3October2006

Technicalaspectsofthemanagementofinterestrateriskarisingfromnontradingactivitiesunderthesupervisoryreviewprocess

ExecutiveSummary

1. CEBSrefersinitsguidelinesontheApplicationoftheSupervisoryReviewProcess under Pillar 2 issued in January 2006 (GL03) to a structureddialogue between supervisors and institutions that should embrace fourtypesof risks (i)Pillar1 risks, (ii) risksnot fullycapturedunderPillar1,(iii) risks covered by Pillar 2 and (iv) external factors not alreadyconsideredinthepreviouscases1.

2. In particular, institutions should develop and maintain an ICAAP thatidentifies risks they are or might be exposed to and allocate adequatefinancialresourcesagainstthoserisks.

3. This paper sets out technical guidelines applicable to one of those risks:interestrateriskarisingfromnontradingactivities(here,interestrateriskinthebankingbookorIRRBB),asafollowuptoCEBSGL03.

4. Thedocumentputstheemphasisonhighlevelguidance,someofwhichisaddressed to institutions (both credit institutions and investment firms)andsometosupervisors.Itisnotmeanttoprovidedetailedguidanceonwhether and how quantitative tools and models should be used ordeveloped. The responsibility for this must rest with the institutions,though supervisors will expect to see institutions develop their ownsystems and stress testswhich are commensuratewith their risk profileandriskmanagementpolicies.

5. Itsetsoutgeneralconsiderationsincludingcurrentinternationalthinking,adefinitionofwhattheIRRBBshouldcover,therelevantlegalrequirementsoftheDirective2006/48/EC,andasummaryofcurrentmarketpractices.This, together with the supervisory considerations, explains the contextthathasled to theguidelines. It is recognised thatmarketpracticesandsupervisory approachesmay evolve over time, and therefore there is aneed toensure that sucha technicalpaper iskept under reviewand, totheextentnecessary,adaptedtoreflectanysuchdevelopments.

6. The concept of proportionality, as laid down in the provisions of theDirective2006/48/ECrelatedtoPillar2andunderlinedintheintroductory

1SeeChapter4:theSREPICAAPinteractionandprudentialmeasures.Dialogue2.page34.

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statements of CEBS guidelines on the application of the supervisoryreviewprocess,appliesalsotoIRRBBmeasurementandmanagement,thecomplexity of which will be expected to be related to the size of theinstitutions as well as to the sophistication and diversification of theiractivities.

7. Thepaperthensetsout:

a. guidanceonwhatthesupervisorsshouldexpecttoseeintheICAAP2,under which it is the institutions own responsibility to manageadequately (i.e. identify,measure,monitor and control) these risksandallocateinternalcapital,whereconsiderednecessary, insupportoftheinterestrateriskinastructuredmanner,

b. the corresponding guidance to supervisors in conducting theSupervisoryReviewandEvaluationProcess(SREP)inrelationtotheICAAP.Supervisorswillrequireinstitutionstoshowthattheirinternalcapital,whereconsiderednecessary,iscommensuratewiththelevelof the interest rate risk in the banking book. In doing so, and inaccordance with CEBS guidelines on the application of thesupervisoryreviewprocessunderPillar2,thesupervisoryauthoritieswilladapttheirapproachtoensureit isproportionatetothenature,scaleandcomplexityoftheactivitiesofan institution.Similarly,thedepth, frequencyand intensity of thesupervisory evaluationwillbedeterminedbytherisksposedtothesupervisor'sstatutoryobjectiveofensuringthesoundnessofthebankingsector.

8. In relation to nontrading activities, the Directive 2006/48/EC requiresunder Article 124(5) that measures shall be taken by supervisoryauthorities in cases where an institutions economic value declines bymore than 20% of own funds as a result of a standard shock. As theDirective 2006/48/EC does not definewhat that standard shock shouldbe, CEBS proposes a common definition. This is intended to achieve acommonstandardwhichsupervisorscanapplyconsistentlyacrosstheEU.,therebydeliveringalevelplayingfield.

9. This would enable banking groups operating on a cross border basis tocalculate the standard shock required by the Directive 2006/48/EC in acomparableway. Ifnecessary,national supervisors canset a shockof adifferentmagnitude than the one derived by the calculation method ofIRRBB5.InthecontextoftheCEBSguidelinesonsupervisorycooperationforcrossborderbankingandinvestmentfirmgroups(GL09),Coordinationand dialogue under the aegis of the consolidating supervisor throughoperational networking will be crucial to ensure that commonality overtime.

