44 Interest Rate Risk in the Banking Book (IRRBB)

This appendix gives you information on functionalities in ALM for Interest Rate Risk in the Banking Book (IRRBB ) regulation.

IRRBB refers to the current or prospective risk to the bank’s capital and earnings a rising from adverse movements in interest rates that affect the bank’s banking book positions. When interest rates change, the present value and timing of future cash flows change. This in turn changes the underlying value of a bank’s assets, liabilities, and off-balance sheet items and hence its economic value. Changes in interest rates also affect a bank’s earnings by altering interest rate sensitive income and expenses, affecting its net interest income (NII). Excessive IRRBB can pose a significant threat to a bank’s current capital base and/or future earnings if not managed appropriately.

Basel Committee on Banking Supervision (BCBS) has prescribed 12 updated principles to banks to manage IRRBB.

The following three main sub-types of IRRBB are defined for these Principles:

1. Gap risk arises from the term structure of banking book instruments, and describes the risk aris­ing from the timing of instruments’ rate changes. The extent of gap risk depends on whether changes to the term structure of interest rates occur consistently across the yield curve (parallel risk) or differentially by period (non-parallel risk).
2. Basis risk describes the impact of relative changes in interest rates for financial instruments that have similar tenors but are priced using different interest rate indices.
3. Option risk arises from option derivative positions or from optional elements embedded 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 characteriszed into auto­matic option risk and behavioral option risk.

All three sub-types of IRRBB potentially change the price/value or earnings/costs of interest-rate-sen­sitive assets, liabilities, and/or off-balance sheet items in a way, or at a time, that can adversely affect a bank’s financial condition.

BCBS has proposed a standardized approach that supervisor could mandate their banks to follow or a bank could choose to adopt it. The following functionalities have been added to ALM to meet the standardized approach requirements and also enable banks to adopt the advanced approach.

Approach

IRRBB approach in OFS ALM are explained below following sections.

• Amenability Category
• Retail/Wholesale and Transactional Non-Maturing Deposits
• Option Valuation
• Deposit Penalty for Early Withdrawal
• Identify Intra and Inter-Company Accounts
• Behavior Pattern Loader
• Material Currency