EBA · 2016_2697 Archive

Discount rates in Economic Value of Equity calculations

Regulation
Directive 2013/36/EU (CRD)
Article
98, para. 5
Topic
Supervisory review and evaluation (SREP) and Pillar 2
Submitted by
Individual
Submitted
2016-04-04
Answer provided by
ESAs (EBA, ESMA, EIOPA)
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Question

Is the usage of different yield curves related to the calculation of value risk measures (e.g. Economic Value of Equity) or is it related to the calculation of earnings measures (e.g. Earnings-at-Risk) or both? If an institution prefers to base the Economic Value of Equity on the risk-free swapcurve (also for its internal IRRBB management), is the institution still required to use different yield curves (including a yield curve with a credit spread curve) other than the swapcurve for Economic Value of Equity? If it is mandatory to use different yield curves for the Economic Value of Equity calculations, is the following sufficient in order to meet the paragraphs 42c and 42d: (a) to base the Economic Value of Equity (and its related risk measures such as duration of equity) on the risk-free swapcurve, and (b) to base the Earnings-at-Risk measures and the Market Value of Equity on different yield curves (including instrument/credit-specific curves)?

Background

Our financial institution prefers to determine the Economic Value of Equity based on the risk-free swapcurve (without instrument/credit-specific curve and without entity’s own spread curve) as discount rates. The cash flows of instruments which are to be discounted are aligned with the discount curve whereby only the interest rate component in the coupons is used. The reason for discounting with solely the risk-free swapcurve is to be able to isolate the impact of interest rate movements. By isolating the impact of interest rate movements it becomes feasible to perfectly hedge for interest rate movements using for example interest rates swaps. The approach of risk-free swapcurve as discount rates is not only used for the Outlier criterion but also for the internal IRRBB management (e.g. duration of equity).

Answer

As stated in Paragraph 42(d) of the Guidelines on the management of interest rate risk arising from non-trading activities ( EBA/GL/2015/08 ), when assessing IRRBB institutions are encouraged but not obligated to use different types of yield curves, including instrument/credit-specific yield curves but only for their own internal calculations of IRRBB. However the set of calculations should always include a measurement of IRRBB using a risk-free yield curve that does not include instrument-specific or entity-specific credit or liquidity spreads. This rationale applies to both economic value measures and earnings-based measures. For supervisory purposes the IRRBB measurements should always include calculations utilizing the risk-free yield curve which isolates movements in market interest rates; this would ensure that the IRRBB measurements are comparable across institutions, which, for example, is an important aspect of appropriately identifying outliers.

Original source: European Banking Authority, Q&A ID 2016_2697

This Q&A is published by European Banking Authority and is non-binding. It does not constitute legal advice. Updated weekly from official ESA sources.

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