Consultation on Implementation of Interest Rate Risk in the Banking Book (IRRBB) – Enclosure 2: Draft Supervisory Policy Manual Module IR-1 "Interest Rate Risk in the Banking Book"

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Hong Kong Monetary Authority 香港金融管理局

This module should be read in conjunction with the Introduction and with the Glossary, which contains an explanation of abbreviations and other terms used in this Manual. If reading on-line, click on blue underlined headings to activate hyperlinks to the relevant module.

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Purpose

To set out the approach which the HKMA will adopt in the supervision of interest rate risk in the banking book (IRRBB) and in monitoring AIs' level of interest rate risk (IRRBB) exposures

Classification

A non-statutory guideline issued by the MA as a guidance note

Previous guidelines superseded

This is a new guideline. IR-1 “Interest Rate Risk Management” (V.1) dated 13.12.2002

Application

To all AIs

Structure

1. Introduction

1.1 Terminology

1.2 Background

1.3 Scope

2. Sources of interest rate risk (IRRBB)

2.1 Summary

2.2 Repricing (or maturity mismatch) Gap risk

2.3 Yield curve risk

2.4 Basis risk

2.4 Option risk

2.5 Credit spread risk

3. Effects of interest rate risk (IRRBB)

3.1 Summary

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3.2 Earnings perspective

3.3 Economic value perspective

3.4 Embedded losses

4. Supervisory approach to interest rate riskIRRBB

4.1 Objectives and process

4.2 Basel Committee principles

4.3 Factors to be considered

4.4 Monitoring of interest rate riskIRRBB (earnings approach)

4.5 Review of capital adequacy (economic value approach)

4.6 Criteria for adequate internal systems

5. Standardised framework for measuring IRRBB exposure

5.1 Standardised EVE risk measure

5.2 Slotting cash flows with optionality

5.3 Standardised interest rate shock scenarios

56. Oversight by AIs

56.1 Responsibilities of Board and senior management

56.2 Asset and Liability Management Committee

56.3 Independent risk management

67. Risk management policies, procedures and controls

67.1 Coverage

67.2 New services and strategies

67.3 Risk measurement, monitoring and control

67.4 Stress-testing

67.5 Limits

67.6 Internal controls and independent audits

Annex A : Basel principles for the management of interest rate riskIRRBB

B: Factors influencing behavioural optionality

B : Interest rate risk measurement techniques

C : A simulation model of net interest income

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1. Introduction

1.1 Terminology

1.1.1 In this module

• "interest rate riskIRRBB" means the risk to an AI’s financial condition resulting from adverse movements in interest rates that affect the AI’s banking book positions; and

• "OBS" means off-balance sheet.

1.2 Background

1.2.1 AIs' normal activities of lending, taking deposits with differing maturities and interest rates and buying securities may expose them to interest rate riskIRRBB.

1.2.2 Interest rate risk may apply to the banking book as well as the trading book.

1.2.32 While accepting some interest rate riskIRRBB is inherent in banking business, excessive interest rate riskIRRBB can pose a significant threat to AIs' earnings and capital adequacy. AIs should therefore have a process to identify, measure, monitor and manage control interest rate riskIRRBB in a timely and comprehensive fashion.

1.3 Scope

1.3.1 This module:

• provides guidance on the processes for effective interest rate riskIRRBB management;

• aims to help AIs evaluate the adequacy and effectiveness of their interest rate riskIRRBB management; and

• sets out how the HKMA monitors and supervises AIs' level and management of interest rate riskIRRBB.

1.3.2 The main focus of this module is on the management and measurement of interest rate risk in the banking book, although the HKMA will also take into account an AI’s exposures in the trading book in evaluating the overall complexity and level of its interest rate risk. Sound practices for the management and measurement

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of interest rate risk in the trading book are covered in TA-1 “Market Risk Management”1 and TA-3 “Management of Trading in Derivatives and Other Instruments”1 . For locally incorporated AIs that are exempted from the market risk capital adequacy regime1 and overseas incorporated AIs, this module applies to their positions in both the banking book and the trading book.

1.3.3 This module should be read in conjunction with IC-1 “General Risk Management Controls”2 . The criteria and sound practices for general risk management contained therein are also applicable to effective interest rate riskIRRBB management.

2. Sources of interest rate riskIRRBB

2.1 Summary

2.1.1 The following subsections describe the primary forms of interest rate riskIRRBB faced by AIs. They can be divided into four three broad categories:

• repricing (or maturity mismatch) risk;

• yield curvegap risk;

• basis risk; and

• option risk.

2.1.2 Repricing risk Gap risk and basis risk, in particular, are the major sources of risk underlying the interest rate riskIRRBB exposures of AIs that are active in retail banking activities.

2.2 Repricing (or maturity mismatch)Gap risk

2.2.1 Gap risk is the risk arising from changes in the interest rates on instruments of different maturities. The extent of gap risk depends on whether changes to the term structure of interest rates occur consistently across the yield curve (parallel risk) or differentially by period (non-parallel risk).Repricing risk is caused by timing differences in rate changes and cash flows that occur in the repricing and maturity of fixed and floating rate

[1] Details of the market risk capital adequacy regime and the de minimis exemption criteria as well as the requirements relevant to exempted AIs are set out in the Banking (Capital) Rules.

[2] Module under development.

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assets, liabilities and OBS instruments. It is the most obvious source of interest rate risk for an AI.

2.2.2 Repricing Parallel risk is fundamental to banking business and some AIs may take on this risk in their balance sheet as part of their strategy to improve earnings. It can, however, affect the income and economic value of an AI as interest rates fluctuate. For example, an AI that has funded a long-term fixed rate loan with a short-term deposit could face a decline in future income if interest rates increase. This is because the cash flows from the loan are fixed while interest payable on replacement funding will be higher after the short-term deposit matures.

2.2.3 Non-parallel risk materialises when unanticipated changes in the shape of the yield curve have adverse effects on an AI’s income or economic value. As an example, the economic value of an AI’s long position in ten-year government bonds hedged by a short position in five-year government bonds could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve. For example, an AI that has funded a long-term fixed rate loan with a short-term deposit could face a decline in future income arising from the positions and their values if interest rates increase. This is because the cash flows from the loan are fixed while interest payable on replacement funding will be higher after the short-term deposit matures.

2.3 Yield curve risk

2.3.1 Repricing mismatches can expose an AI to changes in both the overall level of interest rates (parallel shifts in the yield curve) and the relative level of rates across the yield curve (non-parallel shifts in the yield curve, e.g. steepening or flattening yield curves). Yield curve risk materialises when unanticipated changes in the yield curve have adverse effects on an AI’s income or economic value.

2.3.2 As an example, the economic value of an AI’s long position in ten-year government bonds hedged by a short position in five-year government bonds could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve.

2.4 Basis risk

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2.43.1 Basis risk arises from imperfect correlation between changes in the rates earned and paid on different instruments with otherwise similar repricing characteristics. As a result of these differences, the cash flows and earnings spread between assets, liabilities and OBS instruments of similar maturities or repricing frequencies will change.

2.43.2 For example, an AI may have mortgage loans priced at a different rate to that for its funding, e.g. priced at the prime rate and funded by HIBOR. HIBOR may rise while the prime rate remains unchanged. The AI has the option of increasing its prime rate but in practice its scope to do so may depend on whether other AIs will do the same.

2.43.3 This scenario affects the AI’s current net interest margin through changes in the spread between earnings and payments on instruments that are being repriced. It will also affect future cash flows from these instruments, which will in turn affect the economic value of the AI.

