Interest Rate Risk in the Banking Book

Ahraz Sheikh

11.1 INTRODUCTION

While Parts I and II of this book focused on the losses incurred by the core material risks, the generalised risk modelling framework in Chapter 9 introduced the need for wider cashflow modelling, incorporating the revenue and cost components, for the simultaneous and consistent modelling of liquidity risk, economic capital and stress testing. Chapter 10 introduced business risk, which provides models for new (future) business and operating costs of the cashflow forecast. This chapter focuses on generating cashflow forecasts for banking book business lines. This is referred to as interest rate risk in the banking book (IRRBB), since most of the risks to banking book revenues are driven by changes in interest rates. However, the cashflows of these portfolios are subject to more risks than interest rate risk alone. For example, banks may have subsidiaries in many countries, and cashflow forecasts may require conversion to the bank’s “home” currency for consistent incorporation into forecasts and for risk and profitability comparisons for business decision-making processes. For this reason, many banks also refer to IRRBB as “non-traded market risk”. In this book we