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BaFin Interest Rate Shock - New draft of the circular regarding "Interest rate risks in the banking book"

BaFin Interest Rate Shock - New draft of the circular

The article focuses on key elements of the draft of the new BaFin circular on reporting of key figures on interest rate risks in the banking book, describes the most important changes as well as concrete recommendations for action.

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Summary

On 29 March 2019, the German Financial Supervisory Authority (BaFin) published a draft for the revision of Circular 09/2018 "Interest rate risks in the banking book" (IRRBB), also known as "BaFin interest rate shock" or "standard shock". All German credit institutions are affected. The circular specifies the quarterly reporting of key figures on interest rate risk to the BaFin and the Bundesbank. It focuses on present-value effects of interest rate shocks predefined by the supervisory authorities and applied to the positions in the banking book.

The circular now clarifies how the requirements for the regulatory standard interest rate shock defined by the European Banking Authority’s (EBA) guidelines on the management of interest rate risk arising from non-trading book activities, which were published in 2018 and are effective from 30 June 2019, are to be applied in Germany.

Compared to Circular 09/2018, one particular amendment is the six additional interest rate scenarios that are to be implemented. In addition, a number of requirements for the calculation of present value losses have been specified.

According to the information provided by the IRRBB expert committee, the first reporting of the interest rate shocks using the new calculation requirements is required for 30 September 2019. The first reporting of the six newly introduced interest rate scenarios is planned for 31 December 2019.

Content and amendments to the draft

The regulatory reporting requirements for the standard interest rate shocks for German banks will be expanded. As before, individual credit institutions in Germany must report the present value of the banking book and the corresponding changes in present value on a quarterly basis in the event of a 200 bp increase in the interest rate curve and a 200 bp decrease in the interest rate curve. A change in the present value of more than 20% of total equity must be reported, including changes occurring between the quarterly reporting dates. Moreover, six further interest rate scenarios are introduced in which, different to the previous scenarios, present-value changes will be considered in relation to CET1 capital. In future, the 15% threshold being exceeded will constitute an "early warning indicator". The supervisory authorities have defined specific interest rate shock levels for the new scenarios for each currency.

In addition, financial institutions must now report at both entity and group level. If a group waiver is used in accordance with section 2(5) of the German Banking Act (KWG), the requirements need not be considered at entity level but only at group level. In line with Circular 09/2018, financial institutions are permitted to exclude margins from their cash flows. The new consultation has provided further detail to the requirements concerning this matter. In order to exclude margins, a transparent margin calculation must be ensured based on risk-free interest rates at the time the transaction is concluded. Additionally, the supervisory authority must be informed about the treatment of margins.

Banks may use their own models and methods for the calculation. However, BaFin defines a number of requirements for the calculation of the present value loss:

  • If the financial institution's NPE ratio is above 2%, non-performing exposures (NPE) must be included and modelled as general interest-sensitive instruments.
  • Pension obligations may be excluded from the interest rate shock if they are included in another risk category in the bank’s internal risk manage-ment approach.
  • The assumed behavioural repricing date for retail and non-financial wholesale depos-its without any specific repric-ing dates (non-maturity deposits) is to be limited to a maximum average of 5 years. This limit applies individually for each currency. Deposits from financial institutions may not be modelled and must be considered as overnight positions.
  • Changes in present value must be calculated for each currency. When calculating the aggregate EVE change for each interest rate shock scenario, institutions are to add together any negative and positive changes to EVE occurring in each currency. Positive changes are to be weighted by a factor of 50%. This differs significantly from the previous, rather conservative approach of BaFin Circular 09/2018, which excluded the consideration of positive changes in present value in foreign currencies. Foreign currencies may also be excluded from the calculation if their share does not exceed 5% of the total volume and at least 90% of the total volume is considered. 
  • There is a maturity-dependent interest rate floor for the currency-specific yield curves when applying the interest rate scenarios. The lower limit starts at -100 bp and then increases by 5 bp per year, resulting in a floor at 0% for a term of 20 years. Should optionalities be taken into account, instrument-specific floors must be considered. 
  • The risk-free yield curve for each currency must be used for discounting. In supervisory practice, interest rate swap curves are recognized as “risk-free”.

