EBF: Interest rate risk in the banking book – FAQs

13 February 2015

This publication has been prepared in response to the questions raised during outreach meetings.

This publication is subject to regular updates.

Question 1 - Do financial institutions run open asset-liability mismatches that can be the source of value depletion in a rising rate environment?

Bank’s ALM departments perform comprehensive measurement and management of balance sheet positions to effectively steer liquidity and interest rate risk. Oversight is done by independent risk and control functions. Applying extensive analysis to align bank’s positions arising from their usual business includes the aggregation of contractual positions as well as the behavioural modelling where contractual information are not sufficient.

The above descriptions aim to briefly outline examples where and how banks manage their risks on a daily basis. A proper governance and control around this function is key to manage this according to a bank’s senior management risk appetite and subject to regulatory requirements.

Question 2 - What is meant by Economic Value and why does the industry view differ to that of the Task Force on the Interest Rate Risk of the Basel Committee for Banking Supervision (TFIR)?

The economic value (EV) has never been formally defined neither by the industry nor by the Basel Committee. There are several possible ways to define EV:

• The simplest approach is to compute the Net Present Value (NPV) of all existing principal fixed cash flows using a “risk free” curve, and then to re-compute using an appropriately “shocked” curve. The difference in NPV then constitutes the EV sensitivity to a given rate shock. This is the approach that is often referred to as a static cash flow gap approach as the re-pricing or maturity dates of products are assumed to be the same regardless of the interest rate shock


• One variation to this approach is to include fixed interest cash flows (besides the principal cash flows). This appears to be the approach envisaged by the TFIR based on the first QIS template


• A more significant variation is a dynamic gap approach whereby re-pricing dates and maturity dates are themselves modelled as being a function of the interest rate shock; to an extent, this can help capture margin compression, pre-payment risk etc


• Others consider EV as a measure of the market or fair value of the book, but, because there is no market for some Banking Book products-and therefore no market price-the term “economic value” is used instead. In this approach, the value of such non-traded products is computed as the NPV of all their cash flows using, for each product category, a separate risk adjusted discount curve. Clearly this is an advantage over the above approaches, as the base EV is likely to be a far truer representation of the value of the book, but whether, for the purposes solely of computing a sensitivity to a change in the level of general interest rates, this approach has any real advantage is not clear


• Another view is that EV is the present value of all projected future NII – i.e. taking into account future business and the bank’s ability to re-margin. This seems to be fundamentally an income approach, modified solely to give a view as to the true likely value of the bank in the event of its sale or liquidation

Question 3 - What is meant by behavioural risk? Is it possible to hedge this?

The nature of IRRBB is to a large extent a combination of behaviours and conventions. Behaviours and business developments are not only based on efficient-financial-market-rationality. Behaviours can be driven by many other factors, including, for example, social and demographic circumstances. Those behaviours affect loans and deposits’ balances (prepayment, rollover, product switching) and customer rates.

IRRBB is therefore dependent on those behaviours. Models are developed and maintained on the basis of a combination of historical data analyses and customer behaviour assumptions as not everything can be derived from historical experience. In order to manage the IRRBB, the modelled interest rate risk exposure must be translated into theoretical marketable financial instruments that are similar to those of the trading environment.

Behavioural risk refers to the possibility of reduced P&L or losses due to customer behaviour being uncertain and different to that which is expected/modelled. The ability to fully immunise a bank against variance is not possible due to the behavioural nature of Banking Book items. As such, the role of ALM in conjunction with business units is to identify and actively monitor customer behaviour on a periodic basis to minimise any variance in realised vs expected customer behaviours

Question 4 - Could the new proposals reduce bank's incentives to provide fixed-rate products?

The mini QIS required banks to enter into the re-pricing gap not just the principal amounts of loans, deposits and derivatives, but also all interest flows which were fixed as at the date of submission. Typically banks will hedge all fixed rate products, either with derivatives or offsetting customer positions, with the result that the net fixed interest rate position will effectively equal the margin on the fixed rate product, and generally this will be positive for both asset products (loans) and liability products (deposits). Applying this rule, therefore, will almost invariably create a net asset position on the gap report for those banks that offer fixed rate products, and any EV or EVE methodology will suggest that the bank is at risk to rates rising.

Full FAQ

EBF_position paper on Interest Rate Risk in the Banking Book

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