FINMA Circular 2019/2 Interest Rate Risks – Banks

Laupenstrasse 27 3003 Bern Tel. +41 (0)31 327 91 00 Fax +41 (0)31 327 91 01 www.finma.ch Circular 2019/2 Interest Rate Risks – Banks Measurement, Management, Monitoring and Control of Interest Rate Risks in the Banking Book Reference: FINMA-Circular 19/2 "Interest Rate Risks – Banks" Issued: 20 June 2018 Entry into force: 1 January 2019 Last amendment: 4 November 2020 Concordance: formerly FINMA-Circular 08/6 "Interest Rate Risks Banks" of 20 November 2008 Legal Basis: FINMA Act Art. 7 para. 1 lit. b, 29 para. 1 Banking Act Art. 4 Banking Ordinance Art. 12 Capital Adequacy Ordinance Art. 45, 96 Financial Institutions Ordinance Art. 68 Annex 1 Outlier Institutions: Identification, Assessment and Possible Measures Annex 2 Standardized Interest Rate Shock Scenarios

Addressees Banking Act Banking Supervision Act Financial Institutions Act Financial Market Infrastructure Act Collective Investment Schemes Act Anti-Money Laundering Act Others Banks Financial Groups and Conglomerates Other Intermediaries Insurers Insurance Groups and Conglomerates Intermediaries Asset Managers Trustees Managers of Collective Investment Assets Fund Management Companies Custodian Securities Firms Non-Custodian Securities Firms Trading Venues Central Counterparties Central Securities Depositories Transaction Registers Payment Systems Participants SICAV KmG for KKA SICAF Custody Banks Representatives of Foreign KKA Other Intermediaries SRO SRO-Supervised Audit Firms Rating Agencies X

Table of Contents 2/19 I. Subject Matter, Scope of Application II. Basel Minimum Standards III. Fundamentals IV. Principles A. Principle 1: Interest Rate Risk Management B. Principle 2: Governing Body C. Principle 3: Risk Tolerance D. Principle 4: Internal Interest Rate Risk Measurement System E. Principle 5: Model Assumptions F. Principle 6: Data Integrity and Validation G. Principle 7: Reporting H. Principle 8: Disclosure I. Principle 9: Internal Risk Bearing Capacity V. Data Collection and Data Assessment Rz 1-4 5-7 8-15 16-48 16 17-18 19 20-32 33-34 35-38 39-40 41 42-48 49-50

3/19 I. Subject Matter, Scope of Application This circular describes minimum standards for the measurement, management, monitoring and control of interest rate risks in the banking book and concretizes Art. 12 of the Banking Ordinance (BankV; SR 952.02), Art. 68 of the Financial Institutions Ordinance (FINIV; SR 954.11) as well as Art. 45 and 96 of the Capital Adequacy Ordinance (ERV; SR 952.03). It contains clarifications to the FINMA Circular 2017/1 "Corporate Governance – Banks". The scope of application of the circular covers all positions that do not meet the conditions under Art. 5 ERV (Trading Book). However, a joint consideration of all interest rate risks within and outside the trading book must be carried out at least periodically. The measurement, management, monitoring and control of interest rate risks in the banking book must be carried out on an individual institution and group basis. If the interest rate risks taken in the banking book in controlled companies in the banking or financial sector, individually or in total, are immaterial in relation to the interest rate risks taken in the bank, their inclusion in the consolidated view may be waived with the consent of the audit firm. The bank must ensure by means of directives, limits or other specifications that these units do not take on material interest rate risks in the banking book. This circular does not apply to securities firms that do not hold a banking license, provided they do not take on material interest rate risks outside the trading book. The audit firm must confirm this as part of its annual risk analysis.

II. Basel Minimum Standards This circular is based on the Basel Standards on Interest Rate Risk in the Banking Book: • "Interest rate risk in the banking book" from April 2016 (IRRBB)1. References to the underlying text passages of the Basel standards are made in square brackets in the following explanations.

III. Fundamentals [IRRBB§8] Interest rate risk in the banking book2 is the risk to a bank's equity and earnings that arises from interest rate movements. Changes in interest rates affect the economic value of a bank's assets, liabilities and off-balance sheet positions (present value perspective). They also touch upon the earnings from interest-bearing business (earnings perspective). 1 The IRRBB standards of the Basel Committee on Banking Supervision can be accessed on the internet at: www.bis.org > Committees & associations > Basel Committee on Banking Supervision > Publications > Interest rate risk in the banking book. 2 Hereinafter referred to only as interest rate risk.

