Draft Guidelines on governance, measurement and management of Interest Rate Risk in Banking Book - आरबीआय - Reserve Bank of India
Draft Guidelines on governance, measurement and management of Interest Rate Risk in Banking Book
RBI/2016-17/ February 2, 2017 The Managing Director/ Madam / Dear Sir, Draft Guidelines on governance, measurement and management of Interest Rate Risk in Banking Book Please refer to the paragraph 5 of the Statement on Developmental and Regulatory Policies, by RBI, dated October 4, 2016. It was indicated therein that RBI would issue draft guidelines on Interest Rate Risk in Banking Book (IRRBB). 2. The draft guidelines on IRRBB are annexed. You are requested to provide your feedback/comments on the provisions of the draft guidelines by March 3, 2017. Yours faithfully, (S. S. Barik) Encl: as above Draft Guidelines on Interest Rate Risk in Banking Book Interest Rate Risk 1. The Interest Rate Risk (IRR) is the risk where changes in market interest rates affect a bank’s financial position. The changes in interest rates impact a bank’s earnings (i.e. reported profits) through changes in its Net Interest Income (NII) and also impact Market Value of Equity (MVE) or Net Worth through changes in the economic value of its rate sensitive assets, liabilities and off-balance sheet positions. The interest rate risks, when viewed from these two perspectives, are known as ‘earnings perspective’ and ‘economic value perspective’, respectively. Generally, the former is measured using the Traditional Gap Analysis (TGA) and the latter is measured by using more sophisticated methods like Duration Gap Analysis (DGA). The present RBI guidelines on IRR require banks to carry out both the analyses. The focus of the TGA is to measure the level of a bank’s exposure to interest rate risk in terms of sensitivity of its NII to interest rate movements over a period of one year. It involves bucketing of all rate sensitive assets (RSA) and rate sensitive liabilities (RSL) and off balance sheet items as per residual maturity/ re-pricing date in various time bands, (circular DBOD.BP.BC.8/21.04.098/99 dated February 10, 1999) and computing Earnings at Risk (EaR) i.e. loss of income under different interest rate scenarios over a time horizon of one year. The focus of the DGA is to measure the level of a bank’s exposure to interest rate risk in terms of sensitivity of MVE to interest rate movements. The DGA involves bucketing of all RSA and RSL as per residual maturity/ re-pricing dates in various time bands and computing the Modified Duration Gap (MDG). The RSA and RSL include the rate sensitive off balance sheet asset and liabilities. MDG can be used to evaluate the impact on the MVE of the bank under different interest rate scenarios. 2. The RBI guidelines on Asset liability Management (ALM) system dated February 10, 1999 require banks to perform Traditional Gap Analysis (TGA). The gap analysis measures mismatches between rate sensitive assets and rate sensitive liabilities by grouping them into various time buckets. Banks are required to set prudential limits on individual gaps with the approval of their Board/Management Committee. Banks are also required to perform DGA vide circular dated November 4, 2010. 3. Banks are required to set appropriate internal limits on Earnings at Risk (EaR) and on the volatility in the Market Value of Equity with the approval of its Board / Risk Management Committee of the Board. These limits may be linked to MVE for DGA and the NII (for TGA). Further, the Board / Asset Liability Management Committee (ALCO) must also periodically review the above limits after assessing various scenarios of interest rates and the resultant volatility of earnings in terms of Net Interest Income and volatility in net worth. 4. The extant guidelines provide detailed guidance to banks to bucket various positions in different time bands depending on their interest rate risk sensitivity. For certain types of deposits, like current deposits or savings bank deposits which are essentially Non Maturity Deposits (NMDs), banks are required to estimate behavioural patterns and place them into appropriate buckets. Banks, which are not able to estimate these behavioural patterns, are required to follow the standardised approach. Interest Rate Risk in Banking Book 5. Interest Rate Risk in Banking Book (IRRBB) refers to the current or prospective risk to a bank’s capital and earnings arising from adverse movements in interest rates that affect banking book positions. When interest rates change, the present value and timing of future cash flows change. This in turn changes the underlying value of a bank’s assets, liabilities and off-balance sheet items and hence its economic value. Changes in interest rates also affect a bank’s earnings by altering interest rate-sensitive income and expenses, affecting its net interest income (NII). Excessive IRRBB can pose a significant threat to a bank’s current capital base and/or future earnings if not managed appropriately. Capital requirements for Interest Rate Risk 6. Banks are required to compute capital requirements for interest rate risk in trading book positions, and the resultant risk weighted assets are added to banks’ total risk weighted assets. As a part of Pillar 2 of Basel III Capital regulations, banks are required to identify the risks associated with the changing interest rates on its on-balance sheet and off-balance sheet exposures in the banking book from both, short-term and long-term perspective. It is also mentioned that banks can decide, with the approval of the Board, on the appropriate level of interest rate risk in the banking book, which they would like to carry keeping in view their capital level, interest rate management skills and the ability to re-balance the banking book portfolios quickly in case of adverse movement in the interest rates. 