Bank of Albania Guideline on Managing Interest Rate Risk in the Banking Book

REPUBLIC OF ALBANIA BANK OF ALBANIA SUPERVISORY COUNCIL D E C I S I O N No. 33, dated 30.04. 2013 ON APPROVAL OF THE GUIDELINE "ON MANAGING INTEREST RATE RISK IN THE BANKING BOOK" Pursuant to Article 12 (a) and Article 43 "c" of the Law No. 8269, dated 23.12 1997 “On the Bank of Albania”, as amended, and Article 58, paragraph 1 (b) and (c) of the Law No. 9662, dated 18.12.2006 “On banks in the Republic of Albania" as amended, the Bank of Albania's Supervisory Council having regard to the proposal from Supervision Department, DECIDED:

1. To approve the guideline “On managing interest rate risk in the banking book", as provided in the text attached therein.
2. The Supervision Department and the Department of Statistics are responsible for the implementation of this Decision.
3. The Department of Foreign Relations, European Integration and Communication is responsible for the publication of this Guideline in Bank of Albania's Official Bulletin and in the Republic of Albania's Official Journal.
4. The Guideline on the management of interest rate risk, adopted with the Supervisory Council's decision No. 61, dated 05.07.2000 will be repealed upon the entry into force of this Decision. This Decision shall enter into force 15 days after its publication in the Official Journal of the Republic of Albania. SECRETARY CHAIRMAN YLLI MEMISHA ARDIAN FULLANI

2 GUIDELINE "ON MANAGING INTEREST RATE RISK IN THE BANKING BOOK" CHAPTER I GENERAL PROVISIONS Article 1 Purpose This Guideline aims to set forth the requirements and basic rules on managing interest rate risk in the banking book, the calculation process for the exposure to this risk and the reporting to the Bank of Albania. Article 2 Scope of Application This Guideline will be applied to banks and branches of foreign banks, which conduct banking and financial activity in the Republic of Albania, in compliance with the licence granted by the Bank of Albania (hereinafter referred to as "banks"). Article 3 Legal grounds This Guideline is issued in compliance with Article 12 (a) and Article 43 (c) of the Law No. 8269, dated 23 December 1997 “On the Bank of Albania”, as amended, and Article 58, 1 (b)and (c) of the Law No. 9662, dated 18.12.2006 “On banks in the Republic of Albania”, as amended. Article 4 Definitions

1. The terms used in this guideline shall have the same meaning of the terms defined in the Law No. 9662, dated 18.12.2006 “On banks in the Republic of Albania”, as amended.
2. In addition to the stipulations in paragraph 1 of this Article, and for the purposes of this Guideline, the following terms shall mean: a) “repricing risk” – is the risk when the banks incurs losses, which arise from mismatches of maturity (fixed interest rate) and repricing of interest rate (variable interest rates) in the banking book positions; b) “yield curve risk” – is the risk when the bank incurs financial losses due to changes in the slope of the yield curve;

3 c) “basis risk” – is the risk when the bank incurs financial losses, which arise from the changes in interest reference rate for similar instruments related to maturity/or time, until the next change in the interest rate; d) “optinality risk" – is the risk when the bank incurs financial losses, which arise from options embedded in interest sensitive positions (e.g. early redemption rights loans, deposits with early withdrawal option, etc); e) “trading book” – comprises positions in financial instruments and commodities held either with a trading intent or in order to hedge other elements in the trading book, provided that such positions are either free of any boundary provision regarding their tradability or have the ability to be completely hedged. f) “banking book" – encompasses on-balance-sheet and off-balance-sheet items of a bank other than those considered to be trading book positions; g) “exposure to interest rate risk” – is the current value of expected net cash flows in the banking book positions (e.g. the expected cash flows of a bank's asset, reduced by the expected cash flows of a bank's liabilities); h) “major currency” – is any currency accounting for over than five per cent of the total balance-sheet assets; i) “standardized interest rate shock” – is a parallel upward or downward interest rate shift in the reference yield curve by 200 basis points j) “basis point” – is the unit equal to one hundredth of one percent. Article 5 Requirements for the managing system of interest rate risk in the banking book

1. Banks shall have in place the management system of interest rate risk in the banking book consistent with the nature, volume and complexity of their activities and with their risk profile.
2. Banks, in compliance with requirement stipulated in paragraph 1 of this Article, shall draft and approve the strategy, policy and other internal bylaws for the managing of interest rate risk in the banking book, and ensure their persistent implementation.
3. Banks shall establish adequate organisational units, with precisely defined, clear and unequivocally divided lines of authorities and responsibilities among employees, which ensure both independence of interest rate risk management function from the functioning of assuming interest-bearing positions in the banking book, and technical conditions for the measuring, monitoring and controlling interest rate risk in the banking book.

