Differences Between Interest Rate Risk (IRR) in the Banking and Trading Book
There is often confusion about the different nature of the Interest Rate Risk (IRR) in the banking book versus the trading book and what needs to be measured. Before we go into the differences, let’s reflect on the main differences between the trading and banking books.
The trading book refers to assets held by a bank that are available for sale and hence regularly traded. The trading book is required under Basel II and III to be marked-to-market on a daily basis. The Value-at-Risk (VaR) for assets in the trading book is measured on a 10-day time horizon under Basel II.
The banking book refers to assets on a bank’s balance sheet that are expected to be held to maturity. Banks are not required to mark these to market. They are usually held at historical cost.
With the interest rate risk of the banking book, the Basel Committee on Banking Supervision (BCBS)1 aims primarily to address the potential loss of economic value of institutions from a change in the interest rates called IRR and Credit Spread Risk (CSR) in the banking book2. BCBS addresses IRR in the trading book under the Fundamental Review of the Trading Book (FRTB)3 Pillar I capital charges. IRR in the trading book is subject to Pillar I and hence carries a capital charge, whereas Interest Rate Risk in the Banking Book (IRRBB) is subject to Pillar 2 and does not carry a regulatory charge. As such, this provides an opportunity for regulatory arbitrage.
Banks of all sizes and levels of sophistication are required to calculate IRRBB, hence a simple sensitivity approach has been imposed by the regulators. However, such a model is not capable of portraying the risks accurately and is not a good basis for holding capital.
In IRRBB, the shift in interest rates is not necessarily the main driver of risk; unexpected customer behavior and the treatment of Non-Maturing Assets (NMA) can also have a significant influence on interest income.
Pessimistic customer behavior includes pre-payment of loans for assets and early withdrawal of term deposits for liabilities. However, customer behavior normally does not have an impact on the trading book because the deals are normally contractual in nature.
NMA models are typically specific to business units as well as sector and jurisdictions, and therefore aim to move cash flow further down the maturity ladder, which is normally designed by the bank.
FRTB demands a clear segregation of banking book and trading book instruments. There is a clear criterion for assigning instruments to the trading book with the objective of ensuring only traded instruments are included in capital calculations and that regulatory arbitrage is minimized. This methodology is involved with exposures to interest rates regardless of the type of instrument. It is also concerned with the exposure to other risk factors such as FX rates and commodities. It is a portfolio approach to calculating capital and the methodologies used in FRTB are designed to calculate capital charges. Banks will need to decide whether they only seek to comply with the Standardized Approach (SA) or also the Internal Model Approach for calculating the market risk capital charge, subject to the approval of the national authorities.
Banking Book Exposures
For the banking book, changes in interest rates affect a bank’s earnings by changing its Net Interest Income (NII), because banking book assets and liabilities are accounted for at amortized cost. They also affect the Economic Value (EV) of the bank’s assets, liabilities, and off-balance sheet instruments since the present value of future cash flows—and in some cases, the cash flows themselves—change when interest rates change.
Economic Value of Equity (EVE) = Assets – Liabilities.
Changes in interest rates affect a bank’s earnings by changing its NII.
A balanced balance sheet requires the EVE to change accordingly. This change is called Economic Value at Risk (EVR).
1. EVR = change (IRate and duration delta) in assets – change (IRate and Duration
delta) in liabilities.
2. EVE consists of non-earning assets and is the shareholders’ equity, consisting of share capital, regulatory capital, retained earnings, and capital reserves. Most of these are CET1 capital items, i.e. a buffer to absorb unexpected losses.
3. It is fair to say that EVR would represent the drop/increase in EVE equal to the NII change in assets and liabilities.
4. This NII or EVE are both relevant measures in the context of managing IRRBB.
IRRBB Risk Metrics
For IRR management purposes, two broad categories of risk measurement approaches are being applied in the industry: earnings-based metrics and EV metrics.
EV measures mainly focus on valuing the cash flows arising from existing assets and liabilities under different future interest scenarios, ignoring future business flows. The change in EV (i.e. the change in the NPV of future cash flows as a result of a change in rates) can be calculated across all types of assets and liabilities. When a change in the EV of the whole banking book is calculated, the outcome is highly influenced by the treatment of the bank’s own equity capital liability in the calculation. The market value of equity is computed as the present value of asset cash flows, less the present value of liability cash flows, without including assumptions on the interest rate sensitivity of the equity. If surplus capital is used to finance assets, the impact of IR changes should be taken into consideration—this is called the earning-adjusted-EV method. Under this approach, IRRBB is measured by means of the following six scenarios:
- parallel shock up
- parallel shock down
- steepener shock (short rates down and long rates up)
- flattener shock (short rates up and long rates down)
- short rates shock up
- short rates shock down
Earnings-based measures look at the expected increase or reduction in NII over a shorter time horizon (typically one-to-three years, up to a maximum five years) resulting from interest rate movements that are composed of either a gradual or a one-time large interest rate shock. The change in NII is the difference in the expected NII between a base scenario and an alternative, more stressful scenario. In assessing the possible extent of change in NII, banks can use models to predict the path of rates and the run-off of existing assets and liabilities.
Banking Book instruments are accounted for on an amortized basis. The purpose of calculating IR risk in the banking book is to assess the impact on future earnings as well as the impact on shareholders’ equity. Thus we are measuring the impact on profitability; we are not trying to estimate potential losses. Trading book instruments are accounted for on a mark-to-market basis. The purpose of calculating IR risk in the trading book is to assess the impact on unrealized P&L and hold capital against such a potential unexpected loss.