Interest Rate Risk Management Procedure Union Bank

Union Bank
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Interest Rate Risk Management Procedure Union Bank

Contents
1. Introduction........................................................................................................................................2
1.1 Scope..........................................................................................................................................2
2. Definition of Interest Rate Risk........................................................................................................2
2.1 Source of Interest Rate Risk....................................................................................................2
2.2 Impacts of Interest Rate Risk..................................................................................................3
2.2.1 Bank’s earning...................................................................................................................3
2.2.2 Economic Value of Equity................................................................................................3
3. Interest Rate Risk Measurement Methodology.............................................................................4
3.1 Gap Analysis...................................................................................................................................5
3.2 Modified Duration...........................................................................................................................6
3.3 Economic Value of Equity and earning based measure...........................................................6
4 Interest rate risk report......................................................................................................................7
4.1 General Report characteristics/requirements.........................................................................7
4.2 Report preparation workflow and main logic...........................................................................7
5 Interest rate risk calculation & Limits..............................................................................................8
Annex 1........................................................................................................................................................9
Annex 2....................................................................................................................................................16

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Interest Rate Risk Management Procedure Union Bank

1. Introduction

1.1Scope
Union Bank (the Bank) in order to achieve its objective of protecting the Bank from
negative effect on interest income or exposure of the banking book to adversefrom
changes due to changes in the market interest rates has prepared this Interest Rate
Risk Management Procedure.

The purpose of this procedure is to define the Bank’s attitude towards interest rate risk
on the banking book and especially to present tools, instruments, methodologies and
control mechanism which are in line with sound international banking principle and
Albanian regulatory framework.

The ultimate goal of the interest rate risk management system is to maintain the interest
rate risk within the acceptable risk profile boundaries of the bank and ensure safety and
soundness of the banking activity.

The Procedure is based on ALM Policy and regulatory requirements.

2. Definition of Interest Rate Risk

Interest rate risk (IRR) is defined as the sensitivity of the Bank’s earnings and equity to
changes in the market interest rates. IRR results from the differences in the way assets,
liabilities and off-balance sheet instruments are affected by interest-rate changes. For
the purpose of this policy, assets and liabilities refer only to interest rate sensitive assets
and liabilities, unless otherwise stated.

2.1 Source of Interest Rate Risk

a) Reprising risk is the risk when the bank incurs losses, which arise from mismatches
of maturity (fixed interest rate) and reprising of interest rate (variable interest rates)
in the banking book positions.
Re-pricing risk (or mismatch risk) is caused by either borrowing short-term to fund
long term assets or by borrowing long-term to fund short term assets. For instance,
funding a long-term fixed-rate loan with a short-term deposit could result in a decline
in both the future income arising from the position and the Bank’s underlying value, if
interest rates increase.
b) Yield curve risk is the risk when the bank incurs financial losses due to changes in
the slope of the yield curve. Yield curve risk arises when unanticipated shifts of the

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Interest Rate Risk Management Procedure Union Bank

yield curve have adverse effects on the Bank’s income or underlying economic
value.
c) Basis risk is the risk when the bank incurs financial losses, which arise from the
changes in interest reference rate for similar instruments related to maturity/or time,
until the next change in the interest rate.
d) Optionality is the risk when the bank incurs financial losses, which arise from options
embedded in interest sensitive positions (loans prepayment, deposits with early
withdrawal option, etc).
Examples of instruments with embedded options include loans which give borrowers
the right to prepay balances, and various types of deposit which give depositors the
right to withdraw funds at any time.

2.2 Impacts of Interest Rate Risk

2.2.1 Bank’s earning

The Bank will focus in analyzing the impact that changes of interest rates has on
accrual or reported earnings in the near terms, usually within one year.

Variation in earnings is an important point for interest rate risk analysis because
reduced earnings or outright losses can threaten the financial stability of the Bank by
undermining its capital adequacy and by reducing market confidence.

The component of earnings that attracts the most attention is Net Interest Income (NII)
which is defined as the difference between total interest income and total interest
expense arising from the banking book items. However, fluctuations in interest rates
may also affect the level of non-interest income arising from banking book activities,
such as loan servicing and deposits that generate fee-related income.

