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MITIGATING MARKET RISK IN BANKING AND TRADING BOOKS
UNDER EVOLVING ECONOMIC CONDITIONS
4.1 Introduction:
Market risk is the risk of loss due to a decline in market prices, which occurs due to changes
in market factors, and has the potential to harm the bank's portfolio position.
Market factors include interest rates, exchange rates, stock prices and commodity prices.
Market factors change beyond the bank's control.
Market risk can occur in both the banking book and trading book. In the trading book, the
impact of market risk directly affects profit loss. Meanwhile, in the banking book, the impact
of market risk indirectly affects the acquisition of NII (net interest income) and EVE
(Economic Value of Equity). After completing the discussion in this chapter, it is expected
that the reader will:
•
Understand the risk management process in managing trading book and banking book
risks.
•
Understand trading policies and segregation of duties principles.
•
Know the types of limits used in treasury trading activities.
•
Understand the calculation of capital requirements using the standardized approach.
•
Understand the parameters used in the Internal Model approach.
•
Understand the measurement principles and use of gap analysis in
banking book, as well as the effect on NII and EVE.
•
Knowing the sources of interest rate risk in the banking book.
•
Understand interest rate risk management strategies in the banking book.
4.1.1
Risk-related positions market:
What counts as a bank's position is its net position, including on balance sheet positions and
off balance sheet positions, which can be either long or short. A long position means that total
assets are greater than total liabilities, and earns a profit if the price or market value rises. A
short position is the opposite, earning a profit if the price or market value falls.
Portfolio position means the market value of the bank's positions in the portfolio.
Instruments in the portfolio can be of various types, both on balance sheet and off balance
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sheet, including the following.
Different kinds of risk positions have different ways of calculating the value of pa sar. For
example, a spot foreign exchange position is the face value of the position, while a forward
foreign exchange position is the cash value. (The present value of the forward corresponds to
the remaining term before the maturity of the contract. The zero coupon bond and FRA
positions are the market value of the bond and FRA positions.
To define a position, it is not always necessary to use a no-minal value. Various positions
that involve risk use different notional amounts. For example, a foreign exchange position
uses the face value of the position, while a forward FX position is the cash value of the
forward based on the remaining time to maturity. ZCB (zero coupon bond) and FRA (forward
rate agreement) positions are based on the cash value as per prevailing market factors.
4.1.1.1
Bond:
i.
Plain Vanilla Bonds
There are various types of bonds based on the type of issuer and the type of currency.
Bonds issued by local entities in local currency are called domestic bonds. In contrast,
foreign bonds are securities issued by foreign entities in the local currency (e.g. a bond
issue by the Indonesian government in US Dollars, marketed in the United States). A
Eurobond is an obligation issued outside the issuing country in the currency of the issuing
country (e.g. a bond issued by an American company in USD, marketed in Europe).
Foreign bonds and Eurobonds circulate in the international securities market.
•
Government bonds, issued by the central government or often referred to as sovereign
bonds.
•
Corporate bond, issued by a company/corporation.
Classification of securities in terms of coupon type, namely:
•
Fixed-coupon bond, where the coupon interest rate paid is fixed until the bond matures.
Interest is paid according to the agreement. Semiannual coupon bonds pay coupons
every 6 months, annual coupon bonds once a year. The principal of the bond is paid at
maturity.
•
Zero-coupon bond, no coupon payments. Bonds are sold at a discount to the interest
rate. Investment returns are derived from capital gains on the purchase price and sale
price of the bond.
•
Annuities, there are payments of a certain amount over a period of time including
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interest and amortization of principal, or gradual payments of principal.
•
Perpetual bonds, which are bonds that have no maturity date. The market value of the
bond is based on interest payments.
•
Floating-coupon bond, interest payment is based on floating/variable interest according
to the reference interest rate plus margin.
ii.
Complex Bonds
•
Callable Bonds
Callable bonds give the issuer the flexibility to repurchase the securities issued at a
specified price on a certain date before the bond matures. The purpose of the issuer
repurchasing the securities is when the cost of issuing new bonds is lower than the cost
of interest on the outstanding securities, for example when market interest rates fall or
when the company's rating increases.
The market price of a callable bond is determined by using a bond term equal to
when the issuer can exercise the right to call the bond.
•
Putable Bonds
The feature provided in these securities is to provide flexibility for investors to resell
securities owned to the issuer at a certain price and a certain date before the bond
matures. The purpose of selling the securities is because the price of the securities has
decreased which can cause investors to experience greater losses if the sale is not made.
The market price of a putable bond is higher because the investor has the option to
sell, and options have a market price.
•
Convertible Bonds
The feature of these securities is that they can be converted into shares of the issuer at a
predetermined price on a certain date before the bond matures. The purpose of this
conversion is to provide benefits to investors if the share price increases.
