Interest Rate Risk

in The Banking Book (IRRBB)

JOHN N.CHALOUHI
Chief Risk Officer, FNB group

Table of Contents

I. Interest Rate Risk in the Banking Book

1. Overview
2. Banking Book v/s Trading Book
3. Possible Introduction of IRRBB in Pillar I
II. Assessing Interest Rate Risk in the Banking Book
III. Economic Value of Equity

Interest Rate Risk in The Banking Book

Overview

Definition

The Risk to Earnings or Capital arising from the movement of Interest Rates

Causes

Interest Rate Risk in the Banking Book arises when there is a mismatch
between the maturity profiles of Rate Sensitive Assets (RSA) and Rate
Sensitive Liabilities (RSL)

Impact

Short Term : On Banks Net Interest Income

Long Term: On Banks Net Worth since the Economic value of Banks
assets, liabilities and off-balance sheet exposures is affected
*** STRICTLY CONFIDENTIAL***

Banks monitor IRRBB under Pillar 2 within the integrated risk management
framework through ICAAP for assessing additional capital requirements.

Banking Book Vs. Trading Book

IRRBB

IRRBB
Assessment
tools

Trading Book

Pillar 2

Pillar 1

Earnings at Risk

Maturity schedule

Capital
Charges
Tools

Economic Value Of
Equity

Specific Risk

Capital Framework

*** STRICTLY CONFIDENTIAL***

A surprising Basel Committee proposal

A possible new capital charge for IRRBB is set to challenge banks business
models, by this costly proposal, which ignores the fundamental difference
between banks trading and banking books.

Supervisors, under Pillar II, may require banks to hold capital for their IRRBB

Work is now under way, and a task force on interest rate risk has been set up to examine
options for a Pillar I charge.

Most probably regulators will require banks to use the economic value of equity (EVE)
approach.
The use of the economic value perspective is one area where the application of this
approach to banks outside the G10 internationally active population might be varied.

*** STRICTLY CONFIDENTIAL***

Table of Contents

I.

Interest Rate Risk in the Banking Book

II. Assessing Interest Rate Risk in the Banking Book

III. Economic Value of Equity

Measurement of Interest Rate Risk in The Banking Book

Earnings at Risk (EaR) Vs. Economic Value of Equity (EVE)

Measurement
Maturity/repricing
schedules can be used
to generate simple
indicators of the
interest rate risk
sensitivity of both
earnings and economic
value to changing
interest rates

EaR

Focuses on the impact interest rate changes have on

a banks earnings in the near term, typically
considers a 1 year period.

EVE

Focuses on the impact interest rate changes may

have on the Economic Value Equity by discounting
future Cash Flows.

*** STRICTLY CONFIDENTIAL***

Table of Contents

I.

Introducing Interest Rate Risk in the Banking Book

II. Assessing Interest Rate Risk in the Banking Book

III.Economic Value of Equity
1. Methodology
2. Assumptions
3. Suggestion on Capital Charges Calculation

Economic Value of Equity (EVE)

Methodology
Concept

Economic Value Of
Equity

Formula

EVE = Fair Value of Assets Fair value of Liabilities

EVR = EVE= value of Assets - value of liabilities

( reflecting an assumed change in the yield curve i )

value of assets = DA x Assets x i

value of liabilities = DL x Liabilities x i

Economic Value at
Risk

Deriving
Economic
Value
at Risk

value of assets & of

liabilities

Economic Value at Risk highly depends highly on

duration of the banks assets and liabilities
Conclusion

Thus proper assessment of IRR exposure requires

accurate information about the maturity composition of
the portfolio

*** STRICTLY CONFIDENTIAL***

Bond Duration and Convexity

One of the limitations of using Duration only is overstating the
drop in value following a rise in interest rates

X=estimate
y
x

*** STRICTLY CONFIDENTIAL***

Estimation
error

Y= Actual

EVE Measurement using Gap Reprising Schedule

Assumptions

Shortcomings
of
Some
Assumptions

Buckets may not capture exact maturities

Reprising gap table is snapshot in time, whereas balance sheet is dynamic
Ignores prepayment options
Duration may only accurately estimate price sensitivity for rather small (up
to 100 bp) interest rate changes. Convexity-adjusted duration should be
used to more accurately estimate price sensitivity for larger interest rate
changes.
Assumes rates on A and L will rise or fall by the same amount as the yield
curve changes
Unlikely in practice : The treatment of some deposits is complicated by the fact
that the rates received by depositors tend not to move in close correlation with
changes in the general level of market interest rates

*** STRICTLY CONFIDENTIAL***

10

Contractual versus Behavioral Maturity

Balance Sheet Item

Characteristics

Assets
Placements
Bonds
Structured Products
Loans ( assuming no option for

Contractual maturity applies with minimum error

prepayment)

Liabilities
Contractual
v/s
Behavioral
Maturity

Bank Borrowings
Bank Loans
Fiduciary deposits
Hot Deposits

Contractual maturity applies with minimum error

Other Deposits
Demand/site deposits,
Savings accounts,
small denomination time
deposits ( Core Deposits)

Contractual maturity doesnt apply

Should consider behavioral Maturities
(Rates on some deposits tend NOT to move in close correlation with
market interest rates)

*** STRICTLY CONFIDENTIAL***

11

Rates on some deposits tend NOT to move in close correlation with

market interest rates.

RetailFundingexperiencebetalessthan100%

Measures deposit rate changes relative to market rate changes

Beta =

Beta
Measure

Change in product Rate

Change in market rate

For Instance, deposits might witness an increase of 40bp in rates for a 100 bp
upward shift in market rates. So they have a beta of 40%.

Beta =

40 = 40%
100

*** STRICTLY CONFIDENTIAL***

12

Suggestions on capital charges calculations using EVE

Regulators/ banks may expand their analysis by preparing

gap schedules that assume different customer behaviors
Deposits
Separate Core from Hot deposits (Regulators might define Hot deposits based on amount)
Adjusting the
Duration
Measure

Converting contractual maturity to a behavioral maturity for Core deposits based on historical
data/ experience
Methodology

Core deposits
may then
slotted according to an assumed maturity of no longer than five years.
Adjusting
Duration
ofbeliabilities
Derive a new duration reading
Adjust weighted average duration for liabilities
Assets
On the asset side, adjust the investment portfolio for convexity

Capital
Charge
Calculation

Introduce a limit on EVE (outliers defined as those banks experiencing decline in economic value
of equity by more than 20% following a 200-basis-point shift in interest rates.
20% is not applicable to emerging markets
Apply capital charges on the excess EVE assuming a 200bp shift in yield curve.
Fair value of equity might be a subject for discussion when calculating drop in value, since most
banks have a fair value above book value.

*** STRICTLY CONFIDENTIAL***

13

THANK YOU

*** STRICTLY CONFIDENTIAL***