RBI/2022-23/180
DOR.MRG.REC.102/00-00-009/2022-23

February 17, 2023

Madam / Sir,

Governance, measurement and management of Interest Rate Risk in Banking Book

Interest Rate Risk in Banking Book (IRRBB) refers to the current or prospective risk to banks’ capital and earnings arising from adverse movements in interest rates that affect its banking book positions. Excessive IRRBB can pose a significant risk to banks’ current capital base and/or future earnings. These guidelines, accordingly, require banks to measure, monitor, and disclose their exposure to IRRBB.

2. The final guidelines on Interest Rate Risk in Banking Book (IRRBB), in alignment with the revised framework issued by the Basel Committee on Banking Supervision (BCBS), are enclosed in Annex.

3. Commencement

(a) The date for implementation will be communicated in due course. Banks are advised to be in preparedness for measuring, monitoring, and disclosing their exposure to interest rate risk in the banking book in terms of this circular.

(b) Ahead of the implementation, banks shall submit the disclosures stipulated in Table B of Appendix-3 to the Department of Regulation, Reserve Bank of India (by e-mail: mrgdor@rbi.org.in) within two months from the end of the respective quarter, as per following schedule:

4. It may be noted that the extant instructions on interest rate risk management issued vide circular DBOD.No.BP.BC.8/21.04.098/99 dated February 10, 1999 on ‘Asset Liability Management (ALM) system’ which require banks to undertake Traditional Gap Analysis and circular DBOD.No.BP.BC.59/21.04.098/2010-11 dated November 04, 2010 on ‘Guidelines on Banks’ Asset Liability Management Framework - Interest Rate Risk’ which require banks to undertake Duration Gap Analysis, shall be phased out post implementation of these guidelines, the details of which shall be advised in due course.

Applicability

5. This circular is applicable to all commercial banks (other than Regional Rural Banks, Small Finance Banks, Payments Banks and Local Area Banks).

(Usha Janakiraman)
Chief General Manager

Annex

Governance, measurement and management
of Interest Rate Risk in Banking Book

1. Introduction

1.1 Interest Rate Risk in Banking Book (IRRBB) refers to the current or prospective risk to banks’ capital and earnings arising from adverse movements in interest rates that affect its banking book positions. When interest rates change, the present value and timing of future cash flows change. These changes in turn affect the underlying value of banks’ rate sensitive assets, liabilities, and off-balance sheet items and, hence, their economic value (EV). Changes in interest rates also affect banks’ earnings by altering interest rate-sensitive income and expenses, affecting their net interest income (NII). Excessive IRRBB can pose a significant risk to banks’ current capital base and/or future earnings if not managed appropriately. These guidelines, accordingly, require banks to measure, monitor, and disclose their exposure to IRRBB in terms of potential change in Economic Value of Equity (ΔEVE) and Net Interest Income (ΔNII), computed based on a set of prescribed interest rate shock scenarios.

1.2 IRRBB arises from banking activities and is encountered by all banks. It arises because interest rates can vary significantly over time, while the business of banking typically involves intermediation activity that produces exposures to both maturity mismatch (eg. long-maturity assets funded by short-maturity liabilities) and rate mismatch (eg. variable rate loans funded by fixed rate deposits). In addition, there are optionalities embedded in many of the common banking products (eg. non-maturity deposits, term deposits, fixed rate loans) that are triggered in accordance with changes in interest rates. Banks must be familiar with all elements of IRRBB, actively identify their IRRBB exposures and take appropriate steps to identify, measure, monitor and control it.