The market price of a convertible bond is the bond price plus the option price to
exchange the bond for shares.
4.1.1.2
Foreign Exchange Position:
Foreign exchange position is a product based on sale/purchase transactions made in cash,
or futures, between two types of currencies with the delivery of funds according to the
agreement. This foreign exchange position becomes the bank's position or exposure
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because the bank at the end of the day sells/buys two types of currencies with the delivery
of funds in accordance with the agreement the position is held in the bank's portfolio (not
sold directly to other parties). The market value of a foreign exchange position is the
volume of foreign exchange multiplied by the prevailing exchange rate at the time.
Foreign exchange positions also include loans granted in foreign currencies, or banks
buying bonds in foreign denominations.
4.1.1.3
Derivative Positions:
Derivatives are transactions based on a contract or payment agreement, with value
depending on the movement of the underlying asset or the value of the underlying
instrument such as interest rates, exchange rates, equity, indices, and a combination of
various market factors.
Types of derivative transactions or structured products that can be transacted include
products related to interest rates and exchange rates, or combinations with other financial
instruments. Derivative positions can be divided into two major groups, namely derivatives
with interest rate-related values such as interest rate swaps, forward rate agreements
(FRA), and derivatives with exchange rate-related values such as FX swaps, FX forwards.
In Indonesia, derivatives related to stock prices and commodity bags are not yet developed.
4.1.1.4
Securities Accounting:
If the bank purchases securities, it records the position in the account in accordance with
the purpose of the purchase. If the purchase is intended to be resold in the short term at a
profit from the price gap, the bank records the position in the trading account (TA).
If the purchase is intended for resale when the bank needs liquidity, the bank records the
position in the Available for Sale (AFS) account.
If the purchase is intended to obtain coupon or interest payments, and principal
payments at maturity, the bank records the position in the investment account or Hold to
Maturity (HTM).
4.1.1.5
Mark-to-Market (M2M) Process:
For TA and AFS positions, banks conduct a daily valuation process called marked-to-
market (M2M). From the results of M2M every day, the bank will experience gains or
losses on TA and AFS positions. For HTM positions, the bank will record at book value or
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purchase price.
For TA positions, if the market price is higher than the previous day's price, the bank
earns an unrealized profit. Conversely, if the market price is lower than the previous day's
price, the bank earns an unrealized loss. The impact of market value changes on TA
positions will be part of the profit and loss component.
For AFS positions, if the market price is higher than the previous day's price, the bank
earns an unrealized profit. Conversely, if the market price is lower than the previous day's
price, the bank earns an unrealized loss. The impact of market value changes on TA
positions will be a component of the capital account (equity).
Trading book is all the bank's positions on trading accounts. Bank- ing book is all bank
positions other than trading book, i.e. available for sale and hold to maturity positions,
including credit positions.
4.1.2
Types of Risk Factors Market
There are four categories of market risk factors that can affect the market value of a bank's
portfolio positions, namely:
1) market interest rates
2) exchange rate
3) stock market price
4) commodity market prices
Since banks are currently not allowed to buy and sell stocks and commodities, there are
only two market factors for banks: interest rates and exchange rates. However, for banks that
have subsidiaries engaged in securities, banks can have all four market factors.
4.1.3
Trading Market Risk Control
To manage the risk of trading activities, banks require governance of trading activities
through policies and operational standards. In general, the governance can be described as
follows:
4.1.3.1
Trading Activity Policy:
The trading activity policy serves as the main guideline for treasury activities and
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treasury activity risk management. To be able to better accommodate business activities
and to keep it up to date, the trading activity policy must be reviewed periodically by
taking into account the latest developments in trading activities, while still taking into
account the principle of prudence.
4.1.3.2
Trading Activity Standard Procedure:
Trading activity standard procedure is an internal provision of the bank that contains in
detail the implementation of treasury trading activities and market risk management on
trading activities, including market risk measurement flow chart, marked-to-market
process, and trading activity implementation manual.
4.1.3.3
Trading Book Policy:
The trading portfolio serves, among others, to meet the needs of the bank, as well as
trading activities for the bank's own interests (proprietary) to gain short-term profits on
market price movements.
Bank customers sometimes require the bank's services for various derivative
transactions for risk management purposes. For example, a customer who has a USD bill
three months in the future faces the risk that if the value of the USD weakens by the time
the bill matures, the amount of rupiah he will receive will be less.
To hedge the risk of loss due to changes in exchange rates, the nasa bah can sell USD
forwards with a maturity of 3 months, and the bank needs to serve by buying 3-month
USD forwards. In this example, the bank has a long USD position. If the bank expects the
USD to weaken, the bank can also enter into other derivative transactions with other
counterparties to manage this exchange rate risk, for example by selling forward
transactions or cross currency swaps.
