BSOCS 5
Financial risk management
BSOCS 5.1
Introduction
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BSOCS 5.1.1
See Notes
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BSOCS 5.1.2
See Notes
As part of the implementation of the Capital Adequacy Directive (CAD), the Banking Consolidation Directive (BCD) and the Markets in Financial Instruments Directive (MiFID), provisions relating to a society's organisational and risk systems and controls have been introduced in SYSC 4 to SYSC 7. The guidance in this chapter generally explains the application of the high level requirements in SYSC 4 to SYSC 7 (even if there may not be a specific cross reference) in the context of financial risk management.
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BSOCS 5.1.3
See Notes
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BSOCS 5.1.4
See Notes
Societies with a trading book will also be subject to a market risk capital requirement calculated in accordance with BIPRU 7. This is unlikely to be applicable to any societies apart from those on the "Trading" approach: see BSOCS 1.10. A society with foreign currency exposures will however be subject to the foreign exchange capital requirements in BIPRU 7 whether or not it has a trading book.
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BSOCS 5.2
General
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Systems for controlling and managing financial risks
BSOCS 5.2.1
See Notes
In meeting the requirements of SYSC 4.1.1 R and SYSC 7.1.2 R in the context of financial risk management, a society should have an adequate system for managing and containing financial risks to the net worth of its business, and risks to its net income, whether arising from fluctuations in interest or exchange rates or from other factors.
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Systems for controlling index-related risks
BSOCS 5.2.2
See Notes
The arrangements, processes, and mechanisms required in SYSC 7.1.3 R should include systems and procedures for identifying, monitoring and controlling all material maturity mismatch, interest rate, base rate, foreign exchange and similar (e.g. index-related) risks, and for reporting exposures to senior management and the board of the society on a regular, and timely, basis. Societies should also have interest margin management systems in place to estimate the expected profitability of new mortgage and savings products, and to project forward the cumulative effect of mortgage incentives and loyalty schemes.
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Credit limits for counterparties
BSOCS 5.2.3
See Notes
Societies should have credit limits in place for all counterparties both for making treasury investments and for transacting derivative contracts (further guidance also in GENPRU 1.2 and BIPRU 12.4: stress testing and scenario analysis, and contingency funding plans).
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Policy statement on financial risk management
BSOCS 5.2.4
See Notes
In meeting the requirements in SYSC 7.1.4 R in the context of financial risk management, the board of a society should approve and periodically review a policy statement on financial risk management.
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BSOCS 5.2.5
See Notes
The policy statement establishes guidelines for the society's senior managers on the control of financial risks, including: operational risk; structural risk; funding risk; and counterparty credit risk (including settlement). These documents should be consistent with the type of business undertaken by the society and compliant with sections 7 and 9A of the 1986 Act.
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Policy statements on strategic framework for treasury operations
BSOCS 5.2.6
See Notes
Policy statements should set out the strategic framework for treasury operations, recording the rationale for that framework, i.e. why and how treasury activities are expected to support the society's core business, and the "approach" category being followed, derived, where possible, from the results of a financial risk review (either by the society's internal audit function or using external resources). They should clearly state the conditions under which authority is delegated to a board sub-committee, or to management, and should establish the operating limits and high level controls that will maintain exposures within levels consistent with the policy, and the procedures/controls on the introduction of new products or activities. Copies of the policy statements should be made available to, and read by, all personnel involved in treasury operations.
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BSOCS 5.3
Structural risks
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BSOCS 5.3.1
See Notes
Most societies are susceptible to interest rate exposure arising not only as a result of changes (or potential changes) in the general level of interest rates or the relationship between short term and long term rates, but also from divergence of rates for different balance sheet elements (basis risk), for example, the risk that it may not be possible to decrease administered savings rates in line with decreases in money market (LIBOR) rates, resulting in a margin squeeze where lending is LIBOR-based. In this chapter, risks which arise from the different interest rate or currency characteristics of assets and liabilities, and from transactions based on other financial reference rates or indices, are referred to as "structural" risks.
