April 2009

Introduction

Fluctuations in market interest rates, the frequency and extent of the movements and the impact on the structure of an institution’s financial intermediationAn activity in which an institutional unit incurs liabilities on its own account for the purpose of acquiring financial assets by engaging in financial transactions on the market. The role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them. activities and its trading bookAll positions in financial instruments and commodities held either for trading or hedging purposes. can significantly affect the institution’s profitability and, ultimately, its solvency. Consequently, effective management of interest rate riskRefers to the exposure of a financial institution to adverse movements in interest rates. is critical to protecting consumers of financial products and the financial strength of an institution.

Given the interrelation and interdependence of the various risks to which financial institutions are exposed, interest rate risk should form part of an institution’s integrated risk managementA set of practices and processes, supported by a risk-aware culture and enabling technologies, that improves decision making and performance through a holistic view of a financial institution’s set of risks. approach.Autorité des marchés financiers, Integrated Risk Management Guideline. Financial institutions should adopt an effective interest rate risk management strategy and ensure that the strategy is monitored and controlled.

This guidelineA document that describes the steps that financial institutions can take to satisfy their legal obligation to follow sound and prudent management practices and sound commercial practices. is intended to set out the expectations of the AMF with respect to sound and prudent management of interest rate risk by financial services cooperativesA legal person in which persons with common economic needs unite to form a deposit and financial services institution to meet those needs. . Under the Act respecting financial services cooperatives, which it administers, the AMF has the authorityAct respecting financial services cooperatives, CQLR, c. C-67.3, s. 565.1. See also Deposit institution and deposit protection act, CQLR, c. I-13.2.2, section 42.2. to establish guidelines regarding sound and prudent management practicesA financial institution’s management practices ensuring good governance and compliance with the laws governing its activities, in particular, the assurance that the financial institution will maintain adequate assets to meet its liabilities as and when they become due and adequate capital to ensure its sustainability. .

The AMF’s expectations with regard to interest rate risk management are based on the core principles and guidance issued by international bodies, specifically those of the Bank for International Settlements regarding management and supervision of interest rate risk.Basel Committee on Banking Supervision, Bank for International Settlements, Principles for the Management and Supervision of Interest Rate Risk, July 2004.

Proposed definitions of certain terms and expressions used in this guideline are provided in attached Appendix.

1. Interest Rate Risk

Interest rate risk is the vulnerability of an institution’s financial condition to adverse movements in interest rates. It corresponds to the potential effects of interest rate changes on the institution’s profitability, in particular net interest income and its net value.

Exposure to this risk primarily results from timing spread in the repricing of both on- and off-balance sheet assets and liabilities as they mature (fixed rate instruments) or contractually reprice (floating rate instruments). Interest rate risk is one of the risks that constitute market riskThe risk of losses in on- and off-balance sheet positions arising from movements in market prices of financial instruments. .

An interest rate is a percentage that measures, over a given period and in line with the timing of cash flows, the return on an interest-bearing asset or the cost of an interest-bearing liability. In accordance with current Canadian generally accepted accounting principles, this asset or liability may be presented on or off balance sheet.

2. Sound and Prudent Interest Rate Risk Management

This guidelineA document that describes the steps that financial institutions can take to satisfy their legal obligation to follow sound and prudent management practices and sound commercial practices. pertains to the implementation of sound and prudent interest rate risk management by financial institutions. Such practices should enable the institution to ensure that its interest rate risk exposure does not exceed its self-imposed limits for mitigating the possible impacts of this risk on its profitability.

This guideline does not set out quantitative ratio or threshold requirements with respect to the management of interest rate risk.

The AMF considers that financial institutions should, at the outset, comply with the principles set out in the integrated risk managementA set of practices and processes, supported by a risk-aware culture and enabling technologies, that improves decision making and performance through a holistic view of a financial institution’s set of risks. guideline, which constitutes the foundation stone of sound and prudent risk management. For purposes of this guideline, the AMF proposes eight principles arranged under two fundamental aspects in support of dynamic interest rate risk management.

