managing interest rate risk in the banking...

G u i d e l i n e s o n

Managing Interest Rate Riskin the Banking Book

These guidelines were prepared by the Oesterreichische Nationalbank (OeNB)

in cooperation with the Financial Market Authority (FMA)

Publisher and editor:Oesterreichische Nationalbank (OeNB)Otto-Wagner-Platz 3, 1090 Vienna, Austria

Financial Market Authority (FMA)Praterstraße 23, 1020 Vienna, Austria

Produced by:Oesterreichische Nationalbank

Editors in chief:Günther Thonabauer, Communications Division (OeNB)Barbara Nösslinger, Executive Board Affairs and Public Relations (FMA)

Coordinating editors:Gerhard Coosmann, Christian Doppler, Mario Plieschnig, Johannes Turner (all OeNB)Benedikt Hejda, Elisabeth Lehner, Elmar Mitterbuchner, Dagmar Urbanek, Ferdinand Wenzl (all FMA)

Translation:OeNB Language Services

Design:Peter Buchegger, Communications Division (OeNB)

Typesetting, printing and production:OeNB Printing Offi ceOtto-Wagner-Platz 3, 1090 Vienna, Austria

Inquiries:Oesterreichische NationalbankCommunications DivisionPostal address: P.O. Box 61, 1011 Vienna, AustriaPhone: (+43-1) 404 20-6666Fax: (+43-1) 404 20-6698

E-Mail: [email protected]

Financial Market Authority (FMA)

Executive Board Affairs and Public RelationsPraterstraße 23, 1090 Vienna, Austria Phone: (+43-1) 249 59-5100

Orders:Oesterreichische NationalbankDocumentation Management and Communications ServicesPostal address: P.O. Box 61, 1011 Vienna, AustriaPhone: (+43-1) 404 20-2345Fax: (+43-1) 404 20-2398

E-Mail: [email protected]

Internet:www.oenb.atwww.fma.gv.at

Paper:Salzer Demeter, 100% woodpulp paper, bleached without chlorine, acid-free without optical whiteners

DVR 0031577

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The dynamic growth of fi 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 insti-tutions need to implement sound risk control and management systems. As a signifi cant 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 reli-ably. 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 suit-ability of individual approaches depend to a large extent on the complexity of each bank’s 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 Austria’s banks. We hope that these guidelines make for interesting and insightful reading.

Vienna, spring 2008

Preface

Univ. Doz. Mag. Dr. Josef ChristlMember of the Governing Board

of the Oesterreichischen Nationalbank

Dr. Kurt Pribil,Mag. Helmut Ettl

Management Board of FMA

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1 Introduction 7 1.1 Motivation and Business Rationale 7 1.2 Defi nitions of Risk and Other Defi nitions 7 1.2.1 Defi nition of Interest Rate Risk 7 1.2.2 Earnings Perspective and Economic Value Perspective 8 1.2.3 Sources of Interest Rate Risk 8 1.2.4 Trading Book vs. Banking Book 9

2 International Regulations and Transposition into Austrian Legislation 11 2.1 Interest Rate Risks in the Banking Book from the Basel II Perspective 11 2.1.1 Pillar 2 – Inclusion of Interest Rate Risks 12 2.1.2 Pillar 3 – Disclosure Obligations Relating to Interest Rate Risk 12 2.1.3 Principles for Managing Interest Rate Risk – The Basel Paper on Interest Rate Risk 13 2.2 EU Statutory Requirements for Transposition into Austrian Legislation 17 2.2.1 Basel II Guidelines 17 2.2.2 Further Specifi cations by CEBS 18 2.3 Reporting Requirements for Interest Rate Statistics 19 2.3.1 Revised Reporting Regime 19 2.3.2 Statutory Reporting Requirements 19 2.3.3 Scope of Interest Rate Risk Reporting 20 2.3.4 Limitations of Interest Rate Risk Statistics and the Internal Model 20 2.4 Evaluation and Treatment of Interest Rate Statistics by Banking Supervisors 21 2.4.1 Refl ections on Capital Adequacy 22 2.4.2 Standardized Interest Rate Shock 23 2.4.3 Defi nition and Treatment of Outlier Banks 23

3 Measuring and Managing Interest Rate Risk in the Banking Book 26 3.1 To Choose an Economic Value or an Earnings Perspective? 26 3.1.1 Managing Interest Rate Risk from an Earnings Perspective 27 3.1.2 Managing Interest Rate Risk from an Economic Value Perspective 27 3.1.3 “Optimal” Interest Rate Risk Management Strategies 28 3.2 Instruments for Quantifying Interest Rate Risks 31 3.2.1 Gap Analysis 32 3.2.2 Simulation Models 34 3.2.3 Elasticity Analysis 38

Table of Contents

4 Integrated (Dual) Management of the Interest Rate Book 41 4.1 Defi nition of the Risk Strategy 46 4.1.1 Defi nition of Benchmarks 46 4.1.2 Defi nition of Interest Rate Management Philosophy 47 4.1.3 Interest Rate Risk Limits 48 4.1.4 Product Innovation Process 49 4.2 Cash Flow Modeling 51 4.2.1 Retail Transactions 52 4.2.2 Proprietary Trading Activities – Derivatives and Structured Products 71 4.2.3 Noninterest-Sensitive Positions with an Imputed Repricing Profi le 77 4.3 Yield/Risk Analysis 78 4.3.1 Yield Analysis 78 4.3.2 Risk Analysis 79 4.3.3 Risk-Adjusted Performance Measures 83 4.4 Putting Interest Rate Risk Management into Action 84 4.4.1 Establishing the Need for Action 84 4.4.2 Rollover (Earnings Perspective) 86 4.4.3 Inclusion of Stress Tests 87 4.5 Ex Post Analysis 92

References 93

Abbreviation Key 95

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1.1 Motivation and Business RationaleOne of the key economic functions of credit institutions is to convert short-term deposits into long-term loans. Depending on the scale of this maturity transformation – which essentially determines the risk arising from a bank’s balance sheet structure – sharply fl uctuating market interest rates can have a considerable impact on banks’ earnings and on their capital base. The increas-ing complexity of markets makes effective processes for measuring and man-aging interest rate exposure an essential business requirement for credit insti-tutions. The fi rst challenge in this respect is to choose the right instruments from among the wide variety that is available to effi ciently manage maturity transformation in line with interest rate expectations.

The growing importance of interest rate risk in integrated risk manage-ment is also refl ected in the relevant regulatory provisions. Following the latest amendment of the Austrian Banking Act, interest rate risk is now, for the fi rst time, explicitly cited among the due diligence obligations (under Article 39 paragraph 2b No 8 of the Austrian Banking Act).

1.2 Defi nitions of Risk and Other Defi nitions1.2.1 Defi nition of Interest Rate Risk

Interest rate exposure is generally described as the risk of a reduction in a pro-jected or anticipated measure of net interest income (target measure) resulting from changes in market interest rates.1 Yet from a practical perspective such a defi nition is somewhat fl awed, as the use of an anticipated (or projected) mea-sure of net interest income is fraught with risks. Any inappropriate assum ption in the projection phase will produce an inaccurate target measure and, conse-quently, result in an inaccurate assessment of interest rate risk.

In a more useful way, interest rate exposure could be defi 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. Con-versely, banks stand to benefi t from an “interest rate opportunity” should favorable changes in market interest rates drive up net interest income. Using a “zero line”2 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 institution’s perfor-mance. The Basel Committee on Banking Supervision, for instance, bases its defi nition on the different effects of interest rate exposure: 3

“Interest rate risk is the exposure of a bank’s fi nancial condition to adverse movements in interest rates. […] Changes in interest rates affect a bank’s 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 bank’s assets, liabilities, and off-balance-sheet (OBS) instruments because the economic value of future cash fl ows (and in some cases, the cash fl ows themselves) change when interest rates change.”

1 See Schwanitz (1996), p.5. 2 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.3 See Basel Committee on Banking Supervision (2004b) ref. 11.

1 Introduction

1 Introduction

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1.2.2 Earnings Perspective and Economic Value Perspective

Changes in interest rates affect a bank’s earnings and its risk situation in differ-ent ways. With regard to assessing a bank’s 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 bank’s near-term earnings. After all, changes in the yield curve have a direct impact on a bank’s future net interest income (including the estimated net income from asset securitization programs). Even noninter-est 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 earn-ings 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 fl 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 fl ows included in the calculation (= primary economic value perspective) and by the change in the discount rates of all future cash fl 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) fee-based fi nancial services (loan servicing, asset securitization programs, pay-ments 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 fi 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 Com-mittee on Banking Supervision breaks down interest rate risk into four main types:4

repricing risk, which arises from mismatches in interest rate fi 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

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

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1 Introduction

9

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 differ-entiate between interest rate risks in the trading book and interest rate risks in the banking book.

Under Article 22n paragraph 1 of the Austrian Banking Act, all positions in fi nancial instruments and commodities held for trading purposes are to be assigned to the trading book. Likewise, fi nancial instruments and commodi-ties used to hedge or refi nance specifi c 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 regula-tory 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 institution’s 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 simplifi ed 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 identifi ed in the trad-ing book8 – i.e. interest rate risks in the banking book – should be considered

5 A revised version was published in 1998.6 See Article 22o of the Austrian Banking Act and § 195ff of the Solvency Regulation.7 See Article 22p of the Austrian Banking Act and § 224ff of the Solvency Regulation.8 See Article 39 paragraph 2b of the Austrian Banking Act.

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Chart 1

Source: OeNB.

interest rate risk in the trading 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

Article 22n paragraph1 of the Austrian Banking Act

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

Recognition of Interest Rate Risk in the Trading and Banking Books

interest rate risk in the banking book

1 Introduction

10

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 profi le.

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.

9 See OeNB (2003).

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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 refl ect current developments in banking and to strengthen the stability of the international fi nancial system. On Novem -ber 15, 2005, the Basel Committee on Banking Supervision presented the revised version of the “Basel II” Capital Accord’s framework agreement, ini-tially released under the title “International Convergence of Capital Measure-ment 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 obliga-tions (Pillar 3).

The Basel Committee had originally planned to consider interest rate risks from the banking book under Pillar 1. However, given considerable differ-ences 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.

2 International Regulations

and Trans position into Austrian Legislation

Chart 2

Source: OeNB.

PILLAR 1

minimum capital requirements

Three-Pillar Architecture of Basel II

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)

PILLAR 2

supervisory review process

requirements for banks (ICAAP)• capital control including risk management

recognition of interest riskin the banking book

requirements for banking supervisors(SREP)• evaluation of banks’ internal systems• assessment of risk profile• monitoring compliance with

all requirements• supervisory measures

PILLAR 3

market disciplinecontrol by the market

disclosure obligations of banks

• transparency for market participantsin respect of a bank’s risk situation(scope of application, risk management,comprehensive regulatory capital data)

• enhanced comparability ofcredit institutions

Stability of the Financial System

Disclosure obligations forinterest rate risk in the banking book


and Transposition into Austrian Legislation

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2.1.1 Pillar 2 – Inclusion of Interest Rate Risks

The fi rst component of Pillar 2 is the internal capital adequacy assessment pro-cess (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 profi le, 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 exam-ples 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 redefi ning the calculation of capital requirements and establish-ing 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 fi 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 See Article 26 paragraphs 5 and 6 of the Austrian Banking Act.12 Federal Law Gazette II No. 375/2006.



