Hong Kong

Speaking points

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 Agenda
• Objective of presentation: take the group through the
US approach to monitoring and supervising IRRBB

• Summarize the US policy statements on IRR

• Discuss the two pronged approach to monitoring,

including inherent risk monitoring and risk management
review

• Discuss the current supervisory approach, given the

on-going extended low rate environment, and other
banking trends
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 Key rates landscape

• Overview on the landscape of where rates are

• Given the protracted period of low interest rates, industry

margins continue to compress as higher yielding assets
run off balance sheets and are replaced by lower yielding
assets, and rms have essentially bottomed out in their
ability to lower funding costs any further

• The at yield curve continues to put downward pressures

on NIM

US bank margins fell to 3.02% at 1Q15, which is the

lowest average NIM since 1984

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US banking: optionality & complexities

• Set up rest of presentation by highlighting the unique features of
the US banking market, which give rise to complexities and
challenges for evaluating IRR

• US mortgages comprise about 40% of total nancial assets, and

are highly negatively convex, due to the borrower prepayment
option

• In addition, depositor behavioral modeling adds additional

complexities on the liability side, as banks must anticipate
customer behaviors, in response to pricing stances

This is a big deal, since deposits often comprise between 50

and 90% of overall funding at banks

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 Primary drivers of IRR - not uniform

• In addition to the optionality and convexity on both sides of the
balance sheet, the complexity and nuance can vary widely
between banks

• Individual banks can have very different risk pro les, based on the
composition of key drivers on their balance sheets or within their
investment portfolios

• For example, I've provided consolidated nancials from Bank of

America and Citigroup, which are two of the largest banking
organizations in the United States. The differing investment portfolio
allocation and domestic vs. non-domestic deposit mix at these two
rms, leads to vast differences in primary drivers of their IRR

• Thus, different approaches, including highly customized analysis,

must be taken to measure and manage risk appropriately

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 • Given the diversity and nuance within the US

banking system, a one-size- ts-all approach is not
feasible, particularly for the largest, most complex
rms.

• As such, we (as supervisors) rely on rm derived

IRR metrics, based on the rms' own internal
models and highly customized assumptions

• So, as I will discuss on subsequent slides, and in

the next section, appropriate supervisory
monitoring includes clear communication of
expectations, and well as detailed and rigorous
customized reviews and examinations

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 IRR supervisory approach:

customized
• In the US, we use a customized 'two-pronged'
supervisory approach, including:

Expectations, which are set out through several

pieces of established, principles based
guidance, as well as

Monitoring, including detailed reviews of banks'

model parameter estimates and approach

 Clear supervisory expectations

• In terms of expectations, the two chief pieces of guidance that relate to IRRBB, include:
the "1996 joint policy statement on IRR", and the "2010 advisory on IRR management"

• In our guidance, we set out clear supervisory expectations for:

Corporate governance over IRR, including expectations for board of directors' ability
to monitor the level and trend of IRR, and specify appropriate risk tolerances for the
rm

Policies and procedures for IRR management, including expectations for the
development of IRR metrics, corresponding risk limits, as well as escalation
processes or committee review, as appropriate

Measurement and monitoring expectations, including requirements for both

earnings and valuation style metrics, stress testing expectations across yield curve
moves of various sizes and shapes, as well as rigorous assumption development

Risk mitigation process, including ability to measure for excessive IRR exposures
and take appropriate risk mitigating steps, and lastly

Internal controls and validation, including expectations for rms to have adequate
control frameworks over the IRR process, as well as independent review
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• As I noted, after the establishment of clear

supervisory expectations, the second part of our
supervisory approach includes detailed and
rigorous monitoring

• In our supervisory monitoring, we assess both:

Quantitative indicators of inherent risk exposures,

on a rm by rm, and peer benchmarking basis,
as well as

Qualitative review factors, to monitor quality,

appropriateness, and comprehensiveness of risk
management frameworks

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 IRRBB risk assessment framework

• On this slide I've provided a diagram of our qualitative and quantitative monitoring
approach, and how this combines into an overall assessment

• Starting with IRR management, using a 5-point rating scale (from strong to
unsatisfactory), we assess the frameworks across 4 broad categories, which combine
into an overall risk management assessment for IRRBB

These categories broadly align with the expectations over governance, policies,
procedures, measurement, monitoring, etc., that we set out in our guidance

• Then, we assess several indicators of inherent risk, including rm derived EAR and
EVE metrics, as well as trends in risk, hedging strategies, and size and stability of
earnings or capital.

