This new update is triggered by the revised Capital Requirements Regulation (CRR2) and Capital Requirements Directive (CRD5). Both documents were adopted by the Council of the EU and the European Parliament in 2019 as part of the Risk Reduction Measures package. The CRR2 and CRD5 included numerous mandates for the EBA to come up with new or adjusted technical standards and guidelines. These are now covered in three separate consultation papers

1. The first consultation paper¹ describes the update of the IRRBB Guidelines themselves.
2. The second paper² concerns the introduction of a standardized approach (SA) which should be applied when a competent authority deems a bank’s internal model for IRRBB management non-satisfactory. It also introduces a simplified SA for smaller and non-complex institutions.
3. The third consultation paper³ offers updates to the supervisory outlier test (SOT) for the Economic Value of Equity (EVE) and the introduction of an SOT for Net Interest Income (NII). Read our analysis on this consultation paper here »

In this article we focus on the first consultation paper. The update of the IRRBB Guidelines can be split up in three topics and each will be discussed in further detail:

• Additional criteria for the assessment and monitoring of the credit spread risk arising from non-trading book activities (CSRBB)
• The criteria for non-satisfactory IRRBB internal systems
• A general update of the existing IRBBB Guidelines

CSRBB

The 2018 IRRBB Guidelines introduced the obligation for banks to monitor CSRBB. However, the publication did not describe how to do this. In the updated consultation paper the EBA defines the measurement of CSRBB as a separate risk class in more detail. The general governance related aspects such as (management) responsibilities, IT systems and internal reporting framework are separately defined for CSRBB, but are similar to those for IRRBB.

Also similar to IRRBB is that banks must express their risk appetite for CSRBB both from an NII as well as an economic value perspective.

The EBA defines CSRBB as:

“The risk driven by changes of the market price for credit risk, for liquidity and for potentially other characteristics of credit-risky instruments, which is not captured by IRRBB or by expected credit/(jump-to-) default risk. CSRBB captures the risk of an instrument’s changing spread while assuming the same level of creditworthiness, i.e. how the credit spread is moving within a certain rating/PD range.”

EBA

Compared to the previous definition, rating/PD migrations are explicitly excluded from CSRBB. Including idiosyncratic spreads could lead to double counting since these are generally covered by a credit risk framework. However, the guidelines give some flexibility to include idiosyncratic spreads, as long as the results are more conservative than when idiosyncratic spreads are excluded. This is because, based on the Quantitative Impact Study of December 2020 (QIS 2020), banks indicated to find it difficult to separate the idiosyncratic spreads from the credit spread.

Also, the scope of CSRBB has changed from the current IRRBB Guidelines. All assets, liabilities and off-balance-sheet items in the banking book that are sensitive to credit spread changes are within the scope of CSRBB whereas the 2018 IRRBB Guidelines focused only on the asset side. Based on the results of the QIS 2020, the EBA concluded that most of the exposures to CSRBB are debt securities which are accounted for at fair value (via Profit and Loss or Other Comprehensive Income). However, this does not rule out that other assets or liabilities could be exposed to CSRBB. It is stated that banks cannot ex-ante exclude positions from the scope of CSRBB. Any potential exclusion of instruments from the scope of CSRBB must be based on the absence of sensitivity to credit spread risk and appropriately documented. At a minimum, banks must include assets accounted at fair value in their scope.

We believe that the obligation to report CSRBB for all assets accounted for at fair value will be challenging for exposures that do not have quoted market prices. Without a deep liquid market, it will be difficult to establish the credits spread risk (even when idiosyncratic risk is included).

Another possible candidate to be included in the scope of CSRBB is the issued funding on the liability side of the banking book, especially in a NII context. When market spreads increase, this could become harmful when the wholesale funding needs to be rolled over against higher credit spread without being able to increase client interest on the asset side. Similar to IRRBB, the exposure to this risk depends on the repricing gap of the assets and liabilities. In this case, however, swaps cannot be used as hedge.

