Chapter Five: Requirements of Pillar 2 of Basel Accords

Part Three: Interest Rate Risk for Non-Trading Book Positions

First: General Framework

1. Introduction

Interest rate risk is generally defined as the risk arising from adverse movements in prevailing market interest rates over a specific period, which may negatively impact the bank's profitability and/or the economic value of its equity, thereby affecting its financial position.

Interest rate risk is divided into two main types: interest rate risk for non-trading book positions (Book Banking), which arises from the bank's main activities not conducted for trading purposes, and interest rate risk for the trading book (Book Trading), which arises from taking positions for trading purposes in financial markets. The latter has been addressed in the instructions regarding the minimum capital adequacy standard within market risk.

The issuance of these instructions regarding the management of interest rate risk for non-trading book positions falls within the implementation of Pillar 2 of the Basel II Accords concerning the Supervisory Review Process (SRP), reflecting the Central Bank of Egypt's pursuit of applying the latest international best practices to continue enhancing the efficiency and capacity of the Egyptian banking sector to face any financial crises the sector may be exposed to.

In this context, banks must comply with qualitative and quantitative requirements (the standardized approach) regarding interest rate risk for non-trading book positions, as well as conducting the necessary stress tests in this regard, as will be mentioned later.

2. Scope of Application

These instructions apply to all banks operating in the Arab Republic of Egypt, including branches of foreign banks. Interest rate risk for non-trading book positions shall be measured according to the standardized approach (to be mentioned in Part Four of these instructions) on an individual basis (including the bank's branches domestically and abroad) for individual banks and foreign bank branches, and on a consolidated basis for banking groups. The bank must report to the Central Bank of Egypt quarterly within 20 days from the end of each quarter.

Second: Basic Concepts

3. Criteria for Distinguishing Between the Trading Book and Non-Trading Book Positions

1/3 Criteria for Inclusion in Non-Trading Book Positions

Items held for non-trading purposes (as a minimum) include:

• Balances with the Central Bank of Egypt.
• Balances due from banks.
• Shares not listed in the securities market.
• Financial investments held to maturity.
• Financial instruments purchased for holding over medium or long-term periods for the purpose of providing liquidity rather than for resale and profit realization.
• Loans granted to customers (including real estate financing) and discounted commercial papers.
• Investment fund documents held for non-trading purposes.
• Financial derivatives where the underlying financial instrument is a non-trading book instrument.
• Instruments held for hedging risks arising from financial positions held for non-trading purposes.

Any instrument that was not held at acquisition for any of the trading purposes to be mentioned (other than the items mentioned above) is considered a non-trading book instrument.

2/3 Criteria for Inclusion in the Trading Book

Financial instruments are considered part of the trading book if the bank holds them for any of the following purposes:

• If the bank holds them for a short period for resale.
• If the purpose of acquisition is to realize short-term profits resulting from market price movements or to benefit from price differences between different markets.
• If the purpose of acquisition is to use them to cover risks arising from other financial instruments in the trading book.
• If the purpose of acquisition results from the bank's commitment to cover issuances by other parties (Underwriting commitments).

It should be noted that financial instruments in the trading book are valued at fair value, with valuation differences recognized in the income statement.

The Central Bank of Egypt may request the bank to provide evidence that a financial instrument is held for non-trading purposes and not for any trading book purposes. If the supervisory authority deems the evidence insufficient or if the nature of the instrument requires its inclusion in the trading book, the bank must correct its status within a specified period.

Internal audit officers at the bank, within its internal control system, must continuously review positions listed in the trading book and those held for non-trading purposes to ensure the correctness of classification since acquisition. Full documentation of compliance with related policies and procedures must be maintained, and these must be subject to periodic internal audit (at least once a year).

4. Sources of Interest Rate Risk for Non-Trading Book Positions:

The sources of interest rate risk for non-trading book positions are summarized as follows:

1/4 Gap Risk: This is the risk arising from the mismatch in the maturity structure of assets and liabilities, and thus their repricing at different dates, in response to changes in the structure of prevailing interest rates, whether as a result of parallel or non-parallel movements of the yield curve. This may lead to a decrease in net interest income and/or equity.

2/4 Basis Risk: This is the risk arising from differences in the magnitude of interest rate changes on financial instruments with similar maturities due to the lack of complete correlation between changes in interest rates for two or more interest rate indices (e.g., a mismatch between the change in the interest rate for a loan based on the 3-month USD LIBOR rate in the London market and the change in the interest rate for deposits used to finance this loan, which depend on the USD interbank market interest rate for the same maturity).

3/4 Option Risk: This is the risk arising from embedded options in the bank's assets and liabilities (for example, accelerated repayment of loans, or withdrawals from non-maturity deposits), or arising from explicit options on financial derivative transactions. This affects the timing and volume of cash flows for financial positions.

