Assessing various sources of interest rate risk can help institutions implement other supervisory regimens and become more efficient businesses, too.
Interest Rate Risk in the Banking Book (IRRBB) is just one among a multitude of regulatory frameworks that financial institutions must put into practice in the months and years ahead. What makes it so important is that the finalized Basel III standard encompasses, directly or indirectly, much of the spectrum of risks that banks face. When implemented in the right way, an institution can learn important lessons that will help when putting other pieces of the supervisory architecture in place, while also serving as a valuable business resource long after implementation is complete.
Effective management of interest rate risk is especially important in today’s uncertain operating environment. Net interest margins at banks, and therefore earnings, have been squeezed since the late 1990s by natural and artificial factors that have depressed interest rates.
Rate expectations at last are rising again amid an improvement in global economic growth. That bodes well for margins, but it remains to be seen what toll will be taken by flattening yield curves in many bond markets and the dismantling of a decade of unorthodox monetary policy. The final version of IRRBB includes two methods of measuring appropriate capital levels under various stress scenarios – Economic Value of Equity (EVE) and Net Interest Income (NII) – that amount to a tacit recognition of this challenging backdrop.
Whatever operating conditions banks encounter, the relationships among different sources of risk – changes in liquidity arising from anticipated and unforeseen economic developments; mismatches in rates on assets and liabilities; behavioral factors manifested in customer responses to rate movements; changes to the shape of the yield curve, and a host of others – are intricate and complex, often in unpredictable ways. Understanding and measuring them, and reporting their impact, call for similar approaches, conceptually and practically, to those needed for managing finance, risk and regulatory reporting practices (FRR) in general.
Like the IFRS 9 accounting standard, capital assessment procedures like ICAAP and CCAR, and the various sets of regulations that arise from Basel III guidelines, IRRBB protocols rely heavily on organizational integration, particularly among key functions like risk, finance and reporting; sophisticated data management; and prospective, principles-based analysis. IRRBB, therefore, can serve as a laboratory for testing on a small scale how prepared an institution is for putting into practice the big ideas that underpin today’s broad risk management and reporting regime.
If a bank gets IRRBB right, including the modeling, calculations and reporting methods that together create a comprehensive picture of interest rate risk and total liquidity, then it knows it’s probably on the right track in implementing other regulations and standards. In particular, the IRRBB implementation process allows firms to verify the accuracy of liquidity assessments carried out through ICAAP and similar frameworks, and to reconcile any discrepancies.
Perhaps more important, the principles and practices that form the right approach to IRRBB can help an institution to become a better business, not just a more compliant and well governed one, by establishing sound practices with respect to asset and liability management overall. Success in implementing the standard will provide critical details about the components of risk and the contribution of each to revenues and profits, all while simplifying data management and analysis. The reports filed to regulators can be the start of a process, not the end.
Straightforward in a roundabout way
The objective that the Basel Committee on Banking Supervision has set for financial institutions through IRRBB seems simple: to gauge the risk to earnings arising from movements in interest rates. But achieving it turns out to be no small task at many firms for two main reasons:
- The complex links among the various components of interest rate risk and the resulting knock-on effects that changes in one component will have on others make it hard to isolate and measure any single source of risk. As rates move up or down, for instance, liquidity is also likely to change, affecting the amount of funds available at any given rate. Changing rates will provoke changes in customer behavior too; higher rates (and declining interest rate expectations) might persuade depositors to put more money into fixed-term deposits, while lower rates (and higher rate expectations) might stimulate greater refinancing among mortgage holders. These behavioral changes, in turn, will have an impact on cash flows in and out, thereby affecting liquidity, and so on.
- Each department at a bank is likely to view and calculate risk from the perspective of its primary mission at the firm. Treasury officers might concentrate on the intraday impact on payment systems and liquidity management under ordinary operating conditions and during times of crisis. The compliance department might limit its focus to details required in periodic disclosures. Risk officers might be concerned more with tolerances in stress scenarios, and for finance the aim might be to incorporate risk modeling and calculations into commercial best practices.
The prospect of such choose-your-own-adventure risk modeling and analysis highlights the need for full organizational integration. A firm’s auditors, not to mention regulatory authorities, would find it strange, to say the least, to be presented with multiple calculations producing a range of results arrived at using different probability scenarios executed within different parts of the bank, all purporting to convey the same portrait of its circumstances.
To offer regulators a total risk picture – or any other mandated information – an institution must speak with one voice, and that calls for an integrated data management system telling it what to say. The ideal system will use a single set of rules and calculation engines, and other analytical processes and forecasting models, to convert data from any source within an organization into a common format and make it available to all users for any purpose.
A universal data hub enables more straightforward analysis that makes it easier to evaluate the connections among different sources of risk and allows the various components of risk to be broken out, simplifying revenue projections from existing and prospective activities and investments. Pricing can be fine-tuned, thanks to a heightened ability to measure how much each funding source is contributing to profitability and drawing on capital, facilitating balance sheet management and optimization. Looking still further ahead, a common data repository permits much faster analysis and the application of data to new uses.
The right IRRBB management practices will vary from bank to bank depending on its mix of activities and where and how it does business. But implementation methods should have these common objectives: to develop a unified source of clean, verifiable, consistent data to be used to combine disparate assessments of risk into a single accurate picture for regulators, and as a set of vital tools to be employed continuously for balance sheet optimization and revenue enhancement. It’s important to remember that work at the IRRBB lab is a never-ending process of experimentation and discovery.