10. CEBS nevertheless acknowledges the broad brush nature of a standardshock and recognises that , as part of their dialogue with individualinstitutions, supervisorsmay require their institutions to apply routinely

2 ICAAPstandsforInternalCapitalAdequacy

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shocks of a different order of magnitude, both in amount and time,reflectingthenature,sizeandcomplexityofthoseinstitutions.

11. Thedraftguidelineswentthroughathreemonthpublicconsultationasthefirstpartofthe11thConsultationpaperofCEBS(CP11).

12. Overall, although respondents welcomed the CEBS efforts to provideguidelines in these aspects, they raised concerns on the level of detailsand prescriptiveness of the guidelines. CEBS has addressed thesecommentsbyclarifyingtheproposedguidelinesandreadjustingthelevelofprescriptiveness.

13. Attachedtothispaperisafeedbacktablewhichcontainsasummaryofthekey points arising from the consultation and the responses made toaddressthem.ItincludesanannexreflectingCEBSviewsonthedetailedcommentsreceived.

Tableofcontents

Generalconsiderations .................................................................................................. 4

Internationalcontext ..............................................................................................................4

Definition ...............................................................................................................................4

LegalBasis............................................................................................................................5

Currentmarketpractices .......................................................................................................5

Supervisoryconsiderations....................................................................................................7

Guidanceforinstitutions................................................................................................ 9

Guidanceforsupervisors.............................................................................................11

AppendixI:BaselCommitteeonBankingSupervisionSupportingDocumentPrinciplesfortheManagementandSupervisionofInterestRateRisk,July2004.

Appendix II : Basel Committee on Banking Supervision Principles for theManagementandSupervisionofInterestRateRisk,Annex4AnexampleofastandardizedframeworkJuly2004.

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GENERALCONSIDERATIONS

1. Themeasurementofinterestrateriskinthebankingbookinanonmarktomarket world poses a number of major practical difficulties. Most ofthesedifficultiesaredealtwithbyinstitutionsmakingcertainassumptionswhich may differ between institutions and which may be modified overtime evenwithin one institution. Hence interest rate risk in the bankingbookispartofPillar2whereatailoredapproachispossible.

2. Some issues, such as the consequences of IFRS for the reporting andmanagementof interest rate risk,havenotbeencaptured in thepresentdocumentbutmaybethesubjectoffurtherworkbyCEBSinduecourse.

3. Under the IFRS framework, the fair value option in IAS 39 will allowinstitutions to fairvaluebanking book items. Although the effect of thechangeisstillnotclear,itislikelythatinstitutionswillincreasetheuseoffairvalueratherthanhistoricalcostforthemeasurementofanumberof financial assets (including derivatives) held in the banking book, andeventually some of their liabilities. IFRS additionally asks institutions toperformanddiscloseasensitivityanalysis foreachofthemarketriskstowhich they are exposed, including the interest rate risk on financialinstruments. The disclosure could take a number of forms such as amaturityrepricing schedule. Financial risk management policies andobjectivesmust alsobedisclosed. Therewill clearly be some differenceswith the regulatory framework for interest rate risk in the bankingbook,becausetheobjectivesofprudentialregulationandIFRS,andsomeofthedefinitionsused,willnotbethesameinallcases.

Internationalcontext4. Interest rate risk in thebankingbook formspartof theBaselCommittee

onBankingSupervisionsrevisedframeworkonInternationalConvergenceof Capital Measurement and Capital Standards (June 2004) (the Baseltext). In particular Section III, paragraphs 761764, which werecomplemented by a Supporting Document to the Capital AdequacyFramework, deal with interest rate risk (in both the banking and thetradingbook)(PrinciplesfortheManagementandSupervisionofInterestRateRisk,July2004).Thesedocumentshavebeenusedasasoundbasisfor this paper. Guidance on qualitative aspects of the management andmeasurement of risks has been set out in the CEBS guidelines on theapplicationofthesupervisoryreviewprocessunderPillar2,(Chapter2.1.GuidelinesonInternalGovernance).TheseguidelinesapplynaturallytotheIRRBBrisk.Overall,ithasbeenensuredthatthispaperisconsistentwithcurrentinternationalthinking.

Definition5. Forthepurposeofthispaper,interestrateriskistakentobethecurrent

orprospective risktoboth theearningsandcapitalof institutionsarisingfromadversemovementsininterestrates.InthecontextofPillar2,thisis

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in respect of the banking book only, given that interest rate risk in thetradingbookisalreadycoveredunderthePillar1marketriskregulations.