Present-value changes are determined in all interest rate scenarios taking into account these restrictions. Financial institutions are to use their internal methods and procedures.

Practical implications and recommendations

First and foremost, we recommend that banks take the following steps:

1. Perform test calculations

In our experience, the additional scenarios, the application of a ratio with CET1 capital and the new flooring requirement could lead to the early warning indicator being exceeded, even by banks that previously have not shown large risk exposures. As the estimation of all these effects is no small matter and the period for possible remedies in asset/liability management is limited to 31 December 2019, we recommend that banks begin test calculations immediately. This applies in particular to smaller institutions, which, according to current practice, often manage their IRRBB position solely on the basis of parallel shift scenarios. Institutions are also advised to include the scenarios in their internal risk management if this has not yet been done.

2. Margin separation

The separation of margins in the calculation of interest rate scenario results is linked to various requirements that have been further specified in comparison to Circular 09/2018. To utilise the “internal cash flow perspective”, a transparent margin calculation must now be implemented. While this might require some effort, it could well pay off: as we have already seen in practice, a 30% - 40% reduction in the coefficient to be reported is by no means unrealistic when margins are excluded. We therefore recommend that all institutions which have not yet implemented margin separation critically analyze this approach.

3. Modelling pension obligations

In our experience, the modelling of direct pension obligations within interest rate risk management is subject to much debate. For the first time, the circular now allows pension obligations to be excluded from the calculation if they are measured in the internal risk man-agement as part of another (possibly separate) risk type. Analyses show that some banks already report separate "pension risks" under Pillar II. Whether this ad-justment in the interest rate shock calculation really leads to lower disclosure must be determined individually. If the position is al-most completely closed or open with respect to present value risk, the optimal approach is something of a trivial matter. However, if pen-sion liabilities are only partially offset by positions on the assets side, we recommend scenario calculations to simulate the effects of a potential exclusion. 

4. Modelling non-performing loans

Due to the low level of loan de-faults over recent years and the resulting historically low NPE ratios, many banks see little or no need for action for the Pillar II procedures when it comes to modelling non-performing loans. However, should the NPE ratios increase in the short term due to the looming economic downturn, we will see many banks faced with the huge challenge of implementing a modelling approach within a short space of time that is consistent with risk provisioning.

For this reason, we recommend that banks actively address this issue at this early stage. In order to reduce to a minimum the work required for adjustment, we also recommend that institutions use the cash flows already available in the balance sheet calculation of loan loss provisioning to determine their interest rate risks in the banking book.

BaFin's revision of Circular 09/2018 became necessary in order to implement the new EBA guidelines for managing interest rate risk in the banking book. In this respect, the EBA guidelines are mandatory for all German banks. While we have seen that many banks have already addressed the fundamental points during implementation of the previous Circular 09/2018, there has been hardly any optimization.

Next steps

The industry consultation phase ends on 30 April 2019. Based on previous announcements, we expect the new version to come into force as early as the third quarter of 2019. We assume that the final circular will correspond to the consultation draft, as previous versions have already been discussed in the IRRBB committee and BaFin must also implement the EBA requirements.

In order to be able to report the additional scenarios, it is expected that the adjusted reporting forms will be made available by 31 December 2019 at the latest.

While this is not expected to lead to insurmountable challenges for large institutions, small institutions, especially those which currently have limited simulation options available in their calculation framework, should prepare intensively for the requirements. 

Feel free to contact us!

Our team of experienced experts in IRRBB, overall regulatory matters and risk management will be glad to assist you in adapting to the amended requirements and identifying any need for action.

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