2.54 Option risk

2.54.1 Option risk arises from interest rate option derivatives or from optional elements embedded in an AI’s assets, liabilities and/or OBS instruments, where the AI or its customer can alter the level and timing of their cash flows. Option risk can be further characterised into automatic option risk and behavioural option risk. The options embedded in many AIs' assets, liabilities and OBS portfolios pose an additional and increasingly important source of interest rate risk. Options may be stand-alone instruments such as exchange-traded bond options and over-the-counter contracts such as caps and floors or they may be embedded within otherwise standard instruments.

2.54.2 Automatic option risk arises from standalone instruments, such as exchange-traded and over-the-counter option contracts, or options explicitly embedded within an otherwise standard financial instrument (e.g. a capped rate loan), where the option will almost certainly be exercised if it is in the holder’s financial interest to do so. Embedded options include various types of bonds and notes with call or put provisions, loans which give borrowers the right to prepay outstandings (e.g. in some syndicated lending) and various types of demand

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deposits which give depositors the right to withdraw funds at any time, often without any penalty.

2.54.3 Behavioural option risk arises from the flexibility embedded implicitly or within the terms of financial contracts, such that changes in interest rates may affect the behaviour of the client. For example, the early repayment of residential mortgage and commercial loans by customers is as if an AI had written an option to the customers. If the spread over the reference rate, or the mortgage rate offered by other AIs, is lower, customers may prepay a mortgage loan, notwithstanding any applicable penalties. Conversely, customers will leave their loans outstanding if the spread rises. Both scenarios will reduce AIs' potential future earnings. Similarly, AIs may experience a higher proportion of fixed rate loan commitments to be drawn down when the spread increases, and vice versa.

2.54.4 On the deposit side, customers can generally withdraw early. Early withdrawal rights are equivalent to put options on deposits. If rates increase, the market value of customer deposits declines and customers may withdraw them and place them with the same AI, or a different one, at a higher rate. Another common product with behavioural optionality is non-maturity deposits (NMDs) which can be withdrawn at any time without notice, but a portion of which tend to remain with the AI in practice (i.e. core deposits).

2.5 Credit spread risk

2.5.1 While the three sources of risks listed above are directly linked to IRRBB, credit spread risk in the banking book (CSRBB) is a related risk that AIs need to monitor and assess in their interest rate risk management framework. CSRBB refers to any kind of asset/liability spread risk of credit-risky instruments that is not explained by IRRBB or by the expected credit risk or jump to default risk.

3. Effects of interest rate riskIRRBB

3.1 Summary

3.1.1 As described in section 2 above, changes in interest rates can have adverse effects both on an AI’s earnings and economic value. Its interest rate riskIRRBB exposure must be assessed from two

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separate but complementary perspectives, i.e. earnings and economic value.

3.2 Earnings perspective

3.2.1 In this traditional approach to interest rate riskIRRBB assessment, the analysis focuses on the impact of changes in interest rates on accruing or reported earnings. Reduced earnings or outright losses can threaten the financial stability of an AI by undermining its capital adequacy and by reducing market confidence in it.

3.2.2 The component of earnings that usually receives most attention is net interest income (NII), i.e. the difference between total interest income and total interest expense, taking account of hedging activity (e.g. via derivatives). Net interest income is important for AIs' overall earnings and has a direct, obvious link to changes in interest rates. Net interest income will vary because of differences in the timing of accrual changes (repricing risk), changing rate and yield curve relationships (basis and yield curve risks) and option positions.This focus reflects both the importance of NII in AIs’ overall earnings and its direct link to changes in interest rates.

3.2.3 Market interest rate changes can also have an impact on banking activities that generate fee-based and other non-interest income. Non-interest income arising from many activities such as loan servicing and asset securitisation programmes can be highly sensitive to market interest rates.

3.3 Economic value perspective

3.3.1 Variations in market interest rates can affect the economic value of an AI's assets, liabilities and OBS positions. The economic value of an instrument represents an assessment of the present value of its expected net cash flows, discounted to reflect market rates. As fluctuations in interest rates will affect an AI's earnings, they will also affect its net worth.

3.3.2 The economic value perspective reflects this sensitivity. It provides a more comprehensive view of the potential long-term effects of changes in interest rates than is offered by the earnings perspective. In contrast, changes in short-term earnings, the typical focus of the earnings

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perspective, may not provide an accurate indication of the impact of interest rate movements on an AI’s overall positions.

3.4 Embedded losses

3.4.1 An AI should also consider the impact that past interest rates may have on future performance. Instruments that are not marked-to-market may already contain embedded gains or losses due to past rate movements. These gains or losses may be reflected over time in the AI's earnings. For example, a long-term fixed rate loan entered into when interest rates were low will result in an embedded loss when its funding is subsequently replaced by liabilities bearing higher interest rates over the remaining life of the loan. This embedded loss will be materialised over time until the loan is settled.

4. Supervisory approach to interest rate riskIRRBB

4.1 Objectives and process

4.1.1 The HKMA adopts a risk-based supervisory approach which enables continuous supervision of AIs’ interest rate riskIRRBB through a combination of on-site examinations, off-site reviews and prudential meetings. The objective is to assess the adequacy and effectiveness of an AI's interest rate riskIRRBB management process, the level and trend of the AI's risk exposure and, in the case of a locally incorporated AI, the adequacy of its capital relative to the size of its exposure. See SA-1 "Risk-based Supervisory Approach" for details of the HKMA’s risk-based supervisory methodology.

4.1.2 AIs are required to submit timely and comprehensive information on their interest rate riskIRRBB exposures through the “Return of Interest Rate Risk Exposures – MA(BS)12” (“Interest Rate RiskIRR Return”) on a quarterly basis. The HKMA uses this Return to evaluate AIs’ level of interest rate riskIRRBB based on both the earnings approach and the economic value approach (see subsections 4.4 and 4.5 below for more details). The information collected takes appropriate account of the range of maturities and currencies in each AI's portfolio, including OBS items, as well as other relevant factors such as basis risk.

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4.1.3 Locally incorporated AIs that are exempted from the market risk capital adequacy regime 3 and overseas incorporated AIs are required to report in the Interest Rate RiskIRR Return the aggregate of their interest rate risk exposures in the trading book and banking book. Where necessary, the HKMA may request individual overseas incorporated AIs that have material trading positions to comply with additional reporting requirements in order to distinguish between their trading and non-trading activities for monitoring purposes.

4.1.4 Locally incorporated AIs that are subject to the market risk capital adequacy regime are only required to report their interest rate risk exposures in the banking book in the Interest Rate RiskIRR Return as their trading positions in interest rate risk are monitored through the “Return of Capital Adequacy Ratio – MA(BS)3Return of Market Risk Exposures - MA(BS)3A” (“Market Risk Return”).

4.1.5 The HKMA will discuss with an AI's management to identify the major sources of the AI's interest rate riskIRRBB exposures and evaluate whether its measurement systems can identify and quantify adequately such risk exposures. The HKMA will also analyse the integrity and effectiveness of the AI's interest rate riskIRRBB management process to ensure that its practices comply with the objectives and risk tolerance limits approved by the Board of Directors.

4.1.6 In considering whether an AI has appropriate systems for managing interest rate riskIRRBB, the HKMA will have regard to the nature and complexity of the AI’s interest rate riskIRRBB exposures and its compliance with the standards and sound practices set out in IC-1 “General Risk Management ControlsRisk Management Framework” and this module.

4.2 Basel Committee principles

4.2.1 The supervisory approach to interest rate riskIRRBB set out in this module is based on the principles and practices expounded in the Basel Committee paper of September 1997April 2016, "Interest rate risk in the

[3] Details of the market risk capital adequacy regime and the de minimis exemption criteria as well as the requirements relevant to exempted AIs are set out in CA-G-2 “Maintenance of Adequate Capital Against Market Risk”.

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banking bookPrinciples for the Management of Interest Rate Risk". Details of the principles are listed in Annex A.

