Interest rate risk: SBP asks banks and DFIs to allocate appropriate capital

The State Bank of Pakistan (SBP) Thursday directed banks and DFIs to determine and allocate appropriate capital for interest rate risk in the banking book.
In order to strengthen interest rate risk monitoring and avert risks emanating from adverse movements in interest rates, the central bank has issued guidelines on Interest Rate Risk Management (IRRM) on April 16, 2015, asking banks and DFIs to develop an IRRM policy as a separate document or as a distinct part of a comprehensive risk management policy duly approved by the Board of Directors.
Effective measurement and management of interest rate risk is crucial for banks to manage liabilities and assets portfolio, which are exposed to risks emanating from adverse movements in interest rates. The changes in interest rates not only impair the current and potential future earnings but may also potentially threaten the bank's solvency. Consequently, to strengthen interest rate risk monitoring and measurement, SBP has developed guidelines on IRRM.
The SBP has directed banks and DFIs to make adequate and reliable arrangements for adoption of the guidelines and formulate IRRM processes and procedures for covering trading and banking books aspects separately.
Banks and DFIs have been advised to ensure to determine the impact of interest rate exposure arising from balance sheet structure on the bank's earnings and economic value of equity. In addition, they are urged to determine and allocate appropriate capital for interest rate risk in the banking book as also required under Internal Capital Adequacy Assessment Process of Pillar II-Basel Accord.
The SBP has asked bank and DFIs to use any appropriate statistical tools along with other qualitative and quantitative techniques for measuring interest rate risk and models mentioned in SBP's IRRM guidelines are for the illustration purposes.
However, the banks have been advised to clearly spell out the rationale for selection of a particular technique or model for managing their interest rate exposures. Annexures at the end of these guidelines are provided by SBP to facilitate and enhance understanding on the subject.
According to size and complexity of the activities, all banks/DFIs have been advised to make adequate and reliable arrangements for adoption of the guidelines and put in place effective interest rate risk monitoring and management system by 30th September, 2015. The compliance will also be reviewed by the State Bank's inspection team during their on-site inspections.
According to SBP interest rate risk is the exposure of a bank's financial condition to adverse movements in interest rates. The changes in interest rates can have considerable negative impact on a bank's earnings or value of a portfolio causing reduction of its equity.
Presently, banks are required to hold capital against interest rate risk in the trading book as part of market risk under Pillar 1 of Basel Capital Accord. Whereas for interest rate risk in the banking book, the State Bank has already advised banks to develop internal methodologies to estimate interest rate exposure and allocate adequate capital under Internal Capital Adequacy Assessment Process (ICAAP) of Pillar II of the Basel Capital Accord as adopted in Pakistan.