4 4. Banks shall have in place a system for the measuring of interest rate risk in the banking book, which provides the covering of all interest rate risk sources. 5. Banks shall set up a system of reporting on exposure to interest rate risk in the banking book, which is independent of the function of assuming interest-bearing positions in the banking book and includes regular reporting to the management board and employees or bodies of the bank in charge of determining, measuring, monitoring and controlling interest rate risk in the banking book. 6. Banks shall prescribe acceptable assumptions of the system for interest rate risk management that are adequate, documented and stable over time. 7. Banks shall ensure that any major changes in assumptions shall be documented, explained and approved by the bank's management board. 8. Banks shall set up a system of internal controls of the interest rate risk management process in the banking book. 9. Banks shall conduct, at minimum once a year, stress tests related to interest rate risk in the banking book and use the results of such stress testing in decision￾making and in the revision of policies, internal bylaws and limits relating to interest rate risk. 10. When conducting stress testing, banks shall take into account all significant sources of interest rate risk. Article 6 Sources / forms of interest rate risk

1. Banks shall assess the different sources / forms of interest rate risk that may have a negative effect on earnings (net interest income) or exposure of the banking book of a bank.
2. Sources / forms of interest rate risk include: a. Repricing risk, b. Yield curve risk, c. Basis risk, and d. Optionality. Chapter II Methods for calculating exposure to interest rate risk in the banking book Article 7 General requirements
3. For the purposes of calculating exposure to interest rate risk in the banking book, banks shall use the method for estimating the change in the exposure of the banking book by applying a standard interest rate shock to the banking book

5 positions in all major currencies individually and to those in other currencies on an aggregate basis. 2. For the purposes of calculation as per the method of the estimate of change in the exposure of the banking book, banks shall distribute interest rate sensitive positions into 14 time bands, as shown in the Table 1 attached to this guideline. 3. Banks shall slot positions with fixed interest rate in time bands according to the remaining maturity, and the positions with variable interest rate in time bands according to the time till the next interest rate change 4. Banks shall use the weighting factors established in Table 1 of this Guideline, which are calculated as a multiplication of the interest rate shock of 200 basis points with the estimated modified duration for each time band. 5. When using the method of the estimate of change in the exposure of the banking book, banks shall follow the following steps: a. for each major currency, individually and for other currencies on aggregate basis, sum up assets and liabilities positions and derivative financial instruments (or off-balance sheet assets and liabilities items) in each time zone to obtain one net position per zone; b. multiply the obtained total net position referred to in letter “a” of this paragraph in each time band with the prescribed weights given in the Table 1 of this Guideline for each major currency individually and for all other currencies on an aggregate basis; c. sum up the obtained weighted positions in all time bands to obtain a net long or a net short position for each major currency individually and for all other currencies on an aggregate basis; d. sum up net long and net short positions in all currencies to obtain a total net weighted position in the banking book. 6. The total net weighted position of the banking book referred to in letter “d” of paragraph 1 of this Article shall be expressed in an absolute amount and shall represent a change in the exposure of a banking book as a result of application of the standard interest rate shock. 7. Banks shall calculate the ratio in percentage of the change in the exposure of the banking book to the regulatory capital. This ratio should not fall below 20%. Article 8 Derivative financial instruments When employing a derivative financial instrument of the banking book, to manage interest rate risk in the banking book, banks shall include this (derivative financial) instrument in calculating the change ratio in the exposure in the banking book to the regulatory capital.

6 Article 9 Reporting requirements

1. Banks shall report to the Bank of Albania on quarterly basis, in compliance with forms No. 1, No. 2 and No. 3, Annex 2 of this Guideline, part of the Unified Reporting System.
2. Banks shall report on the exposures to the interest rate risk in the banking book, on individual and consolidated basis, including the reporting individually for each major currency and on aggregated basis for all the other currencies. CHAPTER III FINAL PROVISIONS Annex 1 and 2 are an integral part of this Guideline. CHAIRMAN OF THE SUPERVISORY COUNCIL

