2014 Quantitative Risk Management, Inc.

Best Practices in
Interest Rate Risk
Management for
the Banking
Book
0
Chicago
| London
| SingaporeInc.
© 2014
Quantitative
Risk Management,
Best Practices in Interest Rate Risk
Management for the Banking Book
I.
Introduction
II. Defining and Measuring IRRBB
III. Global Perspectives of IRRBB
IV. Challenges in IRRBB Management
V. Moving Towards Best Practices
VI. Conclusion
1
© 2014 Quantitative Risk Management, Inc.
Banks Must Manage
Interest Rate Risk in the Banking Book (IRRBB)
 Managing interest rate risk in the banking book (IRRBB) is
more important now than in recent history

Interest rate levels and volatility
 Increasing scrutiny of measurement processes
 Typically, Asset-Liability management struggles to balance
two primary objectives of IRRBB management:

Maximize earnings growth while minimizing earnings volatility
 Maximize long-term shareholder returns through market-based
metrics
 An approach that integrates both earnings-based and
market-value-based approaches enables best-practice
management of IRRBB
2
© 2014 Quantitative Risk Management, Inc.
Best Practices in Interest Rate Risk
Management for the Banking Book
I.
Introduction
II. Defining and Measuring IRRBB
III. Global Perspectives of IRRBB
IV. Challenges in IRRBB Management
V. Moving Towards Best Practices
VI. Conclusion
3
© 2014 Quantitative Risk Management, Inc.
What Is IRRBB?
 Interest rate risk (IRR) is the exposure of the bank’s capital and
earnings to adverse movements in interest rates
 The banking book is usually considered to be all of the bank’s
assets and liabilities, and its off-balance sheet, excluding the
trading book
 Changes in interest rates affect the underlying economic value of
the bank’s assets, liabilities, and off-balance sheet

Changes in cash flows

Present value of future cash flows
 Changes in interest rates affect the accrual earnings of the bank
4

Changes in net interest income

Changes in other interest-sensitive income and expenses
© 2014 Quantitative Risk Management, Inc.
There Are Many Sources and Drivers
of IRRBB
 Sources
All sources of
IRRBB must
be captured




 Risk factors
Repricing
Yield curve
Basis
Optionality
 Practices around the world vary with
respect to including credit spread risk
in the banking book

Basel has separated out IRRBB from
CSRBB

EBA requires that the curve used for
EVE analysis exclude instrument- or
entity-specific credit spreads and
liquidity risk
5
 Interest rates
 Volatilities
© 2014 Quantitative Risk Management, Inc.
Additional Best Practice Considerations:
Model Interest-Sensitive Non-Interest Income
Interestsensitive
non-interest
income must
be modeled
6
 For many institutions,
non-interest income has
become a significant
component of net income
 Non-interest income
arising from loan servicing
or origination can have a
complex relationship with
market interest rates
© 2014 Quantitative Risk Management, Inc.
Additional Best Practice Considerations:
Integrate Robust Behavioral Models
Robust, wellparameterized
behavioral
models must
be integrated
 In addition to loan prepayment
models and line-of-credit draw
models, focus on deposit
segmentation and runoff analysis
is increasing with respect to both
IRRBB and liquidity
 There are more advanced
modeling techniques being used,
but at a minimum, segmentation of
core vs. non-core deposit attrition
should be used
 Administered rate pricing models are also a
key input. For instance, deposit models should
incorporate the appropriate sensitivity to the
underlying market drivers
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© 2014 Quantitative Risk Management, Inc.
Typical IRRBB Risk Metrics
 Economic value perspective
Economic value of equity (EVE) is the present value of the bank’s expected
net cash flows (including assets, liabilities, and off-balance sheet)
discounted using current market rate
Duration of equity (DOE) measures the sensitivity of EVE in different
scenarios
 Earnings perspective
Net interest income (NII) is the difference between interest received from
assets and interest paid on liabilities
NII sensitivity is usually the focus of earnings risk analysis, though best
practice dictates the use of net income (NI) which also includes important
sources of interest-sensitive income/expense
 Total return perspective
Combines the best attributes of the economic value and earnings
perspectives
8
© 2014 Quantitative Risk Management, Inc.
Best Practices in Interest Rate Risk
Management for the Banking Book
I.
Introduction
II. Defining and Measuring IRRBB
III. Global Perspectives of IRRBB
IV. Challenges in IRRBB Management
V. Moving Towards Best Practices
VI. Conclusion
9
© 2014 Quantitative Risk Management, Inc.
Regulators Have Emphasized the
Economic Value-Based Approach
 Regulators recognize that institutions use both economic-valueand earnings-based approaches for IRRBB

