In this article we shed some light on the possible technical solutions in SAP Treasury to implement CLS in the corporate treasury operations. This includes CLS deal capture, limit utilization implications in Credit risk analyzer, and changes in the correspondence framework of SAP TRM.

Technical solution in SAP Treasury

There is no SAP standard solution for CLS as such. However, SAP standard functionality can be used to cover major parts of the CLS solution. The solution may vary depending on the existing functionality for hedge management/accounting and limit management as well as the technical landscape accounting for SAP version and SWIFT connectivity.

Below is a simplified workflow of CLS deal processing:

The proposed solution may be applicable for a corporate using SAP TRM (ECC to S/4HANA), having Credit risk analyzer activated and using SWIFT connection for connectivity with the banks.

Capturing CLS FX deals

There are a few options on how to register the FX deal as a CLS deal, with two described below:

Option 1: CLS Business partner – a replica of your usual business partner (BP) which would have CLS BIC code and complete settlement instructions.
Option 2: CLS FX product type/transaction type – a replica of normal FX SPOT, FX FORWARD or FX SWAP product type/transaction type.

Each option has pros and cons and may be applied as per a client technical specific.

FX deals trading and capturing may be executed via SAP Trade Platform Integration (TPI), which would improve the processing efficiency, but development may still be required depending on characteristics of the scope of FX dealing. In particular, the currency, product type, counterparty scope and volume of transactions would drive whether additional development is required, or whether standard mapping logic can be used to isolate CLS deals.

For the scenarios where a custom solution is required to convert standard FX deals into CLS FX deals during its creation, a custom program could be created that includes an additional mapping table to help SAP determine CLS eligible deals. The bespoke mapping table could help identify CLS eligibility based on the below characteristics:

• Counterparty
• Currency Pair
• Product Type (Spot, Forward, SWAP)

Correspondence framework

Once CLS deal is captured in SAP TRM, it needs to be counter-confirmed with the trading counterparty and with CLS Bank. Three new types of correspondence need to be configured:

• MT300 with CLS specifics to be used to communicate with the trading counterparty;
• MT304 to communicate with CLS Custody service;
• SWIFT MT396 to get the matching status from CLS bank.

Credit Risk Analyzer (CRA)

FX CLS deals do not bring settlement exposure, thus CLS deals need to be exempt from the settlement risk utilization. Configuration of the limit characteristics must include either business partner number (for CLS Business Partner) or transaction type (for CLS transaction type). This will help determine the limits without FX CLS deals.

No automatic limits creation should be allowed for the respective limit type; this will disable a settlement limit creation based on CLS deal capture in SAP.
CLS Business partner setting must be done with ‘parent <-> subsidiary’ relationship with the regular business partner. This is required to keep a single credit limit utilization and having FX deals being done with two business partners.

Deal execution

Accounting for CLS FX deals is normally the same as for regular FX deals, though it depends on the corporate requirements. We do not see any need for a separate FX unrealized result treatment for CLS deals.

However, settlement of CLS deals is different and standard settlement instructions of CLS deals vary from normal FX deals.

Either the bank’s virtual accounts or separate house bank accounts are opened to settle CLS FX deals.

Since CLS partner performs the net settlement on-behalf of a corporate there is no need to generate payment request for every CLS deal separately. Posting to the bank’s CLS clearing account with cash flow postings (TBB1) is sufficient at this level.

The following day the bank statement will clear the postings on the CLS settlement account on a net basis based on the total amount and posting date.

Cash Management

A liquidity manager needs to know the net result of the CLS deals in advance to replenish the CLS bank account in case the net settlement amount for CLS deal is negative. In addition, the funds would need to be transmitted between the house bank accounts either manually or automatically, with cash concentration requiring transparency on the projected cash position.

The solution may require extra settings in the cash management module with CLS bank accounts to be added to specific groupings.

Conclusion

Designing a CLS solution in SAP requires deep understanding of a client’s treasury operations, bank account structure and SAP TMS specifics. Together with a client and based on the unique business landscape, we review the pros and cons of possible solutions and help choosing the best one. Eventually we can design and implement a solution that makes treasury operations more efficient and transparent.

Our corporate clients are requesting our support with design and implementation of Continuous Linked Settlement (CLS) solutions for FX settlements in their SAP Treasury system. If you are interested, please do not hesitate to contact us.

Why does this aim matter? Well, in this age of digitization, almost every aspect of the business has a digital footprint. Some significantly more than the others. This presents a unique opportunity where potentially all information can be reliably processed to take tactical and strategic decisions from a position of knowledge. Good data can facilitate hedging, forecasting and other key corporate activities. Having said all that, care must also be taken to not drown in the data lake¹ and become over-burdened with useless information. Take the example of Amazon in 2006 when it reported that cross-selling attributed for 35% of their revenue². This strategy looked at data from shopping carts and recommended other items that may be of interest to the consumer. The uplift in sales was achieved only because Amazon made the best use of their data.

Treasury is no exception. It too can become data-driven thanks to its access to multiple functions and information flows. There are numerous ways to access and assess multiple sets of data (see Figure 1), thereby finding solutions to some of the perennial problems facing any organization that wants to mitigate or harness risk, study behavior, or optimize its finances and cashflow to better shape its future.

Time is money

The practical business use cases that can be realized by harnessing data in the Treasury often revolve around mastering the time function. Cash optimization, pooling for interest and so on often depend on a good understanding of time – even risk hedging strategies can depend on the seasons, for instance, if we’re talking about energy usage.

When we look at the same set of data from a time perspective, it can be used for three different purposes:
I.       Understand the ‘The Past’ – to determine what transpired,
II.     Ascertain ‘The Present’ situation,
III.   Predict ‘The Future’ based on probable scenarios and business projections.

I – The Past

“Study the past if you would define the future”

Confucius

The data in an organization is the undeniable proof of what transpired in the past. This fact makes it ideal to perform analysis through Key Performance Indicators (KPIs), perform statistical analysis on bank wallet distribution & fee costs, and it can also help to find the root cause of any irregularities in the payments arena. Harnessing historical data can also positively impact hedging strategies.

II – The Present

“The future depends on what we do in the present”

M Gandhi

Data when analyzed in real-time can keep stakeholders updated and more importantly provide a substantial basis for taking better informed tactical decisions. Things like exposure, limits & exceptions management, intra-day cash visibility or near real-time insight/access to global cash positions all benefit, as does payment statuses which are particularly important for day-to-day treasury operations.

III – The Future

“The best way to predict the future is to create it.”