7. A level of interest rate risk, which generates a drop in the MVE of more than 20 per cent with an interest rate shock of 200 basis points, is treated as excessive, and such banks may be required by the RBI to hold additional capital against IRRBB as determined during the Supervisory Review and Evaluation Process (SREP). Banks, which have IRRBB exposure equivalent to less than 20 per cent drop in the MVE may be required to hold additional capital if the level of interest rate risk is considered, by the RBI, to be high in relation to their capital level or the quality of interest rate risk management framework obtaining in the bank. While banks may on their own decide to hold additional capital towards IRRBB keeping in view the potential drop in their MVE, the IRR management skills and the ability to re-balance the portfolios quickly in case of adverse movement in the interest rates, the amount of exact capital add-on, if considered necessary, may have to be decided by the RBI as part of the SREP, in consultation with the bank concerned. Need for specific requirements on IRRBB 8. Basel Committee on Banking Supervision (BCBS) in April 2016, finalised its standards on Interest Rate Risk in Banking Book (IRRBB), with a target of implementation by 2018. This standard, inter alia, requires banks to disclose the impact of interest rate shocks on their change in economic value of equity (ΔEVE) and net interest income (ΔNII), computed based on a set of prescribed interest rate shock scenarios. As mentioned earlier, the present guidelines require banks in India to compute ΔEVE and ΔNII for the entire balance sheet and not just for the banking book positions and report to RBI. However, in order to promote global consistency, transparency and comparability of IRRBB with that of global banks, it is considered appropriate to require banks to compute IRRBB separately and disclose it based on BCBS prescribed standards. While there is an explicit capital requirement for IRR for positions in the trading book under pillar 1, there is no capital requirement for Interest Rate Risk in Banking Book (IRRBB) under Pillar 1. IRRBB is covered under Pillar 2. As IRRBB is a material source of risk to the banks in the long run, it is considered desirable to enhance the requirements applicable to IRRBB. 9. IRRBB is an important risk that 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 fixed rate loans funded by variable 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. 10. It has been considered appropriate to enhance guidelines on IRRBB. The enhanced guidelines on IRRBB governance and measurement are provided below. Banks are required to implement these guidelines from April 1, 2019. Banks would continue to follow existing guidelines on IRR which is applicable to entire balance sheet. Enhanced Guidelines on IRRBB: Governance 11. Banks should have clearly defined risk appetite statement for IRRBB approved by their Board which lays down policies and procedures for limiting and controlling IRRBB. The risk appetite statement should lay down aggregate risk limit which is the amount of IRRBB acceptable to the Board for the consolidated bank level. Risk limits may also be prescribed at the level of individual entities as well. The limits may 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. 12. The Board should regularly monitor the nature and the level of the bank’s IRRBB exposure. The Board should approve broad business strategies as well as overall policies with respect to IRRBB. It should ensure that there is clear guidance regarding the acceptable level of IRRBB, given the bank’s business strategies. 13. Banks should have clearly defined procedures to approve major hedging or risk-taking initiatives in advance of 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 the resources required to establish sound and effective IRRBB management of the product or activity have been identified, that the proposed activities are in line with banks’ overall risk appetite, and procedures to identify, measure, monitor and control the risks of the proposed product or activity have been established. 14. There should be systems in place to ensure that positions that 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. 15. Banks must identify the IRRBB inherent in all products and activities, and ensure that IRR is subjected to well-laid out effective risk management procedures which are consistent with these guidelines. Significant hedging or risk management initiatives must be approved before being implemented. New products and activities must be analysed from the perspective of IRR before their roll out. Prior to introducing a new product, hedging or risk-taking strategy, adequate operational procedures and risk control systems must be in place. The management of banks’ IRRBB should be integrated within its broader risk management framework and aligned with its business planning and budgeting activities. Measurement 16. The extant guidelines issued by RBI are applicable to the computation of IRR for the entire bank and banks should continue to follow these guidelines. Additionally for the purpose of computing, reporting, and disclosing risks separately for IRRBB from both earnings as well as economic value perspective, banks should follow the guidelines as given in the following paragraphs: Development of interest rate shocks and other scenarios: 17. Banks should be able to compute the IRRBB as impact on economic value and earnings, based on:
18. An indicative standardised methodology for computing IRRBB from the perspective of change in EVE is given in Appendix 2. General requirements on stress scenarios 19. Banks should measure their vulnerability to loss under stressful market conditions – including the breakdown of key assumptions – and consider those results when establishing and reviewing their policies and limits for IRRBB. Banks should also develop and implement an effective stress testing framework for IRRBB as part of their broader risk management and governance processes. These should feed into the decision-making process at the appropriate management level, including strategic decisions (eg 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 behaviour of its customer base. 20. The stress testing framework for IRRBB should be commensurate with its nature, size and complexity as well as business activities and overall risk profile. The framework should include clearly defined objectives, scenarios tailored to the bank’s businesses and risks, well documented assumptions and sound methodologies. The framework will be used to assess the potential impact of the scenarios on the bank’s financial condition, enable ongoing and effective review processes for stress tests and recommend actions based on the stress test results. IRRBB stress tests should play an important role in the communication of risks, both within the bank and externally. 