A Basel Committee paper on economic capital practices highlighted
EVE, VaR, and EaR-based techniques as commonly used approaches
for IRRBB economic capital
 However, their emphasis has been on the economic value-based
approach

Basel and EBA have both provided supervisory guidance centered on
using EVE-based measures to ensure sufficient capital for IRRBB
 APRA mandates an EVE-based VaR calculation with a 99% confidence
level and 1-year holding period in determining the IRRBB capital
requirements for re-pricing and yield curve risk
 The Federal Home Loan Banks are subject to a regulatory “market risk”
capital requirement based on a banking book VaR calculation with 99%
confidence over a 6-month horizon
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© 2014 Quantitative Risk Management, Inc.
No Explicit Standards for Earnings-Based
Approaches Have Been Established Yet
 No explicit, standardized regulatory analysis has been
prescribed for earnings-based approaches
 Recently, the Basel Committee set up a Task Force on
Interest Rate Risk geared toward capturing IRRBB within
the regulatory capital framework
To prevent “regulatory arbitrage” between the trading and banking
books
 To address the concern of potential losses stemming from rising
interest rates

 Regulators have begun collecting data from banks for this
task force, but no guidelines on preferred approaches (EVE
or NII) have been published yet
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© 2014 Quantitative Risk Management, Inc.
Management Views May Differ from
the Current Regulatory View
 Regulatory capital metrics commonly used for other risks
(e.g. market risk in the trading book, operational risk) are
consistent with measurement techniques used for risk
management
 However, there is not a clear link with IRRBB

Balance sheet management is typically focused around earnings,
while regulators typically focus on EVE-based capital metrics
 Lower earnings do not necessarily translate into loss of capital
 Across the world, we see variation in the focus of IRR
measurement
Brasil, Australia – EVE
 Europe – EVE and interest rate gap
 US – earnings and EVE (to a lesser degree)

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© 2014 Quantitative Risk Management, Inc.
Stress Testing Has Helped Align Management
Objectives with Regulatory Objectives
 One of the difficulties of coming up with earnings-based
regulatory guidance has to do with standardization

Earnings results are heavily impacted by underlying assumptions about
how the balance sheet evolves
 “Runoff” or “constant” assumptions are not realistic or in-line with how a
bank will manage its balance sheet
 Realistic new business assumptions are institution-specific and
therefore hard to standardize
 Some jurisdictions, particularly the US, have instituted stress
testing combined with a comprehensive review of assumptions
(CCAR)

