many developments, little consensus
The high level of interest in the topic of Interest Rate Risk in the Banking Book (IRRBB) was highlighted in the banking survey Zanders conducted at the end of 2014, and from the round table discussions that were subsequently held. There appeared to be quite a few different opinions on how to set up a solid framework to measure and manage this risk.
In 2015, some prominent IRRBB-related developments took place; the European Banking Authority presented a new guideline, while the Bank for International Settlements (BIS) initiated a consultative process. The banks are to submit their quantitative impact study (QIS) as part of this consultative process by the end of September. What is the origin of this ongoing debate? What can we expect from it and what does it mean for the banks?
Until now, banks were given rather extensive freedom in setting up the IRRBB. This is mostly since the BIS opted to accommodate this risk as part of the second Basel pillar, which allows banks to determine how to manage this risk as they see fit, subject to the Supervisory Review Process (SREP). In recent years, regulators shifted their focus to other types of risk, but they have since caught up in this area. They intend to make several improvements such as creating greater clarity concerning IRRBB.
Do the complexity of this topic and the diversity of the various banks permit this risk to be further standardized?
We will first review the most relevant developments from a best market practice perspective and then review the regulator’s proposals from this same perspective. Just as the crisis years taught us that you cannot blindly rely on models, we will see that this risk is also inherent in the new proposals. The introduction of new guidelines does not automatically mean that they will facilitate better management decision-making in this area. It is therefore important to retain a clear, internal view of this risk.
What are the essential building blocks of a good interest rate risk framework? The current best market practice is to first of all develop a strategic vision for the allowed interest rate risk. Generally this vision is laid down in the form of policies, which clearly delineate the tasks and responsibilities of the various relevant departments and committees, and the organization’s risk appetite or risk attitude. This defines the bank’s maximum risk appetite in relation to the interest rate risk and is subsequently translated into standards and associated limits.
Key in this translation into standards and associated limits is to ensure that the economic value perspective is addressed, as well as the income perspective. Stabilizing both income and economic value are conflicting objectives, however. A decrease in an income standard (e.g. earnings at risk) often goes hand-in-hand with an increase in the economic value standard (for instance, a delta, duration or value at risk).
For example, when interest rates decline, the future total interest income will generally decline as well, while the net present value of all future cash flows will rise as a result. In actual practice, a compromise is aimed for between both types of standards, whereby a certain degree of volatility in income, as well as economic value, is accepted. The responsibility for managing this is generally assigned to the central treasury department, while the risk management department has a monitoring and supporting task.
Managing and hedging the interest rate risk can be considerably simplified by transferring the interest rate risk to treasury, for example via internal transactions on the basis of funds transfer pricing (FTP).
Unfortunately, in actual practice, things are not as simple and there are choices to be made. For example, how is the economic value calculated? Is this a market value that must also take (embedded) options and credit spreads into account? How, and with what instruments, is this economic value managed? Does it make sense that changes in this value by credit spread change impacts the set of interest rate swaps that is intended to manage this economic value? To what extent is it sensible to involve all future cash flows in this, including the expected future interest rate margins?
We are proposing a framework that makes a clear distinction between the various types of interest rate risk. The risks that ultimately can be hedged using interest rate derivatives, such as interest rate swaps, are transferred to treasury, while options and future interest rate margins remain and are managed within the relevant business lines. Earnings at risk (EaR) limits can be used to manage the future interest rate margins.
Finally, all types of interest rate risk can be consolidated and addressed at the total level, for example via the economic capital. The abovereferenced separation must be effected by establishing the interest cash flows for each transaction without margins/spreads. It is also important to make a distinction between interest rate and liquidity type cash flows.
IRRBB-related guidelines were for the first time specified by the BIS in 2004. The guidelines introduced a series of principles for managing interest rate risk and a specific decision was made to accommodate these guidelines as part of the second Basel pillar. In 2006, the Committee of European Banking Supervisors (CEBS – now known as the EBA), further defined these principles. At the end of 2013, in the context of the review of the trading book, the BIS created a task force with the objective of harmonizing the treatment of the interest rate risk in the trading book and the banking book.
Although the BIS proposals have not yet been finalized, the EBA decided to publish an update of the 2006 guidelines by May 2015. The updated guidelines still provide for a second pillar-based approach, but with stricter requirements for internally determining the interest rate risk and for developing scenarios to assess the financial implications for internal management, as well as stress tests. For example, repricing, yield curve, basic risk and option risk must be determined and reported separately, and have to be reflected in the risk appetite as well. In addition, the guidelines require stress tests to be performed on the basis of economic value, while disregarding the credit spreads. Cash flows must be calculated at their net present value using a risk-free interest rate curve (generally based on swap rates).
The requirements related to modeling client behavior are far-reaching because for instance the modeling of mortgage repayment behavior must not only take the dependence on the interest rate into account, but also, for example, the economic situation and the behavior of competitors. It therefore would appear that the use of a constant prepayment rate is precluded, while the model risks in such client behavior models can become substantial. The implementation date of the EBA guidelines has been set at 1 January 2016. Given the complexity of the required adjustments this is expected to represent a significant challenge for many banks.
In June, the BIS subsequently published an IRRBB consultative paper. The paper discusses two proposals that are not directly in line with the proposed EBA guidelines. On the one hand, an alternative to replace IRRBB with a Pillar 1 approach is presented, while the other proposal consists of a Pillar 2 approach with the requisite adjustments. The proposals in the consultative paper will be tested in the third quarter on the basis of a quantitative impact study (QIS). One of these proposals will be selected on the basis of this quantitative impact study and the risk drivers in the proposals will be calibrated.
Where do we go from here?
Because the banks in the past were relatively free to measure and manage the interest rate risk in the banking book, the models currently used for this purpose vary significantly. As is to be expected, larger banks, for example, in general have more advanced models than the smaller banks, where measuring and modeling this risk is often still in its infancy. Due to these variances, comparisons of this risk among financial institutions, certainly within the European context, are difficult to make. This is what prompted the BIS and EBA to develop refined guidelines.
The standards to be reported to the regulator on the basis of the planned guidelines are not per se also the right standards needed to measure and control this risk internally. For example, the economic value that results from the proposals is a standard that has no other economic significance and cannot be used internally for any other purpose. In addition, aside from the specified scenarios – in spite of their expansion – it may still be useful to assess the financial implications of tailormade scenarios.
It goes without saying that given the new regulatory developments, the need for banks to develop a solid IRRBB framework has not diminished. It is expected that over the long term a consensus will be reached regarding the internal, BIS and EBA frameworks. What that result will then look like – and whether this will simplify the current method of work – is something that remains to be seen.