4.3 Factors to be considered

4.3.1 In assessing the safety and soundness of an AI’s interest rate riskIRRBB management and exposures, the HKMA will consider:

• the complexity and level of risk posed by its assets, liabilities and OBS activities, including both trading and non-trading sources;

• the adequacy and effectiveness of Board and senior management oversight;

• management's knowledge and ability to identify and manage sources of interest rate riskIRRBB;

• the adequacy of and compliance with risk management policies and procedures;internal validation of IRRBB measures, including sensitivity analysis and backtesting, in particular where changes in key parameters have occurred;

• the adequacy of internal measurement, monitoring and management information systems;

• the adequacy and effectiveness of risk limits on and controls over income and capital losses;

• the effectiveness of the AI’s IRRBB stress testing programme;

• the adequacy of the AI's internal review and audit of its interest rate risk management process;

• the adequacy and effectiveness of the AI's risk management practices and strategies, as evidenced from past and projected financial performance;

• the effectiveness of hedging strategies used by the AI to control IRRBB; and

• the appropriateness of the AI's level of interest rate riskIRRBB in relation to its earnings, capital and risk management systems.

4.3.2 These topics are discussed further in sections 56 and 67 below.

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4.4 Monitoring of interest rate riskIRRBB (earnings approach)

4.4.1 The HKMA reviews the level and trend of AIs’ interest rate riskIRRBB exposures using the quarterly Interest Rate RiskIRR Return. The Return collects information on the following:

• the repricing positions of interest bearing assets, interest bearing liabilities and OBS positions by different time bands and currencies (i.e. Hong Kong dollar, US dollar and any other major foreign currency that accounts for 5% or more of an AI’s total on-balance sheet assets in all currencies);

• a breakdown of interest bearing assets and liabilities into fixed rate, variable floating rate and managed rate items 4 which have different repricing features and reference rates;

• the repricing positions of residential mortgage loans and deposits, which are the major components of AIs’ interest bearing assets and liabilities respectively;

• the weighted average yield and interest costs of interest bearing assets and liabilities, which provide more information for analysing AIs’ net interest income; and

• a breakdown of the major types of OBS positions (e.g. interest rate swaps, cross currency swaps and options).

• the impact of interest rate shock scenarios on economic value of equity (EVE) and earnings

4.4.2 AIs are allowed to use behavioural maturityshould follow the Completion Instructions for the purpose of reporting interest rate risksIRRBB in the Interest Rate RiskIRR Return if they can satisfy the minimum criteria set out in the Completion Instructions. The HKMA may request additional information on those positions where the

[4] Fixed rate items are those assets and liabilities with interest rates fixed up to their final maturities. Variable Floating rate items are those which will automatically be repriced at the next repricing date during the life of the items in accordance with movements in the relevant "reference rates" (such as HIBOR) and include those items for which the interest rates can be varied at the discretion of the counterparty. Managed rate items are those variable rate items (e.g. mortgage loans and savings non-maturity deposits) for which there are no fixed repricing dates and the interest rates can be adjusted at any time at the discretion of the reporting AI.

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behavioural maturity is different from the contractual maturity. It may also review AIs’ internal processes and assumptions for determining the behavioural maturity of interest rate risk positions in their portfolios.

4.4.3 Based on the reported interest rate repricing positions in the Interest Rate RiskIRR Return, the HKMA assesses the impact on an AI’s earnings over the next 12 months if the interest rates change by 200 basis pointsbased on two standardised interest rate shock scenarios (parallel up and parallel down) as set out in subsection 5.3. The HKMA will be particularly attentive to those AIs whose repricing riskIRRBB leads to a significant decline in earnings having regard to the nature and complexity of their activities.

4.4.4 As basis risk is a major risk factor underlying AIs’ interest rate riskIRRBB exposures, the HKMA assesses the impact of changes in the relationships between key market rates on AIs’ earnings using two hypothetical stress scenarios set out in the Interest Rate RiskIRR Return. They are:

• all rates except for fixed and managed rates (e.g. the prime rate) on interest bearing assets rise by 200 basis points; and

• managed rates on interest bearing assets drop by 200 basis points while other rates remain unchanged.

The changes are assumed to last for one month, three months, six months and 12 months respectively. The HKMA will be particularly attentive to those AIs whose basis risk leads to a significant decline in earnings having regard to the nature and complexity of their activities.

4.4.5 Where an AI has significant exposures to repricing gap risk or basis risk, the HKMA may review information from the AI’s internal management reports such as maturity/repricing gaps, earnings and economic value simulation estimates and the results of stress tests conducted. The HKMA will also discuss with the AI's management to evaluate its strategy for managing those exposures and assess its capacity to absorb the risk of loss. Depending on the circumstances of each case, the AI may be asked to strengthen its capital position or

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reduce its interest rate riskIRRBB (through, for example, hedging or restructuring existing positions) if necessary.

4.5 Review of capital adequacy (economic value approach)

4.5.1 Capital has an important role to play in mitigating and absorbing the risk of loss from changes in interest rates. As part of sound management, AIs should incorporate the level of interest rate riskIRRBB they undertake, whether arising from their trading or non-trading activities, into their overall evaluation of capital adequacy. Where AIs undertake significant interest rate riskIRRBB in the course of their business, an appropriate amount of capital should be allocated specifically to support this risk.

4.5.2 The HKMA expects locally incorporated AIs to maintain adequate capital for the risks they undertakeIRRBB and to develop their own processes for internal assessment of capital adequacy.. As regards interest rate risk in the trading book, they are required to provide capital in accordance with the methodology set out in the Market Risk Return5 .

4.5.3 While no capital charges are currently required for interest rate risk in the banking book6 , the HKMA will evaluate whether an AI has adequate capital to support its level of interest rate risk exposures and the risk those exposures may pose to its future financial performance. Specifically, locally incorporated AIs should consider their capital adequacy for IRRBB as part of the capital adequacy assessment process (CAAP, see CA-G-5 “Supervisory Review Process”), taking into account the following:

• the size and tenor of internal limits on IRRBB, and whether they have been reached;

• the effectiveness and expected cost of open hedging positions;

[5] Those AIs that fulfil the de minimis exemption criteria and other relevant requirements set out in CA-G-2 “Maintenance of Adequate Capital Against Market Risk”the Banking (Capital) Rules are exempted from the market risk capital adequacy regime. However, they are required to report their market risk exposures in the Market Risk Return annually for the HKMA’s monitoring purposes.

[6] The Basel Committee on Banking Supervision has concluded that no explicit capital requirements should be set for interest rate risk in the banking book in the New Basel Capital Accord but supervisors will be required to take account of a bank's interest rate risk under Pillar 2 (supervisory review process).

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• the sensitivity of IRRBB measures to key assumptions;

• basis risk;

• the impact on economic value and earnings of mismatched positions in different currencies;

• the impact of embedded losses;

• the distribution of capital relative to risks across legal entities in the consolidation group;

• the drivers of the underlying risk; and

• the circumstances under which the risk might crystallise.

4.5.43 The HKMA will evaluate whether an AI has adequate capital to support its level of IRRBB exposures and the risk those exposures may pose to its future financial performance. To facilitate the monitoring of an AI’s interest rate risk (IRRBB) and its capital adequacy, the HKMA models a standardised 200-basis-point parallel rate shock six interest rate shock scenarios to the AI’s interest rate risk (IRRBB) exposures as reported in the Interest Rate Risk (IRR) Return, and measures the economic value (EVE) impact of the shocks using the standardised framework (see section 5).

4.5.54 The HKMA will be particularly attentive to the capital sufficiency of “outlier AIs” – those whose interest rate risk (IRRBB) leads to an economic value (EVE) decline of more than 20% of their capital base (Tier 1 capital) as a result of applying one of the six standardised interest rate shocks to the banking book7 .

