What is Interest Rate Risk in the Banking Book (IRRBB)?
In 2016, the Basel Committee on Banking Supervision (BCBS) issued new standards on Interest Rate Risk in the Banking Book commonly referred to as IRRBB. Before these standards, the Basel Committee had issued guidance on interest rate risk management in their 2004 paper “Principles for the management and supervision of interest rate risk” The new standards are expected to replace this old guidance.
The interest rate risk in banking book refers to the risk to a bank’s capital and earnings arising from adverse movements in interest rates that affect banking book positions. Any changes in interest rates have an impact on the present value of future cash flows on the bank. This impacts the underlying value of the bank’s assets, liabilities and off-balance sheet items. This results in a chance in its economic value. When interest rates change, it will impact the bank’s earnings as its net interest income (NII) will change that depends on interest-rate sensitive income and expenses.
The IRRBB arises in three forms:
- Gap risk: This arises from the changes in term structure of interest rates that impacts the banking book instruments.
- Basis risk: This describes the impact of relative changes in interest rates for financial instruments that have similar tenors but are priced using different interest rate indices.
- Option risk: This arises from option derivative positions or from optional elements embedded in a bank’s assets, liabilities and/or off-balance sheet items
As per the new IRRBB standards, banks are required to calculate their IRRBB exposures based on the impact on economic value of equity (EVE) under a set of prescribed interest rate shock scenarios, either using the standardised framework or internal models.
Banks that have IRRBB exposures exceeding 15% of their Tier 1 capital are identified as “outliers” and considered as potentially having undue IRRBB and subject to review. In addition, banks are required to disclose their IRRBB exposures to the public on a regular basis.
The Revised IRR Principles
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