Different types of products are treated differently using methods previously discussed to measure IRRBB. Sensitivity models and economic valuations are analysed to accurately portray a banks’ exposure to IRRBB.
Key learning objectives:
- Understand the differing treatment of financial products
- Interpret sensitivity analyses for Net Interest Income and Economic Value of Equity
What are Variable Rate Financial Products?
Variable rate products are normally linked to a benchmark rate that either re-fixes explicitly on a regular basis (for example, 1 month or 3 month LIBOR) or may refix at any time but not on a fixed regular basis, for example, the Central Bank Base Rate or the bank’s own “Standard Variable Rate” (SVR), which is informally linked, but heavily influenced by the base rate and market rates.
What are Fixed Maturity Products?
The principal amounts of fixed rate loans and deposits, with market related early repayment/redemption charges, should be reflected in the interest rate gap report according to their contractual repayment profile. These would normally be associated with wholesale, corporate or commercial clients.
For bullet repayment loans, the entire principal balance should be shown in the gap report in a time bucket corresponding to the maturity of each loan. In the case of amortising loans though, the regular repayments of principal are allocated to the time period in which they are scheduled to occur.
When it comes to fixed rate retail bank products, these tend to be homogenous and are characterised by early repayment charges that do not reflect the potential underlying funding cost to banks.
What are some examples of Non-Interest Bearing Balances?
Typical examples of items in this category include Non-Interest Bearing deposits and Cash (notes and coin) balances. Neither of them carry an interest rate, so cannot re price as such. However, the items need to be included in the gap report if it is being used to calculate the Economic Value sensitivity of the balance sheet. Banks should aim for a stable net interest margin over time. With these balance sheet items, this will be best achieved by treating them as long term as possible in the gap report.
What are some Managed Rate Products?
Examples of products in this category include credit cards, interest-bearing current accounts and obsolete accounts that are no longer on sale. In these instances, a bank may not re-price these products in line with an established market benchmark rate. This is where production of the Static Interest Rate Gap report becomes part art and part science. To establish the treatment of managed rate products in the Gap report, the ALM Manager must estimate which market benchmark rate their interest rate correlates most closely to.
What is Net Interest Income Sensitivity, and how is it calculated?
Lets now consider the principal measure of IRRBB, the sensitivity of its net interest income (NII), or Delta NII. There are a range of different mechanisms used by banks to calculate the sensitivity of their NII to movements in interest rates.
In its simplest form, the repricing profile of assets and liabilities, established in the production of the Interest Rate Gap report is subjected to a parallel shock of 1% or 2%, either upwards or downwards, in the level of interest rates across the yield curve, which is assumed to be sustained for 12 months.
As a first step to developing the analysis, banks will look to factor in how much and when products are likely to be re-priced in response to a given rate shock:
- Depending upon the competitive environment and P&L and market share aspirations, management may choose to re-price managed rate products by either more than, less than or by the same amount as the underlying market interest rate movement
- Leads or lags that management may choose to impose on when managed rate products are re-priced
What are the uses of EVE, and how is it calculated?
The starting point for an EVE sensitivity calculation is the static interest rate gap report. In this case, the gaps in each time bucket are turned into a net present value (or NPV) by discounting using discount factors based upon the current level of interest rates. As a second step, the NPVs for each time bucket are summed to produce a high-level estimate of the bank’s economic value. The exercise is repeated for a given interest rate shock, for example a 1% parallel upward movement in the yield curve.
Typically, banks will evaluate their EVE sensitivities to a variety of different shock scenarios. Based on risk appetite, a bank’s ALCO will set limits on the change in EVE it is prepared to accept to a sudden movement in interest rates.
Simulation models, adopted by some banks, can be used to assess either NII or economic value sensitivities. Rather than relying upon a constant or static balance sheet, these models allow management to introduce assumptions on how prepayment/early redemption levels of new business and margins will be affected by interest rate movements. Also, they allow multiple interest rate shocks or rate paths to be modelled using Monte-Carlo analysis.