RBS plc – 90% RBS Securities Inc – 4% NatWest Plc – 3% RBS NV – 2% Other – 1%
Market risk RWAs by legal entity and by regulatory approach Market risk RWAs of £21 billion and minimum capital requirement of £1.7 billion are composed as presented below.
Regulatory VaR
RBS’s VaR model has been approved by the PRA to calculate its regulatory market risk capital requirement for the trading book for those legal entities under its jurisdiction. These legal entities are RBS plc, NatWest Plc, RBS Securities Inc and RBS Financial Products Inc.
*unaudited
While internal VaR provides a measure of the economic risk, regulatory VaR is one of the measures of regulatory capital requirements by legal entity.
The calculation of regulatory VaR differs from that of the internal VaR as it takes into account only regulator-approved products, locations and legal entities and it is based on a ten-day, rather than a one-day, holding period for market risk capital calculations.
The PRA approval covers general market risk in interest rate, foreign exchange, equity and commodity products and specific market risk in interest rate and equity products.
Regulatory SVaR*
RBS’s SVaR model has also been approved by the PRA for use in the capital requirement calculation. The distinction between regulatory SVaR and internal SVaR is the same as that between regulatory VaR and internal VaR.
Risks not in VaR
As discussed earlier, RBS has an established RNIV framework that ensures that the risks not captured in VaR are adequately covered by its capital.
Incremental risk charge (IRC)*
The IRC model quantifies the impact of rating migration and default events on the market value of instruments with embedded credit risk (in particular, bonds and credit default swaps) that are held in the trading book. It further captures basis risk between different instruments, maturities and reference entities. Following the internal ratings-based approach for credit risk, the IRC is calculated over a one-year capital horizon with a 99.9% confidence level. The dependency of positions is modelled using a single-factor Gaussian copula.
The IRC is mainly driven by three-month credit rating transition, default and correlation parameters. The portfolio impact of correlated defaults and rating changes is assessed by observing changes in the market value of positions using stressed recovery rates and modelled credit spread changes. Revaluation matrices are used to capture any non-linear behaviour.
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240 Market risk continued
Market risk capital*
Minimum capital requirements
The following table analyses RBS’s total market risk minimum capital requirement at 31 December 2015, calculated in accordance with the Capital Requirements Regulation (CRR); this represents 8% of the corresponding RWA amount, £21 billion. It comprises a number of regulatory capital requirements split into two categories: (i) the non-modelled position risk requirement (PRR) of £377 million, which has several components; and (ii) the Pillar 1 model-based PRR of £1.3 billion, which comprises several modelled charges.
2015 2014
£m £m
Interest rate position risk requirement 85 116
Equity position risk requirement 1 1
Option position risk requirement 6 7
Commodity position risk requirement — 2
Foreign currency position risk requirement 155 63
Specific interest rate risk of securitisation positions 130 270
Total (non-modelled approach) 377 459
Pillar 1 model based position risk requirement 1,323 1,458
Total market risk minimum capital requirement 1,700 1,917
The following table analyses the principal contributors to the Pillar 1 model-based PRR presented in the previous table.
2015 2014
Average Maximum Minimum Period end Period end
£m £m £m £m £m
Value-at-risk 359 400 319 377 329
Stressed VaR 512 556 477 477 511
Incremental risk charge 276 348 248 248 299
Risks not in VaR 261 319 221 221 319
1,323 1,458
Key points
•
RBS’s total market risk minimum capital requirement fell in 2015, driven by decreases in both the non-modelled component and the overall Pillar 1 model-based component.•
The decrease in the non-modelled PRR was largely drivenby a decline in trading book securitisations as a result of asset disposals, in line with the wind-down of the US ABP business. This was partially offset by an increase in the foreign currency PRR, reflecting the sale of Citizens, which led to an increase in the US dollar capital position.
•
Overall, the Pillar 1 model-based PRR decreased by 9%during 2015, primarily driven by reductions in the IRC and the RNIV charge, offset partly by an increase in the VaR charge.
*unaudited
•
The IRC fell by 17%, driven by a reduction in investment grade corporate bond inventory for the US business, in line with risk reduction strategy. In addition, the European market-making business slightly reduced its shorter-dated exposure to the eurozone periphery. The IRC figures presented in the table above differ from those in the table on the following page for the reasons explained in the note to that table. The average liquidity horizon by position at the year end was 3.2 months (2014 - 3.3 months).•
The decline in the RNIV charge is explained on page 238.•
The SVaR charge fell by 7%, reflecting risk reduction in RBSNV, in line with strategy, and risk reduction in the US Rates and ABP businesses.