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Within banking groups it is, as a rule, the responsibility of the highest con-solidation level to disclose all details that are relevant under Pillar 3.13 Unless specifi ed 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 institution’s 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 satisfi ed 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 Requirements”15 published by the Basel Committee on Banking Super-vision provides only general information on interest rate risk in the banking book. More specifi c 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 defi 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 specifi ed by the Basel paper on interest rate risk published in 2004. The following section briefl y describes the individual principles and indicates the corresponding passages in the Austrian Banking Act through which they have been trans-posed into Austrian legislation.

13 There is an exception in respect of signifi cant 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 classifi ed as being signifi cant subsidiaries by the FMA by way of an administrative ruling, subject to the criteria stipu-lated in Article 26a paragraph 5 of the Austrian Banking Act.

14 See Article 26 paragraph 3 of the Austrian Banking Act.15 Basel Committee on Banking Supervision (2004a), ref. 762Ð764.16 The related consultation paper was published in January 2001. See Basel Committee on Banking

Supervision (2001).17 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).



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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 fulfi lling 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 obli-gations must be defi ned accordingly to ensure adequate assessment of the credit institution’s risk sensitivity as well as effective and effi cient 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 institution’s banking activities. In this instance, the principle of proportionality is a major

18 For defi nitions 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.

19 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.

Chart 3

Source: OeNB.

Qualitative Principles of Interest Rate Risk Outlined by the Basel Paper on Interest Rate Risk

guidelines forbanking supervisors14. Basel standardized market risk

scenarios

15. sanction mechanisms

Qualitative Principlesof the Basel Paper

on Interest Rate Risk

management responsibility1. supreme management body

2. senior management

3. functional independence of unitsrisk strategy requirements1. principles/processes

2. product innovation

integrated risk managementprocess, internal controls6. measurement, methodology

2. risk limitation

3. stress testing

4. monitoring

5. internal audit

11. information for banking supervisors

12. capital adequacy

1. disclosure



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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 com-mittees. In addition, the relevant units must be functionally independent to avoid potential confl 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 indepen-dence vis-à-vis individuals who undertake risk positions.

Senior management is responsible, above all, for the existence of appropri-ate 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 effec-tive internal controls. Staff members, in turn, need to be suffi ciently 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 require-ment for the proper management of a bank’s interest rate risk is the defi nition of the relevant principles and processes based on proportionality. More specifi cally, it is important to clearly defi 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 specifi ed as well. Qualitative points of this nature should be supple-mented 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 speci-fi es that due consideration must be given to the safety of customers’ deposits and to the preservation of the bank’s 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.



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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 quanti-fi ed. 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 specifi ed 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. Subsec-tion 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 defi ned principles and processes, and that the defi ned processes accomplish the intended objectives.

Article 39 paragraph 2 of the Austrian Banking Act specifi es that the appro-priateness of the processes and their application should be reviewed by the bank’s internal audit unit at least once a year. The duties of the internal audit unit are specifi ed 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 commen-surate with the capital allocated.23 In Principle 12, the Basel Committee on

21 See Article 39a paragraph 2 Austrian Banking Act.22 See OeNB (1999), and subsection 4.4.3, Inclusion of Stress Testing.23 See subsection 2.1.1, Pillar 2 – Inclusion of Interest Rate Risks.



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Banking Supervision specifi es that credit institutions undertaking signifi cant 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 Bank-ing Supervision explains that banking supervisors should have enough infor-mation 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 bank’s 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 trans-posed into EU legislation as Directives 2006/48/EC27 and 2006/49/EC28 and published in the Offi cial 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 corpo-rate governance with clear organizational structures and lines of responsi-

24 See section 2.3, Supervisory Reporting on Interest Rate Risk.25 See notes on Article 39a paragraph 1 of the Austrian Banking Act (1558 d.B. XXII. GP).26 See subsection 2.4.3, Defi nition and Treatment of Outlier Banks. 27 Directive relating to the taking up and pursuit of the business of credit institutions (new version)

[previously: Directive 2000/12/EC]. 28 Directive on the capital adequacy of investment fi rms and credit institutions (new version) [previ-

ously: Directive 93/6/EEC].

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18

bility. Annex V, No 10 defi nes the technical criteria relating to the organi-zation and treatment of interest rate risks in the banking book.Article 123 of the Capital Requirements Directive defi nes the requirement for credit institutions to have in place comprehensive strategies and pro-cesses for ensuring on an ongoing basis the assessment of the amount, com-position 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 institu-tion’s activities Article 123 of the Capital Requirements Directive specifi -cally 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 trans-posed 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 Specifi cations by CEBS

In respect of interest rate risk in the banking book, the Committee of Euro-pean Banking Supervisors (CEBS) discussed the Basel II regulations in greater detail and issued a set of guidelines entitled “Technical aspects of the manage-ment of interest rate risk arising from non-trading activities under the super-visory review process.” This paper, published after offi cial 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 specifi ed the points already addressed in subsec-tion 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 tech-niques, systems and processes – after all, it is up to each bank how to imple-ment the system quantitatively.29 Basically, CEBS confi rms the importance of the principle of proportionality as a yardstick for the complexity of methodol-ogies. Moreover, credit institutions are expected to show that their internal capital calculated is suffi cient 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 insti-tutions to be able to calculate at the very least the effects of a standardized

29 See CEBS (2006a), p.1. 30 See Article 39a paragraph 1 of the Austrian Banking Act and also CEBS (2006b), p.9.

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19

interest rate shock,31 which is defi ned as a sudden and unexpected change in money market and/or capital market rates. The need for supervisory interven-tion 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 particu-lar, 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 fi 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 wide-ranging 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 fi 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-specifi c due diligence obligations (Articles 39 and 39a of the Austrian Banking Act). Furthermore, Article 74 paragraph 1 fi nal sentence of the Austrian Banking Act requires superordinate credit insti-

31 See CEBS (2006a), pp. 9 and 11.32 COREP = Common European Reporting for Solvency; FINREP = Financial Reporting (for corpo-

rate fi nancial statements under IFRS).33 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.



20

tutions to prepare the report of condition and income also for fully consoli-dated 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 subsidiar-ies.

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 defi ned in Article 22q paragraph 1 of the Austrian Banking Act. Credit institutions which use complex processes (models pursu-ant to Article 22p of the Austrian Banking Act) for calculating their capital in the trading book may – with the OeNB’s 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 simplifi ed form. For instance, credit institutions need not include subsidiaries with no signifi cant 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 simplifi cations 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 fl ows dis-regarded, book value reporting, fl 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).



21

separate sets of interest rate data (III. Standardized Approach, IV. Internal Risk Management):

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 specifi ed at 200 basis points in the reporting guidelines on the risk statement). Credit institutions with an inter-nal risk measurement system in place that differs from the selected standard-ized 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 manage-ment framework. Specifi cally, credit institutions must establish an internal capital adequacy assessment process (ICAAP) for assessing capital adequacy in relation to their risk profi le.

Moreover, Pillar 2 requires banking supervisors to subject all credit insti-tutions to a supervisory review and evaluation process (SREP). SREP includes the evaluation of a credit institution’s own internal processes, systems, mecha-nisms and strategies, as well as the evaluation of its risk profi le.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 Repricing method or duration method 36 See Reporting guidelines on the risk statement.37 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.

Table 1

Presentation of Interest Rate Risk in Interest Rate Risk Statistics

III. Standardized approach IV. Internal risk management

change in economic value triggered by the assumed

change in interest rates

change in economic value triggered by the assumed

change in interest rates

% of eligible capital % of eligible capital



22

scale and risk inherent in bank activities (proportionality principle).38 If neces-sary, supervisory measures can be imposed in the event of noncompliance.

2.4.1 Refl ections on Capital Adequacy

Credit institutions undertake risks as part of their business activities and bear the fi 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 identifi ed in the banking book must be measured by sound systems, com-mensurate with risk-bearing capacity and covered by adequate capital. A credit institution’s risk-bearing capacity can only be guaranteed in the long term if the capital it holds is adequately suffi cient 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 measur-ing 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 mon-itoring earnings, best practice is to react to increases (changes) in the eco-nomic 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 defi 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 institu-tions 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 Article 124 paragraph 4 of the Capital Requirements Directive: Competent authorities shall estab-lish 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.

39 See Büschgen/Börner (2003), p. 18ff. 40 See Basel Committee on Banking Supervision (2004b), ref. 719ff.41 See OeNB/FMA (2006), p. 69.42 See Reporting guidelines on the risk statement.43 See Eller/Schwaiger/Federa (2001), p. 3ff.44 See Eller/Schwaiger/Federa (2001), p. 2.



23

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 differ-ent levels.45 To estimate the impact of potential sudden and unexpected inter-est 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 insti-tutions 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 applica-tion 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 standard-ized 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 defi 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 fi ndings, the standardized interest rate risk shock may be adjusted in the future.

2.4.3 Defi nition and Treatment of Outlier Banks

Outlier banks are identifi ed based on the impact the standardized interest rate shock has on their capital base. Credit institutions must disclose the corre-sponding 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 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.

46 In this instance, capital is defi ned 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 Arti-cle 23 paragraph 13 No 3/4 of the Austrian Banking Act). Profi t brought forward can be counted toward eligible capital.

47 See Grundke (2006), p. 288.48 See Basel Committee on Banking Supervision (2004b), Annex 3.49 See Reporting guidelines on the risk statement.



24

decline by more than 20%. In this event, the FMA must take measures pursu-ant to Article 69 paragraph 3 of the Austrian Banking Act.

It should be noted here that supervisors generally take a broader perspec-tive 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 mea-sures. 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 suffi ciently covered by capital or that the ICAAP pro-cesses were inadequate, the banking supervisors will introduce appropriate countermeasures.

Article 136 of Directive 2006/48/EC lists a number of measures super-visors may take rapidly in the event of noncompliance with the directive (and, consequently, Pillar 2). These measures were transposed into Austrian legisla-tion in Articles 70 paras 4 and 4a of the Austrian Banking Act.

Essentially, the FMA has been empowered to impose specifi c capital charges if other measures provided for by the Banking Act do not appear ade-quate (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 specifi cally instructions to remedy the situation (Article 70 paragraph 4 No 1 of the Austrian Banking Act), are not appropri-ate 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 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 fl uctuations in interest rates.

51 See Article 2 paragraph 1 of the Administrative Enforcement Act.52 See explanatory notes on Article 70 paragraph 4a of the Austrian Banking Act (1558 d.B.XXII. GP).

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25

bank’s or banking group’s operational risks, the FMA may instruct the credit institution under Article 70 paragraph 4 No 1 of the Austrian Bank-ing Act to restore statutory compliance within an adequate period of time on pain of penalties (e.g. a fi ne53).If statutory compliance is not restored within the stipulated period, the FMA will impose a penalty, or renew the instruction to remedy the situa-tion 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 limita-tion 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 mea-sures laid down in the Austrian Banking Act do not appear satisfactory and if the FMA’s previous instructions remain ineffective. When imposing specifi c 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 specifi ed 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 pro-hibit 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 pur-suant 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 See Article 5 of the Administrative Enforcement Act. 54 Up to a maximum of 150% of the total minimum capital requirements pursuant to Article 22

paragraph 1 of the Austrian Banking Act55 See explanatory notes on Article 70 paragraph 4a of the Austrian Banking Act (1558 d.B.XXII.

GP).