Abraham Lincoln

There are various areas where an organization would like to know how it would perform under changing conditions. Simulating outcomes and running future probable scenarios can help firms prepare better for the near and long-term future.

These forecast analyses broadly fall under two categories:

Historical data: assumes that history repeats itself. Predictive analytics on forecast models therefore deliver results.

Probabilistic modelling: this creates scenarios for the future based on the best available knowledge in the present.

Some of the more standard uses of forecasting capabilities include:

• risk scenarios analysis,
• sensitivity analysis,
• stress testing,
• analysis of tax implications on cash management structures across countries,
• & collateral management based on predictive cash forecasting, adjusted for different currencies.

Working capital forecasting is also relevant, but has typically been a complex process. The predication accuracy can be improved by analyzing historical trends and business projections of variables like receivables, liabilities, payments, collections, sales, and so on. These can feed the forecasting algorithms. In conjunction with analysis of cash requirements in each business through studying the trends in key variables like balances, intercompany payments and receipts, variance between forecasts and actuals, this approach can lead to more accurate working capital management.

How to become a data-driven organization

“Data is a precious thing and will last longer than the systems themselves.”

Tim Berners-Lee

There can be many uses of data. Some may not be linked directly to the workings of the treasury or may not even have immediate tangible benefits, although they might in the future for comparative purposes. That is why data is like a gold mine that is waiting to be explored. However, accessing it and making it usable is a challenging proposition. It needs a roadmap.

The most important thing that can be done in the beginning is to perform a gap analysis of the data ecosystem in an organization and to develop a data strategy, which would embed importance of data into the organization’s culture. This would then act as a catalyst for treasury and organizational transformation to reach the target state of being data-driven.

The below roadmap offers a path to corporates that want to consistently make the best use of one of their most critical and under-appreciated resources – namely, data.

We have seen examples like Amazon and countless others where organizations have become data- driven and are reaping the benefits. The same can be said about some of the best treasury departments we at Zanders have interacted with. They are already creating substantial value by analyzing and making the optimum use of their digital footprint. The best part is that they are still on their journey to find better uses of data and have never stopped innovating.

The only thing that one should be asking now is: “Do we have opportunities to look at our digital footprint and create value (like Amazon did), and how soon can we act on it?”

References:

1. https://zandersgroup.com/en/latest-insights/data-analytics-for-treasury-dont-drown-in-the-data-lake/
2. https://www.forbes.com/sites/chuckcohn/2015/05/15/a-beginners-guide-to-upselling-and-cross-selling/?sh=395a58042912

Since the first sustainability-linked derivative was executed in 2019, market participants have entered into a variety of ESG-related derivatives and products. In this article we provide you with an overview of the different ESG derivatives. We will touch upon the regulatory and valuation implications of this relatively new derivative class in a subsequent article, which will be published later this year.

Types of ESG-related derivatives products

Driven by regulatory pressure and public scrutiny, corporates have been increasingly looking for ways to manage their sustainability footprint. As a result of a blooming ESG funding market, the role of derivatives to help meet sustainability goals has grown. ESG-related derivatives cover a broad spectrum of derivative products such as forwards, futures and swaps. Five types (see figure 1) of derivatives related to ESG can be identified; of which three are currently deemed most relevant from an ESG perspective.

The first category consists of traditional derivatives such as interest rate swaps or cross currency swaps that are linked to a sustainable funding instrument. The derivative as such does not contain a sustainability element.

Sustainability-linked derivatives

Sustainability-linked derivatives are agreements between two counterparties (let’s assume a bank and a corporate) which contain a commitment of the corporate counterparty to achieve specific sustainability performance targets. When the sustainability performance targets are met by the corporate during the lifetime of the derivative, a discount is applied by the bank to the hedging instrument. When the targets are not met, a premium is added. Usually, banks invest the premium they receive in sustainable projects or investments. Sustainability-linked derivative transactions are highly customizable and use tailor-made KPIs to determine sustainability goals. Sustainability-linked derivatives provide market participants with a financial incentive to improve their ESG performance. An example is Enel’s sustainability-linked cross currency swap, which was executed in July 2021 to hedge their USD/EUR exchange rate and interest rate exposures.

Emission trading derivatives

Other ESG-related derivatives support meeting sustainable business models and consist of trading carbon offsets, emission trading derivatives, and renewable energy and renewable fuels derivatives, amongst others. Contrary to sustainability-linked derivatives, the use of proceeds of ESG-related derivatives are allocated to specific ESG-related purposes. For example, emissions trading is a market-based approach to reduce pollution by setting a (geographical) limit on the amount of greenhouse gases that can be emitted. It consists of a limit or cap on pollution and tradable instruments that authorize holders to emit a specific quantity of the respective greenhouse gas. Market participants can trade derivatives based on emission allowances on exchanges or OTC markets as spots, forwards, futures and option contracts. The market consists of mandatory compliance schemes and voluntary emission reduction programs.

Renewable energy and fuel derivatives

Another type of ESG-related derivatives are renewable energy and renewable fuel hedging transactions, which are a valuable tool for market participants to hedge risks associated with fluctuations in renewable energy production. These ESG-related credit derivatives encourage more capital to be contributed to renewable energy projects. Examples are Power Purchase Agreements (PPAs), Renewable Energy Certificate (REC) futures, wind index futures and low carbon fuel standard futures.

ESG related credit derivatives

ESG-related CDS products can be used to manage the credit risk of a counterparty when financial results may be impacted by climate change or, more indirectly, if results are affected due to substitution of a specific product/service. An example of this could be in the airline industry where short-haul flights may be replaced by train travel. Popularity of ESG-related CDS products will probably increase with the rising perception that companies with high ESG ratings exhibit low credit risk.

Catastrophe and weather derivatives

Catastrophe and weather derivatives are insurance-like products as well. Both markets have existed for several decades and are used to hedge exposures to weather or natural disasters. Catastrophe derivatives are financial instruments that allow for transferral of natural disaster risk between market participants. These derivatives are traded on OTC markets and enable protection from enormous potential losses following from natural disasters such as earthquakes to be obtained. The World Bank has designed catastrophe swaps that support the transfer of risks related to natural disasters by emerging countries to capital markets. An example if this is the swap issued for the Philippines in 2017. Weather derivatives are financial instruments that derive their value from weather-related factors such as temperature and wind. There derivatives are used to mitigate risks associated with adverse or unexpected weather conditions and are most commonly used in the food and agriculture industry.

What’s old, what’s new and what’s next?

ESG-related credit derivatives would be best applied by organizations with credit exposures to certain industries and financial institutions. Despite the link to an environmental element, we do not consider catastrophe bonds and weather derivatives as a sustainability-linked derivative. Neither is it an innovative, new product that is applicable to corporates in various sectors.