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BSOCS 5.4
Operational risks
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BSOCS 5.4.1
See Notes
The extension of society activities into more complex forms of funding, liquidity and off balance sheet instruments has dramatically increased the operational risks involved. The documentation, accounting treatment and settlement procedures for such instruments can be highly complex, with significant costs and penalties arising from operational mistakes. Societies involved in these areas of activity need rigorous management procedures and control systems to ensure that robust legal documentation is used, that compliance with market practice is achieved, and that deal recording and settlement systems are effective (with appropriate contingency arrangements in place).
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Key risk categories
BSOCS 5.4.2
See Notes
The key financial risks which, as envisaged in BSOCS 5.2.1 G, societies should manage and control, are:
(1) maturity mismatch, including the risks:
(a) that the society may be unable to refinance term wholesale borrowings on a rollover date due to general market conditions (which may or may not be related to the position of the society itself);
(b) associated with the bunching of roll-over dates for wholesale funding or maturities of term retail funding;
(c) from concentration on a limited number of funding providers, giving rise to increased dependence particularly on roll-over days; and
(d) arising from the prepayment (early repayment) profile of mortgages, and those inherent in the early withdrawal characteristics of retail savings products (i.e. behavioural as opposed to contractual maturity risks);
(2) interest rate risk to a society's earnings (most significantly, to its interest margin) and to its economic value (the present value of future cashflows) arising from:
(a) repricing mismatches, e.g. where, in a rising interest rate environment, liabilities reprice earlier than the assets which they are funding, or, in a falling rate environment, assets reprice earlier than the liabilities funding them (in both cases leaving the society with a reduction in future income); repricing risk is inherent in fixed rate instruments, the market value of which will change with interest rate movements (e.g. gilts), and unhedged fixed rate retail products (e.g. unhedged fixed rate mortgages funded by variable rate liabilities would yield less margin should the cost of the liabilities increase due to changes in market rates);
(b) yield curve risk, where unanticipated changes to the shape or slope of the yield curve will cause assets and liabilities to reprice relative to each other - possibly exposing positions which were hedged against a parallel shift in rates only;
(c) interest basis mismatches, arising from the imperfect correlation of rates on instruments with similar repricing characteristics, e.g. between LIBOR rates and mortgage rates (both of which are variable but are subject to different market forces), or between LIBOR and reference gilt rates, or between 3 and 12 month LIBOR rates etc. Risk can also arise where the underlying market rate is the same for matching assets and liabilities, but the margin paid relative to the offer rate diverges from the margin received relative to the bid rate;
(d) balance sheet composition, where an increase in the proportion of assets and liabilities repricing at fixed or variable wholesale market rates implies a reduced administered rate element in the balance sheet, which will nevertheless have to bear (at least in the short term) the full brunt of any rate changes required in order for a society to widen its margins, if necessary for business or profitability reasons (e.g. in the event of a significant credit deterioration leading to rising provision levels);
(e) optionality (i.e. explicit/contracted option contracts, such as "caps", "collars" and "floors", which confer the right, but not the obligation, to fix an interest rate for an agreed amount and for an agreed period and embedded/implied options included within products, such as early withdrawal or redemption entitlements), magnifying the effect of other interest rate risks: in particular, societies may be subject to implied optionality in respect of retail savings rates (for which a minimum rate payable - a "floor" - above 0% may need to be assumed), and from prepayment of mortgages/pre-withdrawal of deposits (where the customer may effectively have an "option" which may not be adequately "hedged" by way of early repayment charges); and
(f) product pricing, arising particularly where products are not immediately profitable and where longer term payback is dependent upon the achievement of specific cost and/or pricing assumptions;
(3) currency risk, arising from the effects of changing exchange rates on unmatched assets and liabilities denominated in different currencies; and
(4) index-related risk, arising from the effects of movements in an index of financial assets (e.g. the FTSE 100), or similar reference rate, on unmatched assets or liabilities paying or receiving a return based on that index/rate.
