6.4.2
| In order to model option risk appropriately, all institutions should, at a minimum, undertake the following steps:
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| | (i) | Identify all material products subject to embedded options, |
| | (ii) | Ensure that assumptions employed in modelling are justified by historical data, |
| | (iii)
| Understand the sensitivity of the IRRBB metrics to change in the assumptions related to option risk, and (iv) Fully document the method and assumptions used to model option risk.
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6.4.3
| LSIs should incorporate option risks at a granular level and undertake the necessary analysis to substantiate their assumptions. Option risk can be modelled and estimated at an aggregated level that displays similar behavioural characteristics, but the model results should be applied as a granular level. For that purpose, LSIs can use the standardised approach as a starting point and elaborate on it, in such a way that the approach meets the size and complexity of the institution. Ultimately, cash flows from assets and liabilities should be conditional upon the level of interest rates in each scenario. The methodology and assumptions employed to model optionality should be fully documented.
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6.4.4
| Non-LSIs should use the EVE approach articulated in the Basel Standards on IRRBB, whereby option risk is incorporated via the dependency of cash flows on interest rate levels by using conditional scalers. Subsequently, under each stress scenario with specific interest rate shocks, institutions should employ a different set of netted cash flows per bucket to compute EVE. In other words and using the Basel formulation, the cash flow CFi,c(tk) should vary for each interest rate scenario, where i, c and tk are respectively the interest rate scenario, the currency and the time bucket. The below steps explain further the standardised approach.
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6.4.5
| Non-maturity Deposits (“NMD”): All institutions should model option risk for NMD, as described in the Basel Standards on IRRBB, from article 110 to 115. The objective is to assess the behavioural repricing dates and cash flow profiles of NMD. In particular, institutions should undertake the following steps:
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| | (i)
| Segregate NMD into categories of depositors, considering at a minimum, retail clients, wholesale clients and Islamic products.
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| | (ii)
| Identify stable and core deposits, defined as those that are unlikely to be repriced, even under significant changes in the interest rate environment. For that purpose, institutions should analyse historical patterns and observe the change in volume of deposits over long periods. Institutions should describe the data sample and the statistical methodology used for this analysis. |
| | (iii)
| For each segment, apply the caps mentioned in Table 2 of the Basel Standards on IRRBB and allocate the cash flows in the appropriate time bucket based on their estimated maturity. |
| | (iv)
| Construct assumptions regarding the proportion of core deposits and their associated maturity under each interest rate scenario and in particular the potential migrations between NMD and other types of deposit. These assumptions should reflect the most likely client behaviour but with a degree of conservatism. Institutions should bear in mind the importance of portfolio segmentation on behavioural modelling.
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6.4.6
| Fixed rate loans: Such instruments are subject to prepayment risk because a drop in interest rates is susceptible to accelerate their early prepayment. In addition, restructuring events can also change their expected cash flow profiles. Consequently, all institutions should implement the approach mentioned in articles 120 to 124 of the Basel Standards on IRRBB. In particular, institutions should proceed as follows.
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| | (i) | Business-as-usual prepayment ratios should be estimated per product type and per currency. |
| | (ii)
| These ratios should be multiplied by the scalers in Table 3 of the Basel Standards on IRRBB, that depend on the interest rate shock scenarios, in order to derive adjusted prepayment rates. If the institution has already defined prepayment rates under each scenario based on its own internal historical data, then it can use these rates, provided that they are fully documented and justified. Portfolio concentration and segmentation should be taken into account when performing such behavioural modelling. |
| | (iii)
| The adjusted prepayment rates should be employed to construct the repayment schedule under a given scenario. The choice of the time buckets where the prepayments are made, should also be justified and documented.
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6.4.7
| Term deposits: Such instruments are subject to redemption risk because an increase in interest rates is susceptible to accelerate their early withdrawal. Consequently, all institutions should implement the approach mentioned in the articles 125 to 129 of the Basel Standards on IRRBB. In particular, institutions should proceed as follows:
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| | (i) | Business-as-usual redemption ratios should be estimated per product type and per currency. |
| | (ii)
| These ratios should be multiplied by the scalers in Table 4 of the Basel Standards on IRRBB, that depend on the interest rate shock scenarios, in order to derive adjusted redemption rates. |
| | (iv)
| The adjusted redemption rates should be used to derive the proportion of outstanding amount of term deposits that will be withdrawn early under a given scenario. If the institution has already defined redemption rates under each scenario based on its own internal historical data, then it can use these rates, provided that they are fully documented and justified. Portfolio concentration and segmentation should be taken into account when performing such behavioural modelling. |
| | (iii)
| That proportion is finally allocated to the overnight time bucket, per product type and per currency, as per article 127 of the Basel Standards on IRRBB. |
| | (iv)
| Finally, institutions should take into consideration off-balance sheet exposures in the form of future loans and expected drawings on committed facilities.
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6.4.8
| Automatic interest rate options: All institutions should follow the methodology articulated in the Basel Standards on IRRBB in articles 130 to 131. Automatic interest rate options should be fully taken into account in the estimation of both EVE and NII.
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