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26

3.1 To Choose an Economic Value Perspective or an Earnings Perspective?

Interest rate risk management involves a tradeoff between maximizing the interest rate book’s economic value, optimizing the yield/risk ratio and real-izing the desired earnings. Moreover, interest rate risk is perceived differently under economic value considerations than when viewed from an earnings per-spective. 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 fi nal analysis.56 Yet annual net interest income and thus the earn-ings result depend heavily on the level of the nominal interest rate.57 Figure 4 below illustrates the different perspectives by plotting the cash fl ow structure against the market performance for straight bonds and for fl oating rate notes.

56 See Schierenbeck (2003a), p. 194. 57 Adjustment is made partly via net income from the valuation of the securities portfolio.

Cash Flow and Market Performance of Straight Bonds and Floating Rate Notes

Chart 4

cash flow (left-hand side)

market value (right-hand side)

Source: OeNB.

1

20

16

12

8

4

0

years

102

100

98

96

942 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1

20

16

12

8

4

0

years

102

100

98

96

942 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

floating rate notes

straight bondsEUR

EUR

3 Measuring and Managing Interest Rate Risk

in the Banking Book


in the Banking Book

27

Since, apart from valuation effects for marketable securities, economic value fl 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 dif-fi cult in practice to establish economic value-based measures as the key inter-est rate risk management measures, at the neglect of earnings-based measures. The following sections examine the specifi c 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 manage-ment).58

3.1.1 Managing Interest Rate Risk from an Earnings Perspective

Given the high visibility of income fi 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 con-sists in how earnings effects are distributed over time. Unlike economic value calculations, income statements refl ect earnings accrued up to the underlying balance sheet date while providing only incomplete profi t 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 earn-ings 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 manage-ment subject to yield/risk considerations.

Pros and cons of earnings perspectives:

Target measures refl ect 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 supple-ments the traditional earnings perspective with performance and risk target measures that may prompt management action. The economic value refl ects the aggregated effects of a change in market interest rates by discounting (inde-

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

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●


in the Banking Book

28

pendent of accounting rules) all future cash fl ows. Thus, changes in relevant risk parameters are refl ected in the interest rate book’s economic value imme-diately. The risk exposure from an economic value perspective can be inter-preted as a potential lead indicator for future earnings and may prompt management to change the cash fl ow structure accordingly. The economic value concept facilitates effi cient 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 refl ect the accrual of economic value effects over time in the income state-ment. From an economic value perspective, it is not relevant how the risk situ-ation appears in individual periods: the earnings effects are disclosed in the form of aggregate risk fi gures and analyzed on the basis of those fi 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. Perfor-mance is presented in an aggregated form. The ability to determine the interest rate book’s 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 avail-able.

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 refl ect the aggregate future effects of market interest rate changes, is frequently given short shrift. Obviously, the prevailing fi nan-cial 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 fi nds itself in a “valuation situation,” e.g. capital increase, disposal process.

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●


in the Banking Book

29

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 effi cient and meaningful economic value analysis.

Despite the economic superiority of the economic value concept, the earn-ings 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 deter-minants for earnings performance?Which business strategies permit optimizing the yield/risk ratio, given specifi c 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

60 Pursuant to IAS 39.

●

●

●

●

●

Comparison of Pointers for Interest Rate Risk Management

Chart 5

1

5

4

3

2

1

0year2 3

maturity spread1.58%

4.47%

2.89%

3.97%

%

Comparison of Pointers for

Interest Rate Risk Management

current yield curve

t0

t1

1st year 2.89% 5.50%

2st year 3.97% 6.50%

3st year 4.47% 7.50%

transformation strategy

3-year retail loan at 4.47%

1-year refi nancing (1st year : 2.89%)

amount: EUR 100,000


in the Banking Book

30

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 posi-tive maturity premium. Table 2 shows the cash fl ow structure based on the underlying trend in interest rates:

An analysis of the earnings effect of activities in table 3 shows that increas-ing refi nancing costs offset the positive transformation amount observed in the fi rst period (earnings effect in t

1: +1.580) in the following periods (t

2: –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 eco-nomic value perspective in t

1: –2.133), earnings-based reporting does not

allow to assign future transformation losses on a cost-causative basis to the fi rst period – although the negative earnings effects in successive periods were evidently triggered by transactions in the fi 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.

Although earnings-based analyses and economic value calculations gener-ate identical results on balance, the results may prompt different paths of action at interim points (profi t from an earnings perspective in t

1: +1.580; loss from

an economic value in t1: –2.133). Potential tradeoffs between the two perspec-

tives 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 earn-ings and an economic value perspective.61 After all, the two approaches are

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

Table 2

Performance Measured from an Economic Value Perspective transactions

cash fl ow of transactions t = 0 t = 1 t = 2 t = 3

3-year retail loan at 4.47% –100,000 +4,470 + 4,470 +104,470

1-year refi nancing at 2.89% +100,000 –102,890

1-year investment in t1 at an underlying rate of 5.50% –1,807 +1,906

2-year refi nancing in t1 at an underlying rate of 6.50% 0 +98,094 –6,376 –104,470

income from an economic value perspective 0 –2,133 0 0

Table 3

Performance Measured from an Earnings Perspective

earnings effect of activities t = 1 t = 2 t = 3 Total

3-year retail loan at 4.47% +4,470 +4,470 +4,470

1-year refi nancing at 2.89% –2,890

1-year investment in t1 at an underlying rate of 5.50% +99

2-year refi nancing in t1 at an underlying rate of 6.50% –6,376 –6,376

income from an earnings perspective +1,580 –1,807 –1,906 –2,133


in the Banking Book

31

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 tech-niques and processes available that differ from each other in terms of complex-ity 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 con-cerned should be. Both earnings measures refl ecting 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 fl uctuations, economic value analyses refl ect all the effects of interest rate changes in an aggregated form.

The instruments and methods for analyzing interest rate risk can basically be divided into two categories: instruments based on accounting-related earn-ings measures (elasticity analysis, earnings simulation) and economic value-related tools (economic value simulation, value at risk). A further differentia-tion can be made in terms of the nature and scale of the transactions covered. Whereas static simulations solely assess the cash fl ows from the bank’s 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 See chapter 4, Integrated (Dual) Interest Rate Book Management.63 All interest-sensitive on and off balance positions in the banking book are included.

Instruments/Methods for Quantifying Risk in the Banking Book

Chart 6

Source: OeNB.

performance measuredfrom an earnings perspective

performance measuredfrom an economic value perspective

gap analysis

simulation models

earnings simulation economic value simulation value at risk

elasticity analysis


in the Banking Book

32

The basis for reliable interest rate risk measurement is the completeness, accuracy and timeliness of the underlying data. Data must refl ect the relevant characteristics of interest-sensitive positions as well as the cash fl ow structures of individual products such as the amount and frequency of interest cash fl ows, repricing profi les, repayment modalities and embedded options (rights to accelerate repayment and to early redemption, interest rate ceilings and fl 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 predefi ned time bands64 according to maturity (fi xed rate assets) or according to the remaining time to repricing (fl oating rate assets). To simplify the process, allocation is based on par or book values.65 Since numerous banks use gap analysis as a fi rst step in analyzing interest risk (from an economic value perspective), it is important that they model the cash fl ows arising from their transactions as accurately as possible66 to produce a meaningful breakdown of their interest-sensitive 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. differ-ent 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 depict-ing 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 earn-ings 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 cal-culated by multiplying the gap by the defi ned interest rate scenario. Gap analy-

64 Noninterest rate sensitive positions can also be included using cash fl ow assumptions. See subsection 4.2.3, Noninterest Rate Sensitive Positions.

65 Within the framework of interest rate statistics, simplifi ed gap analysis (reporting transactions at book values) is used to depict interest rate risk.

66 See section 4.2, Cash Flow Modeling.


in the Banking Book

33

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).

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

If fl 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 quantifi ed properly only if the average fl oating rate of risk positions is subject to the same fl uctuations as the market interest rate. Moreover, average interest rates of fl 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 sensi-tivities of different fl oating balance sheet positions have a considerable impact on a credit institution’s risk profi le 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 chang-ing customer behavior, new business activities, etc). Earnings effects aris-ing from the imperfect correlation of earned and paid interest rates (basis risk) and embedded options are depicted and quantifi ed inappropriately. The static approach assumes that fi 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 determi-nation of the cash fl ow structure of individual transactions and the subsequent mapping of cash fl ows onto the gap analysis time bands. The accuracy of this calculation can be improved by augmenting the number of time bands. Sensi-tivity factors assigned to each time band (modifi ed duration, key rates, basis

67 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.

68 All positions in this section are understood as having fl oating rates or as being locked into indefi nite periods of the rate.

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Net Positions and their Earnings Profile

Chart 7

Source: OeNB.

rising interest rates

net asset positions

net liability positions

opportunity

falling interest rates

risk

risk opportunity


in the Banking Book

34

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 insti-tution (economic value perspective). The main difference between the two methods is that economic value-based simulation includes all future cash fl ows that are currently known whereas earnings-based simulation refl ects only cash fl ows within the observation period. Simulation models facilitate risk expo-sure calculations with a very high degree of accuracy and fl exibility, even for very complex portfolios.

There are static and dynamic simulations. The latter also refl ect the poten-tial (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 develop-ment, 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 institution’s decision-makers obtain a comprehen-sive picture of the expected earnings and risks arising from cash fl ows from the bank’s on and off balance sheet positions.

69 The aforementioned sensitivity measures are subjected to a brief SWOT analysis in subsection 4.3.2.2. 70 This approach basically corresponds to a simulation of net economic value; see subsection 3.2.2.2

Simulation of Economic value.

How Simulation Models Work

Chart 8

Source: OeNB.

targetmeasures

market data scenarios

balance sheet evolution scenarios

Chance

sim

ula

tion

retail behavior models

control measures

economic valueof interestrate book

losses

currentvalue

target measures

derivation of control measuresrisk

Return


in the Banking Book

35

3.2.2.1. Dynamic Simulation of Earnings

The development of net interest income depends on two key factors: the inter-est rate component as such (average return on portfolios, interest rate sensi-tivity of fl 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 simula-tion models.

To specify expected (likely) external and corporate scenarios, credit insti-tutions can use empirically estimated regularities, balance sheet evolution forecasts, target defi nitions or other behavioral assumptions. The basic pre-requisite 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 specifi c 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 scenariosbalance sheet evolution scenariosretail behavior modelsMarket data scenarios: Market data scenarios may refer to interest rate

scenarios for specifi c 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 diversifi ed 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. Specifi cally, they defi ne the characteristics of new activities/products (e.g. volumes, repricing profi le, type of coupon etc.) including the rules governing pricing adjustments (interest rate elasticities, maturity margins etc.). Volume forecasts (and fore-casts of selected balance sheet items) can also be derived through univariate and/or multivariate analytical methods.74 Furthermore, balance sheet evolu-tion scenarios need to refl ect 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 Also referred to as the dynamic component. 72 Adding noninterest-rate sensitive income components (net fee-based income, valuation effects etc.)

is relatively simple. 73 Firm cause-effect relationships enable a step-by-step analysis of how different shifts in the balance

sheet structure affect interest rate risk. 74 To estimate portfolio performance, time series analyses, correlation analyses, or regression tech-

niques are used.

●

●

●


in the Banking Book

36

scenario and the underlying corporate strategy. In this respect, credit institu-tions must reconcile three factors: the targeted balance sheet structure, the retail behavior to be expected in light of the interest rate development, and management’s 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 sim-ulated and planned earnings measure in the baseline scenario.75 The simula-tion 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 refl ect cause-and-effect relationships as accu-rately 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 infl ows and outfl ows 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 defi nes, for instance, earnings measures that can be generated at constant market interest rates.

