Monday, 14 November 2016

The new Basel IRRBB: regulatory and internal consequences

Last April, the Basel Committee issued its new standard on the interest rate risk in the banking book presenting a new standardised framework. This new standard is to be implemented by 2018. Here Xavier Dubois, Senior Risk & Finance Specialist for Wolters Kluwer’s Finance, Risk and Reporting business looks at some aspects of the standardised framework, how it could be implemented in Europe and its interest for the bank governing bodies.

In April, the Basel Committee on Banking Supervision issued standards for Interest Rate Risk in the Banking Book (IRRBB). The standards revise the Committee's 2004 Principles for the management and supervision of interest rate risk, which set out supervisory expectations for banks' identification, measurement, monitoring and control of IRRBB as well as its supervision.

In a nutshell the new standard realises a significant improvement in the management of interest rate risk in the banking book. Not only does it provide a standardised measurement closer to economic reality, and thus more useful for the bank management, particularly in this time of low interest rates, but it also provides standardisation that increases transparency, not only from banks, but also from supervisors. Banks will have to adopt this new framework and should take this opportunity to move towards a technologically sound and solid risk framework with automation and integration, for supervision and, last but not least, for the governing body.

A real improvement: the new standardised interest rate shocks

The current prescribed interest rate shocks for IRRBB by Basel are at +/- 200 basis point parallel shift. This simple shock had the advantage of being simple and easy to compute, but it is way too far from reality.

The new standardised framework for IRRBB comes with six scenarios to measure changes of the economic value of equity (EVE): 2 parallel (up and down), a “steepener” and a “flattener”, and two short shocks (up and down). More than the names, the below graphics make these shocks easy to understand.

Obviously, these shocks provide significant improvement in the coverage of shock patterns, which the market could face. They make the shocks more realistic and still understandable for the governing body of each bank (that) is responsible for oversight of the IRRBB management framework, and the bank’s risk appetite for IRRBB (Principle 2).

Not only are these standardised interest rate shocks more instructive, but they are now better linked to the actual local market situation. In order to do this, the Basel Committee determined the size of the shocks (parallel, long, short) for each major currency based on historical rates. So the standard parallel shock can range from 100 bps for CHF and JPY to 400 bps for BRL and RUB, keeping 200 bps for EUR and USD.

Reflecting historical data (from 2000 to 2015) of local rates, this second adaptation definitely improves the relevancy of the scenario results. Another positive point is theses shock sizes per currency are meant to be reviewed to really keeping up with the local market reality of interest rates.

No doubt that the combination of the new six scenarios accommodating the local currency conditions bring better insight into the interest rate risk of the bank and are of direct benefit to the “governing body” of the bank. It is another good example of the movement of regulatory requirements getting closer to economic reality, and thus of the movement to increase their added value for the management of banks.

Coincidence? Low interest rate environment

Coincidence or not, the low interest rate environment makes the new standardized framework and its six interest rate shocks even more relevant to the situation. Low, and sometimes negative, interest rates reduce bank margins and have significant impact on profitability, depending on the part of interest margin in the bank overall revenue. In some countries, the move towards more revenue resulting from fees is already sensible, such as a general increase fixed costs for current accounts.

The new standardised framework and interest rate shocks get even more value, such as the impacts of changes on very low interest rates, which are more difficult to evaluate. It is a macro-economic of which we have very limited or no experience and it is the same for consumers and corporate behaviors in such circumstances. Therefore, with its far more accurate measurements, the new framework really provides better tools for banks to assess their interest rate risk in such an unknown environment. As implementation must be finished by 2018, early adopters might still experience the new framework in the current interest rate environment.

What will Europe do? 3 questions

Last year (22 May 2015) the European Banking Authority (EBA) published its revised guidelines on interest rate risk arising from non-trading activities, and less than one year after, the Basel Committee updates its guidelines introducing the standardised framework for IRRBB. Will EBA update its guidelines so shortly after revising it is the first question? The second question is: will EBA impose the standardised framework for IRRBB? The last question relates to regulatory reporting: will EBA take the opportunity of the standardised framework for IRRBB to create a standardised IRRBB reporting within the EU reporting framework?

Regarding the first question, there is a high probability that EBA will update its guidelines – effectively, European supervisors are active members of the Basel Committee. The contrary would be odd.

Secondly, will the EU/EBA impose the standardised framework for IRRBB to all member states? There has been no publication from EBA about this. However, we can acknowledge that imposing a standardised framework would fit the current trend of standardisation in order to achieve comparability. This is true in general, with e.g. IFRS, and, closer to the subject, with the new market risk framework that redefined more strictly the boundaries between trading and banking book, and imposed a standardised framework for market risk for all banks, even the ones applying internal models. It would also fit the will to reduce the number of national discretion in general within the CRR-CRDIV. Therefore, considering EU track record, we expect the standardised framework for IRRBB to be imposed in Europe.

The last question is about regulatory reporting. Currently reporting about interest rate risk of non-trading activities is part of the local reporting defined by national supervisors. Is the standardised framework not an opportunity for European authorities to strengthen and enlarge the Single Rule Book to a key risk factor for banks? It would make sense.

The final element: Brexit. Now that the UK voted for Brexit, the FCA and Bank of England will be clearly out of the negotiations. Will this have any influence on the decision, or its speed of application? Wait and see.

What’s in for the governing body? What should it expect?

As per the Basel Committee standard principle 2, “the governing body is the body that supervises the bank management and that is responsible for the oversight of the IRRBB management framework, and the bank’s risk appetite for IRRBB.(…) While governing body members do not need individually to have detailed technical knowledge of complex financial instruments, or of quantitative risk management techniques, they should understand the implications of the bank’s IRRBB strategies, including the potential linkages with and impact on market, liquidity, credit and operational risk.”

In the first instance, and as mentioned earlier, the six standardised scenarios are really understandable and thus the governing body should get better insight in the implications of the bank’s IRRBB strategies.

The governing body should also understand “the potential linkages with and impact on market, liquidity, credit and operational risk.” This is something where technology can really help and where vendors such as Wolters Kluwer demonstrate an innovative approach. While the standardised framework for IRRBB will need a significant time to be calculated according to the book (and the same applies to market, liquidity, credit risk), a top-down approach (using proxy of exact calculation) allows the governing body to see the impact of interest rate changes on IRRBB within a few seconds, together with the impact on liquidity or credit risk, applying the same proxy techniques on a top-down approach. Firms could benefit from technology to assess the impact of any key risk factor on all key risk metrics at the same time, within seconds. As the new IRRBB standard requires supervisors to publish their detailed criteria to determine outlier banks, the same technology could show outlying limits and limits breaches to the governing body in nearly real-time mode.

In conclusion, the new standard realises a significant improvement in the management of interest rate risk in the banking book. Banks will have to adopt this new framework and have an opportunity to move towards solid risk framework with automation and integration.

Xavier Dubois
Senior Risk & Finance Specialist
Wolters Kluwer Finance, Risk and Reporting

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