Proposed rules to impose a capital charge on interest rate risk on the banking book could make managing core lending much more complicated.

What is it?

In June 2015, the Basel Committee on Banking Supervision (BCBS) began consulting on a capital framework for interest rate risk in the banking book (IRRBB). This is designed to ensure that banks hold sufficient capital to protect against a sharp move in interest rates. The other stated aim of the BCBS is to prevent arbitrage between the banking and trading books, by ensuring that interest rate risk is well capitalised in both. A working group has been preparing this paper for some years, but it remains highly contentious because different countries have very divergent approaches to regulating such a core activity.

Which way to go?

To reconcile those differences, the BCBS offered multiple options in its consultation, for which responses are due by September 11, 2015. First, respondents are asked whether IRRBB should be incorporated into pillar 1 capital requirements, or under pillar 2 (supervisory reporting and capital add-ons) with enhanced disclosure under pillar 3 (public reporting). The BCBS expresses a preference for maximum harmonisation using pillar 1, but will incorporate the consultation feedback.

Second, the methodology for calculating the IRRBB capital charge incorporates both the effect of interest rate changes on the economic value of the bank’s equity (EV), and on net interest income (NII). Regulators would apply whichever of these methods resulted in a higher capital requirement.

This dual approach lays bare the divide between regulators such as the Bank of England, who favour market-consistent valuations of all aspects of the balance sheet, or those who prefer a cash-flow-based approach to banking book accounting. The BCBS recognised that the majority of jurisdictions use the NII approach.

“The problem is that banks manage their risks using one method or the other. Trying to manage to both is like trying to drive a car with two steering wheels that could be pulling in opposite directions,” says Paul Sharma, co-head of financial industry advisory services at Alvarez & Marsal and a former BCBS member during his time as deputy head of the UK Prudential Regulatory Authority.

What do the banks say?

Support for the NII approach was clear in the immediate response issued by the American Bankers’ Association (ABA). ABA chief executive Frank Keating warned that Basel’s “global one-size-fits-all approach” would only disrupt banks’ current strategies to prepare for higher interest rates.

Reg rage extreme fear

“While interest rate risk is real, a new set of international rules that will confuse efforts to manage it and make it even harder for banks to serve their customers is not the answer,” said Mr Keating.

A further aspect likely to attract most industry criticism is the assumptions around the behaviour of assets and liabilities. The exact impact of rising interest rates on a bank – whether measured by EV or NII – partly depends on how far depositors demand a repricing of liabilities, or the bank itself is able to reprice loans.

The IRRBB paper sets a minimum assumption of 40% for the proportion of non-maturity deposits that should be treated as overnight liabilities. That is, they would be immediately withdrawn if rates are hiked even by a minimal sum, unless the bank raised deposit rates. This seems extremely harsh, especially compared with the 3% to 5% retail deposit run-off assumptions in the Basel liquidity coverage ratio. Paul Newson, an independent consultant who was head of non-traded market risk oversight at the UK’s Lloyds Bank until 2014, says the problem stems from efforts to prevent trading book arbitrage.

“You can decompose the trading book into its approximate cashflows because all positions are fungible and banks take the net present value up front so it matters what happens to interest rates tomorrow. That is not the case for the banking book where the way banks make money is mainly based on the assumptions about the behaviour of customers, competitors and the bank itself. There seems to be no provision here for loan book remargining,” says Mr Newson.

What happens next?

With almost half of the 65-page paper devoted to mathematical formulae, the IRRBB framework will make maturity transformation and fixed-rate lending a more complex and expensive business, especially if Basel takes a pillar 1 approach. Mr Sharma says even if the pillar 2 and 3 approach is adopted, public disclosure is likely to push banks to capitalise interest rate risks with a higher safety margin than a confidential pillar 2 disclosure to supervisors only.

“I am not sure whether Basel has modelled the potential impacts on credit availability depending on the business models and make-up of individual markets today,” says Ruth Wandhofer, global head of regulatory strategy at Citi transaction services.

Mr Sharma says banks in each jurisdiction will need to present those hard numbers on the impact of IRRBB rules on the supply of credit to the real economy as part of their responses. If the implications are serious, national governments will become progressively less likely to implement a pillar 1 approach.

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