Other products such as consumer loans, mortgages, and consumer deposits, which are typically accounted for at amortized cost, are less likely to be included. This is also stated by the BCBS standards. The BCBS states that the margin (administrative rate) is under absolute control of the bank and hence not impacted by credit spreads. However, it is unclear whether this is sufficient to rule these products out of scope.

Non-satisfactory IRRBB internal systems

The EBA is mandated to specify the criteria for determining an IRRBB internal system as non-satisfactory. The EBA has identified specific items for this that should be considered. At a minimum, banks should have implemented their internal system in compliance with the IRRBB Guidelines, taking into account the principle of proportionality. More specifically:

• Such a system must cover all material interest rate risk components (gap risk, basis risk, option risk).
• The system should capture all material risks for significant assets, liabilities and off-balance sheet type instruments (e.g. non-maturing deposits, loans, and options).
• All estimated parameters must be sufficiently back tested and reviewed, considering the nature, scale and complexity of the bank.
• The internal system must comply with the model governance and the minimum required validation, review and control of IRRBB exposures as detailed by the IRRBB guidelines.
• Competent authorities may require banks to use the standardized approach³ if the internal systems are deemed non-satisfactory.

General update of existing IRRBB Guidelines

Major parts of the guidelines for managing IRRBB have not changed. In the section on IRRBB stress testing, however, a new article (#103) for products with significant repricing restrictions (e.g. an explicit floor on non-maturing deposits – NMDs) is introduced. As part of their stress testing, banks should consider the impact when these products are replaced with contracts with similar characteristics, even under a run-off assumption. The exact intention of this article is unclear. For NII-purposes it is common practice to roll over products with similar characteristics (or use another balance sheet development assumption). Our interpretation of this article is that banks are expected to measure the risk of continued repricing restrictions in an economic value perspective when the maturity of those funding sources is smaller than the maturity of the asset portfolio. This may for example materialize when banks roll over NMDs that are subject to a legally imposed floor.

Another update is the restriction on the maximum weighted average repricing maturity of five years for NMDs. This cap was prescribed for the EVE SOT and is now included for the internal measurement of IRRBB. We believe that the impact of this will be limited since only a few banks will have separate NMD models for internal measurement and the SOT.

Finally, some minor additions have been included in the guidelines. For example, the guidelines emphasize multiple times that when diversification assumptions are used for the measurement of IRRBB, these must be appropriately stressed and validated.

Conclusion

It is expected that the final guidelines will not deviate significantly from the consultation paper. Banks can therefore start preparing for these new expectations. For the measurement of IRRBB, limited changes are introduced in the consultation. Although the exact intention of the EBA is unclear to us, it is interesting to notice that the updated IRRBB Guidelines include the expectation that banks pay special attention in their stress tests to products with significant repricing restrictions. Furthermore, banks must invest in their CSRBB measurement. For their entire banking book, banks need to assess whether market wide credit spread changes will have an impact on an NII and/or economic value perspective. The scope of CSRBB measurement may need to be extended to include the funding issued by the bank. And to conclude, the obligation to measure CSRBB for fair value assets that do not have quoted market prices will be a challenge for banks.

References

1. CP Draft GL on IRRBB and CSRBB.pdf
2. CP Draft RTS on SA.pdf
3. CP Draft RTS on SOTs.pdf

The current version of the IRRBB Guidelines, published in 2018, came into force on 30 June 2019. At that time, the IRRBB Guidelines were aligned with the Standards on interest rate risk in the banking book, published by the Basel Committee on Banking Supervision (in short, the BCBS Standards) in April 2016.

The new updates are triggered by the revised Capital Requirements Regulation (CRR2) and Capital Requirements Directive (CRD5). Both documents were adopted by the Council of the EU and the European Parliament in 2019 as part of the Risk Reduction Measures package. The CRR2 and CRD5 included numerous mandates for the EBA to come up with new or adjusted technical standards and guidelines. These are now covered in three separate consultation papers:

1. The first consultation paper_¹ describes an update of the IRRBB Guidelines themselves. The main changes are the specification of criteria to identify “non-satisfactory internal models for IRRBB management” and the specification of criteria to assess and monitor Credit Spread Risk in the Banking Book (CSRBB). Read our analysis on this consultation paper here »
2. The second paper² concerns the introduction of a standardized approach (SA) which should be used when a competent authority deems a bank’s internal model for IRRBB management non-satisfactory. It also introduces a Simplified SA for smaller and non-complex institutions.
3. The third consultation paper³ offers updates to the supervisory outlier test (SOT) for the Economic Value of Equity (EVE) and the introduction of an SOT for Net Interest Income (NII).

