RiskTech Forum

AxiomSL: IRRBB - Identify, Mitigate and Effectively Manage This Regulatory Challenge

Posted: 24 January 2017  |  Source: AxiomSL

Interest rate risk is a bank’s exposure to adverse movements in interest rates. Interest rate risk in the banking book (IRRBB) refers to the current or prospective risk to the bank’s capital and earnings arising from adverse movements in interest rates that affect the institution’s banking book positions. It arises because interest rates can vary significantly over time, while the business of banking typically involves intermediation activity that produces exposures to both maturity mismatch and rate mismatch together with options that are embedded in many of the common banking products that can get triggered when interest rates change.

Changes in interest rates affect a bank’s earnings by altering interest-sensitive income and expenses, thus affecting its net interest income (NII). When interest rates change, the present value and timing of future cash flows change as well. This in turn affects the underlying value of a bank’s portfolio and hence its economic value (EV). Excessive levels of interest rate risks in the banking book can, therefore, pose a significant threat to an institution’s earnings and capital base. Accordingly, effective risk management that maintains interest rate risks at prudent levels is essential to the safety and soundness of banking institutions. It is therefore important for banks to be able to (a) identify interest rate risks- IRRBB risk types, profiles and how it affects the different instruments in the bank’s portfolio (both balance and off-balance sheet), (b) measure these risks using different methodologies, models and assumptions, (c) mitigate and control some of these risks in accordance to the bank’s risk strategy through portfolio changes, limit setting, hedging or other means, and (d) monitor these risks on a regular basis through effective governance and periodic reporting based on a sound infrastructure.

Of late, management of Interest Rate Risk in the Banking Book (IRRBB) is receiving considerable attention, mainly owing to two complementary factors. First is the market condition wherein interest rates have been at a historical low for a long time and the resultant uncertainties posed by the possibly divergent policy response from the central banks together with recent market volatility and customer response to such rate changes. The second and probably immediate reason is the regulatory compliance requirement wherein the Basel Committee on Banking Supervision (BCBS) has issued Standards to be implemented by January 2018 that prescribes a strengthened Pillar II approach and set out broad guidelines for banks’ identification, measurement, monitoring and control of IRRBB. As a result of these, banks are giving special attention to the enhancement of IRRBB management and integration with other risk and finance compliance and operational framework. This is supplemented by increasing focus on improvement of IRRBB governance and closer attention to the assumptions and management techniques used for IRRBB.

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