New Swiss standard on interest-rate risk in the banking book (IRRBB)
One of the most fundamental drivers for a retail bank’s net interest income is inherent in the bank’s balance sheet structure and is related to the fact that assets and liabilities do not have similar maturities.
Retail banks apply maturity transformation that typically results in maturities of loans and mortgages exceeding the maturities of client deposits. This maturity transformation results in a structural tenor mismatch.
The size of the structural tenor mismatch is the result of the chosen Asset and Liability Management (ALM) strategy and the level of interest-rate risk (mismatch risk) the bank is willing to take on the banking book. Interest-rate risk is the current and prospective risk to both economic value of equity (changes in economic value of equity) and earnings (changes in net interest income) following adverse movements in interest rates.
In April 2016, the Basel Committee on Banking Supervision introduced principles (BCBS 368) on how banks should manage their IRRBB. In October last year, FINMA issued a consultation paper setting out how it intends to include the new BCBS principles in the national banking regulation. This article provides an overview of the new principles and explains how these principles will impact Swiss banks.
Behavioral option risk in the banking book
The banking book contains many heterogeneous positions which have contractual maturities that are substantially different from their behavioral maturities (e.g. savings and current accounts). There is considerable uncertainty about the amount by which a product will reprice as well as the date when this will happen. What happens is a consequence of a combination of factors, like behavior by the bank (client rate adjustments), its customers (volume withdrawals) and competitors. Resulting behavior is expected to vary according to the size and direction of the interest-rate movement.
The bank eventually hedges interest-rate risk based on the best estimate of likely behavior. Consequently, the real risk in the banking book is that these behavioral assumptions are wrong (model risk). Behavioral assumptions are difficult to capture in economic value models. Earnings risk simulations are better suited for this purpose. In the earnings risk simulations, repricing of individual products under various paths of interest rates can be reflected. Simulations can also better consider how behavioral assumptions vary themselves in accordance with interest-rate changes.
FINMA consultation paper on IRRBB is based on BCBS
In “Rundschreiben Zinsrisiken – Banken” (October 2017), FINMA explains how the new IRRBB principles are intended to be included in the Swiss banking regulation by 1st January 2019. The consultation paper closely follows the principles as defined in BCBS 368 and presents the expectation by the Swiss regulator for the identification, measurement, monitoring and control of IRRBB by Swiss banks. The new principles continue to allow banks to develop their own IRRBB model that best reflects the business model, heterogeneous nature, size and complexity of the bank. The new principles can be summarized in the following way:
- The governing body and its delegates (Asset & Liability Committee, ALCO) are responsible for establishing a rigid IRRBB governance framework. Identification, measurement and monitoring of risk must be embedded in a framework with adequate internal controls.
- Banks need to enhance their risk measurement and system capabilities. Going forward, IRRBB must be measured, assessed and reported from an economic value risk perspective, as well as from an earnings risk perspective. This means that the changes in economic value of equity and the changes in net interest income relative to a basis scenario need to be measured under various scenarios. Six internal regulatory shock and stress interest-rate scenarios are expected to be used from both perspectives. The new standard poses additional quantitative requirements.
- Banks need to adhere to stricter internal reporting and external disclosure requirements. The governing body must be informed in a timely manner to enable a thorough assessment of the bank’s exposure to IRRBB and sensitivity to changing market conditions. Besides additional qualitative information, also quantitative risk measures, i.e. economic value risk and earnings risk measures, must also be publicly disclosed for the six regulatory scenarios.
- Banks will be confronted with a reduced limit on the maximum level of interest-rate risk (mismatch risk) the bank is allowed to have. An outlier test is applied in order to identify outlier banks with potentially inadequate risk management or excessive interest-rate risk relative to their capital and earnings. A bank will be an outlier bank in case the decline in economic value of equity (under any of the six regulatory scenarios) exceeds 15% of Common Equity Tier 1 (CET1) capital. In the past this limit was set at 20%. Outlier banks could be forced by the national regulator to take mitigating actions. Actions could be a reduction and restructuring of the bank’s risk positions and improvement of the capital base. A lower limit does not imply that banks immediately need to raise additional capital for the current levels of interest-rate risk.
Based on the size, risk and complexity of the bank, FINMA can grant small banks (category 4 and 5 banks) easing on one or more principles of the new standard.
