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Balance sheet management at retail banks

ZandersTreasury & Finance Solutions

January 26, 2016

Jaap Karelse

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1 Introduction

2 Perspectives & complications

3 Balance sheet management

Agenda

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• Provide lending at higher price than its cost of funding, securing stable margin

• In a typical retail bank, lending/mortgage portfolios are funded primarily by non-maturing deposits (e.g. savings and current accounts)

Introduction: what is balance sheet management?

The business model of the bank

Main (financial) risks in the retail bank’s balance sheet

Objective of balance sheet management

• Credit risk/counterparty risk => out of scope for today

• FX and price risk of stocks/commodities => also out of scope here

• Interest rate risk arises from the timing (and size) mismatch between the

interest cashflows of assets and liabilities => impacting the margin stability

• (Funding) liquidity risk reflects the ability to meet obligations, for instance

this can arise if deposits are drawn immediately, without notice

• Manage the liquidity and interest rate risk mismatch between assets and liabilities - taking into account the various requirements and constraints posed by stakeholders

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• Funding liquidity risk was to some extent neglected before the credit crisis

– Regulators acknowledged the risk by embedding quantitative (e.g. LCR/NSFR) and qualitative requirements (see various BCBS publications)

• Interest rate risk for the banking book (IRRBB) had been in scope for decades

– As part of Basel II’s pillar II, banks developed internal approaches to manage it

– However, recently this topic got significant additional attention!

Introduction: what did we learn in the past years?

Post credit crisis, balance sheet management changed considerably

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Recent regulatory developments on IRRBB

• EBA published their Final Report on the ‘Guidelines on the management of interest rate risk arising from non-trading activities’ on 22 May 2015:

– The guidelines apply from 1 January 2016

– The scope is banking book only

– Credit spread risk is explicitly out of scope of EBA guidelines

– Sophistication matrix introduced on interest rate risk measurement

– Focus is on clarification of Pillar 2

• BCBS published their Consultative Document on Interest Rate Risk in the Banking Book on 8 June 2015:

– Issued for comments by 11 September 2015

– Supported by Qualitative Impact Study in September / October 2015

– Focus is on creation of common standardised measure for IRRBB (either in Pillar 1 or Pillar 2)

– Implementation date: 2018/2019?

– Recent rumours: ‘Basel abandons plans for Pillar 1 rates risk charge’ (Risk.net, 12 January 2016)

Introduction: further regulatory developments

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– EBA 2016 EU-wide stress test

– BCBS239: Principles for effective risk data aggregation and risk reporting

– MREL, TLAC…

– Less focus on ‘complicated’ internal (VaR/EC) models => ‘what’s the use’??

– Increased focus on EaR

– Integration of Finance and Risk

Introduction: many other topics are related…

Additional regulatory initiatives

Other trends

In the meantime, there are also

some interesting market

circumstances…

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1 Introduction

2 Perspectives & complications

3 Balance sheet management

Agenda

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• In balance sheet management, the relevant risks can be evaluated and interpreted from a number of different angles or perfectives

• The following perspectives are further explored in the next sheets:

I. Balance sheet: market value versus book value

II. Gaps: liquidity typical versus interest rate typical

Bonus sheets: incorporating customer behavior…

III. Risk measures: earnings based versus value based

Bonus sheets: internal versus regulatory views…

• Satisfying objectives in all of these perspectives can be complicating

• This is illustrated by means of: an example…

Perspectives & complications

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• Interest rates were a flat 1.6% per year at current date

• The bank does not perform any hedging of the risk (e.g. by swaps)

I – Balance sheet

Assets Notional Coupon Market value

Cash 100 0.00% 100

Commercial loans (floating rate 1Y, 8Y maturity) 300 2.20% 300

Residential mortgages (fixed rate, 30Y maturity) 600 2.60% 600

Total 1,000 1,000

Liabilities Notional Coupon Market value

Client deposits (floating rate, overnight) 700 1.10% 700

Capital market funding (floating rate 1Y) 220 1.60% 220

Equity 80 80

Total 1,000 1,000

The SE Bank! (SE stands for: Simple Example)

When the bank started out:

• The SE Bank recently started, with just a few items on its balance sheet

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• Interest rates rose by 100 basis points to 2.6%, affecting the interest on cash, commercial loans and funding, and (to some extent) client deposits

• Some mortgage clients prepaying their mortgage

• Earnings of 11 in interest income & operational cash flow

I – Balance sheet

In their first year of operation, the SE bank experienced:

Assets Notional Coupon Market value

Cash (+47) 147 1.00% (+47) 147

Commercial loans (floating rate, 1 year) 300 3.20% 300

Residential mortgages (fixed rate, 30 years) (-36) 564 2.60% (-91) 509

Total 1,011 (-44) 956

Liabilities Notional Coupon Market value

Client deposits (floating rate, overnight) 700 1.35% (-11) 689

Capital market funding (floating rate, 1 year) 220 2.60% 220

Equity (+11) 91 (-33) 47

Total 1,011 (-44) 956

? So, how did the bank perform?

