www.pwc.

ch

Implementing BCBS
368 (Interest Rate Risk
in the Banking Book) in
Switzerland
Your contacts at PwC

Andrea Martin Schnoz

Director, Assurance
[email protected]
+41 58 792 23 35

Dr. Manuel Plattner

Director, Advisory
[email protected]
+41 58 792 24 44

Philip van Hövell

Senior Manager,
Data Analytics & Modeling The Basel Committee on Banking Supervision (BCBS)
[email protected] finalised its Pillar 2 capital framework for Interest Rate
+41 58 792 10 76 Risk in the Banking Book (IRRBB) in April 2016. The new
Dr. Sebastian Gerigk framework replaces its previous version from 2004 and
Senior Manager, Advisory sets out nine principles for banks and three principles for
[email protected] supervisors for the management and supervision of IRRBB.
+41 58 792 29 46
The key upgrades triggered by the financial crisis and
the following long period of low interest rates can be
summarised below.

IRRBB process Enhanced guidance on the expectations around a bank’s

IRRBB process: models used, shock and stress scenarios,
key behavioural assumptions and validation processes for
the internal measurement systems
Credit spread risk Banks need to monitor and assess CSRBB in the IRRBB
in the banking book management framework. CSRBB is defined as spread
(CSRBB) risk of credit-risky instruments which is not explained by
IRRBB, nor by the expected credit/jump-to-default risk
Disclosures More comprehensive and standardised disclosures
promote consistency, transparency and comparability,
including a quantitative reporting based on a set of
common interest rate shock scenarios
Outlier banks A tighter 15% threshold applied to the sensitivity of
interest rate shocks to Tier 1 capital (previously 20%)
Supervisory process Elements that supervisors should consider when assessing
the bank’s level and management of IRRBB exposures
 Basel Committee principles on
IRRBB for banks
1. IRRBB elements
IRRBB must be identified, measured, monitored and
controlled. In addition, banks should monitor and assess
CSRBB.

2. Governing body
The governing body of each bank is responsible for
oversight of the IRRBB management framework,
and the bank’s risk appetite for IRRBB. Monitoring
and management of IRRBB may be delegated by the
governing body to delegates. Banks must havean
adequate IRRBB management framework, involving
regular independent reviews and evaluations of the
effectiveness of the system.

3. Risk appetite
Banks’ risk appetite for IRRBB should be articulated in
terms of the risk to both economic value and earnings.
Banks must implement policy limits that target
maintaining IRRBB exposures consistent with their risk
appetite.

4. IRRBB measurement
Measurement of IRRBB should be based on outcome
of both economic value and earning-based measures,
arising from a wide and appropriate range of interest rate
shock and stress scenarios.

