Market risk is the risk of losses in on and off-balance positions arising from movements in market prices. For Triodos Bank this means changes in interest rates and foreign exchange rates in particular. Triodos Bank doesn’t have a trading book, but interest rate risk is present in the banking book.

Interest rate risk in the banking book

Triodos Bank defines interest rate risk in the banking book (IRRBB) as the risk that changes in prevailing interest rates will adversely affect the market value of assets versus that of liabilities and/or income versus expenses. Triodos Bank identifies the following four main sources of IRRBB:

  • Repricing risk, the risk of adverse consequences due to differences in timing of the impact of interest rate changes on the value and interest of assets and liabilities.
  • Yield curve risk, the risk of adverse consequences which result from a change in the shape of the yield curve.
  • Basis risk, the risk of adverse consequences which result from changes in the difference between two or more rates for different instruments with the same maturity.
  • Option risk, the risk that changes in market interest rates prompt changes in the value or maturity of instruments.

Interest rate risk management and mitigation strategies

Interest rate risk is generated by normal customer related banking activities. Triodos Bank uses retail funding to finance clients and projects which aim to improve society and the environment. In addition, the bank maintains solid capital and liquidity buffers to support its resilience.

The level of interest rate risk is managed in a four-stage risk control cycle. In this cycle, first the relevant definitions, indicators, measurement methods, and analysis for IRRBB are set. Next, the limits for the main IRRBB indicators are specified in the risk appetite statement. The third stage defines the roles and responsibilities for IRRBB management, model governance, and escalation procedures and exceptions. Lastly, the risks are monitored and reported.

The new production at the individual branches determines an important part of the risk development. Each branch sets up a budget for the new production for the next three years and updates it quarterly with a forecast. The budgets are consolidated and compliance with the risk appetite is checked. Adherence to the budget means that asset and liability management is predictable and therefore the fulfilment of the budget is closely monitored.

Triodos Bank is to a limited extent able to steer the volume and interest rate terms of new assets and the interest rate of its liabilities in order to maintain Triodos Bank’s interest rate risk exposure within desired limits. However, changes in client rates and terms will not be made to the extent that they would materially impair Triodos Bank’s customer service, market position, profitability, capital adequacy and reasonable customer expectations. Triodos Bank also uses Interest Rate Swap (IRS) contracts to maintain the bank’s IRR exposure within the limits.

The ALCo is delegated by the Executive Board to monitor and take decisions related to the management of the IRRBB. Additionally, the ALCo approves material changes to IRRBB models and changes to important model assumptions. Finally, the ALCo decides on approval of and monitors adherence to the group-wide pricing framework for retail and business banking products.

Triodos Bank mainly hedges its IRRBB through its liquidity buffer and by using derivatives. Firstly, Triodos Bank may decide to change the duration of holdings of liquid marketable investments to maintain the bank’s IRRBB exposure within the limits. This will be used when needed. Secondly, it may enter into IRS contracts to maintain the bank’s IRR exposure within the limits. The use of IRS is subject to hedge accounting to avoid volatility in the results.

One of our main strategic risks is the low interest rate environment. With the slow phasing out of the quantitative easing, low interest rates are likely to continue for some time, with a negative impact on Triodos Bank’s return.

Main measures

Triodos Bank uses various indicators to measure interest rate risk. The interest rate risk position is monitored by the ALCo monthly and reported quarterly to the Executive Board. The main IRRBB indicators used are Earnings at Risk, Economic Value of Equity at Risk, Modified Duration of Equity, and Gap analysis. Below follows a brief description:

  • Earnings at Risk: a short-term indicator which shows the effect of an interest rate shock on Triodos Bank’s net interest income over a one year and two-year horizon.
  • Economic Value of Equity at Risk: a long-term indicator which represents the change of the Economic Value of Equity (which is the net present value of the future cash flows of all assets and liabilities) in the event of an interest rate shock.
  • Modified Duration of Equity: an indicator that expresses the sensitivity of the Economic Value of Equity in the event of interest rate changes.
  • Gap analysis: allows to get a quick and intuitive sense of how Triodos is positioned by comparing the values of the assets and liabilities that roll over – or reprice – at various time periods in the future. While a Gap analysis is a good measure of repricing risk, it is not able to measure interest rate risk stemming from options risk, basis risk or yield curve risk. Therefore, Triodos Bank monitors the sensitivity of economic value of the banking book items to interest rate changes for different parts of the yield curve, by calculation of key rate durations.

Option risk is typically present in the form of caps and/or floors on floating interest rates and as a result of prepayment. Both are considered in the IRRBB measures.