4/19 [IRRBB§9] Interest rate risk can take three forms: • The repricing risk arises from the temporal incongruity or the repricing of assets, liabilities and off-balance sheet positions. • Basis risk describes the impact of changes in interest rates for instruments that have a similar maturity but are valued based on different interest rates. • Option risk arises from options or embedded (implicit) options where the bank or the customer can change the amount and timing of cash flows (e.g. in deposits without a fixed term, term deposits or fixed-rate loans). [IRRBB§10] Changes in interest rates can indirectly lead to changes in borrower creditworthiness (creditworthiness effect3) without a jump into default. The principles of this circular are to be applied depending on the size of the bank as well as the nature, scope, complexity and risk content of the business activities (principle of proportionality). Small banks according to Rz 15 are exempt from implementing certain marginal paragraphs of this circular; this exception also applies to banks of category 3 according to Annex 3 BankV with low earnings from interest business according to Rz 15. As small banks within the meaning of this circular, banks of categories 4 and 5 according to Annex 3 BankV are considered. Banks with low earnings from interest business are considered category 3 banks, where the share of net earnings from interest business is less than one third of the ordinary earnings figures.4 The FINMA can order relaxations or tightening in individual cases.

IV. Principles A. Principle 1: Interest Rate Risk Management [IRRBB§12–15] Banks identify, measure, monitor and control their interest rate risks in a timely and comprehensive manner. In this context, creditworthiness effects of tradable financial instruments must also be taken into account according to their relevance. In this sense, high quality liquid assets (HQLA) of category 1 according to Art. 15a LiqV and mortgage bonds of category 2a according to Art. 15b LiqV issued by the Pfandbriefbank of Swiss Mortgage Institutes AG or the Pfandbriefzentrale of the Swiss Cantonal Banks AG generally do not need to be taken into account. 3 This refers to credit spread risk in the banking book. 4 I.e. based on the values according to Rz 2 FINMA-Circular 08/14 "Supervisory Reporting – Banks", form AU302 applies: Subtotal Net Earnings Interest Business / (Subtotal Net Earnings Interest Business + Subtotal Earnings from Commission and Service Business + Earnings from Trading Business and Fair Value Option + Subtotal Other Ordinary Earnings) < 1/3.

5/19 B. Principle 2: Governing Body [IRRBB§16–27] The governing body is responsible for supervising and approving an appropriate framework concept for interest rate risks and for defining the risk tolerance regarding interest rate risks. [IRRBB§17] The governing body or its delegates make specifications for interest rate risk, based on which it is to be measured, monitored and controlled in accordance with the approved strategies and guidelines. This also includes specifications for interest rate shock and stress scenarios. C. Principle 3: Risk Tolerance [IRRBB§29–31] The risk tolerance regarding interest rate risks must be formulated at least for the present value perspective. Appropriate limits are formulated that are oriented towards the risk tolerance with regard to the short-term and long-term effects of fluctuating interest rates and map meaningful shock and stress scenarios. Additionally, limits for the earnings perspective can be defined if relevant in the individual case. D. Principle 4: Internal Interest Rate Risk Measurement System The measurement of interest rate risk is based on a broad and appropriate range of interest rate shock and stress scenarios. [IRRBB§35] The internal interest rate risk measurement system takes into account the following scenarios: • internally selected interest rate shock scenarios, which appropriately cover the bank's risk profile; • historical and hypothetical interest rate stress scenarios, which tend to be more severe than the scenarios according to Rz 22; • the six standardized interest rate shock scenarios according to Annex 2; and • interest rate shock scenarios additionally specified by the FINMA. [IRRBB§40] When developing the scenarios according to Rz 22 and 23, the relevant factors must be taken into account (such as currencies5, the form and level of the current maturity structure of interest rates, the historical and implicit volatility of interest rates). In a low interest rate environment, banks also consider scenarios of negative interest rates and their impact on assets and liabilities. [IRRBB§41–42] The following elements are typically taken into account when developing interest rate shock and stress scenarios for interest rate risk: • severe and plausible interest rate shock and stress scenarios; • the current interest rate level, the interest rate cycle and the interest rate risk concentrations (products and currencies), interest rate volatilities, creditworthiness effects, dependencies on other risk types, balance sheet structure effects and customer conditions; 5 The relevant currencies according to SNB survey ZIRU, ZIRK must be taken into account.