2. Definitions

(a) In this Circular, unless the context states otherwise, the terms herein shall bear the meanings assigned to them below:

i. Amenable to standardisation – Positions with certain cash flow till maturity / repricing date.

ii. Banking Book - All items which are not included under trading book as defined in paragraph 8.2.1 of the circular DOR.CAP.REC.3/21.06.201/2022-23 dated April 1, 2022 on Basel III Capital Regulations, as amended from time to time, shall be considered as part of banking book.

iii. Basis risk - Describes the relative impact of changes in interest rates for financial instruments that have similar tenors but are priced using different interest rate indices.

iv. Commercial Margins or credit margin - A specific add-on to internal benchmark rate.

v. Constant balance sheet - Total balance sheet size maintained by assuming like-for-like replacement of assets and liabilities as they run off.

vi. Embedded loss – Loss embedded in the instruments that are not marked to market, which 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.

vii. Gap risk- Risk arising from the term structure of instruments in banking book that arises from differences in the timing of their rate changes. The extent of gap risk depends on whether the changes to the term structure of interest rates occur consistently across the yield curve (parallel risk) or differentially by period (non-parallel risk).

viii. Less amenable to standardisation - Positions with optionality that makes the timing of notional repricing of cash flows uncertain by introducing a non-linearity, which suggests that delta-equivalent approximations are imprecise for large interest rate shock scenarios.

ix. Non-maturity deposits (NMD) - Deposits which can be withdrawn, with or without penalty, at the discretion of the depositor.

x. Not amenable to standardization – Positions not amenable to standardisation include: Non-maturity deposits (NMDs), fixed rate loans subject to prepayment risk and term deposits subject to early redemption risk.

xi. Notional Repricing Cash Flow (CF)

1. any repayment of principal (e.g., at contractual maturity);

2. any repricing of principal; repricing is said to occur at the earliest date at which either the bank or its counterparty is entitled to unilaterally change the interest rate, or at which the rate on a floating rate instrument changes automatically in response to a change in an external benchmark; or

3. any interest payment on a tranche of principal that has not yet been repaid or repriced; spread components of interest payments on a tranche of principal that has not yet been repaid and which do not reprice must be slotted at their contractual maturity irrespective of whether the non-amortised principal has been repriced or not.

xii. Option risk – Risk arising from options (embedded or explicit) in a bank’s assets, liabilities and/or off-balance sheet items where the bank or its customer can alter the level and timing of their cash flows. Option risk can be further characterized into automatic option risk and behavioural option risk.

1. Embedded or explicit automatic option risk - Risk arising from standalone instruments, such as exchange-traded and over-the-counter option contracts, or explicitly embedded within the contractual terms of an otherwise standard financial instrument (e.g., floating rate mortgage loan with embedded caps and / or floors) and where the holder will almost certainly exercise the option if it is in their financial interest to do so.

2. Embedded behavioural option risk – Risk arising from flexibility embedded implicitly or within the terms of financial contracts, such that changes in interest rates may effect a change in the behaviour of the client (e.g., Rights of a borrower to prepay a loan, with or without penalty, or the right of a depositor to withdraw their balance in search of higher yield).

xiii. Repricing Date: The date of each repayment, repricing or interest payment.

xiv. Risk- appetite statement - Written articulation of the aggregated level and types of IRRBB exposures that a bank will accept, or avoid, in order to achieve its business objectives.

xv. Risk-free rate – The theoretical rate of interest an investor would expect from a risk-free investment for a given maturity.

xvi. Run-off balance sheet - Existing assets and liabilities are not replaced as they mature, except to the extent necessary to fund the remaining balance sheet.

(b) All other expressions unless defined herein shall have the same meaning as have been assigned to them under the Banking Regulation Act, 1949 or the Reserve Bank of India Act, 1934 and rules/regulations made thereunder, or any statutory modification or re-enactment thereto or as used in commercial parlance, as the case may be.

3. Governance and Control

3.1 The Board of the banks has the responsibility for understanding the nature and the level of the bank’s IRRBB exposure. The Board shall approve broad business strategies as well as overall policies with respect to IRRBB. Accordingly, the Board is responsible for ensuring that steps are taken by the bank to identify, measure, monitor and control IRRBB consistent with the approved strategies and policies. Monitoring and management of IRRBB can be delegated by the Board to ALCO, which should regularly monitor the nature and the level of the bank’s IRRBB exposure. The management of banks’ IRRBB should be integrated within its broader risk management framework and aligned with its business planning and budgeting activities. More specifically, the Board/ALCO is responsible for setting:

1. appropriate limits on IRRBB, including the definition of specific procedures and approvals necessary for exceptions, and ensuring compliance with those limits;

2. adequate systems and standards for measuring IRRBB;

3. valuing positions and assessing performance, including procedures for updating interest rate shock and stress scenarios and key underlying assumptions driving the institution’s IRRBB analysis;

4. a comprehensive IRRBB reporting and review process; and

5. effective internal controls and management information systems (MIS).

