Interest Rate Risk in the Banking Book

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Sidney Leever, Frank Pardoel,
Pim Poppe.
March 2016
Interest Rate Risk in
the Banking Book
White paper: Interest Rate Risk in the Banking Book
March 2016
Interest Rate Risk in the Banking Book
In 2015, two documents were published that will have a significant impact on the risk management
framework of banking institutions. In May 2015, the European Banking Authority (EBA) published an
update to the guidelines for managing Interest Rate Risk in the Banking Book (IRRBB). These guidelines provide technical guidance on how banks should account for IRRBB in their Internal Capital
Adequacy Assessment Process (ICAAP) and furthermore provide guidance on policies, risk measurement, reporting requirements, corporate planning, systems and governance. In June 2015,
the Bank for International Settlements (BIS) also published a consultative document regarding
IRRBB. Similarly to the EBA guidelines, this document requires banks to appropriately estimate
their capital levels for IRRBB. Moreover, the document consults whether these capital estimates
should be captured under Pillar I or Pillar II, provides high level principles for the management
of IRRBB and addresses the interdependence between interest rate risk in trading book and the
banking book.
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Both papers combined will have a significant impact on how banks measure, monitor, hedge
and manage their interest rate risk. The papers will affect the bank’s organization: its governance, its risk models, its systems and its policies. In this white paper RiskQuest provides
an overview of the impact on the different roles within a financial institutions focusing on
European commercial banks.
Main takeaways:
•
EBA and BIS papers provide transparent guidelines for IRRBB risk management in the near future.
•
Supervisors receive guidance to establish a transparent and uniform European supervisory framework.
•
The degrees of freedom in the IRRBB risk management framework will decrease in the future.
•
Convergence of IRRBB risk management will increase, providing benchmark opportunities; analysts,
supervisors and rating agencies will use these benchmark opportunities.
•
The capital markets for equity and debt will demand more disclosure in terms of IRRBB.
•
Differing levels of complexity and size will determine each bank’s level of IRRBB sophistication.
•
Fulfilling the IRRBB guidelines will require a significant investment from a governance, policies,
measurement and IT perspective.
•
The IRRBB guidelines will require a significant combined effort between board, ALM, risk management, finance, modelling and IT.
•
RiskQuest advises a readiness check and the set-up of a guidelines implementation program.
•
RiskQuest has extensive knowledge both in modelling, risk governance and capital assessment;
with a special attention to the field of ALM.
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Introduction
Regulators felt that that a renewed focus on IRRBB was necessary since – in contrast to credit risk, market risk and operational risk – IRRBB is not captured in Pillar I of the Basel accord. As a consequence, it was found that IRRBB practices diverge widely across banks. Moreover, as the savings and loans crisis in the 1980s
has shown, IRRBB is a significant risk within the banking industry. The current
exceptionally low interest rate regime is all the more reason to pay proper attention to this risk.
IRRBB relates to both the asset and liability side of the balance sheet, e.g. mortgages and savings, but also to off-balance sheet exposures, e.g. mortgage offers,
new business. Four sources of interest rate risk can be discerned:
• Repricing risk arises from timing differences between rate changes (or cash
flows) from on- and off-balance sheet instruments.
• Yield curve risk arises from (non-parallel) changes in the shape of the curves.
• Option risk arises from the risk of having embedded options.
• Basis risk arises since different curves and indices do not move in a uniform
manner.
Each of the risk components impact the asset and liability positions of the bank
both on-balance and off-balance. Being aware of the quantitative and qualitative
aspects is necessary. Therefore, per sub-risk component, an illustrative example
is provided in Table 1.
Repricing risk
Yield Curve Risk
Suppose a bank finances a 20-year mortgage Flattening of the yield curve forces the shortusing short term deposits. If the deposit rate term rate to rise more significantly than longrises, the spread on the contract and profit de- term rates. A borrow short, lend long strategy
creases.
becomes less profitable.
(Embedded) Option risk
Basis Risk
A decrease in interest rates increases the in- Whenever a strategy profits from the spread
centive of prepaying on a (mortgage) loan. The between the LIBOR and US T-bills and a differloan is replaced by one with a lower interest ent shock is observed, basis risk arises.
rate. Thereby, future interest rate profits diminish.
Table 1: Per IRRBB risk component, one finds an illustrative example1.
1
Note that there is not one unique interest rate curve. Various curves impact the capital and
earnings of a bank depending on its positions, geographical location and type of business.
Examples of interest rate curves are EURIBOR, LIBOR, AAA swap curve and BB swap curve
-
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March 2016
The EBA and BIS IRRBB documents
The consultative document on IRRBB proposes twelve principles for banks as guidance for development of their risk management process, including models for asset liabilities management, internal process management, business strategy and monitoring. By publishing the principles, the supervisory authority reveals the points of attention in case the IRRBB risk management framework
is under supervisory review. Some interesting considerations from the consultative paper in light
of IRRBB are:
• Senior management should carefully formulate the risk appetite for IRRBB both from an
earnings perspective and from economic value perspective.
