Market risk and interest rate risk

The interest rate risk arising from Banking Book activities (IRRBB) encompasses current or prospective impact to both the earnings and the economic value of the Group’s portfolio arising from adverse movements in interest rates that affect interest rate sensitive instruments. The risk includes gap risk, basis risk and option risk.

In 2021, the Group was preparing to fully adjust to implement statutory replacement rate for two interest rate benchmarks, the Swiss Franc London Interbank Offered Rate (CHF LIBOR) and the Euro Overnight Index Change (EONIA). As of 1 January 2022 (for CHF LIBOR) and 3 January 2022 (for EONIA), all references to these rates in contracts and financial instruments were statutorily and automatically replaced with references to new risk-free rates as per decision of the European Commission. For CHF LIBOR, the nominated replacement rate is the new Swiss Franc risk-free rate SARON and for EONIA – euro risk-free rate €STR.

The framework of market risk and interest rate risk management and its control are defined on a centralized basis with the use of the same concepts and metrics which are used in all the entities of the BCP Group.

The Group’s market risk measurement allows monitoring of all the risk types, which are generic risk (including interest rate risk, foreign exchange risk, and equity risk), non-linear risk, specific risk and commodity risk. In 2021 the commodities risk did not exist in the Group. The equity risk assumed to be irrelevant since the Group’s engagement in equity instruments is immaterial.

Each market risk type is measured individually using an appropriate risk model and then integrated measurement of total market risk is built from those assessments without considering any type of diversification between the four risk types (the worst-case scenario).

The main measure used by the Group to evaluate market risks (interest rate risk, foreign exchange risk, equity risk) is the parametric VaR (Value at Risk) model – an expected loss that may arise on the portfolio over a specified period (holding period) and with specified probability (confidence level) from an adverse market movement.

The Value at Risk in the Group (VaR) is calculated considering the holding period of 10 working days and a 99% confidence level (one tail). In line with regulatory requirements of CRDIV / CRR, the volatility associated with each market risk vertex considered in the VaR model (and respective correlation between them) has been estimated by the equally weighted changes of market parameters using the effective observation period of historical data of last year. The EWMA method (exponentially weighted moving average method) with effectively shorter observation period is only justified by a significant upsurge in price volatility.

To monitor and limit the positions in instruments, for which it is not possible to properly assess market risk with the use of the VaR model (non-linear risk, commodity risk and specific risk), the appropriate assessment rules were defined. The non-linear risk is measured according to internally developed methodology which is in line with the VaR methodology – the same time horizon and significant level is used. Specific and commodities’ risks are measured through standard approach defined in supervisory regulations, with a corresponding change of the time horizon considered.

The market risk measurement is carried out daily (intra-day and end-of-day), both on an individual basis for each of the areas responsible for risk taking and risk management, and in consolidated terms for Global Bank, Trading and Banking Book considering the effect of the diversification that exists between the portfolios. In addition, each Book is divided into the risk management areas.

To ensure that the VaR model adopted is appropriate for the evaluation of the risks involved in the open positions, a back-testing process has been instituted and is carried out daily.

All reported excesses are documented. This includes an explanation of their causes and their incorporation in one of the three classes of excess explanation: adequacy of the model, insufficient model accuracy or unanticipated market movements.

Parallel to the VaR calculation the portfolios are subject to a set of sensitivity analysis and stress scenarios, to:

• Estimate the potential economic loss resulting from extreme variations in market risk factors,
• Identify the market risk movements, possibly not captured by VaR, to which the portfolios are more sensitive,
• Identify the actions that can be taken to reduce the impact of extreme variations in the risk factors.

The following types of market scenarios are being applied:

• Parallel shifts of the yield curves;
• More steep or flat shape of the yield curves;
• Variations of the exchange rates;
• Historical adverse scenarios;
• Customized scenarios based on observed, adverse changes of market risk parameters.

The global VaR limit is expressed as a fraction of the consolidated Own Funds.in 2021, the VaR limits were very conservative – set for Global Bank at no more than 2,6% and for Trading Book at 0,31% of Own Funds). The limit is divided into the books, risk management areas and various types of risk, which enables the Group for full measurement, monitoring and control of market risk. The market risk exposure (VaR) together with the limit utilization is reported daily to all areas responsible for management and control of market risk in the Group.

The market risk limits are revised at least once a year and to consider, inter alia, the change of the consolidated Own Funds, current and projected balance sheet structure as well as the market environment. The market risk limits valid for 2021 reflected the assumptions and risk appetite defined under Risk Strategy 2021 – 2023.