Truly innovative products are sustainability-linked derivatives, voluntary emissions trading and renewable energy and fuel derivatives. These products strengthen a corporate’s commitment to meet sustainability targets or support investments in sustainable initiatives. A lack of sustainability regulation for derivatives raises the question to what extent these innovative products are sustainable on their own? An explicit incentive for financial institutions to execute ESG-related derivatives, such as a capital relief, is currently absent. This implies that any price advantage will be driven by supply and demand.

Corporate Treasury should ensure they consider the implications of using ESG-related derivatives that affect the cashflows of derivatives transactions. Examples of possible regulatory obligations consist of valuation requirements, dispute resolution and reporting requirements. Since ESG-related derivatives and products are here to stay, Zanders recommends that corporate treasurers closely monitor the added value of specific instruments, as well as the regulatory, tax and accounting implications. Part II of this series, later in the year, will focus on the regulatory and valuation implications of this relatively new derivative class.

For more information on ESG issues, please contact Sander van Tol.

In an earlier report², the EBA defined ESG-related risks as “the risks of any negative financial impact on the institution stemming from the current or prospective impacts of ESG factors on its counterparties or invested assets”. Hence, the focus is not on the direct impact of ESG factors on the institution, but on the indirect impact through the exposure of counterparties and invested assets to ESG-related risks. The EBA report also provides examples for typical ESG-related factors.
While the ITS have been streamlined and simplified compared to the consultation paper published in March 2021, there are plenty of challenges remaining for banks to implement these standards.

Development of the ITS

The EBA has been mandated to develop the ITS on P3 disclosures on ESG risks in Article 434a of the Capital Requirements Regulation (CRR). The EBA has opted for a sequential approach, with an initial focus on climate change-related risks. This is further narrowed down by only considering the banking book. The short maturity and fast revolving positions in the trading book are out of scope for now. The scope of the ITS will be extended to included other environmental risks (like loss of biodiversity), and social and governance risks, in later stages.

In the development of the ITS, the EBA has strived for alignment with several other regulations and initiatives on climate-related disclosures that apply to banks. The most notable ones are listed below (and in Figure 1):

Figure 1 – Overview of related regulations and initiatives considered in the development of the ITS

• Capital Requirements Directive and Regulation (CRD and CRR): article 98(8) of the CRD³ mandated the EBA to publish the EBA report on Management and Supervision of ESG risks, which includes the split of climate change-related risks in physical and transition risks. Article 434a of the CRR⁴ mandated the EBA to develop the draft ITS to specify the ESG disclosure requirements described in article 449a.
• EBA report on Management and Supervision of ESG risks²: the report provides common definitions of ESG risks and contains proposals on how to include ESG risks in the risk frameworks of banks, covering its identification, assessment, and management. It also discusses the way to include ESG risks in the supervisory review process.
• Task Force on Climate-related Financial Disclosures (TCFD)⁵: the Financial Stability Board’s TFCD has published recommendations on climate-related disclosures. The metrics and Key Performance Indicators (KPIs) included in the ITS have been aligned with the TCFD recommendations.
• Taxonomy Regulation⁶: the European Union’s common classification system of environmentally sustainable economic activities is underpinning the main KPIs introduced in the ITS.
• Climate Benchmark Regulation (CBR)⁷: In the CBR, two types of climate benchmarks were introduced (‘EU Climate Transition’ and ‘EU Paris-aligned’ benchmarks) and ESG disclosures for all other benchmarks (excluding interest rate and currency benchmarks) were required.
• Non-Financial Reporting Directive (NFRD)⁸: the NFRD introduces ESG disclosure obligations for large companies, which include climate-related information.
• Corporate Sustainability Reporting Directive (CSRD)⁹: a proposal by the European Commission to extend the scope of the NFRD to also include all companies listed on regulated markets (except listed micro-enterprises). One of the ITS’s KPIs, the Green Asset Ratio (GAR) is directly linked to the scope of the NFRD/CSRD.
• Sustainable Finance Disclosure Regulation (SFDR)¹⁰: the SFDR lays down sustainability disclosure obligations for manufacturers of financial products and financial advisers towards end-investors. It applies to banks that provide portfolio management investment advice services.

Compared to the consultation paper for the ITS, several changes have been made to the required templates. Some templates have been combined (e.g., templates #1 and #2 from the consultation paper have been combined into template #1 of the final draft ITS) and several templates have been reorganized and trimmed down (e.g., the requirement to report exposures to top EU or top national polluters has been removed).

Quantitative disclosures

The ITS on P3 disclosure on ESG risks introduce ten templates on quantitative disclosures. These can be grouped in four templates on transition risks, one on physical risks, and five on mitigating actions:

• Transition risks
  Two of the required templates are relatively straightforward. Banks need to report the energy efficiency of real estate collateral in the loan portfolio (#2) and report their aggregate exposure to the top 20 of the most carbon-intensive firms in the world (#4).
  The main challenge for banks though will be in completing the other two templates:
  • Template #1 requires banks to disclose the gross carrying amount of loans and advances provided to non-financial corporates, classified by NACE sector codes and residual maturities. It is also required to report on the counterparties’ scope 1, 2, and 3 greenhouse gas (GHG) emissions. Reflecting the challenge in reporting on scope 3 emissions, a transitional measure is in place. Full reporting needs to be in place by June 2024. Until then, banks need to report their available estimates (if any) and explain the methodologies and data sources they intend to use.
  • In the last template (#3), banks also need to report scope 3 emissions, but relate these to the alignment metrics defined by the International Energy Agency (IEA) for the ‘net zero by 2050’ scenario. For this scenario, a target for a CO2 intensity metric is defined for 2030. By calculating the distance to this target, it becomes clear how banks are progressing (over time) towards supporting a sustainable economy. A similar transitional measure applies as for template #1.
• Physical risks
  In template #5, banks are required to disclose how their banking book positions are exposed to physical risks, i.e., “chronic and acute climate-related hazards”. The exposures need to be reported by residual maturity and by NACE sector codes and should reflect exposure to risks like heat waves, droughts, floods, hurricanes, and wildfires. Specialized databases need to be consulted to compile a detailed understanding of these exposures. To support their submissions, banks further need to compile a narrative that explains the methodologies they used.
• Mitigating actions
  The final set of templates covers quantitative information on the actions a bank takes to mitigate or adapt to climate change risks.
  • Templates #6-8 all relate to the GAR, which indicates what part of the bank’s banking book is aligned with the EU’s Taxonomy:
    • In template #7, banks need to report the outstanding banking book exposures to different types of clients/issuers, as well as the amount of these exposures that are taxonomy-eligible (that is, to sectors included in the EU Taxonomy) and taxonomy-aligned (that is, taxonomy-eligible exposures financing activities that contribute to climate change mitigation or adaptation). Based on this information, the bank’s GAR can be determined.
    • In template #8, a GAR needs to be reported for the exposures to each type of client/issuer distinguished in template #7, with a distinction between a GAR for the full outstanding stock of exposures per client/issuer type, and a GAR for newly originated (‘flow’) exposures.
    • Template #6 contains a summary of the GARs from templates #7 and #8.
      In these templates, the numerator of the GAR only includes exposures to non-financial corporations that are required to publish non-financial information under the NFRD. Any exposures to other corporate counterparties therefore are considered 0% Taxonomy-aligned.
  • The main challenge in this group of templates is in template #9. To incentivize banks to support all of their counterparties to transition to a more sustainable business model, and to collect ESG data on these counterparties, the EBA introduces the Banking Book Taxonomy Alignment Ratio (BTAR). In this metric, the numerator does include the exposures to counterparties that are not subject to NFRD disclosure obligations. The BTAR ratios obtained from the information in template #9 therefore complement the GAR ratios obtained in templates #7 and #8.
  • In the final template (#10), banks have the opportunity to include any other climate change mitigating actions that are not covered by the EU Taxonomy. They can for example report on their use of green or sustainable bonds and loans.

