Document Properties
- Type of Publication: Guideline
- Category: Sound Business and Financial Practices
- Date: February 2005
- No: B-12
- Audiences: Banks / T&L
In July 2004, the Basel Committee on Banking Supervision released
the final version of its
Principles for the Management and Supervision of Interest Rate
Risk. These principles support the Pillar 2 approach to
interest rate risk in the banking book in the new capital framework.
The principles document is the result of significant consultation
dating back to before 1993 when the Basel Committee released guidance
dealing with the measurement of bank exposure to interest rate risk.
OSFI believes that a risk control framework that manages interest
rate risk (IRR) to prudent levels is a cornerstone of sound banking
practice. As such, OSFI supports the principles outlined in the
Basel Committee’s July 2004 document. We would also like to highlight
and or make further recommendations with respect to a number of
issues outlined below.
1. Senior Management Oversight
OSFI concurs with the Basel Committee’s view that senior management
should have an integrated view of IRR. We stress that senior management
is a key force in “institutionalizing” a control culture across
the deposit taking institution (DTI). As such, we expect senior management to understand IRR
management methodologies and encourage discussion between the risk
management function(s) and position-taking operations.
OSFI also expects complex DTIs to establish a committee to oversee
asset liability management. Such committees would be responsible
for managing and vetting the strategic direction of IRR (such as
positions and policies) within the DTI. To the extent that risk
management personnel form part of this committee, they are expected
to be an impartial observer(s) under normal operating conditions
and thus not participate in tactical decisions regarding IRR position
taking.
OSFI recognizes that treasury operations in a number of DTIs report to the finance function, which is viewed as a key control. Although there is no intention at this time to prescribe reorganizations, OSFI expects financial institutions to maintain an adequate degree of impartial oversight over treasury operations.
Please refer to OSFI’s Corporate Governance Guideline for OSFI’s expectations of DTI Boards of Directors in regards to operational, business, risk and crisis management policies.
2. Measurement of IRR
OSFI supports the Basel Committee’s principle that the degree
of sophistication of IRR measurement techniques should be commensurate
with the degree of risk inherent in the DTI. Where DTIs utilize
models to measure and mitigate their IRR exposure, OSFI expects
these models to be thoroughly vetted by an independent function.
Additionally, OSFI expects that DTIs will periodically undertake
full reviews of their IRR measurement models. The frequency of these
reviews depends on various factors, such as complexity of the DTI
and size of IRR exposures, nature of market changes and complexity
of innovation with respect to measuring IRR.
3. Disclosure of IRR
OSFI endorses the Basel Committee’s principles on the disclosure
of IRR and will assess the degree of IRR at DTIs based on these
principles. OSFI will also review the following additional measures:
- Sensitivity (pre-tax)1 of net interest income and economic value
to parallel shifts in the yield curve of 10, 25, 100 and 200 basis
points, the latter metric additionally as a percentage of capital,
- Sensitivity (pre-tax)1 of net interest income and economic value
to three non-parallel shifts in the yield curve to which the DTI
is vulnerable,
- Sensitivity (pre-tax)
of net interest income and economic value to key rates to which
the DTI is vulnerable,
- Monthly sensitivity and stress testing (the comprehensiveness
of which should be commensurate with the size and complexity of
the DTI), and
- The robustness of the annual review (at a minimum) of assumptions
underlying IRR measurement techniques for less sophisticated DTIs,
and more frequent reviews (as appropriate) for complex DTIs.
4. Limit Setting
OSFI fully supports the Basel Committee’s view that limits should
be commensurate with the risks undertaken by the DTI. A DTI should
express limits relative to its balance sheet and earnings base.
Limits are expected to be reflective of the DTI’s prospective expectations
of interest rate volatility and be calibrated to historic utilization
levels. Material fluctuations in volatility should result in breaches
of the limits. These breaches should prompt discussion on the overall
risk direction of the DTI.
5. Funds Transfer Pricing
OSFI believes that the allocation of capital to risk is an integral
component of sound IRR management. In the case of complex DTIs,
OSFI expects that IRR management and IRR risk will be transferred
to centre(s) of expertise, with risk capital and associated profit
and loss being allocated and measured accordingly. As part of this
process of centralization, OSFI expects complex DTIs to utilize
an appropriate fund transfer pricing mechanism to manage this transfer,
with such pricing mechanism to be managed independently of position-taking
operations.
6. Role of Internal Audit
Due to OSFI’s reliance-based supervisory framework, we emphasize
the importance of internal audit as a key check in ensuring that
control functions are operating effectively. We also encourage management
and audit to ensure that any audit findings and follow-up are addressed
in a timely manner.