General interest rate risk management frameworkA set of policies, procedures and controls for managing an organization’s key functions.

An effective interest rate risk management strategy should include a policyA set of general principles adopted by a financial institution for conducting its activities in a given area. and proceduresA set series of tasks to be performed. It is generally the result of imperatives that cannot be negotiated by the individual who applies it. and reflect the institution’s risk appetiteThe aggregate level and types of risk a financial institution is willing to assume to achieve its strategic objectives and business plan. . In addition, the terms of managing this risk should be clearly articulated so that the strategy can be applied to the group to which the institution belongs.

Monitoring and Control of Interest Rate Risk

Once the sources of interest rate risk have been identified, the institution must take the necessary steps to ensure day-to-day, proactive monitoring and control of interest rate risk, including:

• interest rates and sensitivity of earnings and net value to interest rate fluctuations;

• matchingInvolves co-ordinating cash inflows and outflows of on- and off-balance sheet assets and liabilities whose maturity or interest rate repricing dates correspond to a given period. of on- and off-balance sheet assets and liabilities in local and foreign currency.

Interest rate risk limits should be established based on prospective analysis, using scenario analysis and stress testingA risk management technique used to assess the potential vulnerability of a financial institution by testing defined and exceptional, but plausible, adverse scenario. in particular. The institution could also utilize hedgingA technique used to protect the income generated by a financial institution by reducing its exposure to market risk by establishing symmetrical positions. Usually, a gain or loss arising from mismatching can be offset by a hedging gain or loss. strategies to reduce its interest rate risk exposure.

Certain principles lend themselves to a broader application of interest rate risk management, whereas others specifically account for the financial institution’s risk profileA financial institution’s overall level of risk exposure that is based on an evaluation of the risks inherent in the financial institution’s significant activities, its ability to manage risks, its financial condition and its commercial practices. , the scope of its matching positions and the type and features of its products and financial instrumentA contract that gives rise to a financial asset or a financial liability.s.

3. General Interest Rate Risk Management Framework

Principle 1: Strategy, policy and procedures

Although the focus of an interest rate risk management strategy may be the optimization of profitability, the board of directorsA body of elected or appointed individuals ultimately responsible for the governance and oversight of a financial institution. and senior managementThe group of individuals responsible for managing a financial institution on a day-to-day basis in accordance with the strategies and policies set by the board of directors. should bear in mind that this risk could, conversely, pose a significant threat to the institution’s earnings and capital base.

Financial institutions should develop an interest rate risk management strategy and periodically review the strategy, taking into account notably:

• the internal and external sources of risk that might affect its exposure to interest rate risk;

• sufficient capitalization to cover this risk as well as the methods for evaluating its ability to absorb potential losses stemming from unfavourable interest rate movements;

• the interrelation and interdependence with other risks to which an institution is exposed.

This interest rate risk management strategy should provide for the implementation of a clearly defined policy and procedures that are compatible with the nature and the complexity of the activities, and the size and risk profileA financial institution’s overall level of risk exposure that is based on an evaluation of the risks inherent in the financial institution’s significant activities, its ability to manage risks, its financial condition and its commercial practices. of the institution. The following considerations should notably be reflected in the institution’s interest rate risk management policy and procedures:

• operational objectives;

• segregation of roles and responsibilities and designation of competent and experienced individuals responsible for managing interest rate risk;

• risk appetiteThe aggregate level and types of risk a financial institution is willing to assume to achieve its strategic objectives and business plan. for that risk;

• terms of intra-group management of interest rates;

• monitoring and control of interest rate risk, including:

  • explicit and prudent limits in line with the risk toleranceRisk tolerance sets boundaries on the level of risks a financial institution is prepared to accept based on its risk appetite. ;

  • effective and reliable information systems for controlling matching positions and ensuring compliance with limits;

  • terms of foreign currency activities;

  • measures to unwind an undesirable matching position, mainly through hedgingA technique used to protect the income generated by a financial institution by reducing its exposure to market risk by establishing symmetrical positions. Usually, a gain or loss arising from mismatching can be offset by a hedging gain or loss. .