For example, when interest rates fall, the Bank may experience an increase in its fee
and commission income as the loan mortgages prepay. So, the amounts and the effects
of penalties and charges of prepaying loans or withdraw of fix deposits must be taken
into account.

2.2.2 Economic Value of Equity

When interest rates change, the present value and timing of future cash flows change.
This in turn changes the underlying value of a bank’s assets, liabilities and off-balance
sheet instruments and hence its economic value (EV).

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Interest Rate Risk Management Procedure Union Bank

Since the economic value approachperspective takes into account the potential impact
of interest rate changes on the present value of all future cash flows, it provides a more
comprehensive view of the potential long-term effects of changes in interest rates than
is offered by the earnings perspectiveapproach. This comprehensive view is important
since changes in near-term earnings – the typical focus of the earnings perspective
approach - may not provide a sufficient evaluation of the impact of interest rate
movements on the Bank’s overall positions.

2.3 New products and activities

The Bank should identify the interest rate risks inherent in new products and activities,
especially those with original maturity over 5 years to ensure these are subject to
adequate procedures and controls before being introduced or undertaken.

3. Interest Rate Risk Measurement Methodology

The bank calculates and assesses the interest rate risk individually for each interest rate
relevant currency and in an aggregated way for noninterest rate relevant currencies. A
relevant currency is the currency that makes up at least 5% of the total assets.

According to their maturity/repricsing schedule, assets, liabilities, and oOff Balance

Sheet positions are distributed into “time bands”, and then summed up in each time
bucket to produce a reprising “gap”, which is then multiplied by an assumed change in
interest rates. The size of the overall gap, divided to the Bank’s capital, serves as an
indication of the bank's interest risk exposure.

The Bank in measuring interest rate risk will take into consideration the following
elements:
- Defined Maturity products
- Indefinite Maturity Products
- Reprising frequency
- Nature of the interest rate ( Fixed / Variable )
- Currency
- Outstanding Balance
- Loan prepayments and deposits withdrawal rates.

The Bank will assess the potential risk arising from loan prepayments and deposit early
withdrawal as a consequence of changes in market interest rates based on internal
historical data. The Bank, if deemed necessary, will incorporate relevant assumptions

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Interest Rate Risk Management Procedure Union Bank

into the NII and EVE calculation, however the effects of penalties or charges that are
imposed onto clients will be taken into consideration.

3.1 Gap Analysis

The Bank will use Reprising Gap (Form 1 (FIR) and Form 2 (VIR) in annex 1) in order to
measure the difference between interest rate sensitive assets and liabilities on the
banking book.

The distribution of interest-sensitive assets, liabilities, and off-balance sheet positions

into “time bands” is performed according to their contractual maturity (if fixed-rate) or
time remaining to their next reprising (if floating-rate) by filling the respective Form
( FIR / VIR).

Positions without definitive reprising intervals or contractual maturity (current and saving
deposits) oin the liability side will be assigned according to the following:

- at sight time band, a fixed percentage (25 per cent) of current accounts and
demand deposits;
- remaining amounts from those mentioned in “ a” , above (75%) in time bands1
from “up to 1 month” to “4-5 years” in a proportional manner with the number of
months that the time band contains;

In cases of predetermined maturity positions, or when the period of interest rate change
is unknown or may not be definitely determined, the Bank shall assign the time band
positions, based on internal historical data or based on the behavior of these positions.

Cash, fFixed assets, shareholder capital and off-balance sheet items such guarantees,
letters of credit, unused credit lines and other off-balance sheet items will be not
considered as interest rate sensitive items.

Albanian lek reserve requirements set aside with the central Bank of Albania shall be
reported in the Form VIR, within the time band “up to 1 month”. Other reserves with
Bank of Albania should be considering non-sensitive to interest rate risk.

Non-performing items (loans) will be assigned to the time band from 2 to 3 years on
their net value after subtracting the reserve funds created at the reporting date

Assets and liabilities with instalment payments will be assigned in the time bands in
accordance with the agreed repayment plan.

