BCBS Consultation Paper – Recalibration of shocks for interest rate in the banking book

In February this year, the Basel Committee on Banking Supervision (BCBS) released consultative document for recalibration of shocks for interest rate risk in the banking book, issued for comment by 28 March 2024.

In April 2016 the Basel Committee published its standard on interest rate risk in the banking book (IRRBB), which was most recently updated with SPR98 on 15 December 2019. The standard requires banks to calculate measures of interest rate risk for their banking book exposures with the measures based on a specified set of interest rate shocks for each currency for which the bank has material positions. The Committee noted the severity of the specified shocks would be subject to periodic review. The purpose of December 2023’s Consultative Document is to detail a set of prescribed adjustments to the specified interest rate shocks in the IRRBB standard, alongside adjustments to the current methodology used to calculate the shocks. These changes are deemed necessary to address problems with how the current methodology captures interest rate changes during periods when rates are close to zero due to fundamental shortcomings in basic risk management of traditional interest rate risk.

Current Interest Rate Shocks

The IRRBB standard requires banks to apply specified interest rate shocks to risk-free yield curves for each currency for which the bank has material positions. Under the standardised approach, banks must determine the impact of these shocks on their economic value of equity (EVE) and net interest income (NII). The shocks that must be applied to the risk-free yield curve for each currency is set out in the following table, which is derived from historical data during the period from January 2000 to December 2015:

The methodology used to produce the specified shocks combined three elements: (i) average interest rates for each currency; (ii) global shock parameters that are applied to the average rates for each currency; and, (iii) application of a floor, a set of caps and rounding.

Average interest rates were calculated for each currency using interest rate data from the calculation period, covering tenors from 3 months to 20 years:

The next step used to calculate the specified shocks was to multiply the average interest rates by the following set of global shock parameters:

Applying the global shock factors to the average interest rates for each currency gives the following unfloored, uncapped, unrounded interest rate shocks:

The IRRBB standard notes in SPR98.60 that the methodology can lead to unrealistically low interest rate shocks for some currencies and to unrealistically high shocks for others. To ensure a minimum level of prudence and a level playing field, a floor and a set of caps are applied. The floor is set at 100bp and the caps are set at 400bp for the parallel shock, 500bp for the short-term shock and 300bp for the long-term shock. Finally, the amounts are rounded to the nearest 50bp.

Problems with methodology used to calculate global shock parameters

The main objective of the Committee’s review of the interest rate shocks in the IRRBB standard was to update the interest rate data that is used in the calibration of the shocks. The current standard uses data from the period January 2000 to December 2015 and the Committee would like to extend that period to cover the period January 2000 to December 2022. Expending the period used, however, reveals a problem with the above methodology for calculating global shock parameter.

The shock parameters are generated from the average of 99th and 1st percentiles of rolling six-month percentage changes in interest rates (i.e. [rate in six months – current rate] / current rate). When rates are close to zero, the rate of change can be very large. For example, when the rate went down from 0.02% to 0.001% (0.019% difference) in six-months for a certain currency, the shock parameter is 95%. In another example, however, when the rate went up from 5.5% to 5.519% (the same 0.019% difference), the shock parameter is just 0.35%. The same calculation generates huge differences depending on the original level of interest rates. Therefore, in addition to updating the data period used to calibrate the interest rate shock parameters, the Committee has agreed to propose revisions to the way the shock parameters are calculated.

Comparison of existing and new methodology

• Expansion of the time series used in the calibration from December 2015 to December 2022.
• Removal of the global shock factors calculated using rolling six-month percentage changes in interest rates. These are replaced with local shock factors calculated directly for each currency using the averages of absolute changes in interest rates calculated over a rolling six-month period.
• Move from a 99th percentile value in determining the shock factor to a 99.9th percentile value, to maintain sufficient conservatism in the proposed recalibration.

The table below shows the interest rate shock parameters calculated using the proposed new methodology, with the data through to end-2022. The colours in the table show whether the shock sizes under the proposed new methodology results in an increase, decrease or are unchanged relative to the existing shock factors:

The following table quantifies the impact of the proposed change to the interest rate shock of each currency:

For most currencies the standard shocks have increased, e.g. the current 250bps parallel shock for GBP and 200bps parallel shock for EUR are proposed to increase to 300bps and 250bps respectively. If introduced, this would likely lead to banks revisiting their IRRBB framework including risk appetite, modelling, and hedging capacity

About the Author

Luke Di Rollo , Chief Product Officer, is a seasoned professional in the banking industry with nearly a decade of experience specialising in Asset and Liability Management (ALM) and Interest Rate Risk in the Banking Book (IRRBB). Throughout his career, he has developed and implemented several widely adopted models within the UK banking sector. Luke holds a CertBALM qualification and is a member of the Association of Corporate Treasurers (ACT), underscoring his expertise and commitment to the field.

