Background

This was an education session.

The paper builds on the basic dynamic risk management (DRM) concepts discussed in the May 2017 Board meeting, 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 gave a high-level illustration of the dynamic aspect of DRM. Whenever there is a change in the composition of the DRM portfolio, management would have to make corresponding changes to the derivative portfolio in order to maintain the target NIM profile. As the composition of the DRM portfolio changes frequently, most often due to (1) asset maturity (as discussed in AP 4 to the May 2017 Board meeting), (2) asset growth, (3) the passage of time, and (4) asset prepayment (to be discussed at a future meeting), management would have to react continually to these changes by evaluating whether additional mitigating actions are required. This, in short, is the dynamic aspect of risk management.

Examples

The Staff used two examples to explain how DRM would react to changes in the portfolio arising from asset growth, funded by either a growth in core deposits or by term debt. The examples walk through the steps that management would take in order to react to such a change, as follows:

1. Update the composition of the asset profile and the inputs to the target profile (i.e. quantify the new target profile);
2. Compare the asset profile against the target profile;
3. Identify mitigating actions to align the asset profile with the target profile (i.e. identify what derivatives are needed – their duration, notional amount, pay/receive fix or floating interest etc.);
4. Assess whether those derivatives are already in place:
   • a) If yes, no further action is required.
   • b) If no, take mitigating actions (e.g. by taking out other derivatives).

In another example, the Staff indicated the need for management to define the target profile with sufficient specificity in order to take the effect of the passage of time into account. From a communication point of view (and for financial reporting purposes), the more specifically-defined the target profile is, the easier it is to identify the rationale for mitigating actions taken and understand their impact on NIM.

Discussion

The Staff went through the examples and shared some of their experiences. As discussed in the paper, the constant changes in the DRM portfolio would affect how an entity designates, de-designates and documents its hedging relationships. For fair value hedges, it would also affect the amortisation of the fair value adjustments recognised in the hedged item.

The Staff also observed that organisations change their target profile infrequently, although operational departments may have varying degrees of latitude in adjusting the target profile within a band. The band is typically set narrowly by a risk committee so that the organisation can react to market events without taking on a speculative position. Changes in the target profile are taken very seriously by the organisation and the regulator, sometimes involving regulatory approvals. Typically all changes must be justified and documented. The effectiveness of the change in target profile is also monitored, e.g. the actual exposure is measured against the new and old profiles and differences have to be explained.