FINMA implementation of IRRBB 5. Assumptions

In measuring IRRBB, key behavioural and modelling
FINMA proposed in a consultation in Q4 2017 to adapt the Basel
assumptions should be fully understood, conceptually
IRRBB by 1 January 2019 whereby the relevant FINMA Circular
sound and documented. Such assumptions should be
is yet to be finalised (refer to the appendix for an unofficial
rigorously tested and aligned with the bank’s business
translation).
strategies.
The following points are important:
6. Measurement and model validation
• FINMA decided not to require by default the Basel Committee Measurement systems and models used for IRRBB
optional standardised approach which will have come with should be based on accurate data, and subject to
some relief for banks appropriate documentation, testing and controls to give
• Instead, to promote market discipline, FINMA requires public assurance on the accuracy of calculations. Models used
disclosures that go beyond the requirements of the Basel to measure IRRBB should be comprehensive and covered
Committee. These relate to repricing dates by position types by governance processes for model risk management,
which banks will have to disclose in a separate table. The new including a validation function that is independent of the
annual disclosures will be required from 1 January 2019, i.e. development process.
will be effective 31 December 2019 for most banks
7. Internal Reporting
• FINMA also upgraded the SNB/FINMA Interest Rate Risk Measurement outcomes of IRRBB and hedging strategies
Report which is required from stand-alone banks (quarterly) should be reported to the governing body or its delegates
and consolidated banks (semi-annually). Branches of foreign on a regular basis, at relevant levels of aggregation (by
banks are excluded. The implementation date of the new form consolidation level and currency).
is 31 March 2019
8. External disclosures
• In adapting the Basel Committee principles 10 to 12, FINMA Information on the level of IRRBB exposure and practices
will require additional information from outlier banks and for measuring and controlling IRRBB must be disclosed
may impose additional capital requirements should the specific on a regular basis.
circumstances require such measures. For the assessment of
banks’ IRRBB approaches, FINMA will in principle rely on 9. Capital adequacy
the work of the external auditors but will also continue with Capital adequacy for IRRBB must be specifically
on-site audits considered as part of the Internal Capital Adequacy
Assessment Process (ICAAP) approved by the governing
body.
Action points
All banks In that latter context, banks should participate in the dry run
We would expect that principles 1 to 7 around the governance FINMA will offer for 31 March 2018 to test the new quarterly
and expectations on the identification, measurement, reporting requirements and calculate the standardised EVE and
monitoring, control and management of IRRBB are in some NII sensitivities in advance of the go-live in 2019. This will allow
form already in place at many banks in Switzerland. This also banks to compare the new standardised sensitivities to their
applies to principle 9 concerning the internal capital adequacy existing ALM framework and take any necessary action (to be no
assessment processes (ICAAP) for IRRBB. This is consistent with outlier) on a timely basis.
the comments made by FINMA in its consultative report. For the standardised EVE calculations, banks will need to assess
Banks will nevertheless need to perform a gap analysis and whether they continue to discount cash flows with risk-free
then adapt the new framework in their asset and liability rates which could push them towards an outlier or whether they
management processes. This will include incorporating the new would invest in a model that allows them to discount future cash
IRRBB principles into policies and procedures, upgrading ALM flows with rates that include a commercial margin.
and validation tools, reassessing assumptions and revising the Finally, banks should rethink their existing deposit
internal governance, reporting and escalation of market events characterisation when the country enters a rising interest rate
and movements in sensitivities. environment after nearly a decade of low or negative interest
Importantly, for principle 8, “public disclosures”, all banks will rates. The currently used replication factors may have been
be required to implement the revised regulatory reporting on calibrated during a time when most banks were overwhelmed
interest rate risks and the standardised EVE (Economic Value of with deposits, which are the main source of funding for many
Equity) and NII (Net Interest Income) calculations which will be banks.
subject to annual disclosure requirements. It is difficult to predict though how quickly money will leave the
The key reform costs will arise from the implementation of the balance sheets of banks once higher returns will be available
standardised and possibly additional internal EVE scenario elsewhere. For that purpose banks will require well-designed
calculations and the implementation of the revised SNB/FINMA “what if” scenarios to make good decisions in an environment of
Interest Rate Risk Report. increasing interest rates.
Category 4 to 5 banks (small banks) primarily driven by the procedures, models and IT systems
The steps that FINMA envisions to make IRRBB more employed by smaller banks as opposed to their general interest
proportional for category 4 and 5 banks only impact a certain rate risk profiles.
number of principles. This means that smaller banks still have
Specifically, the potential exclusions for category 4 and
to implement the vast majority of the IRRBB framework. This
5 banks are:
demonstrates the motivation of FINMA that the exclusions are