ALMIS® International has a team of experts in bank Asset Liability Management, Regulatory Reporting, Hedge Accounting and Treasury Management supporting over 65 Financial Institutions. Please get in touch to learn more about how we can help.

This article explores

• What is Earnings at Risk (EaR) and the importance of managing this risk. 
• The different approaches to measuring EaR. 
• How ALMIS® International can help you manage this risk. 

What is Earnings at Risk (EaR)? 

EaR is a measure of the estimated impact to a bank’s earnings under an economic scenario.  Whereas Economic Value of Equity (EVE) – another key measure of IRRBB that measures the sensitivity of the net present value of repricing cash flows to an interest rate movement – is primarily a concern to the Treasury function and the regulator, EaR is a metric with business-wide implications. Institutions, whose earnings have an overly elastic sensitivity to interest rate movements, could see effects such as their profitability and dividend capacity reduce; erosion of key investor metrics and share price reduction; or operational impacts, such as lower capital expenditure capacity or reduced bonus pots in the event of an adverse movement in interest rates. 

EaR arises where the structure of a firm’s balance sheet does not allow them to adequately reprice their balance sheet to maintain their net interest margin (NIM) and typically meaning the interest they are paying on their funding increases more than (or decreases less than) the movement in interest they are earning on their assets. 

Understanding and satisfying Regulatory Requirements 

There is no formal return that firms must file to calculate or disclose an earnings metric, unlike the FSA017 for EVE. 

However, 9.1(2) from the Internal Capital Adequacy Assessment section of the PRA rulebook confirms (UK regulated) firms must have a system of identifying, evaluating and managing the risk to earnings from potential interest rate changes.  The PRA’s Standardised methodology – positioned as an alternative to a bank’s own internal systems – does not include a methodology for assessing earnings sensitivity and this is consistent with the Basel’s standardised methodology as well.  As of 2022, the EBA, however, have introduced both an earnings Supervisory Outlier Test (SOT) and Standardised (& simplified Standardised) methodology. 

The PRA do not provide guidance in this section around the appropriate time horizon to consider your earning risk, although the general convention is one year in the UK.  The Basel principles suggest firms should consider a horizon of between one and three years and no more than five and the 2018 EBA Guidelines essentially paraphrase this.  Under the newer (replacing the repealed 2018 Guidelines) EBA Supervisory Outlier Test (SOT), there is a prescribed one year horizon whereas the Standardised (& simplified-Standardised) methodology a more ‘opaque’ minimum of one year. 

It is generally accepted that the longer the horizon you consider the less accurate and meaningful the analysis will be due to the level of assumptions necessary to project the impact. 

Approach to measurement 

For the purposes of measuring EaR, there are three balance sheet profiles that Basel make reference to in their standards for earnings and IRRBB: 

• Run-off; 
• Constant, and; 
• Dynamic. 

A run-off balance sheet, as typically used to manage EVE, is where the assets and liabilities of a firm roll off as items reprice or mature. 

A constant balance sheet assumes that as each item on your balance sheet reprices it is replaced by an equivalently sized item and therefore, in essence, the size and composition of your balance sheet remains constant across the scenario’s horizon. 

A dynamic balance sheet overlays assumptions of how you expect the composition of your balance sheet to change over the scenario’s horizon. 

The most common approach ALMIS® International see firms taking is looking at their EaR on the constant balance sheet basis – also the basis the EBA prescribe for the SOT and Standardised methodologies – but we do also see firms evaluating their earnings on a dynamic modelling basis as well, so we will focus on the benefits and limitations of these two main approaches.  

Let’s consider the benefits and limitations of each scenario 

The benefits under a constant balance methodology are: 

• It gives a much truer representation of the interest rate risk in your balance sheet today. 
• It can be very quick to produce.  No inputs or assumptions are required to be computed and collated from the business. 
• It makes comparison easier.  By using a consistent methodology any period on period movements have a better and direct correlation to increases / reduction in risk on your balance sheet. 

The limitations of a static balance sheet are: 

• It doesn’t represent the true risk your balance sheet will face as it is improbable your balance sheet will remain constant over the horizon. 
• It doesn’t capture risk from growth, product mix changes, strategic shifts. 
• It can lead to a false sense of security if the risk appears low, but may not be under evolving conditions. 
• It is less useful for long term decision making and planning. 

The benefits to using dynamic balance sheet modelling: 

• It can be a truer representation of the interest rate risk that will be faced by the institution as it takes account of the expected activity the business will undertake. 
• It can allow an institution to take into account the micro-economic behaviours of new/existing customers under different scenarios e.g. a propensity for higher-yield, term deposits than lower-yield, open maturity deposits in a rising rate environment. 
• It allows for better proactive risk management through early identification of risk. 
• It aligns the risk management with the strategic direction of the business. 

The limitations to using a dynamic balance sheet are: 

• It is complex and time-consuming to perform as it requires the modelling and validation of assumptions from across the business. 
• It is more resource intensive and requires more data, insight and expertise to produce and analyse. 
• The output is highly sensitive to assumption risk as the meaningfulness of the output can only ever be as accurate as the assumptions feeding the scenario. 
• It can be difficult to segregate the risk between what exists on your balance sheet today and what is being introduced through expected activity. 