Aside from their roles and responsibilities with respect to sound governance, the board of directors and senior management should communicate with the persons responsible for interest rate risk management as soon as exposure limits are exceeded and continue to liaise with them thereafter. In addition, specific approvals should be secured for major interest rate risk hedging initiatives.

The institution should use appropriate mechanisms to conduct regular and independent assessments of the effectiveness of its interest rate risk management strategy. Similarly, it must ensure compliance with the policy and procedures resulting from the strategy.

Principle 2: Risk Appetite

The primary purpose of managing interest rate risk is to monitor and control the impacts of this risk on a financial institution’s profitability. The institution should have sufficient leeway to optimize its profitability, yet still remain prudent and within its risk appetite.

The institution should establish and impose interest rate risk limits and ensure that exposure levels do not exceed these limits.

Principle 3: Intra-group management

Interest rate risk affecting a group of institutions should be managed on a combined or consolidated basis that includes the positions of subsidiaries and other group entities. As necessary, risk management procedures should be adapted to include the legal nature and complexity of the activities of the group members. However, the AMF considers that financial institutions that are part of a group are responsible for managing their internal interest rate risk, even if monitoring and control mechanisms are applicable across the group. Moreover, the AMF recognizes the roles and responsibilities conferred under the Act on a federation and on a financial services cooperative acting as group treasurer of a group.

Given the provisions governing financial services cooperatives and federations under the Act respecting financial services cooperatives, the AMF considers that:

• federations are responsible for co-ordinating their own on- and off-balance sheet asset and liability matching activities, as well as the combined positions of member financial services cooperatives.

• federations must also establish a matching profile and a target for the financial groupRefers to any group of legal persons composed of a parent company (financial institution or holding company) and legal persons affiliated therewith. as a whole, including related entities and controlled persons, which include a security fund. A federation is also responsible for ensuring compliance with the exposure limits it sets for member financial services cooperatives and is required to take steps to address non-compliance for the latest.

• financial services cooperative, acting as group treasurer, that manage the group’s interest rate risk may, in addition to managing their own treasury activities, cause a range of hedging instruments to be available to the network. At the federation’s request, these financial services cooperative may also take hedging positions on behalf of the network.

4. Monitoring and Control of Interest Rate Risk

Principle 4: Sources of Interest Rate Risk

Depending on the nature of the asset or liability, interest rates may be fixed (for the durationThe number of years after which bond profitability is no longer affected by interest rate changes. of a term) or repriceable (based on a term), or variable (indexed) according to the contract between the parties or the financial instrumentA contract that gives rise to a financial asset or a financial liability.. In addition, certain assets or liabilities may not be considered interest-bearing. This is notably the case for non-performing loans or qualifying shares of a financial services cooperative.

Financial institutions may be exposed to interest rate risk in different ways. It is therefore essential that they be fully aware of the factors that could influence their management of this risk, as well as interest rate changes and volatilityA measure of the variability of the price of an asset.. Some of these factors are:

• the nature and complexity of the structure of assets and liabilities affecting interest rate sensitivity of earnings and net value;

• the importance of loan risk premiums and the frequency of repricing dates;

• changes in monetary policies;

• the principal components of the economic environment, including inflation rates, and possible declines in return generated by certain financial products.

Therefore, financial institutions should identify their principal sources of interest rate risk associated with their positions resulting from financial intermediary and trading activities. The main factors that could affect interest rate risk exposure are:

• rate changes: Maturity/repricing schedules expose an institution’s profitability and net value to unanticipated variations;

• changes in yield curve: Interest rate movements may influence the relationship between rates associated with various portfolios held by an institution and change the slope and shape of the yield curve;

• institution’s prime rate and rate change parameters: An imperfect correlation in the adjustment of the rates earned and paid on different products with repricing parameters may influence rates for similar maturities or repricing frequencies;

• optionA contract under which the holder has the right, but not the obligation, to buy or sell a specific number of shares at a predetermined price during a specific period of time. al clauses and nature of certain financial products and instruments: The features of certain financial products and instruments may cause a change in the cash flows of a class of on- and off-balance sheet assets and liabilities;

• sources of funding and product volume: The interest rate matching structure of assets and liabilities could change based on the close relationship between the institution’s funding needs and its product volume. Demand for certain product categories and product mix could also vary significantly depending on consumer reaction to interest rate movements.

