Banks perform important roles in the economy by acting as financial intermediaries whereby they collect deposits from sectors with surplus liquidity and deploy these funds to finance long term development requirements of social and corporate infrastructure of the economy. The deposits typically are short term in nature reflecting general investment appetite and cash settlement requirements of the society while the financing needs are of longer term in nature thereby requiring banks to extend the maturities of their deposits through maturity transformation of their balance sheet. This act of maturity transformation involves building up structural maturity mismatches, pricing and currency basis mismatches on the balance sheet in addition to accommodating customer deviations from contractual terms leading to volatility in earnings and economic value of the bank. These risks involved in maturity transformation are named together as the Interest Rate Risk in the Banking Book (IRRBB).
A dynamic interest rate environment has prevailed since the 2008 financial crisis, during which yield curves in all major economies witnessed multiple steepening and flattening episodes even as short rates stayed at historically low levels. However, at the time of writing this, there are clear indications that a rising rate environment accompanied by a steepening of yield curves has set in given the recent positive GDP and employment data coming out of US buttressed by strong Fed action.
The Committee, through the revised guidelines has provided a more specific guidance on measurement of interest rate risk in terms of shock scenarios, behavioural and modelling assumptions, updated standardised framework which could be optionally adopted based on national discretion stricter thresholds for national regulators to identify outlier banks through the Pillar 2 supervisory process and lastly enhanced disclosure requirements to promote consistency and comparability across jurisdictions. To this effect, the guidance issued by the Committee as part of the "Principles for the management and supervision of interest rate risk, 2004" has been revised.
STANDARDISED APPROACH AND ASSOCIATED CHALLENGES
The Committee, despite leaving the implementation of the proposed approach to national discretion, has nevertheless sought to make the approach a benchmark for measuring IRRBB from a regulatory perspective making it a key component of managing banks' IRRBB. In its guidance to supervisors, the committee has recommended that they collect additional information on internal models of the banks, if approved, along with the EVE sensitivity as calculated using the standardised approach. While most banks already have systems that can measure NII and EVE sensitivity on a periodic basis, the reporting requirements under the new standardised approach make it necessary that banks build interest rate behaviouralisation models as prescribed in the guidelines or at the least amend/refit existing internal models to suit the reporting requirements.
Classification of balance sheet items: The first step of the standardised approach pertains to slotting of rate sensitive assets, liabilities and off-balance sheet items into predefined re-pricing buckets. While standard products with defined repricing nature can be slotted directly, less amenable products like non-maturing deposits or demand deposits (NMDs), prepayments in fixed rate loans, early terminations in term deposits and embedded optionality are subject to interest rate risk behaviouralisation. The guidelines are specific on inclusion of all interest rate sensitive items excluding CET1 capital. The implication is that rate sensitive equity instruments like perpetuals and other hybrid capital instruments that may form part of Tier 1 and Additional Tier 1 will be included as part of the analysis despite the interest expense of these items not being included as part of NII. It is important to note that the sensitivity of the NII thus computed may differ from the actual accounting NII and could be unfavourable if the re-pricing maturity of the equity instrument falls within the NII measurement horizon. On the other hand, the EVE measure will improve given discounting of additional balances on the liability side. Another category is the non-performing portfolio which under the approach is to be excluded from the analysis. It may however have a real impact on the balance sheet and earnings as it can start performing again.
Treatment of NMDs: As NMDs do not have contractual maturity dates, it becomes necessary for banks to assess what percent of the balances would run-off over various tenors. Banks typically classify these deposits into several groups which are expected to behave in a similar manner and perform a historical balance run-off analysis to observe the behaviour. The change in balance levels can further be analysed with respect to various other factors like interest rates, relationship history, etc. In the first step, the stable portion of balances which are expected to remain, undrawn for a long period of time are identified and in the second step, core deposits among these stable deposits which are unlikely to re-price even under significant changes to interest rate environment are identified. Banks typically model the historical balance run-offs for NMDs categorising them in tocurrent vs. savings and retail vs. wholesale. The guidelines also include transactional vs. non- transactional category also as well as part of the NMD modelling which will require keeping track of account wise historical transactional data along with balances. The guidelines also talk about introducing a separate category of "non-remunerated deposits" under NMD modelling. It is not clear if current account balances which are typically considered non-rate sensitive are also to be considered as part of interest rate risk behavioralisation of NMDs.
Divergence between regulatory and internal measures of risk: The committee has prescribed caps on the portion of deposits that can be considered as core as well as on the average maturity of core deposits. Measurement of interest rate risk under these caps may not reconcile with measurements made under internal models which do not use such thresholds. Special reconciliation analysis may be needed as results from both approaches which are expected to be submitted to supervisors. This further diminishes the natural hedging ability of NMDs and may lead to over-hedging of interest rate risks or curtailing the issuance of longer tenor fixed rate financing. Thus, banks forced to apply the standardised approach maybe ata disadvantage compared to bankswhich are approved to use internal models.
