An AxiomSL Whitepaper

IRRBB
Identify, mitigate and effectively manage this regulatory
challenge

www.axiomsl.com | sales@axiomsl.com
Table of Contents

1. Introduction .................................................................................................................................... 3

2. Identification, Measurement and Mitigation of IRRBB .................................................................. 4

3. Main Challenges in Managing IRRBB .............................................................................................. 7

4. Opportunities going forward .......................................................................................................... 9

5. How AxiomSL can help ................................................................................................................. 10

6. Appendix ....................................................................................................................................... 11

7. About AxiomSL.............................................................................................................................. 12

©2016 AxiomSL Page | 2

1. Introduction
Interest rate risk is a bank’s exposure to adverse movements in interest rates. Interest rate risk in
the banking book (IRRBB) refers to the current or prospective risk to the bank’s capital and earnings
arising from adverse movements in interest rates that affect the institution’s banking book
positions. It arises because interest rates can vary significantly over time, while the business of
banking typically involves intermediation activity that produces exposures to both maturity
mismatch and rate mismatch together with options that are embedded in many of the common
banking products that can get triggered when interest rates change.

Changes in interest rates affect a bank’s earnings by altering interest-sensitive income and
expenses, thus affecting its net interest income (NII). When interest rates change, the present value
and timing of future cash flows change as well. This in turn affects the underlying value of a bank’s
portfolio and hence its economic value (EV). Excessive levels of interest rate risks in the banking
book can, therefore, pose a significant threat to an institution’s earnings and capital base.
Accordingly, effective risk management that maintains interest rate risks at prudent levels is
essential to the safety and soundness of banking institutions. It is therefore important for banks to
be able to (a) identify interest rate risks- IRRBB risk types, profiles and how it affects the different
instruments in the bank’s portfolio (both balance and off-balance sheet), (b) measure these risks
using different methodologies, models and assumptions, (c) mitigate and control some of these
risks in accordance to the bank’s risk strategy through portfolio changes, limit setting, hedging or
other means, and (d) monitor these risks on a regular basis through effective governance and
periodic reporting based on a sound infrastructure.

Of late, management of Interest Rate Risk in the Banking Book (IRRBB) is receiving considerable
attention, mainly owing to two complementary factors. First is the market condition wherein
interest rates have been at a historical low for a long time and the resultant uncertainties posed
by the possibly divergent policy response from the central banks together with recent market
volatility and customer response to such rate changes. The second and probably immediate reason
is the regulatory compliance requirement wherein the Basel Committee on Banking Supervision
(BCBS) has issued Standards to be implemented by January 2018 that prescribes a strengthened
Pillar II approach and set out broad guidelines for banks’ identification, measurement, monitoring
and control of IRRBB. As a result of these, banks are giving special attention to the enhancement
of IRRBB management and integration with other risk and finance compliance and operational
framework. This is supplemented by increasing focus on improvement of IRRBB governance and
closer attention to the assumptions and management techniques used for IRRBB.

©2016 AxiomSL Page | 3

2. Identification, Measurement and Mitigation of IRRBB
The main sources of IRRBB can be classified into the following areas:

 Gap Risk: Risk arising from the timing of instrument rate changes

 Optionality Risk: Risk arising from price movements in instruments that are either
automatic or behavioral to changes in interest rates

 Basis Risk: Impact of relative changes in interest rates for financial instruments that have
either similar tenors but are priced using different interest rate reference curves (reference
rate basis risk); or which have (ii) different tenors but the same reference curve (tenor basis
risk or short-term non-parallel gap risk); or which have (iii) similar tenors and reference
curves but in different currencies (currency basis risk)

All types of IRRBB ultimately result in the potential for change in the price/value or earnings/costs
of interest-sensitive assets, liabilities and/or off-balance sheet items in a way, or at a time, that
can adversely affect a bank’s financial condition. This outcome of general interest rate risk is
sometimes collectively referred to as repricing risk or revaluation risk. At the same time, even
though not directly linked to IRRBB, Credit Spread Risk in the Banking Book (CSRBB)1 also forms an
integral part in the assessment and monitoring of the bank’s interest rate risk management
framework.

