Guidelines On Managing Interest Rate Risk in The Banking Book

Guidelines on
Managing Interest Rate Risk in the Banking Book
These guidelines were prepared by the Oesterreichische Nationalbank (OeNB) in cooperation with the Financial Market Authority (FMA)
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Oesterreichische Nationalbank (OeNB) Otto-Wagner-Platz 3, 1090 Vienna, Austria Financial Market Authority (FMA) Praterstrae 23, 1020 Vienna, Austria
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Oesterreichische Nationalbank
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Gnther Thonabauer, Communications Division (OeNB) Barbara Nsslinger, Executive Board Affairs and Public Relations (FMA)
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Gerhard Coosmann, Christian Doppler, Mario Plieschnig, Johannes Turner (all OeNB) Benedikt Hejda, Elisabeth Lehner, Elmar Mitterbuchner, Dagmar Urbanek, Ferdinand Wenzl (all FMA)
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Preface
The dynamic growth of nancial markets and the increased use of complex products have been fundamentally changing the conditions under which credit institutions do business. To be able to cope with these challenges, credit institutions need to implement sound risk control and management systems. As a signicant source of earnings, banks interest rate business is at the same time one of their major factors of risk, and therefore needs to be assessed reliably. Under the new regulatory capital requirements of Basel II, interest rate risk in the trading book continues to carry a minimum capital charge (Pillar 1 of Basel II). What is new is that interest rate risk in the banking book needs to be assessed in the review of capital adequacy (Pillar 2 of Basel II). To this effect, banks need to implement sound processes and systems to ensure that they are adequately capitalized at all times in view of all material risks. In other words, banks must correctly map and evaluate any positions that are subject to interest rate risk within the framework of integrated (bank-wide) risk management. These Guidelines on Managing Interest Rate Risk in the Banking Book are intended to provide guidance on designing the strategies and processes required for identifying, measuring, controlling and monitoring interest rate risks in the banking book. The processes described in these guidelines are provided as examples and should solely be seen as such. After all, the selection and suitability of individual approaches depend to a large extent on the complexity of each banks business. In accordance with the principle of proportionality, these guidelines therefore focus on the nature, scale and complexity of banking activities rather than on bank size alone. The aim of these guidelines is to develop a mutual understanding between credit institutions and banking supervisors in respect of the management of interest rate risk in the banking book. In this context, the Oesterreichische Nationalbank (OeNB) and the Financial Market Authority (FMA) consider themselves as partners of Austrias banks. We hope that these guidelines make for interesting and insightful reading. Vienna, spring 2008
Univ. Doz. Mag. Dr. Josef Christl

Member of the Governing Board of the Oesterreichischen Nationalbank
Dr. Kurt Pribil, Mag. Helmut Ettl

Management Board of FMA
Table of Contents
Introduction 1.1 Motivation and Business Rationale 1.2 De nitions of Risk and Other De nitions 1.2.1 De nition of Interest Rate Risk 1.2.2 Earnings Perspective and Economic Value Perspective 1.2.3 Sources of Interest Rate Risk 1.2.4 Trading Book vs. Banking Book
International Regulations and Transposition into Austrian Legislation
7 7 7 7 8 8 9
11
2.1
2.2
2.3
2.4
Interest Rate Risks in the Banking Book from the Basel II Perspective 2.1.1 Pillar 2 Inclusion of Interest Rate Risks 2.1.2 Pillar 3 Disclosure Obligations Relating to Interest Rate Risk 2.1.3 Principles for Managing Interest Rate Risk The Basel Paper on Interest Rate Risk EU Statutory Requirements for Transposition into Austrian Legislation 2.2.1 Basel II Guidelines 2.2.2 Further Specications by CEBS Reporting Requirements for Interest Rate Statistics 2.3.1 Revised Reporting Regime 2.3.2 Statutory Reporting Requirements 2.3.3 Scope of Interest Rate Risk Reporting 2.3.4 Limitations of Interest Rate Risk Statistics and the Internal Model Evaluation and Treatment of Interest Rate Statistics by Banking Supervisors 2.4.1 Reections on Capital Adequacy 2.4.2 Standardized Interest Rate Shock 2.4.3 De nition and Treatment of Outlier Banks
11 12 12 13 17 17 18 19 19 19 20 20 21 22 23 23
26
Measuring and Managing Interest Rate Risk in the Banking Book
3.1
3.2
To Choose an Economic Value or an Earnings Perspective? 3.1.1 Managing Interest Rate Risk from an Earnings Perspective 3.1.2 Managing Interest Rate Risk from an Economic Value Perspective 3.1.3 Optimal Interest Rate Risk Management Strategies Instruments for Quantifying Interest Rate Risks 3.2.1 Gap Analysis 3.2.2 Simulation Models 3.2.3 Elasticity Analysis
26 27 27 28 31 32 34 38
Integrated (Dual) Management of the Interest Rate Book
41
4.1
4.2
4.3
4.4
4.5
References
De nition of the Risk Strategy 4.1.1 De nition of Benchmarks 4.1.2 De nition of Interest Rate Management Philosophy 4.1.3 Interest Rate Risk Limits 4.1.4 Product Innovation Process Cash Flow Modeling 4.2.1 Retail Transactions 4.2.2 Proprietary Trading Activities Derivatives and Structured Products 4.2.3 Noninterest-Sensitive Positions with an Imputed Repricing Prole Yield/Risk Analysis 4.3.1 Yield Analysis 4.3.2 Risk Analysis 4.3.3 Risk-Adjusted Performance Measures Putting Interest Rate Risk Management into Action 4.4.1 Establishing the Need for Action 4.4.2 Rollover (Earnings Perspective) 4.4.3 Inclusion of Stress Tests Ex Post Analysis
46 46 47 48 49 51 52 71 77 78 78 79 83 84 84 86 87 92
93 95
Abbreviation Key
1 Introduction
1.1 Motivation and Business Rationale One of the key economic functions of credit institutions is to convert shortterm deposits into long-term loans. Depending on the scale of this maturity transformation which essentially determines the risk arising from a banks balance sheet structure sharply uctuating market interest rates can have a considerable impact on banks earnings and on their capital base. The increasing complexity of markets makes effective processes for measuring and managing interest rate exposure an essential business requirement for credit institutions. The rst challenge in this respect is to choose the right instruments from among the wide variety that is available to efciently manage maturity transformation in line with interest rate expectations. The growing importance of interest rate risk in integrated risk management is also reected in the relevant regulatory provisions. Following the latest amendment of the Austrian Banking Act, interest rate risk is now, for the rst time, explicitly cited among the due diligence obligations (under Article 39 paragraph 2b No 8 of the Austrian Banking Act). 1.2 Denitions of Risk and Other Denitions
1.2.1 Denition of Interest Rate Risk
Interest rate exposure is generally described as the risk of a reduction in a projected or anticipated measure of net interest income (target measure) resulting from changes in market interest rates.1 Yet from a practical perspective such a de nition is somewhat awed, as the use of an anticipated (or projected) measure of net interest income is fraught with risks. Any inappropriate assumption in the projection phase will produce an inaccurate target measure and, consequently, result in an inaccurate assessment of interest rate risk. In a more useful way, interest rate exposure could be de ned as the risk that the amount of net interest income obtainable at unchanged interest rates may not be attained given an adverse change in market interest rates. Conversely, banks stand to benet from an interest rate opportunity should favorable changes in market interest rates drive up net interest income. Using a zero line2 thus makes it possible to rate the risks and opportunities that arise from changes in market interest rates. Another key factor in the equation is the target measure to be used for evaluating the a credit institutions performance. The Basel Committee on Banking Supervision, for instance, bases its de nition on the different effects of interest rate exposure: 3 Interest rate risk is the exposure of a banks nancial condition to adverse movements in interest rates. [] Changes in interest rates affect a banks earnings by changing its net interest income and the level of other interest sensitive income and operating expenses. Changes in interest rates also affect the underlying value of the banks assets, liabilities, and off-balance-sheet (OBS) instruments because the economic value of future cash ows (and in some cases, the cash ows themselves) change when interest rates change.
1 2
See Schwanitz (1996), p.5. Also called a baseline scenario, indicating the measure of net interest income that can be generated in the absence of any future changes in market interest rates. See Basel Committee on Banking Supervision (2004b) ref. 11.
1 Introduction
1.2.2 Earnings Perspective and Economic Value Perspective
Changes in interest rates affect a banks earnings and its risk situation in different ways. With regard to assessing a banks interest rate exposure, the two most common perspectives are the earnings perspective and the economic value perspective: The earnings perspective focuses on the impact interest rate changes have on a banks near-term earnings. After all, changes in the yield curve have a direct impact on a banks future net interest income (including the estimated net income from asset securitization programs). Even noninterest income components, particularly fee-based income, can indirectly depend on the future development of interest rates. Hence, interest rate risk analysis from an earnings perspective will focus on assessing the earnings effects that may arise from changes in market interest rates. The economic value perspective focuses on the impact interest rate changes may have on the economic value of future cash ows and thus on the economic value of both the interest rate book and capital. The present economic value is affected in two ways by changes in interest rates: by the change in future interest cash ows included in the calculation (= primary economic value perspective) and by the change in the discount rates of all future cash ows used for this calculation (= secondary economic value perspective).
1.2.3 Sources of Interest Rate Risk
As the Basel Committee on Banking Supervision has pointed out, it has become increasingly important to look beyond the traditional earnings and economic value effects and assess indirect interest rate effects as well. Taking a broader view of the potential earnings impact of changing interest rates, banks also need to take into consideration the growing share of (interest-sensitive) feebased nancial services (loan servicing, asset securitization programs, payments etc.). Further indirect effects stem from in the evolution of the balance sheet (structural effects) and from the downgrading of borrowers (credit rating effect). As a case in point, portfolio shifts from savings deposits to short-term xed deposits (structural effects), coupled with an inverse yield curve, resulted in a massive adverse effect on earnings in the early 1990s. With a view to capturing interest rate risk appropriately, the Basel Committee on Banking Supervision breaks down interest rate risk into four main types:4 repricing risk, which arises from mismatches in interest rate xation periods, yield curve risk, which is caused by changes in the slope and shape of the yield curve, basis risk, which arises from an imperfect correlation in the adjustment of the rates earned and paid on different products with otherwise similar repricing characteristics, and
See Basel Committee on Banking Supervision (2004b), ref. 13ff
1 Introduction
optionality risk, which arises primarily from options (gamma and vega effect) that are embedded in many banking book positions (e.g. early redemption rights in the case of loans).
1.2.4 Trading Book vs. Banking Book
To calculate the minimum regulatory capital requirements, banks must differentiate between interest rate risks in the trading book and interest rate risks in the banking book.
Chart 1
Recognition of Interest Rate Risk in the Trading and Banking Books

Article 22n paragraph 1 of the Austrian Banking Act interest rate risk in the trading book interest rate risk in the banking book
PILLAR 1 minimum regulatory capital requirements standardized approach, Article 22o of the Austrian Banking Act internal VaR model, Article 22p of the Austrian Banking Act
Source: OeNB.
PILLAR 2 integrated risk management (ICAAP) Articles 39b paragraph 2b Nos 3 and 8 of the Austrian Banking Act Article 39a of the Austrian Banking Act
Under Article 22n paragraph 1 of the Austrian Banking Act, all positions in nancial instruments and commodities held for trading purposes are to be assigned to the trading book. Likewise, nancial instruments and commodities used to hedge or re nance specic risks in the trading book are also to be assigned to the trading book. To cover the market risks arising from the trading book, credit institutions must retain a minimum amount of capital, as was already laid down in the Basel paper on market risk entitled Amendment to the Capital Accord to Incorporate Market Risks of 1996.5 In the new regulatory capital framework (Basel II), the requirement to adequately recognize interest rate risks in the trading book is now covered by Pillar 1. The minimum capital requirements for different risk types in the trading book are determined either in accordance with the stipulated standardized approaches6 or with the credit institutions own risk model (VaR model)7 as approved by its banking supervisor. Credit institutions that do not exceed the thresholds foreseen by Article 22q of the Austrian Banking Act may calculate their minimum capital requirements for the corresponding risk types in the trading book in a simplied manner pursuant to Article 22 paragraph 1 No 1 of the Austrian Banking Act (8 % of risk-weighted assets). The interest rate risk of all activities other than those identied in the trading book8 i.e. interest rate risks in the banking book should be considered
5 6 7 8
A revised version was published in 1998. See Article 22o of the Austrian Banking Act and 195ff of the Solvency Regulation. See Article 22p of the Austrian Banking Act and 224ff of the Solvency Regulation. See Article 39 paragraph 2b of the Austrian Banking Act.
1 Introduction
under Pillar 2. Although current regulations do not stipulate standardized capital charges for interest rate risks in the banking book, Article 39a of the Austrian Banking Act compels credit institutions to include them in their internal capital adequacy assessment process (ICAAP) for assessing capital adequacy in relation to their risk prole. These guidelines focus on interest rate risks derived from transactions in the banking book. For guidance on interest rate risks in the trading book, please see the Guidelines on market risk 9 published earlier by the OeNB.
See OeNB (2003).
10
2 International Regulations and Transposition into Austrian Legislation
2.1 Interest Rate Risks in the Banking Book from the Basel II Perspective The Basel Committee on Banking Supervision, after an extensive consultation process, redrafted its recommendations for credit institutions regulatory capital requirements (Basel I) issued in 1988. The revision was motivated by the wish to adequately reect current developments in banking and to strengthen the stability of the international nancial system. On November 15, 2005, the Basel Committee on Banking Supervision presented the revised version of the Basel II Capital Accords framework agreement, initially released under the title International Convergence of Capital Measurement and Capital Requirements on June 26, 2004. The major difference between this document and the Basel I framework, which merely imposed minimum capital requirements on credit institutions, is that Basel II forsees also a supervisory reviewing process (Pillar 2) and broader disclosure obligations (Pillar 3).
Chart 2
Three-Pillar Architecture of Basel II
Stability of the Financial System

PILLAR 1 minimum capital requirements PILLAR 2 supervisory review process PILLAR 3 market discipline control by the market disclosure obligations of banks transparency for market participants in respect of a banks risk situation (scope of application, risk management, comprehensive regulatory capital data) enhanced comparability of credit institutions
capital requirement for: credit risk standardized approach foundation IRB approach advanced IRB approach market risk standardized approach internal VaR model operational risk basic indicator approach (alternative) standardized approach advanced management approaches (AMA)
Source: OeNB.
requirements for banks (ICAAP) capital control including risk management recognition of interest risk in the banking book requirements for banking supervisors (SREP) evaluation of banks internal systems assessment of risk profile monitoring compliance with all requirements supervisory measures
Disclosure obligations for interest rate risk in the banking book
The Basel Committee had originally planned to consider interest rate risks from the banking book under Pillar 1. However, given considerable differences between banks in terms of both the nature of their underlying interest rate risk exposure and their monitoring and controlling processes, interest rate risks were eventually assigned to Pillar 2.10
10
See Basel Committee on Banking Supervision (2004a), ref. 762.
11
2.1.1 Pillar 2 Inclusion of Interest Rate Risks
The rst component of Pillar 2 is the internal capital adequacy assessment process (ICAAP). According to Article 39a paragraph 1 of the Austrian Banking Act, credit institutions must have effective systems and processes in place to determine the amount, composition and distribution of internal capital on an ongoing basis and to hold capital commensurate with the required level. The second component of Pillar 2 is the supervisory review and evaluation process (SREP). The purpose of SREP is to evaluate banks risk prole, to assess qualitative aspects (management, strategy, internal processes), and to impose supervisory measures if necessary. Basically, any risks that are not taken into account, or considered but not fully captured under Pillar 1 (minimum capital requirements), are treated under Pillar 2. Article 39 paragraph 2b of the Austrian Banking Act includes a set of examples comprising the most important and frequent risks of banking transactions and operations including the interest rate risk arising from any transaction not covered yet by trading book risk types.
2.1.2 Pillar 3 Disclosure Obligations Relating to Interest Rate Risk
In addition to rede ning the calculation of capital requirements and establishing a supervisory review process under Pillars 1 and 2, Basel II imposes new and enhanced disclosure obligations on credit institutions under its third pillar. The purpose of Pillar 3 is to ensure greater transparency in terms of banks activities and risk strategies, as well as to enhance comparability across credit institutions which is all in the interests of market participants. At the same time, the provisions of Pillar 3 do not entail additional capital requirements but are limited to mandating the publication of key data, the disclosure of which neither weakens banks competitive positions nor violates banking secrecy.11 The range of data credit institutions in Austria are obliged to disclose in respect of their interest rate risk in the banking book is described in Article 14 of a corresponding Disclosure Regulation announced on October 9, 2006, in the Federal Law Gazette.12 According to this regulation, credit institutions must disclose the type of interest rate risks they are exposed to, the frequency with which they measure these risks, and the key assumptions they use for that purpose (including their assumptions relating to early loan repayment and investor behavior in respect of deposits with no xed maturity). Moreover, banks have to disclose changes in earnings, economic value or other target measures they use to measure interest rate risk. These data are to be published currency by currency.
11 12
See Article 26 paragraphs 5 and 6 of the Austrian Banking Act. Federal Law Gazette II No. 375/2006.
12
Within banking groups it is, as a rule, the responsibility of the highest consolidation level to disclose all details that are relevant under Pillar 3.13 Unless specied otherwise, the minimum disclosure frequency is once a year.14 While it is up to each bank to decide what disclosure medium to use, all data must be published through the same channel, which must also be accessible to the public (e.g. the credit institutions annual report, website etc.). To avoid a duplication of efforts, credit institutions publishing the relevant data in conformity with accounting and stock exchange standards as well as with other regulations are deemed to have satised the requirements under Pillar 3.
2.1.3 Principles for Managing Interest Rate Risk The Basel Paper on Interest Rate Risk
The paper entitled International Convergence of Capital Measurement and Capital Requirements15 published by the Basel Committee on Banking Supervision provides only general information on interest rate risk in the banking book. More specic information is contained in an additional paper entitled Principles for the Management and Supervision of Interest Rate Risk (July 2004).16 This paper lists 15 principles that represent minimum requirements for the management of interest rate risk by credit institutions17 and that de ne the supervisory treatment of interest rate risk in the banking book. This paper is a revised and expanded version of the Principles for the Management of Interest Rate Risk published in September 1997. The revision primarily concerns Principle 12 (capital adequacy), Principle 13 (disclosure obligations relating to interest rate risk), Principles 14 and 15 (regulatory aspects) as well as Annexes 3 (standardized interest rate shock) and 4 (example of a master agreement). Figure 3 presents an overview of the qualitative principles specied by the Basel paper on interest rate risk published in 2004. The following section briey describes the individual principles and indicates the corresponding passages in the Austrian Banking Act through which they have been transposed into Austrian legislation.
13
14 15 16
17
There is an exception in respect of signicant subsidiaries (Article 26a paragraph 4 Austrian Banking Act), which must disclose their capital structure (Article 4 Disclosure Regulation) and minimum capital requirements (Article 5 Disclosure Regulation). Credit institutions are classied as being signicant subsidiaries by the FMA by way of an administrative ruling, subject to the criteria stipulated in Article 26a paragraph 5 of the Austrian Banking Act. See Article 26 paragraph 3 of the Austrian Banking Act. Basel Committee on Banking Supervision (2004a), ref. 762764. The related consultation paper was published in January 2001. See Basel Committee on Banking Supervision (2001). These principles concerning the minimum requirements for the management of credit institutions interest rate risk apply to all risk positions (trading portfolio and other banking business).
13
Chart 3
Qualitative Principles of Interest Rate Risk Outlined by the Basel Paper on Interest Rate Risk
management responsibility guidelines for banking supervisors

14. Basel standardized market risk scenarios 15. sanction mechanisms 1. supreme management body 2. senior management 3. functional independence of units
risk strategy requirements