An overview of the templates for quantitative disclosures in presented in Figure 2.

Qualitative disclosures

In the ITS on P3 disclosures on ESG risks, three tables are included for qualitative disclosures. The EBA has aligned these tables with their Report on Management and Supervision of ESG risks¹¹. The three tables are set up for qualitative information on environmental, social, and governance risks, respectively. For each of these topics, banks need to address three aspects: on business strategy and processes, governance, and risk management. An overview of the required disclosures is presented in Figure 3.

Figure 3 – Overview of qualitative ESG disclosures (based on templates & section 2.3.2 of the EBA ITS on P3 disclosures on ESG risks)

Timelines and transitional measures

The ITS on P3 disclosure on ESG risks become effective per 30 June 2022 for large institutions that have securities traded on a regulated market of an EU member state. A semi-annual disclosure is required, but the first disclosure is annual. Consequently, based on 31 December 2022 data, the first reporting will take place in the first quarter of 2023.

The EBA has introduced a number of transitional measures. These can be summarized as follows:

• The reporting of information on the GAR is only required as of 31 December 2023.
• The reporting of information on the BTAR, the bank’s financed scope 3 emissions, and the alignment metrics is only required as of June 2024.

The EBA has further indicated in the ITS that they will conduct a review of the ITS’s requirements during 2024. They may then also extend the ITS with other environmental risks (other than the climate change-related risks in the current version). The EU Taxonomy is expected to cover a broader range of environmental risks by the end of 2022. Sometime after 2024, it is expected that the EBA will further extend the ITS by including disclosure requirements on social and governance risks.

An overview of the main timelines and transitional measures is presented in Figure 4.

Figure 4 – Overview of the main timelines and transitional measures for the ESG disclosures

Conclusion

Society, and consequently banks too, are increasingly facing risks stemming from changes in our climate. In recent years, supervisory authorities have stepped up by introducing more and more guidance and regulation to create transparency about climate change risk, and more broadly ESG risks. The publication of the ITS on P3 disclosures on ESG risks by the EBA marks an important milestone. It offers banks the opportunity to disseminate a constructive and positive role in the transition to a sustainable economy.

Nonetheless, implementing the disclosure requirements will be a challenge. Developing detailed assessments of the physical risks to which their asset portfolio is exposed and to estimate the scope 3 emissions of their clients and counterparties (‘financed emissions’) will not be straightforward. For their largest counterparties, banks will be able to profit from the NFRD disclosure obligations, but especially in Europe a bank’s portfolio typically has many exposures to small- and medium-sized enterprises. Meeting the disclosure requirements introduced by the EBA will require timely and intensive discussions with a substantial part of the bank’s counterparties.

Banks also need to provide detailed information on how ESG risks are reflected in the bank’s strategy and governance and incorporated in the risk management framework. With our extensive knowledge on market risk, credit risk, liquidity risk, and business risk, Zanders is well equipped to support banks with integrating the identification, measurement, and management of climate change-related risks into existing risk frameworks. For more information, please contact Pieter Klaassen or Sjoerd Blijlevens via +31 88 991 02 00.

References

1. See the EBA 2022 Work Programme.
2. The EBA’s Report on Management and Supervision of ESG risks for credit institutions and investment firms, published in June 2021.
3. See the EBA’s interactive Single Rulebook.
4. See Regulation (EU) 2019/876.
5. See the TCFD’s Final Report on Recommendations of the Task Force on Climate-related Financial Disclosures published in June 2017.
6. See the EBA’s response to EC Call for Advice on Article 8 Taxonomy Regulation.
7. See Regulation (EU) 2019/2089.
8. See Directive 2014/95/EU.
9. See the European Commission’s Proposal for a Corporate Sustainability Reporting Directive.
10. See Regulation (EU) 2019/2088.
11. The EBA report can be found here.

This publication fits nicely into the ‘horizon priority’ of the EBA to provide tools to banks to measure and manage ESG-related risks. In this article we present a brief overview of the way the ITS have been developed, what qualitative and quantitative disclosures are required, what timelines and transitional measures apply – and where the largest challenges arise.

By requiring banks to disclose information on their exposure to ESG-related risks and the actions they take to mitigate those risks – for example by supporting their clients and counterparties in the adaptation process – the EBA wants to contribute to a transition to a more sustainable economy. The Pillar 3 disclosure requirements apply to large institutions with securities traded on a regulated market of an EU member state.

In an earlier report², the EBA defined ESG-related risks as “the risks of any negative financial impact on the institution stemming from the current or prospective impacts of ESG factors on its counterparties or invested assets”. Hence, the focus is not on the direct impact of ESG factors on the institution, but on the indirect impact through the exposure of counterparties and invested assets to ESG-related risks. The EBA report also provides examples for typical ESG-related factors.
While the ITS have been streamlined and simplified compared to the consultation paper published in March 2021, there are plenty of challenges remaining for banks to implement these standards.