3.2 Banks should have a clearly defined Board approved risk appetite statement which lays down policies and procedures for limiting and controlling IRRBB. The risk appetite statement should be articulated in terms of the risk to both economic value and earnings. It should lay down Board approved aggregate IRRBB limit given the bank’s business strategies at the consolidated bank level as also at the level of individual entities as appropriate. These limits shall be associated with specific scenarios of changes in interest rates and/or term structures, such as an increase or decrease of a particular size or a change in shape. The interest rate movements used in developing these limits should represent meaningful shock and stress situations, taking into account historical interest rate volatility and the time required by management to mitigate those risk exposures. Depending on the nature of a bank's activities and business model, sub-limits may also be identified for individual business units, portfolios, instrument types or specific instruments. The risk appetite framework should delineate delegated powers, lines of responsibility and accountability over IRRBB management decisions and should clearly define authorised instruments, hedging strategies and risk-taking opportunities.

3.3 Banks must identify the IRRBB inherent in products and activities and ensure that these are subject to adequate procedures and controls. Significant hedging or risk management initiatives must be approved before being implemented. Products and activities that are new to a bank must undergo a careful pre-acquisition review to ensure that the IRRBB characteristics are well understood and subject to a predetermined test phase before being fully rolled out. Prior to introducing a new product, hedging or risk-taking strategy, adequate operational procedures and risk control systems must be in place. Procedures should be clearly laid out to approve major hedging or risk-taking initiatives prior to implementation. A dedicated set of risk limits should be developed to monitor the evolution of hedging strategies that rely on instruments such as derivatives, and to control mark-to-market risks in instruments that are accounted for at market value. The proposals to use new instrument types or new strategies (including hedging) should be assessed to ensure that (a) the resources required to establish sound and effective IRRBB management of the product or activity have been identified, (b) the proposed activities are in line with banks’ overall risk appetite, and (c) the procedures to identify, measure, monitor and control the risks of the proposed product or activity have been established.

3.4 Systems should be in place to ensure that positions which exceed or are likely to exceed limits defined by the Board should receive prompt management attention and be escalated without delay. There should be a clear policy on who will be informed, how the communication will take place and the actions which will be taken in response to such exceptions.

3.5 Banks should have adequate internal controls to ensure the integrity of their IRRBB management process. In addition, banks should have in place regular evaluations and reviews of their internal control system and risk management processes. Banks should have their IRRBB identification, measurement, monitoring and control processes reviewed by an independent auditing function (such as an internal or external auditor) on a regular basis. In such cases, reports written by internal/external auditors or other equivalent external parties should be made available to the concerned SSM team of RBI. All IRRBB policies should be reviewed periodically (at least annually) and revised as needed.

4. IRRBB Measurement

4.1 Banks’ systems for IRRBB should be able to compute the impact on the economic value and earnings in various scenarios, based on:

1. internally selected interest rate shock scenarios addressing the bank’s risk profile, according to its Internal Capital Adequacy Assessment Process (ICAAP);

2. historical and hypothetical interest rate stress scenarios, which tend to be more severe than shock scenarios;

3. the six prescribed interest rate shock scenarios as given in Appendix 1; and

4. any additional interest rate shock scenarios required by the Reserve Bank of India.

4.2 An indicative standardised methodology for computing IRRBB from the perspective of change in EVE is given in Appendix 2.