6. Consideration of interest rate risk from the perspectives of both shorttermearningsandeconomicvalueisimportant.Volatilityofearningsisanimportant focal point for interest rate analysis because significantlyreduced earnings can pose a threat to capital adequacy. However,measurementof the impact oneconomicvalue(thepresentvalueof thebanks expected net cash flows) providesamore comprehensive view ofthe potential longterm effects on an institution's overall exposures.Therefore, the supervisory focus will primarily be on measuring interestrate risk in relation to economic value. However, and subject toproportionality considerations, institutions are also expected to considerinterestrateriskinrelationtoearningsasasupplementarymeasure.

LegalBasis7. In theDirective2006/48/EC, interestraterisk in thenontradingbook is

treatedunder the ICAAP/SREP framework. Similar to other Pillar 2 risks,theDirective2006/48/ECrequiresthat:

an institution shall implementsystems to evaluateandmanage theriskarisingfrompotential changes in interest ratesas theyaffectacreditinstitutionsnontradingactivities(AnnexV.para.10)3,

credit institution shall have in place sound, effective and completestrategiesandprocessestoassessandmaintainonanongoingbasisthe amounts, types and distribution of internal capital that theyconsideradequatetocoverthenatureandleveloftheriskstowhichtheyareormightbeexposed(Article123),and

competent authorities have to review risk management processesandcapitaladequacy(Article124).

8. In contrast to other Pillar 2 risks however, Article 124(5) places on thesupervisor the specific obligation to take action in cases where theeconomicvalueofaninstitutiondeclinesbymorethan20%ofownfundsasaresultofapplyingasupervisorystandardshocktoitsinterestrateriskinthenontradingbook.

Currentmarketpractices

(i)IdentificationofIRRBB

9. Therearenumerousways that financial institutionscurrently identifyandmeasure IRRBB. Their methods reflect the specific form of the risk in

3 Article 22dealswith governance arrangements.AnnexVsets out technical criteria onorganisationandtreatmentofrisksundertheheadingInterestrateriskarisingfromnontradingactivities.

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question and the nature, scale and complexity of their activities. IRRBBencompasses:

a. risksrelatedtothetimingmismatchinthematurityandrepricingofassets and liabilities and off balance sheet short and long termpositions(repricingrisk),

b. risk arising from changes in the slope and the shape of the yieldcurve(yieldcurverisk),

c. risks arising from hedging exposure to one interest rate withexposure toa ratewhich repricesunderslightly different conditions(basisrisk),and

d. risks arising from options, including embedded options, e.gconsumersredeemingfixedrateproductswhenmarketrateschange(i.e.optionrisk)

(ii)MonitoringandmanagementofIRRBB

10.AwiderangeoftoolsmaybeusedbyinstitutionstomeasureandmonitorIRRBB.Thechoiceofmonitoringsystemandmanagementtechniqueusedis determined by the banks management to be most appropriatedepending on the nature, scale and complexity of their business.Institutionsareusuallyusing:

a. systems which track the progress of transactions, based on whichinstitutionsestimatethepipelinerisks4,

b. gap analysis showing the assets and liabilities at the differentrepricing dates, and the sensitivity of the present value of thesebucketstodifferentscenariosininterestrates,and

c. simulation techniques using scenarios that calculate the impact ofchanges in market conditions, e.g. the different repricinginstruments, simulationof interest rate paths, customerbehavioursetc.

11.Furthermore, stress testing can also performed, in order to measurefinancial institutions vulnerability under stressed market conditions likeabrupt changes in the level and slope of the term structure of interestrates,changesintherelationshipsamongkeymarketrates,etc.5

12.When using gap analysis and/or simulation techniques, institutionsmeasuretheIRRBBunderdifferentshiftsofthetermstructureofinterestrate(parallelshiftsandyieldcurvetwists).

4Apipelineriskwouldoccurforinstancewhenatrancheoffixedratemortgagesstilltobesoldwherethecorrespondinginterestswaphasalreadybeenexecuted5Furtherguidanceonthis issueisprovidedintheCEBSConsultationpaperonstresstesting(CP12).www.cebs.org

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13.Basedonthesevarioustools,institutionsusedifferenttypesofhedgestomitigate the risks, or use limits usually on earnings and/or economicvalue.Someinstitutionssetasidecapitalbuffers.

14.Themanagement body sets out the IRRBB policy. Although the specificorganisationestablished toput intoeffect the IRRBBpolicymayvary, inlargeormorecomplexinstitutions,measuring,monitoringandcontrollingIRRBB is usually vested in a "Asset and Liability Management" (ALM)function.It isusuallyassigned toan independent riskcontrolunit.Someinstitutions also have a committee with powers delegated by the board,usually called "Asset and Liability Committee (ALCO), responsible formajorinterestrateriskhedgingandnewassetandliabilitydecisions.

