IRRBB : Decomposing the Risks 14 th June 2019 IRRBB: DtR - Contents - - PowerPoint PPT Presentation

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IRRBB : Decomposing the Risks 14 th June 2019 IRRBB: DtR - Contents - - PowerPoint PPT Presentation

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IRRBB : Decomposing the Risks 14 th June 2019 IRRBB: DtR - Contents Objectjves Background (brief) Difgering Measurement Methodologies for EVE The Case for pure Risk-Free-Rate (RFR) EVE Measuring other IRRBB Risks

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SLIDE 1

IRRBB :

Decomposing the Risks

14th June 2019

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SLIDE 2

www.ukalma.org.uk

James Leeming

IRRBB: DtR - Contents

  • Objectjves
  • Background (brief)
  • Difgering Measurement Methodologies for EVE
  • The Case for pure Risk-Free-Rate (RFR) EVE
  • Measuring other “IRRBB” Risks
  • Conclusions
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SLIDE 3

James Leeming

www.ukalma.org.uk

IRRBB: DtR - Objectjves

  • Is doing IRRBB “per the regs” a suitable way to

manage your risks?

  • Is IRRBB trying to capture too many risk-types in
  • ne metric?
  • Considering the methodologies for computjng

EVE.

  • How and why do I think about the risks

independently? To consider,

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SLIDE 4

James Leeming

www.ukalma.org.uk

IRRBB: DtR – (brief) Background

  • Too many ‘black boxes’?
  • Intent to ensure comparison across fjrms.

– Shock levels – Disclosures – Updated standard outlier test

  • Strengthening risk management practjces
  • BCBS368 : Interest Rate Risk in the Banking Book
  • Adoptjon, RTS, Publicatjon (voluntary qualitatjve

disclosures in advance). The Why?

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SLIDE 5

James Leeming

www.ukalma.org.uk

IRRBB: DtR – (brief) Background

  • Compute EVE under base case and 6 interest

rate shock scenarios – run ofg balance sheet.

  • Compute NII in base case and (at least) 2 parallel

shock scenarios – statjc reinvestment balance sheet.

  • Consider risks under a ‘dynamic’ balance sheet.
  • Not directly used for P2A capital, but SOT

compliance (or add on?) – gone concern basis.

  • Strengthen governance of IRRBB (to board).

The What?

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SLIDE 6

James Leeming

www.ukalma.org.uk

IRRBB: DtR – (brief) Background

Run-ofg vs. Statjc vs. Dynamic Balance Sheets

Run-ofg Run-ofg Statjc/Reinvest

  • Statjc/Reinvest

Dynamic/Growth Dynamic/Growth Assets Liabilitjes £m (£m) t tn

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SLIDE 7

James Leeming

www.ukalma.org.uk

IRRBB: DtR – EVE Measures

  • Methodologies for modelling future cashfmows

and discount factors for measuring EVE changes.

  • Some simplifjed maths!
  • I’m going to assume we’re risk averse (well-

hedged).

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SLIDE 8

James Leeming

www.ukalma.org.uk

IRRBB: DtR – EVE Measures

  • Forecast future cashfmows – at current rates.
  • Run-ofg balance sheet
  • Discount back future cashfmows to establish a PV
  • Shock interest rates
  • Discount back (new) future cashfmows with new

DFs

  • Measure the change in value

Basics of EVE,

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SLIDE 9

James Leeming

www.ukalma.org.uk

IRRBB: DtR – EVE Measures

Cashfmow and discountjng choices – Recap.

1% 5% 2% Customer Rate 8% Profjt (incl. credit risk) Funding Spread (LTP/CoF/Basis) Reference Rate/Swap Rate (Risk-Free?)

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SLIDE 10

James Leeming

www.ukalma.org.uk

IRRBB: DtR – EVE Measures

Cashfmow and discountjng choices – Recap.

Cash-fmow Components Term of Cash-Flows Discountjng Curve Full Customer Rate Risk-Free-Rate + Funding Spread Risk Free Rate Only Ultjmate Maturity Fixed Rate Period Only Next Reset Date Risk Free Curve (Sonia) Risk Free Curve (Libor) Risk Free + “Other” Margin Components e.g. term premia

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SLIDE 11

James Leeming

www.ukalma.org.uk

IRRBB: DtR – The Case for RFR

Worked Example (simplifjed).