21. 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. 22. The banks should determine, currency-wise, a range of potential interest rate movements against which they will measure their IRRBB exposures. Management should ensure that risk is measured under a reasonable range of potential interest rate scenarios, including some containing severe stress elements. In developing the scenarios, banks should consider a variety of factors, such as the shape and level of the current term structure of interest rates and the historical and implied volatility of interest rates. In low interest rate environments, banks should also consider negative interest rate scenarios and the possibility of asymmetrical effects of negative interest rates on their assets and liabilities. 23. Banks should select scenarios that provide meaningful estimates of risk and include a range of shocks that is sufficiently wide to allow the Board to understand the risk inherent in the banks’ products and activities. When developing interest rate shock and stress scenarios for IRRBB, banks should consider the nature and sources of its IRRBB exposures, the time it would need to take action to reduce or unwind unfavourable IRRBB exposures, and its capability/willingness to withstand accounting losses in order to reposition its risk profile. 24. The scenarios should be sufficiently wide-ranging to identify parallel and non-parallel gap risk, basis risk and option risk. In many cases, static interest rate shocks may be insufficient to assess IRRBB exposure adequately. Banks should ensure that the scenarios are both severe and plausible, in light of the existing level of interest rates and the interest rate cycle. Special consideration should be given to instruments or markets where concentrations exist, because those positions may be more difficult to liquidate or offset in a stressful market environment. Banks should assess the possible interaction of IRRBB with its related risks, as well as other risks (eg credit risk, liquidity risk). Banks should assess the effect of adverse changes in the spreads of new assets/liabilities replacing those assets/liabilities maturing over the horizon of the forecast on their NII. 25. Banks having positions 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. Given that the market value of options also fluctuates with changes in the volatility of interest rates, banks should develop interest rate assumptions to measure their IRRBB exposures to changes in interest rate volatilities. 26. Banks should specify, in building their interest rate shock and stress scenarios, the term structure of interest rates that will be incorporated and the basis relationship between yield curves, rate indices etc. Banks should also estimate how interest rates that are administered or managed by the management (eg prime rates or retail deposit rates, as opposed to those that are purely market driven) might change. Management should document how these assumptions are derived. In addition, forward-looking scenarios should incorporate changes in portfolio composition due to factors under the control of the bank (eg the bank’s acquisition and production plans) as well as external factors (eg changing competitive, legal or tax environments); new products where only limited historical data are available; new market information and new emerging risks that are not necessarily covered by historical stress episodes. 27. Further, banks should perform qualitative and quantitative reverse stress tests in order to identify interest rate scenarios that could severely threaten banks’ capital and earnings; and reveal vulnerabilities arising from its hedging strategies and the potential behavioural reactions of its customers. Assumptions required for computation of IRRBB 28. Both economic value and earnings-based measures of IRRBB are significantly impacted by a number of assumptions made for the purposes of risk quantification, namely:
29. When assessing its IRRBB exposures, banks should 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. In this context, all modelling assumptions should be conceptually sound and reasonable, and consistent with historical experience. Banks must carefully consider how the exercise of the behavioural optionality will vary not only under the interest rate shock and stress scenario but also across other dimensions. For instance, considerations may include:
30. 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 generally need to 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’ economic value of equity. 31. Banks should be able to test the appropriateness of key behavioural assumptions, and all changes to the assumptions of key parameters should be documented (eg by comparing the economic value of equity measured under their internal systems with the framework and caps prescribed 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. 32. The most significant assumptions underlying the system should be documented and clearly understood by the Board or its committee. Documentation should also include descriptions on how those assumptions could potentially affect bank’s hedging strategies. 33. 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. Data and Measurement Systems for computing IRRBB Measurement systems and data integrity 34. Accurate and timely measurement of IRRBB is necessary for effective risk management and control. Banks’ risk measurement system should be able to identify and quantify the major sources of IRRBB exposure. The mix of a bank’s business lines and the risk characteristics of its activities should guide management’s selection of the most appropriate form of measurement system. 