Managing and Hedging IRRBB

Paul Newson

The previous chapter discussed how IRRBB is usually identified and measured; this chapter will now provide a description of how it is controlled and managed by banks. The prime focus is on those open mismatch positions that are essentially discretionary – ie, fairly easily closed – and how a bank might best organise itself to reduce such unnecessary risk in a way that is also efficient and cost-effective. In this, the general presumption is that the bank has no appetite for expressing a particular interest rate “view” in its banking book or, in other words, that it will want a gap report that generally shows a minimum of mismatch risk.

USE OF DERIVATIVES

As mentioned in Chapter 2, interest rate derivates, particularly IRSs, in theory provide a ready means of hedging any simple interest rate risk that arises from the origination of customer products, particularly fixed rate loan products where cash funding is unlikely to be available at the same re-pricing maturity as the customer product.

For example, a three-year fixed rate mortgage initially cash-funded at three-month Libor creates an exposure to the funding rate rising. A three-year pay fixed/receive Libor closes the