For the purpose of conducting a comprehensive assessment of interest rate risk for non-trading book positions, all the aforementioned sources must be taken into account.

5. Implications of Interest Rate Risk for Non-Trading Book Positions:

The bank assesses interest rate risk for non-trading book positions by measuring the impact of adverse movements in interest rates on the following:

1/5 Earnings at Risk (EaR): This measures the sensitivity of the bank's earnings to short-term interest rate movements, specifically through their impact on net interest income. Although interest rate risk has an increasing impact on all bank revenues, including other revenues besides net interest income (such as commissions), the focus will be primarily on net interest income.

2/5 Economic Value of Equity (EVE): This measures the impact of interest rate movements on the economic value of the bank's equity, which reflects the present value of the bank's expected net cash flows (asset cash flows minus liability cash flows). This provides a more comprehensive evaluation of the impact of interest rate movements than earnings assessment by analyzing long-term effects, complementing the expected results of interest rate movements on the bank's overall risk volume.

a- Principles that banks must follow

1- Interest rate risk for non-trading book positions is considered a risk of importance to banks

It must be identified, measured, monitored, and controlled, in addition to monitoring and evaluating Credit Spread risk for non-trading book positions. The bank must be aware of all elements related to interest rate risk for non-trading book positions and identify them for the products it deals in and the activities it engages in, ensuring that these products and activities are subject to sufficient procedures and controls. Policies involving hedging and risk management methods of importance must be adopted before they enter into application. New products must be subjected to detailed review before being offered and before dealing in them to ensure adequate awareness of the characteristics of interest rate risk for non-trading book positions associated with those instruments.

Furthermore, the management of interest rate risk for non-trading book positions must align with the bank's general risk management framework and be consistent with the planned work and activities. The bank must also verify the appropriate evaluation and monitoring of Credit Spread risk through internal measurement methods for these risks.

2- The responsibility for monitoring how interest rate risk for non-trading book positions is managed within the bank's accepted risk appetite level lies with the bank's Asset and Liability Committee (ALCO).

This is done through reports prepared and submitted to it by the officials responsible for asset and liability management at the bank. The committee, in turn, must present these reports to the Board of Directors to take appropriate decisions in this regard.

Generally, the bank must form a committee to manage its assets and liabilities, with its members selected by the Board of Directors. The committee should include representatives from Credit, Treasury, Internal Audit, Financial Management, and Information Management departments. The committee should meet monthly (or less frequently if necessary). The committee must submit its reports periodically to the CEO, the Audit Committee, or the Board of Directors. The committee's tasks include:

• Setting the strategy for managing the bank's assets and liabilities, including related policies, operations, and procedures, and monitoring their appropriate implementation, updating them when necessary.
• Developing strategies and methods for managing and mitigating major risks faced by the bank, particularly credit risk, liquidity risk, and interest rate risk, and conducting periodic independent reviews and assessments of the effectiveness of the system applied to manage these risks.
• Setting and updating contingency funding plans.
• Determining the bank's annual budget by forecasting future funding uses and sources, along with associated expected costs and revenues, and evaluating potential risks related thereto.
• Ensuring the availability of analytical tools, management systems, and necessary information enabling the committee to perform its duties.
• Monitoring the performance of investment portfolios and reviewing the work of the bank's investment managers.

1/2 Supervisory Role of the Board of Directors

The Board of Directors must be aware of the nature and level of interest rate risk for non-trading book positions at the bank, in addition to ensuring that necessary steps are taken to measure, monitor, and control it in accordance with the strategies and policies approved by the Board in this regard.

The Board of Directors must also adopt the following:

• Adequate limits for interest rate risk for non-trading book positions, including clarification of procedures to be taken and necessary approvals in case of any exceptions, and ensuring continuous compliance with these limits.
• Sufficient methods for measuring interest rate risk for non-trading book positions.
• Procedures for evaluating and updating scenarios for interest rate shocks, stress tests, and the basic assumptions used in the process of analyzing interest rate risk for non-trading book positions at the bank.
• Comprehensive reporting and audit systems regarding interest rate risk for non-trading book positions.
• Effective internal control systems and Information Management Systems (MIS).

The Board of Directors must also be informed regularly (at least semi-annually) regarding the level and trend of interest rate risk for non-trading book positions at the bank to take appropriate decisions at the right time, based on the reports received, in accordance with approved policies. Board members must have sufficient expertise to understand and comment on reports presented to the Board regarding interest rate risk for non-trading book positions. It is generally the responsibility of Board members to ensure that officials responsible for asset and liability management at the bank have the necessary capabilities and skills to manage interest rate risk for non-trading book positions.

2/2 Separation of Duties and Responsibilities

There must be a complete separation of duties and responsibilities related to the main elements of measuring, monitoring, and controlling interest rate risk for non-trading book positions to avoid potential conflicts of interest. These functions must be completely independent of those whose core work involves taking positions at the bank.