The process of determining the market price or marked to market is carried out on a
daily basis on the trading portfolio. If there is a profit or loss (un- realized) due to
changes in market prices, the profit or loss is recorded directly in the profit and loss
account. To reduce
In order to minimize the impact of losses due to the movement of market factors, it is
necessary to determine the rules of trading activities, namely by setting trading limits. If
the limit is exceeded, the bank needs to take certain actions necessary to reduce the level
of risk.
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Trading policies are established so that treasury activities are carried out in
accordance with the corridors specified in the treasury policies and procedures, according
to the level of risk acceptable to the bank. Limits can be set in several levels so that the
bank is neither too conservative nor too aggressive. Policies also govern the types of
activities that are allowed or prohibited.
4.1.3.4
Segregation of Duties:
The management of trading activities is not the responsibility of the treasury trading unit
alone, but is the responsibility of several related parties, namely the front office (dealers),
middle office (market risk managers), and back office (settlement officers). The separation
of responsibilities is necessary to anticipate fraud committed by the front office unit as
the executor of trading activities. For example, a transaction with a counterparty is
conducted by the front office, but the settlement of the transaction is conducted by the
back office.
4.1.3.4.1
Front Office:
The executor of trading activities is the front office unit, namely treasury. Treasury
activities can be to serve the needs of customers or for their own purposes (proprietary
trading). Front office transactions include foreign exchange, money market,
derivatives, buying and selling of priced securities, liquidity management, funding and
marketing activities. Treasury is responsible for all matters related to profit/loss
associated with the implementation of trading activities.
In carrying out its duties, the treasury organization sets up a tiered authority system
where each level of authority is regulated by a limit system.
In addition to trading, treasury is generally responsible for managing liquidity,
maintaining liquid assets, and managing interest rate risk on the banking book.
4.1.3.4.2
Middle Office:
Activities carried out by treasury involve risk. Therefore, to control the risk of
treasury activities, corridors are established in accordance with policies and
procedures approved by management. Market risk management of treasury trading
activities is carried out by the middle office, which is responsible for developing
policies and procedures, discussing the proposed limit system proposed by the front
office and determining the method of determining market prices for approval by the
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Board of Directors.
The middle office organizational structure is tailored to the objectives, business
policies, size and complexity of treasury activities, as well as the bank's market risk,
financial condition and human resources. The middle office is an independent work
unit separated from treasury or business units as (risk taking unit), and also
independent of the back office unit and internal audit unit. Thus, it is expected that
objective and impartial policies or decisions will be obtained. This is in accordance
with the concept of segregation of duties in risk management.
4.1.3.4.3
Back Office:
The back office is also an independent work unit, formed separately from treasury,
middle office and internal audit unit. The separation aims to avoid conflicts of interest
in the treasury transaction settlement process, and ensure that all operational processes
of treasury transaction settlement can run effectively and efficiently.
The back office unit is also in charge of determining the daily market price of the
treasury unit's trading portfolio using the methodology issued by the middle office.
This is to prevent market price manipulation to hide potential trading position losses.
The back office is in charge of handling the completion of all treasury transaction
activities. The back office organizational structure is adjusted by taking into account
the objectives, business policies, size and complexity of treasury transaction activities,
as well as human resources while still applying the principles of prudence,
transparency or openness and continuous improvement.
4.1.3.5
Determining Limits:
In order for treasury activities not to exceed the risk tolerance set by the bank, in
conducting transactions that contain market risk, it is necessary to pay attention to several
trading limits, including the following.
4.1.3.5.1
Limit VaR:
VaR limits are set so that market risk management can be monitored periodically and
is not excessive in accordance with the risk tolerance set by the bank. If there is a
movement in market factors outside normal circumstances then the bank can take
mitigating actions on its trading positions. The VaR limit can be converted into a
nominal limit by dividing the VaR limit by the volatility of the current market factor.
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Thus, the VaR limit will always be fixed and in accordance with the bank's risk
tolerance, while the nominal limit will change according to the prevailing volatility.
4.1.3.5.2
Dealer Limit:
In carrying out trading activities, dealers must pay attention to the limits set, including
intraday net open position limit (daily maximum open position) and net open position
limit (maximum open position at any time). The dealer limit is determined so that the
bank can control the risk of loss that may be experienced by the dealer. Dealer limits
are set by taking into account the dealer's experience in conducting trading activities,
their skills, and the bank's risk tolerance. The dealer limit should be linked to the profit
target imposed on the dealer. If a dealer wants a higher trading activity limit, the
profit target should also be adjusted accordingly, as a higher limit entails greater
potential risk.
4.1.3.5.3
Loss Limit (Cut Loss Limit or Stop Loss Limit)
A stop loss limit is also used as a limit to the loss that can be tolerated on a particular
securities position taken by a dealer. Loss limits are set to limit losses due to trading
activities. Loss limits can be divided into daily loss limits, monthly loss limits and
annual loss limits. The portfolio of the grounded dealer's position will be taken over
by an official one level above the dealer.
