European Banking Authority Publishes Final Guidelines on Corrections to Duration for Debt Instruments under Capital Requirements Regulation


Shearman & Sterling LLP

The European Banking Authority published final Guidelines on the correction required for the calculation of Modified Duration for debt instruments subject to prepayment risk under the Capital Requirements Regulation. The CRR establishes two methods to calculate capital requirements for general interest rate risk. The relevant methods are the Maturity-Based calculation and the Duration-Based calculation of general risk. The final Guidelines apply to the Duration-Based calculation. The Duration-Based calculation uses the concept of Modified Duration pursuant to the formulae outlined in the CRR. This method is only valid for instruments that are not subject to repayment risk. The EBA has is mandated to issue guidelines establishing how to correct the Modified Duration calculation to reflect prepayment risk. The EBA has proposed two approaches to correct the calculation. One option is to treat the debt instrument with prepayment risk as if it is a combination of a plain vanilla bond and an embedded option. The Modified Duration of the plain vanilla bond is therefore corrected with the change in value of the embedded option; which is estimated according to its theoretical delta, resulting from a 100 basis point movement in interest rates. The other option is directly to calculate the change in value of the whole instrument subject to a repayment risk resulting from a 100 basis point movement in interest rates. The Guidelines will apply from March 1, 2017.

View the final Guidelines.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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