MORNBFI Vol. 1 - Planters Development Bank

APP. Q-4308.12.31Exposure to earnings typically receivesthe most attention. Many FIs use a modifiedinterest rate gap or earnings simulationmodel to forecast earnings over a runningnext twelve (12) month time horizon undera variety of interest rate scenarios. Giventhat a large portion of a typical FI’s liabilitiesand even assets re-price in less than one (1)year, there is value in such a system. Forexample, earnings are a key measure indetermining if the board of directors iscreating value for the shareholders.However, earnings over the next twelve(12) months do not present a completepicture of an FI’s exposure to interest raterisk. Many FIs hold assets such as bonds andfixed rate loans with extended terms. Thefull effect of changes in interest rates on thevalue of these assets cannot be fullycaptured by a short-term earnings model.Thus, it is also important to consider a morecomprehensive picture of the FI’s exposureto interest rate risk through an assessmentof the FI’s economic value.The BSP will not consider market riskto be “well managed” unless the FI has fullyimplemented an effective risk measurementsystem whose sophistication is commensuratewith the nature and complexity of the riskassumed. Smaller FIs with non-complex singlecurrency balance sheets may be able to use asingle non-complex measurementmethodology, such as re-pricing gap analysisto manage their interest rate risk. However,large commercial or universal banks withcomplex, multi-currency balance sheets, orFIs that accept large exposures of interestrate risk relative to capital will be expectedto measure interest rate risk through acombination of earnings simulation andeconomic value. Trading activities shouldcontinue to be managed through the use ofan effective, and independently validatedValue-at-Risk (VaR) methodology.a. Earnings perspectiveAn FI should consider how changes ininterest rates may affect future earnings. Thefocus of analysis under the earningsperspective is the impact of changes ininterest rates on accrual or reportedearnings. Volatility in earnings should bemonitored and controlled because reducedearnings or outright losses can threaten thefinancial stability of an FI by underminingits capital adequacy. Further, unexpectedvolatility in earnings can undermine an FI’sreputation and result in an erosion of publicconfidence.Fluctuations in interest rates generallyhave the greatest impact on reportedearnings through changes in net interestincome (i.e., the difference between totalinterest income and total interest expense).Thus, the BSP will expect FIs to adoptsystems that are capable of estimatingchanges to net interest income under avariety of interest rate scenarios. Forexample, non-complex FIs with traditionalbusiness lines and balance sheets couldpotentially limit their simulations to a single±100 basis point parallel rate shock.However, FIs that hold significant levels ofderivatives and structured products relativeto capital should incorporate more severerate movements (e.g., ± 100, 200 and 300basis points) to determine what happens ifstrike prices are breached or “events” aretriggered. Further, the BSP will expect an FIto employ alternative scenarios such aschanges to the shape of the yield curve ifthe FI is exposed to significant levels ofyield curve or basis risk.Changes in market interest rates mayalso affect the volume of activities thatgenerate fee income and other non-interestincome. Thus, FIs should incorporate abroader focus on overall net income –incorporating both interest and non-interestincome and expenses – if the FI reportssignificant levels of interest rate sensitivenon-interest income.b. Economic value perspectiveThe economic value of an FI can beviewed as the present value of an FI’sQ RegulationsAppendix Q-43 - Page 4Manual of Regulations for Non-Bank Financial Institutions