• The risk should be measured, monitored and managed accordingly (earnings perspective
and economic value perspective).
• Stress testing and scenario analysis are powerful tools for measuring and monitor IRRBB.
• Models used for IRRBB will heavily depend on behavioral assumptions. Therefore, behavioral assumptions should be understood, thoroughly analyzed, documented properly
and supported by sufficient and high-quality data.
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• Senior management should be informed about IRRBB levels and hedging strategies.
Moreover, they are in charge of IRRBB capital allocation decisions.
A consideration, which is often overlooked, is the trade-off between the short-term IRRBB effects finding its origin in the earnings of a bank versus the long-term IRRBB effects
finding its origin in the economic value, i.e. capital position. Therefore, IRRBB can also
be described form the perspective of two components: economic value volatility and
earning volatility. The types of trades, risk profile and balance sheet composition will
determine the strategy of how to manage these IRRBB components. A take-away is that
monitoring both metrics will be crucial. The decision to stabilize one or the other will
differ per bank. Nevertheless the IRRBB framework needs to cover both components.
Both the EBA guidelines and the BIS consultative paper, introduce the link between
size and complexity of the bank and the sophistication level of the risk management
framework 2. Four levels of sophistication are introduced. The more complex and
larger the bank, the more sophisticated the risk management framework should be.
The first instance of where the level of sophistication enters into the risk management framework is the risk measures. In Figure 1, one finds an illustration of the
level of sophistication and the implications for the risk measures.
2
Similar to the distinction between standardized, foundations IRB or advanced IRB approaches defined for credit risk management.
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As an example, consider the Earnings-at-Risk (EaR) risk measure where the sophistication levels differ as follows:
• Level 1: apply the standard shock, i.e. 200bps, to earnings on a constant balance sheet.
• Level 2: apply the standard shock and other yield curve shocks, on scenarios
and stress tests.
• Level 3: apply yield curve, basis risk and option stress tests on scenarios and
stress tests.
• Level 4: add behavioral assumptions to reforecast business volumes and
earnings.
A bank will determine its own level of ambition. The larger Dutch banks will probably opt for level 4. The level of sophistication will automatically provide insight
in the magnitude of the risk management framework.
IRRBB: Pillar I or Pillar II
IRRBB is currently part of Pillar II of the Basel framework. Being part of the second
pillar allows banks to differentiate and not being forced into a uniform capital
calculation framework. The main reasoning behind the Pillar II classification was
that IRRBB was not to be harmonized and differences in IRRBB could arise due
to geographical location or type of business. The risk would have been too heterogeneous. One example is prepayment risk. In for example the Netherlands,
clients are allowed to prepay an annual fixed percentage (usually 10%) without
being charged a penalty and for the rest of the loan a penalty applies (with exception of relocation)3. In other countries different terms and conditions apply
and prepayment risk constitutes of walking away from the loan. Both risks are
part of the IRRBB, however allow for a different approach, modelling and governance wise. Another consideration is that harmonizing the risk management
framework may increase systemic risk, since all banks will use the same tools and
approaches.
Pillar system in a nutshell
The three pillar system in the Basel accords is intended to introduce standards for capital,
risk management and supervision. The level of required capital depends on the risk profile
and business profile of the individual banks. The first pillar addresses the regulatory capital
and identifies the three major risk components, i.e. credit, market and operational risk.
The second pillar relates to the ICAAP. Under this assessment, the bank should evaluate
the major sources of risk from a capital perspective. Hereto stress testing and scenario
analysis are helpful tools. The third pillar focuses on disclosures. The business terminology
reads: minimum capital requirement for the first pillar, supervisory review for the second
pillar and market discipline for the third pillar.
3
Refer to the RiskQuest white paper named ALM Risk Penalty Methodology.
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March 2016
Figure 1: Overview of the key metrics from the banking book effected by interest rate movements.
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On the other hand, a standardized methodology for IRRBB, i.e. capturing IRRBB under Pillar
I, will introduce a larger consistency in the risk management framework. Thereby, banks
will be more uniform in their IRRBB approach. At the same time, the importance of IRRBB
will be highlighted. One could argue that the risk of IRRBB has a comparable magnitude as
for example credit, market and operational risk. The argument of difficulty in harmonization also applies for the other Pillar I risk classes.
The pillar structure immediately relates to the most important consideration of the consultative document of the BIS: treating IRRBB as an element of the first pillar or letting
IRRBB be part of the second pillar. RiskQuest believes that capturing IRRBB under Pillar I emphasizes the importance of IRRBB. Nevertheless a standardized approach for
IRRBB may overlook individual risk components. Therefore, IRRBB and certain bank
specific or country specific elements (e.g. the Dutch prepayment option mentioned
before) should also be captured under Pillar II. This way an increase in systemic risk
is prevented, banks are still allowed to deal with the heterogeneous nature of IRRBB
and at the same time IRRBB is given same priority as credit, market and operational
risk.