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BSOCS 5.4.3
See Notes
Societies' financial risk management policies should also cover:
(1) settlement risk: the risk of losses arising from failure to settle transactions accurately, or on a timely basis;
(2) counterparty risk: associated with settlement risk, where a counterparty cannot or will not complete a transaction; and
(3)
operational risk in treasury and related activities: including failure of internal controls or procedures, and the risk arising from errors in legal documentation.
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IT security
BSOCS 5.4.4
See Notes
Reliance on computerised dealing, information, treasury management and risk assessment systems renders societies particularly vulnerable to software or hardware failure. Boards of societies should:
(1) ensure that treasury IT systems' access, both physical and logical, is subject to robust security;
(2) exercise strong control over the development and modification of treasury IT systems; and
(3) involve internal audit in reviewing the development or modification of treasury IT systems.
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BSOCS 5.5
Risk management systems
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BSOCS 5.5.1
See Notes
The guidance in this section amplifies SYSC 7.1.2 R and SYSC 7.1.3 R specifically in the context of treasury management. A society should have in place information systems that are capable of:
(1) measuring the level of maturity mismatch and structural risk inherent in its balance sheet;
(2) assessing the potential impact of interest rate (and, if applicable, currency exchange rate) changes on its earnings and its economic value (including the effect of any standard interest rate shock as specified by the
FSA
in BIPRU 2.3);
(3) reporting accurately, and promptly, on risk positions (to management, to the board and, if requested, to the
FSA) including generating the information necessary to carry out its ICAAP and reporting the results of stress testing for interest rate risk in the banking book;
(4) recording accurately, and on a timely basis, all new transactions and/or cashflows which will affect calculations of structural risk exposures;
(5) managing the settlement timetable and processes for individual treasury instruments; and
(6) monitoring credit risk and settlement risk positions incurred with individual and groups of counterparties.
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BSOCS 5.5.2
See Notes
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Control limits
BSOCS 5.5.3
See Notes
Control limits confine structural risk positions within levels considered by board and management to be prudent, given the size, complexity and capital needs of the society's business. Where applicable, limits should also be applied to individual instrument types, asset/liability portfolios, and to separate business activities or subsidiary undertakings. Limits should also cover both the quantum and term/run-off of positions and should take due account of the extent to which margins are constrained, limiting business flexibility.
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BSOCS 5.5.4
See Notes
The structure of limits should enable the board and management to monitor actual levels of sensitivity, under different pre-defined market index, interest rate and exchange rate scenarios, against the policy specified maxima, to ensure that corrective action can be taken if required.
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BSOCS 5.5.5
See Notes
The number and type of limits which should be applied will depend upon the relative sophistication of a society's treasury operations, and further guidance on the
FSA's
expectations for each policy approach is set out in BSOCS 1.6 to BSOCS 1.10.
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BSOCS 5.5.6
See Notes
Where limits are set as part of the overall board policy, these should be treated as absolute. Therefore any limit exceptions should be reported immediately to executive managers, and the policy should make clear what action is expected of management in those circumstances (including arrangements for informing the board and the
FSA
of the breach). Limits set by management should similarly be subject to clear guidelines covering the circumstances and periods for which breaches may be permitted (if at all) and the arrangements for notification of exceptions.
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Stress testing
BSOCS 5.5.7
See Notes
(1) The risk measurement systems put in place should evaluate the impact, on income or economic value as appropriate, of abnormal market conditions. The amount and type of the stress testing required will depend upon the sophistication of treasury operations undertaken, and the level of risk taken, but where required should be regular and systematic. Within the range of scenarios tested, it is good practice for the scenario to reflect the events that would cause the society's business model to fail without any mitigating management action. Boards and management should, periodically, review the extent of that stress testing to ensure that any "worst case" scenarios remain valid. Contingency plans should be in place to deal with the consequences should those scenarios become reality.
(2)
Rules and guidance on stress testing and scenario analysis are in GENPRU 1.2 and BIPRU 2.2. Material on this subject specifically relating to liquidity risk, including liquidity contingency funding plans, is in BIPRU 12.4. Requirements for stress testing for interest rate risk in the banking book are set out in BIPRU 2.3.