•
The VaR charge increased by 15%, driven by risk increases across the Rates business, primarily related to the European and US swap portfolios and the US options business.Business reviewCapital and risk management
IRC by rating and product category
The following table analyses the IRC by rating and product.
Internal ratings (1) 2015
AAA AA A BBB BB B CCC Total
£m £m £m £m £m £m £m £m
Product categories
Cash - asset-backed securities — — — — 0.2 — — 0.2
Cash - regular 16.1 17.5 82.7 74.1 48.8 0.5 3.1 242.8
Derivatives - credit (0.1) (8.5) 3.9 (20.1) (8.2) (3.4) (3.4) (39.8)
Derivatives - interest rate (0.7) 1.8 1.6 (18.0) (1.0) 0.3 — (16.0)
Total 15.3 10.8 88.2 36.0 39.8 (2.6) (0.3) 187.2
2014
Product categories
Cash - asset-backed securities 1.6 — 0.2 0.3 (1.6) 0.6 — 1.1
Cash - regular 36.3 49.4 71.0 67.0 53.4 3.5 2.3 282.9
Derivatives - credit (3.9) (11.8) 4.4 3.2 (19.1) 0.8 (0.3) (26.7)
Derivatives - interest rate (10.0) (1.4) 0.2 1.5 1.2 — — (8.5)
Other 0.8 — — — — — — 0.8
Total 24.8 36.2 75.8 72.0 33.9 4.9 2.0 249.6
Notes:
(1) Based on an assessment of S&P, Moody’s and Fitch ratings, where available, or on RBS’s internal master grading scale.
(2) The figures presented are based on the spot IRC charge at 31 December 2015 and will therefore not agree with the IRC position risk requirement, as this is based on the 60-day average. The figures presented above are in capital terms.
(3) The IRC figures by product category presented above are based on an internal allocation and do not constitute standalone position risk requirements.
Key point
•
Spot IRC capital fell £62.4 million or 25% year on year, for the same reasons noted on the previous page for the IRC PRR.Securitisation positions in the trading book
The following table shows the capital requirement for trading book securitisation positions by rating.
Ratings (1)
Non Non-
investment modelled
AAA AA A BBB grade Unrated Total (1,2) PRR (3)
2015 £m £m £m £m £m £m £m %
Trading book securitisation charge 1.1 0.2 0.6 4.3 81.4 42.8 130.4 0.7
2014
Trading book securitisation charge 3.9 1.0 4.1 22.1 148.9 90.3 270.3 10.0
Notes:
(1) Based on S&P ratings.
(2) Includes both long and short positions.
(3) Percentage of total non-modelled position risk requirement. (4) There were no capital deductions in 2014 or 2015.
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242 Market risk continued
Valuation and independent price verification
Traders are responsible for marking-to-market their trading book positions daily, ensuring that assets and liabilities in the trading book are measured at their fair value. Any profits or losses on the revaluation of positions are recognised daily.
Product controllers are responsible for ensuring that independent price verification processes are in place covering all trading book positions held by their business. Independent price verification and trader supervision are the key controls over front office marking of positions.
Model validation*
RBS uses a variety of models to manage and measure market risk. These include pricing models (used for valuation of positions) and risk models (for risk measurement and capital calculation purposes). They are developed in both RBS-level and lower-level functions and are subject to independent review and sign-off.
For general information on the independent model validation carried out by Model Risk Management (MRM), which applies also to market risk models (including VaR), refer to page 138. Additional details relating to pricing and market risk models are presented below.
Pricing models
Pricing models are developed by a dedicated front office quantitative team, in conjunction with the trading desk. They are used for the valuation of positions for which prices are not directly observable and for the risk management of the portfolio.
Any pricing models that are used as the basis for valuing books and records are subject to approval and oversight by asset-level modelled product review committees.
These committees comprise representatives of the major stakeholders in the valuation process - trading, finance, market risk, model development and model review functions.