Assumptions required for computation of IRRBB

4.3 Both economic value and earnings-based measures of IRRBB are significantly impacted by the assumptions made for the purposes of risk quantification, namely

1. expectations for the exercise of interest rate options by both the bank and its customers under specific interest rate shock and stress scenarios;

2. treatment of balances and interest flows arising from non-maturity deposits (NMDs);

3. treatment of own equity in economic value measures; and

4. implication of accounting practices for IRRBB.

4.4 Hence, when assessing its IRRBB exposures, banks should inter-alia make judgments and assumptions about how an instrument’s actual maturity or repricing behaviour may vary from the instrument’s contractual terms because of behavioural optionalities. Accordingly, all modelling assumptions should be conceptually sound and reasonable, and consistent with historical experience. Banks must carefully consider how the exercise of the behavioral optionality will vary not only under the interest rate shock and stress scenario but also across other dimensions. For instance, considerations may include:

4.5 In addition, banks with positions denominated in different currencies can expose themselves to IRRBB in each of those currencies. Since yield curves vary from currency to currency, banks should assess exposures in each currency. Further, banks should consider the materiality of the impact of behavioural optionalities within floating rate loans. For instance, the behaviour of prepayments arising from embedded caps and floors could impact banks’ EVE.

4.6 Banks should be able to test the appropriateness of key behavioural assumptions and should also document all changes to the assumptions of key parameters (e.g. by comparing the EVE measured under their internal systems with the indicative standardized framework given in Appendix 2). Banks should periodically perform sensitivity analyses for key assumptions to monitor their impact on measured IRRBB. Sensitivity analyses should be performed with reference to both economic value and earnings-based measures.

4.7 The most significant assumptions underlying the system should be documented and clearly understood by the Board or its Committee. Documentation should also include description on how those assumptions could potentially affect bank’s hedging strategies.

4.8 As market conditions, competitive environments and strategies change over time, banks should review significant measurement assumptions at least annually and more frequently during rapidly changing market conditions. For example, if the competitive market has changed such that consumers now have lower transaction costs available to them for refinancing their residential mortgages, prepayments may become more sensitive to smaller reductions in interest rates.

5. Stress testing framework

5.1 Banks should also develop and implement an effective stress testing framework for IRRBB as part of their broader risk management and governance processes, which should be commensurate with their nature, size and complexity as well as business activities and overall risk profile. It should include clearly defined objectives, scenarios tailored to the bank’s businesses and risks, well documented assumptions and sound methodologies. This framework should be used to assess the potential impact of the scenarios on the bank’s financial condition, enable ongoing and effective review of stress tests and recommend actions based on the stress test results.

5.2 The stress testing framework should feed into the decision-making process at the appropriate management level, including strategic decisions (e.g. business and capital planning decisions) of the Board or its Committee. In particular, IRRBB stress testing should be considered in the ICAAP, requiring banks to undertake rigorous, forward-looking stress testing that identifies events of severe changes in market conditions which could adversely impact the bank’s capital or earnings, possibly also through changes in the behavior of its customer base. IRRBB stress tests should play an important role in the communication of risks, both within the bank and externally.

5.3 The identification of relevant shock and stress scenarios for IRRBB, the application of sound modelling approaches and the appropriate use of the stress testing results require the collaboration of different experts within a bank (e.g., traders, the treasury department, the finance department, the ALCO, the risk management and risk control departments and/or the bank’s economists). A stress-testing programme for IRRBB should ensure that the opinions of the experts are taken into account.

5.4 The banks should determine a range of potential interest rate movement scenarios currency-wise, against which they will measure their IRRBB exposures. When developing interest rate shock and stress scenarios, bank should consider the following:

1. Scenarios should be sufficiently wide-ranging to identify parallel and non-parallel gap risk, basis risk, and option risk. Scenarios should be both severe and plausible, in light of the existing level of interest rates and the interest rate cycle;

2. Special consideration should be given to instruments or markets where concentration exists;

3. Possible interaction of IRRBB with related risks as well as other risks (eg. credit risk, liquidity risk);

4. Banks should assess the effect of adverse changes in the spreads of new assets or liabilities replacing those positions maturing over the horizon of the forecast on their NII;

