Reviewing guidance for IRRBB and impact on the business

Reviewing guidance for IRRBB and impact on the business

By Fabio Perata, Head of Section/Joint Supervisory Team Coordinator, European Central Bank 

Fabio, can you please tell the Risk Insights readers a little bit about yourself, your experiences and what your current professional focus is?

I have been working in the Financial Services industry since 1993, developing a cross-border and have extensive experience in the areas of Internal/External Audit, Business and Financial control, Risk Management, Compliance and Internal Controls and Banking Supervision.

In May 2014 I was appointed as Head of Section at the European Central Bank in Frankfurt, in the context of the newly created Single Supervisory Mechanism, fulfilling in particular the role of Joint Supervisory Team Coordinator for the supervision of some large institutions in the Belgian and French market. I have also been member of the steering committees of several relevant SSM-horizontal projects such as the Cyber Risk Thematic Review, held in 2015 and the TRIM, still on-going.

Can you briefly explain the importance of conducting ECB stress test reviews?

The stress test exercise, besides being an annual obligation imposed by CRDIV, fulfils the superior supervisory interest of testing the sensitivity and resilience of credit institutions to macro-economic adverse scenarios affecting all their main risk drivers (EBA general stress test, every 2 years) or some specific risk drivers (as the 2017 IRRBB ECB stress test).

The outcome of stress test exercise is incorporated as key additional information on the overall risk profile of credit institutions in the annual Supervisory Review and Evaluation Process (SREP), resulting in the calibration of the P2G component of the PII capital requirements.

At the Risk EMEA 2018 Summit, you will be speaking on your insight regarding ‘Reviewing guidance for IRRBB and impact on the business’. Why is this a key concern right now? And what are the essential things to remember?

The management and control framework of IRRBB has remained in the shadows for a long time, both within banks and from a supervisory perspective, due to the wide spread perception of being more a technical issue for ALCOs rather than a strategic topic able to affect the profitability and the value of the credit institutions.

The ECB stress test performed in 2017 has shown the large impact on both the profitability and the value of credit institutions of model assumptions and hedging decision taken in the context of the ALM, hence a strong, two ways correlation between the business model and ALM framework and policies.

This correlation needs to be under close scrutiny in this particular moment, where we are approaching a possible turn-around in the “low for long” interest rate scenario as well as some possible disruptions of the competitive framework driven by relevant technological changes such as the increasing relevance of on-line deposits.

What do you think are the main post implementation challenges?

The implementation of the new requirements might be very challenging for banks that, due to their limited size/complexity and/or the peculiarity of their business models, currently do have weaknesses in one or more dimensions tackled by the new regulation (governance and risk appetite framework, internal and external reporting, modelling assumptions and measurement techniques, effectiveness and oversight of hedging strategies).

We can therefore expect a large heterogeneity in terms of compliance by institutions with the new requirements after the deadline of 31.12.2018. This may result both in business impacts (mainly due to wrong modelling assumptions and/or ineffective hedging strategies) and in reputational risks (related to the disclosure requirements and outcomes of the outliers test). Supervisory authorities are therefore expected to pay special attention to possible drawbacks stemming from the implementation of the new requirements and to ask remedial actions on a timely basis before considering more constraining measures in terms of capital add-on.

What are some of the important things to remember when dealing with disclosure requirements?

The outcome of the quantitative analysis is largely affected by the business model (contractual asset’s duration) and the model assumptions and hedging strategies decided in the context of ALM framework and policies for steering the IRRBB generated by the business model. Therefore, the Institutions should focus their communication effort in providing insight on these assumptions and hedging strategies, highlighting also the priorities assigned in case of a clear trade-off between the  protection of earnings and the protection of the economic values and their possible evolution in view of a change in the their economic and competitive environment.

How do you see the risk landscape evolving over the next 6-12 months?

The relevance of IRRBB is increasing due to the convergence in the foreseeable future of a combination of relevant changes:

  • Macro-economic, with the likely progressive return to a more normal IR context following the end of ECB QE (although with relevant uncertainties about the timeline and the strengths of IR rise);
  • Technological, such as on-line deposits;
  • Tax-related, such as the evolution of tax regime of deposits in some countries.

All these changes are likely to not be properly captured by most of models that are currently used for ALM purposes (NMD, pre-payment), which were developed in a substantially different context. Institutions  and supervisors should therefore pay a particular attention to the governance and risk management framework around the ALM models and hedging strategies, aimed at fostering the prompt design and implementation of pre-emptive measures based on the analysis of credible alternatives both in models’ design (e.g. impact on duration of liabilities with different assumption on the “stable layer”) and hedging strategies (e.g. reduction/stop of fixed rate receiver swaps, recourse to “swaptions”…).

 

 

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