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• Balance sheet is based on the notional view, so little change => movement from mortgages to cash, and P&L added to cash and equity

• P&L equals the interest income minus expense on accrual basis => +11

• From a financial reporting perspective: the bank did pretty well

• Despite the positive P&L, the market value of equity changed by -33

I – Analysis of the outcomes

Accounting to the accountants

? Should we care?

• Yes. Financial statements look back, and say nothing about the future Look e.g. at the future expected earnings: they show a decrease:

Net interest income T=2 T=3 T=4 T=5

Expectation at reporting date 12 11 13 12

After interest rates +100 bp 8 10 13 14

Change -4 -1 0 +2

• The explanation is easy: expected net interest income decrease => funding is largely floating rate, but most of the assets are fixed rate

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I – Analysis of the outcomes

? But what is the appropriate discounting rate?

• The rate that corresponds to the default risk and opportunity cost of capital• For example, a loan to a firm listed on the stock exchange can be discounted with the

CDS spread to reflect the default risk, plus an illiquidity premium • For default risk of non-listed counterparties, you can look for representative industries or indices• However, for a mortgage portfolio you need to take the loan to value of the collateral into account• Etcetera, etcetera, etcetera, etcetera….

Market value of equity, also: economic value of equity (EVE)

• Definition: market value of assets minus the market value of liabilities

– Measure that is sensitive to risk over the full life of the product

– Contradicts the accounting definition of equity, but note that this is also how Solvency II defines … solvency!

• Market values are, if not observable in the market, calculated on the basis of future cash flows, discounted using an appropriate interest rate curve

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• The future cashflows (‘gap profile’) from an interest rate or liquidity typicalperspective look completely different, in case interest rates are reset before the maturity of the product

• Consider the simple, commercial floating-rate loan on the balance sheet:

– Interest rate typically, it ‘matures’ at the next refixing date (1Y)

– Liquidity typically, however, the notional will only return at the contractual maturity (8Y), future (uncertain) interest cashflows based on forward rates

II – Gaps: zoom into some balance sheet items

Interest rate typical vs. liquidity typical

? Which profile should you use to calculate the NPV?

• For a floating rate loan, both profiles should provide the same NPV

0

100

200

300

1 2 3 4 5 6 7 8 9 10years

Liquidity typical

Interest rate typical

So, future cashflowprofiles differ, depending on the perspective!

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• Particular balance sheet items have uncertain cashflows, both in terms of size and timing

• For options or products with standardized options (e.g. callable loans) => option pricing models available

• However, bank portfolios also have embedded ‘options’ where option pricing theory is less evident:

– Mortgages have the option to be repaid before contractual maturity

– Non-maturing deposits (savings, current accounts) do not have a pre-specified contractual maturity or coupon:

• The client can withdraw these funds at his own discretion

• The bank can change the client rate at any one moment

II – Behavioral aspects

Things are not that simple, though

! These products require their client behavior to be modelled!

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• Without adequate future expected cash flows, treasury and risk management steer on incorrect measures

II – How can this be helpful?

Assets Delta Duration Delta Duration

Cash 0.00 0.0 0.00 0.0

Commercial loans (floating rate, 1 year) 0.03 1.0 0.03 1.0

Residential mortgages (fixed rate, 30 years) 0.65 10.9 1.26 26.9

Total 0.68 6.8 1.29 12.8

Liabilities Delta Duration Delta Duration

Client deposits (floating rate, overnight) 0.18 2.6 0.00 0.0

Capital market funding (floating rate, 1 year) 0.02 1.0 0.02 1.0

Equity 0.48 59.6 1.26 157.9

Total 0.68 6.8 1.29 12.8

-400

-200

0

200

400

1 2 3 4 5 6 7 8 9 10

Difference behavioral and contractual cash flows

• This shows especially when comparing the interest rate sensitivity in the SE bank balance sheet from behavioral and contractual perspectives

Relevance of behavioral cash flows

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III – Risk measures: earnings vs value