5. Banks with significant option risk should include scenarios that capture the exercise of such options. For example, banks that have products with sold caps or floors should include scenarios that assess how the risk positions would change should those caps or floors move into the money. Banks should also develop interest rate assumptions to measure their IRRBB exposures given changes in interest rate volatilities;

6. Banks should specify the term structure of interest rates that will be incorporated (including shape, level), historical and implied volatility of interest rates, and the basis relationship between yield curves when building interest rate shock and stress scenarios;

7. Banks should estimate how interest rates that are administered or managed by the management (e.g. prime rates or retail deposit rates, as opposed to those that are purely market driven) might change;

8. Banks should also measure the time they would need to take action to reduce or unwind unfavorable IRRBB exposures, and their capability / willingness to withstand accounting losses in order to reposition their risk profile; and

9. Forward-looking scenarios should incorporate changes in portfolio composition due to factors under the control of the bank (e.g. the bank’s acquisition and production plans) as well as external factors (e.g. changing competitive, legal or tax environments); new products where only limited historical data is available; new market information and new emerging risks that are not necessarily covered by historical stress episodes.

5.5 Further, banks should perform qualitative and quantitative reverse stress tests in order to identify interest rate scenarios that could severely threaten bank’s capital and earnings; and reveal vulnerabilities arising from its hedging strategies and the potential behavioural reactions of its customers.

6. Data integrity and model validation

6.1 Banks’ risk measurement system should be able to identify and quantify major sources of IRRBB exposure. The mix of banks’ business lines and the risk characteristics of its activities should guide management’s selection of the most appropriate form of measurement system.

6.2 The banks should not rely on a single measure of risk. They should use a variety of methodologies to quantify their IRRBB exposures under both the economic value¹ and earnings-based measures², ranging from simple calculations based on static simulations using current holdings to more sophisticated dynamic modelling techniques that reflect potential future business activities.

6.3 Management Information System (MIS) in banks should be able to retrieve accurate IRRBB information in a timely manner and should capture interest rate risk data on all of the bank’s material IRRBB exposures. There should be sufficient documentation of the major data sources used in the risk measurement process. Data inputs should be automated as much as possible to reduce administrative errors. Data mapping should be reviewed periodically and tested against an approved model. Banks should monitor the type of data extracts and set appropriate controls.

6.4 The validation of IRRBB measurement methods and assessment of corresponding model/measurement risk should be included in a formal policy process and reviewed/approved by the Board / its Committee. The policy should specify the management roles and designate who is responsible for the development, implementation and use of models. In addition, the model oversight responsibilities as well as policies including the development of initial and ongoing validation procedures, evaluation of results, approval, version control, exception, escalation, modification and decommission processes need to be specified and integrated within the governance processes for model risk management. An effective validation framework should include three core elements:

1. evaluation of conceptual/methodological soundness, including developmental evidence;

2. ongoing model monitoring, including process verification and benchmarking; and

3. outcomes analysis, including back-testing of key internal parameters (e.g. stability of deposits, prepayments, early redemptions, pricing of instruments).

6.5 In addressing the expected initial and ongoing validation activities, the policy should establish a hierarchical process for determining model risk soundness based on both quantitative and qualitative dimensions such as size, impact, past performance and familiarity with the modelling technique employed. The ongoing validation process should establish a set of exception trigger events that obligate the model reviewers to notify the Board or its Committee in a timely fashion, in order to determine corrective actions and/or restrictions on model usage. Clear version control authorizations should be designated, where appropriate, to model owners. With the passage of time and due to observations and new information gained over time, an approved model shall be modified or decommissioned. Banks should articulate policies for model transition, including change and version control authorizations and documentation.

6.6 Prior to receiving authorization for usage, the process for determining model inputs, assumptions, modelling methodologies and outputs should be reviewed and validated independently of the development of IRRBB models. The review and validation results and any recommendations on model usage should be presented to and approved by the Board or its Committee or ALCO. Upon approval, the model should be subject to ongoing review, process verification and validation at a frequency that is consistent with the level of model risk determined and approved by the Board.