Development of the ITS

The EBA has been mandated to develop the ITS on P3 disclosures on ESG risks in Article 434a of the Capital Requirements Regulation (CRR). The EBA has opted for a sequential approach, with an initial focus on climate change-related risks. This is further narrowed down by only considering the banking book. The short maturity and fast revolving positions in the trading book are out of scope for now. The scope of the ITS will be extended to included other environmental risks (like loss of biodiversity), and social and governance risks, in later stages.

In the development of the ITS, the EBA has strived for alignment with several other regulations and initiatives on climate-related disclosures that apply to banks. The most notable ones are listed below (and in Figure 1):

Figure 1 – Overview of related regulations and initiatives considered in the development of the ITS

• Capital Requirements Directive and Regulation (CRD and CRR): article 98(8) of the CRD³ mandated the EBA to publish the EBA report on Management and Supervision of ESG risks, which includes the split of climate change-related risks in physical and transition risks. Article 434a of the CRR⁴ mandated the EBA to develop the draft ITS to specify the ESG disclosure requirements described in article 449a.
• EBA report on Management and Supervision of ESG risks²: the report provides common definitions of ESG risks and contains proposals on how to include ESG risks in the risk frameworks of banks, covering its identification, assessment, and management. It also discusses the way to include ESG risks in the supervisory review process.
• Task Force on Climate-related Financial Disclosures (TCFD)⁵: the Financial Stability Board’s TFCD has published recommendations on climate-related disclosures. The metrics and Key Performance Indicators (KPIs) included in the ITS have been aligned with the TCFD recommendations.
• Taxonomy Regulation⁶: the European Union’s common classification system of environmentally sustainable economic activities is underpinning the main KPIs introduced in the ITS.
• Climate Benchmark Regulation (CBR)⁷: In the CBR, two types of climate benchmarks were introduced (‘EU Climate Transition’ and ‘EU Paris-aligned’ benchmarks) and ESG disclosures for all other benchmarks (excluding interest rate and currency benchmarks) were required.
• Non-Financial Reporting Directive (NFRD)⁸: the NFRD introduces ESG disclosure obligations for large companies, which include climate-related information.
• Corporate Sustainability Reporting Directive (CSRD)⁹: a proposal by the European Commission to extend the scope of the NFRD to also include all companies listed on regulated markets (except listed micro-enterprises). One of the ITS’s KPIs, the Green Asset Ratio (GAR) is directly linked to the scope of the NFRD/CSRD.
• Sustainable Finance Disclosure Regulation (SFDR)¹⁰: the SFDR lays down sustainability disclosure obligations for manufacturers of financial products and financial advisers towards end-investors. It applies to banks that provide portfolio management investment advice services.

Compared to the consultation paper for the ITS, several changes have been made to the required templates. Some templates have been combined (e.g., templates #1 and #2 from the consultation paper have been combined into template #1 of the final draft ITS) and several templates have been reorganized and trimmed down (e.g., the requirement to report exposures to top EU or top national polluters has been removed).

Quantitative disclosures

The ITS on P3 disclosure on ESG risks introduce ten templates on quantitative disclosures. These can be grouped in four templates on transition risks, one on physical risks, and five on mitigating actions:

• Transition risks
  Two of the required templates are relatively straightforward. Banks need to report the energy efficiency of real estate collateral in the loan portfolio (#2) and report their aggregate exposure to the top 20 of the most carbon-intensive firms in the world (#4).
  The main challenge for banks though will be in completing the other two templates:
  • Template #1 requires banks to disclose the gross carrying amount of loans and advances provided to non-financial corporates, classified by NACE sector codes and residual maturities. It is also required to report on the counterparties’ scope 1, 2, and 3 greenhouse gas (GHG) emissions. Reflecting the challenge in reporting on scope 3 emissions, a transitional measure is in place. Full reporting needs to be in place by June 2024. Until then, banks need to report their available estimates (if any) and explain the methodologies and data sources they intend to use.
  • In the last template (#3), banks also need to report scope 3 emissions, but relate these to the alignment metrics defined by the International Energy Agency (IEA) for the ‘net zero by 2050’ scenario. For this scenario, a target for a CO2 intensity metric is defined for 2030. By calculating the distance to this target, it becomes clear how banks are progressing (over time) towards supporting a sustainable economy. A similar transitional measure applies as for template #1.
• Physical risks
  In template #5, banks are required to disclose how their banking book positions are exposed to physical risks, i.e., “chronic and acute climate-related hazards”. The exposures need to be reported by residual maturity and by NACE sector codes and should reflect exposure to risks like heat waves, droughts, floods, hurricanes, and wildfires. Specialized databases need to be consulted to compile a detailed understanding of these exposures. To support their submissions, banks further need to compile a narrative that explains the methodologies they used.
• Mitigating actions
  The final set of templates covers quantitative information on the actions a bank takes to mitigate or adapt to climate change risks.
  • Templates #6-8 all relate to the GAR, which indicates what part of the bank’s banking book is aligned with the EU’s Taxonomy:
    • In template #7, banks need to report the outstanding banking book exposures to different types of clients/issuers, as well as the amount of these exposures that are taxonomy-eligible (that is, to sectors included in the EU Taxonomy) and taxonomy-aligned (that is, taxonomy-eligible exposures financing activities that contribute to climate change mitigation or adaptation). Based on this information, the bank’s GAR can be determined.
    • In template #8, a GAR needs to be reported for the exposures to each type of client/issuer distinguished in template #7, with a distinction between a GAR for the full outstanding stock of exposures per client/issuer type, and a GAR for newly originated (‘flow’) exposures.
    • Template #6 contains a summary of the GARs from templates #7 and #8.
      In these templates, the numerator of the GAR only includes exposures to non-financial corporations that are required to publish non-financial information under the NFRD. Any exposures to other corporate counterparties therefore are considered 0% Taxonomy-aligned.
  • The main challenge in this group of templates is in template #9. To incentivize banks to support all of their counterparties to transition to a more sustainable business model, and to collect ESG data on these counterparties, the EBA introduces the Banking Book Taxonomy Alignment Ratio (BTAR). In this metric, the numerator does include the exposures to counterparties that are not subject to NFRD disclosure obligations. The BTAR ratios obtained from the information in template #9 therefore complement the GAR ratios obtained in templates #7 and #8.
  • In the final template (#10), banks have the opportunity to include any other climate change mitigating actions that are not covered by the EU Taxonomy. They can for example report on their use of green or sustainable bonds and loans.

An overview of the templates for quantitative disclosures in presented in Figure 2.

