Interest Rate Risk
One of the objects of Canada Deposit Insurance Corporation ("CDIC" or
"the Corporation") under the CDIC Act is to be instrumental in the
promotion of standards of sound business and financial practices for
member institutions. The Act also empowers the CDIC Board of Directors
to make by-laws respecting standards of sound business and financial
practices for member institutions. The CDIC Act further sets out that
examiners must provide CDIC with their opinion as to whether or not the
operations of a member institution are being conducted in accordance
with the standards of sound business and financial practices established
under the by-laws. Finally, the Act provides that CDIC may initiate the
termination of a member's deposit insurance if, in the opinion of CDIC,
a member is not following a standard of sound business and financial
practice established under the by-laws.
The CDIC Board of Directors has made by-laws respecting standards of
sound business and financial practices. Under the CDIC Interest Rate
Risk Management Standards By-law (the "By-law"), the Corporation shall,
in furtherance of its objectives, including the promotion of sound
business and financial practices in respect of interest rate risk,
publish a document entitled Standards of Sound Business and Financial
Practices: Interest Rate Risk Management, to assist member
institutions in developing interest rate risk management policies,
techniques, procedures and information systems.
This document sets out CDIC's standards of sound business and
financial practices for the management and control of exposure to
interest rate risk. Its development reflects the insightful and helpful
comments received as a result of an extensive consultation and review
process with industry and regulators. The Board of Directors of CDIC
will use compliance with this standards document as the basis for
determining whether a member institution is following standards of sound
business and financial practices for interest rate risk management
established under the By-law.
CANADA DEPOSIT INSURANCE CORPORATION
INTEREST RATE RISK MANAGEMENT
This document sets out the minimum policies and procedures that each
member of the Canada Deposit Insurance Corporation (CDIC) needs to have
in place and apply within its interest rate risk management program, and
the minimum criteria it should use, to prudently manage and control its
exposure to interest rate risk.
Interest rate risk management must be conducted within the context of
a comprehensive business plan. Although this document focuses on a
member's responsibility for managing interest rate risk, it is not meant
to imply that interest rate risk can be managed in isolation from other
asset/liability management considerations such as the paramount need to
maintain adequate liquidity, or other risks.
Moreover, interest rates are affected by factors such as government
monetary and fiscal policies, and general economic conditions such as
the rate of inflation. Consequently, interest rate yield curves (the
term structure of interest rates), although often related, vary from
currency to currency. Accordingly, the management of interest rate risk
by members with significant operations in foreign currencies needs to be
undertaken separately on a currency-by-currency basis.
Interest rate risk is the potential impact on a member's earnings and
net asset values of changes in interest rates. Interest rate risk arises
when an institution's principal and interest cash flows (including final
maturities), both on- and off-balance sheet, have mismatched repricing
dates. The amount at risk is a function of the magnitude and direction
of interest rate changes and the size and maturity structure of the
C. INTEREST RATE RISK MANAGEMENT PROGRAM
Managing interest rate risk is a fundamental component in the safe
and sound management of CDIC member institutions. It involves prudently
managing mismatch positions in order to control, within set parameters,
the impact of changes in interest rates on the member. Significant
factors in managing the risk include the frequency, volatility and
direction of rate changes, the slope of the interest rate yield curve,
the size of the interest-sensitive position and the basis for repricing
at rollover dates.
Although the particulars of interest rate risk management will differ
among members depending upon the nature and complexity of their asset
and liability structure (both on and off-balance sheet), interest rate
risk positions and risk profile, a comprehensive interest rate risk
management program requires:
- establishing and implementing sound and prudent interest rate risk
- developing and implementing appropriate interest rate risk
measurement techniques; and
- developing and implementing effective interest rate risk
management and control procedures.
Interest Rate Risk Management Policies
Sound and prudent interest rate risk management requires clear
policies. These policies need to include:
- an interest rate risk philosophy governing the extent to which the
institution is willing to assume interest rate risk; and
- explicit and prudent limits on the institution's interest rate
i) Interest Rate Risk Philosophy
The tolerance of each CDIC member to assume interest rate risk will
vary with the extent of other risks (e.g., liquidity, credit risk,
foreign exchange risk, investment risk) and its ability to absorb
potential losses. As with other aspects of financial management, a
tradeoff exists between risk and return. Although a fully matched
position eliminates interest rate risk, such a position may not be
desirable for other sound business reasons. The objective of interest
rate risk management need not necessarily be the complete elimination of
exposure to changes in interest rates. Rather, it should be to manage
the impact of interest rate changes within self-imposed limits set after
careful consideration of a range of possible interest rate environments.
ii) Interest Rate Risk Limits
Each CDIC member needs to establish explicit and prudent interest
rate risk limits, and ensure that the level of interest rate risk
exposure does not exceed these limits.