35. The banks should not rely on a single measure of risk, given that risk management systems tend to vary in how they capture the components of IRRBB. Instead, banks should use a variety of methodologies to quantify their IRRBB exposures under both the economic value and earnings-based measures, ranging from simple calculations based on static simulations using current holdings to more sophisticated dynamic modelling techniques that reflect potential future business activities. 36. Management Information System (MIS) in banks should be able to retrieve accurate IRRBB information in a timely manner. The MIS should also capture interest rate risk data on all of the banks’ 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 periodically reviewed and tested against an approved model version. Banks should monitor the type of data extracts and set appropriate controls. 37. Wherever cash flows are slotted into different time buckets (eg for gap analyses) or assigned to different vertex points to reflect the different tenors of the interest rate curve, the slotting criteria should be stable over time to allow for a meaningful comparison of risk figures over different periods. 38. Banks’ internal systems should be able to compute economic value and earnings-based measures of IRRBB, based on the interest rate shock and stress scenarios as given in Appendix 1. 39. The validation of IRRBB measurement methods and assessment of corresponding model/measurement risk should be included in a formal policy process that should be reviewed and approved by the Board or 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. 40. An effective validation framework should include three core elements:
41. 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. 42. Model risk management for IRRBB measures should follow a holistic approach that begins with motivation, development and implementation by model owners and users. Prior to receiving authorisation 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. 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 within banks. 43. 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 authorisations 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 may be modified or decommissioned. Banks should articulate policies for model transition, including change and version control authorisations and documentation. 44. IRRBB measurement method might include those developed by third-party vendors. Model inputs or assumptions may also be sourced from related modelling processes or sub-models (both in-house and vendor-sourced) and should be included in the validation process. Banks should document and explain model specification choices as part of the validation process. 45. Banks that purchase IRRBB models should ensure there is adequate documentation of their use of those models, including any specific customisation. If vendors provide input for market data, behavioural 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. 46. Internal audit should review the model risk management process as part of its annual risk assessment and audit plans. The audit activity should not duplicate model risk management processes, but 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 in detail. If persistent deficiencies are observed, RBI may require banks to compute IRRBB based on ΔEVE as given in the Appendix 2 till such time all deficiencies are removed. 47. Computation of impacts on EVE and NII should be based on following for the purpose of disclosure of these values: (i) ∆EVE
(ii) ∆NII
Reporting 48. The reporting of risk measures to the Board, it committees and other senior management committees should be regular and should compare current exposure with policy limits. In particular, reporting should include the 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 on a regular basis. 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. 49. While the types of reports prepared for the Board or its committee will vary based on the banks’ portfolio composition, they should include at least the following:
50. Reports detailing the IRRBB exposures should be provided to the Board and other committees on a timely basis and reviewed regularly. The IRRBB reports should provide aggregate information as well as sufficient supporting detail to enable the Board or its committee to assess the sensitivity of the bank to changes in market conditions, with particular reference to portfolios that may potentially be subject to significant mark-to-market movements. The Board or its appropriate committees should review the bank’s IRRBB management policies and procedures in light of the reports, to ensure that they remain appropriate and sound. The Board or its appropriate committees should also ensure 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. Disclosure: 51. Banks should disclose the measured ∆EVE and ∆NII under the prescribed interest rate shock scenarios set out in Appendix 2. Disclosure should be in the formats given in Appendix 3. Capital for IRRBB under Pillar 2 52. Banks are responsible for evaluating the level of capital that they should hold, and for ensuring that this 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’ IMS 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. 53. 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. 54. The capital adequacy for IRBBB 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 may be lower than expected, banks should consider capital buffers. Capital adequacy assessments for IRRBB should factor in:
The outcomes of the capital adequacy for IRRBB should be considered in banks’ ICAAP and flow through to assessments of capital associated with business lines. Outlier banks 55. Banks having maximum ∆EVE, under the six prescribed interest rate shock scenarios as reported under table B of Appendix 3 which is equal to or more than 15% of its Tier 1 capital will be considered to be having materially high IRRBB and RBI may under SREP of Pillar 2 ask these banks to either reduce their exposure to IRRBB or enhance their capital base. |
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