These are also rated using a 5-point scale, from low to high, and roll into an overall
level and trend assessment of inherent risk

• I want to point out the signi cance of the right arrow in the center of the diagram. We
place quite a bit of signi cance on the assessment of risk management, as due to the
intricate and highly complex processes required, inherent risk really can't be
accurately determined without the fundamentals of risk management met
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 Key risk scenario: attening yield curves

• For the next three slides, I've provided some examples of some of the
quantitative factors we assess across our banking organizations

• Right now, a key risk scenario we are monitoring is a further attening of

the yield curve, including either a bear attening (short rates up) or bull
attening (long rates down) situations (raihan provided an example of
this this morning, of how the US treasury curve has experienced a bear
attening since 2013 vs today)

• Both of these scenarios pose threats to near term earnings

• In the chart, I show a distribution of earnings at risk results (which is

%change in NII) for both a traditional +200 parallel shock, as well as a
bear attener, where only the short end of the curve rises 200bps

• As you can see in the chart, the distribution shifts to the left and narrows,
under the bear attener, indicating increased risk under this scenario

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 Risk from elevated deposit sensitivity

• As I mentioned in the beginning, depositor behavioral considerations
add a good deal of complexity and uncertainty to IRR measurement

• Due to the overall reliance on deposits as a source of funds, IRR

measures have a high degree of sensitivity to behavioral assumptions
that are applied

• As a result, we tend to look at a range of outputs for a given metric,

rather than just point estimates, using sensitivity tests of changing
assumptions

• In the graph on this page, I've provided an example where we've looked
at EVE results, using three different assumption sets for deposit behavior

• The chart shows that as we increase pricing response rates and run-off
rates, the distribution of EVE results broadens and shifts to the left

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Investments and unrealized gains/losses

• Next, I've provided some other conditions and trends that we've been
monitoring, as an example of other quantitative factors we consider,
beyond EAR and EVE metrics

• The investment portfolio can be a key source or driver of balance sheet

rate sensitivity, and also requires speci c consideration and targeted
analysis

• The charts across the top of the page are examples of some broad
factors we are monitoring for evidence of higher risk investment
strategies

• We monitor for increased risk taking activities, such as taking on more

duration or credit risk in the portfolio, or for increased leverage or other
yield chasing strategies

• We want to be able to catch rms who may be chasing yield today, at

the expense of securities depreciation under rising rate scenarios

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 Risk management
assessment framework
• In terms of qualitative review of risk management, I've provided
here a summary of our assessment framework, and detailed
considerations

• I know the font is a bit small, and there is a lot of text here, but I
mostly want to give you a sense of the thoroughness and depth
of our assessment, as well as the range of our consideration

• As I noted, we review 4 broad categories (we call these pillars

of risk management), which combine into an overall rating

• Each of these pillars has 2 or 3 sub-pillars that are also rated

and combine into the individual pillar rating

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 Example: ratings criteria - board oversight

• For example, I've highlighted here and example of internal guidelines
we use to assess the "board oversight" sub-pillar of the governance
pillar, as well as the key considerations for review

• As you can see across the table, we have set our examiner guidelines
for assessing the quality of the risk management approach along our 5
point scale

For example, under marginal or unsatisfactory ratings, you'll see

language such as "de cient oversight" or "critical absence" vs

Language such as "adequate" and "comprehensive" in the better

rated categories

• Each of the sub-pillars has a corresponding table like this to provide

guidelines across the ratings framework, the full set of which leading to
the consolidated overall risk management rating

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• In this next section of the presentation, I wanted to

spend some time talking about our current
supervisory focus and considerations

• Given the unprecedented ultra low rate

environment of the last 8 years, as well as
uncertainty regarding the timing and size of future
rate moves and their impacts, we've been highly
focused on aspects of model risk management

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 US banking trends: deposit growth

• US banks have experienced signi cant growth in deposits since 2008

• Much of this growth has been in non or indeterminate maturity deposits

• In the charts on this slide I highlight this growth, with the chart on the
left depicting the overall growth in deposits, and the chart on the right
showing the mix change

• Mix change tends to be correlated with levels of short term rates

in periods of lower rates, customers prefer the additional liquidity

and exibility of non-maturity accounts (such as checking or
savings)

In periods of higher rates, customers are more willing to lock away

their money in time deposits, such as 5 year CDs

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US banking trends: increased cash

• Several years ago, the outlook for increasing rates
resulted in much of the banking industry restructuring
their balance sheet to bene t

• We have seen expectations for rate rise manifest over

the years with balance sheet allocation shifts showing
greater cash and short term positions, particularly at the
largest rms, depicted in green

• However, in general, the more rms have structured their

balance sheets to bene t from short term rates, the more
they have given up on current earnings when rate rises
haven’t materialized.
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 MRM: key assumption development

• Given the overall changes in banks' balance sheets since the crisis, we
have focused on several aspects of model risk management, including:

Key assumption development, particularly around deposit modeling

and assumptions, sensitivity testing of those assumptions, and back
testing of the ALM model and assumptions, to avoid unforeseen
model risk

• Model risk is an important consideration in IRR measurement, as the

ALM setup typically requires a complex mix of hundreds of assumptions
or inputs from various sources, each of which has the potential to
introduce model risk errors

• Inputs include relatively certain inputs, such as contractual features,

historical product behavior, or spot yield curves, but they also include
more subjective or strategic factors, such as loan growth targets,
deposit pricing stance, and behavioral assumptions for optionality

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MRM: key assumption - deposits