Appropriate communication channels must also exist between the departments concerned with this matter.

3/2 Internal Control

Banks must comply with the instructions issued by the Central Bank of Egypt on September 2, 2014, regarding internal control in banks, particularly concerning interest rate risk within those instructions.

Additionally, periodic evaluations and reviews of the process of managing interest rate risk for non-trading book positions, including its various elements, must be conducted annually (at least) by independent external parties (other than external auditors, unless they are specifically tasked with reviewing the bank's financial positions). These reviews must reflect any fundamental changes that could affect the integrity and effectiveness of the review process, such as changes in market conditions, personnel, systems, and the structure of limits. They must also verify the adoption of appropriate escalation procedures in case any established limits are exceeded, and reports prepared in this regard must be available to the Central Bank of Egypt upon request.

3- The accepted level of interest rate risk for non-trading book positions must be determined based on its impact on both the Economic Value of Equity and Earnings.

The bank must apply limits aimed at keeping its interest rate risk exposures in line with the bank's accepted risk level.

Furthermore, the risk level framework must define the authorities and responsibilities for making decisions related to managing interest rate risk for non-trading book positions. The instruments authorized to limit and mitigate risks and hedging methods within the bank's accepted risk level must be specified. Policies regarding interest rate risk for non-trading book positions must be reviewed periodically (at least annually) and modified if necessary.

Policy for Setting Limits for Interest Rate Risk for Non-Trading Book Positions

• The policy for setting limits for interest rate risk for non-trading book positions must align with the approach the bank uses to measure these risks. Limits reflecting the total accepted interest rate risk for non-trading book positions must be applied on a consolidated/individual basis (as mentioned in the Scope of Application). Limits are set based on specific scenarios for interest rate/term structure changes, taking into account historical interest rate volatility and the time required by management to hedge against these risks.

• The limits policy must be appropriate for the nature, size, and degree of complexity of the activity, capital adequacy, and the effectiveness and profitability of the bank's activities and its business model. Sub-limits must be set for each activity or business line or financial instrument in a manner that reflects the characteristics and causes of interest rate risk for non-trading book positions at the bank. The bank must also set an appropriate maximum risk tolerance level for this type of risk, through which significant exposures related to interest rate risk for non-trading book positions can be identified and managed.

• Any proposals regarding the use of new instruments or strategies must be evaluated to ensure the availability of necessary resources to manage risks that may arise from new products or activities, and to verify that the proposed activities align with the bank's accepted risk level.

• Systems must be available that allow verification that positions exceeding or likely to exceed limits set by the Board of Directors or those delegated by it receive immediate attention from management and are escalated without delay. A clear policy must also exist defining the departments to be notified, how to communicate with them, and the procedures to be taken regarding any exceptions that may be permitted.

4- The measurement of interest rate risk for non-trading book positions must be based on the results of both Economic Value of Equity and Earnings, which rely on a suitable number of interest rate shocks and stress test scenarios.

1/4 Measurement Approaches Based on Economic Value of Equity and Earnings

Banks must identify all major sources from which interest rate risk for non-trading book positions may arise and evaluate the impact of market changes on their main activities, in addition to taking into account the impact of interest rate shocks on the Economic Value of Equity and the bank's earnings, and thus its ability to continue its normal activities.

2/4 Interest Rate Shocks and Stress Tests

The bank's information management system must reflect the impact of different scenarios for interest rate changes on both the Economic Value of Equity and Earnings, based on:

• Internal interest rate shock scenarios prepared by the bank within the Internal Capital Adequacy Assessment Process (ICAAP), reflecting the bank's risk profile.
• Stress test scenarios, taking into account historical or assumed interest rate trends, which may be more severe than normal interest rate shock scenarios.
• Interest rate shock scenarios mentioned in Part Four of these instructions.
• Any additional interest rate shock scenarios requested by the Central Bank of Egypt when necessary.

The bank's stress testing framework must align with the nature, size, and complexity of the bank's activities and its overall risk structure. This framework must include clearly defined objectives and scenarios designed according to the bank's operations, appropriate assumptions, and effective mechanisms for conducting these tests, documented properly.

5- The bank must have full awareness of the behavioral assumptions of depositors and borrowers, and the assumptions underlying the models used to measure and manage interest rate risk for non-trading book positions.

These assumptions must be conceptually appropriate and documented, consistent with business strategies, and tested rigorously.

The Economic Value of Equity and Earnings, as measures of interest rate risk for non-trading book positions, are affected by a number of assumptions used for quantitative risk measurement, specifically:

• Expectations regarding the exercise of interest rate options (explicit or implicit) by the bank or its customers under specific interest rate shocks and stress test scenarios.
• Treatment of balances and yield flows arising from deposits with no maturity date.
• Impacts resulting from accounting treatments for financial positions held for non-trading purposes that are sensitive to interest rates.