4.5.65 Where the HKMA is of the view that an AI’s level of interest rate risk (IRRBB) exposures is high in relation to its capital, the HKMA will discuss the concern with the AI’s management. Depending on the circumstances of each case, the AI may be asked to strengthen its capital position or reduce its interest rate risk (IRRBB) (through, for example, hedging or restructuring existing positions). The AI may also be subject to additional reporting requirements for its interest rate risk (IRRBB) exposures.

[7] For locally incorporated AIs which are exempted from the market risk capital adequacy regime, the HKMA will have regard to their positions in both the banking book and trading book.

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However, the AI may not need to take any action if it can demonstrate that its outlier status results from the AI’s specific IRRBB profile that is not adequately captured by the standardised framework and that the AI’s firm-specific internal model would be able to better reflect its actual IRRBB exposure.

4.5.76 While overseas incorporated AIs are not subject to the capital adequacy regime in Hong Kong, the HKMA uses the standardised interest rate shocks to monitor their interest rate riskIRRBB in terms of economic value. In view of the limitations of the earnings approach, the economic value approach provides supplementary information about the impact of interest rate movements on an AI’s overall positions (see para. 3.3.2 above).

4.5.87 In monitoring the impact of the standardised interest rate shock on the economic value of overseas incorporated AIs, the HKMA will have regard to the capital baseTier 1 capital of their head office. Nevertheless, the 2015% benchmark mentioned in para. 4.5.5 4 above will not apply.

4.6 Criteria for adequate internal systems

4.6.1 The HKMA will assess whether an AI's internal measurement system for interest rate riskIRRBB is adequate for managing risk in a safe and sound manner and for evaluation of its capital adequacy8 in the case of a locally incorporated AI.

4.6.2 An AI’s interest rate riskIRRBB management system should meet the criteria set out in subsection 67.3 below. The system should be integrated into the AI's daily risk management practices and its output should be used in reporting the level of interest rate riskIRRBB to the Board of Directors and senior management and, where appropriate, individual business line managers. The system should be capable of measuring risk under both the earnings approach. Depending on the scale and complexity of its activities, the AI may also need to measure risk based on and the economic value approach.

4.6.3 The HKMA will require AIs to bring their internal measurement system up to standard if deficiencies are

[8] But it is the AI's responsibility to ensure that its capital is adequate.

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5. Standardised framework for measuring IRRBB exposure
5.1 Standardised EVE risk measure
5.1.1 The calculation of the standardised EVE risk measure
involves the following key steps:
 For a given currency 𝑐 and time band 𝑘, calculate the net position 𝐶𝐹0,𝑐 (𝑘) (and 𝐶𝐹𝑖,𝑐 (𝑘) under interest rate shock scenario 𝑖) by slotting cash flows into time bands based on their earliest interest rate repricing dates, both under current conditions and under each of the six interest rate shock scenarios (see subsection 5.3). Both notional principals and coupon cash flows should be slotted. Note that the net position under interest rate shock scenarios may vary depending on the way cash flows with optionality are slotted (see subsection 5.2).  For each scenario 𝑖, calculate the impact on EVE (∆𝐸𝑖,𝑐 (𝑘)) for a given currency and time band as ∆𝐸𝑖,𝑐 (𝑘) = 𝐶𝐹0,𝑐 (𝑘) ∙ exp(−𝑟0,𝑐 (𝑘) ∙ 𝑡𝑘) − 𝐶𝐹𝑖,𝑐 (𝑘) ∙ exp(−𝑟𝑖,𝑐 (𝑘) ∙ 𝑡𝑘), where 𝑟0,𝑐 (𝑘) denotes the current risk-free rate9 (at the midpoint of the time band), 𝑟𝑖,𝑐 (𝑘) denotes the risk-free rate under scenario 𝑖 (at the midpoint of the time band) and 𝑡𝑘 denotes the midpoint of each time band 𝑘 (measured in years).  Calculate the interest rate option risk measure 𝐾𝐴𝑂𝑖,𝑐 under each scenario 𝑖 as the current net value of interest rate options10 (𝑉𝐴𝑂0,𝑐 ) minus the net value of interest rate options under the interest rate shock scenario ( 𝑉𝐴𝑂𝑖,𝑐 ), i.e. 𝐾𝐴𝑂𝑖,𝑐 =

9
This may be determined, for example, based on a secured interest rate swap curve.
10 This includes both bought and sold options and should be estimated according to the reporting AI's proprietary options pricing model.

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IR-1 Interest Rate Risk Managementin the Banking Book V.1 2 – 13.12.02Consulta tion 18 𝑉𝐴𝑂0,𝑐 − 𝑉𝐴𝑂𝑖,𝑐 . The net value of interest rate options under the interest rate shock scenario should be calculated using the new yield curve under scenario 𝑖 , and assuming a relative increase in the implicit volatility of 25%.  Calculate the impact on EVE across all time bands for a given currency and scenario as ∆𝐸𝑖,𝑐 = 𝑚𝑎𝑥(0, ∑ ∆𝐸𝑖,𝑐 (𝑘) 𝑘 + 𝐾𝐴𝑂𝑖,𝑐).  Repeat the above for all applicable currencies. The aggregate EVE risk measure (∆𝐸) across all applicable currencies is calculated as the maximum loss across the six interest rate shock scenarios:
∆𝐸 = max
𝑖∈{1,2,…,6}
(∑∆𝐸𝑖,𝑐
𝑐
)
5.1.2 Cash flows should generally be slotted into time bands
according to the earliest interest repricing date. However, there is a separate methodology for slotting cash flows with optionality, including retail fixed rate loans subject to prepayment risk, retail term deposits subject to early redemption risk and non-maturity deposits – see subsection 5.2 for details.
5.2 Slotting cash flows with optionality
5.2.1 Retail fixed rate loans subject to prepayment risk
 Fixed rate loans subject to prepayment risk are fixed rate loan products where the full economic cost of prepayments cannot be charged, or charged only for prepayments above a certain threshold, to the borrower.  This section applies to retail fixed loans only. Retail loans are defined as loans satisfying the criteria in section 64(1)(a) and 64(1)(b) of the Banking (Capital) Rules. Non-retail fixed loans subject to prepayment risk should be considered as positions with embedded interest rate options.  AIs should determine, using own estimates, the baseline conditional prepayment rate 𝐶𝑃𝑅0,𝑐,𝑝 for a given portfolio 𝑝 of homogeneous loan products subject to prepayment risk denominated in a given

Supervisory Policy Manual
IR-1 Interest Rate Risk Managementin the Banking Book V.1 2 – 13.12.02Consulta tion 19 currency 𝑐, under the prevailing term structure of interest rates.11 The conditional prepayment rate under interest rate shock scenario 𝑖 is then given by:
𝐶𝑃𝑅𝑖,𝑐,𝑝 = min(1, 𝛾𝑖
∙ 𝐶𝑃𝑅0,𝑐,𝑝) where 𝐶𝑃𝑅0,𝑐,𝑝 is the (constant) baseline CPR and 𝛾𝑖 is a multiplier for scenario 𝑖 as given in the table below.
Scenario number (𝑖)
Interest rate shock scenarios
𝛾𝑖 (scenario multiplier)
1 Parallel up 0.8
2 Parallel down 1.2
3 Steepener 0.8
4 Flattener 1.2
5 Short rate up 0.8
6 Short rate down 1.2
 The prepayments on the fixed rate loans can be broken down to scheduled payments adjusted for prepayment and uncompensated prepayments.
The cash flows to be slotted into time band 𝑘 is given by:
𝐶𝐹𝑖,𝑐,𝑝
(𝑘) = 𝐶𝐹𝑆,𝑐,𝑝
(𝑘) + 𝐶𝑃𝑅𝑖,𝑐,𝑝 ∙ 𝑁𝑂𝑖,𝑐,𝑝
(𝑘 − 1) where 𝐶𝐹𝑆,𝑐,𝑝
(𝑘) refers to the scheduled interest payment 12 and principal repayment, and 𝑁𝑂𝑖,𝑐,𝑝 (𝑘 − 1) denotes the notional outstanding at the end of the previous time band.
13 AIs should repeat the above for each loan portfolio and currency to calculate the aggregate position in each time band.
5.2.2 Retail term deposits subject to early redemption risk

11 The base 𝐶𝑃𝑅 may vary over the life of the loan. In this case, it is denoted 𝐶𝑃𝑅0,𝑐,𝑝,𝒌 .
12 The scheduled interest payment should only be included when reporting net positions including coupon cash flows.
13 For simplicity, it is assumed that there is no annual limit on prepayments. If an AI has an annual limit on uncompensated prepayments, this limit will apply.

