Interest rate risk and FX risk
Interest rate risk may be defined as a risk of loss due to changes to the specified features of interest rates. Interest rate risk management applies to all balance and off-balance sheet items of the Bank sensitive to interest rate changes.
FX risk is a risk of loss due to FX rates changes.
General approach to interest rate risk and FX risk management
The methods of interest rate risk management are adjusted to the structure of books at the Bank. The risk transfer system plays a key role in the banking books. The risk transfer process is intended to transfer the interest rate risk (including the underlying risk) and the liquidity risk (understood as the revaluation risk of the liquidity premium) of products registered in the commercial books (loans and deposits) to the Treasury Department books, where this risk is further managed as part of the risk appetite adopted at the Bank. Risk transfer encompasses the risk modelling process (optionality risk in particular) and allocation of the internal prices to the products registered in the commercial books.
The acceptable level of interest rate risk (risk appetite) is expressed as a set of limits used for managing the interest rate risk level. The limits system is adjusted to the general level of risk as approved by the Supervisory Board.
The Bank manages the FX risk by transferring it internally to the Financial Markets Division where it is further managed as part of the system of internal limits for FX risk as accepted by the Bank Management Board reflecting the general risk level approved by the Supervisory Board.
For subsidiaries, the Bank’s intent is to keep the market risk at low level, which is reflected in the limits for FX risk and interest rate risk accepted by the Bank Management Board. If necessary, subsidiaries close their FX positions and interest rate exposures with the Bank.
Main methods of interest rate risk and FX rate risk measurement
Value at Risk (VaR) is the main methodology used to measure market risk both in FM books (trading) and Treasury Department books (banking). The VaR index specifies a potential loss, which in line with expectations should not be exceeded with a given confidence (probability) level assumed. The Bank calculates VaR separately for individual interest rate, FX transactions and FX options portfolios. The Market Risk Management Department applies the method of historical simulation for trading books and banking books of the Treasury Department. The VaR measurement does not present a full picture of the risk as it fails to show potential loss under stressed circumstances. In order to cover the above mentioned risk, the Market Risk Management Department calculates a Stressed VaR and runs stress tests for market risk. The interest rate market risk for trading books is measured through the NPV Gap of modelled business volumes against the volumes transferred to the Treasury Department books.
Additionally, to measure interest rate risk for banking book items (both for the Treasury Department and for trading books) the Bank applies:
- Measurement of value of the earnings at risk (with the use of simple and advance method: Earnings at Risk – EaR, Advanced Earnings at Risk) with the use of stress tests,
- Measurement of the NPV of the discounted future cash flows at risk (NPV at Risk), which is a measurement of the economic sensitivity of the interest rate position to sudden changes to the interest rates,
- Measurement of residual risk, which was transferred to the books of the Treasury Department.
In H1 2014, the Bank streamlined the process of market risk (including underlying risk) transfer and centralisation by implementing the Risk Transfer System (RTS) application. The underlying risk is valuated and then transferred to the Treasury Department books, where it is actively managed. Earnings at Risk (EaR) concept is applied to measure that risk which is part of interest rate risk. The Bank applies the measurement of the revaluation reserve change risk. The level of the revaluation reserve resulting from keeping the AFS portfolio is sensitive to changes to the profitability curve following the changes to the interest rates and asset swap levels.
The Bank introduces the following risk measures of the revaluation reserve:
- IR RRaR (Interest Rate Revaluation Reserve at Risk) shows potential impact of the interest rate changes on the revaluation reserve level,
- CS RRaR (Credit Spread Revaluation Reserve at Risk) shows potential impact of the credit spread change on the revaluation reserve.
VaR Exposures and Limits in 2014
In 2014, the Bank maintained its trading exposure at low levels compared with the binding limits. Average limits utilisation for the majority of trading activity types was at 30%. Average utilization of VaR limits for interest rate risk of the banking book was below 23%.
There were three cases where the VaR limits were exceeded in the interest rate trading portfolio (limit utilisations were 117%, 118% and 119%) and one case where the banking book VaR limit was exceeded (limit utilisation arrived at 104%).
The following VaR limits were changed in 2014:
- for the FX transactions portfolio – the limit was moved up from EUR 800 thousand to EUR 1 million,
- for the banking book – following the implementation of the historical simulation for the banking book interest rate risk, the VaR limit was established at EUR 20 million.