15.SupervisorsrecognisethattherearevariouslevelsofcentralisationofALMwithin institutions, e.g. in cross border groups some may have acentralisedmanagementandassessment function for IRRBBwhile othersdonot.

(iii)VariablesmonitoredintheIRRBBprocess

16.Institutions usually consider two different, but complementary,perspectivesintheirprocessofassessingIRRBB.

17.The earnings perspective focuses on the sensitivity of earnings in theshortterm to interest rate movements. Institutions usually adopt thisperspectiveduetotwomainreasons:(i)thisisthevariablethroughwhichan interest rate change has an immediate impact on reported earningsand (ii) the assessment of interest rate risk from an economic valueperspectiveisdifficultbecauseitismainlybasedonassumptionsaboutthebehaviour of longterm instruments, such as stable demand deposits orother noninterest bearing balance sheet items and those with embeddedoptions.

18.Theeconomicvalueperspectivefocusesonthesensitivityoftheeconomicvalues of the banking book items to interest rate changes. Someinstitutions may use this approach as the shorter term earningsperspective will not completely capture the impact of interest ratemovementonthemarketvalueoflongtermpositions.

Supervisoryconsiderations19.Anumberofconsiderationsarisefromtheabove

riskassessmentshouldbedonewithinthescopeoftheSRPprocess,beitataconsolidated,subconsolidatedorsololevel.Whenitcomesto crossborder groups, the cooperation between home and hostsupervisorswill take into consideration the level and themanner inwhichtheIRRmanagementisperformedbytheinstitutions.

As ithasnotbeenstandardpracticetorequireadditionalownfunds(regulatory capital) for interest rate risk in the banking book,

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supervisorswillneed todevelop theirapproaches to theuseof thisprudentialmeasure,whereconsiderednecessary,

incentivesmustbeinplace,asappropriate,forthedevelopmentandapplicationofadvancedmodelsandtechniques,

the level playing field should be disturbed as little as possible intermsofmaintainingaconsistentandfairapproach,

theadministrativeburdenshouldnotbeexcessive,

the supervisory policy on interest rate risk and any informationobtained under that policy should be complementary to aggregatefinancialstabilityanalysesacrossinstitutions,and

because the nontrading books of investment firms are usually(relatively) small, IRRBB guidelines are primarily relevant for thecredit institutions.Consideration shouldbegiven to theabsolute orrelativesizeofthenontradingactivities,inawaycomparabletothePillar 1 market risk regulation for interest rate risk in the tradingbook,with a viewto implement these guidelines in a proportionatemanner.

20.The concept of proportionality, as laid down in the provisions of theDirective2006/48/ECrelatedtoPillar2andunderlinedintheintroductorystatementsofCEBSguidelinesontheapplicationofthesupervisoryreviewprocess, applies also to IRRBB measurement and management, thecomplexity of which will be expected to be related to the size of theinstitutions as well as to the sophistication and diversification of theiractivities.

21.There are arguments both for and against standardised reporting ofinterest rate risk in the banking book, as well as for and against thepossiblemiddle groundof standardised reporting applied to less complexinstitutionsandnonstandardisedreportingappliedtocomplexinstitutions.Thispaperexpressesnopreferencesinthisrespect.

22.Nonetheless, and in the context of Articles 123 and 124(5), institutionsshouldat leastbeabletocomputeandreporttheeffectsofthestandardshockdescribedinIRRBB2and5oneconomicvalueaswellastheamountof internalcapitalsetaside,whereconsiderednecessary,forinterestraterisk in the banking book. As noted in paragraph 6, and subject toproportionality considerations, institutions are also expected to considerinterestrateriskagainstearnings,andshouldthereforeconsidertheeffectof instantaneousorgradual interestratechangesonshorttermearnings.Theresultsofsuchanalysismaybe requested,asadditional information,bynationalsupervisors.

23.Whichever approach to reporting is employed, supervisors should collectsufficient information about internal methodologies and underlyingassumptionsof institutions (e.g.yieldcurvesused, internalmeasurementofpositionswithoutcontractualmaturity,treatmentofoptionalityetc)forthem to evaluate the reported information and to make their own

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assessment of the adequacy of the results of interest rate riskmeasurement.

24.Asitiscurrentlythecase,offsitesupervisioncantakeplaceonthebasisof institutions internal reports and/or following some standardised,supervisoryformat.Supervisorscanalsoundertakeonsiteinspections.