1. principles/processes 2. product innovation
Qualitative Principles of the Basel Paper on Interest Rate Risk integrated risk management process, internal controls
1. disclosure 11. information for banking supervisors 12. capital adequacy 6. measurement, methodology 2. risk limitation 3. stress testing 4. monitoring 5. internal audit
Source: OeNB.
2.1.3.1. Management Responsibility
The Basel paper on interest rate risk divides the responsibilities for interest rate risk management and oversight among the supreme management body and senior management. In the context of Austrian corporate law, the senior management would be the directors of a credit institution authorized to manage and legally represent it under Article 2 No 1 of the Austrian Banking Act. The supreme management body of Austrian corporations would be the supervisory board, whose core function is to oversee the directors in order to ensure that the latter are fullling their responsibilities. In Austrian companies, senior management is responsible for designing risk policy and for determining the principles and strategies for managing interest rate risk, as well as for ensuring that the necessary risk monitoring and control measures are in place.18 As a rule the policies or any adjustments thereof require supervisory board approval.19 Finally, reporting lines and obligations must be de ned accordingly to ensure adequate assessment of the credit institutions risk sensitivity as well as effective and efcient monitoring and control of the existing risks. Effective interest rate risk monitoring requires appropriate framework conditions in line with the nature, scale and complexity of a credit institutions banking activities. In this instance, the principle of proportionality is a major
18
19
For denitions of the responsibility of senior managers/directors is inferable from Article 39 of the Austrian Banking Act on the basis of the current law applicable. See Article 95 paragraph 5 no 8 of the Stock Corporation Act or Article 30j paragraph 5 no 8 of the Act on Limited Liability Companies.
14
yardstick. Banks primarily undertaking low risk transactions can apply simpler methodologies than banks with complex transactions or a high business volume. Responsibilities must be clearly assigned to individual persons and/or committees. In addition, the relevant units must be functionally independent to avoid potential con icts of interests.20 Senior management should ensure that adequate interest rate risk management is in place for measuring, monitoring and controlling interest rate risks, and that all the relevant business units of the bank have been taken on board. Employees entrusted with interest rate risk management duties need to be aware of all types of interest rate risks across the bank, and they need to possess the necessary degree of independence vis--vis individuals who undertake risk positions. Senior management is responsible, above all, for the existence of appropriate risk limits and of sound risk measurement and assessment systems and standards, as well as for the implementation of comprehensive processes for reporting interest rate risks, reviewing risk management and conducting effective internal controls. Staff members, in turn, need to be sufciently skilled and experienced to be able to cope with the nature, scale and complexity of banking activities.
2.1.3.2. Risk Strategy Requirements
As laid down by the Basel Committee on Banking Supervision, a key requirement for the proper management of a banks interest rate risk is the de nition of the relevant principles and processes based on proportionality. More specically, it is important to clearly de ne responsibilities and accountability in taking risk management decisions as well as what kind of instruments are eligible. The purposes or goals for which eligible instruments may be used need to be specied as well. Qualitative points of this nature should be supplemented with quantitative parameters determining the amount of interest rate risk acceptable to the credit institution. As a rule, principles should be reviewed periodically and adjusted where necessary. In addition, sound processes and controls helping to identify interest rate exposures and incorporate them into risk management need to be in place to adequately cover product innovations and new activities. Credit institutions need to be aware of all risk characteristics when implementing new products. In respect of the risk inherent in new transactions with which the bank has no experience yet, Article 39 paragraph 2c of the Austrian Banking Act species that due consideration must be given to the safety of customers deposits and to the preservation of the banks own capital. For further details on the process relating to the introduction of new products, please see subsection 4.1.4, Product Innovation Process.
2.1.3.3. Requirements for Measuring, Monitoring and Managing Interest Rate Risk and for Internal Controls
Credit institutions should have measurement systems in place that capture all material interest rate risk positions and related sources of risk (e.g. repricing
20
See Article 39 paragraph 2 of the Austrian Banking Act.
15
risks, yield curve risks, basis risks and optionality risks) and that include all key maturity and repricing data. The effects on credit institutions earnings and economic value from potential changes in interest rates should be quantied. The quality of data and model assumptions, on which the quality and reliability of credit institutions interest rate risk measurement system depend, are of particular importance. Employees entrusted with interest rate risk management duties need to be familiar with and understand the assumptions and parameters underlying the interest rate risk management system, and they need to review them at least on an annual basis.21 The assumptions should also be documented in a manner transparent to third parties. To limit risks, credit institutions must establish and implement adequate limits in line with their business policy. The aim is to maintain interest rate risk within specied limits over a range of possible changes in interest rates. In addition to applying a ceiling to aggregate interest rate risk, limits are useful for individual portfolios, business units, instruments or departments. Subsection 4.1.3, Interest Rate Risk Limits examines in greater depth the various types of limits as well as the structure of the limit system in asset-liability management. Banks need to be able to make a sound judgment about the impact that adverse market conditions may have on their business. Appropriate stress tests simulating a range of developments should indicate which scenarios may generate extraordinary losses.22 Furthermore, it is essential to check if the underlying assumptions and model parameters remain valid under stress situations. The results of such stress simulations should be taken into account when the principles and limits for interest rate risk are determined and reviewed, and appropriate emergency plans should be in place. Credit institutions should also have in place an adequate system of internal controls over their interest rate risk management process. For instance, credit institutions must ensure that competent employees are aware of and actually apply the de ned principles and processes, and that the de ned processes accomplish the intended objectives. Article 39 paragraph 2 of the Austrian Banking Act species that the appropriateness of the processes and their application should be reviewed by the banks internal audit unit at least once a year. The duties of the internal audit unit are specied in Article 42 of the Austrian Banking Act. These internal reviews should ensure that credit institutions interest rate risk measurement system is accurate enough to capture all the material components of interest rate risk and that any required amendments or improvements are made.
2.1.3.4. Capital Adequacy and Information for Banking Supervisors
Under Pillar 2, all banks must apply the internal capital adequacy assessment process (ICAAP) to ensure that the interest rate risk undertaken is commensurate with the capital allocated.23 In Principle 12, the Basel Committee on
21 22 23
See Article 39a paragraph 2 Austrian Banking Act. See OeNB (1999), and subsection 4.4.3, Inclusion of Stress Testing. See subsection 2.1.1, Pillar 2 Inclusion of Interest Rate Risks.
16
Banking Supervision species that credit institutions undertaking signicant interest rate risk in the banking book should also allocate a substantial amount of capital to support this risk. Banking supervisors require timely data to undertake the review and evaluation processes considered under Pillar 2. In Austria, the relevant data are compiled through standardized supervisory reporting24 channels as well as through on-site examinations. In Principle 11, the Basel Committee on Banking Supervision explains that banking supervisors should have enough information to identify and monitor banks that have repricing mismatches.
2.1.3.5. Disclosure
In Principle 13, the Basel Committee on Banking Supervision stipulates general disclosure requirements for the level of interest rate risk and the policies established for managing those risks. For further details on those policies in Austria, please see subsection 2.1.2, Pillar 3 Disclosure Obligations Relating to Interest Rate Risk.
2.1.3.6. Guidelines for Banking Supervisors
The Basel Committee on Banking Supervision requires banking supervisors to assess the soundness of credit institutions internal systems for measuring interest rate risk in the banking book and to check their risk-bearing capacity in relation to interest rate risks. Again, what is considered sound depends on the nature, scale and complexity of a banks business.25 Banking supervisors may set various measures should they conclude that the level of interest rate risk in the banking book is not commensurate with the capital available, or that the processes used are not suitable for the nature and volume of the exposures.26
2.2 EU Statutory Requirements for Transposition into Austrian Legislation
2.2.1 Basel II Guidelines
At the European level, the recommendations of the Basel II Accord were transposed into EU legislation as Directives 2006/48/EC27 and 2006/49/EC28 and published in the Ofcial Bulletin of the European Union on June 30, 2006. At the national level, these directives serve as a basis for transposition into national legislation and are applicable in Member States from January 1, 2007. In respect of interest rate risk in the banking book, the following points of Directive 2006/48/EC (Capital Requirements Directive) are relevant, in particular: Article 22 of the Capital Requirements Directive prescribes sound corporate governance with clear organizational structures and lines of responsi24 25 26 27
28
See section 2.3, Supervisory Reporting on Interest Rate Risk. See notes on Article 39a paragraph 1 of the Austrian Banking Act (1558 d.B. XXII. GP). See subsection 2.4.3, Denition and Treatment of Outlier Banks. Directive relating to the taking up and pursuit of the business of credit institutions (new version) [previously: Directive 2000/12/EC]. Directive on the capital adequacy of investment rms and credit institutions (new version) [previously: Directive 93/6/EEC].
17
bility. Annex V, No 10 de nes the technical criteria relating to the organization and treatment of interest rate risks in the banking book. Article 123 of the Capital Requirements Directive de nes the requirement for credit institutions to have in place comprehensive strategies and processes for ensuring on an ongoing basis the assessment of the amount, composition and distribution of internal capital that they consider adequate to cover the nature and level of the risks to which they are exposed or might be exposed. With regard to the appropriateness of the rules, processes and mechanisms relative to the nature, scale and complexity of a credit institutions activities Article 123 of the Capital Requirements Directive specically refers to the principle of proportionality. According to Article 124 No 5 of the Capital Requirements Directive, banking supervisors are responsible for monitoring and evaluating interest rate risk in the banking book. Article 136 of the Capital Requirements Directive outlines potential supervisory measures in the event a credit institution does not comply with the requirements of the directive. The disclosure requirements for interest rate risk are outlined in Annex XII, Part 2, point 12 of the Capital Requirements Directive. Due to the wealth of detail in the directives, these provisions were transposed into Austrian legislation by way of an amendment to the Austrian Banking Act as well as by two FMA regulations (Solvency Regulation and Disclosure Regulation).
2.2.2 Further Specications by CEBS
In respect of interest rate risk in the banking book, the Committee of European Banking Supervisors (CEBS) discussed the Basel II regulations in greater detail and issued a set of guidelines entitled Technical aspects of the management of interest rate risk arising from non-trading activities under the supervisory review process. This paper, published after ofcial consultation on October 3, 2006, is conceived to serve as guidance for credit institutions and banking supervisors, and highlights additional technical aspects relating to this subject. The CEBS paper basically specied the points already addressed in subsection 2.1.3, Principles for Managing Interest Rate Risk the Basel Paper on Interest Rate Risk. The CEBS guidelines were not intended to provide a detailed framework for developing and applying quantitative analytical techniques, systems and processes after all, it is up to each bank how to implement the system quantitatively.29 Basically, CEBS conrms the importance of the principle of proportionality as a yardstick for the complexity of methodologies. Moreover, credit institutions are expected to show that their internal capital calculated is sufcient to cover the nature and level of all interest rate risks in the banking book.30 In particular, the CEBS document underlines the need for all credit institutions to be able to calculate at the very least the effects of a standardized
29 30
See CEBS (2006a), p.1. See Article 39a paragraph 1 of the Austrian Banking Act and also CEBS (2006b), p.9.
18
interest rate shock,31 which is de ned as a sudden and unexpected change in money market and/or capital market rates. The need for supervisory intervention by the Austrian FMA with regard to interest rate exposure is laid down in Article 69 paragraph 3 of the Austrian Banking Act and is treated in greater detail in section 2.4, Evaluation and Treatment of Interest Rate Risks by Banking Supervisors.
2.3 Reporting Requirements for Interest Rate Risk Statistics To enable banking supervisors to monitor interest rate risk positions, credit institutions must submit those positions in an appropriate format; in particular, they must use the newly established risk-oriented supervisory reporting (ROSR) framework.
2.3.1 Revised Reporting Regime
In the run-up to the implementation of Basel II provisions in 2007, the OeNB and FMA completed the Risk-Oriented Supervisory Reporting (ROSR) project, which integrates the data requirements for Basel II, innovations in risk orientation and adjustments to international nancial reporting standards. The ROSR framework has also been informed by the international debate on pan-European harmonization of supervisory reporting (COREP and FINREP).32 The adjustment and restructuring of reporting requirements has wideranging importance for the reporting of interest rate risk. Previously, interest rate risk was reported only at an unconsolidated level and then only in respect of the banking book. Within the new ROSR framework, reports are to be led also at a consolidated level and also for foreign subsidiaries. Moreover, individual interest risk positions have to be reported separately for the banking book and trading book (if applicable).
2.3.2 Statutory Reporting Requirements
Following consultation with the OeNB, the Financial Market Authority, with the consent of the Austrian Federal Finance Minister, issued a regulation on the report of condition and income (RRCI) under Article 74 paragraphs 1 and 7 of the Austrian Banking Act. Under Article 74 paragraph 1 of the Austrian Banking Act, credit institutions and superordinate credit institutions must send quarterly reports of condition and income to the FMA using the prescribed RRCI format.33 Under Article 74 paragraph 1 No 2 of the Austrian Banking Act, interest rate risk statistics must contain information that facilitates the assessment and monitoring of compliance with risk-specic due diligence obligations (Articles 39 and 39a of the Austrian Banking Act). Furthermore, Article 74 paragraph 1 nal sentence of the Austrian Banking Act requires superordinate credit insti31 32
33
See CEBS (2006a), pp. 9 and 11. COREP = Common European Reporting for Solvency; FINREP = Financial Reporting (for corporate nancial statements under IFRS). Under Article 16 of RRCI, the FMA made use of the option cited in Article 74 paragraph 7 Austrian Banking Act pursuant to which credit institutions must forward reports of condition and income to the OeNB only.
19
tutions to prepare the report of condition and income also for fully consolidated foreign subsidiaries (Articles 59 and 59a of the Austrian Banking Act).
2.3.3 Scope of Interest Rate Risk Reporting
Under the aforementioned new reporting framework, credit institutions, banking groups and their foreign banking subsidiaries must include interest rate risk statistics in their (consolidated and unconsolidated) reports of condition and income. To provide guidance, the OeNB has published detailed guidelines for compiling interest rate risk statistics (as well as guidelines for the whole reporting framework); these guidelines are also available online at www.oenb.at.34 For the sake of simplicity, this paper will refer only to the unconsolidated version of the guidelines for reporting interest rate risk statistics. For more details, see the reporting guidelines for banking groups and foreign subsidiaries. As mentioned above, the scope of the interest rate statistics was extended to cover the trading book and the consolidated group accounts (including foreign bank subsidiaries). At the same time, the scope of reporting has been considerably reduced for banks foreign subsidiaries. Trading book reports are to be submitted only by credit institutions which exceed the thresholds de ned in Article 22q paragraph 1 of the Austrian Banking Act. Credit institutions which use complex processes (models pursuant to Article 22p of the Austrian Banking Act) for calculating their capital in the trading book may with the OeNBs consent use individual reporting solutions to compile their interest rate risk statistics. Like many other risk statement items, consolidated interest rate risk items may be presented in a simplied form. For instance, credit institutions need not include subsidiaries with no signicant interest rate risk activity, and they may use traditional aggregation methods based on eliminating individual items instead of traditional consolidation methods.
2.3.4 Limitations of Interest Rate Risk Statistics and the Internal Model
For the sake of comparability and broad consistency in reporting within the banking sector, a number of simplications have been agreed for the interest rate risk statistics, which of course also give rise to data weaknesses. In other words, given the underlying assumptions (interest cash ows disregarded, book value reporting, at yield curve, etc.) these statistics provide merely a broad-brush picture, i.e. only an approximate estimation of interest rate risk. Above all, credit institutions which maintain complex products in the banking book must, at any rate, be able to map and evaluate the interest rate risk of these products appropriately. Complex products call for more sophisticated methodologies. The aforementioned shortcomings can largely be avoided by using internal models. Banks applying such models are therefore supposed to report two
34
www.oenb.at/de/stat_melders/melderservice/bankenstatistik/aufsichtsstatistik/vera_neu/vera_ uebersicht.jsp (German only).
20
separate sets of interest rate data (III. Standardized Approach, IV. Internal Risk Management):
Table 1
Presentation of Interest Rate Risk in Interest Rate Risk Statistics

III. Standardized approach change in economic value triggered by the assumed change in interest rates % of eligible capital IV. Internal risk management change in economic value triggered by the assumed change in interest rates % of eligible capital
In their reports of condition and income, credit institutions are, as a rule, required to indicate the aggregated change in economic value triggered by the assumed change in interest rates (currently specied at 200 basis points in the reporting guidelines on the risk statement). Credit institutions with an internal risk measurement system in place that differs from the selected standardized approach35 must also forward the results in accordance with the internal models approach under IV. Internal Risk Management.36 In principle, credit institutions are free to select the process for measuring internal interest rate risk provided this process is considered to be appropriate within the meaning of Article 39 paragraph 2 of the Austrian Banking Act.
2.4 Evaluation and Treatment of Interest Rate Risks by Banking Supervisors As already outlined in subsection 2.1.1 (Pillar 2 Inclusion of Interest Rate Risks) credit institutions are not required to back interest rate risk in the banking book with capital under Pillar 1. Yet they need to monitor interest rate risk in the banking book under Pillar 2 within the integrated risk management framework. Specically, credit institutions must establish an internal capital adequacy assessment process (ICAAP) for assessing capital adequacy in relation to their risk prole. Moreover, Pillar 2 requires banking supervisors to subject all credit institutions to a supervisory review and evaluation process (SREP). SREP includes the evaluation of a credit institutions own internal processes, systems, mechanisms and strategies, as well as the evaluation of its risk prole.37 Banking supervisors must lay down the frequency and intensity of the reviews to be performed at each bank, and actually conduct such reviews at least on an annual basis, having regard to systemic importance as well as to the nature,
35 36 37
Repricing method or duration method See Reporting guidelines on the risk statement. In this respect, SREP should check whether the interest rate risk in the banking book was also included in the internal capital adequacy assessment process.
21
scale and risk inherent in bank activities (proportionality principle).38 If necessary, supervisory measures can be imposed in the event of noncompliance.
2.4.1 Reections on Capital Adequacy
Credit institutions undertake risks as part of their business activities and bear the nancial damage resulting from a materialization of risk.39 In this respect, a key supervisory duty is to ensure that credit institutions are aware of the nature, scale and complexity of the risks undertaken, that they measure these risks, and that they control and limit them accordingly.40 Within the framework of integrated risk management, the interest rate risk identied in the banking book must be measured by sound systems, commensurate with risk-bearing capacity and covered by adequate capital. A credit institutions risk-bearing capacity can only be guaranteed in the long term if the capital it holds is adequately sufcient to support the level of undertaken risks.41 The more complex the interest rate products used, the higher the need under Pillar 2 to put in place sophisticated and appropriate models of risk assessment. In principle, credit institutions are free to choose the process for measuring interest risk in the banking book, provided this process and its application as a management, accounting and control tool is appropriate for capturing interest rate risk within the meaning of Article 39 paragraph 2 of the Austrian Banking Act.42 Integrating interest rate risk management into bank-wide risk management activities is essential for maintaining risk-bearing capacity. In addition to monitoring earnings, best practice is to react to increases (changes) in the economic value of all interest-sensitive positions (interest rate book).43 Adequate interest rate risk management is based on an integrated economic value perspective of performance and risk. The integrated risk management framework covers all available data, all products, all systems applied, and the underlying methods and models. Based on this framework, banks will de ne the three key measures to be managed (earnings, economic value and risk), thus aligning these three perspectives in a management triangle.44 Article 39 paragraph 2 of the Austrian Banking Act requires credit institutions to identify, assess control and monitor interest rate risks in the banking book: All credit institutions must have precise knowledge of the interest rate risks they have undertaken. On a consolidated basis, the superordinate credit institution pursuant to Article 30 paragraph 5 of the Austrian Banking Act is
38
39 40 41 42 43 44
Article 124 paragraph 4 of the Capital Requirements Directive: Competent authorities shall establish the frequency and intensity of the review and evaluation having regard to the size, systemic importance, nature, scale and complexity of the activities of the credit institution concerned and taking into account the principle of proportionality. The review and evaluation shall be updated at least on an annual basis. See Bschgen/Brner (2003), p. 18ff. See Basel Committee on Banking Supervision (2004b), ref. 719ff. See OeNB/FMA (2006), p. 69. See Reporting guidelines on the risk statement. See Eller/Schwaiger/Federa (2001), p. 3ff. See Eller/Schwaiger/Federa (2001), p. 2.
22
responsible for the adequate treatment of interest rate risks in the banking book. Under Article 39a of the Austrian Banking Act, credit institutions must have effective systems and processes in place in order to assess their capital adequacy. Within banking groups, capital adequacy may be assessed at different levels.45 To estimate the impact of potential sudden and unexpected interest rate changes on capital,46 the methods and models used for calculating interest rate risk must be supplemented by the simulation of appropriate (stress) scenarios.
2.4.2 Standardized Interest Rate Shock
Under the reporting requirements for interest rate risk, Austrian credit institutions must communicate the impact of a standardized interest rate shock on their eligible capital. This report is used by banking supervisors to identify, among other things, outlier banks (i.e. banks with an increased interest rate risk in the banking book) and to introduce appropriate measures. The application of an interest rate shock that is standardized for all credit institutions ensures a uniform assessment of credit institutions risk and enables banking supervisors to compare risk across credit institutions.47 In the Basel paper on interest rate risk, the Basel Committee for Banking Supervision sets forth the general requirements for an appropriate standardized interest rate shock. An interest rate shock is presumed to trigger a sudden and unexpected change in money market and/or capital market rates. The scenario must be designed to reveal the effects of embedded options and of convexity within bank products.48 Article 69 paragraph 3 of the Austrian Banking Act currently de nes the standardized interest rate shock as a parallel upward or downward interest rate shift by 200 basis points. Supervisors are considering additional scenarios (1st or 99th percentile of one-year interest rate changes over an observation period of at least 5 years). Based on their ndings, the standardized interest rate risk shock may be adjusted in the future.
2.4.3 Denition and Treatment of Outlier Banks
Outlier banks are identied based on the impact the standardized interest rate shock has on their capital base. Credit institutions must disclose the corresponding ratio (% of eligible capital) in their reports.49 A credit institution is designated an outlier, i.e. found to carry excessive interest rate risk, if the given interest rate shock causes its capital base to
45
46
47 48 49
See Articles 39a paras 3 and 4 of the Austrian Banking Act; for further information on ICAAP application levels, please consult the guidelines on bank-wide risk management already published by the OeNB and FMA see OeNB/FMA (2006), p. 20ff. In this instance, capital is dened by Article 23 paragraph 14 Nos 1-6, and No 8, Austrian Banking Act (tier 1 capital plus tier II capital, less deduction items for equity interests pursuant to Article 23 paragraph 13 No 3/4 of the Austrian Banking Act). Prot brought forward can be counted toward eligible capital. See Grundke (2006), p. 288. See Basel Committee on Banking Supervision (2004b), Annex 3. See Reporting guidelines on the risk statement.
23
decline by more than 20%. In this event, the FMA must take measures pursuant to Article 69 paragraph 3 of the Austrian Banking Act. It should be noted here that supervisors generally take a broader perspective than that. In other words, a more than 20% decline in capital following an interest rate shock is not the sole criterion for introducing supervisory measures. The interest rate shock test basically produces an indication of excessive interest rate risk that alerts supervisors to the necessity of monitoring a given bank more closely. For instance, supervisors will check whether banks have paid due attention to interest rate risk in their integrated risk management activities and ICAAP reviews.50 Such reviews may, in fact, call for FMA action even if the capital base shrinks by less than 20%. However, each individual case will be assessed separately. If, in respect of outlier banks, it should subsequently emerge that the risks undertaken were not sufciently covered by capital or that the ICAAP processes were inadequate, the banking supervisors will introduce appropriate countermeasures. Article 136 of Directive 2006/48/EC lists a number of measures supervisors may take rapidly in the event of noncompliance with the directive (and, consequently, Pillar 2). These measures were transposed into Austrian legislation in Articles 70 paras 4 and 4a of the Austrian Banking Act. Essentially, the FMA has been empowered to impose specic capital charges if other measures provided for by the Banking Act do not appear adequate (Article 70 paragraph 4a of the Austrian Banking Act) especially if extra charges appear appropriate in view of the overall risk situation of a given credit institution. Likewise, the supervisors may require additional capital if other supervisory measures can only be implemented in the medium term. However, Article 70 paragraph 4a of the Austrian Banking Act may be invoked only if milder measures,51 specically instructions to remedy the situation (Article 70 paragraph 4 No 1 of the Austrian Banking Act), are not appropriate or remain ineffective.52 Basically, the FMA may take the following measures against outlier banks: The FMA will subject outlier banks to special supervisory monitoring. As a possible milder measure, the FMA can request outliers to explain their outlier status and to describe the remedial measures they intend to take (Article 70 paragraph 1 No 1 of the Austrian Banking Act). In particular, outliers must describe how they accounted for interest rate risk when calculating capital adequacy (ICAAP). The FMA can require credit institutions to enhance their interest rate risk management framework (regulations, processes, mechanisms and strategies). Credit institutions internal processes for assessing capital adequacy must capture and limit risks appropriately. If noncompliance with the Austrian Banking Act (Articles 39 and 39a) results in an inadequate limitation of a
50
51 52
Adequate risk allocation must be validated to the banking supervisor within the framework of supervisory monitoring especially if capital should decline by more than 20% owing to simulated unexpected uctuations in interest rates. See Article 2 paragraph 1 of the Administrative Enforcement Act. See explanatory notes on Article 70 paragraph 4a of the Austrian Banking Act (1558 d.B.XXII. GP).
24
banks or banking groups operational risks, the FMA may instruct the credit institution under Article 70 paragraph 4 No 1 of the Austrian Banking Act to restore statutory compliance within an adequate period of time on pain of penalties (e.g. a ne53). If statutory compliance is not restored within the stipulated period, the FMA will impose a penalty, or renew the instruction to remedy the situation subject to higher penalties. If the renewed instruction to remedy also remains ineffective, the FMA will request the given credit institution to reduce the risk. If the prescribed measures fail to reestablish adequate coverage and limitation of risks and to restore statutory compliance, the FMA may require the bank to hold more capital.54 However, this will only occur if other measures laid down in the Austrian Banking Act do not appear satisfactory and if the FMAs previous instructions remain ineffective. When imposing specic capital charges, the FMA must take into account quantitative and qualitative as well as time factors.55 The FMA may request banks to reduce their risks and hold more capital at the same time. Furthermore, the FMA may restrict credit institutions and banking groups in their scope of activity. The FMA is not obligated to impose the supervisory measures specied in Article 70 paragraphs 4 and 4a of the Austrian Banking Act in the order in which they are cited therein since, otherwise, it would need to limit or prohibit business operations before imposing additional capital requirements. The FMA will generally adopt the milder of available measures in order to ensure the restoration of statutory compliance. At any rate, banking supervisors may carry out an on-site inspection pursuant to Article 70 paragraph 1 No 3 of the Austrian Banking Act, for instance to determine the correct presentation of transactions or to monitor progress on the restoration of statutory compliance.
53 54
55
See Article 5 of the Administrative Enforcement Act. Up to a maximum of 150% of the total minimum capital requirements pursuant to Article 22 paragraph 1 of the Austrian Banking Act See explanatory notes on Article 70 paragraph 4a of the Austrian Banking Act (1558 d.B.XXII. GP).
25
3 Measuring and Managing Interest Rate Risk in the Banking Book
3.1 To Choose an Economic Value Perspective or an Earnings Perspective? Interest rate risk management involves a tradeoff between maximizing the interest rate books economic value, optimizing the yield/risk ratio and realizing the desired earnings. Moreover, interest rate risk is perceived differently under economic value considerations than when viewed from an earnings perspective. From an economic value perspective, for example, the coupon amount of an asset with a given maturity is not a relevant factor as adjustments are made on the basis of market value; hence the economic value would not differ in the nal analysis.56 Yet annual net interest income and thus the earnings result depend heavily on the level of the nominal interest rate.57 Figure 4 below illustrates the different perspectives by plotting the cash ow structure against the market performance for straight bonds and for oating rate notes.
Chart 4
Cash Flow and Market Performance of Straight Bonds and Floating Rate Notes
EUR 20
straight bonds
102
16
100
12 98 8 96
0 1 EUR 20 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
94 years 102
floating rate notes
16
100
12 98 8 96
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
cash flow (left-hand side) market value (right-hand side) Source: OeNB.
94 years
56 57
See Schierenbeck (2003a), p. 194. Adjustment is made partly via net income from the valuation of the securities portfolio.
26
Since, apart from valuation effects for marketable securities, economic value uctuations in the interest rate book do not have a direct and immediate effect on earnings from the perspective of commercial law, it is generally difcult in practice to establish economic value-based measures as the key interest rate risk management measures, at the neglect of earnings-based measures. The following sections examine the specic pros and cons of earnings-based and economic value-based instruments and ultimately present a modern yield/ risk-oriented management approach (integrated interest rate book management).58
3.1.1 Managing Interest Rate Risk from an Earnings Perspective
Given the high visibility of income gures, many credit institutions are guided by short-term earnings considerations in managing their interest rate book. A key difference between economic value analyses and income statements consists in how earnings effects are distributed over time. Unlike economic value calculations, income statements reect earnings accrued up to the underlying balance sheet date while providing only incomplete prot or loss reports of sorts, as effects beyond the balance sheet date are ignored. Due to the short observation period, however, there is a risk that while improving current earnings with relevant measures, credit institutions ignore the related economic value effects. Such an approach ultimately implies but that current earnings are managed to the detriment of earnings generated in subsequent periods. Since the effects of past maturity transformation decisions tend to span across several reporting periods, it is not possible to assess such decisions on a cost-causative basis in income statements. It should also be mentioned that the income statement may mask accounting effects such as the release of hidden reserves (or formation of hidden charges) as a result of which economic losses may be covered up temporarily or for good. Thus, a purely earnings-based perspective cannot fully satisfy the requirements of interest rate book management subject to yield/risk considerations.
Pros and cons of earnings perspectives:

Target measures reect the accrual of earnings effects over time and are compatible with the income statement. Transparency and acceptance of target measures is high; earnings measures have a strong signaling effect for external users. Potential effects beyond the projection horizon are not taken into account. Moreover, the income statement is highly malleable. Earnings performance can only be assessed to a limited extent from a yield/risk-related perspective.
3.1.2 Managing Interest Rate Risk from an Economic Value Perspective
Interest rate book management from an economic value perspective supplements the traditional earnings perspective with performance and risk target measures that may prompt management action. The economic value reects the aggregated effects of a change in market interest rates by discounting (inde58
See chapter 4, Integrated (Dual) Interest Rate Book Management.
27
pendent of accounting rules) all future cash ows. Thus, changes in relevant risk parameters are reected in the interest rate books economic value immediately. The risk exposure from an economic value perspective can be interpreted as a potential lead indicator for future earnings and may prompt management to change the cash ow structure accordingly. The economic value concept facilitates efcient interest rate risk management by making the earnings and risk situation more transparent. However, managing interest rate risk solely from an economic value perspective ignores the relevant accounting rules, which means that it does not reect the accrual of economic value effects over time in the income statement. From an economic value perspective, it is not relevant how the risk situation appears in individual periods: the earnings effects are disclosed in the form of aggregate risk gures and analyzed on the basis of those gures. Since in banking practice going concern analysis (within the framework of SREP) is based on balance sheet measures, the distribution of earnings effects over time is of great importance, however. Furthermore, it should be mentioned that the implementation of economic value perspectives requires the development of expertise in the competent organizational units.
Pros and cons of economic value perspectives:
Economic value perspectives facilitate integrated risk analysis. Performance is presented in an aggregated form. The ability to determine the interest rate books risk status at all times facilitates the management of the interest rate book on a yield/risk basis. Economic values provide a transparent view of the long-term effects of changes in market rates. The risk exposure from an economic value perspective can be considered as a potential lead indicator for negative earnings effects. Economic values can be rolled over into earnings measures to a limited extent only, as the economic value perspective ignores subperiods. The implementation of interest rate book management based on economic value considerations gives rise to a number of conceptual questions that can be answered only if adequate staff and technical resources are available.
3.1.3 Optimal Interest Rate Risk Management Strategies
In many credit institutions, the practice of interest rate book management is still focused on monitoring changes in earnings over time whereas calculating economic values, which reect the aggregate future effects of market interest rate changes, is frequently given short shrift. Obviously, the prevailing nancial reporting regime under the Austrian Commercial Code under which changes in economic value (unlike changes in net interest income) remain largely undisclosed because marking to market is rarely used provides a strong incentive for conducting earnings-based analyses.59 Yet over time, the increased use of international accounting standards (IFRS, U.S. GAAP) will
59
Market values (and economic values) only become relevant if a credit institution nds itself in a valuation situation, e.g. capital increase, disposal process.
28
strengthen the fair value approach (particularly via the exercise of fair value options60) as a risk analysis tool and thus further enhance the need for efcient and meaningful economic value analysis. Despite the economic superiority of the economic value concept, the earnings perspective should not be ignored, as a number of questions can only be answered when the earnings perspective is taken into consideration as well: How does the accrual of economic value effects appear in the earnings statement? What is the interplay between the two perspectives? What are the determinants for earnings performance? Which business strategies permit optimizing the yield/risk ratio, given specic earnings measures? How high are earnings when the net positions are liquidated? What is the earnings potential in a benchmark strategy selected on the basis of the economic value perspective? In banking practice, economic value and the earnings considerations often prompt fairly divergent paths of action. The following example is meant to highlight the differences over time:
Data Situation in the Base Period
Chart 5
Comparison of Pointers for Interest Rate Risk Management

% 5 4.47% 4 3.97% 3 2.89% 2
maturity spread
1.58%
0 1 2 3
year
transformation strategy
3-year retail loan at 4.47% 1-year renancing (1st year: 2.89%) amount: EUR 100,000
Comparison of Pointers for Interest Rate Risk Management current yield curve
t0 1st year 2st year 3st year 2.89% 3.97% 4.47% t1 5.50% 6.50% 7.50%
60
Pursuant to IAS 39.
29
A normal yield curve is assumed in the base period. In the example above, the credit institution transforms funds borrowed for one year into a three-year retail loan. The aim of this maturity transformation strategy is to earn a positive maturity premium. Table 2 shows the cash ow structure based on the underlying trend in interest rates:
Table 2
Performance Measured from an Economic Value Perspective transactions

cash ow of transactions 3-year retail loan at 4.47% 1-year renancing at 2.89% 1-year investment in t1 at an underlying rate of 5.50% 2-year renancing in t1 at an underlying rate of 6.50% income from an economic value perspective t=0 100,000 +100,000 0 0 t=1 +4,470 102,890 1,807 +98,094 2,133 t=2 + 4,470 +1,906 6,376 0 t=3 +104,470
104,470 0
An analysis of the earnings effect of activities in table 3 shows that increasing re nancing costs offset the positive transformation amount observed in the rst period (earnings effect in t1: +1.580) in the following periods (t2: 1.807; t3: 1.906). Whereas economic value calculations reveal the earnings effects of changes in market interest rates without a time lag (income from an economic value perspective in t1: 2.133), earnings-based reporting does not allow to assign future transformation losses on a cost-causative basis to the rst period although the negative earnings effects in successive periods were evidently triggered by transactions in the rst period. This example shows that earnings-based analysis on an annual basis can result in the mismanagement of interest rate risk. Only economic value-based analysis can ensure an integrated risk perspective that reveals the big picture.
Table 3
Performance Measured from an Earnings Perspective

earnings effect of activities 3-year retail loan at 4.47% 1-year renancing at 2.89% 1-year investment in t1 at an underlying rate of 5.50% 2-year renancing in t1 at an underlying rate of 6.50% income from an earnings perspective t=1 +4,470 2,890 t=2 +4,470 +99 6,376 1,807 t=3 +4,470 Total
+1,580
6,376 1,906
2,133
Although earnings-based analyses and economic value calculations generate identical results on balance, the results may prompt different paths of action at interim points (prot from an earnings perspective in t1: +1.580; loss from an economic value in t1: 2.133). Potential tradeoffs between the two perspectives can largely be resolved through integrated management approaches. Without doubt the optimal interest rate management strategy should include a combined analysis of performance measures from both an earnings and an economic value perspective.61 After all, the two approaches are
61
See Basel Committee on Banking Supervision (2004b), ref. 40.
30
not mutually exclusive but complement each other. Integrated interest rate book management can be considered as an essential cornerstone of successful interest rate risk management.62
3.2 Instruments for Quantifying Interest Rate Risks As for measuring interest rate risk in the banking book, there are many techniques and processes available that differ from each other in terms of complexity and accuracy. In this respect, the following principle applies: the larger and more complex interest rate risks in the banking book are, the more advanced the risk measurement and management processes of the credit institution concerned should be. Both earnings measures reecting net interest income earned in the given reporting period (earnings perspective) and net interest income measures for a given point in time such as the economic value of capital (or of the interest rate book)63 (economic value perspective) can be used as target measures for risk analysis. Whereas interest rate risk measurement from an earnings perspective focuses on analyzing changes in earnings in the current period that are induced by interest rate uctuations, economic value analyses reect all the effects of interest rate changes in an aggregated form.
Chart 6
Instruments/Methods for Quantifying Risk in the Banking Book

performance measured from an earnings perspective gap analysis simulation models earnings simulation elasticity analysis
Source: OeNB.
performance measured from an economic value perspective
economic value simulation value at risk
The instruments and methods for analyzing interest rate risk can basically be divided into two categories: instruments based on accounting-related earnings measures (elasticity analysis, earnings simulation) and economic valuerelated tools (economic value simulation, value at risk). A further differentiation can be made in terms of the nature and scale of the transactions covered. Whereas static simulations solely assess the cash ows from the banks current interest-sensitive positions, dynamic simulations also include the evolution of the balance sheet (through new business, customer behavior etc.). Using gap analysis and elasticity analysis to quantify the earnings effect produces broad-brush results which would need to be cross-checked with other methods. In practice, these techniques have already largely been replaced by simulation models.
62 63
See chapter 4, Integrated (Dual) Interest Rate Book Management. All interest-sensitive on and off balance positions in the banking book are included.
31
The basis for reliable interest rate risk measurement is the completeness, accuracy and timeliness of the underlying data. Data must reect the relevant characteristics of interest-sensitive positions as well as the cash ow structures of individual products such as the amount and frequency of interest cash ows, repricing proles, repayment modalities and embedded options (rights to accelerate repayment and to early redemption, interest rate ceilings and oors etc.). In banking practice, gap analysis data (net asset and liability positions per time band) are frequently used as input for further interest rate risk analysis (economic value simulation, value at risk).
3.2.1 Gap Analysis
Gap analysis refers to the allocation of interest-sensitive assets and liabilities, including off balance sheet (OBS) positions, to a number of prede ned time bands64 according to maturity (xed rate assets) or according to the remaining time to repricing (oating rate assets). To simplify the process, allocation is based on par or book values.65 Since numerous banks use gap analysis as a rst step in analyzing interest risk (from an economic value perspective), it is important that they model the cash ows arising from their transactions as accurately as possible66 to produce a meaningful breakdown of their interestsensitive positions by maturity/repricing dates. Accuracy is increased by augmenting the number of time bands (i.e. reducing the band-width). The number of time bands should be adjusted to the type of transaction (e.g. different currencies) and its complexity as well as to the resulting inherent risk. For instance, a credit institution with a high share of money market transactions will have to narrowly space its near-term time bands. By contrast, a credit institution with commitments primarily in medium- to long-term time bucket will put the main emphasis on medium- to long-term time bands when depicting maturities.
3.2.1.1. Calculation of Earnings Effects
Traditional gap analysis is one of the oldest instruments used to measure banks near-term risk exposure from an earnings perspective. As a rule, gap analysis reports are restricted to a one-year horizon. To calculate the earnings effects, liabilities are subtracted from the corresponding assets in each time band to produce an interest rate gap for that band. This gap is used to estimate the effects on earnings. In the case of a short net position (total assets > total liabilities), for instance, a decrease in market interest rates implies a decrease in net interest income. Conversely, rising interest rates would drive up earnings in such case. The intensity of the change in net interest income as a result of changes in market interest rates depends on the net position. For every time band, the expected change in net interest income the earnings effect is calculated by multiplying the gap by the de ned interest rate scenario. Gap analy64
65
66
Noninterest rate sensitive positions can also be included using cash ow assumptions. See subsection 4.2.3, Noninterest Rate Sensitive Positions. Within the framework of interest rate statistics, simplied gap analysis (reporting transactions at book values) is used to depict interest rate risk. See section 4.2, Cash Flow Modeling.
32
sis, however, can only roughly capture interest rate risk, assuming a simple parallel shift in the yield curve (based on the current balance sheet structure).
Chart 7
Net Positions and their Earnings Profile

rising interest rates net asset positions net liability positions
Source: OeNB.
falling interest rates risk opportunity
opportunity risk
The following points of criticism relating to gap analysis are relevant:67
If oating positions do not react to changes in market interest rates in the way assumed,68 the assessment of the interest rate risk position will be incorrect. Risk can be quantied properly only if the average oating rate of risk positions is subject to the same uctuations as the market interest rate. Moreover, average interest rates of oating assets and liabilities are assumed to react in synch to changes in market interest rates. These assumptions are in sharp contradiction to reality, as the interest rate sensitivities of different oating balance sheet positions have a considerable impact on a credit institutions risk prole in practice. A further weakness lies in the static approach, i.e. the fact that gap analysis does not take account of the evolution of the balance sheet (through changing customer behavior, new business activities, etc). Earnings effects arising from the imperfect correlation of earned and paid interest rates (basis risk) and embedded options are depicted and quantied inappropriately. The static approach assumes that xed positions are not subject to interest rate risk outside the observation period. Indirect earnings effects that arise from changes in portfolio market values are not included because valuation rules are not taken into account in risk analysis.
3.2.1.2. Calculation of Economic Value Effects
Gap analysis also facilitates the analysis of the effects of interest rate changes on the economic value of the interest rate book (and the economic value of capital). Analysis from an economic value perspective is based on the determination of the cash ow structure of individual transactions and the subsequent mapping of cash ows onto the gap analysis time bands. The accuracy of this calculation can be improved by augmenting the number of time bands. Sensitivity factors assigned to each time band (modied duration, key rates, basis
67
68
The aforementioned points of criticism do not relate to gap analysis in general but to the method of calculating earnings effects based on gap analysis. All positions in this section are understood as having oating rates or as being locked into indenite periods of the rate.
33
point value) are used to estimate value effects.69 Zero bond discounting factors can also be used for a more accurate estimation of economic value effects.70
3.2.2 Simulation Models
Simulation approaches are used to map balance sheet and income statement developments based on various external and corporate scenarios. Simulation processes help analyze the potential effects of interest rate changes on current earnings (earnings perspective) and on the economic value of a credit institution (economic value perspective). The main difference between the two methods is that economic value-based simulation includes all future cash ows that are currently known whereas earnings-based simulation reects only cash ows within the observation period. Simulation models facilitate risk exposure calculations with a very high degree of accuracy and exibility, even for very complex portfolios. There are static and dynamic simulations. The latter also reect the potential (likely) evolution of the balance sheet (changes in banks business activity, customer behavior etc.), capturing the dynamic character of the bank balance sheet. Simulation methods lend themselves particularly well to earnings-based analyses, given the near-term horizon of the latter. An essential prerequisite for the implementation of dynamic simulation models is to have mastered static analysis. The future bank balance sheet depends on a number of factors that are both intrinsic to credit institutions (future pricing policy, expiry effects etc.) and extrinsic to them (competitive situation, macroeconomic development, customer-related factors, changes in market interest rates etc). One asset of dynamic simulation is that it strengthens banks decision-making basis for managing interest rate risk by opening up new perspectives. Through dynamic simulation, credit institutions decision-makers obtain a comprehensive picture of the expected earnings and risks arising from cash ows from the banks on and off balance sheet positions.
Chart 8
How Simulation Models Work

