2. The supervisory capital requirements established by the Basle Committee will, as from the end of 1997, cover interest rate risk in the trading activities of banks. This paper is intended to set out principles of more general application for the management of interest rate risk, independent of whether the positions are part of the trading book or reflect banks' non-trading activities. It refers to an interest rate risk management process, which includes the development of a business strategy, the assumption of assets and liabilities in banking and trading activities, as well as a system of internal controls. In particular, the paper addresses the need for effective interest rate risk measurement, monitoring and control functions within the interest rate risk management process.

3. In developing these principles, the Committee has drawn not only on supervisory guidance in member countries but also on the comments of the banking industry on the Committee's earlier paper, issued for consultation in April 1993 as well as comments received on the draft of this paper issued for consultation in January 1997. In addition, the present paper incorporates many of the principles contained in the guidance issued by the Committee for derivatives activities, which are reflected in the qualitative parameters for model-users in the recently published capital standards for market risk.

4. These principles are intended to be of general application, based as they are on practices currently used by many international banks, even though their specific application will depend to some extent on the complexity and range of activities undertaken by individual banks. Supervisory authorities should, therefore, use them to re-assess their own supervisory methods and procedures for monitoring how banks control interest rate risk. While the exact approach chosen by individual supervisors will depend upon a host of factors, including their on-site and off-site supervisory techniques and the degree to which external auditors are also used in the supervisory function, all members of the Basle Committee agree that the principles set out here should be used in evaluating the adequacy and effectiveness of a bank's interest rate risk management.

5. The Basle Committee is also distributing this paper to supervisory authorities worldwide in the belief that the principles presented will provide a useful framework for prudent supervision of interest rate risk. More generally, the Committee wishes to emphasise that sound risk management practices are essential to the prudent operation of banks and to promoting stability in the financial system as a whole.

6. This paper also provides supervisory authorities with a framework for obtaining information on interest rate risk. It broadly describes the types of basic information that should be available to supervisory authorities to help them in evaluating banks' interest rate risk exposures. This information can be used in a variety of ways by supervisory authorities to provide quantitative assessments of the interest rate risk faced by banks.

7. After careful consideration of the comments received, the Committee has set out principles for sound interest rate risk management, rather than establishing a more standardised measure for interest rate risk. The Committee will, however, keep the need for such more standardised measures under review and may, at a later stage, revisit its approach in this area. In that context, the Committee is aware that industry techniques for measuring and managing interest rate risk are continuing to evolve, particularly for products with uncertain cash flows or repricing dates, such as many mortgage-related products and retail deposits.

8. Even though the Committee is not currently proposing capital charges specifically for interest rate risk, all banks should have enough capital to support the risks they incur, including those arising from interest rate risk. Individual supervisors may, of course, decide to apply capital charges to their banking system in general or to individual banks that are more extensively exposed to interest rate risk, or whose risk management processes are unsatisfactory.

9. The Committee stipulates in the five sections III to VII of the paper the following eleven principles for banking supervisory authorities to apply in assessing banks' management of interest rate risk:

The role of the board and senior management

Principle 1:

In order to carry out its responsibilities, the board of directors in a bank should approve strategies and policies with respect to interest rate risk management and ensure that senior management takes the steps necessary to monitor and control these risks. The board of directors should be informed regularly of the interest rate risk exposure of the bank in order to assess the monitoring and controlling of such risk.

Principle 2:

Senior management must ensure that the structure of the bank's business and the level of interest rate risk it assumes are effectively managed, that appropriate policies and procedures are established to control and limit these risks, and that resources are available for evaluating and controlling interest rate risk.

Principle 3:

Banks should clearly define the individuals and/or committees responsible for managing interest rate risk and should ensure that there is adequate separation of duties in key elements of the risk management process to avoid potential conflicts of interest. Banks should have risk measurement, monitoring and control functions with clearly defined duties that are sufficiently independent from position-taking functions of the bank and which report risk exposures directly to senior management and the board of directors. Larger or more complex banks should have a designated independent unit responsible for the design and administration of the bank's interest rate risk measurement, monitoring and control functions.

Policies and procedures

Principle 4:

It is essential that banks' interest rate risk policies and procedures be clearly defined and consistent with the nature and complexity of their activities. These policies should be applied on a consolidated basis and, as appropriate, at the level of individual affiliates, especially when recognising legal distinctions and possible obstacles to cash movements among affiliates.

Principle 5:

It is important that banks identify the risks inherent in new products and activities and ensure these are subject to adequate procedures and controls before being introduced or undertaken. Major hedging or risk management initiatives should be approved in advance by the board or its appropriate delegated committee.

Measurement and monitoring system

Principle 6:

It is essential that banks have interest rate risk measurement systems that capture all material sources of interest rate risk and that assess the effect of interest rate changes in ways that are consistent with the scope of their activities. The assumptions underlying the system should be clearly understood by risk managers and bank management.

Principle 7:

Banks must establish and enforce operating limits and other practices that maintain exposures within levels consistent with their internal policies.

Principle 8:

Banks should measure their vulnerability to loss under stressful market conditions - including the breakdown of key assumptions - and consider those results when establishing and reviewing their policies and limits for interest rate risk.

Principle 9:

Banks must have adequate information systems for measuring, monitoring, controlling and reporting interest rate exposures. Reports must be provided on a timely basis to the bank's board of directors, senior management and, where appropriate, individual business line managers.

Internal controls

Principle 10:

Banks must have an adequate system of internal controls over their interest rate risk management process. A fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that appropriate revisions or enhancements to internal controls are made. The results of such reviews should be available to the relevant supervisory authorities.

Information for supervisory authorities

Principle 11:

Supervisory authorities should obtain from banks sufficient and timely information with which to evaluate their level of interest rate risk. This information should take appropriate account of the range of maturities and currencies in each bank's portfolio, including off-balance sheet items, as well as other relevant factors, such as the distinction between trading and non-trading activities.