Interest rate risk limits need to be set within an institution's
overall risk profile, which reflects factors such as its capital
adequacy, liquidity, credit quality, investment risk and foreign
exchange risk. Interest rate positions should be managed within an
institution's ability to offset such positions if necessary. Moreover,
interest rate risk limits need to be reassessed on a regular basis to
reflect potential changes in interest rate volatility, the institution's
overall risk philosophy and risk profile.
Risk limits are usually defined in terms of earnings or in terms of
the present value of equity at risk and are normally expressed in terms
of the allowable amounts of mismatched positions for specified or
cumulative maturity periods.
Earnings are the reported net income before taxes. Changes in
interest rates may affect earnings by:
- affecting the interest income or expenses relating to assets,
liabilities and off-balance sheet items; and
- affecting the value of fixed-rate assets, liabilities and
off-balance sheet items that are carried on a market valuation basis.
Present value of equity is the present value of assets and
off-balance sheet items generating cash inflows, less the present value
of liabilities and off-balance sheet items generating cash outflows.
Changes in interest rates affect the present value of the cash flows
from, and the value of these items, and therefore the economic value of
Limits may also appropriately be defined in terms of regulatory
capital, shareholders' equity and earning assets.
Measurement of Interest Rate Risk
Managing interest rate risk requires a clear understanding of the
amount at risk and the impact of changes in interest rates on this risk
position. To make these determinations, sufficient information must be
readily available to permit appropriate action to be taken within
acceptable, often very short, time periods. The longer it takes an
institution to eliminate or reverse an unwanted exposure, the greater
the possibility of loss.
Each CDIC member needs to use risk measurement techniques that
accurately and frequently measure the impact of potential interest rate
changes on the institution. In choosing appropriate rate scenarios to
measure the effect of rate changes, the institution should consider the
potential volatility of rates and the time period within which the
institution could realistically react to close the position.
Gap analysis, duration analysis and simulation models are interest
rate risk measurement techniques. Each CDIC member institution should
use at least one, and preferably a combination of these techniques in
managing its interest rate risk exposure. Each technique provides a
different perspective on interest rate risk, has distinct strengths and
weaknesses, and is more effective when used in combination. These
techniques are discussed further in Appendix A.
Interest Rate Risk Management and Control Procedures
Each CDIC member needs to develop and implement effective and
comprehensive procedures and information systems to manage and control
interest rate risk in accordance with its interest rate risk policies.
These procedures should be appropriate to the size and complexity of the
institution's interest rate risk activities.
The use of hedging techniques is one means of managing and
controlling interest rate risk. In this regard, many different financial
instruments can be used for hedging purposes; the more commonly used,
however, are derivative instruments. Examples include foreign exchange
contracts, foreign currency and interest rate futures contracts, foreign
currency and interest rate options, and foreign currency and interest
Generally, few CDIC member institutions will want or need to use the
full range of hedging instruments. Each member should consider which are
appropriate for the nature and extent of its interest rate risk
activities, the skills and experience of management, and the capacity of
interest rate risk reporting and control systems.
Financial instruments used for hedging are not distinguishable in
form from instruments that may be used to take risk positions. Before
using hedging products, member institutions must ensure that they
understand the hedging instrument and that they are satisfied that the
instrument matches their specific hedging needs in a cost effective
Internal inspections/audits are a key element in managing and
controlling an institution's interest rate risk management program. Each
member should use them to ensure compliance with, and the integrity of,
the interest rate risk policies and procedures. Internal
inspections/audits should, at a minimum, randomly test all aspects of
interest rate risk management activities in order to:
- ensure interest rate risk management policies and procedures are
being adhered to;
- ensure effective management controls over interest rate risk
- verify the adequacy and accuracy of management information
- ensure that personnel involved in interest rate risk management
fully understand the institution's interest rate risk policies and
risk limits and have the expertise required to make effective
decisions consistent with the interest rate risk policies.
Assessments of the interest rate risk operations should be presented
to the member's board of directors on a timely basis for review.