market data scenarios balance sheet evolution scenarios retail behavior models control measures
simulation
target measures
economic value of interest rate book
target measures current value Chance losses
derivation of control measures
risk Return
Source: OeNB.
69 70
The aforementioned sensitivity measures are subjected to a brief SWOT analysis in subsection 4.3.2.2. This approach basically corresponds to a simulation of net economic value; see subsection 3.2.2.2 Simulation of Economic value.
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3.2.2.1. Dynamic Simulation of Earnings
The development of net interest income depends on two key factors: the interest rate component as such (average return on portfolios, interest rate sensitivity of oating rate transactions, changes in the yield curve etc.) and the so-called structural component71 (evolution of the balance sheet structure, pricing policy for new and renewed business activities etc.).72 To map these components, banks need to design dynamic, forward-looking earnings simulation models. To specify expected (likely) external and corporate scenarios, credit institutions can use empirically estimated regularities, balance sheet evolution forecasts, target de nitions or other behavioral assumptions. The basic prerequisite for risk analysis to yield meaningful results is a sound cause-effect relationship between the outcomes of individual scenarios and the underlying assumptions.73 (Dynamic) simulation models basically help analyze the effects of economic decisions and derive specic recommendations for action by way of what-if analyses. Essentially, dynamic earnings simulation extrapolates the balance sheet over the future projection horizon using different scenarios, namely: market data scenarios balance sheet evolution scenarios retail behavior models Market data scenarios: Market data scenarios may refer to interest rate scenarios for specic reference dates or to entire probability distributions of future yield curve scenarios, which are statistically generated by a forecasting model (e.g. Monte Carlo simulation). As a rule, this exercise should entail a manageable and diversied selection of scenarios. Balance sheet evolution scenarios: With regard to the evolution of the balance sheet, credit institutions translate strategic management goals into volume forecasts for each individual balance sheet position. Specically, they de ne the characteristics of new activities/products (e.g. volumes, repricing prole, type of coupon etc.) including the rules governing pricing adjustments (interest rate elasticities, maturity margins etc.). Volume forecasts (and forecasts of selected balance sheet items) can also be derived through univariate and/or multivariate analytical methods.74 Furthermore, balance sheet evolution scenarios need to reect assumptions regarding the development in market interest rates, a strategic reorientation of business or the competitive situation. Retail behavior models: Ultimately, credit institutions also need to model adequate retail behavior for every combination of market data or balance sheet evolution scenarios. The aim of these models is to estimate the structural changes in the balance sheet that are induced by the assumed market data
71 72
73
74
Also referred to as the dynamic component. Adding noninterest-rate sensitive income components (net fee-based income, valuation effects etc.) is relatively simple. Firm cause-effect relationships enable a step-by-step analysis of how different shifts in the balance sheet structure affect interest rate risk. To estimate portfolio performance, time series analyses, correlation analyses, or regression techniques are used.
35
scenario and the underlying corporate strategy. In this respect, credit institutions must reconcile three factors: the targeted balance sheet structure, the retail behavior to be expected in light of the interest rate development, and managements initial response. Adequate mapping of retail behavior allows banks to analyze the interplay between the development of market interest rates, the balance sheet structure and retail behavior. Potential interest rate risk is derived from the difference between the simulated and planned earnings measure in the baseline scenario.75 The simulation model renders earnings effects transparent for all scenarios. The model can be expanded at all times to include the analysis of both depreciation and valuation risks. (Dynamic) simulation enables banks to check different market scenarios and balance sheet evolution scenarios (including control measures) for their risk-bearing capacity from an earnings perspective.
The following points of criticism relating to earnings simulation models are relevant:
The meaningfulness of simulation model outcomes depends crucially on the quality of the underlying data, i.e. on whether the available data and assumptions made about new business development, the evolution of the balance sheet and future pricing policies are valid and accurate enough. To avoid inaccurate risk analyses, credit institutions should always validate the predictive quality of their models. The longer the observation period, the greater the potential inaccuracies in the risk analysis. The share of existing business to new business decreases over time, thus depressing the quality of analysis. The simulation of earnings is therefore appropriate for estimating near and medium-term earnings effects. Predictive models need to reect cause-and-effect relationships as accurately as possible. It is therefore crucial to analyze and calculate the causal correlations between factors, and to map the interactive relations between the different scenarios in a realistic way. Thus, banks also need to have the relevant expertise and resources to empirically measure these correlations.
3.2.2.2. Simulation of Economic Value
Economic value is established with a liquidity analysis, i.e. by discounting all future cash inows and outows on the cutoff date of the analysis, independent of any accounting rules. The economic value thus obtained indicates the asset value that credit institutions might realize in their interest-sensitive business (on and off balance sheet) by unwinding all positions (calculation via zero bond discounting factors): ZBDFi).
75
The baseline scenario denes, for instance, earnings measures that can be generated at constant market interest rates.
36
Chart 9
How to Calculate Economic Value
t0
t1
ZBDF1
t2
ZBDF2
t3
ZBDF3
t4
ZBDF4
economic value =
Source: OeNB.
t=1
CFt ZBDFt
The four factors that affect economic value are: cash ow, the discount rate, the method of calculating interest76 and the method of calculating interest days.77 Economic value can be calculated by duplicating cash ows via offsetting money market and capital market transactions. Offsetting transactions to unwind all positions are based (exclusively) on the yield curve prevailing at the time of observation. Alternatively, economic value may be calculated using yield curve-specic (zero bond) discounting factors or zero rates. Zero bond discounting factors can be derived on an arbitrage-free basis using current money market and capital market rates (synthetic construction) or, sequentially, using previous years cumulated zero bond discounting factors.78 For the valuation of credit risk-exposed positions (retail loans, corporate loans etc.), credit institutions must also take debtors credit risk into consideration. The economic value of these positions is determined by adding a risk-free money market and capital market yield curve (interest rate risk) to the individual change in credit quality rating (credit spread risk).79 Credit institutions can isolate the two earnings components by using two different yield curves: one that matches the credit quality rating and one that is credit risk-free. Cash spreads can be inferred from the difference. Earnings can also be segregated by cause, provided banks have data on the risk-free maturity-adequate coupons and on the credit spreads. Credit spreads can be derived on the basis of empirical data or model theory approaches.80 Interest rate exposure arises from uctuations in the economic value of the interest rate book (and capital81) owing to changes in interest rates. Although changes in market interest rates affect a banks asset positions in the same way
76 77
78 79
80 81
In principle, a distinction can be made between continuous and discrete compounding. The methods of calculating interest days are indicated by an oblique stroke whereby the day count for the number of days within a month is specied in front of the oblique stroke and the day count for the number of days within a year is specied behind the stroke. See Schierenbeck (2003a), p. 168ff. The credit spread is the difference between the yield of a credit risk-exposed position and the yield of a credit risk-free position with matching maturities. See Betz (2005), p. 46ff. For noninterest rate-sensitive balance sheet positions, credit institutions must make assumptions that lead to valuation and earnings management decisions dependent on market interest rates.
37
as they affect liability positions, they have an opposite effect on its earnings. As interest rates rise (fall), the economic values of these asset and liability positions fall (rise), generating a negative (positive) earnings effect on the assets side and a positive (negative) earnings effect on the liabilities side. In economic value simulations, the cash ows from a banks interest rate-sensitive positions are initially valued on the basis of the current yield curve. The yield curve is then shifted in line with the de ned interest rate scenarios, and the economic value is recalculated. The difference between the two sets of economic values reects the sensitivity of the interest rate portfolio in relation to changes in market interest rates. In addition to ad-hoc shifts in the yield curve, which take effect immediately on the prevailing reference date, changes in the yield curve can also be analyzed at a specic projected point in time.82 In the latter case, credit institutions must take three aspects into account: First, the shortening in the residual maturity gives rise to price effects. Second, cash ows payable or receivable by the forecast date are compounded and, third, cash ows arising on the forecast day itself are included in the calculation of the projected economic value ( nal value) on a risk-neutral basis. When these conditions are applied, changes in risk parameters are reected in the economic value of the interest rate book without a time lag. Simulations of economic value make it possible to analyze the principal types of interest rate risk (repricing risk, yield curve risk, basis risk and optionality risk).83 The sensitivity of economic value can be calculated on the basis of the most diverse interest rate scenarios. When designing scenarios, credit institutions must include both favorable and unfavorable interest rate trends (worst case, best case) and assume a low-occurrence probability for the worst case scenarios (or stress scenarios). The standard scenario should also include a gradation comprising an upper, middle and lower uctuation band. Moreover, it should be possible to specically model the yield curve at each data point within the projection horizon so as to be able to simulate any change in the yield curve, including nonparallel shifts such as yield curve twists and bends. As with earnings-based simulations, the integration of dynamic effects into economic value simulation is subject to a number of limitations.
3.2.3 Elasticity Analysis
Elasticity analysis is used to assess the interest rate risk that arises from interest rate uctuations of oating rate positions. Since xed rate transactions (elasticity = 0) do not react to changes in market interest rates, the overall earnings effect, unlike in a gap analysis scenario, only stems from oating rate transactions (elasticity > 0). The economic correlation between the change in product-specic interest rates in line with market interest rate uctuations is described by repricing elasticity. As simple differential quotients84 do not provide reliable elasticity values, regression analysis techniques are widely used to calculate repricing elasticity.
82 83
84
As a rule, projection horizons of up to one year are analyzed. The prerequisite for this is that the cash ow structure of products (particularly, that of positions with unreliable cash ows) is mapped as exactly as possible. Repricing elasticity = position interest rateT / market interest rateT
38
A key feature of elasticity analysis is the calculation of appropriate explanatory reference interest rates per transaction item (or transaction type). Regression analysis facilitates the calculation of elasticity values and their predictive quality on the basis of the historical time series of both position and market interest rates. Depending on the goodness of t, either the money market or the capital market rate will be selected as reference interest rate (explanatory variable). The slope parameters of the regression line correspond to the desired elasticity. Credit institutions can considerably improve elasticity estimates by taking into account repricing lags. Lag effects are identiable by elasticity diagrams.85 These effects are included in the calculation by shifting the position rate time series until a maximum goodness of t is reached.86 In addition to these lag effects, further factors such as the direction of interest rate changes can be inserted into the elasticity calculation methodology. This multivariate elasticity analysis provides interest rate time-dependent regression functions that are used depending on the interest rate regime. Different static test methods and ratios (goodness of t, F statistic, standard error of estimation etc.) can be used to describe the quality of the interest rate elasticity calculations.87 The static elasticity approach can be converted into a dynamic analysis by adding both xed rate and structural effects. Integrating these effects largely removes the main constraints of the static balance approach. One of the key characteristics of the dynamic elasticity balance is that the different factors determining net interest income are analyzed and shown separately. In this guideline, the description of dynamic effects starts with the xed interest rate effect of transactions, which is broken down further into an ex post effect and an elasticity effect. The ex post effect characterizes the interest rate change already determined in the observation period in respect of positions coming up for renewal as the difference between the market interest rate at the time of observation and the retail pricing originally contracted. As with oating rate positions, the elasticity effect in xed rate business describes the potential change in new business interest rates at the time of observation depending on the market interest rate scenario predicted. The effect of structural changes in the balance sheet on net interest income and/or in net elasticity can be integrated as a second dynamic factor in risk measurement. Potential effects on the net interest income in future periods are analyzed on the basis of various external and corporate scenarios (evolution of the balance sheet, new retail behavior etc.).88 The so-called balance elasticity arises from the volume-weighted aggregation of the relevant product elasticities. Net elasticity is obtained by subtracting average liability interest rate elasticities from average asset elasticities. Net elasticity is positive if assets react more strongly to changes in market interest rates than liabilities. Negative net elasticity describes the reverse case. The
85
86
87 88
In the elasticity diagram, the combination points of each successive point in time are linked with each other by lines, see Schwanitz (1996), p. 62ff. Real repricing behavior can also be tracked by a differential equation of the rst order, see Schwanitz (1996), p. 152. Backhaus et al. (2003), p. 52ff. This generates projected earnings (forecast of net interest income) for future periods.
39
ensuing change in earnings is derived from the multiplication of net elasticity by an assumed (parallel) shift in the yield curve of 1%. The balance elasticity is a yardstick for the sensitivity of every item to changes in reference interest rates: falling (rising) interest rates depress earnings in the case of net asset (liability) elasticity. Net interest income can be immunized against interest rate changes by achieving a balanced elasticity.
Chart 10
Overview of Net Elasticities

rising interest rates positive net elasticity negative net elasticity
Source: OeNB.
falling interest rates risk opportunity
opportunity risk
The following points of criticism relating to elasticity analysis are relevant:
The economic correlation (interest rate elasticity) between market interest rates and position rates is subject to structural changes over time. The challenge in calculating elasticity is identifying given structural breaks. To work in practice, the empirically calculated elasticities must be stable over time, which is why credit institutions must validate model quality on an ongoing basis. With regard to forecasting new xed rate positions that reect long-term capital market rates to some extent, linking position rates to a single (money) market rate will skew the risk forecast. Since elasticity analysis is as a rule based on the assumption that position and market rates are moving in the same direction, a yield curve twist will produce inaccurate results.89 The regression model assumes a linear correlation between the market rate trend and the position rate trend. Yet products with optional components (caps, oors, etc.), often have a nonlinear correlation (kinked elasticity curve90), as a result of which the resulting balance elasticity will be inaccurate. Elasticity analysis limits the observation horizon to near and medium-term earnings effects and thus does not capture valuation effects from the securities portfolio (indirect market value effects). For a multiperiod (dynamic) perspective, credit institutions must make assumptions about the evolution of their balance sheet and business strategy (structural shifts, renewal of expiring xed rate transactions, retail behavior, change in elasticity values etc.); these assumptions are, of course, subject to forecasting uncertainty.
89 90
Largely for products of which the interest rates are based on several market interest rates. See Schwanitz (1996), p. 158.
40
4 Integrated (Dual) Management of the Interest Rate Book
Aggregate interest-related earnings consist of several components which economic value calculations and earnings-based analyses will fail to reect comprehensively if used on a standalone basis. While both tools will generate identical results for the aggregate period, given the aggregate mutual identity of the two frameworks, they may prompt different paths of action in individual subperiods. Therefore it is essential to instal integrated interest rate book management processes that make it possible to join the two perspectives. Integrated analysis is based on a yield/risk-oriented economic value perspective, which is supplemented by traditional earnings-based considerations. The prime objective of dual interest rate book management is to optimize the increase in value of cash ows from a banks interest rate-sensitive positions by organizing cash ows efciently. Strategies should be selected in a way such that the highest possible increase in economic value is achievable provided specic ancillary requirements are met. In addition to maximizing economic value subject to risk considerations, the dual interest rate book management system must ensure that banks generate the operationally necessary minimum net interest income, meet regulatory requirements (analysis of risk-bearing capacity91) at all times and generate a given net income with securities portfolios. A further requirement is to monitor performance from an economic value perspective in future earnings periods (via simulation calculations and transfers of earnings). The function of integrated interest rate book management is to maximize the ratio of performance and risk subjects to the constraints of both earnings and regulatory perspectives.
Chart 11
Requirements for Integrated Interest Rate Book Management

guarantee of the net income requirement (minimum net interest income)
monitoring net income generated by the valuation of securities portfolio assets
requirements for integrated interest rate book management aim: to optimize the yield/risk ratio
monitoring performance from an economic value perspective in future earnings periods
limitation of interest rate risk: analysis of risk-bearing capacity

Source: OeNB.
91
Maximum risk capital can be inferred from the credit institutions risk-bearing capacity. See OeNB/ FMA (2006).
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Chart 12
Process of Integrated Interest Rate Book Management92

2. modeling cash flows
1. definition of the risk strategy
Asset-LiabilityManagement
5. ex post analysis
3. yield/risk anlaysis
Source: OeNB.
4. control measures
92 This process relies heavily on asset-liability management (ALM), which is the supreme management system for optimizing a credit institutions return on capital (RoC) in relation to the risks it has undertaken. The idea of ALM is to cover the interest-sensitive business units of a bank in their entirety, subject to the paramount objective of integrated (bank-wide) risk management. Thus, individual units should not be able to go ahead with measures in their jurisdiction irrespective of their broader implications. Ultimately, any action taken should improve the overall tradeoff between RoC and overall risk. ALM basically epitomizes a higher rationality than that prevailing in a credit institutions individual units. The purpose of ALM is to coordinate decisions taken by individual units and to optimize the credit institutions nancial situation through concerted action. Without effective ALM, a bank runs the risk that, even when all units take rational decisions in their own specic areas, its aggregate earnings/risk prole may run counter to the wishes and ideas of the banks management and/or owners; therefore decisions should be optimized from a bank-wide perspective. Integration and coordination, planning and a holistic approach are thus of supreme importance, with ALM serving as the key interface.
Tasks Performed by ALM
ALM should be structured as a process that essentially reects the qualitative requirements stipulated by the Basel Committee for the effective management of interest rate risk. This process comprises the following tasks:93 a clear de nition of risk policy a consolidated coverage of risk the establishment of sound risk measurement processes that are commensurate with the scale and complexity of the activities of the bank concerned
92 93
In accordance with OeNB/FMA (2006), p. 76 See 2.1.3, Principles of Managing Interest Rate Risk The Basel Paper on Interest Rate Risk.
42
the design of a system of interest rate risk limits that takes account of riskbearing capacity the performance of stress tests a clear segregation of functions (particularly between risk-assuming and risk-monitoring units) the preparation of meaningful reports by an independent control unit the establishment of a clearly structured procedure for introducing new activities. A well-implemented ALM system must pay adequate attention to each of these aspects de ned in detail in the Basel paper. If individual elements of the list above were systematically ignored when implementing ALM, this would qualify as an infringement of Article 39 of the Austrian Banking Act (due diligence obligations of a credit institutions senior management). Credit institutions must assess whether their risk measurement methodologies, limit systems, stress tests, reporting processes etc. are sound, taking due consideration of the principle of proportionality. At the same time, every credit institution must make provisions that all the components of effective interest rate risk management described by the Basel paper are available in an adequate and structured way and are implemented appropriately.
Organizational Integration of Asset-Liability Management
ALM should basically be seen as a closed control circuit connecting the various divisions (Accounts, Controlling, Lending, Treasury etc.) that requires effective communication channels and feedback loops. ALM decisions and their implementation, accompanying control measures, performance measurement, a presentation of RoC and capital risk targets achieved, as well as feedback in the form of meaningful reports to ALM are all essential stages in this process, which should be gap-free. Forecasts about future business developments and interest rate expectations give rise to ALM decisions that should be implemented. Credit institutions must monitor implementation to check whether it was carried adequately and, last but not least, must evaluate the measures adopted on an ex post basis in terms of their cost-effectiveness. This may prompt corresponding corrections in future forecasts. ALM must include many items of planning data (market data, product data etc.), and its decisions affect the most diverse bank divisions: Controlling, Accounting Budgeting Interest Rate Risk Management Liquidity Planning Product Design and Calculation Treasury Capital Planning Data and Information Flow, IT Owing to the complexity of these tasks, the way in which ALM is integrated into a credit institutions structural organization is crucially important. Above all, it is essential that ALM managers have line responsibility, as this is the only way to ensure that the adopted measures take effect and are implemented in good time.
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ALM Committee
Banks beyond a certain size typically set up an ALM Committee (frequently known as ALCO for short) as the highest coordination body. While ALCO only serves to draw up decisions at most banks, at others its remit goes as far as taking management decisions. The number of committee members depends on the size of the bank. At all events, Treasury, Risk Management and Accounting, together with their competent business managers, generally participate in ALCO meetings, as often do representatives from the Loans and Deposits marketing units (loans, savings products etc.). Another important issue is the question of aligning accounting perspectives with business considerations; after all, all management decisions will ultimately affect corporate nances. This is why Accounting has a permanent representative on the ALM Committee as a rule. This member basically personies accounting logic, whereas Risk Management and Treasury represent economic rationality. What would be a problem is if ALCO were to discuss every measure exclusively from an accounting perspective. Accounting experts will naturally focus on earnings-related matters rather than on economic value effects, with the exception of depreciation effects. In other words, Accounting generally takes economic value effects into consideration only insofar as they affect earnings in line with the valuation principle of imparity. While undoubtedly representing a key aspect, this perspective does not by a long way depict a credit institutions overall risk situation comprehensively. It is therefore very important that the arguments of all ALCO members receive the same weight and are weighed up against each other with due consideration. According to Hegel,94 the whole is truth and, in this sense, prudent business managers should always maintain the interests of the whole. ALCO should not meet too frequently, to avoid that forecasts and measures are changed too frequently in the ALM process. Neither should it meet too infrequently, though, to avoid delayed reactions to major market developments. Monthly intervals, as adopted by many credit institutions, would appear to be a reasonable frequency. Basically, ALCO de nes the banks paramount risk policies and interest rate expectations and approves the structure of limits. Meaningful minutes of ALCO meetings are of the essence, as is transparent and clear documentation of all measures adopted within the framework of the management process. Frequently, ALCO decisions are recorded in great detail whereas the implementation of these decisions is not further documented.
Prot Centers and the Market Interest Rate Method
Moreover, asset and liability management paves the way for sound prot center accounting, which reveals the contributions individual units make to earnings. Banks basically engage in lending and deposit-taking which makes the contribution of lending and deposit units dependent on the correspondent margin on assets. And banks do Treasury business with the Treasury serving as a central coordination function that generates a structural contribution by carrying out maturity transformation activities in line with banks interest rate
94
See Hegel (1970), p. 24.
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forecasts. For this purpose, most credit institutions today rely on the so-called market interest rate method. The market interest rate method makes it possible to neatly split the net interest margin into two components derived from pricing policy (for loans and deposits) and from maturity transformation. The difference between the overall net interest margin and the pricing contribution is the structural contribution. This is the contribution generated by the banks interest rate policy, with some interest rate gaps set specically with a view to beneting from expected changes in market rates. A precondition for applying the market interest rate method is that all activities are valued on the basis of the market rates prevailing for specic periods. The structural contribution depends on the scale of structural imbalances (interest rate gaps), the uctuation in the interest rate level and the yield curve situation. A key requirement for this valuation procedure is that a so-called market interest rate framework is established, in which all types of the banks activities are listed and a corresponding money market or capital market interest rate is allocated to each type.
Chart 13
Breakdown of Earnings by Cause under Market Interest Rate Method

retail lending rate pricing contribution (lending) market (risk-taking) unit money market & capital market structural contribution
management of interest rate risk optimization of yield/risk ratio
opportunity interest rate
Treasury
opportunity interest rate market (risk-taking) unit
money market & capital market

