On March 22, 2016, the European Banking Authority published a consultation paper on standardized methods to compute capital requirements for general interest rate risk under the Capital Requirements Regulation. The CRR provides for two standardized methods, the so-called Maturity-Based calculation for general interest risk and the Duration-Based calculation of general risk. The Duration-Based calculation uses the concept of Modified Duration which is valid only for instruments not subject to repayment risk. Modified Duration is used to measure the sensitivity in price for a unit change in its internal rate of return of any financial asset that consists of fixed cash flows. A correction to the duration is necessary to reflect the repayment risk. The CRR provides the mandate for the EBA to issue guidelines on how the Modified Duration for debt instruments which are subject to repayment risk should be corrected. The EBA proposes two approaches to correct the Modified Duration calculation: (i) treat the debt instrument with repayment risk as if it was a combination of a plain vanilla bond and an embedded bond; or (ii) calculate directly the change in value of the whole instrument subject to repayment risk resulting from a 100-basis-point movement in Interest Rates. Submissions to the consultation are due by June 22, 2016.
The Consultation Paper is available at: http://www.eba.europa.eu/documents/10180/1412589/EBA-CP-2016-03+%28CP+on+GL+on+corrections+to+modified+duration+for+debt+instruments%29.pdf.
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