Principles Exclusions Implications

Shock scenarios If a bank can demonstrate that the standardised Only the six prescribed interest rate
(principle 4) prescribed interest rate shocks are commensurate for their shock scenarios and any additional
interest rate risk profile, the following scenarios are not interest rate shock scenarios that FINMA
required: may require.
• Internally selected interest rate shocks addressing the Unless required by FINMA, no scenarios
bank’s risk profile, according to its ICAAP of negative interest rates will have to be
• Historical and hypothetical interest rate stress considered.
scenarios, which tend to be more severe than shocks
Additionally, no qualitative and quantitative reverse stress
tests are required. These address tail risks by starting from
a known stress test outcome and then asking what events
could lead to such an outcome for the financial institution.
Behavioural and If a bank can demonstrate that behavioural and modelling Instead, assumptions will have to be
modelling assumptions assumptions have not changed significantly, no annual reviewed at least every three years.
(principle 5) review of such assumptions is required.
Data integrity and The validation of data, measurement, models and Validation is only required based on
validation (principle 6) parameters can be implemented in a simplified manner. significant changes, at the minimum
every three years.
IRRBB exposures and For Economic Value of Equity (EVE) calculations, cash Considerable simplification even though
disclosures (principle 8) flows can be discounted with a risk-free rate regardless using risk-free rates without commercial
of whether commercial margins are included in the cash margins will lead to higher EVE
flows in the first place. sensitivities.
Capital adequacy The factors provided to assess the capital adequacy are Instead, category 4 and 5 banks will
(ICAAP) (principle 9) not applicable. assess the capital adequacy for their
IRRBB with simpler measures such as the
size of interest income relative to overall
income.

How PwC can help

• Identify banking book on- and off-balance-sheet • Provide interest rate related accounting assistance to
interest rate risk exposures, establish behavioural address derivative accounting issues and compliance
assumptions and conduct behavioural model requirements
validations • Assess independence and governance controls,
• Design and implement IRRBB stress testing assist in developing IRRBB policies, processes and
methodologies including the required base scenarios procedures
• Implement hedging strategies by identifying • Evaluate IRRBB risk appetite, tolerances, capital
appropriate instruments and strategies considering allocations and monitor capital adequacy (ICAAP)
risk tolerance and costs/benefits • BCBS 368 gap analysis, pre-audits and project
• Design and validate interest rate derivative support in FINMA dry runs
valuations and modelling assumptions

© 2018 PwC. All rights reserved. “PwC” refers to PricewaterhouseCoopers AG, which is a member firm of PricewaterhouseCoopers International Limited,
each member firm of which is a separate legal entity.
Appendix: Unofficial translation of
consultative FINMA documents
Draft Circular 2018/xx interest rate risks – banks
Measurement, management, monitoring and control of interest
rate risks in the banking book

Reference: FINMA circ. 18/xx “Interest rate risks – banks”

Issued: ...
Entry into force: 1 January 2019
Concordance: Previously FINMA circ. 08/6 “Interest rate risks – banks”, dated 20 November 2008
Legal basis: FINMASA art. 7 para. 1 lit. b, 29 para. 1
BankA art. 4
BankO art. 12 SESTO art. 19
CAO art. 45, 96
Appendix: Outlier banks: identification, assessment and actions

Addressees
X Banks
X Financial groups and congl. BankA
Other intermediaries
Insurers
Insurance groups and congl. IOA
Intermediaries
X Securities traders SESTA
Trading platforms
Central clearing houses
Central securities depositories
FMIA
Trade repository
Payment systems
Participants:
Fund mgmt co.
SICAV
Limited partnerships for CIS
SICAF
Custodian banks CISA
CIS asset managers
Distributors
Foreign reps. of CIS
Other intermediaries
SRO
DSFI AMLA
SRO-supervised institutions
Audit firms
Others
Rating agencies
Table of contents

I Subject, scope of application mn 1-4

II Basel Committee minimum standards mn 5-7

III Fundamentals mn 8-15

IV Principles mn 16-48

A Principle 1: Interest rate risk management mn 16

B Principle 2: Governing body mn 17-18
C Principle 3: Risk tolerance mn 19
D Principle 4: Internal interest rate risk measurement system mn 20-32
E Principle 5: Modelling assumptions mn 33-34
F Principle 6: Data integrity and validation mn 35-38
G Principle 7: Reporting mn 39-40
H Principle 8: Disclosure mn 41
I Principle 9: Internal risk capacity mn 42-48