The review process comprises the following steps:
•
The committees prioritise models for review by MRM, considering the materiality of the risk booked against the model and an assessment of the degree of model risk, that is the valuation uncertainty arising from the choice of modelling assumptions.•
MRM quantifies the model risk by comparing front office model outputs with those of alternative models independently developed by MRM.•
The sensitivities derived from the pricing models are validated.•
The conclusions of the review are used by MRM to inform risk limits and by Finance to inform model reserves.*unaudited
Risk models
All model changes are approved through model governance committees at franchise level. Changes to existing models that have an impact on VaR exceeding 5% at legal entity level or 15% at a major business level are also subject to MRM review and sign-off as are all model changes that require regulator approval before implementation.
MRM’s independent oversight provides additional assurance that RBS holds appropriate capital for the market risk to which it is exposed.
In addition to MRM’s independent oversight, the model testing team monitors the model performance for market risk through back-testing, which is discussed in more detail on page 235, and other processes.
Non-traded market risk Risk governance
RBS manages the three key categories of non-traded market risk separately. The categories are: non-traded interest rate risk; non- traded foreign exchange risk; and non-traded equity risk.
The Chief Risk Officer delegates responsibility for day-to-day control of non-traded market risk to the Director of Market Risk.
Non-traded market risk positions are reported to the ALCo and the Board, monthly in the case of interest rate risk and quarterly in the case of foreign exchange and equity risk.
The Executive Risk Forum (ERF) approves the non-traded market risk framework. The non-traded market risk policy statement sets out the governance and risk management framework through effective identification, measurement, reporting, mitigation, monitoring and control.
The key models used for managing non-traded market risk benefit from the validation process described on this page.
Risk assessment, monitoring and mitigation
Interest rate risk*
Non-traded interest rate risk (NTIRR) factors are grouped into the following categories:
•
Repricing risk - which arises when asset and liability positions either mature (in the case of fixed-rate positions) or their interest rates reset (in the case of floating-rate positions) at different dates. These mismatches may give rise to net interest income and economic value volatility as interest rates vary.•
Yield curve risk - which arises from unanticipated changes in the shape of the yield curve, such that rates at different maturity points may move differently. Such movements may give rise to interest income and economic value volatility.•
The two risk factors above incorporate the duration riskarising from the reinvestment of maturing swaps hedging net free reserves (or net exposure to equity and other low fixed- rate or non-interest-bearing liability balances including, but not limited to, current accounts).
Business reviewCapital and risk management
•
Basis risk - which arises when related instruments with the same tenor are valued using different reference yield curves. Changes in the spread between the different reference curves can result in unexpected changes in the valuation of or income difference between assets, liabilities or derivative instruments. This occurs, for example, in the retail and commercial portfolios, when products valued on the basis of the Bank of England base rate are funded with LIBOR-linked instruments.•
Optionality risk - which arises when customers have the right to terminate, prepay or otherwise alter a transaction without penalty, resulting in a change in the timing or magnitude of the cash flows of an asset, liability or off- balance sheet instrument.Due to the long-term nature of many non-trading book portfolios and their varied interest rate repricing characteristics and maturities, it is likely that net interest income will vary from period to period, even if interest rates remain the same. New business originated in any period will alter RBS’s interest rate sensitivity if the resulting portfolio differs from portfolios originated in prior periods, depending on the extent to which exposure has been hedged.
RBS’s policy is to manage the interest rate sensitivity within risk limits that are approved by the ERF and endorsed by the ALCo before being cascaded to lower levels. These include, in particular, interest rate sensitivity and VaR limits.
In order to manage exposures within these limits, RBS
aggregates its interest rate positions and hedges them externally using cash and derivatives - primarily interest rate swaps.
This task is primarily carried out by Treasury, to which all businesses except CIB transfer most of their NTIRR. The main exposures and limit utilisations are reported to the ALCo and the Board monthly.
Foreign exchange risk
The only material non-traded open currency positions are the structural foreign exchange exposures arising from investments in foreign subsidiaries, branches and associates and their related currency funding. These exposures are assessed and managed by Treasury to predefined risk appetite levels under delegated authority from the ALCo. Treasury seeks to limit the potential volatility impact on RBS’s Common Equity Tier 1 (CET1) ratio from exchange rate movements by maintaining a structural open currency position. Gains or losses arising from the retranslation of net investments in overseas operations are recognised in equity reserves and reduce the sensitivity of capital ratios to foreign exchange rate movements primarily arising from the retranslation of non-sterling-denominated RWAs. Sensitivity is minimised where, for a given currency, the ratio of the structural open position to RWAs equals RBS’s CET1 ratio. The sensitivity of the CET1 capital ratio to exchange rates is monitored monthly and reported to the ALCo at least quarterly.