Consequences for Swiss banks
FINMA is less specific in the consultation paper than BCBS regarding the discounting methodology applied for calculating economic value of equity sensitivity. BCBS expects a consistent discounting methodology for calculating economic value risk. This implies that either cash flows are stripped from their commercial margins or that total cash flows (including commercial margins) are discounted. In the first case, the ‘stripped’ cash flows are discounted using the risk-free (LIBOR-Swap) curve, whereas in the latter case, the cash flows are discounted against the appropriate risk-adjusted yield curves (LIBOR-Swap plus a spread). Many retail banks in Switzerland determine economic value risk by discounting total cash flows (including commercial margins) by the LIBOR-Swap curve.
The reason is that these banks do not lack information on commercial margins at transaction level, but that this information isn’t stored in the risk system. This makes margin stripping of cash flows a timely and costly exercise. The construction of risk-adjusted yield curves is also a tedious exercise. Since many retail banks would prefer to continue discounting against LIBOR-Swap in the future, BCBS requires them to focus on margin stripping in order to have a consistent methodology in place. As regulators are predominantly interested in the changes in economic value of equity relative to available capital, banks need to understand how significant the contribution of commercial margins is to the total economic value of equity sensitivity. Since this is not expected to be material, banks could argue for continuing their current approach to calculating economic value risk. It is uncertain whether the FINMA will be receptive to this argument.
Swiss retail banks will need to review (and overhaul if needed) their risk appetite and limit framework as well as redesign their internal risk reporting. Prerequisites for a proper risk appetite and limit setting framework are a sound risk methodology and an adequate risk system as well as a clear understanding of IRRBB and its key modeling assumptions by the governing body. Banks are required to determine risk appetite and limits both in terms of economic value risk as well as earnings risk for specific scenarios and risk appetite and limits need to be approved by the governing body.
In addition, a well-structured risk report should enable delegates and the governing body to assess the sensitivity of the bank to changes in market conditions. An interest-rate risk report typically includes an overview of the economic value and earnings risk measures (for internal and standard regulatory shock and stress scenarios), supported by: an explanation of changes in risk measures, a comparison to the policy limits, as well as a materiality assessment of all major model assumptions.
Swiss banks need to focus more on validation and model risk governance. This means that banks should regularly evaluate and independently review their internal control system and risk management processes, ensuring the integrity of IRRBB management, effective and efficient operations, reliable reporting and compliance with regulation. Validation of IRRBB measurement methods and model risk should be included in a formal policy and approved by the governing body or delegates. Models should be subject to review, process verification and validation on a frequency consistent with the level of model risk determined and approved by the bank.
Systemic relevant banks in Switzerland have system capabilities in place that allow these banks to determine EVE and earnings risk under various interest-rate scenarios using both static and dynamic simulations. Smaller retail banks, however, are expected to make significant improvements to the risk framework and system landscape in order to comply with the new IRRBB standard.
The final standard, expected to be announced by FINMA in spring this year, will come into effect on 1st January 2019. In order to comply with national regulation by January 2019, retail banks need to identify the gaps they have to close to comply with the new FINMA standard. Retail banks in Switzerland are expected to face the following challenges:
- Governing body (and delegates) must ensure they have a proper understanding of IRRBB, risk measures, advantages and disadvantages of risk measures and behavioral assumptions;
- Both economic value and earnings risk models must be enhanced (where needed) in order to measure economic value and earnings risk under a broader range of interest-rate scenarios. Quantitative requirements and level of sophistication of these models are expected to be proportional to the size and complexity of the bank;
- Risk appetite and limit framework as well as risk reporting must reflect both risk perspectives. Interest-rate risk is measured relative to the defined limits and changes in risk are explained in the risk report. Both internal risk reporting and public disclosure has to fulfill additional quantitative requirements. Also here the proportionality principle holds;
- A proper governance framework surrounding behavioral assumptions in the banking book has to be established to mitigate model risk. Key behavioral assumptions should also be tested under stressed market conditions.
Banks are expected to allocate a significant amount of time and resources in the implementation of the new standard in their risk system. After the publication of the final standard by FINMA, banks do not have much time left to comply with the new standard and its principles by the beginning of 2019.
On June 26th 2018 we are hosting an “Interest Rate Risk in the Banking Book” (IRRBB) event at hotel Glockenhof in Zürich. Please feel free to request Martijn Wycisk or Sjoerd Blijlevens for more details if you are interested in attending our event.