Source: OeNB.
pricing contribution (deposits) retail deposit rate
The market interest rate framework must be documented in a way transparent to third parties, preferably in a risk management manual. This document must also indicate, among other things, how nonmaturing assets and liabilities (see 4.2.1.2), are presented, since such products are typically assigned to a range of interest rate bands.95 Usually, the Risk Management function is responsible for establishing the market interest rate framework, maintaining a data basis on market interest rates, determining cash ow assumptions and implementing the framework in practice. Risk Management also has to ensure that the earnings results thus established are communicated to ALCO in a meaningful manner. In connection with the cash ow assumptions made for nonmaturing assets and liabilities, credit institutions must ensure that these products will be treated consistently throughout the risk measurement frame95
See subsection 4.2.1, Retail Transactions.
45
work, the market interest rate framework as well as in the interest rate risk statistics to be reported to the OeNB. The market interest rate method is a widely accepted standard today that is essential for analyzing net interest income and for accurate prot center accounting. It should therefore be carried out as a matter of routine by every banks Risk Management.
4.1 Denition of the Risk Strategy Each bank will have specic risk policies, which are ideally formalized in a central framework of risk strategies. These risk strategies de ne a banks fundamental risk propensity, which is in turn reected in the choice of appropriate benchmarks, the de nition of business segments and products, the allocation of risk capital to individual segments and the de nition of a limit structure that is suitable for balancing the undertaken risks with the allocated risk capital. All these elements are an integral part of ICAAP, which every credit institution must mandatorily carry out under the latest amendment to the Austrian Banking Act. The OeNB und the FMA have issued separate guidelines on how to structure this process.96
4.1.1 Denition of Benchmarks
Benchmarks can be used in interest rate risk management as a basis for taking decisions, evaluating performance, or setting limits. The interest rate books performance can be evaluated by comparing data with a market trend that is considered to be representative. Benchmarks also reect certain earnings expectations and risk perceptions.
Benchmark Requirements
Benchmarks may not be de ned randomly but should satisfy certain criteria: 1. Benchmarks should be easily understood and serve as a transparent yardstick; i.e. it should be possible to actually buy or replicate the benchmark instrument at low cost. 2. It should be possible to test the performance of the benchmark in the market at all times. 3. Repricings should be carried out only in exceptional cases (consistency of the benchmark over time). 4. Benchmarks should constitute an efcient investment opportunity from a yield/risk perspective. To be a meaningful tool, a benchmark must be precisely de ned, transparent and controllable. The requirement for consistency over time is not met in the case of a one-off investment in a specic maturity (e.g. 10-year bond), since the risk of the investment decreases as the residual maturity shortens. A benchmark must, moreover, be efcient from a yield/risk perspective. A benchmark is considered efcient if no other strategy generates a better interest rate book performance for the same risk or has a lower risk for the same performance. Efciency analyses will help divide efcient from inefcient benchmarks.
96
OeNB/FMA (2006).
46
Overview of Potential Benchmarks
Investment opportunities that meet the aforementioned criteria include:97 moving averages or a mix of moving averages investment rules derived from moving averages, which are re nanced in part or in full by moving averages of another maturity pensions indices In addition to standardized benchmarks (pensions indices), benchmarks can also be constructed on a customized basis. A simple benchmark that is frequently used in the management of interest rate risk is the moving average. Unlike pensions indices, moving averages have a constant cash ow structure and a constant residual maturity. The cash ow structure reects revolving investments with identical capital tranches.98 The cash ow structure (share of interest and principal) may be derived from historical interest rates. Credit institutions must undertake corresponding adjustments to ensure that the economic value of the benchmark cash ow corresponds to the economic value of the interest rate book. Benchmarks can be conceived by combining underlying cash ows (moving averages) with additional borrowings. For instance, the combination of 2 x 5 1 means that the volume already invested in the 5-year moving annual investment is doubled by an additional borrowing (1-year maturity). This is what is called a leveraged structure. In addition to dedicated reference portfolios, generally accessible stock exchange indices are also used as benchmarks. The replication of real market indices entails high transaction costs owing to frequent repricings. This is why synthetic indices (e.g. REX-P), with the advantage of a constant residual maturity, have been established. In choosing an appropriate benchmark, it is helpful to consider a number of questions against the backdrop of the credit institutions risk policy principles: What interest rate risk is the credit institution willing and able to bear (analysis of risk-bearing capacity, supervisory limits)? Which cash ow pro le matches the credit institutions earnings and risk preferences? Are potential earnings effects of the selected benchmark sustainable? Which benchmarks have been found efcient in yield/risk analysis?
4.1.2 Denition of Interest Rate Risk Management Philosophy
A fundamental management decision to be taken under economic value considerations concerns the choice of management philosophy. Should the interest rate book be managed passively on a benchmark-oriented basis, or should it be managed actively in line with the credit institutions own interest rate forecasts? Passive management means tracking aggregate cash ow independently of short-term market expectations for an efcient benchmark. The underlying idea is to align the yield/risk ratio of the economic value with the market trend, assuming that the capital market works efciently. Liability management may not be equated with inactivity or passivity. Much rather, it takes
97 98
See Drosdzol (2005), p. 190ff. See Figure 22: Moving Average.
47
recurrent money market and capital market transactions to align the actual interest rate book cash ow consistently. Keeping the benchmark exactly aligned is, however, not always advisable in actual fact in the light of fresh conditions, strategic repositionings, high transaction costs or periodic reporting requirements. This is why credit institutions have developed semiactive asset management approaches. In essence, a semiactive strategy is based on keeping the cash ow aligned with a given benchmark prole while permitting divergences within de ned limits to retain a scope for action in certain interest rate periods. Active management means managing the cash ow structure on the basis of the credit institutions own interest rate expectations, deliberately diverging from the neutral benchmark in view of anticipated additional earnings. The success of strategically positioning the interest rate book depends on how well the bank can predict future interest rates. An active management approach is recommended if a credit institution has typically formed its interest rate expectations and forecast interest rate movements accurately enough to outperform the benchmark investments yield/risk ratio. As a rule, this management approach entails higher transaction costs and more extensive resource requirements than passive management.
4.1.3 Interest Rate Risk Limits
The ALM Committee de nes the credit institutions supreme risk policy and approves the limit structure. It is important that interest rate risk limits together with limits for other sources of risks (particularly for credit risk and operational risk) are adequately reected in the credit institutions overall risk-bearing capacity report. Potential losses incurred owing to the limit structure must be offset by the banks underlying assets. As regards the structure of an adequate risk-bearing capacity report, please see the guidelines on integrated risk management, in which all the related aspects are described in detail.99 Different banks may impose different types of limits; what is important is that the limits are commensurate to the scale, complexity and inherent risk of the banks activities. Limits range from value-at-risk limits to simple aggregate economic value limits based on the Basel requirements. Inside the spectrum, banks may, among others, apply volume limits (e.g. in the form of limits on individual interest rate gaps) or sensitivity limits (e.g. duration limits for subportfolios or gamma limits for individual option books). Banks are free to design their limit systems provided the principle of proportionality is ensured; this must be specically assessed in each individual case. The limit system should be compatible with the measurement methodologies used in the bank and limit the scale of both potential changes in earnings and changes in the economic value of capital, which can arise owing to unfavorable market developments. In addition, the limit system must be based on various different market scenarios. Moreover, credit institutions must include extremely unlikely market developments (stress scenarios) when de ning limits. The limit system as a whole must be documented transparently, ideally in the
99
See OeNB/FMA (2006).
48
risk management manual. Risk Management should monitor compliance with limits on a regular and timely basis. Furthermore, processes of noncompliance with limits must be de ned and documented precisely. It should be recalled here that banking supervisors will take appropriate action in the event of credit institutions exceeding the 20% threshold (outlier banks). Article 69 paragraph 3 of the Austrian Banking Act de nes this case unambiguously: The FMA must take measures in the case of credit institutions whose economic value declines by more than 20% of their own funds as a result of a sudden and unexpected change in interest rates, the size of which is to be prescribed by the FMA and must not differ between credit institutions.100,101
4.1.4 Product Innovation Process
Another key function of ALM is to ensure that banks have in place a sound approval process for new types of activities, in order to clarify whether they can bear the underlying risks (e.g. market risks, credit risks, operational risks) appropriately. Basically, banks would need to apply a check list as such the one below (which is not exhaustive): What does the risk pro le of these activities look like? Do these activities change the tradeoff between earnings and risk and if so, does this change t in with the overall strategy? Is the banks staff adequately qualied to handle the new activities? Or more simply: are these activities understood in all their risk aspects? Can these activities be conducted properly? Can the risk measurement systems map the activities in a risk-adequate way? Does the credit institution ensure an independent and ongoing valuation of these activities? Can the activities be properly mapped in supervisory reporting? How should the activities be presented in the accounts? Might unwanted effects arise in the earnings account? Will senior management be informed regularly about the activities? Are the methods and models for all types of structured product adequately documented? 102 Are the stress test requirements met? This expandable list makes clear that several units are involved in evaluating these questions (Treasury, Accounting, Risk Management, Internal Audit etc.), and that smooth coordination is of the essence. The Basel Committee on Banking Supervision places great store on introducing of new types of activities in a structured manner to ensure that no aspect will be overlooked. Business activities that are not subjected to such scrutiny must not be carried out. Since this matter is of particular importance, the Austrian Banking Act explicitly addressed it in the article relating to the due diligence obligations of senior management.
100
101 102
The reporting guidelines on the risk statement currently stipulate 200 basis points as the sudden and unexpected change in the yield curve. See 2.4.3, Denition and Treatment of Outlier Banks. See 4.4.3.3, Stress Test Requirements
49
In the case of new transactions with which the credit institution has no experience regarding the risks involved, due consideration must be given to the security of thirdparty funds entrusted to the credit institution and to the preservation of the credit institutions own funds. The procedures pursuant to paragraph 2 must ensure that the risks arising from new transactions as well as concentration risks are captured and assessed to the fullest possible extent. 103 It is frequently observed that credit institutions subject new savings products to a product launch process before offering products to customers while at the same time buying for their own account highly complex structured securities they have not tried and tested in a similar way. It should be standard practice to thoroughly test all activities with which the bank has no experience before actually carrying them out. In particular, credit institutions would have to refrain from carrying out activities that are not adequately understood.
103
See Article 39 paragraph 2c of the Austrian Banking Act.
50
4.2 Cash Flow Modeling The rst step in measuring interest rate risk from an economic value perspective is to establish which cash ows arise from a banks interest-sensitive positions. In addition to retail banking activities, both proprietary transactions (including structured securities) and interbank business make up the lions share of the interest rate book. To calculate bank-wide cash ows, consisting of interest and principal cash ows, banks use maturity-gap analysis to establish reliable cash ows and cash ow assumptions to establish unreliable cash ows. Deriving the cash ow directly from the agreed product characteristics is an option only in the case of traditional xed rate products that lock up capital for specied periods and have a specied repricing prole. For all other balance sheet positions with (partially) unspecied product characteristics, credit institutions need to make assumptions about their cash ow structure. On the basis of these cash ow assumptions, transactions are then transformed in positions with xed cash ows.104 Proper cash ow modeling, which serves as a basis for determining performance from an economic value perspective, value-at-risk and RORAC,105 is the key requirement for adequate identifying and managing interest rate risk in the banking book.
Chart 14
Derivation of Aggregate Cash Flow from a Banks Interest Rate-Sensitive Positions

assets liabilities total cash flow assets Simulation
interest-sensitive positions retail transactions current account oans and bonds holdings and savings interbank claims deposits interbank liabilities proprietary transactions nostro securities securitized liabilities
cash flow modeling
off balance sheet noninterest-sensitive positions

Source: OeNB.
liabilities time band (years)
The total cash ow of the interest rate book, i.e. the risk-related measure, can be calculated from the cash ows arising from the banks individual activities.106 From an economic value perspective, the interest rate exposure is calculated on the basis of the net cash ows (balance of cash ows from asset and liability positions). The net cash ows provide some preliminary information
104
105 106
Owing to the inclusion of preference-related valuation criteria, the economic value concept in this instance diverges from market value-based duplication. See subsection 3.2.2.2, Simulation of Economic Value. RORAC: Return on Risk-Adjusted Capital Cash ows can also be derived more simply using gap analysis (including interest cash ows).
51
about the interest rate books strategic positioning. In this respect, the following principle applies: the larger the net asset or liability positions and the further they lie in the future, the greater is the potential interest rate risk. The interest rate books economic value, which is shown as the net economic values of gross assets and liabilities, can be calculated by discounting net cash ows. The cash ow structure may be changed at all times, depending on business requirements, through accounting measures or derivative transactions. The interest rate books economic value is the central target measure on the basis of which interest rate management decisions may be derived from yield/risk analysis.
4.2.1 Retail Transactions
Providing loans and re nancing them via deposits is one of the original roles of credit institutions. Given the volume and structure of those transactions, they have a signicant inuence on the interest rate risk prole of banks. However, many of these transactions come without a given repricing prole, and capital is often locked up for inde nite periods. Retail transactions can be classied as follows:
Chart 15
Retail Banking Activities of Credit Institutions107 capital locked up

for a specified period for an indefinite period
I.
type of interest rate
fixed rate
e.g. fixed rate loans savings bonds
II.
e.g. fixed rate loans subject to early redemption
III. floating rate
e.g. money market and capital market-indexed loans
IV.
e.g. savings deposits with money market and capital market repricing
no given repricing profile
V.
e.g. loans with a UFN (until further notice) agreement
VI.
e.g. current account deposits, current account holdings and savings deposits
Source: OeNB.
107
Category I (xed interest rate, capital locked up for a specied period)108
The interest rates on transactions in category I are xed until maturity. Thus, these transactions are to be allocated to the specied time bands simply according to their residual maturity.109 For other types of instruments, correctly allocating transactions to individual time bands is less straightforward, however, as outlined below.
107 108 109
In accordance with Markus (2002), p. 213, gure 4. See Markus (2002), p. 215. See reporting guidelines on the risk statement.
52
Category II (xed interest rate, capital locked up for an indenite period)
For transactions in category II, the interest rate is xed for the entire term as well, but the originally agreed xed rate maturity may be cut short if counterparties exercise their stipulated early redemption options. The same problem exists for xed rate loans which are swapped for oating rate loans precisely when money market rates fall, i.e. customers cancel their xed rate loan prematurely and switch to a loan with market repricing (e.g. 3-month EURIBOR). Implicitly, such loans also have an early redemption option even if this is not explicitly stipulated in the loan agreement.110 Interest rate risk statistics stipulate the following treatment options: If, in respect of a position with a xed rate coupon, the xed rate maturity may possibly be cut short [], but a shortened residual maturity cannot be assumed with certainty, the position would basically belong in the no xed repricing date category []. However, if embedded product structures (e.g. embedded early redemption options) are detached, the remaining underlying position with a xed interest rate can still be considered as a position in the xed rate category.
Category III (oating interest rate, capital locked up for a specied period)
Allocating oating rate positions that lock up capital for a specied period would appear to be straightforward at rst glance (allocation at next repricing). However, allocation to a time band on the basis of repricing dates would mean that the basis risk is not taken into account in respect of oating rate positions whose interest rates are not determined by money market rates but by constant maturity swaps (CMS) or by secondary market yields (SMY).111 Credit institutions must therefore analyze such positions according to their effective interest rates in terms of expected economic value effects and allocate them to their corresponding time bands,112 using e.g. the constant maturity bond (CMB) method or SMY replication.113
Category IV (oating interest rate, capital locked up for an indenite period)
This category subsumes transactions that are repriced to a money market or capital market rate same as category III transactions but unlike the latter, category IV assets have no specied residual maturity. In principle, such transactions can be allocated on the basis of subsequent repricing (if, however, these positions are repriced to a capital market interest rate, the same problem would arise as for category III assets). As regards savings deposits, an Austrian Supreme Court verdict dating from 2005114 stipulates the timely repricing of saving rates to market interest rates (similar to the escalator clause for consumer loans). As a result, the lions share of savings deposits will come under this category in future. Yet credit institutions would also need to take additional risk aspects into account for savings deposits such as:
110 111 112 113 114
Owing to increasing competitive pressures, this practice is accepted by many credit institutions. The repricing indicator is not linked to the short-term money market rate. See reporting guidelines on the risk statement. See subsection 4.2.1.6, Constant Maturity Bond Approach. Austrian Supreme Court 21.12.2005, 3 Ob 238/05d
53
When the customer market interest rate is referenced to a oating rate offset by a negative spread (e.g. 3-month EURIBOR less 200 basis points), savings rates might theoretically turn negative if the reference rate diminishes. But this is not realistic in practice. The implicit option of setting the minimum interest rate at 0% (oor) would have to be assessed separately. If saving rates are repriced only if the change in the reference interest rate within the repricing period reaches a specied minimum value (e.g. 25 or 50 basis points), repricing dates should be estimated accordingly. These positions would then have to be recorded under positions with no xed repricing date. Both effects could be estimated and modeled using the option-adjusted spread (OAS) approach by decomposing these savings deposits into the underlying transaction and the embedded options.115
Category V (no given repricing prole, capital locked up for a specied period)
Transactions in category V are frequently loans with an agreed maturity, for which a repricing period is not contractually stipulated with customers. Repricing is often carried out with a time lag on the basis of medium-term capital market interest rates. To calculate the cash ow, specialist literature on this subject usually recommends the elasticity approach. Since these transactions are similar in nature to capital market oaters,116 they could also be presented using the CMB approach.117
Category VI (no given repricing prole, capital locked up for an indenite period)
As regards transactions with no given repricing prole locked up for a specied period, customers are basically free to withdraw the entire capital at their discretion and the credit institution is fairly free to price the products (in line with the market) (e.g. overdraft facilities, current account holdings). This gives rise to the following problems when determining cash ow: estimating repricing dates, taking account of the lags with which retail interest rates are adjusted in the event of changes in the money market rate, estimating periods for which capital is locked up, determining future retail interest rates and, nally, 118 future changes in business volume and future new business In respect of transactions in this category, the question arises whether to chose a method that is based on repricing dates or one that is based on capital lockup periods (such transactions tend to be repriced at intervals of less than one year while capital is generally locked up for periods longer than one year).119 If banks use only the repricing criterion to reect positions without a given repricing prole, they assume the retail interest rate to be fully congruent
115 116 117 118 119
See subsection 4.2.1.7, Option-Adjusted Spread (OAS) Approach. See Huber (2004), p. 42. See subsection 4.2.1.6, Constant Maturity Bond Approach. These aspects can also be included within a broader perspective. Irrespective of the selected method, positions in category V and VI must be classied as positions without xed repricing dates in interest rate risk statistics.
54
with the reference interest rate. In reality, however, this is not with the case, as the bank has in fact agreed not to regularly reprice the retail rate to a reference interest rate.120 Using the periods for which capital is locked up as a basis for estimation, in contrast, banks would tend to overestimate interest rate risk. Therefore, specialist literature usually recommends methods that aim for a compromise between repricing dates and capital lockup periods (e.g. the elasticity approach, replicating portfolios). When allocating these positions for their interest rate risk statistics reports, credit institutions are not bound by given assumptions. The assumptions they adopt should be based on sound analysis, applied consistently and documented in a way transparent to third parties (e.g. banking supervision). In respect of positions without a given repricing prole and/or unspecied periods of capital lockup, the Basel paper on interest rate risk also notes:121 Specic attention should be given to items whose behavioral repricings differ from contractual maturities, such as savings deposits, and in some countries mortgage related instruments.
4.2.1.1. Methods and Models
The aim of the models described below is to present the aforementioned transactions in categories II to VI (i.e. products that come without a given repricing prole and/or lock up capital for inde nite periods) as money market and capital market transactions (MCM transactions), the cash ows of which are stated in the gap analysis. Besides, this enables the Treasury to maturity-match their re nancing in line with the market interest rate method. Different models will yield divergent MCM transactions and consequently different cash ows. This is why the selection of a model or method for a given category of transactions should be well-founded.
Chart 16
Models for Mapping Retail Transactions

periods for which capital is locked up nonmaturation theory outflow rate method frequently used seldom used implementation simple complex requirements
elasticity analysis
replicating portfolio theory
CMB approach
capital lockup periods or repricing dates
combination methods
OAS approach
dynamic models
Source: OeNB.
120 121
See Rolfes/Bannert (2001), p. 285. See Basel Committee on Banking Supervision (2004b), ref. 5.
55
Basically, historical analysis focuses either on retail and market interest rates (when repricing dates are the key criterion) or on the historical changes in volume of given transactions (nonmaturation theory, outow rate) (when the periods for which capital is locked up are the key criterion).
4.2.1.2. Nonmaturation Theory
Nonmaturation theory, which is primarily used for transactions in category VI, assumes that banks tend to retain a specic percentage of a product (e.g. savings deposits) for long periods. According to this theory, a banks transactions may be broken down into a stable component (to be allocated to a long time band) and a volatile component (to be allocated to a short time band). Estimates of the shares to be considered short-term and long-term are based on empirical observations. For this purpose, banks need to observe changes in volume in the relevant product category (e.g. savings deposits) during a specic period. On this basis, transactions are split into the two components. The volume which remains under the mean value minus two standard deviations is considered to be stable (non-interest-sensitive). The volume which exceeds the mean value plus two times the standard deviation is supposed to be highly interestsensitive.122
Chart 17
Nonmaturing savings deposits

EUR million 16
12
0 Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. Jan. Apr. July Oct. 2002 2003 2004 2005 2006
volume (EUR million) mean minus two times standard deviation mean Source: OeNB.
observation interval
4.2.1.3. Outow Rate Method
Another approach is to observe and analyze the natural maturation rates of a banks transactions (savings deposits and current account holdings).123 To this end, a sample (e.g. current accounts) representative of the credit institution is used. Within this sample, every account is individually observed and changes in volume and/or redemption are recorded over a certain period.
122 123
In the event of changing market interest rates, customers reaction times are responsible for volatility. See Matz (2005), chapter 6, p. 12ff.
56
nonmaturing assets
Observation intervals must be selected in a way such that these are not too to include interest rate changes (e.g. quarterly intervals). The period of analysis should span the entire interest rate cycle.124
Chart 18
Quarterly Decline in Volumes

EUR million 100
80
60
40
20
0 12
Source: OeNB.
24
36
48
60
72
84
96
108 120 time band (months)
Figure 18 shows an outow ratio of more than two-thirds after 2 years, which rises to 100% (EUR 100 million) after approximately 10 years for current account deposits. The annual outow rate (which is relevant for the allocation of cash ows) is calculated as an average of actual annual outows over the period of observation (in the chart above, this results in roughly 10%
Chart 19
Cash Flow Allocation in Relation to the Outflow Rate

EUR million 10
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 time band (years)

Source: OeNB.
124
This period is generally recommended for all the methods and models presented.
57
for a 10-year period of observation, i.e. in the rst year 10% of 100, thereafter 10% of 90 and so on). This also corresponds to the cash ow to be allocated per annual time band.125 Some drawbacks of this method are: new business and any changes in existing retail products affect the validity of the analysis. the function of volume outow and thus the annual outow rate depend to a signicant degree on the observation period and its length. The methods described above (nonmaturation theory and the volume outow rate method) are subject to a general weakness in that no reference is made to the actual interest rate xation.
4.2.1.4. Elasticity Analysis
As already mentioned in subsection 3.2.3, Elasticity Analysis, interest rate elasticity is a linear measure for the repricing reaction of retail interest rates to the uctuations of a selected market interest rate.126 The quality of elasticities is expressed by the goodness of t (and correlation), which can assume only values between 0 and 1. The closer the goodness of t approaches 1, the better the quality of the regression model, the more accurately unknown retail interest rates, given known money market rates, can be estimated.127 As per de nition, the elasticity of a xed rate bank activity is 0. The aim of elasticity analysis is to split the activity into a variable component and a xed rate component. The elasticity to a given money market rate (e.g. 3-month EURIBOR) is calculated separately for each category of transactions. The variable component corresponds to elasticity-weighted nominal volume of transactions and is allocated to the time band of the given market indicator. The remaining nominal volume is allocated as a xed rate component to the time band that corresponds to the period for which the capital is locked up. The elasticity approach is primarily used for capital locked up for a specied period (category V). In principle, banks could use this approach also for category VI transactions, but in this case they would have to make assumptions about the expiry of the calculated xed rate component. The following example shows how the cash ows are calculated: Loan with UFN contract, volume: EUR 100,000, maturity: 5 years; elasticity to 3-month EURIBOR: 0.3 An elasticity of 0.3 to the 3-month EURIBOR signies that 30% of the volume are to be allocated to the 3-month time band, and 70% to the loans residual maturity.
125
126
127
As a result, stability or smoothing over a longer period is achieved in relation to the allocation of actual outows. According to the denition, interest rate elasticity is the ratio of the absolute rates of change of both these interest rates. A low goodness of t indicates that a linear correlation between market and retail interest rates does not exist. A statement on elasticity cannot therefore be made in this respect.
58
Chart 20
Elasticity Approach Cash Flow Structure

