RBS 2013 Annual Report Download - page 336
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Business review Risk and balance sheet management
334
Market risk continued
Non-traded market risk
Risk management
The governance framework, risk management principles and appetite
and limit framework applicable to the Group’s management of market risk
are covered by the discussion on pages 176. More specific information
on the Group’s management of non-traded market risk is provided below.
The Group manages non-traded market risk, separately for the three key
categories: non-traded interest rate risk; non-traded foreign exchange
risk; and non-traded equity risk.
Non-traded market risk positions are reported on a regular basis to
divisional Asset and Liability Management Committees (ALCOs) and
monthly to the Group Balance Sheet Management Committee (BSMCo),
Group Asset and Liability Committee (GALCO) and the Group Board,
with the exception of equity positions, which are reported quarterly to
GALCO.
Interest rate risk
Non-traded interest rate risk (NTIRR) factors are grouped into the
following categories:
• Repricing risk, which arises when asset and liability positions either
mature (in the case of fixed-rate positions) or their interest rates
reset (in the case of floating-rate positions) at different dates. These
mismatches may give rise to net interest income and economic
value volatility as interest rates vary.
• Yield curve risk, which arises from unanticipated changes in the
shape of the yield curve, such that rates at different maturity points
may move differently. Such movements may give rise to interest
income and economic value volatility.
• The two risk factors above incorporate the duration risk arising from
the reinvestment of maturing swaps hedging the Group’s net free
reserves (or net exposure to equity and other low fixed-rate or non-
interest-bearing liability balances including, but not limited to, current
accounts).
• Basis risk, which arises when related instruments with the same
tenor are valued using different reference yield curves. Changes in
the spread between the different reference curves can result in
unexpected changes in the valuation of or income difference
between assets, liabilities or derivative instruments. This occurs, for
example, in the Group's retail and commercial portfolios, when
products valued on the basis of the Bank of England base rate are
funded with LIBOR-linked instruments.
• Optionality risk, which arises when customers have the right to
terminate, prepay or otherwise alter a transaction without penalty,
resulting in a change in the timing or magnitude of the cash flows of
an asset, liability or off-balance sheet instrument. This risk primarily
arises in the US mortgage business in Citizens Financial Group
where long-term fixed-rate loans are the norm and prepayment
penalties are rare.
Due to the long-term nature of many non-trading book portfolios and their
varied interest rate repricing characteristics and maturities, it is likely that
net interest income will vary from period to period, even if interest rates
remain the same. New business originated in any period will alter the
interest rate sensitivity of the Group if the resulting portfolio differs from
portfolios originated in prior periods, depending on the extent to which
exposure has been hedged.
The Group’s policy is to manage the interest rate sensitivity within risk
limits that are approved by the ERF and endorsed by GALCO before
being cascaded to divisions through divisional ALCOs. These include, in
particular, interest rate sensitivity and VaR limits.
In order to manage exposures within these limits, the Group aggregates
its interest rate positions and hedges them externally using cash and
derivatives - primarily interest rate swaps.
This task is primarily carried out by Group Treasury, to which all divisions
except US Retail & Commercial and Markets transfer most of their
NTIRR. On a monthly basis, the Group’s main exposures and limit
utilisations are reported to the BSMCo, GALCO and the Group Board.
Foreign exchange risk
The Group’s only material non-traded open currency positions are the
structural foreign exchange exposures arising from its investments in
foreign subsidiaries and associates and their related currency funding.
These exposures are assessed and managed by Group Treasury under
delegated authority from GALCO. Group Treasury seeks to limit the
potential volatility impact on the Group’s Core Tier 1 ratio from exchange
rate movements to pre-defined risk appetite levels set by GALCO. The
sensitivity of the Group’s Core Tier 1 capital to exchange rates is updated
and reported to GALCO quarterly.
Foreign exchange exposures arising from customer transactions or profit
and losses are sold down by divisions and businesses on a regular basis
in line with Group policy.
Equity risk
Non-traded equity risk is the potential variation in the Group’s income and
reserves arising from changes in non-trading book equity valuations. Any
such risk is identified prior to any investments and then mitigated through
a framework of controls.
Investments, acquisitions or disposals of a strategic nature are referred to
the Group Acquisitions and Disposals Committee (ADCo). Once
approved by ADCo for execution, such transactions are referred for
approval to the Group Board, Group Executive Committee (ExCo), Group
Finance Director or as otherwise required. Decisions to acquire or hold
equity positions in the non-trading book that are not of a strategic nature,
such as customer restructurings, are taken by authorised persons with
delegated authority under the Group credit approval framework.
Risk measurement
Interest rate risk
NTIRR can be measured from either an economic value-based or
earnings-based perspective (or both). Value-based approaches measure
the change in value of the balance sheet assets and liabilities over a
longer timeframe, including all cash flows. Earnings-based approaches
measure the potential short-term (generally one year) impact on the
income statement of charges in interest rates.