Instructions dated October 4, 2018 regarding managing return rate risks for positions for non-trading purposes

Mr. Chairman of the Board of Directors,

Greetings,

In the context of the Central Bank of Egypt's strategy towards implementing international best practices in banking supervision, particularly the requirements of the Basel Committee, and with reference to the discussion papers previously issued in March 2011 and March 2018 regarding "Interest Rate Risks in the Banking Book according to Pillar 2 of Basel Regulations," which included a comprehensive review of measurement methodologies for these risks and accompanying models for qualitative assessment under Basel II and quantitative impact studies, this was in preparation for issuing the necessary supervisory instructions.

These instructions have been prepared following a study of banks' observations on the last discussion paper issued in March 2018, in accordance with the Basel Committee for Banking Supervision's regulations issued in April 2016. In this regard, the Board of the Central Bank of Egypt issued the following decision at its meeting held on October 3, 2018:

"Issuance of the attached supervisory instructions regarding the management of interest rate risks in the banking book according to Basel regulations, with implementation to begin and submission of the relevant quantitative forms to the Supervision and Inspection Sector on a quarterly basis for supervisory purposes, starting from September 2018. Approval shall be on an individual basis for banks without subsidiary companies and foreign bank branches, and on a consolidated basis for banks with banking groups."

Please be kind enough to alert us via email regarding compliance with the aforementioned instructions, with the quantitative forms for these instructions to be sent subsequently to the Basel Unit at Basel.Unit@cbe.org.eg at the earliest possible time.

Accept our highest regards,

Gamal Naguib Central Bank of Egypt Supervision and Inspection Sector

Supervisory Instructions regarding the management of Interest Rate Risks for Positions Held for Non-Trading Purposes according to Basel Regulations

Part One: General Framework

1. Introduction

Interest rate risks are generally defined as the risks arising from adverse movements in interest rates during a specific period that may negatively affect the bank's profitability and/or the economic value of equity prevailing in the market, thereby affecting its financial position.

Interest rate risks are divided into two main types: Interest rate risks in the banking book, which result from the bank's main activities not conducted for trading purposes, and interest rate risks in the trading book, which result from taking positions for trading purposes in financial markets, which are addressed in the instructions regarding the minimum capital adequacy standard within market risks.

The issuance of these instructions regarding the management of interest rate risks in the banking book comes within the framework of implementing Pillar 2 of the Basel II regulations concerning the Supervisory Review Process (SRP), continuing the Central Bank of Egypt's efforts to apply the latest international best practices to enhance the efficiency and capacity of the Egyptian banking system to face any financial crises the sector may be exposed to.

In this framework, banks must comply with the qualitative and quantitative (Standardized Approach) requirements regarding interest rate risks in the banking book, conducting 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 foreign bank branches, such that interest rate risks in the banking book are measured according to the Standardized Approach (which will be mentioned in Part Four of these instructions) on an individual basis (including banking groups) and on a consolidated basis for foreign banks and branches. Reports must be submitted to the Central Bank of Egypt within 20 days from the end of each quarter.

1. The measurement on a consolidated basis includes the bank and all its branches domestically and abroad, and all other financial subsidiaries it owns (excluding insurance companies) in which the bank (or the bank and its related parties) owns more than 50% of shareholders' equity or any percentage that enables it to control that entity.

Part Two: Basic Concepts

1. Criteria for distinguishing between the trading book and positions held for non-trading purposes

1/1 Criteria for inclusion in positions held for non-trading purposes (as a minimum): The items held for non-trading purposes are:

• Balances with the Central Bank of Egypt.
• Balances due from banks.
• Shares not listed in the securities market.
• Financial investments held until maturity.
• Financial instruments purchased for holding for medium or long-term periods for the purpose of providing liquidity and not for resale and realizing profits from them.
• 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 one of the instruments held for non-trading purposes.
• Instruments held for the purpose of covering risks arising from financial positions held for non-trading purposes.