Figure 2 – Overview of the required quantitative ESG disclosures

Qualitative disclosures

In the ITS on P3 disclosures on ESG risks, three tables are included for qualitative disclosures. The EBA has aligned these tables with their Report on Management and Supervision of ESG risks¹¹. The three tables are set up for qualitative information on environmental, social, and governance risks, respectively. For each of these topics, banks need to address three aspects: on business strategy and processes, governance, and risk management. An overview of the required disclosures is presented in Figure 3.

Figure 3 – Overview of qualitative ESG disclosures (based on templates & section 2.3.2 of the EBA ITS on P3 disclosures on ESG risks)

Timelines and transitional measures

The ITS on P3 disclosure on ESG risks become effective per 30 June 2022 for large institutions that have securities traded on a regulated market of an EU member state. A semi-annual disclosure is required, but the first disclosure is annual. Consequently, based on 31 December 2022 data, the first reporting will take place in the first quarter of 2023.

The EBA has introduced a number of transitional measures. These can be summarized as follows:

• The reporting of information on the GAR is only required as of 31 December 2023.
• The reporting of information on the BTAR, the bank’s financed scope 3 emissions, and the alignment metrics is only required as of June 2024.

The EBA has further indicated in the ITS that they will conduct a review of the ITS’s requirements during 2024. They may then also extend the ITS with other environmental risks (other than the climate change-related risks in the current version). The EU Taxonomy is expected to cover a broader range of environmental risks by the end of 2022. Sometime after 2024, it is expected that the EBA will further extend the ITS by including disclosure requirements on social and governance risks.

An overview of the main timelines and transitional measures is presented in Figure 4.

Figure 4 – Overview of the main timelines and transitional measures for the ESG disclosures

Conclusion

Society, and consequently banks too, are increasingly facing risks stemming from changes in our climate. In recent years, supervisory authorities have stepped up by introducing more and more guidance and regulation to create transparency about climate change risk, and more broadly ESG risks. The publication of the ITS on P3 disclosures on ESG risks by the EBA marks an important milestone. It offers banks the opportunity to disseminate a constructive and positive role in the transition to a sustainable economy.

Nonetheless, implementing the disclosure requirements will be a challenge. Developing detailed assessments of the physical risks to which their asset portfolio is exposed and to estimate the scope 3 emissions of their clients and counterparties (‘financed emissions’) will not be straightforward. For their largest counterparties, banks will be able to profit from the NFRD disclosure obligations, but especially in Europe a bank’s portfolio typically has many exposures to small- and medium-sized enterprises. Meeting the disclosure requirements introduced by the EBA will require timely and intensive discussions with a substantial part of the bank’s counterparties.

Banks also need to provide detailed information on how ESG risks are reflected in the bank’s strategy and governance and incorporated in the risk management framework. With our extensive knowledge on market risk, credit risk, liquidity risk, and business risk, Zanders is well equipped to support banks with integrating the identification, measurement, and management of climate change-related risks into existing risk frameworks. For more information, please contact Pieter Klaassen or Sjoerd Blijlevens via +31 88 991 02 00.

References
1) See the EBA 2022 Work Programme.
2) The EBA’s Report on Management and Supervision of ESG risks for credit institutions and investment firms, published in June 2021.
3) See the EBA’s interactive Single Rulebook.
4) See Regulation (EU) 2019/876.
5) See the TCFD’s Final Report on Recommendations of the Task Force on Climate-related Financial Disclosures published in June 2017.
6) See the EBA’s response to EC Call for Advice on Article 8 Taxonomy Regulation.
7) See Regulation (EU) 2019/2089.
8) See Directive 2014/95/EU.
9) See the European Commission’s Proposal for a Corporate Sustainability Reporting Directive.
10) See Regulation (EU) 2019/2088.
11) The EBA report can be found here.

This new update is triggered by the revised Capital Requirements Regulation (CRR2) and Capital Requirements Directive (CRD5). Both documents were adopted by the Council of the EU and the European Parliament in 2019 as part of the Risk Reduction Measures package. The CRR2 and CRD5 included numerous mandates for the EBA to come up with new or adjusted technical standards and guidelines. These are now covered in three separate consultation papers

1. The first consultation paper¹ describes the update of the IRRBB Guidelines themselves.
2. The second paper² concerns the introduction of a standardized approach (SA) which should be applied when a competent authority deems a bank’s internal model for IRRBB management non-satisfactory. It also introduces a simplified SA for smaller and non-complex institutions.
3. The third consultation paper³ offers updates to the supervisory outlier test (SOT) for the Economic Value of Equity (EVE) and the introduction of an SOT for Net Interest Income (NII). Read our analysis on this consultation paper here »

In this article we focus on the first consultation paper. The update of the IRRBB Guidelines can be split up in three topics and each will be discussed in further detail:

• Additional criteria for the assessment and monitoring of the credit spread risk arising from non-trading book activities (CSRBB)
• The criteria for non-satisfactory IRRBB internal systems
• A general update of the existing IRBBB Guidelines

CSRBB

The 2018 IRRBB Guidelines introduced the obligation for banks to monitor CSRBB. However, the publication did not describe how to do this. In the updated consultation paper the EBA defines the measurement of CSRBB as a separate risk class in more detail. The general governance related aspects such as (management) responsibilities, IT systems and internal reporting framework are separately defined for CSRBB, but are similar to those for IRRBB.

Also similar to IRRBB is that banks must express their risk appetite for CSRBB both from an NII as well as an economic value perspective.

The EBA defines CSRBB as:

“The risk driven by changes of the market price for credit risk, for liquidity and for potentially other characteristics of credit-risky instruments, which is not captured by IRRBB or by expected credit/(jump-to-) default risk. CSRBB captures the risk of an instrument’s changing spread while assuming the same level of creditworthiness, i.e. how the credit spread is moving within a certain rating/PD range.”

EBA

Compared to the previous definition, rating/PD migrations are explicitly excluded from CSRBB. Including idiosyncratic spreads could lead to double counting since these are generally covered by a credit risk framework. However, the guidelines give some flexibility to include idiosyncratic spreads, as long as the results are more conservative than when idiosyncratic spreads are excluded. This is because, based on the Quantitative Impact Study of December 2020 (QIS 2020), banks indicated to find it difficult to separate the idiosyncratic spreads from the credit spread.

Also, the scope of CSRBB has changed from the current IRRBB Guidelines. All assets, liabilities and off-balance-sheet items in the banking book that are sensitive to credit spread changes are within the scope of CSRBB whereas the 2018 IRRBB Guidelines focused only on the asset side. Based on the results of the QIS 2020, the EBA concluded that most of the exposures to CSRBB are debt securities which are accounted for at fair value (via Profit and Loss or Other Comprehensive Income). However, this does not rule out that other assets or liabilities could be exposed to CSRBB. It is stated that banks cannot ex-ante exclude positions from the scope of CSRBB. Any potential exclusion of instruments from the scope of CSRBB must be based on the absence of sensitivity to credit spread risk and appropriately documented. At a minimum, banks must include assets accounted at fair value in their scope.