D. ROLE OF THE BOARD OF DIRECTORS
The board of directors of each CDIC member is ultimately responsible
for the institution's exposure to interest rate risk and the level of
risk assumed. In discharging this responsibility, a board of directors
usually charges management with developing interest rate risk policies
for the board's approval, and developing and implementing procedures to
measure, manage and control interest rate risk within these policies.
A board of directors needs to have a means of ensuring compliance
with the interest rate risk management program. A board of directors
generally ensures compliance through periodic reporting by management
and internal inspectors/auditors. The reports must provide sufficient
information to satisfy the board of directors that the institution is
complying with its interest rate risk management program.
At a minimum, a board of directors should:
- review and approve interest rate risk policies based on
recommendations by the institution's management;
- review periodically, but at least once a year, the interest rate
risk management program;
- ensure that an internal inspection/audit function reviews interest
rate risk operations to ensure that the institution's interest rate
risk management policies and procedures are being adhered to;
- ensure the selection and appointment of qualified and competent
management to administer the interest rate risk management function;
- outline the content and frequency of management interest rate risk
reports to the board.
E. ROLE OF MANAGEMENT
The management of each CDIC member is responsible for managing and
controlling the institution's exposure to interest rate risk in
accordance with the interest rate risk management program.
Although specific interest rate risk management responsibilities will
vary from one institution to another, management at each CDIC member is
- developing and recommending interest rate risk policies for
approval by the board of directors;
- implementing the interest rate risk management policies;
- ensuring that interest rate risk is managed and controlled within
the interest rate risk management program;
- ensuring the development and implementation of an appropriate
management reporting system with respect to the content, format and
frequency of information concerning the institution's interest rate
risk position, in order to permit the effective analysis and the sound
and prudent management and control of existing and potential interest
rate risk exposure;
- establishing and utilizing a method for accurately measuring the
institution's interest rate risk positions;
- ensuring that an internal inspection/audit function reviews and
assesses the interest rate risk management program;
- developing lines of communication to ensure the timely
dissemination of the interest rate risk policies and procedures to all
individuals involved in the interest rate risk management process; and
- reporting comprehensively on the interest rate risk management
program to the board at least once a year.
INTEREST RATE RISK MEASUREMENT TECHNIQUES
A simple gap analysis measures the difference between the amount of
interest-earning assets and interest-bearing liabilities (both on- and
off-balance sheet) that reprice in a particular time period.
A negative or liability-sensitive gap occurs when interest-bearing
liabilities exceed interest-earning assets for a specific or cumulative
maturity period, that is, more liabilities reprice than assets. In this
situation, a decrease in interest rates should improve the net interest
rate spread in the short term, as deposits are rolled over at lower
rates before the corresponding assets. On the other hand, an increase in
interest rates lowers earnings by narrowing or eliminating the interest
A positive or asset-sensitive gap occurs when interest-earning assets
exceed interest-bearing liabilities for a specific or cumulative
maturity period, that is, more assets reprice than liabilities. In this
situation, a decline in interest rates should lower or eliminate the net
interest rate spread in the short term, as assets are rolled over at
lower rates before the corresponding liabilities. An increase in
interest rates should increase the net interest spread.
More sophisticated gap reports measure mismatches of an institution's
principal and interest cash inflows and outflows (including final
maturities), both on- and off-balance sheet, that reprice in a given
Such gap reports measure potential risk to earnings, from changes in
interest rates on these repricing gaps across the institution's full
maturity spectrum. The reports are important to an interest rate risk
management program because they indicate how much net interest income is
at risk, and, to some extent, the timing of the risk. The reports
provide an objective measure of risk associated with current positions
only; forecasts of future business are not included.
Gap analysis is subject to limitations. Gap analysis does not capture
basis risk or investment risk, is generally based on parallel shifts in
the yield curve, does not incorporate future growth or changes in the
mix of business, and does not account for the time value of money.
Moreover, simple gap analysis (based on contractual term to maturity)
assumes that the timing and amount of assets and liabilities maturing
within a specific gap period are fixed and determined, therefore
ignoring the effects of principal and interest cash flows arising from
honouring customer drawdowns on credit commitments, deposit redemptions,
and prepayments, either on mortgages or term loans, as well as the
timing of maturities within the gap period. Depending on the interest
rate environment, the mix of assets and liabilities (both on- and
off-balance sheet), and the exercise of credit and deposit options by
customers, these deficiencies may represent a significant interest rate
risk to a member institution.
