IRRBB: Interest rate risk in the focus of supervisory activities

Supervisory authorities have already been focusing on the interest rate risk in the banking book (IRRBB) since 2015. The first steps were taken by the Basel Committee with the consultative document on IRRBB standards (BCBS #319), the final version of which was published in April 2016 (BCBS #368). Shortly afterwards the European Banking Authority (EBA) published guidelines on IRRBB (EBA/GL/2015/08), which entered into force on January 1, 2016. At the end of 2016, new drafts for the CRR (CRR II) and CRD (CRD V), which among other things deal with IRRBB, were presented for consultation. But ever since the publication of the revised EBA guidelines on IRRBB in October 2017, with consultation closing at the end of January 2018, numerous institutions have tried to identify the correlation between these regulatory publications or between the requirements that may be derived for their specific institution. Figure 1 provides a summary of the regulatory documents which have already been published or which are scheduled for the next few years:

Figure 1: Regulatory roadmap for IRRBB (international perspective)

Figure 1: Regulatory roadmap for IRRBB (international perspective)

In light of this complexity, this article summarizes the content and main challenges of the major regulatory publications and explains the interdependencies among the individual initiatives. The BCBS and EBA papers represent the focus of attention, especially the EBA guidelines update, which is particularly important for institutions subject to ECB supervision.

BCBS #368 standards on IRRBB

Although strictly speaking, the papers published by the Basel Committee on Banking Supervision (BCBS) only represent a recommendation and do not have any direct legal effect, they serve as a guiding framework for the European and national supervisory authorities which use them as a basis for their own regulatory initiatives. The same applies for the standards on interest rate risk in the banking book, which were published in April 2016 and according to the BCBS specifications are to be implemented as of 2018 by the responsible supervisory authorities.

The Basel paper can be divided into three large sections: new requirements for interest rate risk management (Principles 1 to 7), disclosure requirements (Principles 8 and 9) and requirements for supervisory authorities (Principles 10 to 12). The paper also includes a standardized approach for measuring interest rate risk. While in the BCBS #319 original consultative document this standardized approach was still related to capital requirements, in the final version it represents a fallback solution that institutions can voluntarily apply or have to apply if the internal models are deemed inadequate by supervision.

The BCBS paper particularly focuses on the duality of the measurement and control of risks to economic value and to future earnings that could arise from adverse movements in interest rates. In the future, it will not be sufficient to take only one of the two perspectives into account. Instead, banks will have to consider and integrate the implications for capital requirements and management of  both perspectives. Despite the required integrated interest rate book management, institutions will be more flexible in managing and measuring interest rate risk. For instance, according to BCBS #368 institutions will be able to choose whether to include or exclude commercial margins into the cash flow when calculating the change in economic value for the Supervisory outlier test.

In addition to content-related conceptual issues, institutions will face major challenges regarding the technical implementation of these new requirements. BCBS #368 also defines stricter requirements in terms of the numbers and design of applicable interest rate scenarios, disclosure and IRRBB governance. Besides specific IRRBB requirements, the BCBS standards also call for an adequate consideration of credit spread risk in the banking book (CSRBB).

EBA guidelines on IRRBB management (EBA/GL/2015/08)

On a European level, as early as in 2015, the EBA already published new guidelines on the management of interest rate risk in the non-trading book (EBA/GL/2015/08), which replaced the CEBS guidelines on technical aspects of the management of interest rate risk arising from non-trading activities, which had been in force since 2006. The EBA guidelines can be divided into five high-level guidelines (IRRBB 1–5): internal capital, measurement of IRRBB, interest rate shock scenarios, internal governance arrangements / IRRBB policies and supervisory standard shocks. In contrast to BCBS #368, credit spread risk has explicitly not been included in the EBA guidelines.

Similarly to BCBS #368, the EBA guidelines also require interest rate risk to be considered from an economic value and earnings perspective and furthermore contain several methodical and model-specific restrictions and requirements for calculating the Supervisory outlier test.

