The Stakeholders of Interest Rate Risk Behavioural Models

Roberto Virreira

[If we] carry a “small-scale model” of external reality, [we] are able to react to future situations before they arise, utilise the knowledge of past events in dealing with the present and the future, and in every way to react in a much fuller, safer, and more competent manner. Craik (1943)

Behavioural models have been in place in the banking industry since its inception: banking is not possible without understanding whether customers will pay their loans or withdraw their deposits. Assume, in the absence of reliable information, that all customers may withdraw their deposits or that none would repay their loans – this would render banking impossible. Banks need to understand past events and forecast future scenarios as part of their core business. Bankers are also required to discern whether they can lend and borrow in a profitable way, and depend on behavioural models to predict whether customers will keep their deposits, prepay their loans or demand banking products contingent upon the margins they are charged. The concept of interest rate risk in the banking book (IRRBB), along with liquidity and credit risk, define the basics of the business model of a bank.

IRRBB