We believe that the obligation to report CSRBB for all assets accounted for at fair value will be challenging for exposures that do not have quoted market prices. Without a deep liquid market, it will be difficult to establish the credits spread risk (even when idiosyncratic risk is included).

Another possible candidate to be included in the scope of CSRBB is the issued funding on the liability side of the banking book, especially in a NII context. When market spreads increase, this could become harmful when the wholesale funding needs to be rolled over against higher credit spread without being able to increase client interest on the asset side. Similar to IRRBB, the exposure to this risk depends on the repricing gap of the assets and liabilities. In this case, however, swaps cannot be used as hedge.

Other products such as consumer loans, mortgages, and consumer deposits, which are typically accounted for at amortized cost, are less likely to be included. This is also stated by the BCBS standards. The BCBS states that the margin (administrative rate) is under absolute control of the bank and hence not impacted by credit spreads. However, it is unclear whether this is sufficient to rule these products out of scope.

Non-satisfactory IRRBB internal systems

The EBA is mandated to specify the criteria for determining an IRRBB internal system as non-satisfactory. The EBA has identified specific items for this that should be considered. At a minimum, banks should have implemented their internal system in compliance with the IRRBB Guidelines, taking into account the principle of proportionality. More specifically:

• Such a system must cover all material interest rate risk components (gap risk, basis risk, option risk).
• The system should capture all material risks for significant assets, liabilities and off-balance sheet type instruments (e.g. non-maturing deposits, loans, and options).
• All estimated parameters must be sufficiently back tested and reviewed, considering the nature, scale and complexity of the bank.
• The internal system must comply with the model governance and the minimum required validation, review and control of IRRBB exposures as detailed by the IRRBB guidelines.
• Competent authorities may require banks to use the standardized approach³ if the internal systems are deemed non-satisfactory.

General update of existing IRRBB Guidelines

Major parts of the guidelines for managing IRRBB have not changed. In the section on IRRBB stress testing, however, a new article (#103) for products with significant repricing restrictions (e.g. an explicit floor on non-maturing deposits – NMDs) is introduced. As part of their stress testing, banks should consider the impact when these products are replaced with contracts with similar characteristics, even under a run-off assumption. The exact intention of this article is unclear. For NII-purposes it is common practice to roll over products with similar characteristics (or use another balance sheet development assumption). Our interpretation of this article is that banks are expected to measure the risk of continued repricing restrictions in an economic value perspective when the maturity of those funding sources is smaller than the maturity of the asset portfolio. This may for example materialize when banks roll over NMDs that are subject to a legally imposed floor.

Another update is the restriction on the maximum weighted average repricing maturity of five years for NMDs. This cap was prescribed for the EVE SOT and is now included for the internal measurement of IRRBB. We believe that the impact of this will be limited since only a few banks will have separate NMD models for internal measurement and the SOT.

Finally, some minor additions have been included in the guidelines. For example, the guidelines emphasize multiple times that when diversification assumptions are used for the measurement of IRRBB, these must be appropriately stressed and validated.

Conclusion

It is expected that the final guidelines will not deviate significantly from the consultation paper. Banks can therefore start preparing for these new expectations. For the measurement of IRRBB, limited changes are introduced in the consultation. Although the exact intention of the EBA is unclear to us, it is interesting to notice that the updated IRRBB Guidelines include the expectation that banks pay special attention in their stress tests to products with significant repricing restrictions. Furthermore, banks must invest in their CSRBB measurement. For their entire banking book, banks need to assess whether market wide credit spread changes will have an impact on an NII and/or economic value perspective. The scope of CSRBB measurement may need to be extended to include the funding issued by the bank. And to conclude, the obligation to measure CSRBB for fair value assets that do not have quoted market prices will be a challenge for banks.

References

1. CP Draft GL on IRRBB and CSRBB.pdf
2. CP Draft RTS on SA.pdf
3. CP Draft RTS on SOTs.pdf

The current version of the IRRBB Guidelines, published in 2018, came into force on 30 June 2019. At that time, the IRRBB Guidelines were aligned with the Standards on interest rate risk in the banking book, published by the Basel Committee on Banking Supervision (in short, the BCBS Standards) in April 2016.

The new updates are triggered by the revised Capital Requirements Regulation (CRR2) and Capital Requirements Directive (CRD5). Both documents were adopted by the Council of the EU and the European Parliament in 2019 as part of the Risk Reduction Measures package. The CRR2 and CRD5 included numerous mandates for the EBA to come up with new or adjusted technical standards and guidelines. These are now covered in three separate consultation papers:

1. The first consultation paper_¹ describes an update of the IRRBB Guidelines themselves. The main changes are the specification of criteria to identify “non-satisfactory internal models for IRRBB management” and the specification of criteria to assess and monitor Credit Spread Risk in the Banking Book (CSRBB). Read our analysis on this consultation paper here »
2. The second paper² concerns the introduction of a standardized approach (SA) which should be used when a competent authority deems a bank’s internal model for IRRBB management non-satisfactory. It also introduces a Simplified SA for smaller and non-complex institutions.
3. The third consultation paper³ offers updates to the supervisory outlier test (SOT) for the Economic Value of Equity (EVE) and the introduction of an SOT for Net Interest Income (NII).

Please note that we recently also published an article about the new disclosure requirements for IRRBB which is closely related to this topic.

Changes to the supervisory outlier test

Banks have been subject to an SOT already since the 2006 IRRBB Guidelines. The SOT is an important tool for supervisors to perform peer reviews and to compare IRRBB exposures between banks. The SOT measures how the EVE responds to an instantaneous parallel (up and down) yield curve shift of 200 basis points. Changes in EVE that exceed 20% of the institution’s own funds will trigger supervisory discussions and may lead to additional capital requirements.

Some changes to the SOT were included in the 2018 update of the IRRBB Guidelines. Next to further guidance on its calculation, the existing SOT was complemented with an additional SOT. The additional SOT was based on the same metric and guidelines, but the scenarios applied were the six standard interest rate scenarios introduced in the BCBS Standards. Also, a threshold of 15% compared to Tier 1 capital was applied. In the 2018 IRRBB Guidelines, the additional SOT was considered an ‘early warning signal’ only.

