a) Behavioural assumptions for customer accounts with embedded customer optionality

In assessing the implications of optionality, institutions should take into account:

• (a) The potential impact on current and future loan prepayment speeds arising from the interest rate scenario, underlying economic environment and contractual features. Institutions should take into account the various dimensions influencing the embedded behavioural options.
• (b) The elasticity of adjustment of product rates to changes in market interest rates.
• (c) The migration of balances between product types as a result of changes in their features, terms and conditions.

Institutions should have policies in place governing the setting of, and the regular assessment of, the key assumptions for the treatment of on- and off-balance-sheet items that have embedded options in their interest rate risk framework. This means that institutions should:

• (a) identify all material products and items subject to embedded options that could affect either the interest rate charged or the behavioural repricing date (as opposed to contractual maturity date) of the relevant balances;
• (b) have appropriate pricing and risk mitigation strategies (e.g. use of derivatives) to manage the impact of optionality within the risk appetite, which may include early redemption penalties chargeable to the customer as an offset to the potential break costs (where permitted);
• (c) ensure that modelling of key behavioural assumptions is justifiable in relation to the underlying historical data, and based on prudent hypotheses;
• (d) be able to demonstrate that they have accurate modelling (back-tested against experience);
• (e) maintain appropriate documentation of assumptions in their policies and procedures, and have a process for keeping them under review;
• (f) understand the sensitivity of the institution’s risk measurement outputs to these assumptions, including undertaking stress testing of the assumptions and taking the results of such tests into account in internal capital allocation decisions; and
• (g) perform regular internal validation of these assumptions to verify their stability over time and to adjust them if necessary.