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Board information reporting
BSOCS 5.5.8
See Notes
The
FSA
attaches considerable importance to the quality, timeliness, and frequency of the management information which the board uses to satisfy itself that treasury activities are being undertaken in accordance with its policies and guidelines. Information obtained by the board should include regular and systematic stress testing, as described above, which should be taken into account when policies and limits are established or reviewed.
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BSOCS 5.6
Counterparty risk
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BSOCS 5.6.1
See Notes
Counterparty limits should cover:
(1) full risk exposures (e.g. deposits or marketable instruments);
(2)
market risk exposures (e.g. mark to market positive value of swaps, plus appropriate addition for potential future exposure increases arising from changes in market rates); and
(3) settlement risk exposures (e.g. currency deals where amounts are paid out before funds are received).
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BSOCS 5.6.2
See Notes
Boards should determine the extent to which authority to set counterparty limits is delegated to management, but delegation to a single individual should not be permitted. Personnel with dealing mandates should not be given authority to set new or increased counterparty limits. No dealings should take place with counterparties which do not have a pre-approved limit.
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BSOCS 5.6.3
See Notes
Limits should be established on the basis of a robust methodology, which should be fully documented and reviewed regularly. For societies with more active treasury operations, a separate credit risk committee with responsibility for preparing a credit policy statement and counterparty list may be appropriate; less active societies may incorporate a section on credit risk within their liquidity policy statements, with appropriate cross-references to other policy and procedures statements. In all cases, the counterparty list and individual limits should be subject to formal credit review at least annually, with interim arrangements in place to add, amend or remove limits as appropriate.
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BSOCS 5.6.4
See Notes
(1) If reliance is placed on sources of information or opinion external to both the society and the counterparty (e.g. rating agencies), the nature of the source, and arrangements for ensuring that the information relied upon is kept up to date, should be made explicit in the credit risk policy document and in procedures manuals.
(2) Where ratings are reduced (or put on "watch" with "negative implications"), or where a society becomes aware of information on a counterparty which might affect its perceived creditworthiness (whether or not this results in a rate change), it should have systems for reviewing individual counterparty limits and, possibly, suspending or removing individual names from authorised lists in an expeditious manner.
(3) Arrangements for obtaining information on counterparties where this is in the public domain should also be included in procedures manuals.
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BSOCS 5.6.5
See Notes
Exposures to counterparties should be monitored on a consolidated basis, aggregating exposures of the society and any subsidiary undertakings (where applicable), and setting total exposure limits for groups of connected counterparties. Similarly, country, sector and market concentrations should be monitored continuously against agreed limits.
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BSOCS 5.6.6
See Notes
The guidance in this section complements the high level rules and guidance on credit and counterparty risk in SYSC 7.1.9 R to SYSC 7.1.11 R.
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Large shareholdings and deposits
BSOCS 5.6.7
See Notes
Undue dependence on individual funding sources that account for a large proportion of a society's overall liabilities will involve risk of liquidity problems should those funds be withdrawn or not be available for roll-over. These potential problems apply whether the funds in question are raised from the retail or the wholesale markets.
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BSOCS 5.6.8
See Notes
A small society is relatively more exposed to this type of risk, and should consider the implications of concentration on individual shareholders or depositors when assessing its liquidity levels and need for committed facilities. In the management of large retail investment accounts, a society should normally avoid:
(1) obtaining funding from a single shareholder or depositor which exceeds 1% of shares, deposits and loans; and
(2) allowing the aggregate total of funding, from those single shareholders or depositors which individually represent more than one-quarter of 1% of shares, deposits and loans, to exceed 5% of shares, deposits and loans.
