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.

In general, but depending on the complexity and range of activities of the individual bank, banks should have interest rate risk measurement systems that assess the effects of rate changes on both earnings and economic value. These systems should provide meaningful measures of a bank's current levels of interest rate risk exposure, and should be capable of identifying any excessive exposures that might arise.

1.Measurement systems should:

• assess all material interest rate risk associated with a bank's assets, liabilities, and OBS positions;
• utilise generally accepted financial concepts and risk measurement techniques; and
• have well documented assumptions and parameters.

2. As a general rule, it is desirable for any measurement system to incorporate interest rate risk exposures arising from the full scope of a bank's activities, including both trading and non-trading sources. This does not preclude different measurement systems and risk management approaches being used for different activities; however, management should have an integrated view of interest rate risk across products and business lines.

3. A bank's interest rate risk measurement system should address all material sources of interest rate risk including repricing, yield curve, basis and option risk exposures. In many cases, the interest rate characteristics of a bank's largest holdings will dominate its aggregate risk profile. While all of a bank's holdings should receive appropriate treatment, measurement systems should evaluate such concentrations with particular rigour. Interest rate risk measurement systems should also provide rigorous treatment of those instruments which might significantly affect a bank's aggregate position, even if they do not represent a major concentration. Instruments with significant embedded or explicit option characteristics should receive special attention.

4. A number of techniques are available for measuring the interest rate risk exposure of both earnings and economic value. Their complexity ranges from simple calculations to static simulations using current holdings to highly sophisticated dynamic modelling techniques that reflect potential future business and business decisions.

5. The simplest techniques for measuring a bank's interest rate risk exposure begin with a maturity/repricing schedule that distributes interest-sensitive assets, liabilities and OBS positions into "time bands" according to their maturity (if fixed rate) or time remaining to their next repricing (if floating rate). These schedules can be used to generate simple indicators of the interest rate risk sensitivity of both earnings and economic value to changing interest rates. When this approach is used to assess the interest rate risk of current earnings, it is typically referred to as gap analysis. The size of the gap for a given time band - that is, assets minus liabilities plus OBS exposures that reprice or mature within that time band - gives an indication of the bank's repricing risk exposure.

6. A maturity/repricing schedule can also be used to evaluate the effects of changing interest rates on a bank's economic value by applying sensitivity weights to each time band. Typically, such weights are based on estimates of the duration of the assets and liabilities that fall into each time-band, where duration is a measure of the percent change in the economic value of a position that will occur given a small change in the level of interest rates. Duration-based weights can be used in combination with a maturity/repricing schedule to provide a rough approximation of the change in a bank's economic value that would occur given a particular set of changes in market interest rates.

7. Many banks (especially those using complex financial instruments or otherwise having complex risk profiles) employ more sophisticated interest rate risk measurement systems than those based on simple maturity/repricing schedules. These simulation techniques typically involve detailed assessments of the potential effects of changes in interest rates on earnings and economic value by simulating the future path of interest rates and their impact on cash flows. In static simulations, the cash flows arising solely from the bank's current on- and off-balance sheet positions are assessed. In a dynamic simulation approach, the simulation builds in more detailed assumptions about the future course of interest rates and expected changes in a bank's business activity over that time. These more sophisticated techniques allow for dynamic interaction of payments streams and interest rates, and better capture the effect of embedded or explicit options.

8. Regardless of the measurement system, the usefulness of each technique depends on the validity of the underlying assumptions and the accuracy of the basic methodologies used to model interest rate risk exposure. In designing interest rate risk measurement systems, banks should ensure that the degree of detail about the nature of their interest-sensitive positions is commensurate with the complexity and risk inherent in those positions. For instance, using gap analysis, the precision of interest rate risk measurement depends in part on the number of time bands into which positions are aggregated. Clearly, aggregation of positions/cash flows into broad time bands implies some loss of precision. In practice, the bank must assess the significance of the potential loss of precision in determining the extent of aggregation and simplification to be built into the measurement approach.

