Banking : Guidelines on Banks’ Asset Liability Management Framework – Interest Rate Risk
CIRCULAR NO. DBOD. NO. BP. BC. 59/21.04.098/2010-11, DATED 4-11-2010
Please refer to paragraph 155 of Second Quarter Review of Monetary Policy 2009-10 announced on October 27, 2009 on introduction of Duration Gap Analysis for interest rate risk management. Accordingly, Guidelines on Banks’ Asset Liability Management Framework – Interest Rate Risk are furnished in Annex.
2. As banks are aware, interest rate risk is the risk where changes in market interest rates affect a bank’s financial position. Changes in interest rates impact a bank’s earnings (i.e. reported profits) through changes in its Net Interest Income (NII). Changes in interest rates also impact a bank’s Market Value of Equity (MVE) (hereinafter ‘equity’ would mean ‘networth’ unless indicated otherwise) through changes in the economic value of its interest rate sensitive assets, liabilities and off-balance sheet positions. The interest rate risk, when viewed from these two perspectives, is known as ‘earnings perspective’ and ‘economic value perspective’, respectively. The earlier guidelines (DBOD. BP. BC. 8/21.04.098/99, dated February 10, 1999) to banks indicated approach to interest rate risk measurement from the ‘earnings perspective’ using the Traditional Gap Analysis (TGA). To begin with, the TGA was considered as a suitable method to measure Interest Rate Risk. Reserve Bank had also indicated then its intention to move over to modern techniques of Interest Rate Risk measurement like Duration Gap Analysis (DGA), Simulation and Value at Risk over a period of time, when banks acquire sufficient expertise and sophistication in acquiring and handling MIS.
3. In this context, it is clarified that Duration Gap Analysis (DGA) is aimed at providing an indication of the interest rate risk to which the bank is exposed. Accordingly, the estimated drop in MVE as a result of the prescribed shock applied would indicate the economic impact on the banks’ equity should the shock scenario materialise but would not be an accounting loss as banking book is not marked to market.
4. The revised guidelines furnished in Annex will be effective from April 1, 2011. However, banks are advised to start full-fledged test runs on these guidelines with effect from January 1, 2011 with a view to enable them to gain more experience in the operation of the revised framework.
5. The salient features of the guidelines furnished in the Annex are :
(i) Banks shall adopt the DGA for interest rate risk management in addition to the TGA followed presently.
(ii) The framework, both DGA and TGA, should be applied to the global position of assets, liabilities and off-balance sheet items of the bank, which are rate sensitive. Banks should compute their interest rate risk position in each currency applying the DGA and TGA to the rate sensitive assets/liabilities/ off balance sheet items in that currency, where either the assets, or liabilities are 5 per cent or more of the total of either the bank’s global assets or global liabilities. The interest rate risk position in all other residual currencies should be computed separately on an aggregate basis.
(iii) Keeping in view the level of computerisation and the current MIS in banks, adoption of a uniform ALM System for all banks may not be feasible. The proposed guidelines have been formulated to serve as a benchmark for banks. Banks which have already adopted more sophisticated systems may continue their existing systems but should also adopt the DGA and TGA as supervisory reporting/disclosure frameworks.
(iv) Banks should adopt the modified duration gap approach while applying the DGA to measure interest rate risk in their balance sheets from the economic value perspective. In view of the evolving state of computerisation and MIS in banks, a simplified framework has been suggested, which allows banks to:
(a) group rate sensitive assets, liabilities and off balance sheet items under the broad categories indicated in Appendix I under various time buckets; and
(b) compute Modified Duration (MD) of these categories of assets/liabilities and off-balance sheet items using the suggested common maturity, coupon and yield parameters.
(v) Measurement of interest rate risk with the above method is an approximation. Hence banks which have the capability to compute the weighted average MD of their assets and liabilities based on the MD of each item of Rate Sensitive Asset (RSA) / Rate Sensitive Liability (RSL) may do so.
(vi) Each bank should set appropriate internal limits for interest rate risk based on its risk bearing and risk management capacity, with prior approval of its Board / Risk Management Committee of the Board.
(vii) Banks should compute the potential decrease in earnings and fall in MVE under various interest rate scenarios.
(viii) In addition to extant frequency of supervisory reporting of interest rate sensitivity as per Traditional Gap Analysis (TGA), banks shall submit a report on interest rate sensitivity as per DGA in the stipulated format with effect from June 30, 2011 on a quarterly basis till March 31, 2012 and monthly with effect from April 30, 2012.
6. It is clarified that the framework prescribed in this circular is aimed at determining the impact on the MVE of the bank arising from changes in the value of interest rate sensitive positions across the whole bank i.e. both in the banking and trading books. This requirement is in addition to the existing guidelines for assessing capital adequacy requirement for interest rate sensitive positions in the trading book and banking book (under Pillar II) separately. For the purpose of capital adequacy trading and banking books are treated separately because generally no offset of positions between the banking book and trading book is considered due to different accounting/valuation norms.
7. After gaining significant experience with the methodology laid down in the circular, banks may consider switching over to this methodology for management of interest rate risk in the banking book under Pillar II.
8. As per extant guidelines on management of interest rate risk in the banking book under Pillar II, banks where the economic value of the banking book declines by more than 20% of the MVE as a result of a standardised interest rate shock of 200 basis points are considered outlier from supervisory perspective. However, no such calibration is envisaged at this stage for decline in the MVE based on the impact of the standardised interest rate shock of 200 basis points on the entire balance sheet, under the guidelines on banks’ ALM contained in this circular.
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