Any instrument that was not held at acquisition for any of the trading purposes mentioned later (excluding the items mentioned above) is considered an instrument held for non-trading purposes.

2/1 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 the purpose of resale.
• If the purpose of purchasing them is to realize short-term profits resulting from market price movements, or to benefit from price differences between different markets.
• If the purpose of purchasing them is to use them to cover risks arising from other financial instruments in the trading book.
• If the purpose of purchasing them results from the bank's commitment to cover issuances by other parties (Underwriting commitments).

Only items sensitive to interest rate changes are taken into consideration when measuring interest rate risks in the banking book. It should be noted in this regard that financial instruments in the trading book are evaluated at their 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 of the trading book purposes, if the regulatory authority deems the provided evidence insufficient or the nature of the instrument requires its inclusion in the trading book during a specific period. The bank must then correct its status.

Internal audit officials in 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 inclusion since acquisition. They must also subject them to periodic internal review (at least once a year). Full documentation must be maintained regarding compliance with the policies and procedures governing them.

2. Sources of interest rate risks in the banking book: The sources of interest rate risks in the banking book are summarized as follows:

1/2 Gap Risk: Risks arising from the mismatch in the structure of asset and liability maturities, and thus based on changes in the structure of prevailing interest rates, whether as a result of parallel or non-parallel movements of the yield curve, or repricing at different dates, which may result in a decrease in net interest income and/or equity.

2/2 Basis Risk: Risks 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., mismatch between the change in the interest rate on a loan depending on the 3-month US Dollar interest rate index in the London market - LIBOR - and the change in the interest rate on deposits used to finance this loan, which depend on the US Dollar interbank market interest rate index for the same maturity).

3/2 Option Risk: Risks arising from the exercise of implicit options existing in the bank's assets or liabilities (e.g., early loan repayment, or withdrawal from non-maturity deposits), or arising from explicit options on financial derivative transactions, as this affects the timing and volume of cash flows for financial positions.

For the purpose of conducting a comprehensive assessment of interest rate risks in the banking book, it is necessary to take all the aforementioned sources into consideration.

3. Effects arising from interest rate risks in the banking book: The bank evaluates interest rate risks in the banking book by measuring the impact of adverse movements in interest rates on the following:

1/3 Earnings at Risk (EaR): The sensitivity of the bank's earnings to interest rate movements is measured, specifically through their impact on net interest income. Although interest rate risks have an increasing effect on all bank revenues, including other revenues besides net interest income (such as commissions), the focus will be primarily on net interest income.

2/3 Economic Value of Equity (EVE): The impact of interest rate movements on the economic value of equity is measured, which reflects the present value of the bank's expected net cash flows (Asset cash flows - Liability cash flows) for the bank's current balance sheet. This provides a more comprehensive assessment of the long-term expected effects of interest rate movements on the total risk volume at the bank, complementing the results extracted from the earnings assessment.

Part Three: Qualitative Requirements for Managing Interest Rate Risks in the Banking Book

First: Principles that banks must follow

1. Interest rate risks in the banking book are considered risks of importance to banks that must be identified, measured, monitored, and controlled, in addition to monitoring and evaluating the credit spread risks for positions held for non-trading purposes.

The bank must be aware of all elements related to interest rate risks in the banking book and identify them for the products it deals in and the activities it engages in, ensuring that those products and activities are subject to sufficient procedures and controls. Policies involving hedging and risk management methods for important risks must be adopted before they enter into force. New products must be subjected to detailed review before being dealt with to ensure sufficient awareness of the characteristics of interest rate risks in the banking book associated with those instruments.

Furthermore, the management of interest rate risks in the banking book must align with the bank's general risk management framework and be consistent with its action plan and activities. The bank must verify the appropriate evaluation and monitoring of credit spread risks through internal measurement methods for those risks.

