IBOR transition and implications for balance sheet management

For my part of the FRTB, IBOR transition and ALM webinar, I delved into implications of IBOR transition for balance sheet management and funds transfer pricing (FTP) when forward looking term rates are absent or not credible. We also discussed examples of how LIBOR cessations are tackled in some ASEAN countries as well as the opportunity and challenges of the development for financial deepening especially in Indonesia. The slides are available upon request.

Webinar: Proactive Treasury and Asset Liability Management

Over 66 treasurers, alm managers and head of risks attended the webinar. Let me know if you are interested in the slides.

On the 2020 liquidity stress testing exercise by Indonesian banks

A bottom-up stress testing (BUST) exercise is currently ongoing and Indonesian DSIBs are to submit the results using templates that I have helped design.

In contrast to the capital stress testing template, the liquidity ST template underwent significant changes compared to last year's version. In this event, we will discuss in detail its data requirements and design backgrounds in order for the participating banks to achieve accurate and timely submission by end of March 2020. 

The session will also address the linkage of the liquidity ST with the capital stress test exercise to strengthen banks’ liquidity risk measurement, including recovery planning.

In particular, I would like to raise understanding of the background of liquidity stress test requirements; provide rationales behind the design of the new ST liquidity template; explain special features in the cashflow mismatch analysis template and interpretation of the liquidity ST results with fictitious figures, under supervisory and own scenarios. 

A well-executed liquidity ST exercise will raise the confidence of banks and regulators to adopt a more comprehensive Pillar 2 liquidity framework.

#ILAAP #LiquidityStressTesting #Pillar2 #SupervisoryST

How the BSP Circular on IRRBB will affect ALM in Philippine banks?

Against the backdrop of the regulatory initiatives taken by the Basel Committee and other authorities in the region, BSP recently published Circular #1044 to introduce a principles-based approach for identification, measurement, monitoring and control of IRRBB.

On EVE and NII

BSP requires banks to calculate and disclose PV-based economic value effects alongside measures for earnings volatility according to banks’ internal measurement system (IMS). The two perspectives of IRRBB management are complementary, because of their differences in terms of outcomes, assessment horizons and balance sheet assumptions.

ΔEVE is defined as the maximum change in the present value of interest-bearing assets, liabilities (excluding capital), and off-balance sheet items in a wide-range interest rate shocks.

ΔNII is the adverse change in net interest income over a specific time-horizon (12 months) against specific scenarios such as gradual parallel 200 bps shock scenarios. This metric aims to identify earnings volatility and needs to be calculated especially by more complex banks on a dynamic balance sheet approach (e.g Circular #1044 page 7). A dynamic approach “incorporates future business expectations, adjusted for the relevant scenario in a consistent manner”.

In my view, banks need a full-blown balance sheet simulation, where changes in the customer behaviour, volumes and margins are fully rate dependent to comply with the guideline. Minimum norm is set to rise as well, for behavioural modelling, scenario analysis and validation processes as well as their integration into the IRRBB risk appetite and monitoring frameworks.

The greater supervisory expectation is not only a burden, but it is also an opportunity for banks to optimize their ALM strategy. For example, more robust modelling of non-maturity deposits (NMD) might reveal that the duration of NMDs is longer than currently assumed. As a result, more long-dated fixed-rate loans can be added, and thus greater interest revenues without incurring additional tenor mismatch risks.

Comparison with the Basel IRRBB Standards (BCBS 368)

The BSP Circular #1044 is in line with the Basel guideline for the IMS to measure and report banks’ IRRBB exposure, in particular on risk governance aspects and disclosure requirements. However, BSP does not offer the Basel Standardized approach that can be used by banks as their IMS.

Another key distinguishing feature of the BSP Circular is the absence of supervisory outlier tests as an integral part of banks’ internal framework for the management of IRRBB. A supervisory outlier test aims to identify banks with undue risk-taking in terms of ΔEVE based on specific interest rate scenarios such as the six rate scenario shocks prescribed in the BCBS 368. This tool is also useful for external stakeholders to gauge IRRBB exposures in the industry on a more comparable basis.

Similarities and differences of the BSP Circular #1044 and the BCBS 368 are summarized in the following exhibit.

I don't have insights into why the standardized framework is removed. Perhaps it is to avoid undue compliance burden for (smaller) banks...

In anyhow, its absence should compel banks to be thoughtful about their balance sheet assumptions, scenario developments, behavioural modelling and aggregation of calculation results by significant currencies. As a consequence, implementation of the Circular would likely be less box-ticking exercise for Philippine banks compared to banks that are only required to adopt the standardized approach.

ALM strategy under the BSP Framework

How will BSP Circular #1044 affect the field of ALM in the Philippines?

