Interest rate risk in the banking book (IRRBB) refers to bank’s risk arising from changes in interest rates on the money and capital markets. This risk is caused by the differences between the fixed interest rates of the asset and liability side transactions allocated to the banking book as well as by the derivatives used.
LEVEL OF INTEREST RATE RISK (IRRBB)
In this context, the extent of maturity transformation between the fixed-interest periods on both the asset and liability side has a significant influence on the level of interest rate risk. Especially in retail business, natural maturity transformation occurs in the case of long-term customer loans on the asset side and non-maturity deposits at variable interest rates on the liability side. Derivative instruments can be used to selectively manage a maturity transformation position, i.e. to reduce or increase it.
MEASURING INTEREST RATE RISK IN THE BANKING BOOK
The interest rate risk in the banking book can be measured and managed in terms of economic value or from an earnings perspective. The economic value perspective quantifies the risk as a change in economic value of the total banking book cash flow due to changes in the yield curve.
Therefore, the focus is on the impact of the change of the interest rate level on the economic value of a bank’s asset and liability side transactions. An increase in interest rates from today’s point of view, for example, reduces the value of the cash flow of an asset transaction (or of the total banking book cash flow with a long-term asset overhang). The earnings perspective, on the other hand, quantifies the direct impact on a bank’s P&L statement, which is reflected particularly in the net interest income and, if applicable, in the changes of market value of certain instruments depending on their accounting treatment.
Banks should be able to quantify the effects of interest rate changes, both from an economic value and from an earnings perspective, in order to be able to derive steering impulses in line with their strategic objectives and to ensure their risk-bearing capacity.
REGULATORY REQUIREMENTS FOR MEASURING AND MANAGING INTEREST RATE RISK (IRRBB)
Due to the generally high relevance of the interest rate risk in the banking book—particularly in the context of a prolonged period of low interest rates—the international and national regulatory authorities have imposed a large number of regulatory requirements for measuring and managing interest rate risk.
In 2018, the European Banking Authority (EBA) published guidelines (EBA/GL/2018/02) on the management and measurement of interest rate risk. The EBA/GL/2018/02 constitute the foundation for implementing the IRRBB standards (BCBS #368) published by the Basel Committee on Banking Supervision (BCBS) in 2016.
Further elements on the implementation of BCBS #368 include the European Commission’s CRD V (including the economic value based standardized approach) and CRR II (quantitative and qualitative disclosure). In addition, the German regulatory authorities also impose regulations directly related to interest rate risk, which are based on European and international standards and thus ensure consistency of regulatory requirements.
Germany, for example, is subject to the MaRisk regulations (minimum requirements for risk management) and the BaFin circular 06/2019 (BA) on interest rate risk, which addresses the economic value based interest rate shock. The less significant financial institutions (LSIs), which are supervised by the BaFin in Germany, can also be required to hold equity for interest rate risk within the framework of the regulatory review and measurement process (LSI-SREP).
We anticipate further regulatory changes in the upcoming years. These include the definition and measurement of credit spread risks and the implementation of a earnings based outlier test to supplement the economic value based interest rate shock already established.
Sources: BaFin, Bundesbank, BCBS, EBA, zeb.research.
 See also BankingHub: Gramatke/Kollmeyer/Benz (2016): “Final BCBS standards on interest rate risk in the banking book”.
 See also BankingHub: Gramatke/Franke/Kollmeyer (2016): “Neue Kapitalanforderungen für das Zinsänderungsrisiko im Bankbuch im Rahmen des SREP” (German version) as well as BankingHub: Schiele/Franke/Abraham (2020): “LSI-SREP 2.0: Hintergründe, Herausforderungen und Implikationen” (German version).