In 2004, the BCBS issued the Principles for the management and supervision of interest rate risk,
which set out the adequacy of such measurement systems for the purposes of managing the risk,
based on six broad criteria:

i. Systems should incorporate all of the bank’s interest rate sensitive positions

ii. Systems should be capable of measuring interest rate risk using both earnings and economic
value approaches

iii. Data inputs should provide a reasonably accurate portrayal of changes in economic value
and earnings

iv. Model risk management and control systems should be based on assumptions that are
reasonable and stable over time, with proper documentation and changes subject to
approval by senior management

v. Interest rate risk measurement systems should satisfy a use test; and

vi. A standardised parallel interest rate shock (or equivalent parameters) should be
incorporated properly into such systems.

1
CSRBB refers to any kind of asset/liability spread risk of credit-risky instruments that is not explained by IRRBB and by the expected credit/jump to
default risk.

©2016 AxiomSL Page | 4

As part of the continuum, in April 2016 BCBS updated the interest rate risk Principles as well as
prescribed a standardised framework expected to be adopted by banks for measuring, managing,
monitoring and controlling such risks.

BIS IRRBB Standard: Main Features

According to a survey conducted by BCBS of supervisory and regulatory practices with respect to
IRRBB among member jurisdictions, Value-at-risk (VaR) on EV/EVE2 and earnings-at-risk (EaR) on NII
are the most commonly prescribed metrics. In addition, some national supervisors monitor changes
to EV/EVE, to the expected shortfall (ES) of the EV/EVE, and/or require gap reports. In some
jurisdictions, banks are required to consider regional or macroeconomic factors for their interest
rate risk assessments. Some jurisdictions use multi-year stress tests, including specific interest rate
stress scenarios and projections of the impact on income and capital. Most jurisdictions have
identified the proportion and duration of core deposits under interest rate shocks to be the most
complex component of this framework. Also, several jurisdictions do not allow for the recognition
of hedging and offsetting of positions across currencies. Finally, only a handful of jurisdictions
recognise embedded gains and losses, albeit there is variation in the interpretation and
implementation practices.

While the EV and earnings-based measures share certain commonalities, most commercial banks
primarily utilise the latter for internal interest rate risk management, whereas regulators have
tended to endorse the former as a benchmark. If a bank minimises its EVE risk by matching the
repricing of its assets with liabilities beyond the short term, it runs the risk of earnings volatility.
There is, therefore, a trade-off between optimal economic value and earnings stability. A pure EVE
approach would also be likely to underestimate short-term earnings risk and largely fail to

2
Economic Value of Equity (EVE)

©2016 AxiomSL Page | 5

incorporate short-term gains resulting from an upward interest rate shock scenario. A recent survey
conducted by Oliver Wyman3 finds that banks are revisiting past practices focusing on three major
issues. First, there is a secular shift towards a more balanced approach to managing the IRR,
essentially including a ‘value-based’ view to counter-balance a pure earnings objective. Secondly,
banks are enhancing measurement practices, especially for economic value of equity (EVE). Finally,
banks are also rethinking their deposit models given the importance of deposit modelling in a low
interest rate environment and possible structural shifts in the deposit markets caused by
compliance requirements to the new liquidity regime.

Regarding mitigation of interest rate risk in the banking book, multiple approaches are generally
used to manage interest rate risk. A commercial approach involves the choice of maturities or
repricing dates for assets and deposits to ensure matching. A simple method is when the borrower
requests its lender to fix the interest rate of its loan for the period of the loan. Another way of
mitigating such risk is the adherence to pre-set limits. Traditionally, NII sensitivity or value (e.g.
EVE or DV01) sensitivity to interest rate shocks have been the main limits used while recently, many
banks have introduced limits on sensitivity of Other Comprehensive Income (OCI) or Basel III
regulatory capital ratios to interest rate shocks. Another approach has been the use of appropriate
non-derivative and derivative (such as forward rates agreements (FRAs), financial futures, interest
rate options, or swaps) financial instruments as part of the hedging strategy and aligning it with
the overall corporate risk tolerances, costs and benefits, and liquidity and other constraints.