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IR-1 Interest Rate Risk Managementin the Banking Book V.1 2 – 13.12.02Consulta tion 20  Term deposits subject to early redemption risk are term deposits that can be withdrawn early at the discretion of the customer. Term deposits may only be treated as a standard fixed rate deposit and be slotted into the time band according to their contractual maturity dates if o the depositor has no legal right to withdraw the deposit; or o an early withdrawal results in a significant penalty that at least compensates for the loss of interest between the date of withdrawal and the contractual maturity date and the economic cost of breaking the contract.14 If neither of these conditions is met, the depositor holds an option to withdraw and the term deposits are deemed to be subject to early redemption risk.  This section applies to retail term deposits subject to early redemption risk only. Retail deposits are defined as deposits placed with a bank by individual persons. Deposits made by small business customers, as defined in Rule 39 of the Banking (Liquidity) Rules, can also be treated as retail deposits. Deposits from legal entities, sole proprietorships or partnerships should be categorised as non-retail deposits. Non-retail term deposits subject to early redemption risk should be considered as positions with embedded interest rate options.  For each homogeneous portfolio 𝑝 of term deposits in a given currency 𝑐, AIs must determine the baseline term deposit redemption ratio 𝑇𝐷𝑅𝑅0,𝑐,𝑝 and use it to slot the notional repricing cash flows. Term deposits which are expected to be redeemed early should be slotted into the overnight time band (𝑘 = 1).

14 The economic cost of breaking the contract is the additional funding cost the AI would incur due to the early redemption, assuming the AI obtained term funding at the current interest rate, or the interest rate under the relevant interest rate shock scenario, to cover the remaining life of the original term deposit.

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IR-1 Interest Rate Risk Managementin the Banking Book V.1 2 – 13.12.02Consulta tion 21  The term deposit redemption ratio for time band 𝑘 under scenario 𝑖 is obtained by multiplying 𝑇𝐷𝑅𝑅0,𝑐,𝑝 by a scalar 𝑢𝑖 as follows:
𝑇𝐷𝑅𝑅𝑖,𝑐,𝑝 = min(1, 𝑢𝑖
∙ 𝑇𝐷𝑅𝑅0,𝑐,𝑝) where the values of the scalars 𝑢𝑖 are set out in the table below.
Scenario number (𝑖)
Interest rate shock scenarios u𝑖 (scenario multiplier) 1 Parallel up 1.2 2 Parallel down 0.8 3 Steepener 0.8 4 Flattener 1.2 5 Short rate up 1.2 6 Short rate down 0.8  The notional repricing cash flows which are expected to be withdrawn early under interest rate shock scenario 𝑖 are given by:
𝐶𝐹𝑖,𝑐,𝑝
(1) = 𝑇𝐷0,𝑐,𝑝 ∙ 𝑇𝐷𝑅𝑅𝑖,𝑐,𝑝 where 𝑇𝐷0,𝑐,𝑝 is the outstanding amount of term deposits in portfolio 𝑝 . AIs should repeat the above for each loan portfolio and currency to calculate the aggregate position in each time band.
5.2.3 Non-maturity deposits
 AIs have a choice to either slot NMDs into the appropriate time bands according to the earliest date on which their interest rates can be adjusted, or estimate their behavioural maturity using the methodology below.  NMDs should first be segmented into retail and non-retail categories. Retail deposits should be considered as held in a transactional account when regular transactions are carried out in that account (e.g. when salaries are regularly credited) or when the deposit is non-interest bearing. Other

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IR-1 Interest Rate Risk Managementin the Banking Book V.1 2 – 13.12.02Consulta tion 22 retail deposits should be considered as held in a non-transactional account.
 AIs should first identify stable NMDs, i.e. those that are found to remain undrawn with a high degree of likelihood, using observed volume changes over the past 10 years. AIs should then identify core deposits, which are stable NMDs that are unlikely to reprice even under significant changes in the interest rate environment. All other NMDs are non-core deposits. AIs are required to estimate the level of core deposits using this twostep procedure for each NMD category, subject to the caps in the table below. Cap on proportion of core deposits to total NMDs (%) Cap on average maturity of core deposits (years) Retail/transactional 90 5 Retail/nontransactional 70 4.5 Non-retail 50 4  NMDs should finally be slotted into the appropriate time band. Non-core deposits should be considered as overnight deposits and accordingly should be placed into the overnight time band. Core deposits should be slotted according to their average behavioural maturity, which should be determined by AIs using an appropriate procedure subject to the caps in the
table above.
5.3 Standardised interest rate shock scenarios
5.3.1 The change in the risk-free interest rate ∆𝑟𝑖,𝑐
(𝑘) for interest rate shock scenario 𝑖, currency 𝑐 and time band 𝑘 is calculated according to the equations below (see
table below for values of 𝑅̅):
(i) parallel shock up:
∆𝑟1,𝑐
(𝑘) = 𝑅̅
𝑝𝑎𝑟𝑎𝑙𝑙𝑒𝑙,𝑐
(ii) parallel shock down:
∆𝑟2,𝑐
(𝑘) = −𝑅̅
𝑝𝑎𝑟𝑎𝑙𝑙𝑒𝑙,𝑐

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IR-1 Interest Rate Risk Managementin the Banking Book V.1 2 – 13.12.02Consulta tion 23 (iii) steepener shock:
∆𝑟3,𝑐
(𝑘) =
−0.65 ∙ 𝑅̅
𝑠ℎ𝑜𝑟𝑡,𝑐
∙ 𝑒
−𝑡𝑘
4 + 0.9 ∙ 𝑅̅
𝑙𝑜𝑛𝑔,𝑐
∙ (1 − 𝑒
−𝑡𝑘
4 )
(iv) flattener shock:
∆𝑟4,𝑐
(𝑘) =
0.8 ∙ 𝑅̅
𝑠ℎ𝑜𝑟𝑡,𝑐
∙ 𝑒
−𝑡𝑘
4 − 0.6 ∙ 𝑅̅
𝑙𝑜𝑛𝑔,𝑐
∙ (1 − 𝑒
−𝑡𝑘
4 )
(v) short rates shock up:
∆𝑟5,𝑐
(𝑘) = 𝑅̅
𝑠ℎ𝑜𝑟𝑡,𝑐
∙ 𝑒
−𝑡𝑘
4
(vi) short rates shock down:
∆𝑟6,𝑐
(𝑘) = −𝑅̅
𝑠ℎ𝑜𝑟𝑡,𝑐
∙ 𝑒
−𝑡𝑘
4
5.3.2 The final post-shock interest rate, subject to a −2% floor,
is given by
𝑟𝑖,𝑐
(𝑘) = 𝑚𝑎𝑥(𝑟0,𝑐
(𝑘) + ∆𝑟𝑖,𝑐
(𝑘), −2%)
Specified size of interest rate shocks (𝑅̅, in bps) ARS AUD BRL CAD CHF CNY CNH EUR Parallel 400 300 400 200 100 250 250 200 Short 500 450 500 300 150 300 300 250 Long 300 200 300 150 100 150 150 100 GBP HKD IDR INR JPY KRW MXN Parallel 250 200 400 400 100 300 400 Short 300 250 500 500 100 400 500 Long 150 100 350 300 100 200 300 RUB SAR SEK SGD TRY USD ZAR Parallel 400 200 200 150 400 200 400 Short 500 300 300 200 500 300 500 Long 300 150 150 100 300 150 300
5.3.3 The table above will be updated from time to time based

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on parameter updates provided by the BCBS. AIs should contact the HKMA if they need to report a currency that is not in the table.