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in the Banking Book

37

The four factors that affect economic value are: cash fl ow, the discount rate, the method of calculating interest76 and the method of calculating inter-est days.77 Economic value can be calculated by duplicating cash fl ows via off-setting 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-specifi c (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, sequen-tially, 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 empir-ical data or model theory approaches.80

Interest rate exposure arises from fl 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 bank’s asset positions in the same way

76 In principle, a distinction can be made between continuous and discrete compounding. 77 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 specifi ed in front of the oblique stroke and the day count for the number of days within a year is specifi ed behind the stroke.

78 See Schierenbeck (2003a), p. 168ff. 79 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.80 See Betz (2005), p. 46ff.81 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.

Chart 9

Source: OeNB.

How to Calculate Economic Value

n

t=1economic value = Σ CFt • ZBDFt

t0 t1 t2 t3 t4

• ZBDF1 • ZBDF2 • ZBDF3 • ZBDF4


in the Banking Book

38

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 posi-tions 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 fl ows from a bank’s 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 defi ned interest rate scenarios, and the economic value is recalculated. The difference between the two sets of economic values refl ects 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 specifi c projected point in time.82 In the latter case, credit institutions must take three aspects into account: First, the short-ening in the residual maturity gives rise to price effects. Second, cash fl ows payable or receivable by the forecast date are compounded and, third, cash fl ows arising on the forecast day itself are included in the calculation of the projected economic value (fi nal value) on a risk-neutral basis. When these con-ditions are applied, changes in risk parameters are refl ected 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 (repric-ing 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 fl uctuation band. Moreover, it should be possible to specifi -cally 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 simula-tions, the integration of dynamic effects into economic value simulation is sub-ject 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 fl uctuations of fl oating rate positions. Since fi xed rate transactions (elastic-ity = 0) do not react to changes in market interest rates, the overall earnings effect, unlike in a gap analysis scenario, only stems from fl oating rate transac-tions (elasticity > 0). The economic correlation between the change in prod-uct-specifi c interest rates in line with market interest rate fl uctuations is described by repricing elasticity. As simple differential quotients84 do not pro-vide reliable elasticity values, regression analysis techniques are widely used to calculate repricing elasticity.

82 As a rule, projection horizons of up to one year are analyzed. 83 The prerequisite for this is that the cash fl ow structure of products (particularly, that of positions

with unreliable cash fl ows) is mapped as exactly as possible.84 Repricing elasticity = � position interest rateT / � market interest rateT


in the Banking Book

39

A key feature of elasticity analysis is the calculation of appropriate explana-tory reference interest rates per transaction item (or transaction type). Regres-sion 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 fi 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 identifi able by elasticity dia-grams.85 These effects are included in the calculation by shifting the position rate time series until a maximum goodness of fi 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 meth-ods and ratios (goodness of fi 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 fi 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 fi 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 fl oating rate positions, the elasticity effect in fi 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 inte-grated 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 aggrega-tion of the relevant product elasticities. Net elasticity is obtained by subtract-ing 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 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.

86 Real repricing behavior can also be tracked by a differential equation of the fi rst order, see Schwanitz (1996), p. 152.

87 Backhaus et al. (2003), p. 52ff.88 This generates projected earnings (forecast of net interest income) for future periods.


in the Banking Book

40

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.

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 chal-lenge 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 fi xed rate positions that refl ect 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, fl oors, etc.), often have a nonlinear correlation (kinked elasticity curve90), as a result of which the resulting balance elasticity will be inac-curate. Elasticity analysis limits the observation horizon to near and medium-term earnings effects and thus does not capture valuation effects from the secu-rities 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 fi xed rate transactions, retail behavior, change in elasticity values etc.); these assumptions are, of course, subject to forecasting uncertainty.

89 Largely for products of which the interest rates are based on several market interest rates. 90 See Schwanitz (1996), p. 158.

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Overview of Net Elasticities

Chart 10

Source: OeNB.

rising interest rates

positive net elasticity

negative net elasticity

opportunity

falling interest rates

risk

risk opportunity

41

Aggregate interest-related earnings consist of several components which eco-nomic value calculations and earnings-based analyses will fail to refl ect com-prehensively if used on a standalone basis. While both tools will generate iden-tical 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 man-agement processes that make it possible to join the two perspectives. Inte-grated 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 fl ows from a bank’s interest rate-sensitive positions by organizing cash fl ows effi ciently. Strategies should be selected in a way such that the high-est possible increase in economic value is achievable provided specifi c 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 gener-ate 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 moni-tor performance from an economic value perspective in future earnings periods (via simulation calculations and transfers of earnings). The function of inte-grated interest rate book management is to maximize the ratio of performance and risk subjects to the constraints of both earnings and regulatory perspec-tives.

91 Maximum risk capital can be inferred from the credit institution’s risk-bearing capacity. See OeNB/FMA (2006).

4 Integrated (Dual) Management

of the Interest Rate Book

Requirements for Integrated Interest Rate Book Management

Chart 11

Source: OeNB.

guarantee of the netincome requirement

(minimum netinterest income)

limitation ofinterest rate risk:

analysis ofrisk-bearing capacity

monitoring net incomegenerated by the valuation

of securities portfolioassets

monitoring performancefrom an economicvalue perspective

in future earnings periods

requirements forintegrated interest rate

book managementaim: to optimize

the yield/risk ratio



42

92This process relies heavily on asset-liability management (ALM), which is

the supreme management system for optimizing a credit institution’s 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 jurisdic-tion irrespective of their broader implications. Ultimately, any action taken should improve the overall tradeoff between RoC and overall risk. ALM basi-cally epitomizes a higher rationality than that prevailing in a credit institution’s individual units. The purpose of ALM is to coordinate decisions taken by indi-vidual units and to optimize the credit institution’s fi nancial situation through concerted action. Without effective ALM, a bank runs the risk that, even when all units take rational decisions in their own specifi c areas, its aggregate earnings/risk profi le may run counter to the wishes and ideas of the bank’s 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 refl ects 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 defi nition of risk policya consolidated coverage of riskthe establishment of sound risk measurement processes that are commen-surate with the scale and complexity of the activities of the bank con-cerned

92 In accordance with OeNB/FMA (2006), p. 7693 See 2.1.3, Principles of Managing Interest Rate Risk – The Basel Paper on Interest Rate Risk.

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Process of Integrated Interest Rate Book Management92

Chart 12

Source: OeNB.

3. yield/riskanlaysis

Asset-Liability-Management

1. definition ofthe risk strategy

2. modelingcash flows

4. controlmeasures

5. ex postanalysis



43

the design of a system of interest rate risk limits that takes account of risk-bearing capacitythe performance of stress testsa clear segregation of functions (particularly between risk-assuming and risk-monitoring units)the preparation of meaningful reports by an independent control unitthe establishment of a clearly structured procedure for introducing new activities.

A well-implemented ALM system must pay adequate attention to each of these aspects defi ned in detail in the Basel paper. If individual elements of the list above were systematically ignored when implementing ALM, this would qual-ify as an infringement of Article 39 of the Austrian Banking Act (due diligence obligations of a credit institution’s 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 effec-tive 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 imple-mented. 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, AccountingBudgetingInterest Rate Risk ManagementLiquidity PlanningProduct Design and CalculationTreasuryCapital PlanningData and Information Flow, IT

Owing to the complexity of these tasks, the way in which ALM is integrated into a credit institution’s 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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44

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 Account-ing, 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 fi nances. This is why Accounting has a permanent representative on the ALM Commit-tee as a rule. This member basically personifi es 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 account-ing perspective. Accounting experts will naturally focus on earnings-related matters rather than on economic value effects, with the exception of deprecia-tion 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 per-spective does not by a long way depict a credit institution’s overall risk situa-tion 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 mea-sures are changed too frequently in the ALM process. Neither should it meet too infrequently, though, to avoid delayed reactions to major market develop-ments. Monthly intervals, as adopted by many credit institutions, would appear to be a reasonable frequency. Basically, ALCO defi nes the bank’s paramount risk policies and interest rate expectations and approves the structure of lim-its. Meaningful minutes of ALCO meetings are of the essence, as is transpar-ent 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 docu-mented.

Profi t Centers and the Market Interest Rate Method

Moreover, asset and liability management paves the way for sound profi t center accounting, which reveals the contributions individual units make to earnings. Banks basically engage in lending and deposit-taking – which makes the con-tribution 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 car-rying out maturity transformation activities in line with banks’ interest rate

94 See Hegel (1970), p. 24.



45

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 pric-ing policy (for loans and deposits) and from maturity transformation. The difference between the overall net interest margin and the pricing contribu-tion is the structural contribution. This is the contribution generated by the bank’s interest rate policy, with some interest rate gaps set specifi cally with a view to benefi ting 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 specifi c periods. The structural contri-bution depends on the scale of structural imbalances (interest rate gaps), the fl uctuation in the interest rate level and the yield curve situation. A key require-ment for this valuation procedure is that a so-called market interest rate frame-work is established, in which all types of the bank’s activities are listed and a corresponding money market or capital market interest rate is allocated to each type.

The market interest rate framework must be documented in a way trans-parent to third parties, preferably in a risk management manual. This docu-ment 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 fl 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 fl ow assumptions made for nonmaturing assets and liabilities, credit institutions must ensure that these products will be treated consistently throughout the risk measurement frame-

95 See subsection 4.2.1, Retail Transactions.

Breakdown of Earnings by Cause under Market Interest Rate Method

Chart 13

Source: OeNB.

retail lending rate

Treasury

market(risk-taking) unit

opportunity interest rate

pricing contribution(lending)

money market &capital market

structuralcontribution

management of interest rate riskoptimization of yield/risk ratio

opportunity interest rate

market(risk-taking) unit

money market &capital market pricing contribution (deposits)

retail deposit rate



46

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 profi t center accounting. It should therefore be carried out as a matter of routine by every bank’s Risk Management.

4.1 Defi nition of the Risk Strategy

Each bank will have specifi c risk policies, which are ideally formalized in a central framework of risk strategies. These risk strategies defi ne a bank’s fun-damental risk propensity, which is in turn refl ected in the choice of appropri-ate benchmarks, the defi nition of business segments and products, the alloca-tion of risk capital to individual segments and the defi nition of a limit structure that is suitable for balancing the undertaken risks with the allocated risk capi-tal. All these elements are an integral part of ICAAP, which every credit insti-tution 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 Defi nition 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 book’s performance can be evaluated by comparing data with a market trend that is considered to be representative. Benchmarks also refl ect certain earnings expectations and risk perceptions.

Benchmark Requirements

Benchmarks may not be defi ned randomly but should satisfy certain criteria:1. Benchmarks should be easily understood and serve as a transparent yard-

stick; 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 mar-ket at all times.

3. Repricings should be carried out only in exceptional cases (consistency of the benchmark over time).

4. Benchmarks should constitute an effi cient investment opportunity from a yield/risk perspective.

To be a meaningful tool, a benchmark must be precisely defi ned, transparent and controllable. The requirement for consistency over time is not met in the case of a one-off investment in a specifi c maturity (e.g. 10-year bond), since the risk of the investment decreases as the residual maturity shortens. A bench-mark must, moreover, be effi cient from a yield/risk perspective. A benchmark is considered effi cient if no other strategy generates a better interest rate book performance for the same risk or has a lower risk for the same performance. Effi ciency analyses will help divide effi cient from ineffi cient benchmarks.