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Governance and organizational impact
The IRRBB guidelines may also have impact on the organization or governance
of risk. The impact is summarized in matrix form. The matrix in Table 2, shows
on the horizontal dimension the different roles within a bank. On the vertical
dimension, the matrix shows the different themes of the IRRBB risk management
framework.
The board’s main tasks will be to approve the overall IRRBB risk management
framework and define the risk appetite. Understanding the risks and the magnitude will be fundamental tasks. Given the risk management framework, e.g.
limits, ALM conducts business and implements and monitors appropriate hedge
strategies. Finance deals with the accounting consequences of an updated IRRBB
risk management framework. The risk models itself used for risk management
and hedging will be developed by modelling. As mentioned before, the behavioral assumptions and data quality will be important topics. IT plays a significant
role in setting-up, maintaining and controlling the appropriate systems including
infrastructure and data warehouses. As can be observed, IRRBB risk management
will be a joint effort of all roles.
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March 2016
Board
ALM
(1st line)
Risk
(2nd line)
Finance
(2nd line)
Modelling
(1st and 2nd line)
Internal
Capital
•Determines risk
appetite for IRRBB
through a risk appetite statement
•Understand IRRBB
capital impact of
business decisions
•Takes into account
capital restrictions
in its overall IRRBB
strategy
•Reports on internal capital (internal stakeholders)
•Reports outlier
test of standard
shock (external
stakeholders)
•Reports on internal capital (external stakeholders
•Reports outlier
test of standard
shock (external
stakeholders)
•Development
of method to
translate IRRBB
risk measures into
internal capital
requirements
Measurement
•Acting on reported •Takes risks and
limited excesses
hedge risks within
•Understanding
approved limits
fundamentals of
•Makes corporate
IRRBB measureplanning assumpment
tions (e.g. busi•Understanding of
ness growth)
the bank’s overall
IRRBB risk.
•Understanding
of strengths and
weaknesses in
the bank’s IRRBB
approach
•Limit monitoring
•Reporting on limit
excesses
•Monitors risk
metrics from both
earnings perspective and economic
value perspective
•Validates corporate planning
assumptions
•Monitoring of
impact of supervisory standard
shock
•Accounting treatment of fair valued instruments in
banking book
•Hedge accounting
•Proposes
methodology for
measuring IRRBB
(e.g. valuation
principles and risk
metrics)
•Designs relevant
and portfolio specific interest rate
scenarios (incl.
basis risk)
•Models customer
behavior (e.g. savings and mortgage
prepayments)
•Value embedded options (e.g.
prepayment assumption)
Governance
•Approves overall
IRRBB strategy
•Understanding
of interest rate
derivatives
•Understanding of
the bank’s products and client
behavior
•Proposes limits
given risk appetite
statement and approved strategy
•Expertise and
knowledge of
interest rate
derivatives
•Expertise and
knowledge of the
bank’s products
and client behavior
Policies
•Approves policies
•Be aware of design and operating
effectiveness of
IRRBB processes
and controls
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•Proposes IRRBB
strategy on the
basis of the risk
appetite statement
•Expertise and
knowledge of
interest rate
derivatives
•Expertise and
knowledge of the
bank’s products
and client behavior
•Sets policy for distinction between
banking book and
trading book
•Sets IRRBB policy
IT
(1st and 2nd line)
•Recording of all
transactions taking into account
interest rate
characteristics.
•Allows for aggregation and disaggregation (e.g. to
transaction level
•Ensures IRRBB
approach is
implemented in
an appropriate
and robust system
•Sets accounting
policy
Table 2: The IRRBB risk management framework considered per role in a bank.
•Sets modelling
policy
•Establishes controls around data
quality
•Establishes controls to prevent
and handle systems failure and
disruptions
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Conclusion
The change process of the risk management framework related to IRRBB was initiated by the recent BIS consultative paper and the updated EBA guidelines. Understanding the trade-off between economic value and earnings volatility, defining and explaining the behavioral assumptions, sufficient and high-quality data,
stress testing and scenario analysis, connection between complexity of the IRRBB
risk management framework and sophistication level of the bank, governance
and internal control will be important elements for IRRBB in the coming years.
References
Basel Committee on Banking Supervision, “Interest rate risk in the banking book, Consultative
Document”, June 2015.
Basel Committee on Banking Supervision, “Principles for the Management and Supervision of
Interest Rate Risk, Consultative Document”, June 2001.
European Banking Authority, “Guidelines on the management of interest rate risk arising from nontrading activities”, May 2015.
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March 2016
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Interest Rate Risk in the Banking Book

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