The new update of the IRRBB Guidelines includes two important SOT-related changes, which are incorporated through amendments to Article 98 (5) of the CRD: the replacement of the 20% SOT for EVE and the introduction of the SOT for NII. Both changes are discussed in more detail below.

Changes to the supervisory outlier test

Banks have been subject to an SOT already since the 2006 IRRBB Guidelines. The SOT is an important tool for supervisors to perform peer reviews and to compare IRRBB exposures between banks. The SOT measures how the EVE responds to an instantaneous parallel (up and down) yield curve shift of 200 basis points. Changes in EVE that exceed 20% of the institution’s own funds will trigger supervisory discussions and may lead to additional capital requirements.

Some changes to the SOT were included in the 2018 update of the IRRBB Guidelines. Next to further guidance on its calculation, the existing SOT was complemented with an additional SOT. The additional SOT was based on the same metric and guidelines, but the scenarios applied were the six standard interest rate scenarios introduced in the BCBS Standards. Also, a threshold of 15% compared to Tier 1 capital was applied. In the 2018 IRRBB Guidelines, the additional SOT was considered an ‘early warning signal’ only.

The new update of the IRRBB Guidelines includes two important SOT-related changes, which are incorporated through amendments to Article 98 (5) of the CRD: the replacement of the 20% SOT for EVE and the introduction of the SOT for NII. Both changes are discussed in more detail below.

Replacement of the 20% SOT for EVE

The first part of the amended Article 98 (5) concerns the replacement of the original 20% SOT by the 15% SOT. While many banks are probably already targeting levels below 15%, we expect that this change will limit the maneuvering capabilities of banks as they will likely choose to implement a management buffer. Note that not only the threshold is lower (15% instead of 20%), but also the denominator (Tier 1 capital instead of own funds). Furthermore, the worst outcome of all six supervisory scenarios should be used, as opposed to worst outcome of just the two parallel ones. Combined, this leads to a significant reduction in the EVE risk to which a bank may be exposed.

Some other noteworthy updates to the SOT for EVE that are not directly related to the CRD amendment are listed below:

• The post-shock interest floor decreases from -100 to -150 basis points and it increases to 0% over a 50-year instead of a 20-year period.
• In the calibration of the interest rate shocks for currencies for which the shocks have not been prescribed, the most recent 16-year period should be used (instead of the 2000-2015 period which is still underlying the shocks for the other currencies).
• When aggregating the results over currencies, some additional offsetting (80% as opposed to 50%) is granted in case of Exchange Rate Mechanism (ERM) II currencies with a formally agreed fluctuation band narrower than the standard band of +/-15%. Currently, only positions in the Denmark Krona (DKK) qualify for this treatment.

Introduction of the SOT for NII

The second part of the amended Article 98 (5) concerns the introduction of an entirely new SOT. It is aimed at measuring the potential decline in NII for two standard interest rate shock scenarios. Compared to the SOT for EVE, the SOT for NII requires many more modeling assumptions, in particular to determine the expected balance sheet development. The consultation paper provides clarity on the approach the EBA wants to take but two decisions are explicitly consulted.

The SOT for NII compares the NII for a baseline scenario with the NII in a shocked scenario over a one-year horizon. The two shocks that need to be applied are the two instantaneous parallel shocks that are also used in the SOT for EVE. Furthermore, the same requirements that are specified for the SOT for EVE apply, for example the use of the floor and the aggregation approach. The two exceptions are the requirements to use a constant balance sheet assumption (as opposed to a run-off balance sheet) and to include commercial margins and other spread components in the calculations. The commercial margins of new instruments should equal the prevailing levels (as opposed to historical ones).

The two decisions for which the EBA is seeking input are:

The scope/definition of NII
In its narrowest definition, the SOT will focus on the difference between interest income and interest expenses. The EBA, however, also considers using a broader definition where the effect of market value changes of instruments accounted for at Fair Value (∆FV) is added, and possibly also interest rate sensitive fees and commissions.

The definition of the SOT’s threshold
Article 98 (5) requires the EBA to specify what is considered a ‘large decline’ in NII, in which case the competent authorities are entitled to exercise their supervisory powers. This first requires a metric. The EBA is consulting two:

• The first metric is calculating the change in NII (the difference between the shocked and baseline NII) relative to the Tier 1 Capital:
• The second metric is calculating the change in NII relative to the baseline scenario, after correcting for administrative expenses that can be allocated to NII:
• where α is the historical share of NII relative to the operating income as reported based on FINREP input.

The pros of the narrow definition of NII are improved comparability and ease of computation, where the main pro of the broader definition is that it achieves a more comprehensive picture, which is also more in line with the EBA IRRBB Guidelines. With respect to the metrics, the first (capital-based) metric is the simplest and it is comparable to the approach taken for the SOT for EVE. The second metric is close to a P&L-based metric and the EBA argues that its main advantage is that “it takes into account both the business model and cost structure of a bank in the assessment of the continuity of the business operations”. It does involve, however, the application of some assumptions on determining the α parameter.

Thresholds for the four possible combinations

For each of the four possible combinations (definition of NII and specification of the metric), the EBA has determined, using data from the December 2020 Quantitative Impact Study (QIS), what the corresponding thresholds should be. Their starting point has been to make the SOT for NII as stringent as the SOT for EVE. Effectively, they reverse engineered the threshold to achieve a similar number of outliers under both measures. We expect that the proposed threshold for any of the four possible combinations will not be constraining for the majority of banks. The resulting proposed thresholds are included in the table below:

Table 1 – Comparison of the proposed thresholds for each combination of metric and scope

The impact of including Fair Value changes seems arbitrary as it increases the threshold for the capital-based metric and decreases the threshold for the P&L-based metric. Also, from a comparability and computational perspective, the narrow definition of NII may be preferred. Furthermore, the capital-based metric is less intuitive for NII than it is for EVE, and consequently, the P&L-based one may be preferred. It is also noted in the consultation paper that if the shocked NII after the correction for administrative expenses (the numerator) is negative, it will also be considered an outlier.

Conclusion

In the past years, many banks have invested heavily in their IRRBB framework following the 2018 update of the IRRBB Guidelines. Once again, an investment is required. Even though there are not many surprises in the proposed updates related to the SOTs, small and large banks alike will need to carefully assess how the changes to the existing SOT and the introduction of the new SOT will impact their interest rate risk management. Banks still have the opportunity to respond to all three consultation papers until 4 April 2022.

References

1. CP Draft GL on IRRBB and CSRBB.pdf
2. CP Draft RTS on SA.pdf
3. CP Draft RTS on SOTs.pdf