9. Estimates of interest rate risk exposure, whether linked to earnings or economic value, utilise, in some form, forecasts of the potential course of future interest rates. For risk management purposes, banks should incorporate a change in interest rates that is sufficiently large to encompass the risks attendant to their holdings. Banks should consider the use of multiple scenarios, including potential effects in changes in the relationships among interest rates (i.e. yield curve risk and basis risk) as well as changes in the general level of interest rates. For determining probable changes in interest rates, simulation techniques could, for example, be used. Statistical analysis can also play an important role in evaluating correlation assumptions with respect to basis or yield curve risk.

10. The integrity and timeliness of data on current positions is also a key component of the risk measurement process. A bank should ensure that all material positions and cash flows, whether stemming from on- or off-balance-sheet positions, are incorporated into the measurement system on a timely basis. Where applicable, these data should include information on the coupon rates or cash flows of associated instruments and contracts. Any manual adjustments to underlying data should be clearly documented, and the nature and reasons for the adjustments should be clearly understood. In particular, any adjustments to expected cash flows for expected prepayments or early redemptions should be well reasoned and such adjustments should be available for review.

11. In assessing the results of interest rate risk measurement systems, it is important that the assumptions underlying the system be clearly understood by risk managers and bank management. In particular, techniques using sophisticated simulations should be used carefully so that they do not become "black boxes", producing numbers that have the appearance of precision, but that in fact are not very accurate when their specific assumptions and parameters are revealed. Key assumptions should be recognised by senior management and risk managers and should be re-evaluated at least annually. They should also be clearly documented and their significance understood. Assumptions used in assessing the interest rate sensitivity of complex instruments and instruments with uncertain maturities should be subject to particularly rigorous documentation and review.

12. When measuring interest rate risk exposure, two further aspects call for more specific comment: the treatment of those positions where behavioural maturity differs from contractual maturity and the treatment of positions denominated in different currencies. Positions such as savings and sight deposits may have contractual maturities or may be open-ended, but in either case, depositors generally have the option to make withdrawals at any time. In addition, banks often choose not to move rates paid on these deposits in line with changes in market rates. These factors complicate the measurement of interest rate risk exposure, since not only the value of the positions but also the timing of their cash flows can change when interest rates vary. With respect to banks' assets, prepayment features of mortgages and mortgage related instruments also introduce uncertainty about the timing of cash flows on these positions. These issues are described in more detail in Annex A, which forms an integral part of this text.

13. Banks with positions denominated in different currencies can expose themselves to interest rate risk in each of these currencies. Since yield curves vary from currency to currency, banks generally need to assess exposures in each. Banks with the necessary skills and sophistication, and with material multi-currency exposures, may choose to include in their risk measurement process methods to aggregate their exposures in different currencies using assumptions about the correlation between interest rates in different currencies. A bank that uses correlation assumptions to aggregate its risk exposures should periodically review the stability and accuracy of those assumptions. The bank also should evaluate what its potential risk exposure would be in the event that such correlations break down.

B. Limits

Principle 7:

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

1.The goal of interest rate risk management is to maintain a bank's interest rate risk exposure within self-imposed parameters over a range of possible changes in interest rates. A system of interest rate risk limits and risk taking guidelines provides the means for achieving that goal. Such a system should set boundaries for the level of interest rate risk for the bank and, where appropriate, should also provide the capability to allocate limits to individual portfolios, activities or business units. Limit systems should also ensure that positions that exceed certain predetermined levels receive prompt management attention. An appropriate limit system should enable management to control interest rate risk exposures, initiate discussion about opportunities and risks, and monitor actual risk taking against predetermined risk tolerances.

2. A bank's limits should be consistent with its overall approach to measuring interest rate risk. Aggregate interest rate risk limits clearly articulating the amount of interest rate risk acceptable to the bank should be approved by the board of directors and re-evaluated periodically. Such limits should be appropriate to the size, complexity and capital adequacy of the bank as well as its ability to measure and manage its risk. Depending on the nature of a bank's holdings and its general sophistication, limits can also be identified with individual business units, portfolios, instrument types or specific instruments. The level of detail of risk limits should reflect the characteristics of the bank's holdings including the various sources of interest rate risk to which the bank is exposed.