The EBA guidelines entered into force on January 1, 2016, and are specifically relevant to institutions directly supervised by the ECB. But the national supervisory authorities in the EU have also announced their intention to comply with and consequently implement the EBA standards. Germany, for example, is going to implement some of the requirements regarding the Supervisory outlier test with the revision of the BaFin circular 11/2011.[1]

Figure 2 summarizes the main aspects of EBA/GL/2015/08 and BCBS #368:

IRRBB Figure 2

Figure 2: Summary of IRRBB requirements in BCBS #368 and EBA/GL/2015/08

To synchronize the requirements of both papers and to accommodate the latest regulatory developments, the EBA published an update to the IRRBB guidelines in October 2017, which at the same time represents the first step towards the implementation of the Basel standard on a European level.

Revision of EBA guidelines on IRRBB: first step towards the transposition of BCBS #368 into European law

At the beginning of 2017, the EBA already announced an update of EBA/GL/2015/08 in their “Pillar 2 Roadmap”. As mentioned previously, this is to be seen against the background of the new requirements laid down in the BCBS standards and their upcoming transposition into European law. In this context, the EBA guidelines update is to represent a first step in the BCBS #368 implementation.

Consequently, large parts of the requirements for measuring and managing interest rate risk from Principles 1 to 7 of the BCBS standard can also be found in the new EBA guidelines. In addition, some parts of the currently valid EBA guidelines were adopted and some new requirements added which mostly refer to the Supervisory outlier test or the so-called outlier test. With these new requirements, the EBA aims to improve comparability among institutions. Besides some familiar elements from EBA/GL/2015/08, such as the limitation of the maximum average maturity to five years for non-maturity deposits without fixed interest and capital lockup and the consideration of automatic and behavioral optionality, this will also lead to a certain methodical flexibility in the future. For instance, in analogy to the procedure described in BCBS #368, institutions can choose whether to include or exclude commercial margins into the cash flow when calculating the change in economic value for the Supervisory outlier test, but should ensure consistency with the internal risk measurement procedure.

The scope of the EBA guidelines was extended to include not only the new IRRBB-specific requirements, but—similarly to BCBS #368—also CSRBB.

This leads to the five sections illustrated in Figure 3: general (high-level) provisions, internal capital (identification, calculation and allocation), governance, (risk) measurement and outlier test as well as an additional chapter with definitions.

Figure 3: EBA/CP/2017/09 contents and comparison with current EBA/GL/2015/08 and BCBS #368

Figure 3: EBA/CP/2017/09 contents and comparison with current EBA/GL/2015/08 and BCBS #368

However, the update of the EBA guidelines only represents the first step towards BCBS #368 implementation. With the CRR II, CRD V and other already announced EBA papers, more and more components of the BCBS standards will be gradually implemented in the next few years.

Further steps towards BCBS #368 implementation

While BCBS #368 is directed at institutions and supervisory authorities, the EBA and the latest EBA guidelines exclusively address institutions. The BCBS #368 requirements for supervisory authorities, however, can be found in the EBA’s latest SREP guideline (EBA/CP/2017/18), which is also available in a revised version and has been presented for consultation together with the new EBA guidelines. The other elements, such as disclosure and the standardized approach, will be implemented by means of the CRR II and CRD V and EBA’s related additional Regulatory Technical Standards (RTS). The following figure illustrates the interaction between the planned initiatives:

IRRBB Figure 4

Figure 4: Interaction of planned initiatives regarding IRRBB

Conclusion and challenges

With their latest publications, the supervisory authorities have made a first step towards the implementation of IRRBB standards according to BCBS #368 on a European level. What’s more, the future roadmap of upcoming publications has also been clearly defined. Hence more and more elements of the BCBS standards will be gradually implemented and transferred into supervisory practice. This will at least  reduce the uncertainty about regulatory issues to a certain extent. But at the same time, institutions will be facing numerous conceptual and technical challenges. In the future, they will need to control interest rate risk from an economic value and earnings based perspective and consider the stimuli of both control perspectives. Additionally, requirements for scenarios and the related parameters, such as exercise rates, have increased considerably. Depending on the individual complexity, the Supervisory authorities demand a dynamic approach for cash flows subject to behavioral optionality, which requires a sound overall structure of scenarios and parameters, such as exercise rates. Institutions will also have to comply with numerous other requirements and restrictions, for example in the Supervisory outlier test.

Therefore they will be constrained to deal with the latest requirements, implications and potential room for maneuver as early as possible to ensure compliance once the new requirements become effective. And they will have to make sure that the subject-specific requirements will be technically feasible. zeb.control and its IRRBB module already provide for these latest regulatory developments and fully ensure this technical feasibility.

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