6.7 Banks relying on third party vendors for IRRBB measurement models, or sourcing model inputs or assumptions from related modelling processes or sub-models (both in-house and vendor sourced), should include them in the validation process. Banks should document and explain model specification choices as part of the validation process. Banks that purchase IRRBB models should ensure there is adequate documentation of their use of those models, including any specific customization. If vendors provide input for market data, behavioral assumptions or model settings, banks should have a process in place to determine if those inputs are reasonable for its business and the risk characteristics of its activities.

6.8 Internal audit should review the model risk management process as part of its annual risk assessment and audit plans. The audit activity should review the integrity and effectiveness of the risk management system and the model risk management process. RBI will look into the systems and procedures of computation of IRRBB of banks. If persistent deficiencies are observed, RBI shall require banks to compute IRRBB based on ΔEVE as given in the Appendix 2 till such time all deficiencies are removed.

7. Capital assessment for IRRBB under Pillar 2

7.1 Banks are responsible for evaluating the level of capital that they should hold, and for ensuring that it is sufficient to cover IRRBB and its related risks. The contribution of IRRBB to the overall internal capital assessment should be based on the banks’ MIS outputs, taking account of key assumptions and risk limits. The overall level of capital should be commensurate with both the banks’ actual measured level of risk (including for IRRBB) and its risk appetite and be duly documented in its ICAAP report under Pillar 2.

7.2 Banks should develop their own methodologies for capital allocation, based on their risk appetite. In determining the appropriate level of capital, banks should consider both the amount and the quality of capital needed.

7.3 The capital adequacy for IRRBB should be considered in relation to the risks to economic value, given that such risks are embedded in banks’ assets, liabilities and off-balance sheet items. For risks to future earnings, given the possibility that future earnings shall be lower than expected, banks should consider capital buffers.

Capital adequacy assessments for IRRBB should factor in:

1. the size and tenor of internal limits on IRRBB exposures, and whether these limits are reached at the point of capital calculation;

2. the effectiveness and expected cost of hedging open positions that are intended to take advantage of internal expectations of the future level of interest rates;

3. the sensitivity of the internal measures of IRRBB to key modelling assumptions;

4. the impact of shock and stress scenarios on positions priced off different interest rate indices (basis risk);

5. the impact on economic value and NII of mismatched positions in different currencies;

6. the impact of embedded losses;

7. the distribution of capital relative to risks across legal entities that form part of a capital consolidated group, in addition to the adequacy of overall capital on a consolidated basis;

8. the drivers of the underlying risk; and

9. the circumstances under which the risk might crystallise.

The outcomes of the capital adequacy for IRRBB should be considered in bank’s ICAAP and flow through to assessments of capital associated with business lines.

7.4 RBI shall assess the adequacy of capital relative to its IRRBB exposures to determine whether the bank requires more detailed examination and should potentially be subject to additional capital requirements and/or other mitigation actions. This assessment need not be linked to the outlier test set out below.

Outlier Test

7.5 Banks which generate a decline in EVE (i.e. ∆EVE) of more than 15 per cent of its Tier 1 capital under any one of the six prescribed interest rate shock scenarios mentioned in Appendix-1, shall be identified as ‘outliers’ potentially having undue IRRBB exposure. These banks shall be required by the RBI to take one or more of the following actions as determined during the Supervisory Review and Evaluation Process (SREP):

(a) raise additional capital; (b) reduce its IRRBB exposures (e.g., by hedging); (c) set constraints on the internal risk parameters used by a bank; and/or (d) improve its risk management framework.