6/19 • hypothetical assumptions: for portfolio changes due to internal or external factors, for new products with limited historical data basis, for new market information and for new potential risks. [IRRBB§43] Banks take into account interest rate risk as part of the general stress testing framework concept in qualitative and quantitative stress tests (reverse stress tests). In these stress tests, a severe deterioration of earnings or capital is assumed in order to identify weaknesses that result from hedging strategies and the possible behavioral reactions of their customers. Small banks and category 3 banks with low earnings from interest business according to Rz 15 can restrict themselves to qualitative stress tests here. If a small bank according to Rz 15 can plausibly justify and document that the interest rate shock scenarios according to Rz 24 and 25 are appropriate for the interest rate risks taken, it can restrict itself to these; Rz 22–23 and 26–30 then do not apply. E. Principle 5: Model Assumptions [IRRBB§46–51] Significant behavioral assumptions for the measurement of interest rate risks are conceptually sound, appropriate and consistent with relevant historical experience values with regard to options. Sensitivity analyses for behavioral assumptions must be carried out periodically. The other model assumptions and their impact on interest rate risk are conceptually sound, appropriate and are reviewed at least annually and aligned with the bank's business strategies. If a small bank or category 3 bank with low earnings from interest business according to Rz 15 can plausibly justify and document that the business model, customer and product structure, market environment and other factors relevant to the model assumptions have not changed significantly, it is exempt from a review of the model assumptions and their impacts at least annually. The model assumptions and their impacts must, however, be reviewed at least every three years. F. Principle 6: Data Integrity and Validation [IRRBB§52–65] Interest rate risk measurement systems are based on precise data and are appropriately documented, controlled and tested. Models for interest rate risks are also appropriately documented and controlled and, if suitable data is available, tested. Both are part of a risk concept and are subject to independent, appropriately documented validation. [IRRBB§52–54] Both in the present value and earnings perspectives, different methods are used, where appropriate, ranging from static simulations to dynamic models for the earnings perspective. [IRRBB§57] The internal interest rate risk measurement system can calculate the earnings and present value risks on the basis of the scenarios described in Rz 22–25. Small banks and category 3 banks with low earnings from interest business according to Rz 15 can choose appropriately simplified implementations for the validation of data, interest rate risk measurement systems, models and parameters according to Rz 35 and 37.

7/19 The implementation takes into account in particular the simpler organizational structure of these banks (e.g. no independent validation function). A validation must be carried out in the event of material changes to data, interest rate risk measurement systems, models and parameters, but at least every three years. G. Principle 7: Reporting [IRRBB§66] The governing body or its delegates are regularly informed (at least semi-annually) about the scope and development of interest rate risk, its measurement, management, monitoring and control. [IRRBB§67] The reporting includes in particular the exposure to interest rate risk (also under stress considerations), the utilization of limits and significant model assumptions. H. Principle 8: Disclosure [IRRBB§69-71] The requirements regarding disclosure are based on the FINMA Circular 2016/1 "Disclosure – Banks". I. Principle 9: Internal Risk Bearing Capacity [IRRBB§72, 74] As part of the determination of institution-specific adequate capital provision according to FINMA Circular 2011/2 "Capital Buffers and Capital Planning – Banks", in which institutions include all risk types relevant to them, it is shown, if relevant, that adequate risk capital is held for interest rate risk according to Rz 8. [IRRBB§73] The adequacy check of risk capital is not based exclusively on the result of the FINMA's quantitative assessment process for the identification of possibly inappropriately high interest rate risks. [IRRBB§75–76] The assessment of risk bearing capacity takes into account the factors relevant to the institution in an appropriate manner, in particular: • the limits and their degree of utilization; • the effectiveness and expected costs of hedging measures and • the risk-related allocation of equity along the (legal) organizational units. Rz 44 to 47 do not apply to small banks and category 3 banks with low earnings from interest business according to Rz 15.

V. Data Collection and Data Assessment [IRRBB§77–79, Principle 10] The banks, with the exception of branches of foreign banks, transmit the information on their interest rate risks to the FINMA on an individual institution and group basis at periodic intervals using a form specified by the FINMA.

8/19 [IRRBB§88–95, Principle 12] The criteria for the definition and treatment of outlier institutions, which the FINMA uses in its assessment, are described in Annex 1.