The trading book is the bank's entire proprietary position in financial instruments on
balance sheet and/or administrative accounts (off balance sheet) including derivative
transactions. The trading book consists of trading accounts (trading exposures).
Trading positions must be marked to market on a daily basis where the resulting profit
or loss directly affects the bank's profit or loss.
The marked to market process is done by looking at the prevailing market prices for
the bank's portfolio positions. If market prices are not available then market prices are
determined using a valuation model. If the position is illiquid, meaning it is not traded
in the market, the discount factor in the valuation model should be adjusted by a
deflation factor.
Transactions on trading accounts are intended to be held and resold in order to
make short-term profits from price changes. What is meant by short-term, according to
BI's regulation, is the holding period of an instrument is no longer than 90 days.
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4.1.4
Determination of Market Value of Trading Book Positions
Banks are required to perform daily valuation of trading book positions accurately. In
conducting valuation, banks must have valuation policies and procedures, including having an
adequate management information system and control of the valuation process and integrated
with the risk management system.
The valuation process must be carried out based on fair value. For actively traded financial
instruments, the valuation process is carried out using close out prices or quoted market prices
from independent sources, using bid prices for assets to be held or liabilities to be issued;
and/or ask prices for assets to be acquired or liabilities to be held.
In the event that market prices are not available, banks can determine fair value using
models, and make adjustments to less liquid positions by considering certain factors.
4.1.5
Market Risk Identification - Trading Book
Market risk management strategy is a pro-active risk management strategy that begins with
the process of identifying sources of risk. For example, if the bank has a position in Indosat
bonds denominated in USD in the amount of USD 1 million, with a maturity of 5 years,
coupons are paid every 3 months with an interest rate of 3 months Libor + 3%, then the
market risk attached to the instrument is (1) USD interest rate risk with a maturity of 3 months
(2) USDIDR exchange rate risk.
In addition, it is necessary to take into account the correlation between these market
factors, namely the correlation between the 3-month USD interest rate and the USDIDR
exchange rate.
4.1.6
Market Risk Measurement - Trading Book:
After identifying the risk, the next process is to quantify or measure the risk according to the
identified market factors. The next step is to estimate the impact of potential losses due to the
risk and compare with a predetermined limit system. If the limit is exceeded, the bank
mitigates if necessary. The final step is to determine the risk control strategy.
The cost-benefit principle applies to the control of market risk. For example, if the risk is
smaller relative to the company's ability to bear the risk, management may not be profitable in
terms of time and cost. If the bank has decided to manage the risk, managers need to select the
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appropriate tools or instruments e.g. choosing the most optimal derivative transaction.
Calculation of Market Risk (Trading) and Regulatory Capital Expenses:
Banks are required to provide a certain amount of capital to cover market risk on their
portfolio. Market risks that must be calculated by banks individually and/or on a consolidated
basis with subsidiaries are interest rate risk and/or exchange rate risk.
In the event that the bank has subsidiaries that are exposed to equity risk and/or commodity
risk, the bank on a consolidated basis with the subsidiaries shall account for such equity risk
and/or commodity risk.
In accordance with Bank Indonesia regulations, banks that are required to meet CAR by
taking into account market risk are banks that individually meet one of the following criteria.
–
Banks with total assets of IDR10 trillion or more;
–
Foreign exchange banks with financial instrument positions in the form of priced securities
and/or derivative transactions in the trading book of IDR20 billion or more;
–
Non-foreign exchange banks with financial instrument positions in the form of securities
and/or interest rate derivative transactions in the trading book amounting to Rp25 billion or
more;
Banks on a consolidated basis with subsidiaries meet one of the following criteria.
–
Foreign exchange banks that on a consolidated basis with subsidiaries have financial
instrument positions in the form of securities including financial instruments exposed to
equity risk and/or derivative witnesses in the trading book and/or financial instruments
exposed to commodity risk in the trading book and banking book amounting to Rp20
billion or more;
–
Non-foreign exchange banks that on a consolidated basis with subsidiaries have financial
instrument positions in the form of priced securities including financial instruments
exposed to equity risk and/or derivative transactions in the trading book and/or financial
instruments exposed to commodity risk in the trading book and banking book amounting to
Rp25 billion or more.
The calculation of market risk in the CAR calculation is carried out using a standard
model; and/or an internal model.
The approach in measuring capital required to cover market risk is as stipulated in PBI
No.5/23/PBI/2003 which is the standard method approach, which was later amended by Bank
Indonesia Regulation No.15/12/PBI/2012KPMM of commercial banks dated December 12,
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2013.
Standard Model:
Standardized models are used to measure market risk and calculate standardized capital
adequacy for all banks. The calculation of the standardized model is determined by the
regulator. Besides being relatively simple, such standardization can reduce the reporting
burden by banks and provide a reference for supervisors in conducting verification.