2. The responsibility for monitoring how interest rate risks in the banking book are managed lies with the bank's Asset and Liability Committee (ALCO), within the acceptable risk appetite for those risks, through reports prepared and submitted to it by the officials responsible for asset and liability management in the bank. The committee, in turn, must present those 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 chosen by the Board of Directors. The committee should include representatives from the credit, treasury, internal audit, financial management, and information management systems departments. The committee must 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 the main risks the bank is exposed to, particularly credit risk, liquidity risk, and interest rate risk, and conducting periodic independent reviews and evaluations of the effectiveness of the system applied to manage these risks.
• Setting and updating emergency funding plans.
• Determining the bank's annual budget by setting forecasts for future funding uses and sources, and the associated costs and expected revenues, and evaluating potential risks related to that.
• Ensuring the availability of analytical tools, management systems, and necessary information that enable the committee to perform its tasks.
• 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 risks in the banking book at the bank, in addition to ensuring that the necessary steps are taken to measure, monitor, and control them in accordance with the strategies and policies approved by the Board in this regard.

The Board of Directors must adopt the following, including a clarification of procedures:

• Limits appropriate for interest rate risks in the banking book that must be taken, as well as necessary approvals in case of any exceptions, and ensuring continuous compliance with those limits.
• Sufficient methods for measuring interest rate risks in the banking book.
• Procedures for evaluating and updating scenarios for interest rate shocks and stress tests, and the basic assumptions used in the process of analyzing interest rate risks in the banking book at the bank.
• Comprehensive reporting and audit systems regarding interest rate risks in the banking book.
• Effective internal control systems and Information Management Systems (MIS).

The Board of Directors must also be informed regularly (at least on a semi-annual basis) regarding the level and direction of interest rate risks in the banking book at the bank to take appropriate decisions at the right time and in light of the reports received in this regard, in accordance with approved policies.

Furthermore, board members must have sufficient expertise to understand and comment on the reports presented to the Board of Directors regarding interest rate risks in the banking book. Board members generally bear the responsibility of ensuring that officials responsible for asset and liability management at the bank have the necessary capabilities and skills to manage interest rate risks in the banking book.

2/2 Separation of Duties and Responsibilities

There must be a complete separation of duties and responsibilities related to the main elements consisting of measuring, monitoring, and controlling interest rate risks in the banking book to avoid potential conflicts of interest. These functions should be characterized by complete independence from those whose core work involves taking positions at the bank. Appropriate communication channels must also be available 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 regarding interest rate risks within those instructions.

In addition, periodic reviews of the interest rate risk management process in the banking book, including its various elements, must be conducted annually (at least) by independent external parties (excluding external auditors and those who review the bank's financial positions) to ensure the integrity of the audit process. Reviews must reflect any fundamental changes that could affect the effectiveness of the policies and controls in place (such as changes in market conditions, individuals, systems, and limit structures), as well as verifying the adoption of appropriate escalation procedures in case any of the established limits are exceeded. Reports prepared in this regard must be available to the Central Bank of Egypt upon request.

3. The acceptable level of interest rate risks in the banking book must be determined in light of its impact on both the Economic Value of Equity and Earnings. The bank must apply limits aimed at maintaining its interest rate risk exposures in line with the bank's acceptable risk level.

Furthermore, the risk appetite framework must define the authorities and responsibilities for making decisions related to managing interest rate risks in the banking book. The instruments authorized for limiting and mitigating risks and hedging methods within the bank's acceptable risk level must be specified. Policies regarding interest rate risks in the banking book must be reviewed periodically (at least annually) and amended if necessary.

Policy for Setting Limits for Interest Rate Risks in the Banking Book

• The policy for setting limits for interest rate risks in the banking book must align with the approach the bank adopts for measuring these risks. Limits reflecting the total acceptable risk for interest rates in the banking book must be applied on a consolidated/individual basis (according to the scope of application). Limits are set based on specific scenarios for interest rate/maturity structure changes, taking into account historical interest rate fluctuations and the time required by management to hedge against these risks.