Annex 1 Outlier Institutions: Identification, Assessment and Possible Measures 9/19 Identification of institutions with possibly inappropriately high interest rate risks in the banking book or insufficient interest rate risk management (outlier institutions) [IRRBB§88-95] The FINMA identifies outlier institutions based on Rz 2 and 5 of this annex. Criteria for the identification of possibly inappropriately high interest rate risks: • The change in the present value of equity based on the cash flows according to data collection according to Rz 49 of the circular under at least one of the interest rate shock scenarios according to Rz 24 of the circular amounts to at least 15% of the core capital. • The extent of the change in the present value of equity according to Rz 3 calculated taking into account the assumptions of the reporting institutes as well as market-standard assumptions (for comparison purposes). Criteria for the identification of insufficient interest rate risk management: • Deficiencies in compliance with Principles 1 to 9. Assessment of Outlier Institutions Outlier institutions are assessed by the FINMA on an institution-specific basis. The FINMA assesses outlier institutions on a case-by-case basis using the following criteria: • Equity provision in relation to interest rate risks and earnings situation. • Responsiveness to interest rate shock and stress scenarios. The effects of financial investments held at market value as well as the potential effects upon revaluation of financial investments held at amortized cost are taken into account. • Appropriateness of assumptions and parameters for margin payments and other creditworthiness-dependent spread components, for deposits without a fixed term, for the allocation of equity to risk types and entities and for early repayments or withdrawals with regard to institution-specific features. • Regarding the earnings situation, the level and stability of earnings and their impact on future business activities including dividend payments are assessed. Measures If the assessment of outlier institutions by the FINMA in individual cases results in the conclusion that interest rate risk management is insufficient or that the interest rate risk in relation to equity, taking into account the equity target size according to FINMA-Circular 2011/2 "Capital Buffers and Capital Planning – Banks", is inappropriate for earnings or risk bearing capacity under

Annex 1 Outlier Institutions: Identification, Assessment and Possible Measures 10/19 consideration of all risks, the FINMA may require additional equity according to Art. 45 ERV or other measures. The measures according to Rz 13 include in particular: reduction of interest rate risks, active oversteering of assumptions or parameters of the internal interest rate risk measurement system, improvement of the framework concept for interest rate risks or replacement of the internal interest rate risk measurement system with the standardized framework concept of the Basel Standard on Interest Rate Risk in the Banking Book according to Rz 6 of the circular [IRRBB§100-132].

Annex 2 Standardized Interest Rate Shock Scenarios 11/19 Banks apply the standardized interest rate shock scenarios according to Rz 24 to calculate the change in the present value of equity separately by material currencies. The six standardized interest rate shock scenarios are: i. parallel shock upwards; ii. parallel shock downwards; iii. Steepener shock (short-term interest rates fall and long-term interest rates rise); iv. Flattener shock (short-term interest rates rise and long-term interest rates fall); v. Shock of short-term interest rates upwards; and vi. Shock of short-term interest rates downwards. When applying the standardized interest rate shock scenarios, interpolation may be used in the maturity bands if the internal interest rate risk measurement system cannot map the maturity bands specified by the FINMA. When using more, fewer or deviating maturity bands, the results must be equivalent to the results when using the corresponding maturity bands of the FINMA specifications. The definition of the maturity bands and their maturity band midpoints (in years) can be found in the following table: Maturity Band Maturity Band Limits Maturity Band Midpoint Maturity Band Maturity Band Limits Maturity Band Midpoint 1 Overnight 0.0028 11 (4Y;5Y] 4.5 2 (ON;1M] 0.0417 12 (5Y;6Y] 5.5 3 (1M;3M] 0.1667 13 (6Y;7Y] 6.5 4 (3M;6M] 0.375 14 (7Y;8Y] 7.5 5 (6M;9M] 0.625 15 (8Y;9Y] 8.5 6 (9M;1Y] 0.875 16 (9Y;10Y] 9.5 7 (1Y;1.5Y] 1.25 17 (10Y;15Y] 12.5 8 (1.5Y;2Y] 1.75 18 (15Y;20Y] 17.5 9 (2Y;3Y] 2.5 19 >20Y 25 10 (3Y;4Y] 3.5