Principle 5: Measurement of Interest Rate Risk

In establishing interest rate exposure limits, financial institutions should consider, in particular, interest rate volatility, different related factors such as its capital adequacy, and the quality of its credit and investments, and its profitability, generally net interest income or the present value of assets.

Generally, institutions should establish and periodically review the mismatch limits for each on- and off-balance sheet position for given maturities. More sophisticated measurement techniques could be employed according to the type of activity and its complexity. In this regard, it is recommended that institutions have a comprehensive view of interest rate risk that takes into account the significance of their financial intermediary and trading activities.

The AMF considers that a financial institution’s exposure to interest rate risk should be analyzed from an earnings perspective and a net value perspective.

Earnings Perspective

This analysis reflects the occurrence of interest rate changes on institution’s near-term earnings, mainly net interest income, and on non-interest income and operating expenses. It offers the institution a detailed view of the potential effects of changes in market interest rates on earnings under different interest rate environments. A significant variation in earnings can undermine an institution’s profitability and affect its capital adequacy and depositor confidence.

More specifically, changes in market interest rates may influence an institution’s interest rate policy and could affect its profitability, depending on maturity or interest rate changes dates.

The analysis of exposure to interest rate risk from the perspective of changes in near-term earnings is therefore designed to measure matching sensitivity to possible changes in interest rates and to assess the potential impact on, primarily, net interest income. This analysis is not, however, a relevant indicator of the effect of changes in interest rates on the institution’s overall matching situation.

In addition to interest income and expenses, certain other income items and certain other operating expenses may also vary as a result of interest rate changes. For example:

• early redemption fees on term deposits;

• mortgage loans prepayment fees; and

• mortgage loans commissions.

Net Value Perspective

This analysis reflects the occurrence of changes in interest rates on the net value of an institution’s assets, liabilities and off-balance sheet positions, namely, the present value of all future cash flows. It reflects the sensitivity of an institution’s net value to fluctuations in interest rates and anticipates the possible long-term effects of changes in interest rates.

Financial institutions are expected, through reliable information systems, to be aware of the scope of interest rate risk arising from significant movements in interest rates and the materiality of repricing mismatches. Institutions should also consider interest rate exposure inherent in hedgingA technique used to protect the income generated by a financial institution by reducing its exposure to market risk by establishing symmetrical positions. Usually, a gain or loss arising from mismatching can be offset by a hedging gain or loss. activities.

Financial institutions should employ interest rate risk valuation techniques, including gap analyses, commonly known as “asset-liability management” or “ALM,” and duration analyses. These techniques may also be combined.

Principe 6: Scenarios Analysis and Stress Testing

In a dynamic management environment, financial institutions should assess their exposure to interest rate risk arising from movements in interest rates and the potential resulting losses.

Scenario-based analyses enable an institution to analyze, using different probable assumptions, the sensitivity of its on- and off-balance sheet assets and liabilities to interest rate fluctuations in the course of its day-to-day operations as well as during periods where such adverse fluctuations affect the institution’s earnings.

In more critical financial market conditions, such analysis should be supplemented with stress testing. These analyses should provide the institution with information on the conditions under which strategies or positions would be more vulnerable.

Consequently, the AMF considers that financial institution should use scenarios and conduct stress testing to measure the effects of different variables and assess the impact on profitability and net value. The institution should give consideration to the results of different scenarios when establishing and reviewing their interest rate risk policies and limits. It should also periodically review the underlying assumptions used to control and monitor interest rate risk.