Furthermore, when measuring interest rate risk for non-trading book positions, the bank must set maturity (or repricing) dates and assumptions for each financial instrument, which may differ from the contractual maturity of the instrument, taking into account the possibility of customers exercising implicit or explicit options on these instruments.

6- Interest rate risk measurement models must be based on accurate, documented data and be subject to validation tests to ensure the accuracy and integrity of the measurement process.

Independent procedures must be available for approving the measurement systems used, separate from the procedures for designing and developing the models.

Measurement Models and Data Accuracy

Accuracy and timely execution of the interest rate risk measurement process for non-trading book positions are essential for effective risk management and control. The measurement approach must be capable of identifying the main sources of interest rate risk for non-trading book positions. The appropriate measurement approach is determined according to existing business lines and the risk characteristics related to the bank's activity.

For risk management purposes, the bank must not rely on a single measurement approach for risks but must use diverse measurement mechanisms to estimate the volume of interest rate risk and its impact on both the Economic Value of Equity and the bank's earnings. These should range from simple measurement methods based on static simulation methods using current portfolios to more complex dynamic measurement methods reflecting potential future business activities.

7- The Board of Directors or those delegated by it must be regularly informed of measurement results and hedging strategies adopted.

In the case of banking groups, reporting must be on a consolidated basis according to the scope of application, and for each currency separately.

The reporting process must include a comparison of current positions with previously set risk expectations and estimates by the bank, results of periodic model reviews, and actual results to regularly identify deficiencies in the measurement model used.

Although the types of reports prepared for presentation to the Board of Directors or those delegated by it may vary according to the bank's balance sheet components, the bank must have at least the following reports:

• Individual or consolidated positions (at the banking group level), along with sufficient explanations highlighting the components of assets, liabilities, cash flows, and strategies affecting the level and trend of these risks.
• Compliance with established policies and limits.
• Key assumptions for measurement models, such as characteristics of deposits with no maturity date, accelerated repayment of fixed-rate loans, etc.
• Results of stress tests, including an assessment of sensitivity to key assumptions and criteria used in this regard.
• Reviews conducted on policies and procedures regarding interest rate risk for non-trading book positions, and the adequacy of measurement systems, including any observations from internal and external auditors.
• Exceptions and breaches of limits set for interest rate risk for non-trading book positions.

Reports on interest rate risk for non-trading book positions must be presented in detail to the Board of Directors or those delegated by it regularly and reviewed periodically. These reports must include information reflecting the sensitivity of the bank's activities to changes in market conditions on a consolidated basis.

8- Information regarding interest rate risk positions in the non-trading book, as well as their measurement and control methods, must be disclosed regularly.

Measurements of Economic Value of Equity and Earnings must be disclosed based on interest rate shock scenarios to be mentioned in Part Four of these instructions.

Furthermore, detailed quantitative and qualitative disclosure of the interest rate risk management system for non-trading book positions must be provided to enable interested parties to:

• Monitor the sensitivity of the bank's earnings and equity to changes in interest rates.
• Understand the key assumptions underlying the bank's measurement system according to Information Management Systems.
• Be aware of the sources of interest rate risk and how these risks are managed.

9- The capital required to cover interest rate risk for non-trading book positions is an integral part of the Internal Capital Adequacy Assessment Process (ICAAP) approved by the Board of Directors and consistent with the accepted level of this risk.

The bank is responsible for assessing the level of capital to be held to cover interest rate risk for non-trading book positions and verifying its adequacy. The bank must develop methods for measuring these risks, determine the capital required to cover them, and take them into account when conducting its Internal Capital Adequacy Assessment Process. The importance given to interest rate risk for non-trading book positions within the ICAAP process, as well as the capital allocated to face these risks at the bank, depends on the results of internal measurement methods, taking into account the basic assumptions underlying the measurement process and risk limits according to the bank's accepted risk level. In this regard, when determining the appropriate capital level, the bank must consider both the volume and quality of the capital required to be held for this type of risk.

b- Role of the Central Bank of Egypt

• The reporting system established in the Off-Site Supervision Department of the Central Bank of Egypt allows for comparisons between banks,

enabling the bank to monitor trends in interest rate risk for non-trading book positions and evaluate the soundness of risk management mechanisms at banks. This allows for the identification of banks that are in breach and should be subject to continuous review and/or are expected to hold additional regulatory capital, and which may require dedicated on-site inspection for this purpose.

• The Central Bank of Egypt has the right to request banks with high interest rate risk for non-trading book positions to take corrective measures

• which may include holding additional capital - if the review of interest rate risk for non-trading book positions reveals deficiencies or excessive risk levels.

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