Interest rate risk calculations are performed on financial instruments in the trading book
that are exposed to interest rate risk, which include:
–
All debt securities with fixed or floating interest rates and all financial instruments with
similar characteristics, including tradable certificates of deposit (NCDs) and securities sold
by banks on repurchase terms (Repo/Securities Lending);
–
Derivative instruments related to securities or interest rates, including Bond Forwards,
Bond Options, Interest Rate Swaps, Interest Rate Options and Forward Rate Agreements/
FRAs.
A.
Specific Risk
The calculation of capital charges for specific risk is designed to protect the bank from the
risk of loss due to changes in the price of each financial instrument held due to factors
relating to the issuer of the financial instrument.
Security prices tend to fall if the performance of the securities bit issuer deteriorates.
The impact of the price decline only occurs on the securities issued by the issuer, and does
not have an impact on security prices in general.
For example, the selling price of a security, such as a bond (obli gation) may decrease
due to the impact of the issuer rating menu run. This event does not affect the selling price
of bonds issued by other issuers.
In calculating specific risk, banks can only perform the offsetting process between long
positions and short positions if the positions are identical. What is meant by identical
positions in securities transactions and derivative transactions, namely if there are similar
issuers, coupon rates, maturities, types of currencies, call features, and others.
B.
General Market Risk:
General market risk is the risk of changes in the price of financial instruments due to
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general price changes in the market. Such price changes are due to market factors (1)
interest rate risk, (2) exchange rate risk, (3) risk of changes in the market price of option
contracts. For example, the rise and fall of interest rates will affect the market value of
bonds or similar securities.
Market risk generally applies to positions in securities and derivative instruments linked
to price or interest rate securities and recorded in the trading book.
The calculation method that can be done for general risk calculation is by using maturity
method or duration method. Banks can choose between the two methods as long as it is
done consistently and accurately.
C.
Derivative Instruments:
Derivative instruments both in the context of trading and hedging of securities instruments
in trading takes are reported under the two-legged approach.
Example:
Purchase (long position) of Forward Rate Agreement (FRA) at the end of April and fixing
in June with 3-month SBI rate (maturing in September). The transaction is reported as a
long position with a maturity of 5 months and a short position with a maturity of 2 months.
An interest-rate swap transaction in which a bank receives a floating interest rate and
pays a fixed interest rate is reported as a long position in the floating interest rate
instrument for the period until the next interest rate adjustment and as a short position in
the fixed interest rate instrument for the remaining maturity of the swap transaction.
D.
Calculation of Exchange Rate Risk
The calculation of exchange rate risk is carried out on foreign exchange positions in the
trading book and banking book that are exposed to exchange rate risk including gold by
referring to the calculation of net open position (NOP). Example of NPL calculation:
Positions against gold are accounted for similarly to foreign exchange on the basis that
movements in the price of gold ham pears are similar to movements in foreign exchange
rates and banks treat gold transactions similarly to foreign exchange transactions.
The position of an instrument denominated in a foreign currency, in addition to being
exposed to exchange rate risk, also exposes the bank to interest rate risk (for example, for
cross-currency swaps). In such cases, interest rate risk exposure must also be taken into
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account.
The calculation of the capital charge for exchange rate risk from foreign exchange
positions is charged at 8% of the overall net open position at the end of the day.
E.
Limitations of the Standard Model
The calculation of capital charge using the standard model has limitations in measuring
trading book market risk. There are several limitations in the standard model, namely:
–
The amount of risk weight will always remain fixed. The calculation tends to
underestimate when market volatility is high and overestimate when market volatility is
low.
–
The rules regarding the weighting of specific risk are not yet based on the issuer's
performance rating. This still allows for underestimation of specific risk.
Capital calculations using the standard model tend to underestimate highly volatile
market factors such as in Indonesia.
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Internal Model:
In order to use the internal model, banks must first meet qualitative and quantitative
requirements and obtain approval from Bank Indonesia.
The internal model calculates VaR (Value at Risk). VaR is used to calculate the capital
charge for market risk, which is calculated based on a ten-day holding period, and the highest
number between:
1) VaR on the previous business day; and
2) Average daily VaR over the previous 60 business days multiplied by a scaling factor;
Plus capital charges for specific risks calculated using the standard model.
The use of a scale factor in the CAR calculation aims to cover potential weaknesses in the
use of the model. Bank Indonesia sets the scale factor with a range between 3 and 4, based on,
among others, an assessment of the fulfillment of qualitative requirements. Banks may be
subject to a minimum multiplication factor of 3 if they have fulfilled all requirements based
on OJK's assessment. The amount of additional factor imposed ranges from 0 (zero) to 1,
based on the results of back testing reported by banks on a quarterly basis.