56. Oversight by AIs

56.1 Responsibilities of Board and senior management

56.1.1 Effective oversight by an AI’s Board of Directors and senior management is responsible for oversight of the IRRBB management framework and the AI’s risk appetite for IRRBB, critical for sound interest rate risk management practices, which should be articulated in terms of the risk to both economic value and earnings. AIs must implement policy limits that are consistent with their risk appetite. See CG-1 "Corporate Governance of Locally Incorporated Authorized Institutions" and IC-1 “General Risk Management Controls Framework” for details of their risk management responsibilities. Many of the requirements and practices cited have a general application.

56.2 Asset and Liability Management Committee

56.2.1 The Board of Directors may delegate responsibility for establishing interest rate risk monitoring and management of IRRBB policies and strategies to the Asset and Liability Committee (“ALCO”), which is a designated committee usually composed of senior staff. Larger or more complex AIs should have such committees, responsible for the design and administration of IRRBB management. The ALCO should include members with clear lines of authority over the units responsible for establishing and managing positions. The Board should ensure that the AI’s organisational structure enables the ALCO to carry out its responsibilities.

56.2.2 The main role and functions of the ALCO are described in CG-1 “Corporate Governance of Locally Incorporated Authorized Institutions”.

56.3 Independent risk management

56.3.1 The Board or senior management should assign responsibility for managing IRRBB to individuals or units with appropriate experience and expertise. The responsible personnel should have an

Hong Kong Monetary Authority 香港金融管理局

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adequate understanding of all types of interest rate risk IRRBB faced throughout the AI.

56.3.2 There should be adequate segregation of duties in key elements of the risk management process to avoid potential conflicts of interest. For example, the level of interest rate risk IRRBB is determined by how a particular transaction is evaluated based on current market rates. Such evaluation is normally conducted by the risk management or operations department of an AI while the actual transaction is performed by a risk-taking unit or front office. This is to ensure independent risk assessment of the transactions.

67. Risk management policies, procedures and controls

67.1 Coverage

67.1.1 Whatever the methodology chosen, an AI's interest rate risk IRRBB management procedures should be clearly defined and consistent with the nature and complexity of its activities.

67.1.2 The policies, procedures and limits (e.g. limits to fixed rate deals, use of interest rate swaps, etc.) should be properly documented, drawn up after careful consideration of interest rate risk IRRBB associated with different types of lending, and reviewed and approved and reviewed (at least annually) by management at the appropriate level. The policies and procedures should delineate delegated powers, lines of responsibility and accountability over IRRBB management decisions and should clearly define authorised instruments, hedging strategies and risk-taking opportunities.

67.1.3 There should also be an accurate, informative and timely management information system for interest rate risk IRRBB. This is essential both to keep senior management and, where appropriate, individual business line managers in the picture and to facilitate compliance with Board policy.

67.1.4 AIs’ policies and procedures for interest rate risk IRRBB management should cover the general criteria set out in IC-1 “General Risk Management Controls Framework” and other criteria specific to interest rate risk IRRBB as discussed in the following subsections.

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67.2 New services and strategies

67.2.1 AIs should identify the interest rate risks inherent in new services and activities and ensure that these are subject to adequate procedures and controls before being introduced or undertaken. For example, an AI specialising in prime-based mortgage loans that then engages in HIBOR-based mortgage loans with interest rate caps for customers should be aware of the volatility of HIBOR and the embedded option features.

67.2.2 AIs may be exposed to additional interest rate risk if they develop products or services that enable greater access to customers who primarily seek the best rate. The introduction of e-banking services is an example of such services. This reinforces the need for AIs to react quickly to changing market conditions and to ensure that their pricing strategy has catered for an adequate interest spread to absorb any additional interest rate risk.

67.2.3 AIs should consider balancing cash flows and managing the interest rate risk arising from new services or strategies through hedging, e.g. using swaps or other derivative instruments. Major hedging or risk management initiatives should be approved in advance by the Board or a committee such as the ALCO.

67.3 Risk measurement, monitoring and control

67.3.1 AIs should have interest rate riskIRRBB measurement systems that encompass all significant causes of such risk. The systems should evaluate the effect of rate changes on both earnings or and economic value meaningfully and accurately within the context and complexity of their activities. They should be able to flag any excessive exposures.

67.3.2 Measurement systems should:

• evaluate all significant interest rate riskIRRBB arising from the full range of an AI's assets, liabilities and OBS positions, both trading and non-trading. If the same measurement systems and management methods are not used for all activities, an integrated view of interest rate riskIRRBB across products and business lines should be available to management;

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• employ a variety of generally accepted financial models and ways of measuring risk, rather than relying on a single measure of risk;

• have accurate and timely data (in relation to rates, maturities, repricing, embedded options and other details) on current positions15 . Data inputs should be automated as much as possible to reduce administrative errors;

• document the assumptions, parameters and limitations on which they are based. Material changes to assumptions should be documented, justified and approved by senior management. Systems should also be sufficiently flexible to incorporate supervisory-imposed constraints on AIs’ internal risk parameter estimates;

• cover all significant sources of interest rate riskIRRBB (e.g. repricing, yield curvegap, basis and option risks). While all of an AI's positions should be appropriately treated, its largest concentrations and positions should be assessed with special thoroughness, as should instruments which might have a material effect on an AI's overall position (notwithstanding that they are not major concentrations) and instruments with significant embedded or explicit options; and

• assess exposures in different currencies (subject to para. 67.3.6 below).

67.3.3 Techniques to measure interest rate riskIRRBB exposure from an earnings and economic value perspective comprise, in increasing degrees of complexity, simple calculations, static simulations using current holdings and highly sophisticated dynamic modelling techniques based on business forecasts and decisions. These are discussed in greater detail in Annex B. As a minimum, AIs should be able to use the simpler techniquesstandardised framework for measuring interest rate riskIRRBB exposure, such as producing a maturity/repricing schedule and carrying out gap analysis (see section B2 of Annex Bsection 5). Where cash flows

[15] Any manual adjustments to underlying data should be clearly documented and the nature and reasons for the adjustments should be clearly understood.

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are slotted into different time bands (e.g. for gap analyses), the slotting criteria should be stable over time to allow for a meaningful comparison of risk figures over different periods.

67.3.4 As gap analysis provides only a rough approximation of changes in net interest income due to its limitations (see para. B2.7 below), AIs having complex risk profiles should employ more sophisticated interest rate risk IRRBB measurement techniques such as the simulation-based approaches (see section B3 of Annex B and Annex C). The assumptions underlying a simulation model can sometimes make it difficult to determine how much a variable contributes to changes in the simulation results. It is therefore necessary to supplement the simulation model by additional in-depth analysis or other simulation models to isolate the risk of each variable inherent in the existing balance sheet.