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Committed facilities
BSOCS 5.6.9
See Notes
A society with high levels of maturing funding, or vulnerability to withdrawal of individual deposits, may consider arranging committed facilities (or maintain higher than average levels of liquidity). In arranging committed facilities, a society should consider:
(1) the credit standing and capacity of the provider of the facility;
(2) the documented basis of the commitment (i.e. is it an unconditional commitment or a "best endeavours" arrangement); and
(3) the cost/fee structure compared to alternatives.
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BSOCS 5.6.10
See Notes
In extreme cases, there remains a risk that a provider may renege on a contractual commitment to provide funding, or purport to rely on widely drawn "events of default" or "material adverse change" clauses, and face the legal consequences (if any) rather than lend money to a society in difficulties. Societies should not, therefore, become over reliant on committed facilities to plug short term cashflow difficulties and should be cautious on how any such facilities should be treated in stress testing.
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BSOCS 5.7
Independent review and controls
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Internal audit
BSOCS 5.7.1
See Notes
The guidance in this section amplifies SYSC 6.2.1 R in the context of treasury management. Each board should ensure that its society's internal audit department (if it has one) has the skills and resources available to undertake an audit of the treasury function. Internal audit should evaluate, on a continuing basis, the adequacy and integrity of the society's controls over maturity mismatch, over the level of structural risk taken and should assess the effectiveness of treasury management procedures.
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BSOCS 5.7.2
See Notes
Societies with complex treasuries or lacking internal auditors with treasury expertise may outsource treasury audit to an audit firm with the appropriate expertise and experience. The work of outsourced internal audit should be fully integrated into the society's overall audit procedures and plans, with appropriate reporting lines into the audit committee. However, in order to avoid conflicts of interest, internal audit should not be contracted out to the society's own external auditors, even if the function were to be performed by a completely different branch of the audit firm.
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BSOCS 5.7.3
See Notes
This table sets out guidance on financial risk management processes and procedures in accordance with the five approaches (see BSOCS 1.1.2 G). It shows the criteria which societies should use in developing the review of financial risk management, as detailed in BSOCS 1.15. It is designed to draw management and supervisory attention to areas of a society's treasury risk management which are different from the
FSA's
general expectation for societies on their respective treasury management approach. Societies should expect their supervisors to focus in greater detail on those areas of difference, to identify whether business risks and controls are aligned and if not to develop plans to address the mis-alignment. As such, these expectations should not be interpreted as hard limits but as input into establishing appropriate policies and the basis for supervisory dialogue.
FINANCIAL RISK MANAGEMENT
FINANCIAL RISK MANAGEMENT
| ADMINISTERED APPROACH | |
| RISK MANAGEMENT | CEO (+FD/FM) & Board Dealing / settlement segregation (4 eyes) |
| RISK ANALYSIS | None (but MTM fixed rate liquid assets at least monthly) |
| FIXED RATE LENDING/FUNDING | Commercial assets: Minimum 95% on administered rates Liabilities: Minimum 95% SDL on administered rates No fixed rate lending > 1 year |
| COUNTERPARTY LIMITS | Single name/connected group limits UK Counterparties only Instrument type and maturity limits |
| HEDGING INSTRUMENTS | None |
| TREASURY SYSTEMS/CONTROLS | Management accounting system Internal Audit |
| MATCHED APPROACH | |
| RISK MANAGEMENT | CEO + FD (or FM) & Board Dealing / settlement segregation (4 eyes) |
| RISK ANALYSIS | Matching Report + (min mthly) Gap Analysis Minimal gap/NPV limits (to cover residuals, prepayment and pipeline only) No structural hedging (incl reserves) No interest rate view Basis risk report |