Please note that we recently also published an article about the new disclosure requirements for IRRBB which is closely related to this topic.

Changes to the supervisory outlier test

Banks have been subject to an SOT already since the 2006 IRRBB Guidelines. The SOT is an important tool for supervisors to perform peer reviews and to compare IRRBB exposures between banks. The SOT measures how the EVE responds to an instantaneous parallel (up and down) yield curve shift of 200 basis points. Changes in EVE that exceed 20% of the institution’s own funds will trigger supervisory discussions and may lead to additional capital requirements.

Some changes to the SOT were included in the 2018 update of the IRRBB Guidelines. Next to further guidance on its calculation, the existing SOT was complemented with an additional SOT. The additional SOT was based on the same metric and guidelines, but the scenarios applied were the six standard interest rate scenarios introduced in the BCBS Standards. Also, a threshold of 15% compared to Tier 1 capital was applied. In the 2018 IRRBB Guidelines, the additional SOT was considered an ‘early warning signal’ only.

The new update of the IRRBB Guidelines includes two important SOT-related changes, which are incorporated through amendments to Article 98 (5) of the CRD: the replacement of the 20% SOT for EVE and the introduction of the SOT for NII. Both changes are discussed in more detail below.

Changes to the supervisory outlier test

Banks have been subject to an SOT already since the 2006 IRRBB Guidelines. The SOT is an important tool for supervisors to perform peer reviews and to compare IRRBB exposures between banks. The SOT measures how the EVE responds to an instantaneous parallel (up and down) yield curve shift of 200 basis points. Changes in EVE that exceed 20% of the institution’s own funds will trigger supervisory discussions and may lead to additional capital requirements.

Some changes to the SOT were included in the 2018 update of the IRRBB Guidelines. Next to further guidance on its calculation, the existing SOT was complemented with an additional SOT. The additional SOT was based on the same metric and guidelines, but the scenarios applied were the six standard interest rate scenarios introduced in the BCBS Standards. Also, a threshold of 15% compared to Tier 1 capital was applied. In the 2018 IRRBB Guidelines, the additional SOT was considered an ‘early warning signal’ only.

The new update of the IRRBB Guidelines includes two important SOT-related changes, which are incorporated through amendments to Article 98 (5) of the CRD: the replacement of the 20% SOT for EVE and the introduction of the SOT for NII. Both changes are discussed in more detail below.

Replacement of the 20% SOT for EVE

The first part of the amended Article 98 (5) concerns the replacement of the original 20% SOT by the 15% SOT. While many banks are probably already targeting levels below 15%, we expect that this change will limit the maneuvering capabilities of banks as they will likely choose to implement a management buffer. Note that not only the threshold is lower (15% instead of 20%), but also the denominator (Tier 1 capital instead of own funds). Furthermore, the worst outcome of all six supervisory scenarios should be used, as opposed to worst outcome of just the two parallel ones. Combined, this leads to a significant reduction in the EVE risk to which a bank may be exposed.

Some other noteworthy updates to the SOT for EVE that are not directly related to the CRD amendment are listed below:

• The post-shock interest floor decreases from -100 to -150 basis points and it increases to 0% over a 50-year instead of a 20-year period.
• In the calibration of the interest rate shocks for currencies for which the shocks have not been prescribed, the most recent 16-year period should be used (instead of the 2000-2015 period which is still underlying the shocks for the other currencies).
• When aggregating the results over currencies, some additional offsetting (80% as opposed to 50%) is granted in case of Exchange Rate Mechanism (ERM) II currencies with a formally agreed fluctuation band narrower than the standard band of +/-15%. Currently, only positions in the Denmark Krona (DKK) qualify for this treatment.

