Interest Rate Risk in the Banking Book

A Best Practice Guide to Management and Hedging

Beata Lubinska

• Publisher: Wiley
• Year: 2021
• ISBN:
  9781119755036
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Introduces practical approaches for optimizing management and hedging of Interest Rate Risk in the Banking Book (IRRBB) driven by fast evolving regulatory landscape and market expectations.

Interest rate risk in the banking book (IRRBB) gained its importance through the regulatory requirements that have been growing and guiding the banking industry for the last couple of years. The importance of IRRBB is shifting for banks, away from 'just' a regulatory requirement to having an impact on the overall profitability of a financial institution. Interest Rate Risk in the Banking Book sheds light on the best practices for managing this importance risk category and provides detailed analysis of the hedging strategies, practical examples, and case studies based on the author's experience. This handbook is rich in practical insights on methodological approach and contents of ALCO report, IRRBB policy, ICAAP, Risk Appetite Statement (RAS) and model documentation. It is intended for the Treasury, Risk and Finance department and is helpful in improving and optimizing their IRRBB framework and strategy. By the end of this IRRBB journey, the reader will be equipped with all the necessary tools to build a proactive and compliant framework within a financial institution.

• Gain an updated understanding of the evolving regulatory landscape for IRRBB
• Learn to apply maturity gap analysis, sensitivity analysis, and the hedging strategy in banking contexts • Understand how customer behavior impacts interest rate risk and how to manage the consequences
• Examine case studies illustrating key IRRBB exposures and their implications

Written by London market risk expert Beata Lubinska, Interest Rate Risk in the Banking Book is the authoritative resource on this evolving topic.

Chapter 1
What is IRRBB and why is it important?

The common definition of Interest Rate Risk in the Banking Book (IRRBB) describes the threat to the capital position and earnings of a bank driven by changes in the interest rates in the market. Though the definition is simple, the underlying threat to the bank's resilience is potentially serious if IRRBB is mismanaged. There are multiple ways that the interest rate curve can change its shape, i.e., it could take the form of a steepener, a flattener, a humped or an inverted curve. Changes to interest rates threaten a bank's earnings by impacting its Net Interest Income (NII) which is the main source of earnings for a bank. It is estimated that, in the composition of the total income of a bank, NII contributes, on average, about 60% (Figure 1.1).

Changes to interest rates also threaten the underlying value of bank's assets, liabilities and off‐balance sheet instruments, given the adverse impact which may arise on the present value of items, in particular their future cash flows. This is known as the impact on economic value of the banking book, which is understood as the sum of the net present value of assets, the net present value of liabilities and the net present value of off‐balance sheet items.

We can already see that there is a dual view under which interest rate risk in the banking book should be analysed and these two views are complementary. The short‐term view relates to the impact on earnings of a bank and this is known, in the IRRBB parlance, as the short end curve impact. The time horizon for this kind of analysis is short, spanning from 12 months to a maximum of 36 months. Under short‐term analysis we are looking at the negative impact on a bank's earnings (NII) driven by the fluctuation in the interest rate curve. One can argue that not only negative impact should be considered but the earnings variability as well. Excessive earnings sensitivity is considered bad practice in IRRBB management. We will tackle this point at a later stage.

FIGURE 1.1 Composition of the total income in a bank.

Source: own elaboration

The medium‐to‐long‐term view relates to the impact on economic value of a bank and looks at a much longer horizon, i.e., it includes all risk sensitive positions in the banking book. The outcome of the economic value analysis provides the fundamental number...