Interest Rate Risk in the Banking BookSidney Leever, Frank Pardoel,

Pim Poppe.

March 2016

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White paper: Interest Rate Risk in the Banking Book March 2016

Interest Rate Risk in the Banking BookIn 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 guide-lines 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 mea-surement, 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.

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 gov-ernance, 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 manage-

ment, 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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IntroductionRegulators felt that that a renewed focus on IRRBB was necessary since – in con-trast to credit risk, market risk and operational risk – IRRBB is not captured in Pil-lar I of the Basel accord. As a consequence, it was found that IRRBB practices di-verge 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 atten-tion to this risk.IRRBB relates to both the asset and liability side of the balance sheet, e.g. mort-gages 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 RiskSuppose a bank finances a 20-year mortgage

using short term deposits. If the deposit rate

rises, the spread on the contract and profit de-

creases.

Flattening of the yield curve forces the short-

term rate to rise more significantly than long-

term rates. A borrow short, lend long strategy

becomes less profitable.

(Embedded) Option risk Basis RiskA decrease in interest rates increases the in-

centive of prepaying on a (mortgage) loan. The

loan is replaced by one with a lower interest

rate. Thereby, future interest rate profits dimin-

ish.

Whenever a strategy profits from the spread

between the LIBOR and US T-bills and a differ-

ent shock is observed, basis risk arises.

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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White paper: Interest Rate Risk in the Banking Book March 2016

The EBA and BIS IRRBB documentsThe consultative document on IRRBB proposes twelve principles for banks as guidance for develop-ment of their risk management process, including models for asset liabilities management, inter-nal process management, business strategy and monitoring. By publishing the principles, the su-pervisory 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, be-

havioral assumptions should be understood, thoroughly analyzed, documented properly and supported by sufficient and high-quality data.

• 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 IR-RBB 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 manage-ment 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 ap-

proaches defined for credit risk management.

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As an example, consider the Earnings-at-Risk (EaR) risk measure where the so-phistication levels differ as follows:• Level 1: apply the standard shock, i.e. 200bps, to earnings on a constant bal-

ance 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 prob-ably 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 IIIRRBB 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 het-erogeneous. 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 ex-ception 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 gov-ernance 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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White paper: Interest Rate Risk in the Banking Book March 2016

Figure 1: Overview of the key metrics from the banking book effected by interest rate movements.

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 harmoniza-tion also applies for the other Pillar I risk classes.

The pillar structure immediately relates to the most important consideration of the con-sultative 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 Pil-lar 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 impactThe 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 mag-nitude 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 behav-ioral 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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White paper: Interest Rate Risk in the Banking Book March 2016

Board ALM (1st line)

Risk (2nd line)

Finance (2nd line)

Modelling (1st and 2nd line)

IT (1st and 2nd line)

Internal Capital

• Determines risk appetite for IRRBB through a risk ap-petite statement

• Understand IRRBB capital impact of business decisions

• Takes into account capital restrictions in its overall IRRBB strategy

• Reports on inter-nal capital (inter-nal stakeholders)

• Reports outlier test of standard shock (external stakeholders)

• Reports on inter-nal capital (exter-nal stakeholders

• Reports outlier test of standard shock (external stakeholders)

• Development of method to translate IRRBB risk measures into internal capital requirements

Mea-sure-ment

• Acting on reported limited excesses

• Understanding fundamentals of IRRBB measure-ment

• Understanding of the bank’s overall IRRBB risk.

• Understanding of strengths and weaknesses in the bank’s IRRBB approach

• Takes risks and hedge risks within approved limits

• Makes corporate planning assump-tions (e.g. busi-ness growth)

• Limit monitoring• Reporting on limit

excesses• Monitors risk

metrics from both earnings perspec-tive and economic value perspective

• Validates cor-porate planning assumptions

• Monitoring of impact of super-visory standard shock

• Accounting treat-ment of fair val-ued instruments in banking book

• Hedge accounting

• Proposes methodology for measuring IRRBB (e.g. valuation principles and risk metrics)

• Designs relevant and portfolio spe-cific interest rate scenarios (incl. basis risk)

• Models customer behavior (e.g. sav-ings and mortgage prepayments)

• Value embed-ded options (e.g. prepayment as-sumption)

• Recording of all transactions tak-ing into account interest rate characteristics.

• Allows for aggre-gation and disag-gregation (e.g. to transaction level

Gover-nance

• Approves overall IRRBB strategy

• Understanding of interest rate derivatives

• Understanding of the bank’s prod-ucts and client behavior

• Proposes IRRBB strategy on the basis of the risk appetite state-ment

• Expertise and knowledge of interest rate derivatives

• Expertise and knowledge of the bank’s products and client be-havior

• Proposes limits given risk appetite statement and ap-proved strategy

• Expertise and knowledge of interest rate derivatives

• Expertise and knowledge of the bank’s products and client be-havior

• Ensures IRRBB approach is implemented in an appropriate and robust system

Policies • Approves policies• Be aware of de-

sign and operating effectiveness of IRRBB processes and controls

• Sets policy for dis-tinction between banking book and trading book

• Sets IRRBB policy

• Sets accounting policy

• Sets modelling policy

• Establishes con-trols around data quality

• Establishes con-trols to prevent and handle sys-tems failure and disruptions

Table 2: The IRRBB risk management framework considered per role in a bank.

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ConclusionThe change process of the risk management framework related to IRRBB was ini-tiated by the recent BIS consultative paper and the updated EBA guidelines. Un-derstanding the trade-off between economic value and earnings volatility, defin-ing 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 non-

trading activities”, May 2015.

White paper: Interest Rate Risk in the Banking Book March 2016

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