Annex 2 Standardized Interest Rate Shock Scenarios 12/19 Banks can calculate the standardized interest rate shock scenarios per currency themselves according to the specifications of the Basel Minimum Standards1 on interest rate risks. Deviating from this, a value of 150 is to be assumed for the interest rate shock R̅ shock type,CHF (parallel). The interest rate shocks R̅ shock type,ETC amount to 300 (parallel), 350 (short) and 200 (long). The standardized interest rate shocks per currency determined by the banks must correspond in absolute terms to at least those of the FINMA specifications. No interest rate floor is to be applied in the scenarios. Standardized interest rate shock scenarios (in basis points) by currencies: Maturity Band Scenario 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 CHF i 150 ii -150 iii -97 -96 -90 -81 -70 -61 -47 -31 -10 12 29 43 53 61 68 73 82 88 90 iv 120 118 113 104 94 85 72 56 36 15 -2 -14 -25 -32 -39 -43 -52 -58 -60 v 150 148 144 137 128 121 110 97 80 63 49 38 30 23 18 14 7 2 0 vi -150 -148 -144 -137 -128 -121 -110 -97 -80 -63 -49 -38 -30 -23 -18 -14 -7 -2 0 ARS i 400 ii -400 iii -325 -319 -301 -272 -239 -208 -165 -114 -48 22 77 120 153 179 199 215 244 263 269 iv 400 394 376 348 316 286 244 194 130 62 8 -33 -66 -91 -111 -126 -155 -173 -179 v 500 495 480 455 428 402 366 323 268 208 162 126 98 77 60 47 22 6 1 vi -500 -495 -480 -455 -428 -402 -366 -323 -268 -208 -162 -126 -98 -77 -60 -47 -22 -6 -1 1 Cf. Annex 2 of the standards "Interest rate risk in the banking book" of the Basel Committee on Banking Supervision from April 2016. www.bis.org > Committees & associations > Basel Committee on Banking Supervision > Publications > Interest rate risk in the banking book > Annex 2

Annex 2 Standardized Interest Rate Shock Scenarios 13/19 Maturity Band Scenario 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 AUD i 300 ii -300 iii -292 -288 -273 -250 -224 -200 -166 -125 -73 -17 27 61 87 108 124 136 159 174 179 iv 360 355 340 317 291 266 231 190 137 80 36 1 -25 -46 -63 -75 -99 -114 -119 v 450 445 432 410 385 362 329 291 241 188 146 114 89 69 54 42 20 6 1 vi -450 -445 -432 -410 -385 -362 -329 -291 -241 -188 -146 -114 -89 -69 -54 -42 -20 -6 -1 BRL i 400 ii -400 iii -325 -319 -301 -272 -239 -208 -165 -114 -48 22 77 120 153 179 199 215 244 263 269 iv 400 394 376 348 316 286 244 194 130 62 8 -33 -66 -91 -111 -126 -155 -173 -179 v 500 495 480 455 428 402 366 323 268 208 162 126 98 77 60 47 22 6 1 vi -500 -495 -480 -455 -428 -402 -366 -323 -268 -208 -162 -126 -98 -77 -60 -47 -22 -6 -1 CAD i 200 ii -200 iii -195 -192 -182 -165 -147 -130 -106 -78 -42 -3 28 52 70 84 96 104 121 131 134 iv 240 237 227 210 192 175 151 123 87 48 17 -7 -25 -39 -51 -59 -76 -86 -89 v 300 297 288 273 257 241 219 194 161 125 97 76 59 46 36 28 13 4 1 vi -300 -297 -288 -273 -257 -241 -219 -194 -161 -125 -97 -76 -59 -46 -36 -28 -13 -4 -1 CNY i 250 ii -250 iii -195 -192 -182 -165 -147 -130 -106 -78 -42 -3 28 52 70 84 96 104 121 131 134 iv 240 237 227 210 192 175 151 123 87 48 17 -7 -25 -39 -51 -59 -76 -86 -89 v 300 297 288 273 257 241 219 194 161 125 97 76 59 46 36 28 13 4 1 vi -300 -297 -288 -273 -257 -241 -219 -194 -161 -125 -97 -76 -59 -46 -36 -28 -13 -4 -1

Annex 2 Standardized Interest Rate Shock Scenarios 14/19 Maturity Band Scenario 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 EUR i 200 ii -200 iii -162 -160 -152 -140 -126 -113 -95 -73 -45 -15 8 26 40 51 60 67 79 87 90 iv 200 197 189 177 162 149 130 108 79 48 24 6 -9 -20 -29 -36 -49 -57 -59 v 250 247 240 228 214 201 183 161 134 104 81 63 49 38 30 23 11 3 0 vi -250 -247 -240 -228 -214 -201 -183 -161 -134 -104 -81 -63 -49 -38 -30 -23 -11 -3 0 GBP i 250 ii -250 iii -195 -192 -182 -165 -147 -130 -106 -78 -42 -3 28 52 70 84 96 104 121 131 134 iv 240 237 227 210 192 175 151 123 87 48 17 -7 -