8. Reporting and Disclosures

8.1 Reports detailing banks’ IRRBB exposures should be provided to the Board or its appropriate committees, on a timely basis and reviewed regularly. The IRRBB reports should provide aggregate information as well as sufficient reporting detail to enable the Board or its committee to assess the sensitivity of the bank to changes in market conditions. The IRRBB management policies and procedures should be reviewed by the Board or its Committees in light of the reports, to ensure that they remain appropriate and sound. It should be ensured that analysis and risk management activities related to IRRBB are conducted by competent staff with technical knowledge and experience, consistent with the nature and scope of the bank’s activities. Portfolios that may be subject to significant mark-to-market movements should be clearly identified within banks’ MIS and subject to oversight in line with any other portfolios exposed to market risk.

8.2 While the types of reports prepared for the Board or its Committee will vary based on the bank’s portfolio composition, the board should be informed at least semi-annually on the following:

1. summaries of the bank’s aggregate IRRBB exposures, and explanatory text that highlights the assets, liabilities, cash flows, and strategies that are driving the level and direction of IRRBB;

2. reports demonstrating the bank’s compliance with policies and limits;

3. key modelling assumptions such as NMD characteristics, prepayments on fixed rate loans and currency aggregation;

4. results of stress tests, including assessment of sensitivity to key assumptions and parameters;

5. summaries of the reviews of IRRBB policies, procedures and adequacy of the measurement systems, including any findings of internal and external auditors and/or other equivalent external parties (such as consultants); and

6. results of the periodic model reviews and audits as well as comparisons of past forecasts or risk estimates with actual results to inform potential modelling shortcomings.

8.3 Banks shall disclose the measured ∆EVE and ∆NII under the prescribed interest rate shock scenarios set out in Appendix 1. Disclosures shall be in the formats given in Appendix 3.

8.4 Banks shall be guided by the following while computing the impacts on ∆EVE and ∆NII for the purpose of disclosures:

a) For the disclosure of ∆EVE

1. Banks should exclude their own equity from the computation of the exposure level.

2. Banks should include all cash flows from all interest rate-sensitive assets³, liabilities and off-balance sheet items in the banking book in the computation of their exposure. Banks should disclose whether they have excluded or included commercial margins and other spread components in their cash flows.

3. Cash flows should be discounted using either a risk-free rate⁴ or a risk-free rate including commercial margins and other spread components (only if the bank has included commercial margins and other spread components in its cash flows). Banks should disclose whether they have discounted their cash flows using a risk-free rate or a risk-free rate including commercial margins and other spread components.

4. ∆EVE should be computed with the assumption of a run-off balance sheet, where existing banking book positions amortise and are not replaced by any new business.

b) For the disclosure of ∆NII

1. Banks should include expected cash flows (including commercial margins and other spread components) arising from all interest rate-sensitive assets, liabilities and off-balance sheet items in the banking book.

2. ∆NII should be computed assuming a constant balance sheet, where maturing or repricing cash flows are replaced by new cash flows with identical features as regards the amount, repricing period and spread components.

3. ∆NII should be disclosed as the difference in future interest income over a rolling 12-month period.

¹ Change in economic value can be measured using a variety of techniques, the most common of which are: (1) PV01: present value of a single basis point change in interest rates based on gap analysis; (2) EVE: economic value of equity; and (3) EVaR: economic value at risk. However, for reporting and disclosure purpose, banks are advised to use EVE as prescribed in Paragraph 8 of this document.

² Earnings-based measures look at the expected change in NII over a shorter time horizon (typically one to three years) resulting from interest rate movements. Earnings measures can be differentiated according to the complexity of their forward calculations of income, from simple run-off models which assume that existing assets and liabilities mature without replacement, to constant balance sheet models which assume that assets and liabilities are replaced like for like, to the most complex dynamic models which reflect the changes in the volumes and types of business that will be undertaken in differing interest rate environments. However, for reporting and disclosure purpose, banks are advised to use constant balance sheet models as prescribed in Paragraph 8 of this document.

³ Interest rate-sensitive assets are assets which are not deducted from Common Equity Tier 1 capital and which exclude (i) fixed assets such as real estate or intangible assets as well as (ii) equity exposures in the banking book

⁴ The discounting factors must be representative of a risk-free zero-coupon rate. An example of an acceptable yield curve is Zero Coupon Yield Curve published by the benchmark administrator.