3
The State of Interest Rate Risk Management, Oliver Wyman

©2016 AxiomSL Page | 6

3. Main Challenges in Managing IRRBB
The nature of challenges faced by the bank for instituting an effective framework for IRRBB
encompasses a wide spectrum broadly covering (a) overall risk framework consistency and
governance, (b) business understanding, model maintenance, risk mitigation practices, etc. and (c)
having a comprehensive and integrated data and technology infrastructure.

A major challenge of the IRRBB framework is the alignment of the potential commonalities of its
assumptions and engine with other related risk and finance management frameworks such as capital
and liquidity management along with the emerging accounting rules. Moreover, given the increased
demand on analytics and reporting, consistency among these frameworks is needed for increased
efficiency, shorter turnaround times, and to avoid potentially contradictory outcomes. Herein the
overlap with LCR, NSFR and other liquidity frameworks is of particular significance with assumptions
around stressed flows, notably related to deposit run-off, collateral, and off-balance sheet
behavior. Similarly, with new regulations coming up with respect to the trading book requirements
such as the Fundamental Review of the Trading Book (FRTB), it is imperative that the framework
ensures an element of comprehensibility and integration at a broad level. At the same time, it is
vital that though there is close coordination between the respective teams, lines of defense
between the banking book activities and trading book activities are clearly delineated. Similarly, it
is also important to maintain a harmony with accounting rules such as IFRS 9 so that results
generated for finance and banking book risks has a common data structure and transparent cash
flow treatment.

From the business perspective, modelling and maintenance poses significant challenges given the
nature of IRRBB that can be classified into (a) Contractual: the interest rate exposure is derived
directly from the characteristics of the transactions (e.g. fixed rate loans that are not pre-payable

©2016 AxiomSL Page | 7

by the customers); (b) Behavioral: the interest rate exposure is based on behavior of customers,
the bank, competition, taxation, etc. (e.g. loans that are pre-payable by customers, savings
accounts whose rates result from the competition or are administered, etc.), (c) Conventional: the
interest rate exposure is derived from a convention to allocate a specific maturity (or maturity
ladder) to a balance sheet item that does not have a contractual maturity and which cannot or are
difficult to model4, and (d) Combination of the above: some transactions (or balance sheet items)
require a combination of the above to derive their interest rate risk exposure (e.g. non-maturing
deposits whose rates and balances are based on models). For most banks, the nature of IRRBB is to
a large extent a combination of behavioral and conventional since their banking book is
overwhelmingly built of intermediary financing items such as loans, deposits and facilities.

To manage IRRBB, most banks apply processes through which conventional-IRRBB and behavioral-
IRRBB (and combination thereof) are transformed into contractual-equivalent-IRRBB based on both
statistical models calibrated from historical data and simulations-both static and dynamic- that
consider a wider range of hypothetical scenarios. In each step of the contractual-equivalent
transformation, business planning models, market environment, customer behavior, etc. influence
the assumptions used by banks. At the same time, based on the heavy reliance on models for
instrument pricing, cash flow calculation and risk measurement, banks are expected to have
prudent model validation processes in place to assure prompt corrective actions in case model
parameters are proven to lack precision.

IRRBB Framework

4
This practice is generally adopted in the banking book to mitigate the variability in net earnings between non-contractual/non-interest-bearing
items and the investment of such sources of funds (or the funding of such assets). For example, a bank may choose to model a portfolio of zero rate
non-maturity demand deposits with a laddered maturity profile, and then match these deposits by entering into assets of a similar maturity profile.

©2016 AxiomSL Page | 8

Deposit characterization underlying IRRBB analysis is particularly complicated. The objective of
deposit characterization is to identify expected behavior of indeterminate deposits along multiple
dimensions: i) determination of the core portion that will stay with the bank for the longer run, ii)
pricing sensitivity of deposits to changing interest rates and iii) expected maturity of deposit
accounts. It is particularly difficult to include all the above complexities into a rigid framework for
the management and pricing of interest risk given the two embedded options: one option held by
the bank (i.e. the right to change the interest rate) and one behavioral option held by the depositor
(i.e. the right to withdraw their funds). Moreover, there is a growing concern among practitioners
that the existing deposit characterization approach might not be good enough as the global
economy enter a rising rate environment for the first time in nearly a decade. It is observed that
most of the existing deposit models have been calibrated using data from near-zero rate
environments where bank balance sheets have been flooded with deposits. Therefore, given the
uncertainty over the future regional and country-specific monetary policies and the consequent
interest rate regime, it is equally unclear as to how quickly “hot money” will leave bank balance
sheets for more lucrative investment opportunities.