Accordingly, member institutions using gap reports should complement
them with present-value sensitivity systems, such as duration analysis
or simulation models.
Duration is the time-weighted average maturity of the present value
of the cash flows from assets, liabilities and off-balance sheet items.
It measures the relative sensitivity of the value of these instruments
to changing interest rates (the average term to repricing), and
therefore reflects how changes in interest rates will affect the
institution's economic value, that is, the present value of equity. In
this context, the maturity of an investment is used to provide an
indication of interest rate risk. The longer the term to maturity of an
investment, the greater the chance of interest rate movements and,
hence, unfavourable price changes.
Duration measures how price-sensitive an asset, liability or
off-balance sheet item is to small changes in interest rates by using a
single number to index the institution's interest rate risk. This index
represents the average term to maturity of the cash flows.
Like other techniques to measure interest rate risk, the use of
duration analysis is subject to limitations. Duration reflects a linear
approximation to the price changes that constitute interest rate risk.
However, changes in price and yields do not change linearly. A member's
portfolio that is duration neutral when interest rates are at one level
will not necessarily be duration neutral at another level - that is, as
interest rates change, duration will also change. This phenomenon is
called duration drift.
Moreover, traditional duration analysis assumes that the cash flows
of assets and liabilities are known, which may not always be the case.
Option-adjusted duration models may assist in reflecting the variations
in cash flows at different points in time due to the sensitivity of cash
flows to changes in interest rates, and as a result of the exercise of
asset and liability options across interest rate environments - that is,
adjusting for events such as term deposit pre-encashments, mortgage and
term loan pre-payments.
Limitations in using duration analysis arise from the fact that
matching the average term or duration of asset and liability cash flows
does not eliminate all interest rate risk. For this reason, duration
analysis should be used along with additional interest rate risk
measures of cash flow mismatch and cash flow dispersion. These
additional measurement techniques are essential if the member
institution is to control interest rate risks that cannot be summarized
adequately in a single risk measure.
Simulation models are a valuable complement to gap and duration
analysis. Simulation models analyze interest rate risk in a dynamic
context. They evaluate interest rate risk arising from both current and
future business and provide a way to evaluate the effects of strategies
to increase earnings or reduce interest rate risk. Simulation models are
also useful tools for strategic planning; they permit a member
institution to effectively integrate risk management and control into
the planning process. Their forecasts are based on a number of
- future levels and directional changes of interest rates;
- the slope of the yield curve and the relationship between the
various indices that the institution uses to price credits and
- pricing strategies for assets and liabilities as they mature; and
- the growth, volume and mix of future business.
Simulation is usually used to measure interest rate risk by
estimating what effect changes in interest rates, business strategies,
and other factors will have on net interest income, net income and
interest rate risk positions. Simulation models can also be used to
calculate the present value and durations of assets and liabilities.
The management and control, within set parameters, of the impact of
changes in the volume, mix, maturity, quality, and interest and exchange
rate sensitivity of assets and liabilities on a member institution.
The risk that the interest rate relationships between an asset and
its underlying liability will change, even if the asset and liability
Basis risk arises when the interest rate relationship changes between
repricing assets and liabilities within an interest rate risk position -
even if assets and liabilities are matched. This can occur when loan
prices are based on one pricing method (e.g., Prime or LIBOR) while
borrowing costs are based on another.
CDIC Member Institution
A corporation any of whose deposits are insured by the CDIC pursuant
to the CDIC Act. Also referred to as member and member institution.
The risk of financial loss resulting from the failure of a debtor,
for any reason, to fully honour financial or contractual obligations to
a member institution.
The present-value-weighted, average term to repricing of a series of
cash flows. In other words, it is a measure of the average term to
repricing and is commonly expressed in days, months or years. Duration
can be calculated for any instrument, or portfolio of instruments, that
has identifiable cash flows.
Foreign Exchange Risk
The exposure of a member institution to the potential impact of
movements in foreign exchange rates. The risk is that adverse
fluctuations in exchange rates may result in a loss in Canadian dollar
terms to the institution.
Foreign exchange risk arises when there are unhedged currency
mismatches in an institution's assets and liabilities, and related cash
flows (both on- and off-balance sheet) which are not subject to a fixed
exchange rate vis-a-vis the Canadian dollar. This risk continues until
the open position is covered by means of a hedging transaction. The
amount at risk is a function of the magnitude of potential exchange rate
changes and the size and duration of the foreign currency exposure.