4.1.7
Market Risk Identification - Interest Rate:
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Interest rate risk is the most important risk in the banking book. Interest rate risk in the
banking book can be caused by differences in the repricing of assets and liabilities, which is
called repricing risk. Interest rate risk can also arise due to yield curve risk, basis risk, and
options risk.
For example, banks provide loans with repricing terms that differ from the repricing terms
of the source of funds. If there is a change in market interest rates, the bank will be exposed to
interest rate risk in the form of changes in net interest income (NII). The objective of
managing interest rate risk is to measure the amount of exposure to interest rate risk, and to
measure the effect of movements in market interest rates on the bank's net interest income and
economic value.
4.1.7.1
Repricing Risk:
The risk of loss caused by the time difference between re-pricing assets and repricing
liabilities when there is a change in market interest rates. Repricing risk is often referred to as
mismatch risk. As For example, a bank has a 5-year fixed-rate loan position with a 6-month
time deposit as its source of funds.
In general, repricing risk occurs when banks have short-term funding sources to fund long-
term assets (borrowing short term to fund long term assets), or vice versa, long-term funding
sources to fund short-term assets (borrowing long term to fund short term assets). In the first
case, the bank will be exposed to repricing risk if there is an increase in interest rates, while in
the second case, repricing risk arises if market interest rates decrease.
4.1.7.2
Basis Risk:
Basis risk is the risk of loss due to the use of different interest rate indices between the
components of assets and liabilities. Different interest rate indices cause changes in the spread
between revenues on the asset side and costs on the liabilities side. Potential losses occur
because the effect of changes due to repricing of the index used on the asset side is not the
same as the effect of changes due to repricing of the index used on the liabilities side.
For example, the bank has a mortgage with a floating interest rate, with a repricing period
of 6 months, by using the using the 6-month SBI interest rate index + 150 bps. The source of
funds used comes from 6-month time deposits using the LPS guarantee interest rate index. If
the 6-month SBI rate falls by 100 bps, while the LPS rate does not change, there will be a
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potential loss of net interest income.
4.1.7.3
Yield Curve Risk:
Yield curve risk is the potential risk of loss because changes in short-term interest rates are
smaller or larger than changes in long-term interest rates.
In general, short-term interest rates are usually more volatile than long-term interest rates.
When market interest rates decline, generally the yield on 1-year bonds declines more than the
decline in yield for 5-year bonds. Thus, if a bank provides a loan with a floating interest rate
and a repricing period of 3 months, with a 12-month deposit as the source of funds, if short-
term interest rates increase by 2% and long-term interest rates increase by 1%, the market/fair
value of the loan will decrease more than the decrease in the value of the loan
market/reasonable source of funds, so the bank suffers a loss.
4.1.7.4
Option Risk:
Option risk is the potential loss due to changes in the amount or duration of the instrument
from the agreed term. For example, there is prepayment risk or deposit withdrawal before
maturity. For example, if a bank provides a mortgage loan with a fixed interest rate of 10%
for a period of 10 years. As the market interest rate declines, the customer repays the loan
before maturity, so the bank loses the opportunity to receive 10% interest on the loan. If the
bank provides a new loan when interest rates fall, the interest charged to customers will be
smaller.
4.1.8
Market Risk Measurement and Control - Banking Book:
Interest rate risk can be viewed from two perspectives, namely a short-term perspective and a
long-term perspective. The short-term perspective keeps the net interest income (NII) from
decreasing. The long-term perspective keeps the economic value of capital or Economic Valve
Equity (EVE) from decreasing due to changes in market interest rates.
4.1.8.1
Revenue Perspective (Earning at Risk):
The income perspective measures the impact of interest rate changes on net interest income
(NII). This perspective is an approach to see the impact of interest rate changes in the short
term. Fluctuations in income are a major aspect of interest rate risk analysis, as a decline in
income will threaten the financial stability of the bank, namely a decrease in the level of
17
capital adequacy and market confidence. Changes in interest rates will lead to
The analysis process is as follows.
–
Market interest rates change.
–
As a result, there is a change in income on the asset side and a change in interest on
the liabilities side.
–
From the assumption of changes in asset yield, changes in interest income will be
obtained.
–
From the assumption of changes in interest on liabilities, changes in interest costs will
be obtained.
–
From the two changes in yield, changes in NII (Net Interest Income) will be obtained.
4.1.8.1.1
Repricing Gap:
Repricing gap is a basic and simple method to measure interest rate risk exposure and the
impact on net interest income (NII).
The calculation begins by categorizing balance sheet and administrative account items
that are sensitive to interest rates. The asset component that is sensitive to changes in
interest is called Rate Sensitive Asset (RSA). The component of liabilities that is sensitive
to changes in interest is called Rate Sensitive Liabilities (RSL).
