Table 1.9: Elimination of interest rate sensitive gaps
Risk | Possible reactions | |
Positive gap: Wealth | Loss if profit | -Do nothing (because interest rates may rise again) |
interest rate sensitive products | rate REDUCED because | or stable. |
> Interest sensitive debt | Bank NIM | -Extend the maturity of the Asset or shorten the maturity |
rate | sale | Term of Funds. |
-Increase or decrease interest rate sensitive funds | ||
Interest rate sensitive assets. | ||
Negative gap: Sensitivity debt | Loss if profit | -Do nothing (interest rates may decrease or stabilize) |
interest rate > assets | yield INCREASED because | determined). |
interest rate sensitive | Bank NIM | -Narrow the maturity of the Asset or extend the maturity |
sale | Term of Funds. | |
-Reduce interest rate sensitive capital or increase | ||
Interest rate sensitive assets. |
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1.2.3. Content of QLRRLS
1.2.3.1. RRLS management policy
A risk management policy is a system of limits and guidelines for risk activities established for the entire bank. Effective risk management practices must start at the highest level, which is the risk management functions performed by the Board of Directors (BOD) and the Executive Board (BOD).
Senior management is responsible for ensuring that RRLS is managed vertically and on a day-to-day basis. Senior management should: (1) Develop and implement procedures and actions that translate the Board’s risk objectives and tolerances into standards of performance that are understandable and consistent with the Board’s intent, (2) Ensure that the Board’s authority and mandate to measure, manage and report on RRLS is consistent with the Board’s mandate, (3) Review the implementation and maintenance of management information and other systems that identify, measure, monitor and control the bank’s RRLS, and (4) Establish an effective internal audit system to review the risk management process.
The QLRR policy includes the following contents:
a. Objectives of QLRRLS
-The first objective of RRLS management: The most important objective of RRLS management is to minimize the decline in net income as well as the decline in the economic value of assets from future changes in interest rates. These declines will be managed with limits specified in policies, clearly quantified risks, along with clearly defined RRLS management activities and measures.
-The second goal of RRLS management includes:
+Coordinate RRLS management objectives with other management objectives of the bank.
+Establish appropriate management frameworks on requirements to ensure that RRLS are accurately measured, monitored and managed.
+ Assist and improve communication between all leaders, directors,... whose activities affect or are affected by RRLS management activities.
+ Manage RRLS within a legal framework consistent with the bank's internal control.
+Within the scope of the policy, higher risk management objectives will be set while ensuring that customer service and customer needs are served with the lowest possible adverse impact on the bank's profits and equity. The risk management policy is designed to provide managers with written guidance on risk measurement, risk management and monitoring, along with the limits established in the policy.
b. Regulations on organization and operation of QLRRLS
The organization and operation of QLRRLS follow the following basic principles:
The Board of Directors is responsible for overseeing QLRRLS.
Clearly describe the roles and responsibilities of the three lines of RRLS prevention, which are: (1) risk business units, (2) risk control units and (3) internal audit.
Appropriate market risk management policies, limits and control parameters are created to manage all risk-bearing business activities, especially when new activities/products are introduced.
All market risk management policies and methods are reviewed and approved by the ALCO Board and the Chief Risk Officer. All risk limits are reviewed periodically. Ad hoc reviews are conducted when there are market fluctuations.
Appropriate methods are applied to identify, measure, aggregate, monitor and report market exposures. Exposures are assessed at market prices on a consistent basis over appropriate time periods.
The validity of the approaches and assumptions used in the risk model are tested/validated periodically. Periodic performance reviews are conducted to ensure business/investment/balance sheet compliance status.
c. Market risk management policy - RRLS
The formulation of a bank's LDR policy affects the bank's LDR and must take into account the size, nature, scope and complexity of the products traded, market conditions and the bank's risk appetite. These policies include:
- Determine the bank's risk tolerance.
- Specify the acceptable scope of activities.
- Describe the levels of authority and responsibility for implementing and managing the risks arising from these activities.
- Specify measures, controls, reporting structures and risk limits.
- The scope of implementing effective policies also includes risk assessment of new or existing products and services, documented risks, measurement techniques, risk limits and controls.
- Require all risk business units to ensure that risk policies and risk limits are approved before a risk situation can occur.
d. Duties of the Board of Directors, Management Board and relevant Departments
*Duties of the Board of Directors:Through the QLRRLS policies and strategies, ensure that the Board of Directors (BOD) takes the necessary steps to monitor and control risks according to the policies and strategies that have been set out.
The Board of Directors must be regularly informed of the Bank's RRRS in order to assess its performance, monitor and control this risk in accordance with the guidelines on the bank's acceptable risk levels. The Board of Directors must establish and guide the bank's strategy and tolerance for RRRS, and designate senior executives with authority and responsibility for managing this risk.
Monitor the bank’s performance and overall risk profile to ensure that risk is maintained at a prudent level and is adequately funded. When assessing the bank’s capital performance in relation to risk, the Board should consider the bank’s current and potential risk profile as well as other risks that could reduce capital, such as credit, liquidity and transaction risks.
The Board of Directors ensures that the bank implements sound fundamental principles that support the identification, measurement, monitoring and control of interest rate risk. Ensures that human resources are capable of managing interest rate risk, effective risk management requires both technical and human resources.
*Duties of the Board of Directors : The Board of Directors ensures that the bank's business structure and the bank's risk exposure are effectively managed, that appropriate policies and procedures have been established to control and mitigate these risks, and that the bank's resources are always available to assess and control risk exposure.
It is necessary to clearly identify the committees responsible for QLRRLS and ensure that the division of responsibilities is fully implemented for the key activities in the QLRR process to avoid conflicts of interest. Clearly define responsibilities
The functions of calculating, monitoring and controlling risks are completely independent from the functions of performing the bank's business and investment activities and are required to report directly on the risk situation to the Board of Directors and the Board of Management.