ARDIAN FULLANI

ANNEX 1 Table 1 Weighting factors per time band Time band Middle of time band Proxy of modified duration Assumed change in yield Weighting factor (1) (2) (3) (4) (5) = (3)*(4) at sight 0 0 200 bp 0.00% Up to 1 month 0.5 months 0.04 years 200 bp 0.08% 1 to 3 months 2 months 0.16 years 200 bp 0.32% 3 to 6 months 4.5 months 0.36 years 200 bp 0.72% 6 to 12 months 9 months 0.71 years 200 bp 1.43% 1 to 2 years 1.5 years 1.38 years 200 bp 2.77% 2 to 3 years 2.5 years 2.25 years 200 bp 4.49% 3 to 4 years 3.5 years 3.07 years 200 bp 6.14% 4 to 5 years 4.5 years 3.85 years 200 bp 7.71% 5 to 7 years 6 years 5.08 years 200 bp 10.15% 7 to 10 years 8.5 years 6.63 years 200 bp 13.26% 10 to 15 years 12.5 years 8.92 years 200 bp 17.84% 15 to 20 years 17.5 years 11.21 years 200 bp 22.43% Over 20 years 22.5 years 13.01 years 200 bp 26.03%

ANNEX 2 Form No.1 – Change in the exposure of the banking book for Fixed Interest Rate items (FIR) Name of Bank / credit institution: Type of report: Date: at sight to 1 mont h 1-3 month s 3-6 month s 6-12 month s 1-2 years 2-3 years 3-4 years 4-5 years 5-7 years 7-10 years 10-15 years 15-20 years 20+ years 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 Cash and Central Bank 2 Treasury bills and other for refinc. With BoA 3 C/a with banks and other finc.instutions. 4 Deposits with banks and other financ. Institutions demand deposits time deposits 5 Loans from banks and other finc. institutions 6 Other from banks and financial institutions 7 Loans and advances minus provisions 8 Securities Equity securities Investment securities Treasury bond commitments and other debt securities 9 Holdings in banks and other financial institutions other TOTAL ASSETS BALANCE SHEET ASSETS Interest rate sensitive banking book items - fixed interest rate Change in the exposure of the banking book for fixed interest rate items Currenc y Time zones Form FIR

2 1 Central Bank 2 Reverse repo 3 C/a from banks and other finc.instutions. 4 Deposits from banks and other financ. Institutions demand deposits time deposits 5 Loans from banks and other finc. Institutions 6 Other from banks and financial institutions 7 Due to customers current accounts demand deposits time deposits 8 Due to government 9 Other liabilities from bonds and securities 10 Specific provisions 11 Subordinated debt TOTAL LIABILITIES NET BALANCE SHEET POSITION OFF-BALANCE SHEET ITEMS (-) LIABILITIES OFF-BALANCE SHEET ASSETS ITEMS

3 IX. Derivative financial instruments

1. Swap agreements
2. Forwards
3. Futures
4. Options 4.1. Embedded options 4.2. Other options
5. Other derivative financial instruments TOTAL OFF-BALANCE SHEET ASSETS ITEMS X. Derivative financial instruments
6. Swap agreements
7. Forwards
8. Futures
9. Options 4.1. Embedded options 4.2. Other options
10. Other derivative financial instruments TOTAL OFF-BALANCE SHEET LIABILITIES ITEMS NET OFF-BALANCE SHEET POSITION TOTAL NET POSITION WEIGHTS 0.08% 0.32% 0.72% 1.43% 2.77% 4.49% 6.14% 7.71% 10.15% 13.26%17.84% 22.43% 26.03% WEIGHTED POSITION - Fixed-IR NET WEIGHTED POSITION BY CURRENCY - Fixed-IR (-) OFF-BALANCE SHEET LIABILITIES ITEMS

4 Form No.2 - Change in the exposure of the banking book for Variable Interest Rate items (VIR) Name of Bank / credit institution: Type of report: Date: at sight to 1 month 1-3 months 3-6 months 6-12 months 1-2 years 2-3 years 3-4 years 4-5 years 5-7 years 7-10 years 10-15 years 15-20 years 20+ years 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 1 Cash and Central Bank 2 Treasury bills and other for refinc. With BoA 3 C/a with banks and other finc.instutions. 4 Deposits with banks and other financ. Institutions demand deposits time deposits 5 Loans from banks and other finc. institutions 6 Other from banks and financial institutions 7 Loans and advances minus provisions 8 Securities Equity securities Investment securities Treasury bond commitments and other debt securities 9 Holdings in banks and other financial institutions other TOTAL ASSETS BALANCE SHEET ITEMS ASSETS Change in the exposure of the banking book for variable interest rate items Currency Time zones Interest rate sensitive banking book items - variable interest rate Form VIR

