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Guidelines on Interest Rate Risk in Banking Book (IRRBB)

Reserve Bank of India (RBI) had issued guidelines on governance, measurement and management of Interest Rate Risk in Banking Book.

What is Interest Rate Risk in Banking Book (IRRBB)? 

Interest Rate Risk in Banking Book (IRRBB) refers to the current or prospective risk to banks’ capital and earnings arising from adverse movements in interest rates that affect its banking book positions. 

How does the change in interest rates affect banks?

  • When interest rates change, the present value and timing of future cash flows change. These changes in turn affect the underlying value of banks’ rate sensitive assets, liabilities, and off-balance sheet items and, hence, their economic value (EV). 
  • Changes in interest rates also affect banks’ earnings by altering interest rate-sensitive income and expenses, affecting their net interest income (NII). 

What is the impact of excessive IRRBB?

Excessive IRRBB can pose a significant risk to banks’ current capital base and / or future earnings if not managed appropriately. 

What are the guidelines on IRRBB?

  • The guidelines require banks to measure, monitor, and disclose their exposure to IRRBB in terms of potential change in Economic Value of Equity (ΔEVE) and Net Interest Income (ΔNII), computed based on a set of prescribed interest rate shock scenarios.
  • Banks should also develop and implement an effective stress testing framework for IRRBB, which should be commensurate with their nature, size and complexity as well as business activities and overall risk profile. This framework should be used to assess the potential impact of the scenarios on the bank’s financial condition, enable ongoing and effective review of stress tests and recommend actions based on the stress test results.
  • The overall level of capital should be commensurate with both the banks’ actual measured level of risk (including for IRRBB) and its risk appetite and be duly documented in its ICAAP report under Pillar 2.
  • Banks shall disclose the measured ∆EVE and ∆NII under the prescribed interest rate shock scenarios.

What is Outlier Test?

Banks which generate a decline in EVE (i.e. ∆EVE) of more than 15% of its Tier 1 capital under any one of the 6 prescribed interest rate shock scenarios, shall be identified as ‘outliers’ potentially having undue IRRBB exposure. 

These banks shall be required by the RBI to take one or more of the following actions as determined during the Supervisory Review and Evaluation Process (SREP) –

  • Raise additional capital
  • Reduce its IRRBB exposures (e.g., by hedging)
  • Set constraints on the internal risk parameters used by a bank
  • Improve its risk management framework

Which are the prescribed interest rate shock scenarios?

Under this approach, IRRBB is measured by means of the following 6 scenarios –

  • Parallel shock up
  • Parallel shock down
  • Steepened 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

Which entities are covered under the guidelines?

The guidelines are applicable to all commercial banks (other than Regional Rural Banks, Small Finance Banks, Payments Banks and Local Area Banks).

From when are the guidelines applicable?

The date for implementation will be communicated by the RBI in due course. However, banks are required to be in preparedness for measuring, monitoring, and disclosing their exposure to interest rate risk in the banking book.

Ahead of the implementation, banks shall submit the required disclosures, within 2 months from the end of the respective quarter, as per following schedule –

Entities Frequency Return to be submitted from the quarter ended
D-SIBs Quarterly March 2023
Other Banks Quarterly June 2023

What is Gap risk?

  • Gap risk is a risk arising from the term structure of instruments in banking book that arises from differences in the timing of their rate changes. 
  • The extent of gap risk depends on whether the changes to the term structure of interest rates occur consistently across the yield curve (parallel risk) or differentially by period (non-parallel risk).

What is Option risk?

  • Option risk is a risk arising from options (embedded or explicit) in a bank’s assets, liabilities and / or off-balance sheet items where the bank or its customer can alter the level and timing of their cash flows. 
  • Option risk can be further characterized into automatic option risk and behavioural option risk.
  • Embedded or explicit automatic option risk is the risk arising from standalone instruments, such as exchange-traded and over-the-counter option contracts, or explicitly embedded within the contractual terms of an otherwise standard financial instrument (e.g., floating rate mortgage loan with embedded caps and / or floors) and where the holder will almost certainly exercise the option if it is in their financial interest to do so.
  • Embedded behavioural option risk is the risk arising from flexibility embedded implicitly or within the terms of financial contracts, such that changes in interest rates may effect a change in the behaviour of the client (e.g., Rights of a borrower to prepay a loan, with or without penalty, or the right of a depositor to withdraw their balance in search of higher yield).


References

Reserve Bank of India. (2023, February 17). 'Governance, measurement and management of Interest Rate Risk in Banking Book'. Retrieved from https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12456&Mode=0


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