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 three main sources of IRRBB:

  • Gap 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, covering changes to the term structure of interest rates occurring consistently across the yield curve (parallel risk) or differentially by tenor (non-parallel risk).
  • 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 interest maturity but different benchmark rates on which the pricing is based.
  • Option risk, the risk that changes in market interest rates prompt changes in the value or maturity of instruments, due to explicit or implicit optionality embedded in the bank’s products.

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, reported and mitigated if necessary.

The new production at the individual banking entities determines an important part of the risk development. Each banking entity 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 Banks manages its interest rate risk position in three ways. Firstly, 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 the interest rate risk exposure within 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. Secondly, the amount and duration of the marketable investments in the liquidity buffer can be adjusted. Finally, Triodos Bank uses Interest Rate Swap (IRS) contracts to maintain the bank’s IRR exposure within the limits, if the first two methods are not effective enough. The use of IRS is subject to hedge accounting to avoid volatility in the P&L.

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.

One of our main strategic risks is the low interest rate environment. With the economy slowing down, low interest rates are likely to continue for some time, with a negative impact on Triodos Bank’s return. As rates on the assets are decreasing, and the rates on the liabilities have hit the psychological floor of zero percent, the margin is being compressed.

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 netted with the net present value of the future cash flows of the 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 small parallel 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 option risk and basis 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 client and bank behaviour, i.e. due to prepayments on loans and mortgages, withdrawal of funds entrusted, and the discretion to change the interest rate on savings and current accounts. Both embedded options and behavioural characteristics 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, 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.

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 banking entities. 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 the Outlier Criterion has changed and now uses risk-free discounting.

The 2019 year-end interest rate risk position decreased compared to the situation at the end of 2018.

The one-year Earnings at Risk decreased from 2.8% at the end of 2018 to 2.5% at the end of 2019. The worst-case Earnings at Risk occur under a depression scenario, determined by expert judgement, in which the interest rates move further down. Moreover, in that scenario long-term interest rates decrease stronger than short-term interest rates.

Duration of equity decreased from 3.2 years to 0.3 years in 2019. This decrease was mainly caused by the increasing duration of savings accounts, resulting from the behavioural Savings model. This in turn is caused by the lower interest rate environment. The duration of total assets (after hedging) stayed constant, despite the growth in long term fixed rate mortgages.

The Economic Value of Equity (EVE) at Risk decreased slightly from 6.3% at the end of 2018 to 6.2% at the end of 2019. The worst-case scenario from the perspective of EVE at Risk occurs under a steepening of the yield curve. The Outlier Criterion increased from 8.1% at the end of 2018 to 12.9% at the end of 2019. Unlike duration of equity and EVE at Risk, the outlier criterion is now determined using risk-free discounting.

Regarding the EUR portfolio, the duration of equity decreased from 3.6 years at the end of 2018 to 0.4 years at
the end of 2019. The one-year Euro Earnings at Risk, at 2019 year-end, decreased slightly from 2.7% to 2.6%, compared to the end of 2018. The EUR EVE at Risk increased from 6.2% at the end of 2018 to 6.7% at the end of 2019.

Duration of equity of the Pound Sterling (GBP) portfolio increased from -0.2 years at the end of 2018 to +0.4 years at the end of 2019. The one-year GBP Earnings at Risk increased from 3.0% at the end of 2018 to 3.2% at the end of 2019. The GBP EVE at Risk decreased from 6.2% at the end of 2018 to 5.1% at the end of 2019.

2019
in thousands of EUR

Floating-rate

<= 3 months

<= 1 year

<= 5 years

> 5 years

Total

Interest-bearing assets

 

 

 

 

 

Cash

2,270,224

2,270,224

Banks

212,087

474

15,000

227,561

Loans

1,106,829

887,460

1,451,037

2,469,173

2,326,996

8,241,495

Hedged loans

82,800

67,400

–114,700

–35,500

Interest-bearing securities

55,226

161,072

640,717

166,407

1,023,422

Hedged interest-bearing securities

89,500

55,475

–104,975

–40,000

Total

3,589,140

1,115,460

1,749,984

2,890,215

2,417,903

11,762,702

 

 

 

 

 

 

 

Interest-bearing liabilities

 

 

 

 

 

Banks

212

1,359

5,819

28,634

33,999

70,023

Funds entrusted

26,333

1,217,498

1,776,985

5,329,176

2,333,269

10,683,261

Total

26,545

1,218,857

1,782,804

5,357,810

2,367,268

10,753,284

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

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

166,481

1,258,217

Hedged interest-bearing securities

69,500

61,975

–111,475

–20,000

Total

3,138,573

935,639

1,537,389

2,801,232

2,211,459

10,624,292

 

 

 

 

 

 

 

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

Notes:

  • Only interest-bearing assets and liabilities are reported in this table, which results in differences with the balance sheet figures.
  • Interest bearing securities 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 base currency of the UK subsidiary of Triodos is GBP.

Triodos Bank aims to avoid net currency positions with the exception of those arising from strategic investments. The forward positions in foreign currencies is for hedging the currency risk of the UK subsidiary equity participation of Triodos Bank and reflect the currency derivatives of Triodos Investment Funds. The currency derivates of Triodos Investment Funds 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.

2019
in thousands of EUR

Cash position
Debit

Cash position
Credit

Term position
Debit

Term position
Credit

Net position
Debit

Net position
Credit

GBP

1,577,785

1,372,842

192,519

12,424

USD

20,083

1,676

9,708

9,708

18,407

NOK

101

101

AUD

1

1

SEK

49

49

INR

38,786

38,786

IDR

6,172

6,172

CNY

3,309

3,309

Total

1,598,019

1,374,518

57,975

250,494

30,982

Net open foreign currency position (total of net positions debit and credit): 30,982

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

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