67.3.5 When assessing its IRRBB exposures, an AI should make judgments and assumptions about how an instrument’s actual maturity or repricing behaviour may vary from the instrument’s contractual terms because of behavioural optionalities. Regarding positions where the behavioural maturities may differ from contractual maturities, these should be given assumed maturities or repricing frequencies based on past experience of the AI and with sound empirical analysis. Such positions include demand deposits which can be withdrawn without notice, but a portion of which tend to remain with the AI in practice (i.e. core deposits). Conversely, term deposits have contractual maturities but depositors generally have the option to make withdrawals at any time, subject to applicable penalties or charges. On the asset side, prepayment features of mortgages and mortgage-related instruments also introduce uncertainty about the timing of cash flows from these positions. The behavioural assumptions used should be conceptually sound and reasonable, and consistent with historical experience (see Annex B for a list of possible considerations). Such assumptions should be rigorously tested and aligned with the AI’s business strategies. The most significant assumptions should be documented, clearly understood by the Board or the relevant committee and should be subject to periodic review (at

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least annually). The issues are discussed in more detail in section B4 of Annex B.

67.3.6 AIs with positions in different currencies need to measure their exposure to interest rate risk (IRRBB) in each currency. They may do so for each currency separately, on the ground that yield curves for different currencies vary. AIs with material multi-currency exposures may, if they have the requisite skills and sophistication, decide to aggregate their exposures in certain currencies where there is assumed to be some correlation between interest rates for those currencies. Such AIs should review periodically whether these assumptions remain valid and assess their potential exposure if such correlations prove invalid.

7.3.7 Measurement outcomes of IRRBB and hedging strategies should be reported to the Board or the relevant committee on a regular basis (at least semiannually), at relevant levels of aggregation (by consolidation level and currency). The reports should include at least the following:

• summaries of the AI’s aggregate IRRBB exposures, and explanatory text that highlights the assets, liabilities, cash flows, and strategies that are driving the level and direction of IRRBB;

• reports demonstrating the AI’s compliance with policies and limits;

• key assumptions such as NMD characteristics and prepayments on fixed rate loans;

• results of stress tests, including assessment of sensitivity to key assumptions and parameters, as well as sensitivity to changes in market conditions, with particular reference to portfolios that may be subject to significant mark-to-market movements; and

• summaries of the reviews of IRRBB policies, procedures and adequacy of the measurement systems, including any findings of internal and external auditors and/or other equivalent external parties (such as consultants).

67.4 Stress-testing

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67.4.1 AIs should measure their vulnerability to loss in stressed market conditions, including the breakdown of key assumptions, and consider those results when establishing and reviewing their policies and limits for interest rate risk IRRBB, as well as in the CAAP.

67.4.2 An AI’s stress testing framework for IRRBB should be commensurate with its nature, size and complexity as well as business activities and overall risk profile. The framework should have clearly defined objectives, welldocumented assumptions and sound methodologies, and should take into account the opinions of experts within the AI.

7.4.3 AIs’ IRRBB management systems should be able to calculate, by currency, the impact on economic value and earnings of multiple scenarios, including the six standardised interest rate shock scenarios16 set out in subsection 5.3, as well as internally selected interest rate shock scenarios addressing the AI’s risk profile according to its CAAP. Possible stress scenarios include:

• historical scenarios such as the Asian Financial Crisis in the late nineties;

• changes in the general level of interest rates, e.g. changes in yields of 200 basis points or more in one year17;

• changes in the relationships between key market rates (i.e. basis risk), e.g. (i) a surge in term and savings deposit rates and HIBOR but no change in the prime rate, and (ii) a drop in the prime rate but no change in term and savings deposit rates and HIBOR18;

• changes in interest rates in individual time bands to different relative levels (i.e. yield curve nonparallel gap risk);

• changes in the liquidity of key financial markets or changes in the volatility of market rates; and

[16] AIs are only required to calculate the impact of two standardised interest shock scenarios (parallel up and parallel down) on earnings (see para. 4.4.3).

[17] This scenario is incorporated as the standardised 200-basis-point parallel rate shock in the Interest Rate Risk Return.

[18] These scenarios for basis risk are incorporated in the Interest Rate Risk IRR Return.

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• changes in key business assumptions and parameters such as the correlation between Hong Kong dollar and US dollar interest rates. In particular, changes in assumptions used for illiquid instruments and instruments with uncertain contractual maturities help understanding of an AI’s risk profile.

7.4.4 When developing interest rate shock scenarios, AIs should consider the following:

• the scenarios should be severe and plausible, and sufficiently wide-ranging to identify parallel and non-parallel gap risk, basis risk and option risk;

• special consideration should be given to instruments or markets where concentrations exist;

• AIs should assess the possible interaction of IRRBB with other risks, e.g. credit risk and liquidity risk;

• AIs should assess the effect of adverse changes in the spreads of new assets/liabilities replacing those assets/liabilities maturing over the horizon of the forecast on their NII;

• AIs with significant option risk should include scenarios that capture the exercise of such options. For example, AIs that have products with sold caps or floors should include scenarios that assess how the risk positions would change should those caps or floors move into the money. AI should also develop interest rate assumptions to measure their IRRBB exposures given changes in interest rate volatilities;

• AIs should specify the term structure of interest rates that will be incorporated and the basis relationship between yield curves when building interest rate shock scenarios;

• AIs should estimate how interest rates that are administered or managed by management might change;

• AIs should consider the time it would need to reduce or unwind unfavourable IRRBB exposures,

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• and its capability or willingness to withstand accounting losses in order to reposition its risk profile;

• Forward-looking scenarios should incorporate changes in portfolio composition, new products, new market information and emerging risks; and

• AIs should perform qualitative and quantitative reverse stress tests to identify key vulnerabilities.

67.5 Limits

67.5.1 AIs should establish and enforce operating limits and other practices that maintain exposures within levels consistent with their internal policies and that accord with their approach to measuring interest rate risk IRRBB. Such limits should be approved by the Board or a committee such as the ALCO.

67.5.2 In particular, AIs should set a limit on the extent to which floating rate exposures are funded by fixed rate sources and vice versa to limit interest rate risk IRRBB. In floating rate lending, AIs should limit the extent to which they run any basis risk that may arise if lending and funding are not based on precisely the same market interest rate (e.g. HIBOR).

67.5.3 The limits should be consistent with AIs’ underlying approach to interest rate risk IRRBB measurement and should be directed at how reported earnings and capital adequacy might be affected by changes in market interest rates. As regards earnings, AIs should consider limits on earnings volatility in both net income and net interest income under specified interest rate scenarios so as to quantify what portion of their interest rate risk IRRBB exposure arises from non-interest income.

67.5.4 The limits should be appropriate to the nature, size, complexity and capital adequacy of the AI, as well as its ability to measure and manage its risks. Depending on the nature of an AI's activities and business model, sub-limits may also be identified for individual business units, portfolios, instrument types or specific instruments. AIs with significant exposures to gap risk, basis risk or positions with explicit or embedded options should establish risk tolerances appropriate for these risks. Limits on the effect of rates on an AI's earnings and

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economic value should reflect the size and complexity of its positions. Simple limits such as gap limits may be adequate for AIs undertaking mainly traditional banking activities and with few holdings of long-term instruments, options, instruments with embedded options or other instruments whose value may be substantially altered by changes in market rates. More complex AIs may need to use more sophisticated limits such as factor sensitivity limits. Examples of the various types of limits are given in sections B5 and B6 of Annex B.

67.5.5 Limits on interest rate riskIRRBB should be related to explicit scenarios of changes in market interest rates and/or term structures, e.g. movements up or down of specified ranges or a change in shape. These ranges scenarios or changes should constitute genuine stress conditions and should be developed in the light of historic rate volatility and time needed to unwind, restructure or hedge an AI’s interest rate riskIRRBB position. They can also reflect measures from the underlying statistical distribution of interest rates, e.g. earnings at risk or economic value at risk techniques. The scenarios should cover all possible sources of interest rate riskIRRBB, e.g. mismatch, yield curvegap, basis and option risks, and not just parallel shifts in interest rates or other simple scenarios.