High-level difference between earnings and value based risk measures

1 year 5 years1 year 5 years

Aspect Value based Earnings based

Measures uncertainty in Market value Earnings

Interest rate risk model Risk neutral Usually 'real world'

Consistent with Market value balance sheet IFRS balance sheet

Static/dynamic Static, 'run-off' portfolio Including future transactions

Horizon Usually not limited E.g. 1 or 2 years

Focus on Shareholder value Business plans, MTP

Examples Duration, 'greeks', bpvs,VaR, EC

Earnings at Risk

• Graphically:

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• Economic value of equity (EVE) is value based measure, sensitive to interest rate movements

• Duration measures the overall sensitivity of the market values to parallel interest rate changes. However, duration can be misleading:

– Interest rate movements are rarely parallel

– A low duration does not mean a low exposure!

III – Risk measures: value

Interest rate sensitivity

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• Similarly, the interest rate sensitivity of the EVE of SE bank concentrates around certain points of the interest rate curve

– This can be calculated as the average NPV change of both positive and negative shifts of the corresponding curve sections

• Unsurprisingly, the majority of the SE Bank EVE delta of 0.48 originates from the notional repayments (see basis point values (= -PV*D/10.000))

– The replicating portfolios mature at 1, 3 and 10 years

– The mortgage portfolio deals has yearly prepayments (and thus reinvestments) with the remainder due at the end: 30 years

– The floating rate loan and funding slightly affect the sensitivity at their interest rate typical maturity of 1 year, but largely offset each other

III – Risk measures: value

Interest rate sensitivity of the EVE

-0.30

-0.20

-0.10

0.00

0.10

1 2 3 4 5 6 7 8 9 10 11-20 21-29 30

Basis point values

years

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• Earnings based measure for the maximum expected loss in earnings as a result of changes in interest rates:

– Relative to a basis scenario, in which the ‘best estimate’ interest earnings are calculated over a particular horizon (e.g. 1, 2 years)

– Future interest rates are shifted, e.g. by 200 bpup or down, and then earnings are recalculated => leading to EaR

III – Risk measures: earnings

• How should the basis scenario be calculated, using ‘real word’ scenario’s?

• How to keep the balance sheet stable, through virtual, new transactions?

• How to select appropriate scenario’s for interest rates and spreads? User defined, or stochastic?

Some dilemmas in EaR calculations

? What would happen to the SE Bank earnings when interest rates rise?

– In addition to some regulatory required EaRs, also internal, additional EaRs are usually calculated, including e.g. spread impact

-400

-300

-200

-100

0

100

200

300

400

-200 bp 0 +200 bp

EaR, 2 year horizonregulatory scenariosadditional internal scenarios

Earnings at Risk (EaR)

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• The earnings and value measures have different purposes & assumptions

• Limiting the uncertainty in EVE (i.e. lowering duration) thus typically comes at a cost to earnings:

– Shorter interest rate typical maturities provide stable values, but in the short term uncertainty in the margin due to repricing risk

– Vice versa, long, stable earnings provide a stable margin, but also more risk in the value of equity (i.e. higher duration)

• The regulators state on this:

– ‘The guidelines allow an institution to assess, calculate and manage its interest rate risk based on either value or NII/Earnings. However, when managing for value also NII/earnings should be considered/monitored. Vice versa, when managing for NII/earnings also value should be considered/monitored’

III – Risk measures: earnings vs value

! An optimum that stabilizes both does not exist

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• Limits change of EVE, due to changes in interest rates, in relation to regulatory capital => Change in EVE/Regulatory capital

• Regulatory capital: Tier 1 & 2 capital (for SE Bank: book value equity)

• Market valuation based on swap (instead of swap + spreads)

• Instant interest rate shifts of -200/+200 basis points (bp), limit 20%

• When breached, the bank must act to limit interest rate risk

III – Risk measures: regulatory requirements

The IRBBB “outlier criterion”

Description Base case -200 bp shift +200 bp shift

Economic value of Equity 80 (+102) 182 (-76) 4

Economic value of Equity at swap 160 (+119) 279 (-99) 61

Outlier criterion 119/80 = 149% 99/80 = 124%

? The SE Bank EVE duration valued at swap is 39. What would you expect the change in its EVE to be as a result of an immediate +/- 200bp interest rate shift? Would SE Bank satisfy the outlier criterion? (answer: 39*2%*160=125)

! The VU Bank breaches the outlier criterion… by 129%

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• Active balance sheet management is used to manage the interest rate risk profile in line with the board’s risk appetite, typically by

– incentivizing business to ensure that the gap and interest rate sensitivity of assets and liabilities match (better), and/or

– using interest rate swaps to align the remaining mismatch

Some open issues…

Now what?