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Interest Rate Risk Management Procedure Union Bank

Banks shall considerdeal assets and liabilities at variable interest rate and which contain
a minimum and maximum rate (“floor” or “cap”), as combination of an item at variable
rate and an option of “floor” or “cap” type3. Thus, a loan at variable interest rate and
minimum “floor” rate to be paid from the customer will be presented as a combination of:
a) a variable rate loan (to be allocated at the respective box by the date of interest rate
review); and b) a “floor” purchased option for fixed interest rate and in soldale for
variable rate.

The Bank reports fixed interest rate assets or liabilities for a definite number of years,
which for the rest of the period (according to the contract) will have variable interest
rate, in Form No.2 of variable interest rate items. The remaining time to the forthcoming
change of interest rate will be considered the time period between the reporting date
and the first date this rate is reviewed.

For the purpose of obtaining a “total net position” for each band, we shall sum up assets
and liabilities positions (on-balance-sheet and off-balance- sheet), taking account of the
signs preceding each time band. For the purposes of calculating the "total net position",
asset positions shall be deemed to have a (+) sign while liabilities positions shall be
deemed to have a (-) sign.

In order to obtaining a "Weighted position" for each time band, we shall multiply the
obtained total net position per each time band by weights given in the forms No. 1 and
No. 2 under “Weights”.

3.2 Modified Duration

The Bank will use the weighting factors established in Annex 2 of this procedure, which
are calculated as a multiplication of the interest rate shock of 200 basis points with the
estimated modified duration for each time band. Through this method Union Bank will
estimate the change in the exposure of the banking book items.

3.3 Economic Value of Equity and earning based measure

The Bank will follow two approaches (EVE & NII) in order to assess Interest rate risk
under various assumptions regarding the evolution of interest rates. Union Bank will
apply different scenarios to capture parallel and non-parallel Gap risk for EVE and NII.
These scenarios will be applied to interest rate risk exposures in each major currency.
Assumptions used for stress test in order to assess EVE and NII impact:
- parallel shock up by 100, 200 bps
- parallel shock down 100, 200 bps

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Interest Rate Risk Management Procedure Union Bank

- steepened shock ( shock rates up by 50 bps up to 6 month, 100 bps up to 1 year

and 200 bps for the remaining maturities)
- flattener shock ( short rates up by 200 bps for maturities up to 3 month, 100 bps
for the remaining maturities maturities)
- parallel shift up by 100 bps for all time buckets for assets and parallel shift up by
200 bps in all time buckets for liabilities.
- parallel shift up by 200 bps for all time buckets for assets and parallel shift up by
100 bps in all time buckets for liabilities.
- 10% of customer deposits withdrawals & 200 bps parallel shift up
When deemed necessary the Bank will assess the NII and EVE impact based on
market interest rates evolution scenarios. These scenarios may include the shock of
interest rates for specific terms products, for example loans, time deposits and Albanian
Government LEK securities.

4 Interest rate risk report

4.1 General Report characteristics/requirements

Report prepared & analyzed by: Risk Management Department (RMD)

Report source of data: Reporting and Financial Control Department (MIS)
Report presented to: ALCO meetings, summarized data to BoD
Report rules/definitions: ALM Policy, ALCO decisions/rules settled
Report frequency: Monthly
Report prepared for: LEK, EUR, other currencies
Report data/amounts: LEK ‘000
4.2 Report preparation workflow and main logic

Following the closure of the books at the end of month, MIS prepares and delivers to
RMD the Change in the exposure of the banking book for Fixed Interest Rate items
(FIR/VIR) forms (see in Annex 1).
Reporting and Financial Control Department provides the distribution of interest-
sensitive, liabilities and off-balance sheet positions into “time bands” according to their
contractual maturity (if fixed rate) or time remaining to their next reprising (if floating-
rate) as detailed in paragraph 3.1.
RMD fills the relevant ALCO template, where additional calculations are performed
based on the scenarios mentioned in the paragraph 3.3 of this regulation, and delivers
the report to the ALCO members, together with the ALCO monthly report (usually within
15th of each month).