V Data collection and data assessment mn 49-50

I. Subject, scope of application 3. Option risk arises from options or from optional elements
embedded in a bank’s assets, liabilities and/or off-balance
This circular describes the minimum standards for the sheet items, where the bank or its customer can alter the
measurement, management, monitoring and control of level and timing of their cash flows (e.g. deposits without
interest rate risks in the banking book and provides more fixed maturity, term deposits or fixed-rate loans).
details regarding art. 12 of the Banking Ordinance (BankO;
SR 952.02), art. 19 of the Stock Exchange Ordinance (SESTO; [IRRBB§10] Changes in interest rates can lead indirectly to
SR 954.11) as well as art. 45 and 96 of the Capital Adequacy changes in credit worthiness (solvency effect)3 without a jump
Ordinance (CAO; SR 952.03). It contains specifications relating to default.
to FINMA circular 2017/1 “Corporate governance – banks”. The principles of the present circular are to be applied
The scope of application of this circular comprises all positions depending on the size of the bank as well as the type, scope,
that do not fulfil the provisions of art. 5 CAO (trading book). A complexity and riskiness of the business activities (principle of
holistic consideration of all interest rate risks, both inside and proportionality). Small banks according to mn 15 are exempted
outside the trading book, must still be performed on at least a from implementing certain margin numbers of the present
periodic basis. circular.
The measurement, management, monitoring and control of Category 4 and 5 banks according to Annex 3 BankO are
interest rate risks in the banking book has to be performed at the classified as “small banks” for the purposes of the present
level of the individual institution and on a consolidated (group) circular. FINMA is authorised to relax or tighten the rules in
basis. If the interest rate risks in the banking book undertaken individual cases.
by the banking or financial organisations controlled by the bank
are immaterial, individually or in aggregate, in relation to those IV. Principles
undertaken by the bank itself, they may be excluded from the
consolidated approach with the consent of the external auditor. A. Principle 1: Interest rate risk management
The bank shall ensure by means of policies, limits and other [IRRBB§12–15] Banks shall identify, measure, monitor and
provisions that these entities have not undertaken any material control their interest rate risks in a timely and comprehensive
interest rate risks in the banking book. manner. In doing so, solvency effects must also be taken into
consideration.
The present circular does not apply to securities dealers that
do not have a banking licence provided they do not undertake B. Principle 2: Governing body
material interest rate risks outside the trading book. The [IRRBB§16–27] The governing body or its delegates are
external auditor shall confirm this is so. responsible for the oversight and approval of an appropriate
framework relating to interest rate risks and for establishing the
risk tolerances for interest rate risks.
II.Basel Committee minimum standards
[IRRBB§17] The governing body or its delegates establish
The present circular is based on the Basel Committee’s minimum requirements for the measurement, monitoring and control of
standards for interest rate risks in the banking book: interest rate risks consistent with the approved strategies and
• “Interest rate risk in the banking book” of April 2016 policies. This includes provisions relating to interest rate shock
(IRRBB)1 and stress scenarios.
In the following descriptions, references to the text of the Basel C. Principle 3: Risk tolerance
standards are enclosed in square brackets. [IRRBB§29–31] The risk tolerance relating to interest rate risks
has to be formulated for the economic value approach and
the earnings-based approach. In doing so, appropriate limits
III. Fundamentals shall be set that are based on risk tolerance in relation to the
[IRRBB§8] Interest rate risk in the banking book2 is the risk short-term and long-term impacts of interest rate movements
to the bank’s capital and earnings arising from movements in and meaningful shock and stress situations. In order to limit
interest rates. Changes in interest rates affect the economic maturity transformation, limits may also be formulated for the
value of a bank’s assets, liabilities and off-balance-sheet items earnings-based approach.
(economic value approach). They also affect earnings from D. Principle 4: Internal interest rate risk
interest rate operations (earnings-based approach). measurement system
[IRRBB§9] Interest rate risks can take three forms: The measurement of interest rate risk is based on a broad and
appropriate range of interest rate shock and stress scenarios.
1. Gap risk arises from the term structure or differences in the
timing of rate changes of assets, liabilities and off-balance- [IRRBB§35] The internal interest rate risk measurement system
sheet items. considers the following scenarios:
2. Basis risk describes the impact of relative changes in interest • Internally selected interest rate shock scenarios that address
rates for financial instruments that have similar tenors but appropriately the bank’s risk profile;
are priced using different interest rates. • Historical and hypothetical interest rate stress scenarios,
which tend to be more severe than the scenarios as per
mn 22;

1
The IRRBB standards of the Basel Committee on Banking Supervision can be downloaded at: www.bis.org > Committees & associations > Basel Committee on Banking
Supervision > Publications > Interest rate risk in the banking book.
2
In the following, the term “interest rate risks” is used.
3
The credit spread risk in the banking book.
• The six interest rate shock scenarios4; and ranging from static simulations to more dynamic modelling
• Additional interest rate shock scenarios required by FINMA. techniques for the earnings-based approach.