? How does this work in practice?

• How do we exactly manage this risk appetite?

• Whom are the results of these potential swaps allocated to??

• How are the results per business unit calculated???

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1 Introduction

2 Perspectives & complications

3 Balance sheet management

Agenda

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• Using (actual or fictive) internal transactions, e.g. deposits and swaps between business unit (e.g. mortgage book) and Treasury

• Centralization, on the basis of funds transfer pricing, enables effective management by Treasury, including netted (less costly) external hedges

• Schematically:

Active balance sheet management

Business Unit Treasury

Internal funding

Internal funding

Mort-gages

Ext.Funding

Risk management

Treasury

Methodology for internal transfer of linear IRR

Limit monitoring

Manages IRR position

Interest rate and funding liquidity risk centralization in Treasury

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• Transactions on the balance sheet are ‘sold’ to the newly created Treasury department, transferring the risk

• Internal swaps are used that mirror the expected (interest rate typical) notional cash flows:

• Treasury then enters into external swaps to change the interest rate sensitivity of the net position to floating rate (1 year for SE Bank example)

• As a result, the EVE duration of SE Bank (valued at swap + spread) decreases from 59.6 to… -8.9.

The results of risk transfer in the example…

SE Bank interest rate risk centralization

? Why does the duration of the EVE not decrease to 1.0?

-400

-200

0

200

400

1 2 3 4 5 6 7 8 9 10 11-19 20-29 30

Notional cash flows Internal swaps

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• Does the bank intend to stabilize value or earnings?

• Should the risk in margins (i.e. credit spread changes) also be hedged?

• If not, what additional risk mitigating actions may be necessary, e.g. to manage outlier criterion?

• How to allocate these results of these actions… who pays for it?

Risk transfer is not complete!

• Interest rate risk of the floating leg, if using swaps

• Margins, implying (credit) spread risk is not transferred

• Non-linear risks, such as convexity and (implied) volatility risk (if any)

• Model risks, resulting from uncertainty in model parameters

Risks remain after interest rate risk transfer

? To what extend can and should these remaining risks be hedged?

• Economic capital models aggregating all risks

• Stress test outcomes (also used for outlier criterion)

Remaining risks are managed using ‘other’ risk measures

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How to further manage the risks?

Business Unit Mismatch bookTreasury

Internaldeposit

Internal deposit

Internal funding

Internal funding

Mort-gages

Ext.Funding

Risk management

Interest rate

swaps

Treasury

ALCO

Methodology for internal transfer of linear IRR

Limit monitoring

Duration own equity

Limit setting

Limit breach

Manages IRR position

• Additional book can be set up in which the strategic mismatch is managed

• The bank’s asset & liability committee (ALCO) defines the strategic mismatch target for the duration of EVE

• Typically, additional trades are executed to bring the remaining interest rate position in line with the strategic mismatch target on behalf of ALCO

• Schematically:

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• Suppose the EVE duration target is set to 3.0 (this satisfies outlier criterion, see below)

• The EVE duration of the SE bank can be reduced further by entering into an additional swap:

– Closed between mismatch book and treasury, for instance 10Y swap

– Treasury then enters into this swap externally

– Some deviations for Treasury may be allowed for practical reasons; not all position changes need to be reflected in external transactions

– So, Treasury can to some extent leave its interest rate position open => separation of results means this will not be allocated to business

Further risk transfer in the example

What did this achieve?

• Equity is swapped to the desired duration of 3.0, reducing the maximum change in EVE to 12% (≈ 200 bp * 3.0 * 160 = 9.6; 9.6/80 = 12%)

• Treasury and Mismatch book (equity) result can be separated from the results of the business books

• In control of interest rate risk since desired duration of equity is achieved!

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How to interpret these?

Net interest income T=2 T=3 T=4 T=5

Expectation at reporting date 12 11 13 12

EVE unhedged, interest rates -100 bp 11 10 12 11

EVE unhedged, interest rates +100 bp 8 10 13 14

EVE hedged, interest rates -100 bp 10 9 9 9

EVE hedged, interest rates +100 bp 9 11 16 17

? Why does the NII increase at +100 bp when hedged, i.e. higher EaR?

But: volatility of earnings increased!

• The reduction of duration is offset by an increase in the earnings volatility

• Although the margins in the business departments are stabilized, a floating rate component remains (because swaps are used to hedge), which results in earnings volatility

• Challenge: When measuring the duration of the balance sheet at swap (instead of swap + spread) the duration only decreases to 10.5, instead of 3.0!!