EUR million 80
60
40
20
0 3 months
variable tranche Source: OeNB.
6 months
12 months
fix interest tranche
2 years
3 years
4 years
5 years time band
Usually, the xed rate component is shown as rolling, i.e. a transaction with a maturity of 5 years consisting of 60 individual xed rate positions, with one tranche expiring every month. In the above example, this results in a distribution of EUR 70 million among the individual time bands, as outlined below:
Chart 21
Elasticity Analysis Cash Flow Structure with Rolling Tranches

EUR million 40
30
20
10
0 3 months
variable tranche Source: OeNB.
6 months
12 months
fix interest tranche
2 years
3 years
4 years
5 years time band
Elasticities can be calculated for each individual bank transaction and treated separately in gap analysis. However, it is advisable to calculate the elasticity for each category of activities to facilitate sound statements about the performance of the total portfolio. The method works as follows: 1. development of historical time series for every type of activity that locks up capital for a specied or estimated period (category V and VI) 2. calculation of elasticity to the selected money market rate for of every type of activity
59
3. split of the total nominal volume of every type of activity into a variable (short-term) and stable (xed rate) component. 4. rolling presentation of the xed rate tranche to adequately reect new business 5. calculation of the (moving average) mixed interest rate for rolling xed rate tranches128129
Chart 22
Moving Averages129
new tranche 2.73 % 2.58 % 2.72 % 2.95 % 3.09 % moving averages 6 5 4 3 2 3.19 % 1 0 1 2 3 4 5 6 months previous moving average of 2.88% 2.58 % new moving average of 2.78%
Source: OeNB.
4.2.1.5. Replicating Portfolios
This approach attempts to show category VI transactions as a portfolio of xed rate transactions, with a view to nding for every type of transactions (current account holdings, savings deposits etc.) a linear combination of MCM transactions, which mirrors the given activity as accurately as possible.
Chart 23
Repricing Behavior of Retail Interest Rates

% 7
3 margin 2
1 1999 2000 2001 2002 2003 2004 2005
yield of replication portfolio retail interest rate Source: OeNB.
128
129
This takes account of the sluggish change in retail interest rates in response to changes in market interest rates. The moving average (opportunity interest rate) is required to calculate interest cash ows. For simplication purposes, only a rolling of 6 months was assumed. See Huber (2004), p. 17.
60
Structure of Replication Portfolio
The replication portfolio is derived from historical retail interest rates and money market rates. The weights of individual xed rate investments are calculated by means of multivariate regression analysis in a way such that the interest rates of the retail positions (less a margin) are tracked as accurately (efciently) as possible by the yield of the replication portfolio. The sum of these weights must be 1 and the weights may not be negative.130
Efcient Replication Portfolio
Various criteria of optimality can be used to determine an efcient portfolio. Usually a constant margin is de ned. A constant margin is a necessary requirement for separating the pricing contribution from the structural contribution. Such a split allows banks to establish a market-related margin that is independent of market interest rate changes. The constant margin can be calculated by introducing an additional requirement, namely by minimizing the variation in the margin. A number of replication portfolios thus determined will show broadly similar variations. Therefore, other optimality criteria will need to be included to narrow down the selection further, as suggested below. Since interest income is a key criterion, banks might select the replication portfolio with the highest margin. A high goodness of t (high correlation) would imply good repricing behavior. The average maturity of the underlying transactions has a signicant effect on interest rate risk and earnings. Therefore, credit institutions may contain interest rate risk by committing themselves to a maximum desired residual maturity.131 Implementing the optimality procedure outlined above will produce MCM interest rates and corresponding weights. As a result, the total nominal amount of each category of bank activity can be allocated to a time band.132
Example:
current account holdings: Volume of EUR 100 million calculation of interest rates and weightings of the replication portfolio 6-month EURIBOR 50% 3-month EURIBOR 30% 1-month EURIBOR 20%
130
131 132
Negative weights would mean that alternative optimization processes would have to be used for the analysis. See Huber (2004), p. 19ff. For the sake of simplicity, the allocation of interest cash ows is not included in the charts below.
61
The resulting allocation of cash ows is:

Chart 24
Replication portfolio
EUR million 50
40
30
20
10
0 1
1-month EURIBOR 3-month EURIBOR 6-month EURIBOR Source: OeNB.
6 time band (months)
Rolling Presentation:
The volumes distributed in accordance with the weights determined are allocated to corresponding time bands. In respect of the above example, the result is now as follows:
Grafik 25
Replication Portfolio with Rolling Tranches

EUR million 40
30
20
10
0 1
62
The opportunity interest rate is the product of the individual tranches average coupons weighted by par values. For tranches of the same amount, this corresponds to the moving average of the interest rate development in the relevant time band. The models explanatory content (goodness of t, correlation) should be subjected not only to an in-sample test across the entire estimation period but also to an out-of-sample test in order to ensure that the model is also as robust as possible over time.
Combination of Replication and Nonmaturation Theory
A broader approach is to combine the replicating portfolio method with nonmaturation theory. To this end, banks need to collect and analyze not only time series of retail interest rates as in the replication approach but also the related volumes.
Example:
total nominal current account holdings: EUR 100 million sample size: 1,000 current account holdings there are no xed repricing dates and no specied maturities current account holdings may be liquidated on demand credit institutions need not observe notice periods to change interest rates A historical observation carried out across the entire interest rate cycle ranging from 5 to 10 years (e.g. at 1-month intervals) yield the following results: changes in volume average current account rates MCM rates (e.g. 1-month, 3-month, 6-month EURIBOR, 1-year, 2-year, 3-year and 5-year swap rates). The analysis is undertaken in the following steps:133 1. Separation into a variable component and a xed rate component (variable component of, say, 30%, i.e. EUR 30 million, and xed rate component of 70%, i.e. EUR 70 million).134 2. Calculation of the efcient replication portfolio for the variable component. Result: e.g. 50% 1-month EURIBOR, 50% 3-month EURIBOR.135 3. Calculation of the efcient portfolio for the xed rate component. Result: e.g. 20% 1-year swap, 50% 2-year swap and 30% 3-year swap. 4. Rolling allocation of both components.
133 134 135
See Matz (2005), chapter 6, p. 30ff. See subsection 4.2.1.2, Nonmaturation Theory. See subsection 4.2.1.5 Replicating Portfolios.
63
Chart 26
Combination of the Replication Approach and Nonmaturation theory

EUR million 25
20
15
10
0 1
1-month EURIBOR 3-month EURIBOR 1-year swap rate 2-year swap rate 2-year swap rate Source: OeNB.
12
24
While producing a portfolio of money market and capital market products that tracks interest rate changes of current account holdings and savings deposits, this method has the drawback of not taking into account the opportunity interest rate in terms of volume changes. Yet ignoring volume ows means for the Treasury that re nancing can no longer be carried out at the calculated opportunity interest rate should volumes increase and market interest rates change at the same time. As a result, the Treasury prot center alone bears these costs induced by uctuations in volume. Since, however, the Marketing prot center has the largest impact on changes in volume, the banks methods would need to reect volume changes as well.
Rebalancing Portfolio Approach
The rebalancing portfolio approach allows banks to analyze uctuations in volume with a separate portfolio. Fluctuations in volumes are subject to the same residual maturity as those of the original replication portfolio, albeit with up-to-date pricing, i.e. the new volumes are allocated to new tranches with the same residual maturity on the basis of the previous weights.136
Example:
Original amount of current account holdings: EUR 100 million Increase in current account holdings: EUR 10 million (10%) Allocation to the replication portfolio: 6-month EURIBOR 55 (50 + 5) million 3-month EURIBOR 33 (30 + 3) million 1-month EURIBOR 22 (20 + 2) million
136
See Huber (2004), p. 28ff.
64
Chart 27
Replication portfolio with a 10% increase in volume

EUR million 60
40
20
0 1
1-month EURIBOR 1-month EURIBOR (additional) 3-month EURIBOR Source: OeNB.

3-month EURIBOR (additional) 6-month EURIBOR 6-month EURIBOR (additional)
Rolling allocation under the rebalancing portfolio approach is carried out as follows:
Chart 28
Rebalancing-Replication Rolling Presentation

EUR million 40
30
20 historical pricing 10
0 time band (months) 5 volume increase of 10% current pricing 0

1-month EURIBOR Source: OeNB. 3-month EURIBOR 6-month EURIBOR
time band (months)
Repricing of the Renancing Volume at Tranche Maturity
Rather than using two portfolios in parallel, it is possible to increase (or decrease) only the current tranches of the portfolio. The relative shares of individual rolling xed rate investments in the replication portfolio as a whole remain constant. However, the medium-term residual maturity, which depends on volume changes, varies on an ongoing basis. Individual tranches are no longer identical in size, and thus the opportunity interest rate no longer corresponds to the moving average of the corresponding maturitys previous interest rates. Instead, they correspond to the individual tranches average coupon weighted by par values.
65
Chart 29
Repricing at Tranche Maturity

EUR million 50
40
30
20
10
0 1
3
1-month EURIBOR (additional) 3-month EURIBOR (additional) 6-month EURIBOR (additional)
Benets of Replicating Portfolios

Replication portfolios are highly transparent and thus readily accepted by a banks decision-making bodies. Provided historical data are available, this method can be easily implemented, without any special software requirements.
Drawbacks of Replicating Portfolios
As the replicating portfolio methods exclusive focuses exclusively on optimal margins, interest rate risk is not accurately captured. Replication portfolios tend to show longer repricing intervals than actual portfolios. The opportunity interest rate reacts very slowly to changes in market interest rates. The larger and faster these changes are, the more problematic this will be. To solve some or all of these problems, an extended replication approach is presented below.
4.2.1.6. Constant Maturity Bond Approach
The constant maturity bond approach uses both MCM transactions and constant maturity bonds (CMBs) to replicate portfolios. A CMB can be de ned as a oater with a xed rate maturity, which is periodically repriced to a capital market rate. As a result, it reects the same risk prole as that of retail banking transactions, the interest rates of which are also referenced to the capital market. Although CMBs do not exist in the capital market, CMB cash ows can be replicated by forward rates: For instance, a 5-year CMB might be replicated with a xed rate asset position in the 5-year time band and 5 forward positions (1-y x 6-y forward, 2-y x 7-y forward, , 4-y x 9-y forward)
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Cash ows correspond to the key rate durations calculated for the individual time bands.
Chart 30
Synthetic cash flow profile of a constant maturity bond

par amount (EUR million) 300
200
100
100 1
Source: OeNB.
9 time band (years)
In this example, the key rate durations are positive up to a term of 5 years and negative thereafter. The resulting cash ows reect this pattern: Rising interest rates would generate an economic loss up to a period of 5 years and an economic gain thereafter.137
Structure of the Replication Portfolio
To simulate the lag in the passthrough of market interest rates to retail interest rates, lagged CMBs are constructed, i.e. CMBs based on past market conditions (e.g. 6 months). How far back this lag will lie in the past largely depends on the category of transactions and is at the discretion of credit institutions. The replication portfolio is accordingly divided into two subportfolios: The lagged CMBs represents the nonmaturing part of the position, and a rolling money market transaction the variable component. The opportunity interest rate of the lagged CMB is the swap rate less a constant spread, which is chosen such that the CMBs market value at issuance is equal to the par value.138 The opportunity interest rate of the variable component is the moving average of the rolling money market transaction. The overall opportunity interest rate is derived from both subportfolios average coupons weighted by the par amounts. The following example illustrates the cash ow allocation of EUR 300 million: 1. Separation into a variable component and a xed rate component (oating rate component of, say, 30%, i.e. around EUR 90 million, and xed rate component: 70%, i.e. EUR about 210 million)139
137 138
139
See Huber (2004), p. 43. For a normal yield curve, a CMBs economic value always exceeds the par values. See Huber (2004), p. 42. See subsection 4.2.1.2, Nonmaturation Theory.
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2. Calculation of an efcient replication portfolio for the variable component. Result: e.g. 50% 1-month EURIBOR, 50% 3-month EURIBOR. 3. Allocation of both components, with the variable component allocable on a rolling basis.
Chart 31
Cash Flow Profile Based on the CMB Approach

200
100
100 1 2 months
1-month EURIBOR 1-month EURIBOR CMB Source: OeNB.
1 years
9 time band
To sum it up, we can say that the effective interest rate exposure of positions locked up for inde nite periods with no xed repricing dates can be better captured by replication with CMBs than by replication with money market and capital market activities, as CMBs are more sensitive to a twist in the yield curve than to a parallel shift.140
SMY Replication
The replication of SMY products basically works like that of CMB products. SMY-related business is replicated with a xed rate transaction corresponding to the maturity of the position, and several forward positions with a maturity of 5 years (since the secondary market yield is correlated highly with 5-year swaps).141 For an assumed 10-year transaction with annual repricing, this results in: a xed rate asset position in the 10-year time band corresponding to the business volume and 142 9 forward positions (1-y x 6-y forward, 2-y x 7-y forward, , 9-y x 14-y forward), weighted by the hedge ratio.143
140 141 142 143
See Bhler (2000), p. 45. See Finance Trainer (2002), p. 1 In one year for ve years The hedge ratio depends on the duration of underlying cash ows and the steepness of the yield curve, and generally ranges between 20% and 24%.
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Chart 32
Replication of a 10-year transaction with SMY repricing

40
30
20
10
10 1 2 3 4 5 6 7 8 9 10 11 12 13 14
fixed rate transaction active forward transaction passive forward transaction Source: OeNB.
times band (year)
4.2.1.7. Option-Adjusted Spread (OAS) Approach
The option-adjusted spread approach was rst developed for the valuation of securities with embedded options, but is now also used for mortgage-backed securities (MBS). MBS are securitized mortgages that are redeemable on a monthly basis (repayment in part or in full) whereas the underlying mortgages are issued for a specied period at xed interest rates. This method uses Monte Carlo simulations to generate cash ows with an economic value equivalent to the MBS market value. This method can also be applied to loans with early redemption options using simulation and decomposition processes.
Simulation Approach
The simulation approach is based on three submodels: a yield curve model, a mortgage model and an amortization model.144 A yield curve model serves to attain a future yield curve based on a few factors (e.g. historical trend in interest rates; e.g. Hull-White model, Black-Karasinksi model) using Monte Carlo simulations to generate potential scenarios. The mortgage model attempts to simulate future scenarios to match the estimated yield curves. Finally, an amortization model serves to simulate both retail behavior and the resulting shifts in volume.
144
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Decomposition Approach
The decomposition approach attempts to split the contract characteristics of transactions without xed lockup periods or repricing dates into individual components (into a money market or capital market transaction and into individual options). The value of the transaction is then the sum of these individual components. For a loan granted for an unspecied period without xed repricing dates, embedded optionalities could be shown synthetically as follows: short cap option and long oor option, each with a residual maturity, reecting the lag with which money or capital market rates are transmitted to the customer rate) short cap option because high lending rates are hard to enforce long oor option because the credit institution de nes a certain minimum margin
short put option, representing the customers right of early redemption Although this approach is widespread in the literature, it has two drawbacks. First, it is not possible to calculate market values for all individual positions and, second, todays option price models cannot valuate the above options accurately, as the latter are largely overlapping. In conclusion, it is noteworthy that an OAS approach can depict mortgages with early redemption options (and swaps of xed rate loans for oating rate loans) more accurately than replicating portfolios, as it formulates future likely scenarios. A drawback of this method, however, is its high degree of complexity. At all events, the models would need to be backtested. Furthermore, the model would need to be expanded to estimate future volumes, which are ignored by this method.
4.2.1.8. Dynamic Replication
The aforementioned models are of a static nature. The model described below attempts to depict positions dynamically. Once again, three models are required for this purpose: a yield curve model, a mortgage model and volume model.145 The yield curve model differs from the OAS approach only in the sense that, in addition to the interest rate level, the model also includes the spread term (difference between the short and long end of the yield curve). The mortgage model is identical to that in the OAS approach. Unlike the amortization model used in the static approach, the volume model simulates both the repayment of the current volume and future increases in volumes. The difculty is that the factors affecting these uctuations must rst be identied (e.g. through regression analysis). On the basis of a stochastic optimization process, these three models seek to generate a large number of interest rate, volume and retail interest rate scenarios, as well as the corresponding cash ows. The purpose of this exercise is to lter out the one scenario that generates an optimal portfolio in terms of re nancing costs and margin. On this basis it is also possible to calculate valueat-risk (VaR).
145
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This approach has three advantages over static simulation:146 investment decisions are made on an objective basis (optimization process), a lot of data (interest rate, retail interest rate, volumes) can be implemented in the system and the system responds immediately to new data (causing the investment strategy to be changed). The drawback of dynamic replication lies in its estimation of many parameters and in the underlying model risk.
4.2.2 Proprietary Trading Activities Derivatives and Structured Products
Proprietary trading activities generally include all nancial (on and off balance sheet) instruments which credit institutions trade in their own name and for own account. As regards the allocation of cash ows, the same methods can be applied as for the aforementioned categories I VI (xed or oating interest rates, or no given repricing prole).
4.2.2.1. Mutual Funds
Positions without xed repricing dates include, above all, interest-sensitive mutual funds. To fulll their reporting requirements, credit institutions must estimate repricing dates for the interest-sensitive component of their mutual fund holdings and allocate the respective amounts to corresponding time bands. A customary approach is to allocate xed income funds on the basis of their volume-weighted average maturity or duration (or modied duration). However, it should be mentioned that the duration-based approach tends to underestimate interest rate risk since the repricing period of the xed rate component corresponds to the latters residual maturity and not to its duration. Conversely, the maturity-based approach tends to overestimate interest rate risk, as the repricing periods of the oating rate component differ from the latters residual maturity. The right solution would be to analyze mutual funds in terms of their individual items and to allocate these accordingly (lookthrough approach). If, however, banks do not use the look-through approach for proportionality reasons, they should allocate the highest possible share of interest-sensitive transactions (and interest-sensitive derivatives transactions; as laid down in the prospectus).
4.2.2.2. Derivatives
Investment in derivatives and structured products has boomed in recent years. While derivatives are typically meant to hedge trading positions or to be traded, the growing weight of such positions in the Austrian capital market and at credit institutions also reects the at yield curve and the period of low interest rates in the past few years. With the increasing complexity of derivatives and structured products, the need for suitable valuation models and for
146
See Frauendorfer/Schrle (2006).
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methods to incorporate them into the integrated interest rate risk management rises. In their interest rate statistics to be submitted to the OeNB, credit institutions must allocate all interest-sensitive off balance sheet positions, based on par values or their delta equivalents, to time bands. These positions must be decomposed into their synthetic positions and must, as a rule, be allocated to their time bands according to their residual maturity and repricing dates.147 When decomposing products, credit institutions must make a distinction between linear positions (without optionalities), nonlinear positions (with optionalities) and structured positions.
Linear Derivatives
Linear derivatives are de ned as transactions in whose settlement prole reects value changes in the underlying instrument in a linear manner. They include, for instance, interest rate and foreign currency swaps, forward rate agreements, interest rate futures, bond futures etc., which credit institutions must treat as combinations of notional asset and liability positions. In this context, forward foreign exchange contracts should also be mentioned, as they are also exposed to interest rate risk.148
Nonlinear Derivatives
All instruments with optionalities (settlement prole is not linear to the underlying instruments) such as caps, oors, swaptions, bond options are designated as nonlinear derivative products. As the probability with which these options are exercised depends on the delta of the options, such positions are to be allocated, as a rule, at the delta-weighted par value. For example, in the case of a European option on an on balance sheet underlying instrument, the notional asset and liability balance sheet positions should be allocated to the two time bands of the options maturity and the maturity of the underlying instrument at the underlying instruments delta-weighted par value. A further point to be mentioned concerns instruments whose underlying instrument is a linear derivative (i.e. a synthetic off balance sheet position). In this case, the linear derivative must be further decomposed in accordance with the principles outlined above so as to nally allocate the delta-weighted par values of the decomposed asset and liability positions to the corresponding time bands (e.g. a cap must be further broken down into a series of deltaweighted forward rate agreements).
Structured Products
Interest-sensitive structured products are nancial instruments that are pegged to one or more market interest rate(s) and which also include optionalities (e. g. early redemption options or a capital guarantee).149
147
148 149
All interest-sensitive off balance sheet positions in the banking book must be allocated in conformity with the allocation criteria of the trading book (as dened by Article 204 paragraph 1 Nos 1 to 3 of the Solvency Regulation). See reporting guidelines on the risk statement. As per denition, capital market oaters also count as structured bonds.
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In recent years, structured capital market products have grown steadily in number and complexity. The use of these products for valuation and risk quantication purposes requires a sound understanding on the part of credit institutions. In anticipation of the new Basel II regulatory capital framework, the OeNB published a comprehensive Product Manual containing guidelines on the valuation of structured products.150 The growing risk derived from embedded derivatives has also been highlighted in the Basel paper on interest rate risk. For structured instruments, particularly those involving hidden multiple options, the correct allocation of cash ows to individual time bands is extremely complex. This is why these optionalities are often ignored in ALM. Yet the higher their share of the overall portfolio, the more inaccurate is the management of interest rate risk if these options are ignored, i.e. if the products are allocated at their residual maturity. In line with reporting requirements, structured products must be shown as combinations of embedded derivative instruments (as synthetic off balance sheet positions) and their respective underlying instruments (balance sheet positions). In the last few years, however, more and more structured products have been issued on the Austrian capital market that are so complex that they cannot be meaningfully decomposed into synthetic components (e.g. snowballs, steepeners, target coupon bonds). One approach that banks practice is to allocate structured bonds to the time band that corresponds to the duration (or modied duration). However, this approach will seldom reect the actual interest rate risk. The subsections below present more possibilities for integrating these options into ALM.
4.2.2.3. Breakdown by Exercise Probability
In this method, the delta of the embedded early redemption option is used as an approximation for the exercise probability:151 Example:152 A structured security with a residual maturity of 10 years, a right to early redemption in two years and a delta of 0.7 is to be allocated to two different time bands: 70% of the par amount of this security are to be assigned to the 2-year time band (at 70% of the par amount of this security) and 30% of the par amount to the 10-year time. A drawback of this method is, however, that the delta can only be used as a measure of exercise probability for 1. very distant exercise dates, or 2. options other than at-the-money options. Otherwise, the delta could be greater than 1, and it will be meaningless for exotic options.
150 151
152
See OeNB (2003). A delta of 0 signies an exercise probability of 0%, and a delta of 1 signies an exercise probability of 100%. See Katzengruber (2001).
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The exercise probability can be established with trinomial tree or Monte Carlo simulation. This method is, however, not suited for representing other types of optionalities (e.g. oor, cap). A replication approach which is more suitable for measuring such instruments is presented below.
4.2.2.4. Key Rate Duration Replication Approach
Before we apply the key rate duration replication approach153 to structured products, the following example, based on a plain vanilla bond, is meant to show how this approach works. Let us take a coupon bond with a xed coupon rate of 5% and a maturity of 20 years. Based on the current yield curve and current zero bonds, the bond has an assumed market value of 110.54. This bond is now subjected to six scenarios: 1 we specify six data points in the yield curve (e.g. 1, 2, 5, 10, 20, 30 years), 2 we shift each data point by 10 basis points, and 3 we assume the shift to linearly drop to 0 to the left and the right of each data point.
Chart 33
Shift for 10-year time band