5 1 Central Bank 2 Reverse repo 3 C/a from banks and other finc.instutions. 4 Deposits from banks and other financ. Institutions demand deposits time deposits 5 Loans from banks and other finc. Institutions 6 Other from banks and financial institutions 7 Due to customers current accounts demand deposits time deposits 8 Due to government 9 Other liabilities from securities 10 Specific provisions 11 Subordinated debt TOTAL LIABILITIES NET BALANCE SHEET POSITION OFF-BALANCE SHEET ASSETS ITEMS OFF-BALANCE SHEET ITEMS (-) LIABILITIES

6 IX. Derivative financial instruments

1. Swap agreements
2. Forwards
3. Futures
4. Options 4.1. Embedded options 4.2. Other options
5. Other derivative financial instruments TOTAL OFF-BALANCE SHEET ASSETS ITEMS X. Derivative financial instruments
6. Swap agreements
7. Forwards
8. Futures
9. Options 4.1. Embedded options 4.2. Other options
10. Other derivative financial instruments TOTAL OFF-BALANCE SHEET LIABILITIES ITEMS NET OFF-BALANCE SHEET POSITION TOTAL NET POSITION WEIGHTS 0.00% 0.08% 0.32% 0.72% 1.43% 2.77% 4.49% 6.14% 7.71% 10.15% 13.26% 17.84% 22.43% 26.03% WEIGHTED POSITION -Variable-IR NET WEIGHTED POSITION BY CURRENCY -Variable IR (-) OFF-BALANCE SHEET LIABILITIES ITEMS

General instructions

1. When reporting the forms, banks shall convert the positions in foreign currencies to Albanian Lek, using the official exchange rate of the Bank of Albania on the reporting date.
2. In the reporting forms, banks shall include the exposures to interest rate risk included in the banking book, which are considered vulnerable against the changes in these rates. Explanatory notes: Forms No.1 and No.2
3. Banks shall present in Form No. 1 (FIR) the fixed interest rate of on-balance-sheet and off-balance-sheet items assigned to the time band according to the remaining maturity.
4. Banks shall present in Form No. 2 (VIR) variable interest rate of on-balance-sheet and off –balance-sheet items assigned to the time band according to the time left up to the next interest rate change.
5. Banks shall fill in Form No. 1 and Form No. 2, depending on the type of interest rate, for each major currency individually and for all other currencies on an aggregate basis.
6. For the purposes of obtaining a “total net position” for each band, banks shall sum up assets and liabilities positions (on-balance-sheet and off-balance- sheet), taking account of the signs preceding each time band. For the purposes of calculating the "total net position", asset positions shall be deemed to have a (+) sign while liabilities positions shall be deemed to have a (-) sign.
7. For the purposes of obtaining a "Weighted position" for each time band, banks shall multiply the obtained total net position per each time band by weights given in the forms No. 1 and No. 2 under “Weights”.
8. With the purpose to obtain a net long or a net short position, banks shall sum up the obtained weighted positions "Net weighted position by currency" in all time bands for each type of interest rate per currency.
9. In cases of predetermined maturity positions, or when the period of interest rate change is unknown or may not be definitely determined, banks shall assign the time band positions, based on their previous experience on the behaviour of these positions.
10. Banks shall not consider as sensitive to changes in interest rate positions the on￾balance-sheet items, such as: cash, fixed assets, shareholder capital and other similar items, and off-balance -sheet items: guarantees, letters of credit, unused lines of credit, and other standard off-balance sheet items.

2 9. Banks shall assign the current accounts and demand deposits in liability side according to the following: a. at sight time band, a fixed percentage (25 per cent) of current accounts and demand deposits; b. remaining amounts from those mentioned in “ a” , above (75%) in time bands 1 from “up to 1 month” to “4-5 years” in a proportional manner with the number of months that the time band contains; 10. Albanian lek reserve requirements set aside with the central Bank of Albania shall be reported in the Form No. 2, within the time band “up to 1 month”. Foreign currency reserves with Bank of Albania should be considering non-sensitive to interest rate risk. 11. Banks shall assign the holdings in debt securities by time bands, in line with the way agreed in the respective agreements. 12. Banks shall assign non-performing items (loans) to the time band from 2 to 3 years on their net value after subtracting the reserve funds created at the reporting date. 13. Banks shall assign assets and liabilities with instalment payments within the time bands in accordance with the agreed repayment plan. 14. Banks shall assign derivatives according the bands corresponding to instruments, based on which these derivatives are issued. 15. Banks shall report the financial instruments structured in on-balance-sheet or off￾balance-sheet, divided by their constituting elements, excluding those that are included in the tradable portfolio for supervisory purposes. Options, independently of their nature (such as: the early repayment option, the option to change interest rate from fixed to variable one) are slotted by intervals based on the equivalent value, delta2 . 16. Banks shall deal assets and liabilities at variable interest rate and which contain a minimum and maximum rate (“floor” or “cap”), as combination of an item at variable