96 OeNB/FMA (2006).



47

Overview of Potential Benchmarks

Investment opportunities that meet the aforementioned criteria include:97

moving averages or a mix of moving averagesinvestment rules derived from moving averages, which are refi nanced in part or in full by moving averages of another maturitypensions indices

In addition to standardized benchmarks (pensions indices), benchmarks can also be constructed on a customized basis. A simple benchmark that is fre-quently used in the management of interest rate risk is the moving average. Unlike pensions indices, moving averages have a constant cash fl ow structure and a constant residual maturity. The cash fl ow structure refl ects revolving investments with identical capital tranches.98 The cash fl ow structure (share of interest and principal) may be derived from historical interest rates. Credit institutions must undertake corresponding adjustments to ensure that the eco-nomic value of the benchmark cash fl ow corresponds to the economic value of the interest rate book. Benchmarks can be conceived by combining underlying cash fl 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 matu-rity, have been established. In choosing an appropriate benchmark, it is helpful to consider a number of questions against the backdrop of the credit institu-tion’s 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 fl ow profi le matches the credit institution’s earnings and risk preferences? Are potential earnings effects of the selected benchmark sus-tainable?Which benchmarks have been found effi cient in yield/risk analysis?

4.1.2 Defi nition 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 institution’s own interest rate forecasts?

Passive management means tracking aggregate cash fl ow independently of short-term market expectations for an effi cient 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 effi ciently. Liability manage-ment may not be equated with inactivity or passivity. Much rather, it takes

97 See Drosdzol (2005), p. 190ff.98 See Figure 22: Moving Average.

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●



48

recurrent money market and capital market transactions to align the actual interest rate book cash fl ow consistently. Keeping the benchmark exactly aligned is, however, not always advisable in actual fact in the light of fresh con-ditions, 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 fl ow aligned with a given benchmark profi le while permitting diver-gences within defi ned limits to retain a scope for action in certain interest rate periods.

Active management means managing the cash fl ow structure on the basis of the credit institution’s 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 expec-tations and forecast interest rate movements accurately enough to outperform the benchmark investment’s yield/risk ratio. As a rule, this management approach entails higher transaction costs and more extensive resource require-ments than passive management.

4.1.3 Interest Rate Risk Limits

The ALM Committee defi nes the credit institution’s 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 refl ected in the credit institution’s overall risk-bearing capacity report. Potential losses incurred owing to the limit struc-ture must be offset by the bank’s underlying assets. As regards the structure of an adequate risk-bearing capacity report, please see the guidelines on inte-grated 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 bank’s 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 sub-portfolios 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 specifi cally 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 devel-opments. 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 defi ning limits. The limit system as a whole must be documented transparently, ideally in the

99 See OeNB/FMA (2006).



49

risk management manual. Risk Management should monitor compliance with limits on a regular and timely basis. Furthermore, processes of noncompliance with limits must be defi 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 defi nes this case unambiguously: “The FMA must take measures in the case of credit institu-tions 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 institu-tions.”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 profi le of these activities look like? Do these activities change the tradeoff between earnings and risk and if so, does this change fi t in with the overall strategy? Is the bank’s staff adequately qualifi ed 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?Are the stress test requirements met?102

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 activi-ties in a structured manner to ensure that no aspect will be “overlooked.” Busi-ness activities that are not subjected to such scrutiny must not be carried out. Since this matter is of particular importance, the Austrian Banking Act explic-itly addressed it in the article relating to the due diligence obligations of senior management.

100 The reporting guidelines on the risk statement currently stipulate 200 basis points as the sudden and unexpected change in the yield curve.

101 See 2.4.3, Defi nition and Treatment of Outlier Banks. 102 See 4.4.3.3, Stress Test Requirements

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50

“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 third-party funds entrusted to the credit institution and to the preservation of the credit institution’s 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.



51

4.2 Cash Flow ModelingThe fi rst step in measuring interest rate risk from an economic value perspec-tive is to establish which cash fl ows arise from a bank’s interest-sensitive posi-tions. In addition to retail banking activities, both proprietary transactions (including structured securities) and interbank business make up the lion’s share of the interest rate book. To calculate bank-wide cash fl ows, consisting of interest and principal cash fl ows, banks use maturity-gap analysis to estab-lish reliable cash fl ows and cash fl ow assumptions to establish unreliable cash fl ows. Deriving the cash fl ow directly from the agreed product characteristics is an option only in the case of traditional fi xed rate products that lock up capital for specifi ed periods and have a specifi ed repricing profi le. For all other balance sheet positions with (partially) unspecifi ed product characteristics, credit institutions need to make assumptions about their cash fl ow structure. On the basis of these cash fl ow assumptions, transactions are then transformed in positions with fi xed cash fl ows.104 Proper cash fl 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.

The total cash fl ow of the interest rate book, i.e. the risk-related measure, can be calculated from the cash fl ows arising from the bank’s individual activi-ties.106 From an economic value perspective, the interest rate exposure is cal-culated on the basis of the net cash fl ows (balance of cash fl ows from asset and liability positions). The net cash fl ows provide some preliminary information

104 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.

105 RORAC: Return on Risk-Adjusted Capital106 Cash fl ows can also be derived more simply using gap analysis (including interest cash fl ows).

Derivation of Aggregate Cash Flow from a Bank’s Interest Rate-Sensitive Positions

Chart 14

Source: OeNB.

assetsSi

mula

tion

retail transactions

proprietary transactions

interest-sensitive positions

liabilities

oans and bondsinterbank claims

current accountholdings and savingsdeposits interbankliabilities

nostro securities securitized liabilities

off balance sheet

noninterest-sensitivepositions

total cash flow

assets

liabilities

time band (years)

cash flowmodeling



52

about the interest rate book’s strategic positioning. In this respect, the follow-ing 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 book’s economic value, which is shown as the net eco-nomic values of gross assets and liabilities, can be calculated by discounting net cash fl ows. The cash fl ow structure may be changed at all times, depending on business requirements, through accounting measures or derivative trans-actions. The interest rate book’s 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 refi nancing them via deposits is one of the original roles of credit institutions. Given the volume and structure of those trans-actions, they have a signifi cant infl uence on the interest rate risk profi le of banks. However, many of these transactions come without a given repricing profi le, and capital is often locked up for indefi nite periods.

Retail transactions can be classifi ed as follows:

107Category I (fi xed interest rate, capital locked up for a specifi ed period)108

The interest rates on transactions in category I are fi xed until maturity. Thus, these transactions are to be allocated to the specifi ed time bands simply accord-ing to their residual maturity.109 For other types of instruments, correctly allo-cating transactions to individual time bands is less straightforward, however, as outlined below.

107 In accordance with Markus (2002), p. 213, fi gure 4.108 See Markus (2002), p. 215.109 See reporting guidelines on the risk statement.

Retail Banking Activities of Credit Institutions107

Chart 15

Source: OeNB.

for a specified period

fixed rate

for an indefinite period

I.e.g. fixed rate loanssavings bonds

II.e.g. fixed rate loanssubject to earlyredemption

III.e.g. money marketand capitalmarket-indexed loans

IV.e.g. savings depositswith money marketand capital market repricing

V.e.g. loans with a UFN (untilfurther notice) agreement

VI.e.g. current accountdeposits, current accountholdings and savings deposits

floating rate

no givenrepricing profile

type o

f in

tere

st r

ate

capital locked up



53

Category II (fi xed interest rate, capital locked up for an indefi nite period)

For transactions in category II, the interest rate is fi xed for the entire term as well, but the originally agreed fi xed rate maturity may be cut short if counterparties exercise their stipulated early redemption options. The same problem exists for fi xed rate loans which are “swapped” for fl oating rate loans precisely when money market rates fall, i.e. customers cancel their fi 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 fi xed rate coupon, the fi 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 fi xed repricing date” category […]. However, if embedded product structures (e.g. embedded early redemption options) are detached, the remaining underlying position with a fi xed interest rate can still be considered as a position in the ‘fi xed rate’ category.”

Category III (fl oating interest rate, capital locked up for a specifi ed period)

Allocating fl oating rate positions that lock up capital for a specifi ed period would appear to be straightforward at fi rst glance (allocation at next repric-ing). 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 fl 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 allo-cate them to their corresponding time bands,112 using e.g. the constant matu-rity bond (CMB) method or SMY replication.113

Category IV (fl oating interest rate, capital locked up for an indefi nite 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 specifi ed residual maturity. In principle, such trans-actions 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 lion’s 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 Owing to increasing competitive pressures, this practice is accepted by many credit institutions.111 The repricing indicator is not linked to the short-term money market rate.112 See reporting guidelines on the risk statement. 113 See subsection 4.2.1.6, Constant Maturity Bond Approach. 114 Austrian Supreme Court 21.12.2005, 3 Ob 238/05d



54

When the customer market interest rate is referenced to a fl oating rate off-set by a negative spread (e.g. 3-month EURIBOR less 200 basis points), savings rates might theoretically turn negative if the reference rate dimin-ishes. But this is not realistic in practice. The implicit option of setting the minimum interest rate at 0% (fl 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 specifi ed 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 fi 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 profi le, capital locked up for a specifi ed 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 fl ow, specialist literature on this subject usually recommends the elasticity approach. Since these trans-actions are similar in nature to capital market fl oaters,116 they could also be presented using the CMB approach.117

Category VI (no given repricing profi le, capital locked up for an indefi nite period)

As regards transactions with no given repricing profi le locked up for a speci-fi ed 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 fl 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, fi nally,future changes in business volume and future new business118

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 refl ect positions without a given repricing profi le, they assume the retail interest rate to be fully congruent

115 See subsection 4.2.1.7, Option-Adjusted Spread (OAS) Approach.116 See Huber (2004), p. 42.117 See subsection 4.2.1.6, Constant Maturity Bond Approach.118 These aspects can also be included within a broader perspective. 119 Irrespective of the selected method, positions in category V and VI must be classifi ed as “positions

without fi xed repricing dates” in interest rate risk statistics.

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55

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 refer-ence 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 profi le and/or unspecifi ed periods of capital lockup, the Basel paper on interest rate risk also notes:121

“Specifi c 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 trans-actions in categories II to VI (i.e. products that come without a given repricing profi le and/or lock up capital for indefi nite periods) as money market and capital market transactions (MCM transactions), the cash fl ows of which are stated in the gap analysis. Besides, this enables the Treasury to maturity-match their refi nancing in line with the market interest rate method.

Different models will yield divergent MCM transactions and consequently different cash fl ows. This is why the selection of a model or method for a given category of transactions should be well-founded.

120 See Rolfes/Bannert (2001), p. 285.121 See Basel Committee on Banking Supervision (2004b), ref. 5.

Models for Mapping Retail Transactions

Chart 16

Source: OeNB.

nonmaturation theory outflow rate method

elasticity analysis replicating portfolio

theory

CMB approach

combination methods

OAS approach dynamic models

sim

ple

frequently

use

d

requirem

ents

imple

menta

tion

com

ple

x

seld

om

use

d

per

iods

for

whic

h c

apita

lis lo

cked

up

capital

lock

up p

eriods

or

reprici

ng

dat

es



56

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, outfl ow 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 specifi c percentage of a product (e.g. savings deposits) for long periods. According to this theory, a bank’s 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 specifi c period. On this basis, transactions are split into the two components. The volume which remains under the mean value minus two standard deviations is consid-ered to be stable (non-interest-sensitive). The volume which exceeds the mean value plus two times the standard deviation is supposed to be highly interest-sensitive.122

4.2.1.3. Outfl ow Rate Method

Another approach is to observe and analyze the natural maturation rates of a bank’s 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 In the event of changing market interest rates, customers’ reaction times are responsible for volatility.123 See Matz (2005), chapter 6, p. 12ff.