Scenario analysis and stress testing should notably take the following into account:

• significant changes in balance sheet structure;

• possible changes in the institution’s prime rate;

• significant changes in behaviour of consumers of financial products;

• material changes in relationships among market rates and changes in the slope and the shape of the yield curve. Parallel situations are often observed following downward pressure on profitability by competitors;

• optional clauses and features of financial products.

Principle 7: Interest rate risk management related to foreign currencies

To reflect its foreign currency matching positions, financial institutions are expected to measure their interest rate exposure relative to each currency, since yield curves may vary depending on the currency.

Financial institutions may also use foreign currency-denominated deposits, borrowings or on- and off-balance sheet financial instruments to rebalance mismatching in local or foreign currencies. The following factors should be taken into consideration:

• the convertibility of each currency, the volatility of the exchange rate, and the availability of foreign currency funds;

• foreign market conditions, including counterparty riskThe risk that the counterparty to a transaction could default before the final settlement of the transaction’s cash flows. and the level of interest rates as well as their correlation.

Principle 8: Hedging

In periods of wide interest rate fluctuations, sound interest rate management should enable the institution to avoid predatory selling of its income-bearing assets and liabilities or the use of hedging instruments that are costly or have unfavourable conditions.

Where necessary, the institution should employ hedging to mitigate its interest rate risk exposure, by:

• using appropriate financial instruments consistent with the type and scope of its operations, the competence and expertise of its personnel, and the capacity of its data processing and reporting systems;

• prudently managing the risk associated with such financial instruments, in particular, the quality of hedging counterparties; and

• periodically evaluating the impact of these instruments on the institution’s interest rate exposure.

Financial institutions generally use interest rate swaps to offset matching issues. Other hedging instruments may also be used, including option swaps, interest rate and currency swaps, forward rate agreements (FRA), bankers’ acceptance futures (BAX), interest rate caps (CAP) and interest rate floors (FLOOR).

Appendix

Matching consists in co-ordinating cash inflows and outflows of on- and off-balance sheet assets and liabilities whose maturity or repricing dates correspond to a given period.

Matching gap arises when, on the dates rates change, cash inflows and outflows of on- and off-balance sheet items are not aligned. The gap is considered negative where, for a given period, the value of the interest-bearing liability is higher than that of the interest-bearing asset. Conversely, the gap is considered positive where the value of the asset exceeds that of the liability.

Yield curve is a graph-based representation of the relationship between interest rates of interest-bearing assets or liabilities and their maturities. The curve is positive (ascending), when interest rates are higher for long-term maturities than for short-term maturities. Generally, yields are contingent on the expectations of an institution and other financial players with respect to economic condition and supply and demand for financial products.

Duration is a measure of debt price sensitivity to parallel changes in interest rates. Duration is the weighted average of all cash flows of an instrument where the weighting reflects discounted cash flow values.

Asset-liability matching (ALM) is an analysis method used to manage and control, within set parameters, the impact on an institution’s operations of any change in volume, mix, maturities, quality and interest rate-sensitivity of on- and off-balance sheet assets and liabilities. ALM generally consists in classifying interest-bearing assets and liabilities according to the periods in which changes may occur (time bands). Exposure to interest rate fluctuations is measured by the size of the gap between these assets and liabilities for a given time band.

Financial instruments are contracts that create a financial asset for one party and a financial liability or capital instrument for another party.

Hedging is a technique used to protect the income generated by a financial institution by reducing its exposure to market riskThe risk of losses in on- and off-balance sheet positions arising from movements in market prices of financial instruments. by establishing symmetrical positions. Usually, a gain or loss arising from mismatching can be offset by a hedgingA technique used to protect the income generated by a financial institution by reducing its exposure to market risk by establishing symmetrical positions. Usually, a gain or loss arising from mismatching can be offset by a hedging gain or loss. gain or loss.

Market risk is defined as the risk of losses in on and off-balance-sheet positions arising from movements in market prices. The risks subject to this requirement are: foreign exchange risk, commodities risk , interest rate risk and equity risk.

Interest rate swaps are transactions where two counterparties exchange payments of interest rates with different characteristics based on an underlying notional principal amount.