OREANDA-NEWS. The Basel Committee on Banking Supervision's final standards on how banks should measure and control interest-rate risk in the banking book (IRRBB), which were published last week, will improve consistency and make it easier for investors to compare data across banks and banking systems, says Fitch Ratings.

The new rules will force banks to follow a set of prescribed IRRBB principles and apply six common shock and stress scenarios. Greater standardisation of behavioural and modelling assumptions will introduce a level playing field across banks, while enhanced disclosure requirements will provide greater transparency. For example, by forcing banks to split out the impact of changes to economic value of equity and net interest income under the prescribed scenarios, market participants will be able to form a clearer picture of how interest-rate risk affects capital and earnings.

Banks will still be able to apply IRRBB capital requirements under a Pillar 2 approach, which allows them to use internal processes and assumptions to calculate risks, albeit under narrower guidelines. The alternative approach previously proposed - to force banks to use standardised assumptions and prescribed methodologies to model repricing cashflows, and hold an explicit Pillar 1 minimum capital requirement - would most likely have resulted in more onerous capital requirements and implementation costs for banks.

The new standards require banks to hold capital explicitly against credit spread risks in the banking book (CSRBB). This is a separate type of risk, but closely associated with IRRBB. It arises from variations in the premium that the market requires for different types of instrument, reflecting both credit and other market risks, such as liquidity. In the past, some banks would sometimes ignore CSRBB or reassign these risks into their trading book, to be offset and netted out with other trading positions, or to reallocate positions to the banking book. This could mean they were holding reduced or no capital charges to cover CSRRBB. But the Committee's new requirement will limit incentives for arbitrage between banking and trading book assignment.

Changes in interest rates affect a bank's net interest earnings. They affect the underlying value of a bank's assets, impact its funding costs and make it more vulnerable to contingent risks from off-balance sheet exposures. This is why the Basel Committee says that banks must hold capital to protect themselves against these market risks.

If IRRBB is not adequately measured and controlled, a bank's capital base and/or future earnings can come under threat. This is particularly relevant because interest rates in many countries are at historically low levels and there is a risk that interest-rate risk could increase significantly once rates 'normalise'.

Under the new standards, regulators are also given detailed guidelines under which to carry out their supervisory reviews, which could lead to higher common minimum standards. Regulators will have to conduct detailed tests and thresholds to ascertain if a bank is an outlier in terms of its capitalisation of IRRBB, adding more transparency. If supervisors suspect that a bank is not adequately capturing and capitalising IRRBB, they can impose a capital calculation under the more conservative standardised approach, which is likely to lead to higher capital requirements.
Banks will have to disclose their IRRBB requirements under the new enhanced standards from January 2018.