The Handbook of ALM in Banking (2nd Edition)
First published:
ISBN: 9781782723455
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Managing Mortgage Prepayment Risk on the Balance Sheet
Dick Boswinkel
Introduction
Bank Capital and Liquidity
ALM in the Context of Enterprise Risk Management
The New Basel Standards on IRRBB and Their Implications for ALM
Measuring and Managing Interest Rate and Basis Risk
The Modelling of Non-Maturity Deposits
Modelling Non-Maturing Deposits with Stochastic Interest Rates and Credit Spreads
Managing Interest Rate Risk for Non-Maturity Deposits
Replication of Non-Maturing Products in a Low Interest Rate Environment
Managing Mortgage Prepayment Risk on the Balance Sheet
Considerations for ALM in Low and Negative Interest Rate Environments
Credit Spreads
Hedge Accounting
Supervisory Views on Liquidity Regulation, Supervision and Management
Measuring and Managing Liquidity and Funding Risk
Managing Reserve Assets
Instruments for Secured Funding
Asset Encumbrance
Capital Management
A Global Perspective on Stress Testing
Reverse Stress Testing: Linking Risks, Earnings, Capital and Liquidity – A Process-Orientated Framework and Its Application to Asset–Liability Management
XVAs and the Holistic Management of Financial Resources
Optimal Funding Tenors
Funds Transfer Pricing in the New Normal
Balance-Sheet Management with Regulatory Constraints
Mortgage loans form one of the largest asset classes on bank balance sheets. In most markets, they not only bear interest rate risk, but also introduce convexity and prepayment (model) risk to the balance sheet. In this chapter we focus on convexity and prepayment risk in the US mortgage market. Many of the results and ideas, however, can be applied to any mortgage market.
We first describe the different product forms that carry the prepayment risk that can be found on a balance sheet. Then we illustrate some empirical relations between prepayments and the market variables that are typically part of prepayment models. We briefly discuss how to compute value and sensitivities for mortgage products. We conclude by discussing how to incorporate these products into typical balance-sheet metrics.
BALANCE-SHEET PRODUCTS WITH PREPAYMENT RISK
In this section we discuss the different balance-sheet products that are affected by prepayment risk.
Mortgage loans
The most popular mortgage in the US market is the fixed-rate annuity mortgage. Common terms are 15 and 30 years and there are no prepayment penalties. This is the example that we shall follow. We assume a monthly
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