[IRRBB§40] When developing the scenarios in accordance with [IRRBB§57] The internal interest risk measurement system must
mn 22 and 23, the relevant factors shall be considered (such as be able to compute the economic value and earnings-based risks
the currency, the shape and level of the current term structure of based on the scenarios set out in mn 22–25.
interest rates and the historical and implied volatility of interest Small banks, as defined by mn 15, can choose an appropriate,
rates). In low interest rate environments, banks should also simplified implementation for data validation, interest rate risk
consider negative interest rate scenarios and their effects on measurement systems, models and parameters according to mn
assets and liabilities. 35 and 37. The implementation specifically takes into account
[IRRBB§41–42] When developing interest rate shock and the simpler organisational structure of such banks (e.g. no
stress scenarios for interest rate risks, the following should be independent validation function). However, a validation has to
considered: be undertaken if significant changes occur to data, interest rate
risk measurement systems, models and parameters, and at least
• Severe and plausible interest rate shock and stress scenarios.
every three years.
• The existing level of interest rates and the interest rate
cycle as well as interest rate risk concentrations, interest G. Principle 7: Reporting
rate volatility, solvency effects, interactions with other [IRRBB§66] The governing body or its delegates are regularly
types of risk, balance sheet structure effects, changes in the informed (at least every six months) about the extent and the
accounting rules and customer terms. development of interest rate risks as well as their measurement,
management, monitoring and control.
• Hypothetical assumptions: for changes in portfolio
composition due to factors under the control of the bank as [IRRBB§67] The reports include at least the interest rate risk
well as external factors; for new products where only limited exposure (including under stress scenarios), the degree to which
historical data are available; for new market information and limits are reached and key modelling assumptions.
new emerging risks.
H. Principle 8: Disclosure
[IRRBB§43] Banks should consider interest rate risk as part [IRRBB§69-71] The disclosure requirements are based on
of qualitative and quantitative stress tests5 that assume a FINMA circular 2016/1 “Disclosure – banks”.
severe worsening of its capital and earnings in order to reveal
I. Principle 9: Internal risk capacity
vulnerabilities arising from its hedging strategies and the
[IRRBB§72, 74] In determining the level of capacity the
potential behavioural reactions of its customers. Small banks, as
institution should hold in accordance with FINMA circular
defined by mn 15, may perform qualitative stress tests only.
2011/2 “Capital buffer and capital planning – banks”, the
If a small bank, as defined by mn 15, can verifiably justify and institution includes all of the risk types relevant to it and
document that the interest rate shock scenarios according to mn demonstrates, if relevant, that it holds adequate risk capital for
24 and 25 are appropriate for the interest rate risks undertaken, the interest rate risk according to mn 8.
it may limit itself to these; in such cases, mn 22–23 and 26–30
[IRRBB§73] The appropriate level of risk capital is not based
do not apply.
exclusively on the results of FINMA’s quantitative evaluation
E. Principle 5: Modelling assumptions process to identify potentially unduly high interest rate risks.
[IRRBB§46–51] The key behavioural and other modelling
[IRRBB§75–76] The capital adequacy assessments should
assumptions used to measure interest rate risks are conceptually
give appropriate consideration to the factors relevant to the
sound and reasonable, and consistent with historical experience.
institution and specifically:
The key modelling assumptions and their impact on interest
rate risk shall be reviewed at least annually and matched to the • the limits and whether these limits are reached;
bank’s business strategies. • the effectiveness and expected cost of hedging measures; and
Smaller banks, as defined by mn 15, are exempted from a • the allocation of capital relative to risks across the (legal)
minimum annual review of the modelling assumptions and their organisational entities.
impact if it can verifiably justify and document that the business Mn 44 does not apply to small banks, as defined by mn 15.
model, the client and product structure, the market conditions
and other factors relevant to the modelling assumptions have
not changed significantly. The modelling assumptions and their V. Data collection and data assessment
impact must be reviewed every three years, however.
[IRRBB§77–79, Principle 10] With the exception of branches of
F. Principle 6: Data integrity and validation foreign banks, banks submit to FINMA, on a regular basis and
[IRRBB§52–65] Interest rate risk measurement systems and by means of a form specified by FINMA, information on their
models used for interest rate risks shall be based on accurate interest rate risks at both the level of the individual institution
data and appropriately documented, tested and controlled. and a consolidated (group) level.
They should form part of a risk framework and be subject to an
[IRRBB§88–95, Principle 12] The criteria for the definition and
independent and adequately documented validation.
treatment of outlier banks, which FINMA applies during its
[IRRBB§52–54] A variety of methodologies shall be used under assessment, are described in Annex 1.
both the economic value and earnings-based approaches,