Introduction of the SOT for NII

The second part of the amended Article 98 (5) concerns the introduction of an entirely new SOT. It is aimed at measuring the potential decline in NII for two standard interest rate shock scenarios. Compared to the SOT for EVE, the SOT for NII requires many more modeling assumptions, in particular to determine the expected balance sheet development. The consultation paper provides clarity on the approach the EBA wants to take but two decisions are explicitly consulted.

The SOT for NII compares the NII for a baseline scenario with the NII in a shocked scenario over a one-year horizon. The two shocks that need to be applied are the two instantaneous parallel shocks that are also used in the SOT for EVE. Furthermore, the same requirements that are specified for the SOT for EVE apply, for example the use of the floor and the aggregation approach. The two exceptions are the requirements to use a constant balance sheet assumption (as opposed to a run-off balance sheet) and to include commercial margins and other spread components in the calculations. The commercial margins of new instruments should equal the prevailing levels (as opposed to historical ones).

The two decisions for which the EBA is seeking input are:

The scope/definition of NII
In its narrowest definition, the SOT will focus on the difference between interest income and interest expenses. The EBA, however, also considers using a broader definition where the effect of market value changes of instruments accounted for at Fair Value (∆FV) is added, and possibly also interest rate sensitive fees and commissions.

The definition of the SOT’s threshold
Article 98 (5) requires the EBA to specify what is considered a ‘large decline’ in NII, in which case the competent authorities are entitled to exercise their supervisory powers. This first requires a metric. The EBA is consulting two:

• The first metric is calculating the change in NII (the difference between the shocked and baseline NII) relative to the Tier 1 Capital:
• The second metric is calculating the change in NII relative to the baseline scenario, after correcting for administrative expenses that can be allocated to NII:
• where α is the historical share of NII relative to the operating income as reported based on FINREP input.

The pros of the narrow definition of NII are improved comparability and ease of computation, where the main pro of the broader definition is that it achieves a more comprehensive picture, which is also more in line with the EBA IRRBB Guidelines. With respect to the metrics, the first (capital-based) metric is the simplest and it is comparable to the approach taken for the SOT for EVE. The second metric is close to a P&L-based metric and the EBA argues that its main advantage is that “it takes into account both the business model and cost structure of a bank in the assessment of the continuity of the business operations”. It does involve, however, the application of some assumptions on determining the α parameter.

Thresholds for the four possible combinations

For each of the four possible combinations (definition of NII and specification of the metric), the EBA has determined, using data from the December 2020 Quantitative Impact Study (QIS), what the corresponding thresholds should be. Their starting point has been to make the SOT for NII as stringent as the SOT for EVE. Effectively, they reverse engineered the threshold to achieve a similar number of outliers under both measures. We expect that the proposed threshold for any of the four possible combinations will not be constraining for the majority of banks. The resulting proposed thresholds are included in the table below:

Table 1 – Comparison of the proposed thresholds for each combination of metric and scope

The impact of including Fair Value changes seems arbitrary as it increases the threshold for the capital-based metric and decreases the threshold for the P&L-based metric. Also, from a comparability and computational perspective, the narrow definition of NII may be preferred. Furthermore, the capital-based metric is less intuitive for NII than it is for EVE, and consequently, the P&L-based one may be preferred. It is also noted in the consultation paper that if the shocked NII after the correction for administrative expenses (the numerator) is negative, it will also be considered an outlier.

Conclusion

In the past years, many banks have invested heavily in their IRRBB framework following the 2018 update of the IRRBB Guidelines. Once again, an investment is required. Even though there are not many surprises in the proposed updates related to the SOTs, small and large banks alike will need to carefully assess how the changes to the existing SOT and the introduction of the new SOT will impact their interest rate risk management. Banks still have the opportunity to respond to all three consultation papers until 4 April 2022.

References

1. CP Draft GL on IRRBB and CSRBB.pdf
2. CP Draft RTS on SA.pdf
3. CP Draft RTS on SOTs.pdf