»Embedded options have dramatically increased the complexity of measuring the interest rate risk inherent in banking book positions. In order to assess this risk properly, market parameters and client behaviour will need to be modelled on a consistent basis.«

Thomas Hungerkamp, Partner LPA


Financial institutions are currently facing a variety of regulatory changes with regard to the interest rate risk inherent in their banking books (IRRBB). The main challenges when implementing changes include frequently inadequate data on embedded options in banking book exposures, together with a lack of consistent model assumptions from the perspective of economic value and earnings.

A summary of our services for IRRBB

IRRBB and its regulatory backdrop

IRRBB (Interest Rate Risk in the Banking Book) is one of the most significant risks that financial institutions have to contend with, and it is currently a topic of high priority for Europe’s banking supervisory authorities. IRRBB describes the current and future risk to a bank’s earnings and value (and, thus, its capital) arising from movements in interest rates that affect banking book positions.

Financial institutions currently face a raft of regulatory changes with regard to the handling of IRRBB under the Pillar 2 approach. These include BaFin Circular 9/2018 (BA), the standards elaborated by the Basel Committee on Banking Supervision (BCBS 368) and the implementation of the BCBS standards in the European Union via the EBA guidelines (EBA/GL/2018/02), not to mention the Capital Requirements Directive IV (Directive 2013/36/EU).

IRRBB: updated BaFIN circular

On 12 June 2018, the BaFin published a new circular (9/2018 (BA)) that had been submitted for consultation at the end of the previous year. The revision and replacement of the existing circular (11/2011 (BA)) was aimed at aligning the rules with the applicable EBA guidelines (EBA-GL 2015/08) without pre-empting future regulations (final BCBS standards on IRRBB #368, publication of new guidelines EBA/GL/2018/02, and revision of the Capital Requirements Directive IV). Therefore, the circular confined itself, as before, to a description of how to calculate standard interest rate shocks.

The key changes in the revised circular:

  • Incorporation of cashflows without margins: in line with the 2015 EBA guidelines and the final BCBS standards, cashflows can be mapped either using the external interest rate (with margin) or via an internal interest rate (without margin) when calculating interest rate risk.
  • Elimination of the alternate procedure: the alternate procedure introduced for banks not measuring interest rate risk from an economic-value perspective will be eliminated, as interest rate risk must now be measured in terms of both economic value and earnings.
  • Alternative shock level: in order to standardise the procedure for calculating IRRBB, the alternative shock level described in the 2015 EBA guidelines will not be adopted by BaFin.
  • Institutions appointed directly by the ECB: such institutions will be permitted to submit the necessary ECB reporting data to BaFin as well.

The updated circular also deals with other issues, such as the methods to be applied in the case of negative interest rates. In line with the EBA guidelines and the BCBS standards, it also contains an explicit reference to the inclusion of automatic and behavioural interest rate options in the calculation.

Further challenges posed by IRRBB

What is more, the fact that the circular continues to deal only with the scenario of a parallel shift in the yield curve of ± 200 bp and ignores all six of the scenarios named in the final BCBS standards (“parallel up, parallel down, steeper, flatter, short rates up, short rates down”) suggests that a number of additional regulatory changes may be in the offing in the near future.

In addition to the requirements set out in the BaFin circular, financial institutions also face the challenge of having to implement the new EBA guidelines (EBA/GL/2018/02) and the associated parts of the final standards of the Basel Committee on Banking Supervision (BCBS 368).

Further steps and measures are set to follow through the introduction of the CRD V / CRR II and the final draft of the Commission’s regulatory technical standards (RTS) as commissioned by the EBA. These will give rise to even more specific requirements, such as inclusion of credit-spread risk (CSRBB) and in terms of the standard approach to be adopted.

(see also https://www.l-p-a.com/news/die-umsetzung-der-eba-leitlinien-zu-zinsaenderungsrisiken-im-bankbuch-stellt-institute-vor-grosse-herausforderungen/)

The new EBA guidelines once again emphasise the dual approach of measuring and controlling interest rate risk from both the “economic value of equity” (EVE) and “earnings/net interest income (NII)” perspectives. The explicit sub-types of IRRBB risk to be considered are basis risk, gap risk and option risk. In addition to traded options (i.e. contractual options such as interest caps and floors), the latter sub-type must include embedded options (i.e. behavioural options such as early repayment rights in loans).

In certain bank systems, it is not readily possible to map covenants adequately: besides having to identify the relevant components, it may be the case that the requisite measurement models are not available. The very existence of an optionality risk may not always be captured by a bank’s systems and may not even be measurable yet in technological terms.

Important: dynamic models of client behaviour

Besides ensuring that data is captured on a consistent basis and that IRRBB monitoring and reporting is fully automated, banks – depending on their SREP categorisation – face the major challenge of having to deploy appropriate dynamic models capable of mapping customer behaviour in the case of interest rate fluctuations.

When interest rates rise or fall, not only does interest expenditure and income change, but also the economic value of the bank’s in-force business. On the assets side of the balance sheet, banks must continue to take account of possible changes in credit volume arising from new business, special rights of repayment and termination, and changes in the utilisation of credit lines by clients. On the liabilities side, customer behaviour must be factored in when determining the size of the deposit volume. The consistent modelling of assumptions on client behaviour in all scenarios, as well as from the perspective of economic value and earnings, is a major challenge for many financial institutions.

The low and negative interest rate environment that has predominated over the last ten years is proving to be an obstacle to the development of dynamic client models like these, as there are no parallels in history that can be used to predict how clients and banks will respond when interest rates actually begin to rise again.

How we can support you in matters concerning IRRBB

We have amassed years of experience in assessing financial products and the associated risks, as well as in analysing and optimising investment and credit portfolios. And we want you to profit from that know-how by putting our financial market, product and IT expertise to work for you.

We can help you master new challenges in an efficient and sustainable way. Come talk to us.

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Thomas Hungerkamp
Thomas Hungerkamp
Ihr Ansprechpartner für Regulation & Technology

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Thomas Hungerkamp
Thomas Hungerkamp
Ihr Ansprechpartner für Regulation & Technology