Within the current market environment, the Group continued to act very prudently. The strong market volatility in connection with the global COVID-19 pandemic and Monetary Policy Council’s (MPC’s) series of decisions to increase interest rates in Poland resulted in significant increase of the Group’s market and interest rate risk.

In 2021, the VaR for the Group that is jointly Trading Book and Banking Book, increased due to market volatility and in 4Q 2021 breached the limits in place.  All excesses of market risk limits are always reported, documented, and ratified at the proper competence level.

In 2021 the VaR indicators for the Group remained on average at the level of PLN 161.7 million (63% of the limit) and PLN 391.3 million (150% of the limit) as of the end of December 2021. The low level of diversification effect relates to the fact that the Group’s market risk is mainly the interest rate risk. The figures in the Table below also include the exposures to market risk generated in subordinated companies, as the Bank manages market risk at central level. The diversification effect applies to the generic risk and reflects correlation between its constituents.

The market risk in terms of VaR for the Group (‘000 PLN):

The corresponding exposures as of 2020 respectively amounted to (‘000 PLN):

The market risk exposure divided into Trading Book and Banking Book together with risk type division is presented in the table below (‘000 PLN):

Banking Book:

Trading Book:

Open positions mostly included interest-rate instruments and FX risk instruments. The FX risk covers all the foreign exchange exposures of the Group. According to the Risk Strategy approved in the Group, the FX open position is allowed, however should be kept at low levels. For this purpose, the Group has introduced a system of conservative limits for FX open positions (both Intraday and Overnight limits) and allows keeping FX open positions only in Trading Book.

In 2021, as a general rule FX position generated in the Banking Book was fully transferred to the Trading Book where it was managed daily. During 2021 the FX open position remained on average at the level of PLN 9.5 million with maximum of PLN 59.3 million. In 2021, the FX Total open position (Intraday as well as Overnight) remained below 2% of Own Funds and well below the maximum limits in place.

Evolution of the total FX open position (Overnight) in Trading Portfolio (PLN thousand):

In addition to above mentioned market risk limits, the stop loss limits are introduced for the financial markets’ portfolios. The aim is to limit the maximum losses of the trading activity of the Group. In case the limit is reached, a review of the management strategy and assumptions for the positions in question must be undertaken.

In the back-testing calculation for VaR model in Global Bank, nineteen excesses were detected during the last twelve months (see table below, PLN thousand).

In 2021, all excesses in the process of VaR model back testing were caused by unanticipated market movements caused by the COVID-19 pandemic uncertainty and MPC’s decisions to increase interest rates in Poland, of which strong changes in Polish government bonds yields and short-term interest rates in second half of 2021 had the most impact on VaR model performance. In consequences, due to the number of excesses detected, the assessment of VaR model performance felt into red zone: above 15 excesses. It forced immediate action in VaR calculations, including model parameters calibration to most recent market observation and temporary volatility method changed from equal weights to EWMA method, which is better suited during periods of significant upsurge in price volatility. It allowed stopping further excesses in VaR back testing. Due to one year monitoring period, higher number of excesses will be present for foreseeable future.

VaR assessment is supplemented by monitoring the market rate sensitivity to the above-mentioned stress tests scenarios of portfolios carrying market risk.

The results of market risk sensitivity and customized stress tests were regularly reported to the Capital, Assets and Liabilities Committee.

In case of the Banking Book, the main component of the market risk is interest rate risk.

Exposure to interest rate risk in the Banking Book are primarily generated by the differences in repricing dates of assets and liabilities as well as its reference indexes, if contractually existing. It is specifically affected by the unbalance between assets and liabilities that have fixed rate, especially by the liabilities which cannot have interest rate lower than 0. Consequently, the level of sensitivity to interest rate changes is influenced by the level of interest rates taken as a reference. Additionally, due to specificity of the polish legal system, the interest rate of credits is limited (it cannot exceed two times Reference Rate of the National Bank of Poland increased by 7 percentage points). In situations of decreasing interest rates, the impact on Net Interest Income is negative and depends on the share of the loan portfolio that is affected by the new maximum rate. On the other hand, assumptions regarding the timing and size of deposits repricing are also very important when assessing the interest rate sensitivity and risk.

In the first 3 quarters of 2021, the interest rates in Poland stayed at its historical minimum (after three rate cuts in 2020 – reference rate decreased to 0.10%, deposit rate to 0.0% and the Lombard rate to 0,50%). The maximum interest rate for loan portfolio could not exceed 7.2% annually. In 4th quarter 2021, series of interest rates increases driven by MPC’s decisions were reflected in change of interests for loans with gradual or immediate repricing. On the other side, the interest rates on deposits side still lagged increasing market rates.