This leads to one of the most practical aspect of having a robust information technology framework
for IRRBB wherein many banks may need to amend their data and systems in order to undertake
the totality of the various calculations required under these proposals. Given that leveraging
consistent data and systems infrastructure across applications can lead to major cost efficiencies,
the challenge for banks is to incorporate a robust, automated and streamlined overall process which
would incorporate more granular and transparent modelling of assets and liabilities for IRRBB
purposes, deploy efficient engines that are capable of running multiple scenarios quickly, use the
relevant data for various calibrations, and review and refine modelling approaches and assumptions
on a continuous basis.

4. Opportunities going forward

With increasing focus both by supervisors and practitioners, especially in light of the Standards for
IRRBB, strong IRRBB management that is integrated with broader risk and return decision making
frameworks is more important than ever. In order to be best positioned to meet the market and
regulatory requirements to enhance IRRBB analytics and governance, banks are poised to heighten
their focus on improving their IRRBB approaches across several dimensions to follow current and
future best practices. Firstly, it is widely perceived that this environment is gearing the banks to
further strengthening their governance of IRRBB processes, including board-level oversight as also
bringing about a clearer articulation of responsibilities across the different lines of defense in their
structure. Secondly, this environment provides a good opportunity to develop, revisit and follow a
comprehensive quantitative approach including Net Interest Income (NII) and Economic Value of
Equity (EVE) projections under multiple macroeconomic scenarios over a multi-year horizon,
incorporating historical analysis and sensitivity analysis. Thirdly, banks are at a vantage point to
take a more calibrated look at customer behavior analysis such as deposit balances and re-pricing
based on both statistical models calibrated from historical data and “what if” scenarios that
consider a wider range of hypothetical scenarios. This application of a robust model risk
management framework to all IRRBB models and assumptions is particularly crucial given that
decision makers may not have gone through a similarly complex regulatory and economic
environment. Finally, there appears to an increasing trend towards alignment of the potential
commonalities of the assumptions and engine of the IRRBB with related risk and finance
management framework. In summary, there is a growing realisation among the banking fraternity
that the many challenges imposed by the current environment also ultimately present opportunities
for a more integrated approach to treasury risk management, and serve as a catalyst for balance
sheet risk-return optimization.

©2016 AxiomSL Page | 9

5. How AxiomSL can help
AxiomSL IRRBB solution addresses all the above challenges while setting up a solid foundation to
meet the future regulatory changes. Its data-driven multi-jurisdiction platform provides highly
configurable and customizable capabilities (rule-based calculations, aggregations, etc.) and drill-
down allowing for full audit-trail to data sources. The end-to-end solution provides a single unified
framework to meet the interest rate risk requirements- data loading, movement (cash-flow)
generation, scenario maintenance, modelling capability, classification and metrics calculations and
reporting.

Beyond its time-tested capabilities in risk management and regulatory compliance, AxiomSL’s IRRBB
solution encompasses the in-built logic that specifically addresses Basel prescribed Standards. The
solution handles the various components of interest rate risk measurements, such as instrument
categorization, treatment of portfolio as per its amenability to standardization, application of
multiple shock and scenarios, calculation of different interest rate metrics such as change in
economic value of equity (ΔEVE), change in net interest income (ΔNII) etc. It also ensures that the
data, IRRBB treatment and calculation methodologies are consistent with other cash flow generated
streams and liquidity risk calculation metrics such as LCR, NSFR and other monitoring tools.

While conceptualizing and designing the AxiomSL IRRBB module within the broader AxiomSL Risk
and Capital solution, it is ensured that the core value proposition of AxiomSL is retained through
the optimum balance between flexibility to the clients and robustness of the framework. As a
result, the performance-tested offering of AxiomSL ensures that financial institutions are able to
process millions of records within an acceptable time-frame.

©2016 AxiomSL Page | 10

6. Appendix
While most common interest rate measurement involves the sensitivity impact of small changes of
interest rates on the accounting income or economic value, some banks supplement this other
advanced approaches, e.g measurement of the impact of multiple changes in interest rates and
other related variables on the entity’s financial health and stress tests.

