Interest rate risk in the banking book is the risk posed by adverse movements in interest rates that cause a mismatch between the rates banks set on customer loans and on deposits. For example, if rates were to increase and a bank’s deposits repriced sooner than its loans, it could result in the bank paying out more interest on deposits than the interest it is receiving from loans. The mismatch would subsequently bite into the bank’s net interest income, as well as affecting the economic value of its equity (EVE), which is derived by discounting future cash inflows and outflows. In April 2016, the Basel Committee on Banking Supervision finalized a new regulatory framework for IRRBB. Earlier drafts attempted to establish a standardized Pillar 1 capital charge for IRRBB but members were unable to agree on this. Instead, the committee created a set of standardized public disclosures whereby banks have to report outcomes of interest rate shock scenarios calculated based on both net interest income and EVE methodologies. EVE is specifically used to measure banks’ IRRBB in a standardized outlier test, with supervisors entitled to take action if a bank experiences a change in EVE of more than 15% of common equity Tier 1 under the outlier test. The standards also govern the assumptions banks should use when modelling non-maturity items such as deposits that do not have a fixed term, and loan prepayment risks. The final Basel standards allow supervisors to impose capital charges under Pillar 2 of the Basel regime, providing the flexibility to impose charges where they are deemed necessary, specific to each bank. In the European Union, IRRBB is captured under the Capital Requirements Directive while in the US it is regulated by the Federal Reserve and Office of the Comptroller of the Currency.
INTEREST RATE RISK IN THE BANKING BOOK (IRRBB)