4
www.bis.org > Committees & associations > Basel Committee on Banking Supervision > Publications > Interest rate risk in the banking book > Annex 2
5
So-called reverse stress tests in accordance with Principle 9 of the “Principles of sound stress testing practices and supervision”, published by the Basel Committee in May
2009. They can be downloaded at www.bis.org > Committees & associations > Basel Committee on Banking Supervision > Principles for sound stress testing practices
and supervision.
Draft FINMA annex to Circular 2018/xx
Outlier banks: Identification, assessment and actions

I. Identification of institutions with potentially • Assumptions and parameters relating to margin payments
and other spread components based on credit rating; to
unduly high interest rate risks in the banking
deposits without fixed maturity; to the allocation of capital
book or inadequate interest rate risk to risk types and entities; and to anticipated repayments or
management (outlier banks) withdrawals.
[IRRBB§88-95] FINMA identifies outlier banks in accordance • With regard to the earnings situation, the size and stability
with mn 2 and 5 of this annex. of the earnings and their influence on the future business
activities, including dividend payments, will be assessed.
Criteria for the identification of potentially unduly high interest
rate risks:
III. Actions
• The change in the economic value of equity (based on
payment flows according to the data collected as per mn If FINMA’s assessment of outlier banks identifies in some cases
49 of the present circular) under at least one of the interest that interest rate risk management is inadequate or that the
rate shock scenarios (as per mn 24 of the present circular) interest rate risk is inappropriate in relation to the capital
amounts to at least 15% of its Tier 1 capital. (taking into account the adequacy target level according to
FINMA circ. 2011/2 “Capital buffer and capital planning –
• The amount of the change in the economic value of equity banks”), to the earnings or to the risk capacity (taking into
(according to mn 3) calculated by applying the reporting account all of the risks), FINMA can require additional capital to
institution’s assumptions as well as market-conform be held (in accordance with art. 45 CAO) or other actions to be
assumptions (for comparison purposes). taken.
• Criteria to identify inadequate interest rate risk management: The measures in accordance with mn 13 specifically comprise
• Deficiencies relating to compliance with Principles 1 to 9. the following: reducing the interest rate risks, limiting
the assumptions or parameters of the internal interest
rate risk measurement system, improving the interest rate
II. Assessment of outlier banks risk framework or replacing the internal interest rate risk
FINMA assesses outlier banks individually. measurement system by the standardised framework of the
Basel Committee standards for interest rate risk in the banking
FINMA assesses outlier banks on a case-by-case basis, applying book in accordance with mn 6 of this circular
the following criteria: [IRRBB§100- 132].
• Capital adequacy in relation to the interest rate risks and the
earnings position.
• Responsiveness to interest rate shocks and stress scenarios.
In doing so, the impacts on financial assets stated at market
value and the potential impacts of the revaluation of financial
assets stated at amortised acquisition costs are considered.