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Dynamic risk management

Date recorded:

Education session — Agenda paper 4

Background

This was an education session.

The paper built on the basic dynamic risk management (DRM) concepts discussed previously, including the concepts of net interest margin (NIM), the asset profile, the target NIM re-pricing profile and how derivatives could be used to align any given asset profile to the target profile.

In this paper, the Staff discussed prepayment risk and the concept of capacity.

Prepayment risk

Prepayment risk exists when a borrower has the right to prepay a loan. When a borrower prepays a loan, the bank will be subject to re-pricing risk (through generation of a new loan at a new interest rate) which will cause NIM to change. This unexpected re-pricing of NIM may not be aligned with the target profile and banks have to manage this risk.

The strategies in managing NIM re-pricing risks from prepayments are similar to those previously discussed, i.e. using derivatives to align the asset profile with the target profile. However, an additional step is required upfront to estimate the amount and timing of prepayments which will be incorporated into the asset profile. Any deviation of the actual prepayments from estimates will result in NIM volatility. This volatility could be resolved by rebalancing the derivatives portfolio to align the new asset profile with the target. Another way to mitigate it could be to enter into options (as opposed to interest rate swaps) that will compensate the entity for the interest rate differential caused by the NIM re-pricing, thus allowing the bank to maintain a ‘stable’ NIM for a specific term regardless of prepayment risk.

Concept of capacity

As regards the concept of capacity in the hedging context, a lack of capacity refers to an entity’s not having enough hedged items against which derivatives could be designated in a hedging relationship. The Staff had illustrated throughout their examples the need to use two interest rate swaps to align a particular asset profile with the target profile – one to cancel out the existing asset profile and the other to create the desired profile. If a bank funds its fixed rate loans with interest-free deposits, there is only one stream of interest cash flows – those arising from the loan asset – that is subject to fair value risk (the hedged item). This means that only the pay-fixed receive-floating swap could be designated in a hedging relationship with this hedged item. The other swap cannot be designated as a hedge of cash outflows because no such cash flows arise from interest-free deposits.

This capacity problem leads banks to seeking alternative solutions, e.g.

  1. using proxy hedging;
  2. using alternative performance metrics; or
  3. simply do not hedge.

These alternatives naturally affect how the related items are accounted for in the financial statements.

Next steps

 We expect the Board to continue to discuss this over the coming months. The Board has yet to develop any preliminary views. A second Discussion Paper is planned for 2018. 

Discussion

This was the end of the educational sessions on dynamic risk management.

The Staff reiterated that one of the core challenges of managing NIM is the estimation of the population of core deposits. Banks have sophisticated systems that do this and it is a highly regulated area which is monitored as part of the entity’s overall liquidity and interest rate risk management. The Staff also noted that the zero-rate perpetual core deposits used in the paper is a simplified surrogate for non-rate-sensitive deposits that remain outstanding for a very long time. As such, the DRM activities explained in the paper are equally applicable to cases where core deposits are interest-bearing.

The Staff further noted that one of the key focus of the DRM project is to develop accounting requirements that would help entities communicate their DRM activities to users. This includes: what is the actual NIM profile of the bank? How good is it in achieving that profile, especially in cases where there is no capacity to hedge (i.e. not having sufficient qualifying hedged items yet the volatility of NIM is economically hedged)? How can the accounting accommodate the capacity issue so that the actual economics of the transactions are reflected faithfully in the financial statements?

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