 Net Interest Income

To evaluate the impact of a change in interest rate on the net interest income of a bank,
banks compute a repricing gap table, also called an interest rate sensitivity table. For
instance, a 3-month Treasury Bill and a floating rate loan repriced every quarter would be
slotted into the 0-3 month bucket. A five-year-fixed rate bond would be slotted in the five-
year bucket. A positive cumulative gap indicates that there will be a net excess of assets to
reprice, while a negative cumulative gap indicates an excess of deposits to reprice. In the
case of an increase in the interest rate curve, a positive cumulative gap will help the bank
to increase its net interest income, while a negative cumulative gap would generate a loss
of net interest income. This can be extended to compute Earnings-at-Risk (EAR) to calculate
the potential impact of an adverse change of interest rate on the P&L account. The repricing
gap table provides a first tool to measure the interest rate risk of a bank. It must be
completed with the use of a simulation model to factor in the impact of a change of interest
rates on future volumes of business, imperfect correlation between some interest rates,
products with embedded options, etc.

The focus on the impact of interest rate on the net interest income and the P&L account is
understandable when banks focus on the short and medium term impact. However, repricing
gaps most often omits the payment of interest/coupons and taxes, ignores the fixed spread
on the floating rate and its treatment of equity as non-interest sensitive may not be
appropriate.

 Economic Value of Equity

Defining the economic value of the equity of a bank as the difference between the value of
assets and debt, one needs to calculate the impact of a change in interest rate on the
economic value (EV) of equity. The summary measure of interest rate risk is arrived by
measuring the percentage change in the value of the equity of a bank for a change in interest
rates. It is the product of three factors: the leverage (rate sensitive assets over economic
value), the duration mismatch between assets and liabilities, and the change in interest
rate.

Although the duration applies only to a parallel shift in the yield curve, it can easily be
extended to different twists in the yield curve with a vector duration approach. However,
using this approach raises the practical issue of the application of the duration concept to
special accounts, such as demand deposits, savings deposits, or even credit cards loans.

©2016 AxiomSL Page | 11

7. About AxiomSL
AxiomSL is the leading global provider of regulatory reporting and risk management solutions for
financial services firms, including banks, broker dealers, asset managers and insurance companies.
Its unique enterprise data management (EDM) platform delivers data lineage, risk aggregation,
analytics, workflow automation, validation and audit functionality.

The AxiomSL platform seamlessly integrates clients’ source data from disparate systems and
geographical locations without forcing data conversion. It enriches and validates the data before
running it through risk and regulatory calculations to produce both internal and external reports.
The platform supports disclosures in multiple formats, including XBRL. This unparalleled
transparency offered by the high-performance platform gives users the ability to drill down on their
data to any level of granularity.

AxiomSL’s platform also supports compliance with a wide range of global and local regulations,
including Basel III capital and liquidity requirements, the Dodd-Frank Act, FATCA, AEI (CRS), EMIR,
COREP/FINREP, CCAR, FDSF, BCBS 239, Solvency II, AIFMD, IFRS, central bank disclosures, and both
market and credit risk management requirements. The enterprise-wide approach offered by
AxiomSL enables clients to leverage their existing data and risk management infrastructure whilst
reducing implementation costs, time to market and complexity.

AxiomSL was awarded The Asian Banker’s 2016 “Best Compliance Risk Technology Implementation
of the Year” as well as “Best Implementation at a Sell-side Firm” in the 2016 Sell-side Technology
Awards. Its data and process control platform was recognized as “Category Leader” in the 2016
Chartis FinTech Quadrant® for Data integrity and Control Solutions. It was voted Best Reporting
System Provider in the 2015 Waters Rankings and was highlighted as a ‘Category Leader’ by Chartis
Research in its 2015 Sell-side Risk Management Technology report. The company’s work has also
been recognized through several other accolades including success in the Best Reporting Initiative
category of the American Financial Technology Awards and in the Customer Satisfaction section of
the Chartis RiskTech100 rankings.

To find out more about our Risk Management solution or to speak to a member of our sales team,
email sales@axiomsl.com. For more information on AxiomSL, visit www.axiomsl.com.

©2016 AxiomSL Page | 12