RSA and RSL are distributed into time bands based on time remaining to maturity or
contractual maturity for fixed rate instruments or time remaining to the next repricing date
for floating rate instruments.
If the interest rate increases by 1%, the impact on NII is negative Rp4,333.34 million. If
the interest rate decreases by 1%, the impact on NII is positive Rp4,333.34 million.
If the predicted interest rate increases, and the repricing gap is positive, then an increase
in interest rates will increase NII. Conversely, if the predicted interest rate decreases and
the repricing gap is positive, then the increase in interest rates will decrease NII, and
additional efforts are needed to reduce the positive gap, and direct it to become a negative
gap.
4.1.8.1.2
Banking Book Market Risk Control:
Banks cannot control the movement of market factors. What can be done is to strategize
the position of the balance sheet, so that changes in market factors provide benefits to the
bank, or at least minimize the bank's potential losses.
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The steps that banks need to take in managing interest rate risk are as follows.
–
Set predictions of interest rate movements by considering the opinions of economists.
–
Interest rate gap measurement to see the impact of interest rate changes on net interest
income, and duration gap measurement to see the impact of interest rate changes on the
economic value of capital.
–
Establish a limit policy in accordance with the bank's risk tolerance, and ensure that the
existing gap is within the limit tolerance set.
If the change in interest rates is opposite to the gap position, the bank can optimize the
balance sheet structure by:
–
Balance sheet strategy (assets and liabilities) manages the composition of different types
of loans and investments, as well as reorganizes the bank's funding sources. This can be
done by managing the repricing characteristics and maturities of loans, investments and
third party funds, so as to produce the expected gap.
–
Using derivative transactions such as interest rate swaps and FRAs (Forward Rate
Agreements) in order to produce the expected cumulative gap.
Measure the impact of changes in market factors on bank balance sheets:
To determine the impact of changes in market factors on the balance sheet position, banks
use tools called gap analysis including repricing gap, duration gap, foreign exchange gap,
and liquidity gap.
•
Repricing gap measures the effect of interest rate changes on net interest income (NII).
NII sensitivity measures how much the potential decline in NII due to a one unit change
in interest rates, Earning at Risk measures the impact on net interest income measure
the change in NII due to changes in interest rates with a certain level of confidence.
•
Duration gap is used to measure the effect of interest rate changes on the economic
value of capital. EVE sensitivity measures how much the economic value of capital
changes due to a one unit change in interest rates. Capital at Risk measures the change
in the economic value of capital due to changes in interest rates with a certain level of
confidence.
•
Foreign exchange gap is used to measure the change in exchange rate on the bank's
foreign exchange position.
•
Liquidity gap is used to measure the bank's ability to meet its maturing obligations to
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customers or third parties. The liquidity gap measures the potential liquidity shortfall
due to a mismatch between cash inflows and outflows.
•
If the gap position is not in line with the predicted movement of market factors, the
bank will carry out a strategy to change the gap so that the bank benefits if the predicted
movement of the bu nga rate occurs.
Banking Book Interest Rate Risk Limit:
Because there is a possibility that the prediction of the direction of interest changes could
be wrong, a limit system is needed so that the bank's risk can be limited in accordance with
the bank's risk tolerance. To limit the bank's potential loss due to banking book market risk,
the bank sets various limits such as (1) repricing gap limit, (2) duration gap limit, (3)
foreign exchange gap limit, (4) net interest in- come (NII) sensitivity limit, (5) Economic
Value of Equity (EVE) sensitivity limit, (6) Earning at Risk (EaR) limit and (7) Capital at
Risk (CaR) limit and (8) Capital at Risk (CaR) limit (8) liquidity risk limit.
Interest rate risk is monitored by comparing the realization of interest rate risk
indicators with the interest rate risk limit set. The interest rate risk limit is set with
consideration of risk tolerance that is acceptable to the bank. Limits can be set based on
percentages of variables such as total assets, total capital and so on. Gap limits are made
two-sided, both limits for positive gaps, and limits for negative gaps.
If the repricing gap exceeds the limit, action needs to be taken so that the bank does not
take excessive risk. The action taken is called a restructuring strategy. Suppose there is a
negative gap that exceeds the limit set. There are four choices of recovery strategies that
can be done, namely:
1) Asset strategy
2) Liabilities strategy
3) Asset growth or decline strategy.
4) Hedging strategies.
Hedging is the process of making a transaction that aims to reduce risk. The essence of
hedging is that in order to reduce the risk of a transaction, it is possible to make another
opposite transaction to offset the risk. The hedging process requires a very close
relationship between the amount and change in value of the hedged instrument and the
hedging instrument.
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4.1.8.1.3
Positioning Strategy:
The following are some alternative positioning strategies that can be done by banks to
reduce interest rate risk, namely:
a)
Asset Side
Interest Rates Expected to Rise:
–
Reduce exposure to avoid losses due to rising interest rates by increasing RSA
exposure.