Nonmaturing savings deposits

Chart 17

volume (EUR million)

mean minus two times standard deviation

mean

Source: OeNB.

Jan.

16

12

8

4

0 nonm

aturing

asse

ts

Apr. July Oct.

2002

Jan. Apr. July Oct.

2003

Jan. Apr. July Oct.

2004

Jan. Apr. July Oct.

2005

Jan. Apr. July Oct.

2006

EUR million

observation interval



57

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

Figure 18 shows an outfl ow 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 outfl ow rate (which is relevant for the allocation of cash fl ows) is calculated as an average of actual annual outfl ows over the period of observation (in the chart above, this results in roughly 10%

124 This period is generally recommended for all the methods and models presented.

Quarterly Decline in Volumes

Chart 18

Source: OeNB.

12

100

80

60

40

20

0

EUR million

24 36 48 60 72 84 96 108 120

time band (months)

Cash Flow Allocation in Relation to the Outflow Rate

Chart 19

Source: OeNB.

1

10

8

6

4

2

0

EUR million

time band (years)

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



58

for a 10-year period of observation, i.e. in the fi rst year 10% of 100, thereafter 10% of 90 and so on). This also corresponds to the cash fl 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 outfl ow and thus the annual outfl ow rate depend to a signifi cant degree on the observation period and its length.

The methods described above (nonmaturation theory and the volume outfl ow rate method) are subject to a general weakness in that no reference is made to the actual interest rate fi 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 fl uctuations of a selected market interest rate.126

The quality of elasticities is expressed by the goodness of fi t (and correla-tion), which can assume only values between 0 and 1. The closer the goodness of fi 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 defi nition, the elasticity of a fi xed rate bank activity is 0.The aim of elasticity analysis is to split the activity into a variable compo-

nent and a fi xed rate component. The elasticity to a given money market rate (e.g. 3-month EURIBOR) is calculated separately for each category of transac-tions. 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 fi xed rate compo-nent 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 speci-fi ed 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 fi xed rate component.

The following example shows how the cash fl ows are calculated:Loan with UFN contract, volume: EUR 100,000, maturity: 5 years;

elasticity to 3-month EURIBOR: 0.3An elasticity of 0.3 to the 3-month EURIBOR signifi es that 30% of the

volume are to be allocated to the 3-month time band, and 70% to the loan’s residual maturity.

125 As a result, stability or smoothing over a longer period is achieved in relation to the allocation of actual outfl ows.

126 According to the defi nition, interest rate elasticity is the ratio of the absolute rates of change of both these interest rates.

127 A low goodness of fi 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.

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59

Usually, the fi xed rate component is shown as “rolling,” i.e. a transaction with a maturity of 5 years consisting of 60 individual fi 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:

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 specifi ed or estimated period (category V and VI)2. calculation of elasticity to the selected money market rate for of every type

of activity

Elasticity Approach – Cash Flow Structure

Chart 20

Source: OeNB.

3 months

80

60

40

20

0

EUR million

time band

6 months 12 months 2 years 3 years 4 years 5 years

variable tranche fix interest tranche

Elasticity Analysis – Cash Flow Structure with Rolling Tranches

Chart 21

Source: OeNB.

3 months

40

30

20

10

0

EUR million

6 months 12 months 2 years 3 years 4 years 5 years

time bandvariable tranche fix interest tranche



60

3. split of the total nominal volume of every type of activity into a variable (short-term) and stable (fi xed rate) component.

4. rolling presentation of the fi xed rate tranche to adequately refl ect new business 5. calculation of the (moving average) mixed interest rate for rolling fi xed rate

tranches128129

4.2.1.5. Replicating Portfolios

This approach attempts to show category VI transactions as a portfolio of fi xed rate transactions, with a view to fi nding for every type of transactions (current account holdings, savings deposits etc.) a linear combination of MCM trans-actions, which mirrors the given activity as accurately as possible.

128 This takes account of the sluggish change in retail interest rates in response to changes in market inter-est rates. The moving average (opportunity interest rate) is required to calculate interest cash fl ows.

129 For simplifi cation purposes, only a rolling of 6 months was assumed. See Huber (2004), p. 17.

Moving Averages129

Chart 22

Source: OeNB.

–1 0 3 5 months–2–3–4–5–6 1 2 4 6

previousmovingaverageof 2.88%

newmovingaverageof 2.78%

new tranche 2.58 %

2.73 %

2.58 %

2.72 %

2.95 %

3.09 %

3.19 %moving averages

Repricing Behavior of Retail Interest Rates

Chart 23

Source: OeNB.

7

6

5

4

3

2

1

yield of replication portfolio

retail interest rate

1999 2000 2001 2002 2003 2004 2005

margin

%



61

Structure of Replication Portfolio

The replication portfolio is derived from historical retail interest rates and money market rates. The weights of individual fi 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 (effi ciently) 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

Effi cient Replication Portfolio

Various criteria of optimality can be used to determine an effi cient portfolio. Usually a constant margin is defi ned. A constant margin is a necessary require-ment for separating the pricing contribution from the structural contribution. Such a split allows banks to establish a market-related margin that is indepen-dent 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 fi t (high correlation) would imply good repricing behavior.The average maturity of the underlying transactions has a signifi cant 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 millioncalculation of interest rates and weightings of the replication portfolio

6-month EURIBOR – 50%3-month EURIBOR – 30%1-month EURIBOR – 20%

130 Negative weights would mean that alternative optimization processes would have to be used for the analysis.

131 See Huber (2004), p. 19ff.132 For the sake of simplicity, the allocation of interest cash fl ows is not included in the charts below.

●

●

●

●

●

●



62

The resulting allocation of cash fl ows is:

Rolling Presentation:

The volumes distributed in accordance with the weights determined are allo-cated to corresponding time bands. In respect of the above example, the result is now as follows:

Replication portfolio

Chart 24

Source: OeNB.

50

40

30

20

10

0

1-month EURIBOR

3-month EURIBOR

6-month EURIBOR

1

EUR million

2

time band (months)

3 4 5 6

Source: OeNB.

1-month EURIBOR

3-month EURIBOR

6-month EURIBOR

time band (months)

Replication Portfolio with Rolling Tranches

Grafik 25

40

30

20

10

0

1

EUR million

2 3 4 5 6



63

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 model’s explanatory content (goodness of fi 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 non-maturation 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 millionsample size: 1,000 current account holdingsthere are no fi xed repricing dates and no specifi ed maturitiescurrent account holdings may be liquidated on demandcredit 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 volumeaverage current account ratesMCM 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 fi xed rate component (variable component of, say, 30%, i.e. EUR 30 million, and fi xed rate component of 70%, i.e. EUR 70 million).134

2. Calculation of the effi cient replication portfolio for the variable compo-nent. Result: e.g. 50% 1-month EURIBOR, 50% 3-month EURIBOR.135

3. Calculation of the effi cient portfolio for the fi 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 See Matz (2005), chapter 6, p. 30ff. 134 See subsection 4.2.1.2, Nonmaturation Theory.135 See subsection 4.2.1.5 Replicating Portfolios.

●

●

●

●

●

●

●

●



64

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 oppor-tunity interest rate in terms of volume changes. Yet ignoring volume fl ows means for the Treasury that refi nancing can no longer be carried out at the calculated opportunity interest rate should volumes increase and market inter-est rates change at the same time. As a result, the Treasury profi t center alone bears these costs induced by fl uctuations in volume. Since, however, the Marketing profi t center has the largest impact on changes in volume, the bank’s methods would need to refl ect volume changes as well.

Rebalancing Portfolio Approach

The rebalancing portfolio approach allows banks to analyze fl 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 millionIncrease in current account holdings: EUR 10 million (10%)Allocation to the replication portfolio:

6-month EURIBOR – 55 (50 + 5) million3-month EURIBOR – 33 (30 + 3) million1-month EURIBOR – 22 (20 + 2) million

136 See Huber (2004), p. 28ff.

●

●

●

Combination of the Replication Approach and Nonmaturation theory

Chart 26

Source: OeNB.

25

20

15

10

5

0

1-month EURIBOR

3-month EURIBOR

1-year swap rate

2-year swap rate

2-year swap rate

1

EUR million

time band (months)

2 3 6 12 24 36



65

Rolling allocation under the rebalancing portfolio approach is carried out as follows:

Repricing of the Refi nancing 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 fi 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 maturity’s previous interest rates. Instead, they correspond to the individual tranches’ average coupon weighted by par values.

Replication portfolio with a 10% increase in volume

Chart 27

Source: OeNB.

60

40

20

0

1-month EURIBOR

1-month EURIBOR (additional)

3-month EURIBOR

1

EUR million

time band (months)

3 6


6-month EURIBOR


Rebalancing-Replication – Rolling Presentation

Chart 28

Source: OeNB.

40

30

20

10

0

EUR million

time band (months)

5

0

volume increase of 10%

historical pricing

current pricing

time band (months)

1-month EURIBOR 3-month EURIBOR 6-month EURIBOR



66

Benefi ts of Replicating Portfolios

Replication portfolios are highly transparent and thus readily accepted by a bank’s decision-making bodies.Provided historical data are available, this method can be easily imple-mented, without any special software requirements.

Drawbacks of Replicating Portfolios

As the replicating portfolio method’s exclusive focuses exclusively on opti-mal 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 inter-est 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 defi ned as a fl oater with a fi xed rate maturity, which is periodically repriced to a capital market rate. As a result, it refl ects the same risk profi le 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 fl ows can be replicated by forward rates: For instance, a 5-year CMB might be replicated with

a fi xed rate asset position in the 5-year time band and5 forward positions (1-y x 6-y forward, 2-y x 7-y forward, … , 4-y x 9-y forward)

●

●

●

●

●

●

●

Repricing at Tranche Maturity

Chart 29

Source: OeNB.

50

40

30

20

10

0

1-month EURIBOR

3-month EURIBOR

6-month EURIBOR

EUR million

time band (months)1-month EURIBOR (additional)



1 2 3 4 5 6



67

Cash fl ows correspond to the key rate durations calculated for the individual time bands.

In this example, the key rate durations are positive up to a term of 5 years and negative thereafter. The resulting cash fl ows refl ect 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 condi-tions (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 CMB’s 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 fl ow allocation of EUR 300 mil-lion:1. Separation into a variable component and a fi xed rate component (fl oating

rate component of, say, 30%, i.e. around EUR 90 million, and fi xed rate component: 70%, i.e. EUR about 210 million)139

137 See Huber (2004), p. 43.138 For a normal yield curve, a CMB’s economic value always exceeds the par values. See Huber (2004),

p. 42.139 See subsection 4.2.1.2, Nonmaturation Theory.

Synthetic cash flow profile of a constant maturity bond

Chart 30

Source: OeNB.