Regarding the interest rate risk in Banking Book, the following principles are in place:

• The market risk that results from the commercial banking activity is hedged or transferred on the monthly basis to areas that actively manage market risk and that are measured in terms of risk and profit and loss,
• The Bank primarily uses natural hedging between loans and deposits as well as fixed rate bonds and derivatives to manage interest rate risk with the main purpose of protecting the net interest income.

The variations in market interest rate have an influence on the Group’s net interest income, both under a short and medium-term perspective, also affecting its economic value in the long term. The measurement of both is complementary in understanding the complete scope of interest rate risk in Banking Book.

For this reason, apart from daily market risk measurement in terms of value at risk, the scope of the additional measurement of interest rate risk covers both earnings-based and economic value measures, which are quarterly:

• the impact on the economic value of equity (EVE) resulting from different shocks with upward/downward yield curve movements, including scenarios defined by the supervisor (standard, supervisory test assuming sudden parallel +/-200 basis points shift of the yield curve as well as supervisory outlier test, SOT with set of six interest rate risk stress scenarios).

and monthly:

• the interest rate sensitivity in terms of BPVx100, that is the change of the portfolio’s value for the parallel movement in the yield curve by 1 basis point multiplied by 100,
• the impact on net interest income over a time horizon of next 12 months resulting from one-off interest rate shock of 100 basis points.

The interest rate risk measurement is carried for all the risk management areas in the Bank, with the particular attention on Banking Book.

For interest rate risk management for non-maturing assets and liabilities or for the instruments with Client’s option embedded, the Group is defining specific assumptions, including:

• Due date for balances and interest flows arising from non-maturing deposits are defined based on historical data regarding customer behaviour, considering the stability of the volumes and with assumption of a maximum maturity of 3 years,
• The tendency to faster repayment of receivables than contractually scheduled is taken under consideration by calculating a prepayment rate in respect to all relevant Banks’ loan portfolios based on historical data. It should be noted that mortgage loans that are the Group’s loan product with a dominant share, are indexed to floating interest rate. This causes that the tendency to early repayment is less important for the interest rate risk.
• The equity, fixed assets, and other assets that are assumed to have repricing period of 1 year. However, to understand the impact of the chosen maturity profile the IRRBB measurement is carried out without inclusion of the equity capital to isolate the effects on both EVE and earnings perspectives.

The results of the above-mentioned analysis for BPVx100 and economic value measures were regularly monitored and reported to the Capital, Assets and Liabilities Committee, to Risk Committee, the Management Board and Supervisory Board. Taking into account the increase of interest rates that occurred in the 4th quarter 2021, the results of the IRRBB measurement as of the end of December 2021 indicate that the Group is now in a more balanced situation regarding the scenario of a decline or increase in interest rates. The supervisory outlier test results of December 2021 show that even under the most severe outlier test scenario, the decline of EVE for Banking Book is below supervisory limit of 15% of Tier 1. Similarly, decline of EVE under standard scenario of sudden parallel +/-200 basis points shift of the yield curve also stayed far below supervisory maximum of 20% of Own Funds.

The results of the sensitivity of the Banking Book to changes of interest rates in terms of BPVx100 and EVE under supervisory stress tests are presented in Table below.

Sensitivity of the Banking Book to changes of interest rates was as follows (‘000 PLN):

The results of sensitivity of NII for the next 12 months after 31^st December 2021 and for position in Polish Zloty in Banking Book are carried out under the following assumptions:

• static balance sheet structure as of that reference date (no change during the following 12 months),
• reference level of net interest income assuming that all assets and liabilities with variable interest rate already reflect market interest rates levels as of 31^st December 2021 (for example, the NBP Reference rate at the end of 2021 was set at 1.75%),
• application of a parallel move of 100 bps in the yield curve up and down is an additional shock to all market interest rates levels as of 31^st December 2021 and is set at the repricing date of the assets and liabilities that happens during the 12 following months.

In a scenario of parallel decrease of interest rates by 100 bps, the results are negative and equal to -162 mln or -6.0% of the Group’s NII reference level.  In a scenario of parallel increase of interest rates by 100 bps, the results are positive and equal to 160 mln or +5.9% of the Group’s NII reference level. The level of asymmetry that existed in past reporting dates is now lower as interest rates were meaningfully above 0% on 31^st December 2021 and the leverage impact of the maximum interest rate is now less strong than in previous years due to changes in the structure of portfolio and pricing of loans.