Regulatory responses to the strong increase in the interest rate environment
The European Banking Authority (EBA) has updated its supervisory outlier test (SOT) threshold for a ‘large decline’ in net interest income (NII).
The new threshold is set at a 5% decline of Tier 1 capital, replacing the previous level of 2.5%. The EBA plans to review and update the threshold regularly and may revise the methodology in the longer term. The NII SOT is an additional metric in the supervisory review of institutions’ exposures to interest rate risk in the banking book (IRRBB). The EBA states that a breach would not lead to automatic supervisory measures. Integrating the threshold into institutions’ internal systems would not necessarily require recalibration actions.
This increase in the threshold is not deemed sufficient, however, by the banking sector. According to Risk.net, the sector proposes a 7.5% limit. The EBA has calibrated the limit such that the number of banks violating the Economic Value of Equity (EVE) SOT should be similar as for the NII SOT. The sector claims that a 7.5% NII SOT will ensure this, as the original 2.5% was estimated in a low interest rate environment. The new threshold must still be approved by the European Commission (EC). Without this approval, the status of both the SOT for Economic Value of Equity (EVE) and NII is unclear.
Meanwhile, the European Central Bank (ECB) has started to analyse the unrealized losses that banks (could) face due to the recent interest rate movements. The ECB has requested banks to provide detailed information on their interest rate risk models and how they are affected by rising rates. The ECB states that it will use, among other, the results of the ongoing stress test to analyze the resilience of the banks.
In the broader context of banking supervision, the Financial Stability Institute (FSI) of the Bank for International Settlements (BIS) has highlighted the impact of rapid interest rate hikes on banks’ solvency and liquidity positions. Banks’ accounting choices, balance sheet characteristics, and business models play a role in how these effects are experienced. While Pillar 1 sets baseline requirements, rising interest rates and declining asset values expose vulnerabilities that require robust supervision under Pillar 2. Supervisors need to assess risks such as IRRBB and unsustainable business models. Market turmoil has emphasized the need for additional measures, both quantitative and qualitative, to address bank-specific vulnerabilities and enhance risk management. Implementing Pillar 2 consistently across jurisdictions is a challenge, however, that may require further guidance.