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Interest Rate Risk Management Procedure Union Bank

5 Interest rate risk calculation & Limits

The Bank will comply with the regulatory limit (as defined in the relevant guideline “On
interest rate risk management for the banking book”), consisting on the maximum
impact that ±200 bps shift in interest rate has on Bank’s economic value (EVE), up to
20% of the Bank regulatory capital, while the internal limit for this ratio is set at 15%.
When measuring this control limit, the Bank will consider steepening of the yield curve,
an increase of interest rates of +25 bps up to 3 months bucket, +50 bps for 3-6 months
bucket and +100 bps for 6-12 months bucket.
The limit allocated to the Bank for this purpose is 2% of regulatory capital (sensitivities
coming from all currencies aggregate).
In case a limit is exceeded, RMD must analyze the violation and report it to ALCO

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 Annex 1

Form No.1 – Change in the exposure of the banking book for Fixed Interest Rate items (FIR)
Name of Bank / credit institution:
Form FIR Change in the exposure of the banking book for fixed interest rate items
Type of report:
Date:

Time zones
Interest rate sensitive banking book items - Currenc to 1 1-3 3-6 6-12
at 1-2 2-3 3-4 4-5 5-7 7-10 10-15 15-20 20+
fixed interest rate y mont month month month
sight years years years years years years years years years
h s s s
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
BALANCE SHEET
ASSETS
1 Cash and Central Bank
2 Treasury bills and other for refinc. With BoA
3 C/a with banks and other finc.instutions.
Deposits with banks and other financ.
4
Institutions
demand deposits
time deposits
5 Loans from banks and other finc. institutions
6 Other from banks and financial institutions
7 Loans and advances
minus provisions
8 Securities
Equity securities
Investment securities
Treasury bond commitments and other debt
securities
9 Holdings
in banks and other financial institutions
other
TOTAL ASSETS

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Interest Rate Risk Management Procedure Union Bank

(-) LIABILITIES
1 Central Bank
2 Reverse repo
3 C/a from banks and other finc.instutions.
Deposits from banks and other financ.
4
Institutions
demand deposits
time deposits
5 Loans from banks and other finc. Institutions
6 Other from banks and financial institutions
7 Due to customers
current accounts
demand deposits
time deposits
8 Due to government
9 Other liabilities from bonds and securities
10 Specific provisions
11 Subordinated debt
TOTAL LIABILITIES
NET BALANCE SHEET POSITION
OFF-BALANCE SHEET ITEMS
OFF-BALANCE SHEET ASSETS ITEMS
Interest Rate Risk Management Procedure Union Bank

IX. Derivative financial instruments

1. Swap agreements
2. Forwards
3. Futures
4. Options
4.1. Embedded options
4.2. Other options
5. Other derivative financial instruments
TOTAL OFF-BALANCE SHEET ASSETS
ITEMS
(-) OFF-BALANCE SHEET LIABILITIES ITEMS
X. Derivative financial instruments
1. Swap agreements
2. Forwards
3. Futures
4. Options
4.1. Embedded options
4.2. Other options
5. Other derivative financial instruments
TOTAL OFF-BALANCE SHEET LIABILITIES
ITEMS
NET OFF-BALANCE SHEET POSITION
TOTAL NET POSITION
WEIGHTS 0.08% 0.32% 0.72% 1.43% 2.77% 4.49% 6.14% 7.71% 10.15% 13.26% 17.84% 22.43% 26.03%
WEIGHTED POSITION - Fixed-IR
NET WEIGHTED POSITION BY CURRENCY - Fixed-IR
Interest Rate Risk Management Procedure Union Bank

Form No.2 - Change in the exposure of the banking book for Variable Interest Rate items (VIR)

Name of Bank / credit institution:

Form VIR Change in the exposure of the banking book for variable interest rate items
Type of report:
Date:

Time zones
Interest rate sensitive banking book items - Currency to 1 1-3 3-6 6-12 1-2 3-4 4-5 5-7 7-10 10-15 15-20 20+
at sight 2-3 years
variable interest rate month months months months years years years years years years years years
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
BALANCE SHEET ITEMS
ASSETS
1 Cash and Central Bank
2 Treasury bills and other for refinc. With BoA
3 C/a with banks and other finc.instutions.
Deposits with banks and other financ.
4
Institutions
demand deposits
time deposits
5 Loans from banks and other finc. institutions
6 Other from banks and financial institutions
7 Loans and advances
minus provisions
8 Securities
Equity securities
Investment securities
Treasury bond commitments and other debt
securities
9 Holdings
in banks and other financial institutions
other
TOTAL ASSETS
Interest Rate Risk Management Procedure Union Bank

(-) LIABILITIES
1 Central Bank
2 Reverse repo
3 C/a from banks and other finc.instutions.
4 Deposits from banks and other financ.
Institutions
demand deposits
time deposits
5 Loans from banks and other finc. Institutions
6 Other from banks and financial institutions
7 Due to customers
current accounts
demand deposits
time deposits
8 Due to government
9 Other liabilities from securities
10 Specific provisions
11 Subordinated debt
TOTAL LIABILITIES
NET BALANCE SHEET POSITION
OFF-BALANCE SHEET ITEMS
OFF-BALANCE SHEET ASSETS ITEMS
Interest Rate Risk Management Procedure Union Bank

IX. Derivative financial instruments

1. Swap agreements
2. Forwards
3. Futures
4. Options
4.1. Embedded options
4.2. Other options
5. Other derivative financial instruments
TOTAL OFF-BALANCE SHEET ASSETS ITEMS
(-) OFF-BALANCE SHEET LIABILITIES ITEMS
X. Derivative financial instruments
1. Swap agreements
2. Forwards
3. Futures
4. Options
4.1. Embedded options
4.2. Other options
5. Other derivative financial instruments
TOTAL OFF-BALANCE SHEET LIABILITIES
ITEMS
NET OFF-BALANCE SHEET POSITION
TOTAL NET POSITION
WEIGHTS 0.00% 0.08% 0.32% 0.72% 1.43% 2.77% 4.49% 6.14% 7.71% 10.15% 13.26% 17.84% 22.43% 26.03%
WEIGHTED POSITION -Variable-IR
NET WEIGHTED POSITION BY CURRENCY -Variable IR
Interest Rate Risk Management Procedure Union Bank

Form No.3 - Total weighted position (Interest Rate Risk of the Banking Book (IRRBB)

Form total IRRBB Total weighted position

Currency Amount
IRR
1 2
2. CHANGE IN THE EXPOSURE VALUE
3. REGULATORY CAPITAL (own funds)
4. (CHANGE IN THE EXPOSURE VALUE / REGULATORY CAPITAL) * 100
1.1. NET WEIGHTED POSITION BY CURRENCY- (FIR+VIR) ALL
1.2. NET WEIGHTED POSITION BY CURRENCY- (FIR+VIR) USD
1.3. NET WEIGHTED POSITION BY CURRENCY- (FIR+VIR) EUR
 Annex 2

Weighting factors per time band

Time band Middle of time band Proxy of modified duration Assumed change in yield Weighting factor
at sight 0 0 200 bp 0.00%
Up to 1 month 0.5 month 0.04 years 200 bp 0.08%
1 to 3 month 2 month 0.16 years 200 bp 0.32%
3 to 6 month 4.5 month 0.36 years 200 bp 0.72%
6 to 12 month 9 month 0.71 years 200 bp 1.43%
1 to 2 year 1.5 year 1.38 years 200 bp 2.77%
2 to 3 year 2.5 year 2.25 years 200 bp 4.49%
3 to 4 year 3.5 year 3.07 years 200 bp 6.14%
4 to 5 year 4.5 year 3.85 years 200 bp 7.71%
5 to 7 year 6 year 5.08 years 200 bp 10.15%
7 to 10 year 8.5 year 6.63 years 200 bp 13.26%
10 to 15 year 12.5 year 8.92 years 200 bp 17.84%
15 to 20 year 17.5 year 11.21 years 200 bp 22.43%
Over 20 year 22.5 year 13.01 years 200 bp 26.03%
Over 20 years 22.5 year 13.01 year 200 bp 26.03%

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