1 For example, in “up to 1-month” time band, 1 / 60 of the remaining amount and in the time band ”6 to 12 months" 6 / 60 of it should be inserted. 2 "Delta equivalent value” is the market value of base instrument, multiplied with coefficient delta. Delta coefficient is the assumed change in an option price, due to the change in its base instrument price, and is calculated from the stock exchange or according to market standard models or to the bank internal models.

3 rate and an option of “floor” or “cap” type3. Thus, a loan at variable interest rate and minimum “floor” rate to be paid from the customer will be presented as a combination of: a) a variable rate loan (to be allocated at the respective box by the date of interest rate review); and b) a “floor” purchased option for fixed interest rate and in sale for variable rate. 17. Banks shall report fixed interest rate assets or liabilities for a definite number of years, which for the rest of the period (according to the contract) will have variable interest rate, in Form No.2 of variable interest rate items. 4 The remaining time to the forthcoming change of interest rate will be considered the time period between the reporting date and the first date this rate is reviewed.

3 Example: It is assumed a loan with 5-year maturity term, amounting ALL 500, at annual instalments ALL100, at variable interest rate each year and with option interest rate may not fall below X per cent . Delta value of option is assumed equal for each instalment Hypothesis A - delta 0%: in this case the loan will be allocated for the amount ALL 500 within the repricing time band "6-12 months" and shall not be considered purchasing or sale positions for the option; Hypothesis B - delta equivalent to 50%: I n this case the loan will be allocated for the amount ALL 500 within the time band "6-12 months" which corresponds to the reviewing date of interest rate "6-12 months. Option amounting 50 (=100*50%) will be allocated within 5 purchasing positions, at time band “6-12 month”, “1-2 year”, “2-3 years”, “3-4 years” and“4-5 years”, and one sale position amounting 250, at time band related to repricing date, that is “6-12 months”. 4 In case of a mortgage loan with maturity term 15 years and annual instalments for the first 5 years with fixed interest rate and for the next 10 years at variable interest rate, will be disclosed at revisable variable rate at the beginning after 5 years and will remain as such over the forthcoming years. Till the next review of interest rate, the loan will be allocated: a) 5 instalments at fixed rate at time band by remaining maturity, respectively "6-12 months", "1-2 years", and “2-3 years’, “3-4 years”, and “4-5 years”, b) 10 remained installments at variable rate, within the time band “4-5 years”

Form No.3 - Total weighted position (Interest Rate Risk of the Banking Book (IRRBB) Name of Bank / credit institution: Type of report: Date: Currency Amount 1 2 1.1. 1.2. 2. CHANGE IN THE EXPOSURE VALUE 3. OWN FUNDS 4. (CHANGE IN THE EXPOSURE VALUE / REGULATORY CAPITAL) * 100 … Total weighted position NET WEIGHTED POSITION BY CURRENCY- (FIR+VIR) - currency 1 NET WEIGHTED POSITION BY CURRENCY - (FIR+VIR) - currency 2 IRR Form total IRRBB Explanatory notes: Reporting form No. 3

1. Banks shall complete Form No. 3 by entering the amounts given in forms No. 1 and No. 2.
2. For purposes of obtaining a net weighted position by currency, banks shall sum up the obtained net weighted positions (long or short, by individual types of interest rates in forms calculated in forms No. 1 and No. 2. for each major currency individually and for all other currencies on an aggregate basis.
3. Banks shall present the obtained net weighted position by currency in the form No. 3, in lines under number 1 for each major currency individually and for all other currencies on an aggregate basis.
4. To obtain a total weighted position of the banking book, banks shall sum up the net long and short positions by different currencies given in the form No. 3, in lines under number 1, which constitutes a change in the exposure of the banking book of a bank and is shown in an absolute amount under number 2 of this form.
5. Banks shall calculate the ratio of the change in the exposure to the regulatory capital, in the form No. 3, in line 4.