Clearly define appropriate and consistent cash management policies and procedures that are consistent with the nature and complexity of the activities involved. These policies should be applied on a consistent and consistent basis across the various branches, particularly in recognition of legal differences and potential barriers to cash flows between branches.
The Board of Directors should regularly review detailed RRLS reports, which may vary depending on the bank's risk profile but should include at least the following: (1) A summary of the bank's risk exposure, (2) Reports demonstrating compliance with policies and limits, (3) Results of stress testing including assessments of breaches of key assumptions and parameters, (4) Summary of the results of reviews of policies, procedures and the capabilities of the risk measurement system, including results from internal or external audits or consulting.
*Risk Management Department's duties
Having identified potential risks in new products and activities, it is necessary to ensure that these products and activities comply with procedures and are strictly controlled before implementation. Risk management measures or risk contingencies must be approved by the Board of Directors or specialized committees.
Calculate the sensitivity to losses under stressful market conditions, including where assumptions are broken, and consider the consequences when setting policies and limits for RRLS.
Regularly report on risk measurement and compare current risk levels with limits set in policies, and compare risk predictions with actual results to identify weaknesses in the analysis method.
Take measures to reduce risk levels or propose additional capital or a combination of both.
*Duties of the Internal Audit Department
Banks need to have a strong internal audit function to ensure that all business activities are reported to senior management in a timely manner and are consistent with the strategy approved by senior management.
A robust internal control system is in place to support the QMS process. Regular independent reviews and assessments of the effectiveness of this system must be conducted.
e. Set operating limits
Operating limits and other practices are established to ensure that risk is kept at levels consistent with internal policies. The objective of a bank’s risk management is to maintain this risk at the level the bank sets in response to interest rate fluctuations. To achieve this objective, the bank must have a system of risk limits and guidelines. This system sets risk limits for the entire bank and, where appropriate, for individual business units, products and investment portfolios. The limit system ensures that any excess of acceptable limits is brought to the attention of the bank’s management. An appropriate limit system will allow the bank’s management to monitor risk, discuss opportunities and risks, and monitor actual risk levels against expected levels.
Risk limits should be consistent with the bank's overall risk measurement approach. Limits represent the bank's risk tolerance and should be approved and reviewed periodically by the Board of Directors. Limits should be appropriate to the bank's size, complexity, and capital adequacy, as well as its ability to measure and manage risk. Depending on the nature of the bank's holdings and the overall complexity, the bank may set limits for individuals, business units, investment portfolios, and types of instruments. The level of detail of risk limits reflects the characteristics of the bank's holdings and the sources of risk the bank is facing.
Senior management must be quick to acknowledge any limit exceptions. The bank must have a clear policy for these cases, outlining how they will be reported and handled. It is particularly important to clarify whether the limits have ever been breached or whether, in exceptional circumstances, they may only be exceeded for a short period of time.
Limits should be consistent with the bank’s risk measurement methodology and should reflect the expected impact of interest rate movements on the bank’s earnings and economic value. From a profitability perspective, banks should consider limits in terms of the volatility of net income and net interest income to assess the contribution of non-interest income to the bank’s exposure to interest rate risk. These limits represent the level of earnings volatility that the bank can accept in the event of interest rate fluctuations.
The form of the limits reflecting the impact of interest rates on the economic value of the bank should be appropriate to the size and characteristics of the bank’s holdings. If the bank is more traditional in its activities and holds less long-term instruments, options, or other instruments whose value fluctuates regardless of market interest rates, simple limits may be sufficient. If the bank has more complex activities, more detailed limits may be needed.
RRLS limits play an important role in assuming situations where market interest rates fluctuate abnormally. The interest rate fluctuations used to analyze and create limits must take into account both past interest rate fluctuations and the time required for the bank's management to recognize the risk. Limits can be calculated based on statistical interest rate distribution techniques, such as Earning at Risk or economic value at risk. In addition, the situational assumptions must take into account sources of RRLS for the bank such as spread risk, yield curve risk, basis risk, and option risk.
g. Provisions on maintaining equity
Changes in interest rates can expose banks to risk of loss and in some cases can even threaten the bank's survival. In addition
Adequate and sound systems and controls are essential to support and mitigate this risk. To manage it effectively, a bank needs to know and translate its level of liquidity risk, whether it is from operating or non-operating activities, into an overall assessment of its capital adequacy, although there is no consensus on the methods used in this process. In cases where a bank faces significant liquidity risk in the course of implementing its business strategy, it will need to allocate a significant amount of capital to support this risk.
1.2.3.2. QLRRLS process
a. Risk identification: Risk exposures can originate from a variety of sources and there are diverse measurement systems in the approach to each type of risk exposure. Commercial banks should consider the nature and complexity of their products and activities and the risk characteristics of these businesses before identifying the main sources of risk exposures and the relative contribution of each source of risk to the bank’s overall risk exposure profile.
Commercial banks need to establish a risk measurement system that is capable of identifying all sources of risk as well as assessing the impact of interest rate fluctuations on the bank's scope of operations, identifying and quantifying the main sources of risk for the bank.
Bank RRLS signals can be divided into four types: Revaluation risk or maturity mismatch risk, basis risk, yield curve risk and options risk.
b. Risk measurement
The RRLS measurement system must be able to identify all sources of RRLS as well as assess the impact of interest rate fluctuations on the bank's scope of operations (transactional and non-transactional sources). The risk management department and the bank's management board must clearly understand and master the assumptions in these RRLS systems.
Banks also need to prioritize their focus on the more dominant RRLS categories. RRLS measurement systems need to take a more cautious approach to these