Due to the growth of the mortgage portfolio, Triodos has also worked (and continues working) on improving the data on off-balance commitments. Especially fixed rate commitments (which are often present in new mortgages to be paid out) add to the interest rate position of the bank.

Stress scenarios

Triodos Bank runs a variety of interest rate scenarios to assess its level of interest rate risk. The scenarios are expressed as shocks to the market rate. These shocks can vary from parallel shocks to non-parallel shocks, downward to upward shocks, absolute to relative shocks, and instant to gradual shocks. Part of the shocks are prescribed by regulatory guidelines whereas other shocks are developed internally. The interest rate scenarios are regularly reviewed and approved in the ALCo.

Modelling

The model used for calculating IRRBB assumes that the balance sheet develops according to the budget/forecasts. In modelling of IRRBB, client behaviour is complex as it depends on many factors and, as a result, IRRBB models in general build on many assumptions. A brief description of relevant assumptions used in Triodos Bank’s IRRBB modelling follows below.

First of all, behavioural models are used to assess the interest rate risk in savings and current accounts. The interest rate risk stemming from these products is difficult to quantify since these accounts typically have variable interest rates and no fixed maturity. The objective of the models used is to forecast the future outflow of the non-maturing deposits and their sensitivities to market conditions based on historical data, taking into consideration the statistical significance of that data. The model combines the relationship between client interest rates and market interest rates and outflow predictions.

In 2018, Triodos has reviewed its behavioural outflow model for Current Accounts. This resulted in a significant improvement of the model, distinguishing between a stable and a volatile portion of the balance. Savings accounts modelling will be reviewed the coming year, in line with the new EBA guidelines.

Secondly, prepayments on loans and mortgages affect interest rate risk on the asset side of the balance sheet and depend on customer behaviour as well. Due to the low interest rate environment and the maturity of the portfolio, prepayments increased during the last years. Therefore, behavioural assumptions are present in the risk model and the level of prepayments is included in the measurement of IRRBB. Currently, a constant prepayment rate is used, consistent with the forecast made by the branches. Triodos Bank takes into account the correlation between interest rate levels and prepayment behaviour by using sensitivity analyses.

Thirdly, some of Triodos Bank’s loans and mortgages contain caps and floors to prevent interest rates increasing or decreasing below a certain level. This affects the level of IRRBB in these products and both are taken into account in the economic value and earnings analysis. The economic value of the pipeline, which contains loans with a set interest rate which are committed but not yet remitted, is considered as well.

Lastly, the measurement method for Economic Value at Risk uses cash flows which contain commercial margins. These margins are used in the discount factors as well to calculate the necessary net present values. The commercial margins are different for different product types and branches.

The 2018 year-end interest rate risk position increased compared to the situation at the end of 2017.

The one-year Earnings at Risk increased from 2.4% at the end of 2017 to 2.8% at the end of 2018. The worst-case Earnings at Risk occur under a depression scenario, determined by expert judgement, in which the interest rates move down. Moreover, in that scenario long-term interest rates decrease stronger than short-term interest rates. At the end of 2017 the worst-case scenario was a parallel downward shock of the interest curve.

Duration of equity decreased from 5.6 years to 3.2 years in 2018. However, the decrease was mainly caused by the implementation of a new outflow model for current accounts. Underlying, the impact of fixed-rate commitments, an increase in the loans to funds entrusted ratio, and a longer interest rate profile of the assets increased the sensitivity of the equity’s economic value during the year 2018. The longer interest rate profile of the assets is partly caused by the growth in long term fixed rate mortgages.

The Economic Value of Equity (EVE) at Risk decreased from 10.9% at the end of 2017 to 6.3% at the end of 2018. The worst-case scenario from the perspective of EVE at Risk occurs under a parallel upward shock of the yield curve. The Outlier Criterion decreased from 13.7% at the end of 2017 to 8.1% at the end of 2018. Similar to duration of equity, EVE at Risk and the outlier criterion decreased as a result of the implementation of a new current account outflow model.

Regarding the EUR portfolio, the duration of equity decreased from 6.0 years at the end of 2017 to 3.6 years at the end of 2018. The one-year Euro Earnings at Risk, at 2018 year-end, remained constant at 2.7%, compared to the end of 2017. The EUR EVE at Risk decreased from 11.5% at the end of 2017 to 6.2% at the end of 2018.

Duration of equity of the Pound Sterling (GBP) portfolio decreased from 1.4 years at the end of 2017 to -0.2 years at the end of 2018. The one-year GBP Earnings at Risk increased from 1.5% at the end of 2017 to 3.0% at the end of 2018. The GBP EVE at Risk increased from 5.5% at the end of 2017 to 6.2% at the end of 2018.

