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Dynamic risk management

Date recorded:

Dynamic Risk Management - Agenda paper 4

Background

This was an education session.

The paper is dedicated to a discussion of net interest margin (NIM) stabilisation, this being the objective of dynamic risk management (DRM) as described by banks.

The Staff explained NIM management as follows:

  1. NIM is defined as the yield on loans less cost of funding (funding includes term funding and deposits. The focus of the paper is on loans funded from deposits).
  2. Fixed rate perpetual life assets do not exist. This means that loans will mature and they will be replaced by new loans which will be priced based on the interest rate environment at the time of origination.
  3. In contrast, portfolios of perpetual non-interest bearing deposits exist.
  4. Given the above, NIM for deposit-funded portfolios is dominated by loan yields (as the cost of deposits is zero).
  5. Accordingly, by managing the asset profile, it is possible to manage NIM fluctuations.
  6. As part of this management, an entity must decide how and when it would like NIM to re-price, in other words, what is its NIM target profile?
  7. However, as banks cannot force customers to originate loans that are perfectly aligned with the target profile, mitigating actions are required to align the actual asset profile to the target profile, e.g. via the use of derivatives.
  8. In order to work out what mitigating actions are required, the target profile must be quantified. The modelling of deposits is the quantification of the target profile.

Examples

The paper uses several simple yet effective numerical examples to illustrate:

  • what actions a risk manager would take to manage NIM and why;
  • how derivatives are used to transform an asset profile to match the target profile; and
  • how demand deposit modelling is used to quantify the target profile.

The examples show that when a loan asset matures, management would be indifferent as to which type of loan is granted (floating or fixed rate, or its maturity). This is because management has the flexibility to react to customer actions through, for example, the use of derivatives. Furthermore, the examples show that irrespective of whether the entity matched the asset profile to the target profile, or hedged the demand deposits, the actions that management would take to manage NIM and the resulting NIM profile are identical.

The paper also illustrates how an NIM reconciliation that compares actual NIM with expected NIM can capture errors or ineffectiveness throughout the DRM process.

Financial reporting considerations

In light of the DRM activities described above, information about the following questions could be considered relevant for financial reporting purposes:

  1. What target profile has the entity chosen and why?
  2. How successful is management in achieving that target profile?
  3. What factors are considered when determining core versus non-core deposits? - Could errors in assumptions create liquidity risk? What is the amount of loss that could arise from errors in assumptions?

Next steps

The Staff intend to discuss prepayment risk and how the dynamic nature of portfolios would affect the target profile. That will complete the discussion of ‘what is the business of DRM’. Thereafter, the Staff plan to discuss (1) how DRM is currently reflected in the financial statements and (2) how to evaluate the proposed accounting model in Q2 and Q3 of 2017.

Discussion

With regard to example 1A in the agenda paper, one Board member did not see it as liability profile modelling or hedging liabilities. She believed that the modelling of deposits relates to identifying what is core versus non-core deposits, and that ‘hedging’ liabilities is a misnomer because there is no risk in the demand deposits, at least once they have been identified as core (to be discussed at a future Board meeting). More generally, she and the Vice-Chair could not understand why entities speak of ‘hedging core deposits’ or ‘demand deposit modelling’ when entities are actually managing their asset profile, as shown in the examples in the paper. The Staff understood their concern and said that there are various reasons for coining these phrases, one of them being that the future assets that are being hedged mostly do not meet the ‘highly probable forecast transaction’ requirement.

Many Board members also questioned the scope of the project as well as whether, and the extent to which, it will address the current disclosure deficiency for DRM. The Staff observed that the current level of DRM disclosure is minimal and is mostly limited to a contractual maturity analysis of the entity’s loan portfolios. They noted that what investors are really interested in is how much of the NIM will reprice, when they will reprice, and how much of that NIM management have locked in through their structural hedging programme. The Staff noted that feedback from the April 2014 DP indicated that there is a need to balance the disclosure requirements for entities that are actively managing NIM versus those that are not, lest people mistake the voluminous disclosures made by the former as indicating a riskier and more complex business model compared to the latter. The Staff reiterated throughout the discussion that it is still too early to define the project scope and that they will provide the details later bearing in mind all these concerns, as well as how the existing IFRS 7 disclosures could be effective for DRM.

A Board member asked how credit risk would affect the NIM repricing decision. She believed that the NIM profile would be affected by changes in the assets’ credit risk profile even if the overall interest environment does not change. The Staff agreed and will address this in the future.

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