1. The Regulator expects that an Authorised Person's strategy towards Non-Trading Book interest rate risk will set out the approach that the Authorised Person will take towards management of the risk, including various quantitative and qualitative targets. It should be communicated to all relevant functions and staff within the organisation and be set out in the Authorised Person's Non-Trading Book interest rate risk policy.
2. The Regulator expects that an Authorised Person's framework for managing Non-Trading Book interest rate risk will address the following:
a. the Non-Trading Book interest rate risk management framework should be integrated into the Authorised Person's enterprise-wide risk management framework, including but not limited to. integration with its daily risk management practices;
b. the output of the risk measurement system which forms part of the Non-Trading Book interest rate risk management framework should be used in reporting the level of that risk to the senior management and Governing Body of the Authorised Person;
c. the measurement system should be capable of measuring the risk under the earnings approach. Depending on the scale and complexity of Non-Trading Book structure, the Authorised Person may also need to measure the risk based on economic value approach;
d. an Authorised Person's Non-Trading Book interest rate risk measurement system should be clearly defined and consistent with the nature and complexity of its balance sheet structure;
e. the processes, procedures and limits should be clearly documented and should reflect a consideration of the interest rate risk associated with the balance sheet structure of the Authorised Person, considering various asset and liability positions. These processes, procedures and limits should be reviewed and approved by appropriate levels of senior management;
f. the framework should involve an accurate, informative and timely management system for interest rate risk, which is essential to keep the senior management and the Governing Body of the Authorised Person adequately informed to enable them to ensure compliance with the Non-Trading Book interest rate risk policy of the Authorised Person; and
g. the Non-Trading Book interest rate risk framework should include measures to consider balancing cash flows and management of the risk's impact from new products or services through hedging using swaps or other Derivatives. Any such major hedging or risk management initiatives should be approved in advance by the Asset Liability Committee (ALCO) or the Governing Body of the Authorised Person.
3. The Non-Trading Book interest rate risk measurement systems referred to in Rule 7.4.1
(2)(c) should encompass all material drivers of the risk. Such systems should evaluate the effect of rate changes on earnings or economic value meaningfully and accurately within the context and complexity of their activities. They should be able to flag any excessive Exposures. An effective risk measurement system should address the following:
a. evaluate all significant interest rate risk arising from the full range of an Authorised Person's assets, liabilities and off-balance sheet positions, both trading and non-trading;
b. ensure that an integrated view of interest rate risk across products and business lines is available to management, particularly when different measurement systems and methods are used across different business lines;
c. employ generally accepted financial models and ways of measuring risk; and
d. ensure accurate and timely data on all aspects related to current positions.
4. Authorised Persons should measure their vulnerability to loss in stressed market conditions, including the breakdown of key assumptions, and consider those results when establishing and reviewing their policies and limits for interest rate risk. Possible stress scenarios for this exercise should include:
a. historical scenarios;
b. changes in the general level of interest rates, e.g. changes in yields of 200 basis points or more in one year;
c. changes in the relationships between key market rates (i.e. basis risk), e.g.
i. a surge in term and savings Deposit rates and benchmark rates but no change in the prime rate, and
ii. a drop in the prime rate but no change in term and savings Deposit rates and benchmark rates;
d. changes in interest rates in individual time bands to different relative levels (i.e. yield curve risk);
e. changes in the liquidity of key financial markets or changes in the volatility of market rates; and
f. changes in key business assumptions and parameters such as the correlation between two currencies. In particular, changes in assumptions used for illiquid instruments and instruments with uncertain contractual maturities help understanding of an Authorised Person's risk profile.
5. An Authorised Person should consider the standards for stress testing recommended in the paper published in July 2004 by the BCBS — Principles for management and supervision of interest rate risk — in developing the stress testing scenarios. In particular, an Authorised Person should include the technical specifications of a standardised interest rate shock detailed in Annex 3 of that paper.