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.