1yr Fixed Bond 5yr Fixed Rate Loan

  • Assets

Liabilitjes £m (£m) t tn Fixed/Float Swap

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SLIDE 12

James Leeming

www.ukalma.org.uk

IRRBB: DtR – The Case for RFR

Worked Example (simplifjed)

Rate 1 2 3 4 5 Total Loan 7% 7.00 7.00 7.00 7.00 107.00 135.00 Deposit 5% (105.00) (105.00) Pay Fix 5% (5.00) (5.00) (5.00) (5.00) (105.00) (125.00) Rec Float 5% 105.00 105.00 Net Gap 2.00 2.00 2.00 2.00 2.00 10.00 PV YC = 5% Flat 1.90 1.81 1.73 1.65 1.57 8.66 PV YC = 7% Flat 1.87 1.75 1.63 1.53 1.43 8.20 Change (0.46) Rate 1 2 3 4 5 Total Loan 9% 9.00 9.00 9.00 9.00 109.00 145.00 Deposit 5% (105.00) (105.00) Pay Fix 5% (5.00) (5.00) (5.00) (5.00) (105.00) (125.00) Rec Float 5% 105.00 105.00 Net Gap 4.00 4.00 4.00 4.00 4.00 20.00 PV YC = 5% Flat 3.81 3.63 3.46 3.29 3.13 17.32 PV YC = 7% Flat 3.74 3.49 3.27 3.05 2.85 16.40 Change (0.92)

Change due to profjt margin; the more profjtable, the greater the issue.

CF = Full Rate DF = RFR

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SLIDE 13

James Leeming

www.ukalma.org.uk

Rate 1 2 3 4 5 Total Loan 7% 7.00 7.00 7.00 7.00 107.00 135.00 Deposit 6% (106.00) (106.00) Pay Fix 5% (5.00) (5.00) (5.00) (5.00) (105.00) (125.00) Rec Float 5% 105.00 105.00 Net Gap 1.00 2.00 2.00 2.00 2.00 9.00 PV YC = 5% Flat 0.95 1.81 1.73 1.65 1.57 7.71 PV YC = 7% Flat 0.93 1.75 1.63 1.53 1.43 7.27 Change (0.44) Rate 1 2 3 4 5 Total Loan 7% 7.00 7.00 7.00 7.00 107.00 135.00 Deposit 6% (106.00) (1.00) (1.00) (1.00) (1.00) (110.00) Pay Fix 5% (5.00) (5.00) (5.00) (5.00) (105.00) (125.00) Rec Float 5% 105.00 105.00 Net Gap 1.00 1.00 1.00 1.00 1.00 5.00 PV YC = 5% Flat 0.95 0.91 0.86 0.82 0.78 4.33 PV YC = 7% Flat 0.93 0.87 0.82 0.76 0.71 4.10 Change (0.23)

IRRBB: DtR – The Case for RFR

Worked Example (simplifjed)

Ignores future liability margin due to run-ofg B/S

CF = Full Rate

(with depo margin)

DF = RFR

Closer to the truth, but not run-ofg!

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SLIDE 14

James Leeming

www.ukalma.org.uk

Rate 1 2 3 4 5 Total Loan 5% 5.00 5.00 5.00 5.00 105.00 125.00 Deposit 5% (105.00) (105.00) Pay Fix 5% (5.00) (5.00) (5.00) (5.00) (105.00) (125.00) Rec Float 5% 105.00 105.00 Net Gap 0.00 0.00 0.00 0.00 0.00 0.00 PV YC = 5% Flat 0.00 0.00 0.00 0.00 0.00 0.00 PV YC = 6% Flat 0.00 0.00 0.00 0.00 0.00 0.00 Change 0.00 Rate 1 2 3 4 5 Total Loan 5% 5.00 5.00 5.00 5.00 105.00 125.00 Deposit 5% (105.00) (105.00) Pay Fix 5% 0.00 Rec Float 5% 0.00 Net Gap (100.00) 5.00 5.00 5.00 105.00 20.00 PV YC = 5% Flat (95.24) 4.54 4.32 4.11 82.27 0.00 PV YC = 7% Flat (93.46) 4.37 4.08 3.81 74.86 (6.33) Change (6.33)