GUIDANCEFORINSTITUTIONS

IRRBB1

Institutions should be able to demonstrate that their internalcapital iscommensuratewiththeleveloftheinterestraterisk intheirbankingbook.Inthatrespect,institutionsshouldbeabletocalculatethe:

potential changes in their economic value resulting fromchangesinthelevelsofinterestrates.Itistheresponsibilityofthe institutions to develop and use their own methodologies inaccordance with their risk profile and risk management policies.Supervisorsmayhoweverreservetherighttorequireinstitutionstoapplyanadditionalstandardisedmethodology,whenforexampletheinstitutionsinternalmethodologyisinadequateordoesnotexist.Anexample of such a methodology is provided by the standardisedframeworkofAnnex4of thesupportingBaseldocument"Principlesforthemanagementandsupervisionofinterestraterisk"SeeAnnexII,and

the overall interest rate risk in the banking book at variouslevelsofconsolidation,subconsolidationandsoloentityifrequiredtodosobysupervisors.

IRRBB2

Institutions must be able to compute and report to theirsupervisory authority the change in their economic value as aresultofapplyingastandardshockprescribedbytheauthorityinthecontextofArticle124(5)(seeIRRBB5below).

Ifasaresultofthisstandardshockaninstitution'seconomicvalueweretodeclinebymorethan20%ofownfunds itshouldbepreparedtodiscusswiththesupervisoryauthoritymeasureswhichmightneedtobetakentomitigatesuchapotentialdecline.

IRRBB3

Besidesthestandardshock,institutionsshouldbeabletomeasuretheirexposure,ifmaterial,andsensitivitytochangesintheshapeof the yield curve, changes between different market rates (i.e.basis risk)andchangestoassumptions, forexample thoseaboutcustomerbehaviour.

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Institutions should also consider whether a purely static analysis of theimpact on their current portfolio of a given shock or shocks should besupplemented by a more dynamic simulation approach. Larger and/ormore complex institutionsshould also take into account scenarioswheredifferent interest rate paths are computed and where some of theassumptions(e.g.aboutbehaviour,contributiontoriskandbalancesheetsizeandcomposition)arethemselvesfunctionsofinterestratelevels.

IRRBB4

Institutionsshouldhaveawellreasoned,robustanddocumentedpolicy toaddressall issues that are important to their individualcircumstances.

Without prejudice to the principle of proportionality, examples of suchissuesinclude:

The internal definition and boundary between banking book /"tradingactivities.

The definition of economic value and its consistency with themethodused to valueassetsand liabilities (for examplebasedonthediscountedvalueoffuturecashflows,onthediscountedvalueoffutureearnings).

Thesizeandtheformofthedifferentshockstobeusedforinternalcalculations.

Theuseofadynamicand/orstaticapproachintheapplicationofinterestrateshocks.

Thetreatmentofcommonlycalledpipelinetransactions(includinganyrelatedhedging).

Theaggregationofmulticurrencyinterestrateexposures.

The treatment of basis risk resulting from different interest rateindexes

Theinclusion(ornot)ofnoninterestbearingassetsandliabilitiesofthebankingbook(includingcapitalandreserves)

The treatment of current and savings accounts (i.e. the maturityattachedtoexposureswithoutacontractualmaturity).

The appropriate consideration of embedded options in assets orliabilities.

Theextent towhichsensitivities to small shockscanbescaleduplinearly without material loss of accuracy (i.e. covering bothconvexitygenerallyandthenonlinearityofpayoffassociatedwithexplicitoptionproducts).

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The degree of granularity employed (e.g. offsets within a timebucket)

Whether all future cash flows or only principal balances areincluded.

GUIDANCEFORSUPERVISORS

IRRBB5

Supervisory authorities will set a comparable standard shock asreferred to in Article 124(5) of the Directive 2006/48/EC andapplicabletothenontradingbookofalltheirrelevantinstitutions.Supervisors may decide to set different standard shocks fordifferentcurrencies.Thefollowingguidelineswillbeputinplace:

Astandardshockcould,forexample,besetsothatitwillbebroadlyequivalent to the 1st and 99th percentile of observed interest ratechanges(fiveyearsofobservedonedaymovementsscaleduptoa240 day year), This would currently equate approximately to aparallel200basispointsshockformajorcurrenciesassuggestedbytheBaselCommittee(SeeAnnexIIbelow).

National supervisors will be expected to use this as their startingpointwhenconsideringatwhat leveltoset theshock,but theywillalsoneed to take into account factors such as thegeneral level ofinterestrates,theshapeoftheyieldcurveandanyrelevantnationalcharacteristicsintheirfinancialsystems

Nationalsupervisorswillperiodicallyreviewthesizeoftheshocksinthelightofchangingcircumstances,inparticularthegenerallevelofinterest rates (for instance periods of very low interest rates) andtheir volatility. Institutions internal systems should therefore beflexible enough to compute their sensitivity to any standardisedshock that is prescribed. Supervisors will not, however, makefrequentorminoramendmentsforthepurposeofspuriousstatisticalaccuracy.