| FIXED RATE LENDING/FUNDING | Commercial assets: A minimum of 65% either on administered rates or due to revert to administered rates in the next 12 months, and of that a minimum 50% already on administered rates. Liabilities: Minimum 65% SDL on administered rates Fixed rate lending/funding max 5 yrs to reprice date (subject to limits). Max stock fixed rate (> 1 yr) 20% commercial assets + 20% SDL Max fixed rate lending/funding 25% loans advanced/retail funding p.a. |
| COUNTERPARTY LIMITS | Single name/connected group limits Country limits Instrument type and maturity limits |
| HEDGING INSTRUMENTS | Match funding Vanilla interest rate swaps Vanilla interest rate caps/collars/floors (purchase only) FTSE swaps (receive only) |
| TREASURY SYSTEMS/CONTROLS | Management accounting system Simple treasury matching system Internal Audit |
| EXTENDED APPROACH | |
| RISK MANAGEMENT | (CEO)/FD + Treasurer ALCO Front Office + Back Office |
| RISK ANALYSIS | Monthly (min.) static gap (+ static simulation modelling) Gap limits Sensitivity limits (NPV & NII) Structural hedging Reserves hedging (strategic) Interest rate view No FX mismatch Basis risk modelling |
| FIXED RATE LENDING/FUNDING | Commercial assets: A minimum of 50% either on administered rates or due to revert to administered rates in the next 12 months, and of that a minimum 30% already on administered rates. Liabilities: Minimum 45% SDL on administered rates |
| COUNTERPARTY LIMITS | Single name/connected group limits Country limits Sector limits Instrument type limits Currency limits |
| HEDGING INSTRUMENTS | Match funding Vanilla interest rate swaps Vanilla interest rate caps/collars /floors (purchase only) Swaptions (purchase only) FRAs / Futures (purchase only) FTSE swaps (receive only) FX swaps/forward contracts (purchase only) FX options (purchase only) |
| TREASURY SYSTEMS/CONTROLS | Treasury IT system capable of modelling optionality in static balance sheet. Specialist IT and Treasury Internal Audit |
| COMPREHENSIVE APPROACH | |
| RISK MANAGEMENT | FD + Treasurer (+Risk Director) ALCO + Daily Treasury Committee Front + Middle + Back Office |
| RISK ANALYSIS | Very frequent dynamic balance sheet modelling (future flows) Multiple scenario & yield curve simulation modelling with sensitivity limits (NPV & NII) Basis risk modelling Internal transfer pricing systems Structural hedging Reserves hedging (strategic) Interest view FX mismatch < 2% own funds |
| FIXED RATE LENDING/FUNDING | Commercial assets: Minimum 30% on administered rates Liabilities: Minimum 30% SDL on administered rates |
| COUNTERPARTY LIMITS | Comprehensive limit structure |
| HEDGING INSTRUMENTS | Match funding Complex interest rate swaps Complex interest rate caps/collars/floors (purchase only) Swaptions (purchase only) HPI derivatives (purchase only) Credit derivatives (purchase only) FRAs/Futures (purchase only) FTSE swaps (receive only) FX swaps/forward contracts (purchase only) FX options (purchase only) |
| TREASURY SYSTEMS/CONTROLS | Treasury IT system capable of projecting forward balance sheet and simulating different interest rate environments, plus measuring embedded optionality, basis risk etc. Specialist IT and Treasury Audit |
| TRADING APPROACH | |
| RISK MANAGEMENT | FD + Treasurer (+Risk Director) ALCO + Daily Treasury Ctee Front + Middle + Back Office Banking + Trading books |
| RISK ANALYSIS | Banking book: daily (min) duration / simulation analysis. Multiple yield curves and interest rate basis. Structural & reserve hedging Interest rate view. Trading book: Valuation at risk and equivalent measures. Daily P&L (MTM). Product, currency, counterparty limits. Dealing position limits etc. |
| FIXED RATE LENDING/FUNDING | No limits |
| COUNTERPARTY LIMITS | Comprehensive limit structure, including cross banking and trading book limits |
| HEDGING INSTRUMENTS | Any available (subject to the 1986 Act s9A restrictions on use) |
| TREASURY SYSTEMS/CONTROLS | Treasury IT system capable of projecting forward balance sheet and simulating different interest rate environments, plus measuring embedded optionality, basis risk etc. Trading book systems Specialist IT and Treasury Audit |
| In this table: ALCO = Assets and Liabilities Committee HPIs = house price indices MTM = mark to market NII = net interest income NPV = net present value | |
- 06/07/2010