basis points 10
0 1
Source: OeNB.
10
11
12
13
14
15
16
17
18
19
20
time band
The scenario shown in the chart above shifts the 10-year zero rate by 10 basis points, the 5-year and the 20-year zero rate by 0 basis points and linearly interpolates between these two rates on a year-by-year basis (interpolations: 6 years by 2 basis points, 7 years by 4 basis points 11 years by 9 basis points, 12 years by 8 basis points, 13 years by 7 basis points etc.). For numerical reasons, the range should be as broad as possible.
153
See www.unriskderivatives.com/download/KeyRateDuration-Replikation.pdf.
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The following market values are recalculated on the basis of these six scenarios:
Table 4
Interest Rate Shift by 10 Basis Points

economic value given an unchanged curve shift in time band (years) 1 2 5 10 20 30 economic value given an upward shift by 10 basis points 110.5359 110.5328 110.4497 110.2783 109.5557 110.5049 110.5424 difference from original economic value 0.0066 0.0096 0.0928 0.2642 0.9868 0.0376
The next step is to nd a portfolio with zero bonds (maturities: 1, 2, 3, 5, 10, 20, 30 years), which replicates this bond under the aforementioned scenarios. Under the scenario described above which shifts the 10-year curve point by 10 basis points (and linearly interpolates at 5 years and 20 years) only the value of the 10-year zero bond will change. All other zero bond values remain unchanged, as the discounting factors of the relevant cash ows (resulting only from redemption at 100) have not changed. The table below presents the results of these scenarios.
Table 5
Replication with Zero Bonds

maturity of zero coupon bond (years) economic value given an unchanged curve economic value given an upward shift by 10 basis points in the curve point that matches the maturity of the zero coupon bond 97.6559 94.8661 84.6292 66.4032 39.0351 23.4225 difference
1 2 5 10 20 30
97.7536 95.0557 85.0537 67.0709 39.8242 24.1362
0.0977 0.1897 0.4244 0.6677 0.7891 0.7137
Under the above example, a par value of 100 corresponds to an economic value of 39.82 (given an unchanged curve) for a 20-year zero bond. Shifting the 20-year data point upward by 10 basis points causes the economic value to drop by 78.91 basis points. For the par value to mirror the changes in economic value that we calculated for the coupon bond, the par values must be adjusted accordingly. For the 20-year scenario, this means that 0.98678/0.7891 of zero bonds at a par value of 100 undergo exactly the same change in value as the coupon bond (100 for coupon bond = 125.05 for zero bond). When repeating this exercise for the other ve scenarios, we arrive at the following par values representing the replicating allocation of cash ows:
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Table 6
Par Values of the Replication Portfolio

maturity of zero bond (years) 1 2 5 10 20 30 par values in the replication portfolio 6.719 5.062 21.853 39.563 125.050 5.264
Translated into a chart, the results of this exercise look as follows:

Chart 34
Replication of a coupon bond with a 20-year maturity

par values 140 120 100 80 60 40 20 0 1
Source: OeNB.
10
20
30 times band (years)
Extension to Structured Instruments
Transferring the procedure described above to structured instruments works as follows: First, select data points in line with the specied time bands. Second, use a valuation tool to calculate the change in the economic value of the given structured product supposing a 200 basis point-shift scenario per time band.154 Third, calculate the par value of the zero bond which exhibits the identical change in economic value under the same scenario.
Steepeners A Special Case
Given relatively low money market rates in the last few years, credit institutions in Austria have invested more heavily in structured instruments, which pay a high coupon initially but whose coupon becomes very complex in subsequent years. The complexity in valuing these products is illustrated below by way of a steepener.
154
If the data points are selected too narrowly and a shift of 200 basis points is assumed, the resulting replication portfolio can be subject to strong uctuations.
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A steepener is a bond whose cash ows are derived from a multiple (m) of the difference of two interest rates (e.g. 20-year swap rate s20, 5-year swap rate s5). This bond is usually repriced on an annual basis (m (s20 s5)). The steeper the yield curve, the larger the coupons will be. A at yield curve would result in zero-valued coupons. Should the yield curve become inversed, the coupon would be theoretically negative, which is, however, usually prevented with a minimum coupon of zero (oor: 0%). Due to the leverage effect, this product is exposed to high interest rate risk. If the yield curve actually attens as it did at end-2006, a large portion of the market value (economic value) will be lost. At any rate, allocating such a product to a single time band (according to the next repricing date or residual maturity) would not be risk-adequate. A possible approach, which has already been implemented in Austria at some credit institutions, is to represent steepeners via CMS.155 The example below illustrates the decomposition and hedging using CMS: Reference date: February 1, 2006; par value: 100, market value: 80 Coupon: 6 x (20-year swap rate 5-year swap rate) Interest rate repricing every three months (e.g. on April 1) Floor: 0% (this prevents a negative coupon) Annual early redemption right of issuer Decomposition: 1. Sale of an interest rate swap (receiver swap) for 20 years, i.e. allocation of a 20-year bond, on the assets side, 2. Sale of a CMS with repricing to the 20-year benchmark via the sixfold volume (receiver swap), i.e. sixfold allocation of a oater on the assets side, which is repriced to the 20-year CMS rate on an annual basis, and 3. Purchase of a CMS with repricing to the 5-year benchmark via the sixfold volume (payer swap), i.e. sixfold allocation of a oater on the liabilities side, which is repriced to the 5-year CMS rate on an annual basis. Theoretically, such a synthetic decomposition will only be correct when the assumption of the right to early redemption is removed.
4.2.3 Noninterest-Sensitive Positions with an Imputed Repricing Prole
This category includes all balance sheet positions that are not interest-sensitive, i. e. whose market value (economic value) does not depend on changes in market interest rates (e.g. capital, xed tangible assets, provisions, cash reserve assets etc.). Many banks nonetheless apply the market interest rate method also to these positions in order to determine interest rate performance (pricing and structural contributions), basically with a view to calculating the opportunity interest rate that reects the maturity ladder of the positions.156 Since capital or xed tangible assets are usually locked up for long periods, the opportunity interest rate can be calculated as the moving average of swap rates (e. g. 1-year, 5-year and 10-year swap rates). Similarly, the tranches to be
155 156
See Finance Trainer (2005). See Schierenbeck (2003a), p. 109.
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allocated in gap analysis can be calculated with a rolling replication portfolio.157 If integrated risk management extends to analyzing noninterest-sensitive positions with an imputed repricing prole into their analysis of interest rate risk, banks are required to report these positions together with their allocation assumptions, which they need to apply consistently to the OeNB.
4.3 Yield/Risk Analysis Risk-adjusted performance measurement (RAPM) means that banks explicitly consider risk when calculating the interest rate books performance, thus going beyond simple ROC (return on capital) ratios. The most common risk-adjusted ratios are RORAC (return on risk-adjusted capital), RAROC (risk-adjusted return on capital), RARORAC (risk-adjusted return on risk-adjusted capital) and economic value added (EVA). For more details on RORAC (and RAROC), please see the explanations below. Basically, the following analyses put the economic value of cash ows from a banks on and off balance sheet positions in relation to its VaR.
4.3.1 Yield Analysis
In terms of timing, a distinction must be made between analyzing past performance (ex post analysis) and potential future effects on performance (ex ante analysis).158 Economic value added basically reects the change in economic value between two points in time. This gure should not be interpreted in isolation but should always be cross-checked with alternative investment options (benchmarks). In respect of ex ante analysis, different interest rate scenarios need to be de ned. Since a single alternative scenario (a credit institutions own interest rate forecast) does not sufce to valuate future cash ows in a statistically sound manner, credit institutions should use additional scenarios that are derived from historical observations (historical simulations), simulation calculations (Monte Carlo simulations) or alternative statistical processes (e.g. main component analysis159) to estimate the sensitivity of the interest rate books economic value. In a further step, the economic value on the cutoff date of the analysis is compared with the expected economic value, which is based on a projected yield curve. Income components derived from retail banking activities the economic value of the pricing contribution must be separated from the result generated by the performance of economic value. The change in economic value is attributable to two factors: the effect of shortening the residual maturity (sliding yield curve effect), and the effect of a change in market interest rates. The sliding yield curve effect arises from the shortening of the residual maturity of cash ows. For instance, a payment due in three years and accordingly valued with a three-year zero coupon bond discounting factor. When the residual maturity has shortened to two years, the payment must be multiplied by a two-year zero bond discounting factor. In the event of a normal yield curve,
157 158 159
See gure 25: Replication Portfolio with Rolling Tranches. See subsection 3.2.2.2, Simulation of Economic Value. See subsection 4.4.3.1, Recognition of Marked Changes in Market Data.
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this effect gives rise to price gains, whereas an inverted yield curve produces price losses.160 For longer projection horizons, the sliding effect of the yield curve can indeed make a signicant contribution to overall performance. Furthermore, any change in the yield curve, i.e. in market interest rates, also has an impact on economic value. However, the absolute change in economic value must not be interpreted as earnings from maturity transformation since, as an asset can be invested in the money market and capital market on a risk-free basis at all times. The expected change in economic value must therefore be offset against those earnings that are guaranteed. The risk involved will have to be assessed in a separate yield/risk analysis (for which the value-at-risk concept may be used).
4.3.2 Risk Analysis
4.3.2.1. Value at Risk for Interest Rate Instruments
Value at risk (VaR) calculation allows credit institutions to estimate potential losses from interest rate instruments. VaR expresses the maximum loss of the interest rate books economic value with a specied probability (condence level) during a given holding period.161 Losses of economic value, de ned as a negative difference of future economic value from current economic value, are induced by changes in maturity-specic market interest rates. A brief example below describes the VaR calculation process.
Table 7
VaR Calculation for a Zero Coupon Bond

Beispiel VaR-Berechnung: portfolio: 1-year zero coupon bond amount to be repaid: EUR 5,000 1-year MCM rate: 6% zero bond discounting factor: 0.9434
The rst step in VaR calculations is the de nition of risk factors for interest-sensitive positions, such as e.g. zero bond discounting factors. Multiplying the current zero bond discounting factor by the cash ow of the bond will produce its underlying economic value. Based on a 1-year coupon of 6%, the zero bond discounting factor is 0.9434 in the example above, which puts the economic value at EUR 4,717. In the next step, the zero bond discounting factors are varied to calculate alternative economic values. To derive potential changes in economic value, banks may use either analytical approaches,162 which model the behavior of risk factors (zero bond discounting factors) statistically; or they may use simulation approaches based on historical observations (historical simulation) or
160
161
162
The steeper (more inverted) the yield curve, the larger the price gain (loss) arising from the shortening of the residual maturity. The selection of the holding period is a key component of VaR calculation. Credit institutions should dene this parameter in a transparent way, depending on the liquidity of their balance sheet positions. The change in economic value is specied by the central parameter of the assumed distribution (e.g. expectation value, standard deviation).
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stochastic processes (Monte Carlo simulation). In the exercise below, we assumed alternative values for the zero bond discounting factors and calculated the differences between the current economic value EV0 and the future economic value EVt in each case. As an alternative to the direct revaluation of zero coupon bonds, credit institutions can also produce an indirect approximation (rst difference of economic value based on market yield) by using sensitivity measures (duration, key rate duration, basis point value).
Table 8
Scenarios for VaR Calculation

scenarios at time t 1 2 3 4 5 ... MCM rate 6.00 % 5.97 % 6.08 % 5.81 % 6.25 % ZBAFt 0.9434 0.9437 0.9427 0.9451 0.9412 EV 4,717 4,719 4,714 4,726 4,706 EV 0 +2 3 +9 11
The results of the changes in economic value can be used to obtain a probability distribution (indicating how likely given changes in market interest rates are). This probability distribution is, in turn, the basis for deriving the VaR, i.e. a maximum loss for a given condence level and a given holding period. As shown by the chart below, in our exercise the VaR for a probability of 95% is EUR 10.
Chart 35
Probability Distribution of Changes in Economic Value

frequency 12 EV2 9 EV1 empirical distribution 6 EV3 3 EV4 normal distribution
0 10
Source: OeNB.
10
EV
VaR95 %
This exercise can be applied to more comprehensive and complex portfolio compositions, provided the risk factors used adequately describe the interest rate books risk prole. A subsequent mapping process ensures that cash ows are fully allocated to risk-determining factors (so-called risk factors, data
80
points).163 Modeling the dependence structure will show to what extent risk factors offset or reinforce each other. Different model approaches for calculating VaR are discussed in brief below.
Analytical Approach:
Underlying the well-known variance-covariance approach (delta normal method) are two key assumptions: rst, that changes in the economic value of products react linearly to changes in risk factors and, second, that risk factors have a multivariate normal distribution. Then portfolio changes (prot/loss) will also be normally distributed. These assumptions signicantly reduce the complexity of calculating risk, as all the relevant information for estimating potential changes in economic value can be derived from the empirically estimated variance-covariance matrix. Using the variance-covariance approach poses some problems when the two key assumptions are not met, which is the case for portfolios with nonlinear instruments (particularly options). Credit institutions can enhance the approximation for portfolios with options by using delta-gamma approaches. In this case, the distribution of portfolio changes (or quantiles of prot/loss distribution) must be estimated by means of mathematical approximation processes. Even with such additional approximation, the analytical approach has the advantage of involving a limited amount of computation.
Historical Simulation:
The basic idea of historical simulation consists in using historical changes in risk factors (that are not based on statistical distributions) for the purposes of current valuation. Each portfolio is subjected to revaluation on the basis of historical scenarios. To obtain a balanced proportion of falling and rising interest rate scenarios, credit institutions must use longer-term data histories that go beyond the interest rate cycle. VaR can be calculated as a quantile of the orderly time series of simulated changes in economic value (prot/loss distribution). Since explicit statistical assumptions (distribution, estimation of volatilities and correlations) are not required, historical simulation is widely used even for fairly complex portfolio compositions. Credit institutions should critically consider the overriding dependence of earnings on the underlying series.
Monte Carlo Simulation:
The Monte Carlo simulation is far more complex, but also more powerful than analytical assessments and historical simulations. Unlike historical simulation, Monte Carlo simulation creates scenarios by using random generators. That is to say, credit institutions must de ne a stochastic model as a basis for simulating changes in economic value, which means that the risk factors distribution assumptions are implied. Empirical observations show that the trend in interest rates follows a long-term mean. This characteristic, known as mean reversion, can be mapped by integrating yield curve models into the Monte Carlo simulation. Individual models differ in the number and momentum of stochastic factors. In addition to one-factor models, which usually assume the yield
163
A good overview of different mapping processes is found in Jorion (2001) and Hull (2003).
81
curve to be dependent on the short rate, so-called multifactor models exist which can include an unlimited number of stochastic terms.164 As with historical simulation, VaR is calculated as a quantile of the simulated prot/loss distribution of changes in economic value. While reecting the current risk of the overall portfolio in an aggregated gure, VaR does not provide differentiated information on the interest rate books risk prole. Credit institutions can add up individual VaR gures to total VaR only when assuming perfectly correlated risk factors.165 Moreover, they can estimate the potential risk amounts of individual risk factors relative to overall risk by calculating risk subratios. Marginal VaR describes the change in total VaR given a small change in a risk position. In mathmatical terms, marginal VaR is the rst partial difference of total VaR given a change in volume. Component VAR indicates the contribution to risk for individual positions in the portfolio context, with due consideration of correlation effects. Component VaR technically the marginal VaR multiplied by the current value of the position provides information about the effects of portfolio shift effects and thus pointers for optimizing the interest rate books composition. Moreover, banks might integrate these risk measures into their limit system. Finally, banks may calculate incremental VaR, which shows how total VaR changes through the addition of a further position. If there are many opportunities for portfolio restructuring, calculating incremental VaR becomes unpractical, as VaR must be recalculated in each case. In this case, an approximate calculation based on marginal VaR is recommended.
4.3.2.2. Sensitivity Measures
Sensitivity measures are suitable for making quick, approximate estimations of the interest rate risk of individual positions (or portfolios). Unlike VaR, sensitivity measures do not allow probability statements to be made about the nature and scale of market movements. Given their practical relevance, the traditional duration concept, key rate duration and the basis point value method will be briey described below. The Macaulay duration is de ned as a weighted average of payments made, with the weights being proportional to the economic value of each payment.166 The Modied Hicks duration reects a market values sensitivity to changes in market interest rates; technically, it is simply the duration divided by the term (1+ market yield). Modied duration measures the sensitivity of the economic value of capital to parallel shifts in the yield curve. Alternatively, the duration gap simply cross-tabulates the aggregated duration167 of assets with those of liabilities, thus constituting a measure for the nature and scale of maturity transformation. A positive duration gap (positive maturity transformation) means that the credit institution transforms short-term deposits (duration on the liabilities side) into longer-term loans (duration on the assets side). The duration concept assumes a linear correlation between the development of
164 165 166 167
See Hull (2000), Drosdzol (2005). See Jorion (2001), p. 154ff. First derivative of the economic value according to the market yield In the aggregation of a duration, use is made of the durations property of additivity.
82
economic value and that of yield.168 Price losses computed on the basis of duration tend to be overestimated whereas price gains are underestimated. In respect of negative maturity transformation, the systematic underestimation of price losses (in the event of falling interest rates) on the liabilities side of the balance sheet results in an unwise assessment of interest risk of which banks need to be aware. The Fischer-Weil effective duration, nally, allows the assumption of a at yield curve underlying modied duration to be removed. Based on this concept, modied effective duration is established, again by dividing duration by the term (1+ market yield). At the same time, the remaining assumptions of the Macaulay duration (and of modied duration) such as a parallel shift in the yield curve and limited explanatory power (may be used only to interpret minor changes in market interest rates) are retained. The duration concept can be seen as a preliminary form of key rate duration methods, which use modeling assumptions to break down the overall duration of each individual position into several key rate durations. Hos key rate duration has the added advantage of facilitating the mapping of nonparallel shifts in the yield curve. In this case, the sensitivity of the economic value is described by maturity-specic key rates, which are used as points of reference for the shift in the relevant yield curve segment. If all the subsegments are shifted by a uniform interest differential, they add up to a full parallel shift in the overall yield curve. The sum of the key rate durations is equal to the effective duration. An analytical calculation is only possible if the cash ows are an exact match in time with the key rates. Otherwise, it takes a numerical calculation to cross-tabulate the relative change in market value with the assumed change in key rates. The price value of a basis point (also known as basis point value) indicates the absolute change in market value in the event of the zero bond yield changing by 1 basis point. Unlike modied duration, which is a percentage (relative) measure of sensitivity, basis point value is an absolute measure.
4.3.3 Risk-Adjusted Performance Measures
The use of two assessment criteria (performance and risk) facilitates a differentiated assessment of the interest rate books investment performance. Credit institutions can obtain an integrated view of (expected) earnings and underlying risks by using risk-adjusted performance measures. It is important to use standardized periods when calculating the performance of economic value and value at risk. RORAC and RAROC are used as key measures of yield and risk management:169
RORAC = Performance relative Performance absolute Return riskfree = VaR VaR RAROC = ActualRORAC Target RORAC
168
169
In principle, the larger the change in yield, the larger the approximate error owing to the convex trend in the yield curve from an economic value perspective. See Schierenbeck (2003a), p. 43ff.
83
Risk adjustment enables credit institutions to compare portfolio activities efciently under different risk scenarios. To estimate future earnings effects, credit institutions can perform an (ex ante) RORAC simulation based on different interest rate scenarios. Banks can further enhance validity by comparing actual RORAC with target RORAC. Comparing results with benchmarks adds value, as it allows banks to analyze how well they have positioned their interest rate book relative to market developments. In addition to calculating RORAC, credit institutions must monitor and analyze their limit utilization to safeguard their risk-bearing capacity.170 To ensure their continued existence, banks need to dene their limits in relation to their risk capital, with due consideration of their own risk propensity. Risk limits establish clear conditions and boundaries, within which operational decisions may be taken. In this respect, free risk capital is considered to be an indicator of the risk leeway a bank has in managing interest rate risk.
Chart 36
Presentation of RORAC in the Yield-Risk Diagram

economic value
target: Optimizing RORAC through interest rate risk management measures Benchmark
RORAC interest rate book
performance
RORAC= net earnings VaR risk-free earnings risk capital maximum risk capital nonsustainable risk
Source: OeNB.
4.4 Putting Interest Rate Risk Management into Action

