Effectively managing risk and losses in the banking book in line with increasing interest rates

Hadrien van der Vaeren, SVP, Market and Liquidity Risk, BNY Mellon

Below is an insight into what can be expected from Hadrien’s session at Balance Sheet Management Europe 2023.

The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.

How can firms meet capital requirements when managing IRRBB as a risk?

Interest Rate Risk in the Banking Book (IRRBB) impacts capital and capital requirements.

The capital impact is primarily through bonds/investments held under the available-for-sale or fair value through OCI designation. The change in value of these bonds directly impacts capital. As rates have increased, the value of fixed-rate bonds has decreased, eroding the capital. However, as long as banks don’t sell the bonds, these losses will revert naturally as the bonds mature.

IRRBB also impacts the capital requirements via Pillar 2 (i.e. a bank’s own estimate of capital requirements). Under Pillar 2, there are no standard rules to compute capital requirements; hence various banks might take different approaches. Overall, the approach should assess how well the interest income/expenses or value of assets and liabilities are matched and how much this could change under an interest rate shock.

Therefore, managing capital requirements usually takes two main forms:

  • Managing the mismatch between assets and liabilities
  • Managing the accounting treatments

Managing the mismatch is done through incentivizing third parties (e.g., increasing the interest paid on deposits to obtain more) and having the Treasury manage positions they control (e.g., buying bonds with excess liquidity of the bank). When bonds are purchased, deciding on the interest rate characteristics (fixed vs. floating and maturity) is important. In addition, the accounting classification is important. As explained before, if bonds are designated as available for sale / fair value through OCI, interest rate changes will impact available capital. The most main alternative is to designate them as held to maturity, in which case valuation changes will not impact capital, but it offers less flexibility in using these bonds to generate liquidity.

In what ways have IRRBB been mismanaged, and what long-term implications has this had?

IRRBB is getting much more attention given recent bank failures (e.g., SVB). Nonetheless, most banks have continued to provide their services and perform well during this period. In my opinion, this demonstrates adequate management of IRRBB.

Looking at the long-term implications, regulatory expectations might rise and some changes are being discussed. In particular, in the US, some banks were able to ignore the impact of unrealized losses on capital, e.g. SVB. This is likely to change. In Europe, the guidelines on IRRBB were updated recently and I don’t expect additional change. However, I expect the regulators to pay more attention to ensure banks comply with the guidelines.

On the positive side, a lot of pressure that the banking sector felt came from the rapid increase in interest rates. But now that rates have stabilized at a higher level it will provide better fixed income investment opportunities which should benefit banks and financial institutions that are cash rich.

How can financial institutions manage the volume and speed of interest rate changes on the banking booking?

In line with the previous question, my personal view is that most financial institutions have demonstrated that they can manage the recent volatility. I believe the impact on non-banks might not yet be fully reflected. For example, property developers who might have assumed cheap funding would remain available and their financial performance might continue to worsen. Today the risk to financial institutions is probably mainly if they have exposure to counterparties that mismanaged their interest rate risk rather than financial institutions having mismanaged interest rate risk directly.

Another potential risk is if central banks take drastic action. For most banks, higher interest rates are positive as this helps improve net interest margin. As such, a material reduction in Central Bank rates would be negative for banks.

In what ways will the further defined CSRBB impact financial institutions?

New guidelines in Europe provide more detailed expectations with respect to Credit Risk in the Banking Book (CSRBB). The proposed new rules remain relatively high-level but reflect increased regulatory interest in this topic. Given differences in business model the approach taken for CSRBB could vary materially. My expectation is that regulators will use the new requirements to probe the practices of various banks and that this will slowly create more standardisation.