The new guideline on IRRBB would not act as a constraint on the risk-taking and revenue-generating part of IRRBB. But a good implementation can avoid the bank from facing supervisory enforcement actions (page 13):

“…the Bangko Sentral may deploy enforcement actions to promote adherence with the requirements set forth in these guidelines and bring about timely corrective actions. lf a bank's/QB's risk exposures are not well-managed, the Bangko Sentral may direct the bank/QB to increase its capital, reduce its IRRBB exposures and/or strengthen its risk management system.”

Furthermore, the IRRBB framework is a clear catalyst for implementing more robust dynamic ALM and stress scenario analysis that could unveil concentration risks and sub-optimal balance sheet strategy. Based on the ensuing dynamics of margins, maturity preferences of clients and their effect onto the tenor mismatch, and other factors, a strategy for the tenor mismatch can have objectives ranging from boosting NII to stabilizing it over a future rates cycle. The dynamic balance sheet approach makes ALM exciting but, more importantly, a necessity for future profitability.

Concluding Remarks

Despite the absence of the requirement to measure IRRBB exposures according to the Basel standardized approach (BCBS 368) as a fallback or alternative, the implementation of the BSP guideline is set to influence both ALM practices and supervisory priorities.

In particular, the BSP Circular #1044 is expected to bring about significant changes to IRRBB modelling in banks with respect to both behavioural option risks and embedded automatic option risks.

For more complex or larger institutions, the new guideline also requires a robust or enhanced ALM platform. This is because thorough balance sheet simulations based on granular data are a prerequisite for many of the qualitative aspects of the BSP requirements. Capability to implement the dynamic balance sheet approach will also strengthen actual management of IRRBB and the tenor mismatch strategies devised to manage NII over a rate cycle.

IRRBB and Indonesian banks

Basel IRRBB is unlike many other Basel's compliance project. It is first of all naturally relevant for Indonesian commercial banks. And it provides a more discipline approach to ALM and gives a business case for better asset and liability modeling.




Pictures from the event:

Workshop on Basel's IRRBB Framework

Agenda of my one-day seminar on IRRBB organized by BARa, Jakarta, 29 Jan 2019

Implementation of IRRBB for better balance sheet management and stress test practices

  * Modified from the background paper for the BARa Forum on IRRBB, 6 September 2018

One of many relevant topics that needs to be addressed under the new IRRBB framework of Indonesia's Financial Services Authority (OJK) is the requirements for banks to enhance their dynamic balance sheet projections and stress tests. The emphasis on dynamic analysis is a key reason why the new IRRBB framework should not be approached as a mere compliance exercise, but as great opportunity to optimize balance sheet strategies supported by more solid understanding of customer behavior in the face of interest rate shocks.

A good quality implementation of the IRRBB stress tests framework is instrumental for credible IRRBB measurement and limits setting. It is an effective tool to optimize interest rate tenor mismatch strategy in view of, most probably, increasing interest rate environment.

It seems that a wide range of banks welcomes the IRRBB guideline for stress test scenarios and dynamic balance sheet projections.

In a survey of FIS and d-fine GmbH, banks were asked on their approaches for IRRBB implementation. It is notable from the survey results that majority of banks intend to enhance their methodological framework for IRRBB identification and measurement and for performing interest dependent simulation of future volume, margin, repricing period, and maturity.

                                Source: FIS and d-fine survey, 2017


To get meaningful results, such simulations need to be based on very granular data and in coherence with banks’ business planning (i.e., where maturing contracts are replaced by a new-business simulation logic). Based on this, forward-looking ΔEVE metrics can be analyzed too, which allows banks to look at future developments of these metrics under different business and tenor mismatch strategies.

Due to the maximum operator inherent to the ΔEVE metric, ALM infrastructure is a major consideration, particularly when implementing a sophisticated tenor mismatch strategy or in an environment of hefty interactions between interest rate movements and customer behavior.

It is important to note that the two IRRBB quantification, namely ΔEVE and ΔNII is significantly impacted by not only the shocks to the possible changes of the shape of interest rate yield curves, but also ‘by the economic stress scenarios that would be consistent with these shocks’ (SEOJK IRRBB, Annex II, B.4.a).

Hence, when assessing the earnings and economic value impacts from the interest rate shocks, banks should also consider possible correlations with loans quality affecting margin, change of customer behavior affecting banks’ liquidity risk profile, and changes in macroeconomic environment affecting profitability and/or capital adequacy.

The new IRRBB rule will bring significant changes to IRRBB modeling in banks and requires a robust ALM platform to support more dynamic balance sheet management and robust integrated stress tests.  All this is expected to support OJK's campaigns to mandate more rigorous stress testing in banks’ capital, liquidity and contingency/recovery planning.

IRRBB management with a dynamic perspective created added burden on bank resources and will need a greater cooperation among Risk Management, ALM and Planning departments to come up with sensible unified business-as-usual and stress scenarios.

But the benefits from proper dynamic ALM projections and stress tests are considerable. Even without regulations or supervisory expectations for (bottom-up) stress tests, all banks would want and need to know the valuable information and insights from these exercises for better decision making.