Many of ALMIS  International’s clients have adopted a static approach due to it’s ease and speed to implement and assess.  However the Basel principles do infer that institutions may opt (or need) to monitor their EaR under different approaches.  Ultimately, the board and managers of the institution need to consider the appropriate approach for measuring and evaluating this risk, alongside any conversations with regulatory supervisors.  And, upon implementation of these, it is critical to the management of the risk that the methodology is understood, along with any limitations.  Internal education is key to this and ensuring that the ALCO and other relevant committees have the appropriate expertise along with the necessary training in order that the key messages are understood and that effective challenge can be provided. 

Margin & Balance Sheet Report 

A foundation report of ALMIS® Front Office, this allows you to produce your balance sheet for today and drive meaningful insight into your current NIM position.  When combined with ALMIS® Front Office’s forward and backward looking capabilities, this can give you insight into not only where you are today, but where you were and where you are going. 

Static Earnings At Risk 

ALMIS® Front Office’s turn-key and comprehensive EaR sensitivity function allow you to calculate your EaR  on a constant balance sheet basis across user definable time horizons, where one year, two years or beyond.  You can easily apply parallel shifts – for example to model the EBA’s SOT 250bps parallel shift for GBP exposures – but also flexible to allow you define more complex and intricate interest rate scenarios you can define at categories, product or interest rate markets. 

Key benefits of  ALMIS® Financial Planner 

Financial Planner is a powerful tool within the ALMIS® Front Office solution providing clients  with the ability to use their existing balance sheet to automate the calculation of forward balance sheets using comprehensive user-definable scenarios. 

Adapting to change is key with Financial Planner you can create forward plans over a long period using monthly, quarterly or annual intervals or you can create weekly, or even daily plans depending on your needs.  

Embed your business assumptions to build out the resultant balance sheets.  With a user friendly interface you can interface data from Excel as well as comprehensive range of modelling assumptions, including: 

• Assumptions around business retention and roll-over. 
• The different characteristics and types of new lending and new deposit at business line or product level. 
• Model asset acquisition or asset disposals. 
• Embed expected assumptions around arrears, prepayment and early redemptions. 
• Model you funding requirements. 
• Depreciation and accounting adjustments. 
• Any capital raising activity and adjustments. 
• Incorporate overheads including fee income, management & capital expenditure and provisioning. 

Through the application of these assumptions to your existing balance sheet ALMIS® Front Office will project forward the resultant balance sheet position and allow you to see impact of this through a suite of detailed reports outlining the resultant interest income and interest expenditure (and other income statement entries) as a consequence of your plan, but also enabling all of the standard ALMIS® Front Office functionality on these positions as well. 

Report Writer 

Whilst ALMIS® Front Office holds a wealth of rich information, what is essential in order to drive out value from this is being able to flexibly and efficiently present this in a manner that can be put in from of Senior Management, ALCO and other committees.  In being able to do so efficiently, this allows time to be invested in the analysis and understanding of the drivers rather than spent in the manual production of charts and graphs. The ALMIS® Front Office Report Writer enables this precisely by offering a ‘one-click’ solution to publish an array of ALMIS® Front Office data and reports directly to Microsoft Excel and allowing you to: 

• Build custom reports by automating the publication of turn-key reporting directly to Microsoft Excel. 
• Pull data together from multiple reports calculated in ALMIS® Front Office. 
• Incorporate current balance sheet data with prior month comparatives and forward looking forecast data. 
• Incorporate ALMIS® Front Office data with other external data sources. 
• Leverage off Excel functionality to build automated graphics for inclusion in ALCO packs, board papers and other MI reporting. 

Summary 

Earnings at Risk is a subset of Interest Rate Risk in the Banking Book that will affect all institutions holding assets and liabilities that have asymmetric repricing characteristics.  Failure to manage EaR can result in tangible consequences that can be felt across all functions of the institution.  There are different methodologies that you can employ to assess your EaR measure and these differing methodologies have different benefits and limitations, both in terms of what they are telling you and the effort required to produce meaningful analysis.  Institutions need to balance the practicalities and data requirements in producing the analysis with the speed, resources and assumptions required and critical to the value this analysis can provide is ensuring the approach and measurement of this metric is understood. 

About the Author 

Stuart Fairley is Head of Client Experience at ALMIS® International and works closely with clients in his role.  Prior to joining ALMIS® in 2019, Stuart had spent most of his career working in the bank and building society sector and holding a number of finance and project roles.  Stuart is a also member of the Chartered Institute of Management Accountants (CIMA). 

Market leading experts in controlling risk, ALMIS® has been developing solutions to deliver accurate information on current and forward-looking positions for Treasury to proactively manage and plan. If you want to find out more book a demo.