An analysis of the difference between the amount of rate-sensitive
assets and rate-sensitive liabilities, both on- and off-balance sheet,
that reprice in a given period.
A maturity profile report showing the difference between the
repricing of assets and liabilities, both on- and off-balance sheet,
within selected time intervals. This report is usually prepared on the
basis of repricing cash flows including final maturity, scheduled
amortization of principal, and estimated prepayments.
A risk management technique to reduce or eliminate price, interest
rate or foreign exchange risk exposures. The elimination or reduction of
such exposures is accomplished by entering into transactions that create
offsetting risk positions. The concept is that when a member has an open
position which entails a risk that it wishes to avoid or minimize, the
institution can undertake a further transaction which compensates for
the risk and acts as a hedge. If the hedge is effective, any gain or
loss on the hedged risk position will be offset by a loss or gain on the
Interest Rate Gap Positions
See Mismatch Position.
Interest Rate Risk
The potential impact of movements in interest rates on a member
Interest Rate Risk Position
The amount of a member institution's exposure to interest rate risk.
Interest Rate Sensitive Assets/Liabilities
Interest-earning assets and interest-bearing liabilities that mature
or are repriced within specified time periods, or have interest rates
that float in relation to a base rate such as the institution's prime
Interest Rate Sensitive Positions
See Mismatch Position.
Interest Rate Yield Curve
The graphic representation of the relationship between a financial
instruments interest rates and maturity term. A yield curve graph
usually has interest rates on the vertical axis and term-to-maturity on
the horizontal axis. When longer maturities have higher interest rates
than shorter maturities, the curve is called a positive or
upward-sloping yield curve. The opposite type of curve, is called a
negative, downward-sloping, or inverted yield curve.
The difference between the yield on a member institution's earning
assets and the cost of its interest-bearing liabilities.
In the context of interest rate risk management is the exposure of a
member institution to the effect of interest rate changes on the market
value of the institution's fixed-rate assets, liabilities and
off-balance sheet items.
Investment risk is the effect of interest rate changes on the market
value of fixed-rate assets, liabilities and off-balance sheet items.
Many gap reports ignore that these items have an imbedded interest rate
risk because of the historical pricing of some assets, liabilities and
off-balance sheet items for accounting purposes.
London Interbank Offered Rate. The rate of interest at which
financial institutions offer to lend funds in the international
Liquidity is the availability of funds, or assurance that funds will
be available, to honour all cash outflow commitments (both on- and
off-balance sheet) as they fall due. These commitments are generally met
through cash inflows, supplemented by assets readily convertible to cash
or through a member institution's capacity to borrow. The risk of
illiquidity may increase if principal and interest cash flows related to
assets, liabilities and off-balance sheet items are mismatched.
In the context of interest rate risk management, a matched position
occurs when a member institution's principal and interest cash flows
(including final maturities), both on- and off-balance sheet, have
matched repricing dates.
See CDIC Member Institution.
See CDIC Member Institution.
Also referred to as interest rate gap or interest rate sensitive
positions. In the context of interest rate risk management, the position
that arises when a member institution's principal and interest cash
flows (including final maturities), both on- and off-balance sheet, have
differing repricing dates. A negative or liability-sensitive gap occurs
when interest-bearing liabilities exceed interest-earning assets for a
specific maturity, that is, liabilities reprice before assets. A
positive or asset-sensitive gap occurs when interest-earning assets
exceed interest-bearing liabilities for a specific maturity, that is,
assets reprice before liabilities.
Present Value of Equity
The present value of assets and off-balance sheet items generating
cash inflows, less the present value of liabilities and off-balance
sheet items generating cash outflows.
The process of controlling the impact of risk-related events on a
A statement of principles and objectives that outlines a member
institution's willingness to assume risk. A member's risk philosophy
will vary with the nature and complexity of its business, the extent of
other risks assumed, its ability to absorb losses and the minimum
expected return acceptable for a specific level of risk.
The amount of a member institution's exposure to a particular risk.
Simulation Model Analysis
A dynamic analysis of interest rate risk on a member institution
arising from both current and future business, including the effects of
strategies to increase earnings or reduce interest rate risk.
Published by Canada Deposit Insurance Corporation on August 19, 1993.