National competent authorities commit to discuss periodically therelevanceofthe200basispointsasastartingpointwhenconsideringat what level to set the shock and keep it under review in light ofimplementation.

If the required shock (e.g. a 200 basis point shock) would implynegative interest rates or if such a shock would otherwise beconsidered inappropriate, the national supervisor will adjust therequirementsaccordingly,and

Where an institution is a subsidiary of an institution which isauthorised in another EUmember state, the respective supervisors

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will, in accordance with the CEBS guidelines on supervisorycooperation for crossborder banking and investment firm groups,seek to coordinate their approaches on the standard shocks to beapplied.

IRRBB6

Thesupervisoryreviewshouldencompassboththequalitativeandorganisational aspects of interest rate risk management, anevaluation of the institutions quantification of interest rate riskand an assessment of the adequacy of the relationship betweeninterestrateriskandinternalcapital.

This approach will be tailored to an institutions specific risk profile,drawing on the Basel Supporting Document Principles for theManagementandSupervisionofInterestRateRiskSeeAnnexIbelow.

IRRBB7

ThescopeofapplicationofthesupervisorsassessmentofinterestrateriskisthatusedfortheSupervisoryReviewProcess(SRP)6.

Where necessary for the fulfilment of their statutory objectives, forinstancewherethereareobstaclestocashmovementsamongsubsidiariesor separatemanagement processes among subsidiaries, supervisors willhavethediscretiontoapplyassessmentsatthelevelofindividualentities.

IRRBB8

Supervisors should understand the institutions' internal methodfor calculating the IRR in thebankingbook, includingunderlyingassumptions(e.g.yieldcurvesused,treatmentofoptionality).

Thiswillincludeallowingforsupervisorstohaveanindepthanalysisandassessments of institutions internal methods (including institutionsassumptions underlying the issues raised in IRRBB 4 above).This couldformthebasisforpeergroupanalysisand/or(model)benchmarking,andoffer the supervisor a handle for discussions with the institution.Institutionsmaybe requested to calculate theeffects of specific, adhocinterestratescenarios.

IRRBB9

Prompt prudential measures, including both qualitative andquantitative elements tailored to an institution's specificcircumstances, may be required from either the overallsupervisoryassessmentor,asstatedinArticle124(5),inresponsetoaninstitutionreportingthatitseconomicvaluemaydeclineby

6TheScopeofapplicationoftheSRPissetoutonpage9oftheCEBSguidelinesontheApplicationoftheSupervisoryreviewProcessunderPillar2January2006

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more than 20% of own funds as a result of applying thesupervisorystandardshock.

Supervisors should take into account not only the decline on the economicvaluebutalsothecurrentleveloftheeconomicvalue.

Therangeofpossiblesupervisorymeasurescouldbebutarenotlimitedto:

improvementofriskmanagementarrangements,

variationstointernallimits,

reductionoftheriskprofile,and

increaseintheamountofrequiredregulatorycapital.

Themeasure(s)usedinresponsetotheapplicationofthestandardshockwilldepend, interalia,onthecomplexityofthecalculationmethodusedand the appropriateness of the standard shock and the level of theeconomicvalue.

If the reduction in economic value is determined by a relativelystraightforward or standardmethodof calculation, the initial supervisoryreactionmightbetorequestadditional,possibly internal,information.If,however,thereductionisbasedontheoutcomeofamorecomplexmodelaboutwhich the supervisors havegreater information, theymight reachanassessmentoftheappropriatemeasure(s)morequickly.

In the latter case, the choice of the measure can take into accountelementssuchas:

theabsoluteandrelativesizeoftheexposure,

theeffectsofothershiftsortwistsintheyieldcurve(otherthanthestandardised),

thetreatmentofmulticurrencyaggregation,

thetreatmentofoptionalityandbehaviouralmaturity,forexampleofcurrentandsavingsaccounts,

theexpectedimpactonearningsandthetimingthereof,

the quality of risk management, the internal systems andmethodologiesandtheinternalcontrolsystem,

themarketsegmentsinwhichtheinstitutionisactive,

the link with other risk exposures of the institution, for examplecreditrisk,

peergroupcomparison(andbenchmarkingwherethemethodologiesaresimilar),

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thecompositionoftheinstitution'sownfunds,and

the relationship between the quantity of the institution's internalcapital and regulatory own funds and the quantity of its actualsurplusofregulatoryownfunds.