4.4.1 Establishing the Need for Action
The principal aim of integrated interest rate management is to maximize RORAC, subject to earnings and regulatory constraints. Credit institutions must therefore assess possible measures against the background of the current risk situation and their room for risk (free risk capital). In addition, they must assess the situation from an economic value perspective to establish how given measures may affect earnings. To optimize performance and risk, adjustments will be required under both active and passive management approaches. In a passive management framework, operational rules for adjustment can be inferred from the bench170
See Basel Committee on Banking Supervision (2004b), ref. 54ff.
84
marks cash ow structure. Adjustments are necessary all the time given the dynamic nature of cash ows (shortening of residual maturities, new business etc.). The de nition of deviation limits can considerably reduce the transaction costs of the management measures. The difference between the actual cash ow and the benchmark cash ow will indicate adjustment requirements. Banks actively managing their positions take open positions with respect to the given yield curve; they can change their maturity transformation prole by overweighting and by underweighting specic maturity segments. The trend in forward rates relative to the projected yield curve (interest rate expectations) provides pointers for management.171 Figure 5 illustrates this approach: Since forward rates exceed projected interest rates in the short- to mediumterm maturity segment (up to six years), net asset positions (assets > liabilities) raise economic value in these maturity segments when the projected interest rate materializes. Conversely, net liability positions (assets < liabilities) raise economic value in the long-term maturity segment (more than six years), as in this segment the forward rates lie below the projected interest rates.
Chart 37
Pointers for Interest Rate Risk Management in Active and Passive Management Frameworks
EUR 8,000 passive management approach
4,000
4,000
8,000
12,000 1 2 3 4 5 6 7 8
benchmark cash flow projected interest rates Source: OeNB.
9 10 times band (years)
171
Forward rates represent the operational zero line (break-even interest rates) for the alignment of cash ow structure. See Schierenbeck (2003b), p. 632f.
85
Cont. Chart 37
Pointers for Interest Rate Risk Management in Active and Passive Management Frameworks
EUR 12,000 forward rates actual cash flow in the interest rate book active management approach
8,000
4,000
4,000
8,000
12,000 1 2 3 4 5 6 7 8 9 10
benchmark cash flow projected interest rates Source: OeNB.
times band (years)
A simple, exible and cost-effective variant for managing cash ows is to use derivative nancial products. The advantage of interest rate derivatives (over interbank transactions) is that, in addition to being off balance sheet transactions, they do not affect liquidity to the full extent. From a business perspective, managing the cash ow structure through retail transactions is not a viable option.
4.4.2 Rollover (Earnings Perspective)
Economic value added in future earnings periods can be shown by rolling over the gures computed from a balance sheet perspective (interest rate risk management under economic value considerations) into earnings seen from an income state perspective, using rollover computation methods. Aggregate economic value can be rolled over into aggregate earnings on the assumption that all transactions are being unwound at their current money and capital market rates.172 The sum of the par volumes of cash ow-congruent offsetting transactions corresponds to the interest rate books current economic value. Knowledge of the par volumes necessary for liquidation purposes facilitates the calculation of earnings effects. To this effect, interest elements from both interest rate book cash ows and closing transactions must be combined to form the net interest received in the respective period. Such rollovers make it possible to estimate the amount of net interest income that can be reliably generated
172
The mutual identity of economic value and earnings is also applicable if transactions that are expiring are extended to the end of the projection horizon by future money market and capital market activities with forward rates. The sum of discounted net interest received in individual periods corresponds to economic value added.
86
upon immediate or future liquidation of net cash ows. Moreover, rollover methods allow banks to assess the earnings effects their management measures may have on the income statement. The computed contributions to earnings are however only of a calculatory nature, as banks will, as a rule, not fully unwind their interest rate book positions. Another possibility of making economic value added transparent in the current (and/or future) period(s) consists in the synchronic calculation of both economic value added and expected net interest income, including the related appreciation or depreciation of securities.173 What is essential for the interpretation of earnings is that the calculation of both economic value and earnings measures is based on uniform and consistent assumptions and risk parameters (market scenarios, business structures etc.). The logic of simultaneous calculation ensures that the interest rate books strategic positioning is also sustainable from the earnings perspective.
4.4.3 Inclusion of Stress Tests
The methods for calculating interest rate risk cited in section 3.2, Instruments for Quantifying Interest Rate Risks represent only some of the necessary measures for estimating risk. It would be important for credit institutions to also use stress tests. This is explicitly required by the Basel paper on interest rate risk,174 which states: 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 interest rate risk. Such scenarios should be based on historical yield curves and on econometric (e.g. stock exchange crashes, country risks, terrorist attacks or major insolvencies) perspectives. Other scenarios should reect future market estimates derived from ALM or made by ALCO. What is important is that those scenarios must be geared specically to the respective credit institution, as the impact they have on the risk situation very much depends on a banks key exposures.
4.4.3.1. Recognition of Major Market Developments
Once scenario that might be used is the 200 basis point shift proposed for establishing interest rate risk statistics. However, banks should also consider deriving alternative scenarios from past developments to assess the future trend in interest rates, because not all positions react to a parallel shift in the yield curve. Stress scenarios may for instance be de ned with the help of main component analysis. Main component analysis is helpful for deriving potential yield curves, as it not only highlights the components that affect the curve but also shows how strong their impact is. Generally, a few factors are will emerge as the key drivers behind yield curve changes, with main component analysis revealing how much each component contributes to yield curve changes.
173 174
See subsection 3.2.2.1, Dynamic Simulation of Earnings. See Basel Committee on Banking Supervision (2004b), ref. 60ff.
87
To given an example, we have analyzed the euro swap curves uctuations in the period from 1998 to 2006 (Libor and swap rates). In this case, a mere four factors sufced to explain 99% of the changes in the yield curve:175 1. a shift in the money market, giving rise to a parallel shift in money market rates176 2. a shift in the capital market, giving rise to a parallel shift in capital market rates 3. a twist, giving rise to a change in the slope of the yield curve (the difference between short-term rates and long-term rates) 4. a buttery, giving rise to a change in the yield curvature, i.e. yields of short-term and long-term maturities move in the opposite direction to yields of medium-term maturities
175 176
See http://www.unriskderivatives.com/download/Hauptkomponenten_der_Zinsstruktur.pdf. The analysis focused on swap rates. In main component analysis based on zero rates, the money market and capital market shift is combined. However, this means that the buttery scenario, of which the swap rate contribution amounts to only about 0.1%, should also be included as a scenario.
88
Chart 38
The Euro Yield Curve with Scenarios and their Explanatory Contribution
% 5.0 Interest rate scenarios based on the euro swap curve of July 2006
4.5
4.0
3.5
3.0
2.5
2.0 3 6 months % 80 1 2 3 4 5 6 7 8 9 10 11 12 13 years 14 15 16 17 18 19 20 maturity
Explanatory contribution per scenario
60
40
20
0 money market shift capital market shift twist butterfly

twist butterfly
factor
yield curve as of July 06 money market shift capital market shift Quelle: OeNB.
These few components usually reect not only the interest rate risk of the euro yield curve but also that of other important yield curves (e.g. U.S.A., Japan), albeit with other explanatory contributions.177 The following steps are necessary to de ne potential scenarios based on these components: De ne how much of the change in the yield curve (or swap curve) is explained by a given component 178 De ne factor loads (weights of individual components per time band)
177 178
See Flacke and Siemens (2002). For the purposes of a simplied presentation, the factor loads are assumed to be 1 in the example cited.
89
Calculate risk factors (multiplication of factor loads by a multiple of standard deviation)179180 Calculate shift, twist and buttery scenarios Credit institutions may combine the shift, twist and buttery scenarios (both up and down) to dene potential stress scenarios (Si) based on these components.
Chart 39
Developing Scenarios for Stress Tests

S3
180
S7 S8 S1 S4 S10 S11 S5 S2 S12 S13 S6 S14 shift

Source: OeNB.
S9
twist
butterfly
Chart 40
Combined Interest Rate Scenarios

interest rate 5,0
4.5
4.0
3.5
3.0
2.5
2.0 3 6 months
S3 S7 Source: OeNB.
179
4
S6 S14
10 11 12 13 years
14 15 16 17
18
19 20 maturity
180
In order to keep the calculation simple, only a multiple (e.g. the double) of the positive and negative standard deviation is used for simplication purposes. The higher the multiple, the more unlikely is the stress scenario. See Paulus, Sauer and Walther (1998), p. 14.
90
Note that the scenarios S7 (combining shift up, twist up, buttery up) and S14 (combining shift down, twist down, buttery down) represent potential stress scenarios.In addition to these interest rate scenarios based on historical analyses, credit institutions must also de ne worst case scenarios, based e.g. on outliers of historical analyses and credit institutions own specic outlier analyses (extreme value approaches).
Extreme Value Theory
Main component analysis described above, as a rule, ignores the highest and lowest values of historical observations. Extreme value theory specically models the distributions of those values.
Chart 41
Fat Tails
frequency density 40
30 threshold 20
10
0 5.0
theoretical normal distribution actual distribution Quelle: OeNB.
2.5
2.5
5.0
7.5 daily change (%)
Analyses are based on the extreme change in values above a certain threshold (e. g. 95% quantile) and on the underlying distributions (e. g. FrchetWeibull-Gumbel distribution181). Extreme values are derived from underlying distribution (or density) functions. Worst case scenarios may also be based on expert opinions. The idea of such scenarios is to depict particularly negative results (stock exchange crash, terrorist attacks etc.) and involve all policy and decision makers. This holistic approach makes such scenarios highly acceptable within the bank.
4.4.3.2. Recognition of Marked Changes in Retail Behavior
In addition to using scenarios that simulate interest rate developments, notional changes affecting individual segments (e.g. current accounts) and individual items (structured products) should also be tested for their potential impact on banks proprietary and retail transactions. Owing to the growing density of information (e.g. via the internet and other new media), customers sensitivity to market changes and information
181
See Wurzer (2003), p. 16ff.
91
has increased considerably in recent years. Credit institutions should take account of this fact when developing scenarios by factoring in potential retail developments that have a massive impact on interest rate risk (e. g. allocate all positions without xed repricing proles and/or stipulated lock-up periods to the shortest time band). In addition, credit institutions could also use specic positions maximum historical changes in volume.182
4.4.3.3. Stress Test Requirements
Stress test requirements should be based on the requirements that apply to the trading book.183 The most important of these are briey summarized below: 1. Stress scenarios should represent unusual albeit conceivable market movements. Acceptance is best reached by involving all decision-making bodies in de ning these scenarios. 2. Credit institutions should match the scenarios with the risk prole of their transactions. 3. Different scenarios should be combined with different subportfolios. 4. Regular monitoring and measurement are required for credit institutions to react to portfolio shifts, based on the following considerations: What are the worst case scenarios for a given credit institution? What does the potential for losses look like in individual scenarios? To what extent are these risks offset by the banks capital, i.e. what is its risk-bearing capacity? What precautions can credit institutions take to counter these potential scenarios (raising management risk awareness)? 5. Credit institutions should clearly de ne and document what kind of stress test result is a cause for concern. 6. Credit institutions must de ne what action is to be taken when a stress result is a cause for concern. 7. The results of the stress tests must be communicated to senior management.
4.5 Ex Post Analysis In addition to economic value added, which reects both realized (liquidityaffecting) and unrealized (imputed) income components, ex post analysis should also involve the development of earnings measures, as well as the need for appreciation or depreciation of securities. The imputed effects reect those income components that have an effect on earnings when cash ows are repaid. In addition, the Basel Committee for Banking Supervision requires that embedded (imputed) losses are monitored on an ongoing basis.184 A key factor for a transparent presentation of performance is the cost-causative breakdown and allocation of income components. In this connection, the market interest rate method has emerged as a generally accepted standard for analyzing net interest income. Results must be reported to the decisionmaking bodies in a timely manner under a strict reporting regime.
182 183 184
See 4.2.1.2, Nonmaturation Theory. See OeNB (1999). See Basel Committee on Banking Supervision (2004b), ref. 22.
92
To ensure the quality of both risk measurement and management, credit institutions must backtest projected (ex ante) losses of economic value below a given probability (VaR) by comparing them with actual (ex post) changes in economic value. This approach prevents credit institutions from systematically underestimating or overestimating interest rate risk. Furthermore, banks must regularly review their replication rules for products with uncertain cash ows and revise their interest rate forecasts. Additionally, credit institutions must analyze the impact of extreme market situations on economic value and earnings performance.185 Within the integrated management process, banks will, in turn, rede ne and adjust their risk policy principles in the light of ex post ndings (risk-bearing capacity analysis, backtesting, stress tests etc.).
References
Backhaus, Klaus, ERICHSON, Bernd, PLINKE Wulff and WEIBER, Rolf, Multivariate Analysemethoden, May 2005, 11th edition.
Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards A Revised Framework (updated version), November 2005.
Basel Committee on Banking Supervision, Principles for the Management of Interest Rate
Risk, September 1997.
Basel Committee on Banking Supervision, Principles for the Management and Supervision
of Interest Rate Risk, 2001.
Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Requirements, June 2004a.
Basel Committee on Banking Supervision, Principles for the Management and Supervision
of Interest Rate Risk, Juli 2004b.
Betz Heino, Integrierte Credit Spread- und Zinsrisikomessung mit Corporate Bonds, Frankfurt,
2005, 1st edition. Bhler, Alfred, Kapitalmarktzinsen als Referenzgrssen, Modellierung von Bodensatzprodukten (3), 2000, pp. 4446. Bschgen, E. Hans. and BRNER, J. Christoph, Bankbetriebslehre, Stuttgart, 2003. Committee of European Banking Supervisors, Consultation paper on technical aspects of the management of interest rate risk arising from non-trading activities and concentration risk under the supervisiory review process CP 11, March 2006a. Committee of European Banking Supervisors, Technical aspects of the management of interest rate risk arising from non-trading activities under the supervisory review process, October 2006b. Deutsch, Hans-Peter, Derivate und Interne Modelle, 2001, 2nd edition. Drosdzol, Adam, Zinsmanagement mit Zinsstrukturmodellen, Frankfurt, 2005, 1st edition. Eller, Roland, SCHWAIGER, S. A. Walter and FEDERA, Richard: Bankbezogene Risiko und Erfolgsrechnung, 2001. Finance-Trainer, Bank-Forum, July 2002 No. 27. Finance-Trainer, Bank-Forum, October 2005 No. 40.
Flacke, Klaus and SIEMENS, Andreas, Das Faktorenmodell zur Risikoquantifizierung von internationalen Bondportfolios, in: Finanz Betrieb, November 2002, Series 4., volume 11, pp. 667675.
185
See subsection 4.4.3, Inclusion of Stress Tests.
93
Frauendorfer, Karl and SCHRLE, Michael, Dynamic modelling and optimization of nonmaturing accounts. In: Liquidity Risk Global Best Practices, 2006, pp. 327359.
Grttrup, Timo, Praktische Umsetzung einer barwertigen Zinsbuchsteuerung unter GuV Restriktionen in einer Sparkasse, 2005. Grundtke, Peter, Regulatorische Erfassung von Zinsnderungsrisiken im Anlagebuch von Banken, in: Zeitschrift fr Bankrecht und Bankwirtschaft, 2006, Series 18., volume 4, pp. 283295. Hegel, Georg, Wilhelm, Friedrich, Phnomenologie des Geistes, Suhrkamp, 1970. Huber, Otto, Abbildung variabler Hypotheken im Rahmen der Marktzinsmethode, June 2004. Hull, John, Options, Futures & other Derivatives, Prentice Hall, Pearson Education International, Toronto, 2003, 5th edition.
Jorion, Phillipe, Value-at-Risk: The New Benchmark for Managing Financial Risk; McGraw-Hill, New
York, 2001, 2nd edition. Katzengruber, Bruno, Anwendungsprobleme bei Optionen im Aktiv-Passiv-Management, 2001, contribution to: BA 9/2001, pp. 703706. Markus, Daniel, Cashflows im Kundengeschft der Kreditinstitute, in: Handbuch des Risikomanagements, 2002, 2nd edition, pp. 207234. Matz, Leonard M., Interest Rate Risk Management, 2005. OeNB and FMA, Guidelines on bank-wide risk management Internal Capital Adequacy Assessment Process, January 2006. OeNB, Durchfhrung von Krisentests, Guidelines on market risk, September 1999, volume 5. OeNB, Guidelines on financial instruments Product Manual Part A Interest Rates, June 2003. Paulus, Helmut, SAURER, Andreas and WALTHER Bernhard, Faktorbasierte Szenario-Strategien am Deutschen Rentenmarkt, in: Handbuch Portfolio Management, 1998, pp. 124. Rolfes, Bernd and BANNERT, Thomas, Die Kalkulation variabel verzinslicher Bankgeschfte, in: Handbuch Bankcontrolling, 2001, 2nd edition, pp. 281299 Schierenbeck, Henner, Ertragsorientiertes Bankmanagement, Band 1, Grundlagen, Marktzinsmethode und Rentabilitts-Controlling, Wiesbaden 2003a, 8th edition. Schierenbeck, Henner, Ertragsorientiertes Bankmanagement, Band 2, Risiko-Controlling und integrierte Rendite-/Risikosteuerung, Wiesbaden 2003b, 8th edition. Schwanitz, Johannes, Management des Liquidittsrisikos, in: Handbuch Derivater Instrumente Produkte, Strategien, Risikomanagement, Stuttgart, 2005, 3rd edition. Schwanitz, Johannes, Elastizittsorientierte Zinsrisikosteuerung in Kreditinstituten, Schriftenreihe des Zentrums fr Ertragsorientiertes Bankmanagement, 1996. Wurzer, Roland, VaR mit zugrunde liegenden Extremwertverteilung, 2003.
94
Useful Internet Links:
OeNB and FMA, Ausweisrichtlinie zu Risikoausweis, Annexes A3b, B3b, C/D 3b and D/E3b (German only); Download at: www.oenb.at/de/stat_melders/melderservice/bankenstatistik/aufsichtsstatistik/vera_neu/vera_uebersicht.jsp Basel II Publications Series of the OeNB and FMA, Download at: www.oenb.at/en/finanzm_stab/basel_II/publikationen/dokumente_ oesterr/publications_of_the_oenb.jsp#tcm:16-16840 or www.fma.gv.at/cms/basel2/EN/detail.html?channel=CH0281&doc=C MS1144346855538 www.fma.gv.at/cms/basel2/EN/ www.mathconsult.co.at/ www.unriskderivatives.com
Abbreviation Key
ALCO CEBS CMB CMS CRD EC EU Directive or EU Directive 2000/12/EC EVA GAAP MCM IAS/IFRS ICAAP MBS OAS RAROC RARORAC REX-P RORAC SMY SREP UFN VaR Asset-Liability Committee Committee of European Banking Supervisors Constant maturity bond Constant maturity swap Capital Requirements Directive (Directive 2006/48/EC) Escalator clause Directive of the European Commission on the capital adequacy of credit institutions and investment rms in the EU Economic value-added General Accepted Accounting Principles Money and capital market International Accounting Standards/International Financial Reporting Standards Internal Capital Adequacy Assessment Process Mortgage backed securities Option adjusted spread Risk-adjusted return on capital Risk-adjusted return on capital German bond market index (performance index) RORAC: Return on risk-adjusted capital Secondary market yield Supervisory review evaluation process Until further notice Value at risk
95

Guidelines On Managing Interest Rate Risk in The Banking Book

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Guidelines on

Managing Interest Rate Risk in the Banking Book

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Typesetting, printing and production:

Univ. Doz. Mag. Dr. Josef Christl

Dr. Kurt Pribil, Mag. Helmut Ettl

Measuring and Managing Interest Rate Risk in the Banking Book

Integrated (Dual) Management of the Interest Rate Book

1.2.2 Earnings Perspective and Economic Value Perspective

See Basel Committee on Banking Supervision (2004b), ref. 13ff

1.2.4 Trading Book vs. Banking Book

Recognition of Interest Rate Risk in the Trading and Banking Books

See OeNB (2003).

2 International Regulations and Transposition into Austrian Legislation

Three-Pillar Architecture of Basel II

Stability of the Financial System

Disclosure obligations for interest rate risk in the banking book

See Basel Committee on Banking Supervision (2004a), ref. 762.

2 International Regulations and Transposition into Austrian Legislation

2.1.1 Pillar 2 Inclusion of Interest Rate Risks

2 International Regulations and Transposition into Austrian Legislation

2 International Regulations and Transposition into Austrian Legislation

management responsibility guidelines for banking supervisors

risk strategy requirements

2.1.3.1. Management Responsibility

2 International Regulations and Transposition into Austrian Legislation

See Article 39 paragraph 2 of the Austrian Banking Act.

2 International Regulations and Transposition into Austrian Legislation

2 International Regulations and Transposition into Austrian Legislation

2 International Regulations and Transposition into Austrian Legislation

2.2.2 Further Specications by CEBS

2 International Regulations and Transposition into Austrian Legislation

2 International Regulations and Transposition into Austrian Legislation

www.oenb.at/de/stat_melders/melderservice/bankenstatistik/aufsichtsstatistik/vera_neu/vera_ uebersicht.jsp (German only).

2 International Regulations and Transposition into Austrian Legislation

Presentation of Interest Rate Risk in Interest Rate Risk Statistics

2 International Regulations and Transposition into Austrian Legislation

2 International Regulations and Transposition into Austrian Legislation

2 International Regulations and Transposition into Austrian Legislation

2 International Regulations and Transposition into Austrian Legislation

3 Measuring and Managing Interest Rate Risk in the Banking Book

floating rate notes

3 Measuring and Managing Interest Rate Risk in the Banking Book

3.1.2 Managing Interest Rate Risk from an Economic Value Perspective

See chapter 4, Integrated (Dual) Interest Rate Book Management.

3 Measuring and Managing Interest Rate Risk in the Banking Book

3.1.3 Optimal Interest Rate Risk Management Strategies

3 Measuring and Managing Interest Rate Risk in the Banking Book

Comparison of Pointers for Interest Rate Risk Management

Pursuant to IAS 39.

3 Measuring and Managing Interest Rate Risk in the Banking Book

Performance Measured from an Economic Value Perspective transactions

Performance Measured from an Earnings Perspective

See Basel Committee on Banking Supervision (2004b), ref. 40.

3 Measuring and Managing Interest Rate Risk in the Banking Book

Instruments/Methods for Quantifying Risk in the Banking Book

performance measured from an economic value perspective

economic value simulation value at risk

3 Measuring and Managing Interest Rate Risk in the Banking Book

3 Measuring and Managing Interest Rate Risk in the Banking Book

Net Positions and their Earnings Profile

falling interest rates risk opportunity

The following points of criticism relating to gap analysis are relevant:67