300

200

100

0

–100

par amount (EUR million)

1 2 3 4 5 6 7 8 9

time band (years)



68

2. Calculation of an effi cient 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.

To sum it up, we can say that the effective interest rate exposure of positions locked up for indefi nite periods with no fi 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 fi 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 fi xed rate asset position in the 10-year time band corresponding to the business volume and9 forward positions (1-y x 6-y142 forward, 2-y x 7-y forward, … , 9-y x 14-y forward), weighted by the hedge ratio.143

140 See Bühler (2000), p. 45. 141 See Finance Trainer (2002), p. 1142 In one year for fi ve years143 The hedge ratio depends on the duration of underlying cash fl ows and the steepness of the yield

curve, and generally ranges between 20% and 24%.

●

●

Cash Flow Profile Based on the CMB Approach

Chart 31

Source: OeNB.

300

200

100

0

–100


1

months

1

years

2 3 4 5 6

time band

1-month EURIBOR

1-month EURIBOR

CMB

2 3 7 8 9



69

4.2.1.7. Option-Adjusted Spread (OAS) Approach

The option-adjusted spread approach was fi 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 specifi ed period at fi xed interest rates. This method uses Monte Carlo simulations to generate cash fl 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 See Huber (2004), p. 52ff.

Replication of a 10-year transaction with SMY repricing

Chart 32

Source: OeNB.

50

40

30

20

10

0

–10


1 5 6 7 8 9

times band (year)fixed rate transaction

active forward transaction

passive forward transaction

2 3 104 11 12 13 14



70

Decomposition Approach

The decomposition approach attempts to split the contract characteristics of transactions without fi xed lockup periods or repricing dates into individual components (into a money market or capital market transaction and into indi-vidual options). The value of the transaction is then the sum of these individual components.

For a loan granted for an unspecifi ed period without fi xed repricing dates, embedded optionalities could be shown synthetically as follows:

short cap option and long fl oor option, each with a residual maturity, refl ecting the lag with which money or capital market rates are trans-mitted to the customer rate) short cap option because high lending rates are hard to enforcelong fl oor option because the credit institution defi nes a certain mini-mum marginshort put option, representing the customer’s 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, today’s 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 fi xed rate loans for fl 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 complex-ity. 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 diffi culty is that the factors affecting these fl uctuations must fi rst be identifi ed (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 sce-narios, as well as the corresponding cash fl ows. The purpose of this exercise is to fi lter out the one scenario that generates an optimal portfolio in terms of refi nancing costs and margin. On this basis it is also possible to calculate value-at-risk (VaR).

145 See Huber (2004), p. 56ff.

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71

This approach has three advantages over static simulation:146

investment decisions are made on an objective basis (optimization pro-cess),a lot of data (interest rate, retail interest rate, volumes) can be implemented in the system andthe 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 fi 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 fl ows, the same methods can be applied as for the aforementioned categories I – VI (fi xed or fl oating interest rates, or no given repricing profi le).

4.2.2.1. Mutual Funds

Positions without fi xed repricing dates include, above all, interest-sensitive mutual funds. To fulfi ll 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 fi xed income funds on the basis of their volume-weighted average maturity or duration (or modifi ed duration). However, it should be mentioned that the duration-based approach tends to underestimate interest rate risk since the repricing period of the fi xed rate component corresponds to the latter’s residual maturity and not to its dura-tion. Conversely, the maturity-based approach tends to overestimate interest rate risk, as the repricing periods of the fl oating rate component differ from the latter’s residual maturity. The right solution would be to analyze mutual funds in terms of their individual items and to allocate these accordingly (look-through 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 refl ects the fl at yield curve and the period of low interest rates in the past few years. With the increasing complexity of deriva-tives and structured products, the need for suitable valuation models and for

146 See Frauendorfer/Schürle (2006).

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72

methods to incorporate them into the integrated interest rate risk manage-ment rises.

In their interest rate statistics to be submitted to the OeNB, credit institu-tions 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 defi ned as transactions in whose settlement profi le refl ects 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 men-tioned, as they are also exposed to interest rate risk.148

Nonlinear Derivatives

All instruments with optionalities (settlement profi le is not linear to the under-lying instruments) – such as caps, fl oors, swaptions, bond options – are desig-nated 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 option’s maturity and the maturity of the underlying instrument at the underlying instrument’s 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 fi 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 delta-weighted forward rate agreements).

Structured Products

Interest-sensitive structured products are fi 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 All interest-sensitive off balance sheet positions in the banking book must be allocated in confor-mity with the allocation criteria of the trading book (as defi ned by Article 204 paragraph 1 Nos 1 to 3 of the Solvency Regulation).

148 See reporting guidelines on the risk statement. 149 As per defi nition, capital market fl oaters also count as structured bonds.



73

In recent years, structured capital market products have grown steadily in number and complexity. The use of these products – for valuation and risk quantifi cation 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 fl 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. snow-balls, steepeners, target coupon bonds).

One approach that banks practice is to allocate structured bonds to the time band that corresponds to the duration (or modifi ed duration). However, this approach will seldom refl ect 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, or2. options other than at-the-money options.Otherwise, the delta could be greater than 1, and it will be meaningless for exotic options.

150 See OeNB (2003).151 A delta of 0 signifi es an exercise probability of 0%, and a delta of 1 signifi es an exercise probability

of 100%.152 See Katzengruber (2001).



74

The exercise probability can be established with trinomial tree or Monte Carlo simulation.

This method is, however, not suited for representing other types of option-alities (e.g. fl 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 fi 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, and3 we assume the shift to linearly drop to 0 to the left and the right of each

data point.

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 (inter-polations: 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.

Shift for 10-year time band

Chart 33

Source: OeNB.

10

8

6

4

2

0

basis points

1 5 6 7 8 9

time band

2 3 104 11 12 13 14 15 16 17 18 19 20



75

The following market values are recalculated on the basis of these six scenarios:

The next step is to fi 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 fl ows (resulting only from redemption at 100) have not changed. The table below presents the results of these scenarios.

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 calcu-lated 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 fi ve scenarios, we arrive at the following par values representing the replicating allocation of cash fl ows:

Table 4

Interest Rate Shift by 10 Basis Points

economic value given an unchanged curve 110.5424

shift in time band (years) economic value given an upward

shift by 10 basis points

difference from original economic

value

1 110.5359 –0.0066

2 110.5328 –0.0096

5 110.4497 –0.0928

10 110.2783 –0.2642

20 109.5557 –0.9868

30 110.5049 –0.0376

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

difference

1 97.7536 97.6559 –0.0977

2 95.0557 94.8661 –0.1897

5 85.0537 84.6292 –0.4244

10 67.0709 66.4032 –0.6677

20 39.8242 39.0351 –0.7891

30 24.1362 23.4225 –0.7137



76

Translated into a chart, the results of this exercise look as follows:

Extension to Structured Instruments

Transferring the procedure described above to structured instruments works as follows:

First, select data points in line with the specifi ed 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 institu-tions in Austria have invested more heavily in structured instruments, which pay a high coupon initially but whose coupon becomes very complex in sub-sequent 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 fl uctuations.

●

●

●

Table 6

Par Values of the Replication Portfolio

maturity of zero bond (years) par values in the replication portfolio

1 6.719

2 5.062

5 21.853

10 39.563

20 125.050

30 5.264

Replication of a coupon bond with a 20-year maturity

Chart 34

Source: OeNB.

140

120

100

80

60

40

20

0

1 5 10 20 30

times band (years)

2

par values



77

A steepener is a bond whose cash fl 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 fl 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 (fl oor: 0%).

Due to the leverage effect, this product is exposed to high interest rate risk. If the yield curve actually fl 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 steep-eners via CMS.155 The example below illustrates the decomposition and hedg-ing using CMS:

Reference date: February 1, 2006; par value: 100, market value: 80Coupon: 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 fl 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 fl 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 Profi le

This category includes all balance sheet positions that are not interest-sensi-tive, i. e. whose market value (economic value) does not depend on changes in market interest rates (e.g. capital, fi 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 struc-tural contributions), basically with a view to calculating the opportunity inter-est rate that refl ects the maturity ladder of the positions.156

Since capital or fi 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 See Finance Trainer (2005).156 See Schierenbeck (2003a), p. 109.

●

●

●

●

●



78

allocated in gap analysis can be calculated with a rolling replication port-folio.157

If integrated risk management extends to analyzing noninterest-sensitive positions with an imputed repricing profi le 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 book’s 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 fl ows from a bank’s 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 perfor-mance (ex post analysis) and potential future effects on performance (ex ante analysis).158 Economic value added basically refl ects the change in economic value between two points in time. This fi 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 defi ned. Since a single alternative scenario (a credit insti-tution’s own interest rate forecast) does not suffi ce to valuate future cash fl 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 pro-cesses (e.g. main component analysis159) to estimate the sensitivity of the inter-est rate book’s 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), andthe effect of a change in market interest rates.

The “sliding yield curve” effect arises from the shortening of the residual matu-rity of cash fl ows. For instance, a payment due in three years and accordingly valued with a three-year zero coupon bond discounting factor. When the resid-ual 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 See fi gure 25: Replication Portfolio with Rolling Tranches.158 See subsection 3.2.2.2, Simulation of Economic Value. 159 See subsection 4.4.3.1, Recognition of Marked Changes in Market Data.

●

●



79

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 signifi cant 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 book’s economic value with a specifi ed probability (confi dence level) during a given holding period.161 Losses of economic value, defi ned as a negative difference of future economic value from current economic value, are induced by changes in maturity-specifi c market interest rates. A brief example below describes the VaR calculation process.

The fi rst step in VaR calculations is the defi nition of risk factors for inter-est-sensitive positions, such as e.g. zero bond discounting factors. Multiplying the current zero bond discounting factor by the cash fl ow of the bond will pro-duce 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 eco-nomic 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 simu-lation approaches based on historical observations (historical simulation) or

160 The steeper (more inverted) the yield curve, the larger the price gain (loss) arising from the short-ening of the residual maturity.

161 The selection of the holding period is a key component of VaR calculation. Credit institutions should defi ne this parameter in a transparent way, depending on the liquidity of their balance sheet positions.

162 The change in economic value is specifi ed by the central parameter of the assumed distribution (e.g. expectation value, standard deviation).

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



80

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 eco-nomic value EVt in each case. As an alternative to the direct revaluation of zero coupon bonds, credit institutions can also produce an indirect approxi-mation (fi rst difference of economic value based on market yield) by using sensitivity measures (duration, key rate duration, basis point value).

The results of the changes in economic value can be used to obtain a prob-ability 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 confi dence 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.

This exercise can be applied to more comprehensive and complex portfolio compositions, provided the risk factors used adequately describe the interest rate book’s risk profi le. A subsequent mapping process ensures that cash fl ows are fully allocated to risk-determining factors (so-called risk factors, data

Probability Distribution of Changes in Economic Value

Chart 35

Source: OeNB.

12

9

6

3

0

frequency

–10 –5 0 5 10

ΔEV4

ΔEV2

ΔEV1

ΔEV3

empirical distribution

normaldistribution

ΔEV

VaR95 %

Table 8

Scenarios for VaR Calculation

scenarios at time t MCM rate ZBAFt EV ∆ EV

1 6.00 % 0.9434 4,717 0

2 5.97 % 0.9437 4,719 +2

3 6.08 % 0.9427 4,714 –3

4 5.81 % 0.9451 4,726 +9

5 6.25 % 0.9412 4,706 –11

. . .



81

points).163 Modeling the dependence structure will show to what extent risk factors offset or reinforce each other. Different model approaches for calculat-ing VaR are discussed in brief below.