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AppendixI

BaselSupportingDocumentonInterestRateRisk

The15principlesgivenin theBaselSupportingDocumentPrinciples fortheManagementandSupervisionofInterestRateRisk,July2004,arelistedbelow.

Boardandseniormanagementoversightofinterestraterisk

Principle1:Inordertocarryoutitsresponsibilities,theboardofdirectorsinabank should approve strategies andpolicieswith respect to interest rate riskmanagementandensurethatseniormanagementtakesthestepsnecessarytomonitor and control these risks consistent with the approved strategies andpolicies. The board of directors should be informed regularly of the interestrateriskexposureofthebankinordertoassessthemonitoringandcontrollingof such risk against the boards guidance on the levels of risk that areacceptabletothebank.

Principle2:Seniormanagementmust ensure that thestructure of thebank'sbusinessandthelevelofinterestrateriskitassumesareeffectivelymanaged,that appropriate policies and procedures are established to control and limitthese risks, and that resources are available for evaluating and controllinginterestraterisk.

Principle 3: Banks should clearly define the individuals and/or committeesresponsible for managing interest rate risk and should ensure that there isadequateseparationofdutiesinkeyelementsoftheriskmanagementprocessto avoidpotential conflicts of interest. Banks should have riskmeasurement,monitoringandcontrolfunctionswithclearlydefineddutiesthataresufficientlyindependent frompositiontaking functions of the bankandwhich report riskexposuresdirectlytoseniormanagementandtheboardofdirectors.Largerormorecomplexbanksshouldhaveadesignatedindependentunitresponsibleforthe design and administration of the bank's interest rate riskmeasurement,monitoring,andcontrolfunctions.

Adequateriskmanagementpoliciesandprocedures

Principle4:Itisessentialthatbanks'interestrateriskpoliciesandproceduresare clearly defined and consistent with the nature and complexity of theiractivities. These policies should be applied on a consolidated basis and, asappropriate, at the level of individual affiliates, especially when recognizinglegaldistinctionsandpossibleobstaclestocashmovementsamongaffiliates.

Principle 5: It is important that banks identify the risks inherent in newproducts and activities and ensure these are subject to adequateproceduresand controls before being introduced or undertaken. Major hedging or riskmanagement initiatives should be approved in advance by the board or itsappropriatedelegatedcommittee.

Riskmeasurement,monitoring,andcontrolfunctions

Principle 6: It is essential that banks have interest rate risk measurementsystemsthatcaptureallmaterial sourcesof interestrateriskand thatassess

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theeffectofinterestratechangesinwaysthatareconsistentwiththescopeoftheir activities. The assumptions underlying the system should be clearlyunderstoodbyriskmanagersandbankmanagement.

Principle 7: Banks must establish and enforce operating limits and otherpractices that maintain exposures within levels consistent with their internalpolicies.

Principle 8: Banks should measure their vulnerability to loss under stressfulmarketconditionsincludingthebreakdownofkeyassumptionsandconsiderthose results when establishing and reviewing their policies and limits forinterestraterisk.

Principle 9: Banks must have adequate information systems for measuring,monitoring,controllingandreportinginterestrateexposures.Reportsmustbeprovidedonatimelybasistothebank'sboardofdirectors,seniormanagementand,whereappropriate,individualbusinesslinemanagers.

Internalcontrols

Principle 10: Banksmust have an adequate system of internal controls overtheir interestrateriskmanagementprocess.Afundamentalcomponentoftheinternalcontrolsysteminvolvesregularindependentreviewsandevaluationsofthe effectiveness of the system and, where necessary, ensuring thatappropriate revisions or enhancements to internal controls are made. Theresults of such reviews should be available to the relevant supervisoryauthorities.

Informationforsupervisoryauthorities

Principle 11: Supervisory authorities should obtain from banks sufficient andtimely informationwithwhich toevaluatetheir levelof interest rate risk.Thisinformation should take appropriate account of the range of maturities andcurrenciesineachbank'sportfolio,includingoffbalancesheetitems,aswellasotherrelevantfactors,suchasthedistinctionbetweentradingandnontradingactivities.

Capitaladequacy

Principle12:Banksmustholdcapital commensuratewith the levelof interestraterisktheyundertake.

Disclosureofinterestraterisk

Principle 13: Banks should release to the public information on the level ofinterestrateriskandtheirpoliciesforitsmanagement.

Supervisorytreatmentofinterestrateriskinthebankingbook

Principle 14: Supervisory authorities must assess whether the internalmeasurement systems of banks adequately capture the interest rate risk intheir banking book. If a bank's internal measurement system does notadequatelycapturetheinterestraterisk,banksmustbringthesystemtothe

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required standard. To facilitate supervisors' monitoring of interest rate riskexposures across institutions,banksmustprovide the resultsof their internalmeasurement systems, expressed in terms of the threat to economic value,usingastandardizedinterestrateshock.