• The limit policy must be appropriate for the nature, size, and degree of complexity of the activity, capital adequacy, and the effectiveness of risk management at the bank. Based on the nature of the bank's activities and its business model, sub-limits must be set for each activity, business line, or financial instrument in a way that reflects the characteristics and causes of interest rate risks in the banking book at the bank. The bank must also set an appropriate maximum tolerance level for this type of risk, within which fundamental exposures related to interest rate risks in the banking book can be determined.

• 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 acceptable 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 be available defining the departments to be notified and how to communicate with them, and the procedures that will be taken regarding any exceptions allowed.

4. The measurement of interest rate risks in the banking book must be based on the results of both the Economic Value of Equity and Earnings, which rely on a suitable number of interest rate shocks and scenarios for stress tests.

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

Banks must identify all main sources from which interest rate risks in the banking book may arise and evaluate the impact of market changes on their main activities, in addition to taking the effect 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 scenarios for interest rate shocks 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 contained in Part Four of these instructions.
• Any additional interest rate shock scenarios requested by the Central Bank of Egypt when necessary.

Furthermore, the bank's stress testing framework must align with the nature, size, and degree of complexity of the bank's activities and its total risk structure. This framework must include clearly defined objectives and scenarios designed according to the bank's business, well-documented assumptions, and effective mechanisms for conducting these tests.

5. The bank must have full knowledge of the behavioral assumptions of depositors and borrowers, and the assumptions underlying the models used to measure and manage interest rate risks in the banking book. These assumptions must be conceptually appropriate, documented, consistent with business strategies, and accurately tested.

The Economic Value of Equity and Earnings, as measures of interest rate risks in the banking book, 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 interest flows arising from deposits with no maturity date.
• Effects resulting from accounting treatments for financial positions held for non-trading purposes that are sensitive to interest rates.

Furthermore, when measuring interest rate risks in the banking book, the bank must formulate assumptions regarding maturity dates (tenors) or repricing for each financial instrument, which may differ from the contractual tenor 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 testing to verify the accuracy and integrity of the measurement process. Independent procedures must be available for approving the measurement systems used, separate from the procedures for the design and development of models.

Accuracy of Measurement Models and Data Used

The accuracy and timeliness of the interest rate risk measurement process in the banking book are essential for effective risk management and control. The measurement approach must be capable of identifying the main sources of interest rate risks in the banking book. The appropriate measurement approach is determined according to the bank's existing business lines and risk characteristics related to its activities.

Banks must not rely on a single measurement approach for risk management purposes but must use diverse measurement mechanisms to estimate the volume of interest rate risks and their 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 that reflect future business activities.

7. Results of measurement and hedging strategies must be reported regularly to the Board of Directors or those delegated by it, on a consolidated basis (in the case of banking groups, according to the scope of application) and for each currency separately.

The reporting process must include current positions taken compared to the limits set by the bank's policy, results of periodic model reviews, and a comparison of the bank's previously placed risk forecasts and estimates with 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 will vary depending on the components of the bank's budget, the bank must have reports on the following at a minimum:

• Individual or consolidated positions (at the banking group level), as well as sufficient explanations shedding light on the components of assets, liabilities, cash flows, and strategies affecting the level and direction of those risks.
• Compliance with established policies and limits.
• Main assumptions for measurement models, such as characteristics of deposits with no maturity date, early repayment of fixed-rate loans, etc.
• Results of stress tests, including an evaluation of sensitivity to the main assumptions and criteria used in this regard.
• Reviews conducted on policies and procedures regarding interest rate risks in the banking book, and the adequacy of measurement systems, including any observations from internal and external auditors.
• Exceptions and breaches of limits set for interest rate risks in the banking book.

Reports on interest rate risks in the banking book must be presented separately 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. Disclosure

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