IRRBB: DtR – The Case for RFR

Worked Example (simplifjed)

Fully hedged IRR = zero change

CF = RFR Component DF = RFR

Unhedged IRR = change purely due to policy rate expectatjons

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SLIDE 15

James Leeming

www.ukalma.org.uk

IRRBB: DtR – The Case for RFR

Cashfmow and discountjng choices – Recap.

Cash-fmow Components Term of Cash-Flows Discountjng Curve Full Customer Rate Risk-Free-Rate + Funding Spread Risk Free Rate Only Ultjmate Maturity Fixed Rate Period Only Next Reset Date Risk Free Curve (Sonia) Risk Free Curve (Libor) Risk Free + “Other” Margin Components e.g. term premia

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SLIDE 16

James Leeming

www.ukalma.org.uk

IRRBB: DtR – The Case for RFR

Worked Example (simplifjed).

1yr Flt Bond 5yr Flt Rate Loan

  • Assets

Liabilitjes £m (£m) t tn Refjnancing Gap

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SLIDE 17

James Leeming

www.ukalma.org.uk

IRRBB: DtR – The Case for RFR

Example Funding Curve

1yr Flt Bond 5yr Flt Rate Loan Maturity Transformatjon = profjt, which creates EVE noise % tn Maturity Transformatjon

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SLIDE 18

James Leeming

www.ukalma.org.uk

IRRBB: DtR – The Case for RFR

Example IR Curve

1yr Swap 5yr Swap % tn 4yr Swap, 1yr Fwd Rolling through tjme on a risk-free- interest rate yield curve is very difgerent from…

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SLIDE 19

James Leeming

www.ukalma.org.uk

IRRBB: DtR – The Case for RFR

Example Funding Curve

1yr Funding Spread 5yr Funding Spread % tn 4yr Funding Spread (& 1yr Fwd?) ….rolling through tjme on a funding spread curve. My liquidity preference – for a same tenor - doesn’t necessarily increase forward in tjme.

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SLIDE 20

James Leeming

www.ukalma.org.uk

IRRBB: DtR – The Case for RFR

Cashfmow and discountjng choices – Recap. …and now the term of cash-fmows choice doesn’t really matuer…

Cash-fmow Components Term of Cash-Flows Discountjng Curve Full Customer Rate Risk-Free-Rate + Funding Spread Risk Free Rate Only Ultjmate Maturity Fixed Rate Period Only Next Reset Date Risk Free Curve (Sonia) Risk Free Curve (Libor) Risk Free + “Other” Margin Components e.g. term premia

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SLIDE 21

James Leeming

www.ukalma.org.uk

IRRBB: DtR – Other IRRBB Risks

Outright Interest Rate Risk Margin / Earnings Risk Refjnancing Risk Basis Risk Risk of a change in policy rate expectatjons The risk to income

  • f competjtjve

landscape Refjnancing cost risk / Term mismatch Risk in a relatjve change in two rate indices IRRBB EVE Model, fjxed period, using RFR only NII modelling, Financial Planning NII Scenario Modelling Run-ofg B/S, akin to IRRBB EVE but for fmoatjng P2A Hedgeable P2A Hedgeable (Base vs. Sonia?) P2B P2B

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SLIDE 22

James Leeming

www.ukalma.org.uk

IRRBB: DtR - Conclusions

  • IRRBB suitably captures risk measures you can manage

to, as long as you decompose them; EVE for outright risk only, NII for the rest.

  • Basis and Outright risks are hedgeable – measure them

separately from ‘business model’ risk measurement.

  • BCBS368 doesn’t prescribe a basis risk methodology,

but your IRRBB solutjon could help.

  • System restraints – be careful with the EVE results if the

RFR only component isn’t available.

  • CSRBB?