3. Limit exceptions should be made known to appropriate senior management without delay. There should be a clear policy as to how senior management will be informed and what action should be taken by management in such cases. Particularly important is whether limits are absolute in the sense that they should never be exceeded or whether, under specific circumstances, which should be clearly described, breaches of limits can be tolerated for a short period of time. In that context, the relative conservatism of the chosen limits may be an important factor.

4. Regardless of their level of aggregation, limits should be consistent with the bank's overall approach to measuring interest rate risk and should address the potential impact of changes in market interest rates on reported earnings and the bank's economic value of equity. From an earnings perspective, banks should explore limits on the variability of net income as well as net interest income in order to fully assess the contribution of non-interest income to the interest rate risk exposure of the bank. Such limits usually specify acceptable levels of earnings volatility under specified interest rate scenarios.

5. The form of limits for addressing the effect of rates on a bank's economic value of equity should be appropriate for the size and complexity of its underlying positions. For banks engaged in traditional banking activities and with few holdings of long-term instruments, options, instruments with embedded options, or other instruments whose value may be substantially altered given changes in market rates, relatively simple limits on the extent of such holdings may suffice. For more complex banks, however, more detailed limit systems on acceptable changes in the estimated economic value of equity of the bank may be needed.

6. Interest rate risk limits may be keyed to specific scenarios of movements in market interest rates such as an increase or decrease of a particular magnitude. The rate movements used in developing these limits should represent meaningful stress situations taking into account historic rate volatility and the time required for management to address exposures. Limits may also be based on measures derived from the underlying statistical distribution of interest rates, such as earnings at risk or economic value at risk techniques. Moreover, specified scenarios should take account of the full range of possible sources of interest rate risk to the bank including mismatch, yield curve, basis and option risks. Simple scenarios using parallel shifts in interest rates may be insufficient to identify such risks.

C. Stress Testing

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.

The risk measurement system should also support a meaningful evaluation of the effect of stressful market conditions on the bank. Stress testing should be designed to provide information on the kinds of conditions under which the bank's strategies or positions would be most vulnerable, and thus may be tailored to the risk characteristics of the bank. Possible stress scenarios might include abrupt changes in the general level of interest rates, changes in the relationships among key market rates (i.e. basis risk), changes in the slope and the shape of the yield curve (i.e. yield curve risk), changes in the liquidity of key financial markets or changes in the volatility of market rates. In addition, stress scenarios should include conditions under which key business assumptions and parameters break down. The stress testing of assumptions used for illiquid instruments and instruments with uncertain contractual maturities is particularly critical to achieving an understanding of the bank's risk profile. In conducting stress tests, special consideration should be given to instruments or markets where concentrations exist as such positions may be more difficult to liquidate or offset in stressful situations. Banks should consider "worst case" scenarios in addition to more probable events. Management and the board of directors should periodically review both the design and the results of such stress tests, and ensure that appropriate contingency plans are in place.

D. Interest Rate Risk Monitoring and Reporting

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.

1.An accurate, informative, and timely management information system is essential for managing interest rate risk exposure, both to inform management and to support compliance with board policy. Reporting of risk measures should be regular and should clearly compare current exposure to policy limits. In addition, past forecasts or risk estimates should be compared with actual results to identify any modelling shortcomings.

2. Reports detailing the interest rate risk exposure of the bank should be reviewed by the board on a regular basis. While the types of reports prepared for the board and for various levels of management will vary based on the bank's interest rate risk profile, they should, at a minimum include the following:

• summaries of the bank's aggregate exposures;
• reports demonstrating the bank's compliance with policies and limits;
• results of stress tests including those assessing breakdowns in key assumptions and parameters; and
• summaries of the findings of reviews of interest rate risk policies, procedures, and the adequacy of the interest rate risk measurement systems, including any findings of internal and external auditors and retained consultants.