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• Typically a limit framework is created based on:

– Transfer of interest rate typical mismatch from business to Treasury

– Desired strategic mismatch book

– Tactical short term position taken by Treasury

• The risk appetite is translated into risk measures, for instance:

– Duration or delta’s (possibly per bucket) for Mismatch book

– Limits (e.g. delta, vega, gamma) for the tactical short term position of Treasury

– Further limits on total banking book risk measures like delta, Earnings at Risk, interest rate or liquidity typical gaps

A limit framework

How can limits help?

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• To include the interest result of derivatives in the P&L, hedge accounting is necessary => significant burden to accounting and risk management

• Using swaps, additional basis risk arises:

– Swaps are valued using OIS-discounting and are subject to CVA/DVA

– On-balance sheet items typically use single curve approach (swap + spread)

• IRRBB’s outlier criterion requires valuation at swap: high margins on long-term products (great!) quickly result in violation of outlier criterion

• BCBS proposed combined EVE and earnings sensitivity measure, mixing apples and pears… what are we steering on?

To wrap up:

Some complications to make life ‘easier’… ?

Concluding:

• IRRBB may not be such a straightforward topic after all…

• Still quite some developments, and publicity, expected on this in the next years!

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Appendix A: Result in terms of sensitivities (swap + spread)…

Business book Notional Market value MV@swap Delta Duration

Cash 100 100 100 0.00 0.0

Commercial loan (floating rate, 1 year) 300 300 302 0.03 1.0

Residential mortgage (fixed rate, 30 years) 600 600 671 0.65 10.9

Mortgage swap (float) 600 600 600 0.06 1.0

Mortgage swap (fixed) -600 -600 -600 -0.72 12.0

Total assets 1000 1000 1,073 0.02 0.2

Client deposits -700 -700 -691 -0.18 2.6

Client deposit swaps (fixed) 700 700 700 0.18 2.6

Client deposit swaps (float) -700 -700 -700 -0.07 1.0

Capital market funding (floating rate, 1 year) -220 -220 -222 -0.02 1.0

Total liabilities -920 -920 -913 -0.09 1.0

Equity after Treasury swaps -80 -80 -160 0.07 -8.9

Treasury book Notional Market value MV@swap Delta Duration

Mortgage swap (float), opposite position -600 -600 -600 -0.06 -1.0

Mortgage swap (fixed) , opposite position 600 600 600 0.72 -12.0

Client deposit swaps (fixed), opposite position -700 -700 -700 -0.18 -2.6

Client deposit swaps (float), opposite position 700 700 700 0.07 -1.0

External positions (if fully matched) … … … -0.55 …

Total 0 0 0 0

Equity after Treasury & mismatch swaps -80 -80 -160 -0.02 3.0

Mismatch book Notional Market value MV@swap Delta Duration

Strategic mismatch swap (float) -116 -116 -116 -0.01 1.0

Strategic mismatch swap (fixed) 116 116 116 0.10 9.2

Total 0 0 0 0.10

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Appendix B: Result in terms of earnings…

Business Notional 2 3 4 5 2 3 4 5

Cash 100 0 0 0 0 1 1 1 1

Commercial loan, floating rate 1 yr 300 4 4 4 4 10 10 10 10

Residential mortgage, fixed rate 30 yr 600 15 14 13 12 15 14 13 12

Interest income 18 17 17 16 26 25 24 23

Client deposits -700 -4 -4 -1 -1 -9 -7 -4 -1

Capital market funding, floating rate 1 yr -220 -4 -4 -4 -4 -8 -8 -8 -8

Interest expense -8 -8 -4 -4 -17 -15 -11 -9

Net interest income, unhedged 11 10 12 11 8 10 13 14

Business swaps

Mortgage swap (float) 600 3 3 3 3 15 14 13 12

Mortgage swap (fixed) -600 -9 -8 -8 -7 -9 -8 -8 -7

Client deposit swaps (fixed) 700 6 6 1 1 6 6 1 1

Client deposit swaps (float) -700 -2 -2 0 0 -9 -9 -2 -2

Net interest income, business swaps -2 -2 -4 -4 2 2 4 4

Mismatch book (hedging EVE at swap + spread)

Strategic mismatch swap (float) -116 -1 -1 -1 -1 -3 -3 -3 -3

Strategic mismatch swap (fixed) 116 2 2 2 2 2 2 2 2

Net interest income, fully hedged 10 9 9 9 9 11 16 17

Shift -100 bp Shift +100 bp