Institutions that have embraced such integrated analysis have
leveraged the stress testing exercise into a fully integrated balance
sheet management process that can be used to manage the bank in
any scenario
 However, this undertaking can be expensive for both the regulators and
the institutions that they regulate
13
© 2014 Quantitative Risk Management, Inc.
Best Practices in Interest Rate Risk
Management for the Banking Book
I.
Introduction
II. Defining and Measuring IRRBB
III. Global Perspectives of IRRBB
IV. Challenges in IRRBB Management
V. Moving Towards Best Practices
VI. Conclusion
14
© 2014 Quantitative Risk Management, Inc.
There Are Various Constituents Within the Institution,
Each with Different Interest Rate Risk Objectives
 CFO: wants no surprises in reported quarterly NII results
 Investor relations: may identify major shareholder duration
targets that are not being met
 Business and portfolio managers: suggest ways to
restructure balance sheet across asset and liability classes,
to improve level of NII
 AL managers: help balance these objectives
15
© 2014 Quantitative Risk Management, Inc.
Successful AL Managers Are Able to Communicate
with All Constituents and Balance Their Objectives
 They use NII and DOE as appropriate in discussions with
interested parties
 At the same time, they understand and communicate the
relationship between NII sensitivity and DOE
 They define DOE and NII policies that are appropriate to
the structure of their balance sheet and the objectives of
the institution
 They propose hedges and other actions that facilitate
effective management of NII and DOE
16
© 2014 Quantitative Risk Management, Inc.
Leveraging DOE and NII-Sensitivity Information
Can Be Challenging
 Understanding of the complex relationship between DOE
and NII is limited

How are they related?
 Why should management care about DOE limits when NII is the
“real” focus?
 DOE and NII policy limits are too restrictive or loose, and
therefore difficult to manage or meaningless
 Balance sheet actions may impact DOE undesirably,
potentially replacing NII policy violations with DOE policy
violations
 However, these challenges are not insurmountable
17
© 2014 Quantitative Risk Management, Inc.
Best Practices in Interest Rate Risk
Management for the Banking Book
I.
Introduction
II. Defining and Measuring IRRBB
III. Global Perspectives of IRRBB
IV. Challenges in IRRBB Management
V. Moving Towards Best Practices
VI. Conclusion
18
© 2014 Quantitative Risk Management, Inc.
What Can Your Valuation Results Tell You
About Your Income Sensitivity?
 DOE is useful for capturing the IRR of the current position
beyond the typical income-sensitivity horizon

Risk can be placed (intentionally or unintentionally) in later years
 Policy limits now exist for both DOE results and income sensitivity
 DOE is a single measure that provides a directional indicator that
aggregates both long- and short-term NII sensitivity in the current
position

A positive DOE implies income is negatively impacted by rising rates
 A negative DOE implies income is positively impacted by rising rates
 Simultaneously meeting both market value and income
sensitivity policy limits can be challenging if the relationship DOE
and NII is not clear

What does it tell us about the timing of NII risk?
 What does it tell us about the magnitude of NII risk through time?
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© 2014 Quantitative Risk Management, Inc.
AL Managers Should Focus on the
Contribution of NII Risk to DOE
 Many of you think of your balance sheet as two positions:
assets and liabilities
 Conceptually, you also have a third position, the net interest
margin (NIM), which also contributes to the overall level of
DOE
A portion of the NIM’s DOE comes from the change in value due to
discounting
 Another portion of the NIM’s DOE comes from the changes in the
level of income—care needs to be taken to focus on this particular
portion in your DOE analysis

20
© 2014 Quantitative Risk Management, Inc.
A Better Understanding of the Relationship Between DOE
and NII Sensitivity Leads to More Appropriate DOE Limits
 Hedging DOE will not necessarily result in a desirable NII
profile
 However, hedging short- and long-term NII can be used as
a basis to define appropriate DOE limits
 Appropriate DOE limits will only violated when NII limits are
violated
 The following exercise will demonstrate how to determine
DOE limits that are aligned with NII sensitivity limits
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© 2014 Quantitative Risk Management, Inc.
Set DOE Limits That Are Consistent
with NII Risk
 An exercise that minimizes the changes in income will help you to begin
to understand the level of DOE associated with minimal NII risk
1.
Typically, to focus on the current position, you use a runoff assumption—
this should be the starting point of your DOE
limit-setting
2.
Layer hedges to stabilize income based on current balance sheet, to get a
natural/embedded target DOE