• Given the overall signi cance of deposit assumptions on
IRR measurement, as well as the growth and changes in
the deposit market over the last several years, a good deal
of our supervisory attention has been focused on
assessing deposit modeling approaches

• In fact, we have conducted several supervisory

assessment exercises targeted solely on assumption
development around deposits, to understand whether
current methods used to model beta (response rate) and
decay (run-off rate) are suf ciently robust

• Key challenges for us have been to understand what are

reasonable assumptions, particularly given that there are
many divergent industry views
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 MRM: NMD modeling considerations

• Some of the things we need to consider are the following

• As I mentioned, deposits have surged since 2008. Much of this surge

may include parked cash due to the lack of other investment
opportunities or desire to stay liquid in anticipation of higher rates

• Given the extended period of low rates, how has this affected
composition of deposits? When can we expect a reversal of mix
change, into higher cost deposits?

• Also, how will this deposit surge behave in rising rates? Will banks'
historical experience be a viable indicator? How should deposit model
output be adjusted to account for future expectations?

• How will competition dynamics affect pricing stances (beta)? Will banks
price up to retain deposits, if needed? How does this affect P&L?

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MRM: sensitivity testing is imperative

• In order to deal with the uncertainty, as well as the lack of
representative data following this unprecedented period of low
rates, sensitivity testing is imperative

• As discussed, a given assumption leads to a single point

estimate, and actual values may be higher or lower than this point
estimate

• Also, management adjustments (based on judgement or

experience) to deposit model output (derived from historical data)
are naturally prone to human cognitive bias and judgement error

• Rigorous sensitivity testing helps to measure the impact of being

incorrect, by measuring the impact if the assumption is higher or
lower than originally modeled

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MRM: sensitivity test - expectations

• Through our supervisory monitoring over the last several years, we have been
strongly communicating to bankers, our expectations regarding good quality
sensitivity tests

• We've encouraged banks to consider both the range or type of tests

performed, as well as the magnitude of tests

• By range of tests, I mean the following:

NII: beta tests = changes to the response rate. So, for example, changing
the assumption around how much of the market rate change ows through
to deposit cost

NII: balance change (mix) or disintermediation (out ow) tests, which are
tests targeted at volume projections or assumed balances

EVE: we encourage both balance and pricing tests, including tests related
to decay, or the speed at which balances are assumed to runoff or attrite, as
well as truncation point tests, if this assumption is used

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 MRM: sensitivity test - considerations
• In our reviews and examinations, some considerations we make when determining
quality of tests and suf ciency of risk capture include assessments around:

Magnitude of tests, and whether potential convexity is captured. For example, a

test of 1bps perturbation multiplied by 500, is not necessarily the same as
testing a 5% change, depending on modeling approach

We compare tests performed against historical standard deviations from bank

experience (over previous rising rate periods, for example) as well as range of
practice for peer institutions, and market expectations

Also, we consider additional factors related to individual banking pro les, such
as post-crisis deposit growth vs. historical growth patterns, and if there were to
be a reversal of deposit surge growth

Finally, we also consider assumptions and tests related to pricing stance and
funding strategies. For example, if a bank models under market betas (lower
than peer pricing stance), do they also model higher potential run-off rates, due
to competition, etc.

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 MRM: back testing

• In addition to deposit sensitivity testing, we've also placed supervisory attention on
back testing approaches

• A common complaint we've heard from our supervised banks is "why should I back
test my current model, if rates haven't changed? What is there to test?"

• However, we've communicated that now is the time for back testing the model for
several reasons:

First, instituting a good quality and rigorous back testing program during more
stable environments, allows a rm to bolster a models foundation, by identifying
potential modeling errors outside of rate driven effects. This can include data
errors, or cash ow modeling agency errors, or granularity or precision issues

Second, building a more reliable model can help a bank react more swiftly and
prudently in more volatile times

I included the quote to emphasize my point: the time to learn how to sail a ship
is during calm waters, not while sailing into a storm

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 MRM: back testing using the model

• Fortunately, back testing IRR models can be assisted by using the model itself to
execute the back testing.

• ALM systems and models typically facilitate the ability to hold constant a subset of
factors, in order to assess various modeling components individually. This has a
number of advantages and bene ts which assist in assessing the model
performance itself.

• ALM models are often aligned with core data systems and general ledger, so data
related to actual balances and interest income or expense is available on a frequent
basis

This information can help test the models on-going cash ow and interest accrual
accuracy, as well as business forecasting performance (new business
projections, growth, etc.)

In addition, regularly back testing results can reveal modeling consistency issues,
such as upstream modeling or data changes, or other change control issues

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MRM: concepts to keep in mind
• Last slide

• Finally, the most important concept we want to

communicate to our supervised rms is: "models aren't
precise"

• Models are tools that are used to assess potential risk,

and should be treated as such, a tool vs. the correct
answer or correct assumptions

• So, rather than searching for "correct" assumptions, we

look for "good" assumptions, which are those that are
supported by rigorous sensitivity testing and back testing

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