Analytical Approach:

Underlying the well-known variance-covariance approach (delta normal method) are two key assumptions: fi 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 (profi t/loss) will also be normally distributed. These assumptions signifi cantly 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 profi t/loss distribution) must be estimated by means of mathemat-ical approximation processes. Even with such additional approximation, the analytical approach has the advantage of involving a limited amount of compu-tation.

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 his-torical 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 (profi t/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 defi ne a stochastic model as a basis for simulat-ing changes in economic value, which means that the risk factors’ distribution assumptions are implied. Empirical observations show that the trend in inter-est rates follows a long-term mean. This characteristic, known as mean rever-sion, can be mapped by integrating yield curve models into the Monte Carlo simulation. Individual models differ in the number and momentum of stochas-tic 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).



82

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 his-torical simulation, VaR is calculated as a quantile of the simulated profi t/loss distribution of changes in economic value.

While refl ecting the current risk of the overall portfolio in an aggregated fi gure, VaR does not provide differentiated information on the interest rate book’s risk profi le. Credit institutions can add up individual VaR fi 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 fi rst partial difference of total VaR given a change in volume. Component VAR indicates the contribution to risk for individual posi-tions 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 book’s 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 opportu-nities for portfolio restructuring, calculating incremental VaR becomes unpractical, as VaR must be recalculated in each case. In this case, an approxi-mate 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, sensi-tivity 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 briefl y described below.

The Macaulay duration is defi ned as a weighted average of payments made, with the weights being proportional to the economic value of each payment.166 The Modifi ed Hicks duration refl ects a market value’s sensitivity to changes in market interest rates; technically, it is simply the duration divided by the term (1+ market yield). Modifi ed 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 See Hull (2000), Drosdzol (2005).165 See Jorion (2001), p. 154ff.166 First derivative of the economic value according to the market yield167 In the aggregation of a duration, use is made of the duration’s property of additivity.



83

economic value and that of yield.168 Price losses computed on the basis of dura-tion 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, fi nally, allows the assump-tion of a fl at yield curve underlying modifi ed duration to be removed. Based on this concept, modifi ed 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 modifi ed 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. Ho’s 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-specifi c 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 dura-tion. An analytical calculation is only possible if the cash fl 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 modifi ed 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 differ-entiated assessment of the interest rate book’s investment performance. Credit institutions can obtain an integrated view of (expected) earnings and under-lying 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

RORACPerformance

VaR

Performancerelative abs= = oolute riskfreeReturn

VaR

−

RAROC Actual TargetRORAC RORAC= −

168 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.

169 See Schierenbeck (2003a), p. 43ff.



84

Risk adjustment enables credit institutions to compare portfolio activities effi ciently 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 com-paring actual RORAC with target RORAC. Comparing results with bench-marks 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 defi ne 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.

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 bench-

170 See Basel Committee on Banking Supervision (2004b), ref. 54ff.

Presentation of RORAC in the Yield-Risk Diagram

Chart 36

Source: OeNB.

performance

Benchmark

Δ economic value

RORAC

interest rate book

risk-free earnings

maximum risk capital nonsustainable risk

RORAC= net earnings

VaR

target: Optimizing RORAC throughinterest rate risk management measures

risk capital



85

mark’s cash fl ow structure. Adjustments are necessary all the time given the dynamic nature of cash fl ows (shortening of residual maturities, new business etc.). The defi nition of deviation limits can considerably reduce the trans action costs of the management measures. The difference between the actual cash fl ow and the benchmark cash fl 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 profi le by overweighting and by underweighting specifi c maturity segments. The trend in forward rates relative to the projected yield curve (interest rate expecta-tions) provides pointers for management.171 Figure 5 illustrates this approach: Since forward rates exceed projected interest rates in the short- to medium-term 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.

171 Forward rates represent the operational zero line (break-even interest rates) for the alignment of cash fl ow structure. See Schierenbeck (2003b), p. 632f.

Pointers for Interest Rate Risk Management in Active and Passive

Management Frameworks

Chart 37

8,000

4,000

0

– 4,000

– 8,000

– 12,000

passive management approach

Source: OeNB.

benchmark cash flow

projected interest rates

1 2 3 4 5 6 7 8 9 10

EUR

times band (years)



86

A simple, fl exible and cost-effective variant for managing cash fl ows is to use derivative fi 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 fl 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 fi gures computed from a balance sheet perspective (interest rate risk man-agement under economic value considerations) into earnings seen from an income state perspective, using rollover computation methods. Aggregate eco-nomic 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 fl ow-congruent offsetting trans-actions corresponds to the interest rate book’s current economic value. Knowl-edge of the par volumes necessary for liquidation purposes facilitates the cal-culation of earnings effects. To this effect, interest elements from both interest rate book cash fl 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 expir-ing 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 cor-responds to economic value added.

Pointers for Interest Rate Risk Management in Active and Passive

Management Frameworks

Cont. Chart 37

Source: OeNB.

benchmark cash flow

projected interest rates

12,000

8,000

4,000

0

– 4,000

– 8,000

– 12,000

active management approach

forward rates

actual cash flow in theinterest rate book

1 2 3 4 5 6 7 8 9 10

EUR

times band (years)



87

upon immediate or future liquidation of net cash fl 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 posi-tions. 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 interpre-tation 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 calcula-tion ensures that the interest rate book’s strategic positioning is also sustain-able 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 insolven-cies) perspectives. Other scenarios should refl ect future market estimates derived from ALM or made by ALCO. What is important is that those scenarios must be geared specifi cally to the respective credit institution, as the impact they have on the risk situation very much depends on a bank’s 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 defi 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 See subsection 3.2.2.1, Dynamic Simulation of Earnings.174 See Basel Committee on Banking Supervision (2004b), ref. 60ff.



88

To given an example, we have analyzed the euro swap curve’s fl uctuations in the period from 1998 to 2006 (Libor and swap rates). In this case, a mere four factors suffi ced 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 differ-ence between short-term rates and long-term rates)

4. a butterfl y, 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 See http://www.unriskderivatives.com/download/Hauptkomponenten_der_Zinsstruktur.pdf.176 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 “butterfl y” scenario, of which the swap rate contribution amounts to only about 0.1%, should also be included as a scenario.



89

These few components usually refl ect 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 defi ne potential scenarios based on these components:

Defi ne how much of the change in the yield curve (or swap curve) is explained by a given componentDefi ne factor loads (weights of individual components per time band)178

177 See Flacke and Siemens (2002).178 For the purposes of a simplifi ed presentation, the factor loads are assumed to be 1 in the example

cited.

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●

The Euro Yield Curve with Scenarios and their Explanatory Contribution

Chart 38

Quelle: OeNB.

5.0

4.5

4.0

3.5

3.0

2.5

2.0

Interest rate scenarios based on the euro swap curve of July 2006

yield curve as of July 06

money market shift

capital market shift

3

%

6 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

months years

moneymarket shift

80

60

40

20

0capital

market shifttwist butterfly

Explanatory contribution per scenario

maturity

factor

%

twist

butterfly



90

Calculate risk factors (multiplication of factor loads by a multiple of standard deviation)179180Calculate shift, twist and butterfl y scenarios

Credit institutions may combine the shift, twist and butterfl y scenarios (both up and down) to defi ne potential stress scenarios (Si) based on these components.

179 In order to keep the calculation simple, only a multiple (e.g. the double) of the positive and negative standard deviation is used for simplifi cation purposes. The higher the multiple, the more unlikely is the stress scenario.

180 See Paulus, Sauer and Walther (1998), p. 14.

●

●

Combined Interest Rate Scenarios

Chart 40

Source: OeNB.

5,0

4.5

4.0

3.5

3.0

2.5

2.0

S3

S7

3

interest rate

6 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

months years maturity

S6

S14

Developing Scenarios for Stress Tests180

Chart 39

Source: OeNB.

S2

S1

S3

S4

S5

S6

S7

S9

S11

S13

S8

S10

S12

S14

shift twist butterfly



91

Note that the scenarios S7 (combining shift up, twist up, butterfl y up) and S14 (combining shift down, twist down, butterfl y down) represent potential stress scenarios.In addition to these interest rate scenarios based on historical analyses, credit institutions must also defi ne worst case scenarios, based e.g. on outliers of historical analyses and credit institutions’ own specifi c 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 specifi cally models the distributions of those values.

Analyses are based on the extreme change in values above a certain thresh-old (e. g. 95% quantile) and on the underlying distributions (e. g. Frèchet-Weibull-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.

Fat Tails

Chart 41

Quelle: OeNB.

40

30

20

10

0

frequency density

–5.0

daily change (%)

–2.5 0 2.5 5.0 7.5

theoretical normal distribution

actual distribution

threshold



92

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 fi xed repricing profi les and/or stipulated lock-up periods to the shortest time band). In addition, credit institutions could also use specifi c 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 briefl y summarized below:1. Stress scenarios should represent unusual albeit conceivable market move-

ments. Acceptance is best reached by involving all decision-making bodies in defi ning these scenarios.

2. Credit institutions should match the scenarios with the risk profi le 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 bank’s 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 defi ne and document what kind of stress

test result is a cause for concern.6. Credit institutions must defi 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 manage-

ment.

4.5 Ex Post Analysis

In addition to economic value added, which refl ects both realized (liquidity-affecting) 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 refl ect those income components that have an effect on earnings when cash fl ows are repaid. In addition, the Basel Committee for Banking Supervision requires that embed-ded (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 decision–making bodies in a timely manner under a strict reporting regime.

182 See 4.2.1.2, Nonmaturation Theory.183 See OeNB (1999).184 See Basel Committee on Banking Supervision (2004b), ref. 22.



93

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 fl ows and revise their interest rate forecasts. Additionally, credit institutions must analyze the impact of extreme market situations on economic value and earn-ings performance.185 Within the integrated management process, banks will, in turn, redefi ne and adjust their risk policy principles in the light of ex post fi ndings (risk-bearing capacity analysis, backtesting, stress tests etc.).

References

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methoden, May 2005, 11th edition.

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Frauendorfer, Karl and SCHÜRLE, Michael, Dynamic modelling and optimization of non-

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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/aufsich-tsstatistik/vera_neu/vera_uebersicht.jspBasel 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 orwww.fma.gv.at/cms/basel2/EN/detail.html?channel=CH0281&doc=CMS1144346855538 www.fma.gv.at/cms/basel2/EN/www.mathconsult.co.at/www.unriskderivatives.com

Abbreviation Key

ALCO Asset-Liability Committee

CEBS Committee of European Banking Supervisors

CMB Constant maturity bond

CMS Constant maturity swap

CRD Capital Requirements Directive (Directive 2006/48/EC)

EC Escalator clause

EU Directive or

EU Directive 2000/12/EC

Directive of the European Commission on the capital adequacy of

credit institutions and investment fi rms in the EU

EVA® Economic value-added

GAAP General Accepted Accounting Principles

MCM Money and capital market

IAS/IFRS International Accounting Standards/International Financial Reporting Standards

ICAAP Internal Capital Adequacy Assessment Process

MBS Mortgage backed securities

OAS Option adjusted spread

RAROC Risk-adjusted return on capital

RARORAC Risk-adjusted return on capital

REX-P German bond market index (performance index)

RORAC RORAC: Return on risk-adjusted capital

SMY Secondary market yield

SREP Supervisory review evaluation process

UFN Until further notice

VaR Value at risk

managing interest rate risk in the banking...

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