–
Sell existing long-term or medium-term fixed-rate securities.
–
Undertake more expansion of floating rate loans.
–
Increase adjustable-rate loans and investments whose interest is based on a fast-
changing base-rate (index), e.g. short-term LIBOR.
Interest Rate Expected to Fall:
–
Reduce exposure to avoid losses due to falling interest rates by reducing RSA
exposure.
–
Sell short-term securities with floating interest rates and buy long-term and medium-
term securities with fixed interest rates.
–
Increase loans with fixed interest rates.
–
Reduce adjustable-rate loans and investments whose interest is based on a base rate
(index) that changes daily, weekly or monthly.
b)
Pasiva side
Interest Rates Expected to Rise:
–
Reduced exposure to avoid losses due to rising interest rates by lowering interest
bearing liabili- ties by raising funds with long-term deposits.
Interest Rate Expected to Fall:
–
Reduce exposure to avoid losses due to declining interest rates by increasing interest
bearing lia- bilities, such as raising funds by issuing floating rate deposit products
and short-term deposits.
c)
Hedging Strategy
–
Hedging with On Balance Sheet Instruments (Natural Hedges)
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Natural hedges are simple hedges using on-balance sheet instruments such as loans,
investments, and deposits. For example, for a period of 5 years, a mortgage with a fixed
interest rate for 5 years can be hedged with a 5-year bilateral loan.
Natural hedging is the management of the volume, composition, rates, repricing
terms, and maturities of a bank's investments such as loans, deposits, or other funding
sources. This method also called asset restructuring strategy, changes the mix of asset
elements, for example increasing short-term assets and reducing long-term assets.
A liabilities restructuring strategy changes the mix of liabilities elements. For
example, increasing long-term liabilities and reducing short-term liabilities.
Growth strategy, increasing balance sheet growth by increasing the amount of assets
and liabilities. For example, increasing short-term assets with long-term funding
sources.
The strategy of reducing balance sheet volume by reducing the number of assets and
liabilities. For example, reducing long-term assets and paying off short-term funds.
–
Hedging Strategy with Derivative Instruments
Hedging strategies with derivatives, using swaps, futures or forward rate agreements
(FRA). For example, enter into a receive floating/pay fixed swap interest rate contract.
4.1.8.2
Economic Perspective (Economic Value at Risk):
The economic perspective measures the impact of interest rate changes on the economic
value of the assets and liabilities portfolio, which in turn leads to changes in the economic
value of the bank's capital. This perspective is an approach to look at the impact of changes
in interest rates in the long term. The change in economic value is due to the market value
of the portfolio of assets and liabilities.
Changes in interest rates cause changes in the discount rate to determine the market
value of assets and liabilities, thus causing changes in the duration of assets and duration
of liabilities, and causing changes in the gap duration. Furthermore, the gap duration
causes changes to the economic value of equity:
If there is a change in market interest, the discount rate (dis- count rate) will change
with the market interest so that the cash flows from asset income and liability costs change.
Thus, the cash value or present value of asset liabilities changes. Changes in the PV of
asset liabilities will lead to changes in the economic value of asset liabilities, and changes
in the economic value of capital (equity).
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Banks should manage interest rate risk in accordance with the size and complexity of
the bank's business. The management of interest rate risk will be different for each bank,
generally where banks are larger and have more complex transactions, requiring more
complex risk measurement procedures as well. The most commonly used methods to
measure interest rate risk in the banking book are repricing gap and duration gap.
Duration Gap methodology will be discussed in Level 3 module.
Sample Questions :
1.
If the bank has a position in Indosat bonds denominated in USD in the amount of USD 1
million, term of 5 years, coupons paid every 3 months with an interest rate of 3 months Libor
+ 3%, the market risk attached to the instrument is:
a.
Interest rate risk
b.
USD interest rate risk
c.
3-month USD interest rate risk
d.
5-year USD interest rate risk
2.
In the marked to market process, there are functions that develop the marked to market
methodology, and there are functions that use or set the market price on trading book
positions. The function that sets the market price of treasury account trading positions
(marked to market) is:
a.
Front office
b.
Middle office
c.
Back office
d.
Director of treasury
3.
Market risk due to factors related to the issuer of financial instruments (issuer) is called:
a.
Specific risks
b.
General market risk
c.
Exchange rate risk
d.
Liquidity risk
4.
Maturity method and duration method are ways to calculate:
a.
Market risk capital requirement with standardized model
23
b.
Market risk capital requirement with internal model
c.
Liquidity risk
d.
Interest rate risk in the trading book
5.
When interest rates rise, the bank's NII will increase if the bank's balance sheet does:
a.
Positive repricing gap
b.
Negative repricing gap
c.
Positive duration gap
d.
Negative duration gap