2018
in thousands of EUR

Floating-rate

<= 3 months

<= 1 year

<= 5 years

> 5 years

Total

Interest-bearing assets

 

 

 

 

 

Cash

1,795,272

1,795,272

Government paper

Banks

216,196

5,860

14,000

1,000

237,056

Loans

1,127,105

688,440

1,105,434

2,299,490

2,113,278

7,333,747

Hedged loans

70,100

69,400

–91,200

–48,300

Interest-bearing securities

101,739

286,580

703,417

166,480

1,258,216

Hedged interest-bearing securities

69,500

61,975

–111,475

–20,000

Total

3,138,573

935,639

1,537,389

2,801,232

2,211,458

10,624,291

 

 

 

 

 

 

 

Interest-bearing liabilities

 

 

 

 

 

Banks

212

1,380

4,530

32,017

29,078

67,217

Funds entrusted

30,668

1,145,875

1,642,173

4,661,975

2,070,859

9,551,550

Total

30,880

1,147,255

1,646,703

4,693,992

2,099,937

9,618,767

2017
in thousands of EUR

Floating-rate

<= 3 months

<= 1 year

<= 5 years

> 5 years

Total

Interest-bearing assets

 

 

 

 

 

Cash

1,365,729

1,365,729

Government paper

26,504

26,504

Banks

215,262

113

1,000

216,375

Loans

847,238

857,681

961,661

1,762,596

2,059,095

6,488,271

Hedged loans

71,700

73,400

–44,000

–101,100

Interest-bearing securities

172,883

244,682

831,307

184,976

1,433,848

Hedged interest-bearing securities

69,500

41,975

–111,475

Total

2,428,229

1,198,381

1,321,718

2,439,428

2,142,971

9,530,727

 

 

 

 

 

 

 

Interest-bearing liabilities

 

 

 

 

 

Banks

212

2,271

4,017

30,648

27,215

64,363

Funds entrusted

35,240

1,574,167

2,438,341

3,057,618

1,609,363

8,714,729

Total

35,452

1,576,438

2,442,358

3,088,266

1,636,578

8,779,092

Notes:

Only interest-bearing assets and liabilities are reported in this table, which results in differences with the balance sheet figures.

Interest bearing securities and subordinated liabilities are valued at redemption value including bond premium and after deduction of discounts.

For funds entrusted without a fixed interest rate term, the outcome of the quantitative savings and current account model, as mentioned before, is used.

All other interest-bearing assets and liabilities are reported as floating rates or are broken down in the maturity calendar by their remaining contractual interest rate term.

Foreign exchange risk

Foreign exchange risk is the current or prospective risk to earnings and capital that arises from adverse movements in foreign exchange rates. Triodos Bank’s base currency is the euro. The UK Branch balance sheet and profit and loss account are denominated in GBP. Exchange rate differences arising from translating the UK branch balance sheet to euros are accounted for as a hedge of a net investment in a foreign business unit and are taken directly to shareholders’ equity in the statutory reserve for conversion differences, insofar as the hedge is effective.

Triodos Bank aims to avoid net currency positions with the exception of those arising from strategic investments. The forward positions in foreign currencies mainly reflect the currency derivatives of Triodos Investment Funds which are nearly fully hedged.

The foreign exchange position is monitored daily and discussed in the Asset and Liability Committee on a monthly basis. Limits are agreed by the ALCo.

Foreign currency position

The following table shows Triodos Bank’s foreign currency position in thousands of EUR as at 31 December.

2018
in thousands of EUR

Cash position
Debit

Cash position
Credit

Term position
Debit

Term position
Credit

Net position
Debit

Net position
Credit

GBP

1,209,050

1,206,502

2,548

USD

18,079

1,162

26,596

26,596

16,917

NOK

101

101

DKK

AUD

1

1

SEK

49

49

INR

50,237

50,237

IDR

5,837

5,837

CNY

3,287

3,287

Total

1,227,280

1,207,664

85,957

85,957

19,616

Net open foreign currency position (total of net positions debit and credit): 19,616

2017
in thousands of EUR

Cash position
Debit

Cash position
Credit

Term position
Debit

Term position
Credit

Net position
Debit

Net position
Credit

GBP

1,109,863

1,109,417

631

1,077

USD

10,692

827

389,874

390,483

9,256

NOK

102

102

DKK

15,975

15,975

AUD

1

1

SEK

50

8,255

8,255

50

INR

60,341

60,341

IDR

9,600

9,600

CNY

3,315

3,315

Total

1,120,708

1,110,244

487,991

487,969

10,486

Net open foreign currency position (total of net positions debit and credit): 10,486