Principle 15: If supervisors determine that a bank is not holding capitalcommensurate with the level of interest rate risk in the banking book, theyshouldconsiderremedialaction,requiringthebankeithertoreduceitsrisk,toholdaspecificadditionalamountofcapital,oracombinationofboth.

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AppendixII

BaselCommitteeonBankingSupervision

PrinciplesforthemanagementandsupervisionofinterestrateriskJuly2004

Annex4Anexampleofastandardizedframework

1.Thisannexcontainsanexamplesettingoutthemethodologyandcalculationprocess inoneversionofastandardizedframework.Othermethodologiesandcalculationprocessescouldbeequallyapplicableinthiscontext,dependingonthe circumstances of the bank concerned. Such a framework is intended forsupervisory reporting purposes only, and is not intended to represent anadequateframeworkforinternalriskmanagementpurposes.

A.Methodology

2. Positions on the banks balance sheet would be slotted into the maturityapproachaccordingtothefollowingprinciples:

(a)Allassets and liabilities belonging to thebankingbookandallOBS itemsbelongingtothebankingbookwhicharesensitivetochangesininterestrates(including all interest rate derivatives) are slotted into a maturity laddercomprising a number of time bands large enough to capture the nature ofinterest rate risk in a national banking market. Annex 2 discusses issuesrelatingtotheselectionofappropriate timebands.Separatematurity laddersaretobeusedforeachcurrencyaccountingformorethan5%ofeitherbankingbookassetsorliabilities.

(b)Onbalancesheetitemsaretreatedatbookvalue.

(c) Fixedrate instruments are allocated according to the residual term tomaturity and floatingrate instruments according to the residual term to thenextrepricingdate.

(d)Exposureswhichcreatepracticalprocessingproblemsbecauseoftheirlargenumber and relatively small individual amount (e.g. installment ormortgageloans) may be allocated on the basis of statistically supported assessmentmethods.

(e) Coredeposits are slotted according to an assumedmaturity of no longerthanfiveyears.

(f) National supervisors will provide guidance on how other items with abehavioural maturity or repricing that differ from contractual maturity orrepricingaretobeslottedintothetimebandstructure.

(g) Derivatives are converted into positions in the relevant underlying. Theamounts considered are the principal amount of the underlying or of thenotionalunderlying.

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(h) Futures and forward contracts, including forward rate agreements (FRA),aretreatedasacombinationofalongandashortposition.ThematurityofafutureoraFRAwillbetheperioduntildeliveryorexerciseofthecontract,pluswhereapplicablethelifeoftheunderlyinginstrument.Forexample,alongposition in a June three month interest rate future (taken in April) is to bereportedasalongpositionwithamaturityoffivemonthsandashortpositionwithamaturityoftwomonths.

(i) Swaps are treated as two notional positionswith relevantmaturities. Forexample,an interest rate swap underwhich a bank is receiving floatingrateinterest and paying fixedrate interest will be treated as a long floatingratepositionofmaturityequivalenttotheperioduntilthenextinterestfixingandashortfixedratepositionofmaturityequivalenttotheresiduallifeoftheswap.The separate legs of cross currency swaps are to be treated in the relevantmaturityladdersforthecurrenciesconcerned.

(j) Options are considered according to the delta equivalent amount of theunderlyingorofthenotionalunderlying.

B.Calculationprocess

3.Thecalculationprocessconsistsoffivesteps.

(a)Thefirststepistooffsetthelongsandshortsineachtimeband,resultinginasingleshortorlongpositionineachtimeband.

(b)Thesecondstepistoweighttheseresultingshortandlongpositionsbyafactorthatisdesignedtoreflectthesensitivityofthepositionsinthedifferenttimebandstoanassumedchangeininterestrates.ThesetofweightingfactorsforeachtimebandissetoutinTable1below.Thesefactorsarebasedonanassumedparallelshiftof200basispoints throughout the timespectrum,andonaproxyofmodifieddurationofpositionssituatedatthemiddleofeachtimebandandyielding5%.

(c)Thethirdstepistosumtheseresultingweightedpositions,offsettinglongsandshorts, leadingtothenetshortor longweightedpositionofthebankingbookinthegivencurrency.

(d)Thefourthstep is tocalculate theweightedpositionof thewholebankingbook by summing the net short and longweighted positions calculated fordifferentcurrencies.

(e)Thefifthstepistorelatetheweightedpositionofthewholebankingbooktocapital.

Table1isprovidedintheBaseldocumentitself