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.