doubt about ability to continue normal business operations Outliers must be considered to possibly have undue IRRBB and be subject to review 16

Principles for supervisors capital consequences Where management is inadequate OR risk excessive relative to capital, earnings or general risk profile, supervisor must require bank to do one or more of the following: Reduce IRRBB exposure Raise capital Introduce constraints on internal risk parameters Improve risk management Supervisors can mandate bank to follow the standardised framework (eg if they find that the bank s IMS does not adequately capture IRRBB) 17

Standardised framework for IRRBB Interest-rate sensitive banking book positions standardisation Stage 1 Less amenable Not amenable Amenable Non-maturity deposits Behavioural options Stage 2 Slotting of notional repricing cash flows (19 time buckets) Stage 3 Compute EVE per currency (6 shock scenarios) Stage 4 Add-on for options Stage 5 IRRBB EVE calculation (maximum of worst aggregated reductions to EVE across six prescribed interest rate shocks) 18

Standardised framework cash flow slotting Approach captures all future notional repricing cash flows arising from interest rate-sensitive: Assets Liabilities Off-balance sheet items Instruments must first be allocated to one of three categories based on their amenability to standardisation (amenable, less amendable, not amenable) Corresponding cash flows are then slotted into 19 predefined time buckets (by currency) 19

Positions not amenable NMDs Segment non-maturity deposits into retail (transactional and non-transactional) and wholesale categories Identify core and non-core components (subject to cap) based on observed volume changes over 10 years 1. Identify stable part of each category that portion that is highly likely to remain undrawn 2. Core is the proportion of stable that is unlikely to reprice even under significant interest rate shock Slot NMDs into appropriate time bucket (non-core treated as overnight) cap on average maturity 20

NMDs caps 21

Positions not amenable behavioural options Applies to fixed-rate loans subject to prepayment (eg mortgages) and term deposits subject to early redemption risk Customer s exercise of option influenced by interest rate Two-step approach to estimate optionality 1. Baseline estimates calculated by bank (subject to supervisory approval) or prescribed by national supervisor 2. Baseline estimates multiplied by prescribed scalars Scalars vary by scenario and reflect likely behavioural change in the exercise of the options 22

Standardised framework interest rate shock scenarios Six prescribed scenarios for EVE 1. Parallel up 2. Parallel down 3. Steepener 4. Flattener 5. Short up 6. Short down Two prescribed for NII parallel up and parallel down Standard specifies absolute shocks by currency to accommodate different environments across jurisdictions 23

Calculation of standardised EVE risk measure Loss in economic value of equity ( EVE) is calculated for: Each of the six prescribed interest rate scenarios, and in Every currency with material exposures (>5% of banking book assets or liabilities) Across all scenario-currency pairs: Net notional repricing cash flow is calculated for each time bucket All cash flows are discounted to present value and summed to determine the shocked EVE in that pair EVE in a scenario-currency pair = shocked EVE less EVE under current interest rate term structure EVE risk measure = maximum of worst aggregated reductions to EVE across six prescribed scenarios 24

Outline Background Overview of new IRRBB standard Disclosure 25

Disclosure previous requirement (Basel II, Pillar 3) 26

Disclosure new IRRBB standard Disclosure requirements significantly strengthened: Must disclose EVE and NII per prescribed scenarios Own IMS, unless instructed otherwise by national supervisor (eg standardised framework) Prescribed format for qualitative and quantitative disclosures Sufficient qualitative info to enable market to: Monitor sensitivity of EV and earnings to interest rates Understand primary assumptions underlying IMS Gain insight into overall IRRBB objectives, management 27

Disclosure basis for improved comparability EVE Exclude own equity Include all cash flows from all interest-rate sensitive assets, liabilities and off-balance sheet items Discount using risk-free rate or risk-free rate including commercial margins and other spread components Assume run-off balance sheet (no new business) NII Include expected cash flows (including commercial margins) from all interest-rate sensitive assets, Assume constant balance sheet (maturing or repricing cash flows are replaced by identical cash flows) Disclose as difference in future interest income over rolling 12-month period 28

Disclosure qualitative Bank s definition of IRRBB for risk control and measurement Description of IRRBB management and mitigation strategies Periodicity of calculation of IRRBB measures Description of interest rate shock scenarios used for EV and earnings-based measures Where significant modelling assumptions for IMS are different from those for disclosure, description and rationale High-level hedging strategies High-level description of key modelling, parametric assumptions eg, methodology for estimating loan prepayment rates NMDs average and longest repricing maturities 29

Disclosure quantitative 30

BCBS Standard for Interest Rate Risk in the Banking Book Objectives, Approaches and Disclosure Meeting on IRRBB and the Revised Standardised Approach for Credit Risk Sao Paulo, Brazil 27-28 April 2016 Jeff Miller FSI Connect Relationship Manager Financial Stability Institute The views expressed in this presentation are those of the presenters and not necessarily those of the BIS/BCBS