*unaudited
Foreign exchange exposures arising from customer transactions are sold down by businesses on a regular basis in line with RBS policy.
Equity risk
Non-traded equity risk is the potential variation in the income and reserves arising from changes in non-trading book equity valuations. Any such risk is identified prior to any investments and then mitigated through a framework of controls.
Investments, acquisitions or disposals of a strategic nature are referred to RBS’s Acquisitions and Disposals Committee (ADCo). Once approved by ADCo for execution, such transactions are referred for approval to the Board, the Executive Committee, the Chief Executive Officer, the Chief Financial Officer or as otherwise required. Decisions to acquire or hold equity positions in the non-trading book that are not of a strategic nature, such as customer restructurings, are taken by authorised persons with delegated authority under the credit approval framework.
Risk measurement
Interest rate risk*
NTIRR can be measured from either an economic value-based or earnings-based perspective (or both). Value-based approaches measure the change in value of the balance sheet assets and liabilities over a longer timeframe, including all cash flows. Earnings-based approaches measure the potential short-term (generally one year) impact on the income statement of charges in interest rates.
RBS uses both approaches to quantify its interest rate risk: VaR as its value-based approach and sensitivity of net interest income (NII) as its earnings-based approach.
These two approaches provide different yet complementary views of the impact of interest rate risk on the balance sheet at a point in time. The scenarios employed in the NII sensitivity approach incorporate business assumptions and simulated modifications in customer behaviour as interest rates change. In contrast, the VaR approach assumes static underlying positions and therefore does not provide a dynamic measurement of interest rate risk. In addition, while the NII sensitivity calculations are measured to a 12 month horizon and thus provide a shorter-term view of the risks on the balance sheet, the VaR approach can identify risks not captured in the sensitivity analysis, in particular the impact of duration and repricing risk on earnings beyond 12 months.
Value-at-risk*
RBS’s standard VaR metrics - which assume a time horizon of one trading day and a confidence level of 99% - are based on interest rate repricing gaps at the reporting date. Daily rate moves are modelled using observations over the last 500 business days. These incorporate customer products plus associated funding and hedging transactions as well as non- financial assets and liabilities such as property, plant and equipment, capital and reserves. Behavioural assumptions are applied as appropriate.
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244 Market risk continued
The table below shows the NTIRR VaR for RBS’s retail and commercial banking activities at a 99% confidence level together with a currency analysis of period end VaR. It captures the risk resulting from mismatches in the repricing dates of assets and liabilities. This includes any mismatch between structural hedges and stable non and low interest bearing liabilities such as equity and money transmission accounts as regards their interest rate repricing behavioural profile.
Average Period end Maximum Minimum
£m £m £m £m 2015 - excluding Citizens 17 10 25 9 2015 - Citizens 5 — 16 — 2015 - Total 18 10 25 10 2014 - excluding Citizens 38 17 60 17 2014 - Citizens 20 11 42 8 2014 - Total 50 23 79 23
2014
2015 Excluding Citizens Citizens Total
Period end VaR £m £m £m £m
Euro 3 2 — 2
Sterling 5 12 — 12
US dollar 5 16 11 27
Other 4 3 — 3
Key points
•
Average interest rate VaR was lower in 2015 as RBS steered its structural interest rate exposure more closely to the neutral duration prescribed by its internal riskmanagement policy.
•
The main movements by currency in 2015 related to US dollar and sterling VaR, reflecting the disposal of Citizens and the risk management activity described above.•
These movements remained well within RBS’s approvedBusiness reviewCapital and risk management
Sensitivity of net interest income*
Earnings sensitivity to rate movements is derived from a central forecast over a 12 month period. A simplified scenario is shown based on the period-end balance sheet assuming that non- interest rate variables remain constant. Market implied forward rates are used to generate a base case earnings forecast, which is then subjected to interest rate shocks. The variance between the central forecast and the shock gives an indication of underlying sensitivity to interest rate movements.
The following table shows the sensitivity of net interest income, over the next 12 months, to an immediate upward or downward