Prepayment and early redemption risks found in retail portfolios: Customers are more likely to repay loans earlier than expected when interest rates fall as they are able to refinance them through new facilities at lower costs. Many other factors like competitive pricing, lack of alternative investment options, changes in personal circumstances also lead to early repayments of loans. Similar early termination behaviour is observed for term deposits. Under the standardised approach, firstly, the baseline estimates of loan prepayments and deposit early withdrawals are calculated given the prevailing term structure of interest rates. It is important to note that these base line estimates may be biased depending on the nature of interest rate history prevailing in the observation period. In the second stage, these estimates are multiplied with scenario dependent scalars provided in the guidelines to adjust for expected prepayment/early-termination levels for each of the rate scenarios. Using these estimates, cashflows are amended and sensitivities calculated accordingly. The guidelines specifically talk about prepayments and early terminations where no penalty or cost is charged to the customers that will compensate the bank for the economic cost it incurs. However, most banks typically charge a fixed percent of the outstanding balance for prepayments that may or may not compensate for the economic cost. It is not clear if such cases are to be considered as prepayments and cash flows slotted accordingly. Additionally, there is no guidance on the treatment of prepayment behaviour observed in floating rate retail portfolios with longer tenors and on the continuous rollover behaviour observed in term deposits both of which form a significant majority of the retail portfolios in many jurisdictions.
Embedded automatic interest rate options: The guidelines prescribe stripping out embedded automatic interest rate options like rate caps and floors found in all assets, and prepayment options in wholesale assets and liabilities, and be treated together with explicit options. Banks would need to invest in valuation models/tools to perform full revaluation of these options under various rate scenarios for EVE computation.
The question of commercial margins for EVE computation: While it is widely agreed that NII computation will include the full interest income including the customer spreads, there are multiple ways to compute EVE as acknowledged by the Committee. Banks are given a choice to include commercial margins in the cashflows and if they choose to include the margins, the discounting is to be done using a rate curve which has commercial margins added on top of the risk-free rate. However, both the approaches i.e. excluding and including margins come with their own practical challenges. While stripping out commercial margins from customer positions is not straight forward given varying tenors and credit profiles, adding the commercial margins to the risk-free curve is also prone to judgement, which may lead to either over or under estimating the measure. A third and more accurate approach, albeit being a sophisticated one, would be to use the internal transfer pricing rates for estimating the cashflows. The transfer pricing approach seeks to strip out all other risks other than the business mandated credit risk from the customer pricing, thereby providing a pure view of interest rate and liquidity risks as managed by the ALM/funding center. This approach further helps to mitigate the risk of inflated EVE sensitivity on account of differences in the margins between assets and liabilities.
Static vs Dynamic approach: Static approach assumes a simplistic scenario where balances that mature simply rollover thereby keeping the balance sheet similar in volume level and term structure. In addition to the prescribed static balance sheet approach, it would be advisable for banks to consider dynamic balance sheet simulation where planned/budgeted balance growth for various product categories is considered for the measurement of earnings volatility to capture the full expected impact of interest rate risk in the short to medium term. Even then, a majority of banking book products and businesses are of a stable nature, and a full review of a dynamic earnings simulation is typically required only as part of a strategic planning exercise. However, such dynamic approach cannot be applied for the EVE measure which considers the balance sheet run-off over the long term and any growth assumptions will not remain realistic over such long term.
Tackling Credit Spread Risk in the Banking Book (CSRBB): The guidelines define a new associated risk component called CSRBB as any kind of asset/liability spread risk of credit-risky instruments that is not explained by IRRBB and by the expected credit risk. While explaining the various components of interest rates, the guidelines refer to various market related general liquidity/credit risk spreads and funding margins inherent in market prices of various instruments that are distinct from pure interest rates and idiosyncratic credit risk spreads. In December 2011, the Financial Stability Institute published a working paper titled ?Liquidity transfer pricing: A guide to better practice? highlighting the importance of considering liquidity premium in the internal transfer pricing and suggested a methodology to do so. The funding margin and market related spreads discussed in the new guidelines are similar in nature to the proposed liquidity premium and can be used as a basis to define shock scenarios for the measurement of CSRBB. The guidelines imply through the definitions of interest rate components that it is applicable only to fair valued items on the balance sheet. However, it is also implied that the funding margin which forms part of the internal transfer pricing and applicable on all assets and liabilities also incorporates elements of CSRBB. It is important to note that the funding rate applicable for fixed rate loans show in the below illustration can also be broken down into a base interest rate and a liquidity premium/margin.
Implications for IT infrastructure: The interest rate behavioural models require banks to capture more granular positional and transactional data and store it for longer period of time (10 years). These data requirements coupled with analytical requirements could further tax the resources and systems of banks which are already struggling to meet implementation deadlines for other regulations like IFRS 9, Basel III Capital standards and ILAAP requirements. As stated earlier, most banks already have ALM solutions that can compute EV and NII measures. However, what is needed for the implementation of IRRBB guidance is a flexible analytical solution that can sit on top of existing data warehouse or ALM solution and enables development of interest rate risk behavioural models, quick deployment of shock scenarios and computes incremental sensitivities to changes in balance sheet compositions.
FINAL WORDS It stands to reason that the rising rate environment coupled with the new regulatory guidelines pose unique challenges for maintaining an optimum balance sheet mix composition that can ensure to preserve NIM in the short term and the overall economic value-add of the balance sheet position in the long term. It is of paramount importance for banks to consider key issues like funding mix, customer tenor preferences, market competition, declining prepayments and run-off pressure on NMDs as they leave the banking system for better investment alternatives. Furthermore, given the dynamic nature of the current rate environment, regulators are most likely to give stronger emphasis on IRRBB through the supervisory review process and non-compliance will not be an option.
Director & Delivery Head (MEA & India Region)
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