3.
Given the structure of your balance sheet today, this is the DOE associated
with very little NII risk
The next step is to repeat this exercise, but allowing some upside and
downside to earnings, to calibrate limits
 In this manner, you are setting your limits based on NII and then
translating them back into DOE
 This process requires periodic assessment as the structure of your
balance sheet evolves
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© 2014 Quantitative Risk Management, Inc.
Set DOE Limits That Are Consistent
with NII Risk
300
Net Interest Income
(in Millions
200
Upper NII Limit
100
0
Lower NII Limit
-100
NII Sensitivity
-200
-300
1
2
3
4
5
6
7
8
9
10
Year of Forecast
Duration of Equity:
DOE: 3.25
-5
23
-3
-1
0
1
3
© 2014 Quantitative Risk Management, Inc.
Set DOE Limits That Are Consistent
with NII Risk
300
Upper NII Limit
Net Interest Income
(in Millions
200
100
Lower NII Limit
0
NII Sensitivity
-100
Neutralized NII
Position Sensitivity
-200
-300
1
2
3
4
5
6
7
8
9
10
Year of Forecast
Duration of Equity Range Associated with NII Sensitivity Limits:
0 Sensitivity
DOE: 2.5
-5
-3
-1
0
1
3
Original
DOE: 3.25
24
© 2014 Quantitative Risk Management, Inc.
Set DOE Limits That Are Consistent
with NII Risk
300
Upper NII Limit
Net Interest Income
(in Millions
200
Lower NII Limit
100
NII Sensitivity
0
Neutralized NII
Position Sensitivity
Upper Limit DOE NII
-100
-200
-300
1
2
3
4
5
6
7
8
9
10
Year of Forecast
Duration of Equity Range Associated with NII Sensitivity Limits:
0 Sensitivity
DOE: 2.5
-5
-3
-1
0
1
3
Original
DOE: 3.25
25
© 2014 Quantitative Risk Management, Inc.
Upper Limit
DOE: 5.0
Set DOE Limits That Are Consistent
with NII Risk
300
Upper NII Limit
Net Interest Income
(in Millions
200
Lower NII Limit
100
NII Sensitivity
0
Neutralized NII
Position Sensitivity
Upper Limit DOE NII
-100
-200
Lower Limit DOE NII
-300
1
2
3
4
5
6
7
8
9
10
Year of Forecast
Duration of Equity Range Associated with NII Sensitivity Limits:
Lower Limit
DOE: 1.5
-5
-3
-1
0
1
0 Sensitivity
DOE: 2.5
3
Original
DOE: 3.25
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© 2014 Quantitative Risk Management, Inc.
Upper Limit
DOE: 5.0
Best Practices in Interest Rate Risk
Management for the Banking Book
I.
Introduction
II. Defining and Measuring IRRBB
III. Global Perspectives of IRRBB
IV. Challenges in IRRBB Management
V. Moving Towards Best Practices
VI. Conclusion
27
© 2014 Quantitative Risk Management, Inc.
Conclusion
 Measurement of IRRBB has once again become a priority
in terms of both the management and regulatory view
 The global vision of IRRBB has started to change, although
EVE-based metrics are still the standard worldwide

Recognition that both EVE- and earnings-based perspectives are
best practice
 For AL managers, relating DOE and NII sensitivity can be a
challenging task
 Once the relationship is better understood, policies can be
established that will ultimately improve the risk
management process
28
© 2014 Quantitative Risk Management, Inc.
Thank you
29
Chicago
| London
| SingaporeInc.
© 2014
Quantitative
Risk Management,
World Headquarters:
181 West Madison Street, 41st Floor
Chicago, IL 60602
+1 312 782 1880
London Office:
13 Austin Friars
London EC2N 2HE
+44 (0)20 7920 9442
Singapore Office:
65 Chulia Street, #27-08
Singapore 049513
+65 6536 3402
www.qrm.com
30
© 2014 Quantitative Risk Management, Inc.

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