7.5.6 There should be systems in place to ensure that positions that exceed, or are likely to exceed, limits established by the AI should receive prompt management attention and be escalated without delay. There should be a clear policy on who will be informed, how the communication will take place and the actions which will be taken in response to an exception.

67.6 Internal controls and independent audits

67.6.1 As an integral part of the overall internal control system, AIs should have adequate internal controls over interest rate riskIRRBB. The effectiveness of such controls should be evaluated regularly by independent parties, e.g. internal or external auditors.

67.6.2 AIs should conduct periodic reviews of their risk management process for interest rate riskIRRBB to ensure its integrity, accuracy and reasonableness. AIs with more complex profiles and measurement systems

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should have their internal models or calculations audited or validated by an independent internal or external reviewer. Reports written by independent reviewers should be made available to the HKMA.

7.6.3 In such independent reviews, the factors to be considered include the quality of interest rate risk (IRRBB) management and the size of interest rate risk (IRRBB), e.g.:

• the volume and price sensitivity of various products;

• how vulnerable earnings and capital economic value are to all forms of IRRBB, e.g. gap, basis and option risks, differing rate changes including yield curve changes; and

• the exposure of earnings and economic value to various other forms of interest rate risk, including basis and option risks, compliance with established policies and procedures and escalation procedures for any exceeded limits; and

• any significant changes that may affect the effectiveness of controls (including changes in market conditions, personnel, technology and structures of compliance with exposure limits).

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Annex A : Basel principles for the management of interest rate riskIRRBB

A1 Background

A1.1 The Basel Committee issued the paper “Principles for the management and supervision of interest rate risk” (“IRRBB Principles”) in July 2004, setting out supervisory expectations for banks' identification, measurement, monitoring and control of IRRBB as well as its supervision. In April 2016, the Committee published standards for “Interest rate risk in the banking book” with revised IRRBB Principles for banks as summarised below.The Basel Committee issued the paper “Principles for the Management of Interest Rate Risk” (“the paper”) in September 1997. The paper sets out 11 principles covering, inter alia, the role of the Board and senior management, policies and procedures, measurement and monitoring systems, internal controls and information for supervisory authorities. These are summarised below.

A2 Board and senior management oversightPrinciples for banks

A2.1 IRRBB is an important risk for all banks that must be specifically identified, measured, monitored and controlled. In addition, banks should monitor and assess credit spread risk in the banking book.In order to carry out its responsibilities, the Board of Directors of a bank should approve strategies and policies with respect to interest rate risk management and ensure that senior management takes the steps necessary to monitor and control these risks. The Board of Directors should be informed regularly of the interest rate risk exposure of the bank in order to assess the monitoring and controlling of such risk.

A2.2 The governing body of each bank is responsible for oversight of the IRRBB management framework, and the bank’s risk appetite for IRRBB. Monitoring and management of IRRBB may be delegated by the governing body to senior management, expert individuals or an asset and liability management committee (henceforth, its delegates). Banks must have an adequate IRRBB management framework, involving regular independent reviews and evaluations of the

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effectiveness of the system. Senior management should ensure that the structure of the bank's business and the level of interest rate risk it assumes are effectively managed, that appropriate policies and procedures are established to control and limit these risks and that resources are available for evaluating and controlling interest rate risk.

A2.3 The banks’ risk appetite for IRRBB should be articulated in terms of the risk to both economic value and earnings. Banks must implement policy limits that target maintaining IRRBB exposures consistent with their risk appetite.

A2.4 Measurement of IRRBB should be based on outcomes of both economic value and earnings-based measures, arising from a wide and appropriate range of interest rate shock and stress scenarios.

A2.5 In measuring IRRBB, key behavioural assumptions should be fully understood, conceptually sound and documented. Such assumptions should be rigorously tested and aligned with the bank’s business strategies.

A2.6 Measurement systems and models used for IRRBB should be based on accurate data, and subject to appropriate documentation, testing and controls to give assurance on the accuracy of calculations. Models used to measure IRRBB should be comprehensive and covered by governance processes for model risk management, including a validation function that is independent of the development process.

A2.7 Measurement outcomes of IRRBB and hedging strategies should be reported to the governing body or its delegates on a regular basis, at relevant levels of aggregation (by consolidation level and currency).

A2.8 Information on the level of IRRBB exposure and practices for measuring and controlling IRRBB must be disclosed to the public on a regular basis.

A2.9 Capital adequacy for IRRBB must be specifically considered as part of the Internal Capital Adequacy Assessment Process (ICAAP) approved by the governing body, in line with the bank’s risk appetite on IRRBB. Banks should clearly define the individuals or committees responsible for managing interest rate risk

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and should ensure that there is adequate segregation of duties in key elements of the risk management process to avoid potential conflicts of interest. Banks should have risk measurement, monitoring and control functions with clearly defined duties that are sufficiently independent from position-taking functions of the bank and which report risk exposures directly to senior management and the Board of Directors. Larger or more complex banks should have a designated independent unit responsible for the design and administration of the bank's interest rate risk measurement, monitoring and control functions.

A4 Risk measurement, monitoring and control functions

A4.1 It is essential that banks have interest rate risk measurement systems that capture all material sources of interest rate risk and that assess the effect of interest rate changes in ways that are consistent with the scope of their activities. The assumptions underlying the system should be clearly understood by risk managers and bank management.

A4.2 Banks should establish and enforce operating limits and other practices that maintain exposures within levels consistent with their internal policies.

A4.3 Banks should measure their vulnerability to loss under stressed market conditions, including the breakdown of key assumptions, and consider those results when establishing and reviewing their policies and limits for interest rate risk.

A4.4 Banks should have adequate information systems for measuring, monitoring, controlling and reporting interest rate exposures. Reports should be provided on a timely basis to the bank's Board of Directors, senior management and, where appropriate, individual business line managers.

A5 Internal controls

A5.1 Banks should have an adequate system of internal controls over their interest rate risk management process. A fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that appropriate revisions or

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enhancements to internal controls are made. The results of such reviews should be available to the relevant supervisory authorities.

A6 Information for supervisory authorities

A6.1 Banks should provide sufficient and timely information to their supervisory authorities to enable them to evaluate their level of interest rate risk. This information should take appropriate account of the range of maturities and currencies in each bank's portfolio, including OBS items, as well as other relevant factors, such as the distinction between trading and non-trading activities.

Hong Kong Monetary Authority 香港金融管理局

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Annex B : Factors influencing behavioural optionality

Fixed rate loans subject to prepayment risk	Loan size, loan-to-value (LTV) ratio, borrower characteristics, contractual interest rates, seasoning, geographical location, original and remaining maturity, and other historical factors. Other macroeconomic variables such as stock indices, unemployment rates, GDP, inflation and housing price indices.
Fixed rate loan commitments	Borrower characteristics, geographical location (including competitive environment and local premium conventions), customers’ relationship with the AI as evidenced by cross-products, remaining maturity of the commitment, seasoning and remaining term of the mortgage.
Term deposits subject to early redemption risk	Deposit size, depositor characteristics, funding channel (e.g. direct or brokered deposit), contractual interest rates, seasonal factors, geographical location and competitive environment, remaining maturity and other historical factors. Other macroeconomic variables such as stock indices, unemployment rates, GDP, inflation and housing price indices.
NMDs	Responsiveness of product rates to changes in market interest rates, current level of interest rates, spread between an AI’s offer rate and market rate, competition from other firms, the AI’s geographical location and demographic and other relevant characteristics of its customer base.

Annex B : Interest rate risk measurement techniques

[whole section deleted]

Annex C : A simulation model of net interest income

[whole section deleted]

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