We’re all outliers now: Europe’s unflattering IRRBB test

Banks, fearing overreaction from supervisors, urge European Commission to reject NII-based assessment

  • An outlier test helps supervisors identify banks whose loans and deposit books face the greatest risk from changes in interest rates.
  • Banks found to have the highest interest rate risk in their banking book (IRRBB) face increased supervisory scrutiny and additional capital requirements.
  • The European Banking Authority has designed a new IRRBB outlier test that measures earnings from interest-bearing products.
  • However, the industry fears that too many banks will cross the threshold for failure, and some are lobbying the European Commission to reject the proposal.

When the European Banking Authority announced a new supervisory test of banks’ exposure to interest rate shocks in October 2022, its proposals appeared timely. Central banks were hiking interest rates, which had the potential to reveal pricing mismatches in loan and deposit books.

However, the EBA’s calibration of the test, which will measure interest rate risk on the banking book (IRRBB), took place before the rate rises. Banks are now worried the framework could be much more severe than the authority originally intended.

The current test for IRRBB outliers assesses the risk by measuring the change in a bank’s economic value of equity (EVE) – the difference in the value of assets and liabilities before and after hypothetical rates shocks. A bank is deemed to be an outlier if it posts a theoretical loss amounting to 15% of its total Tier 1 capital.

Supervisors have the option to implement additional tests provided they are equally “stringent”. The EBA’s proposed test would assess the impact of shocks on net interest income (NII) – the total amount a bank receives from interest-bearing assets minus what it pays out on interest-bearing liabilities. If a bank’s NII declines, it is less able to retain earnings, which it can use to meet its minimum capital requirements.

If you actually apply the 2.5% threshold, it means that about half of the banks in Europe are outliers. Which is a bit of an odd thing to say, because they’re not really outliers then
Adrian Docherty, BNP Paribas

To ensure its test was as stringent as the current one, the EBA compared the effects of set rate shocks on both EVE and NII for 54 banks that had submitted IRRBB data from December 2020 as part of a quantitative impact study. If a shock reduced NII by an amount equivalent to more than 2.5% of Tier 1 capital, the bank would be classified as an outlier. Such a classification could result in greater supervisory scrutiny, and even Pillar 2 capital add-ons to mitigate risks not covered by minimum capital requirements.

The EBA based its NII threshold on “floor” assumptions about how far rates could drop into negative territory following shocks. It applied the same shocks and floors to both the NII and EVE tests; the intention was for the new test to produce a similar number of outliers as the current one.

A senior IRRBB specialist at a European bank says this approach is flawed because rather than establishing a threshold representing a level of risk that is considered too high, the test is “just a pure comparison of banks”.

Rates were at all-time lows when the EBA’s analysis was conducted – the European Central Bank’s main refinancing rate at the time was set at 0%, which meant banks would not have to apply the full downward shock of 200 basis points for euro-denominated assets and liabilities. Rates have now shot up in many parts of the world to combat soaring inflation. If they stay at the levels they are today – the ECB’s refinancing rate stood at 2.5% last month – when banks carry out their first NII test, they will apply the full supervisory shock.

For this reason, a senior treasury manager at a second European bank says the calibration in the EBA’s proposed test “is based on data that is no longer appropriate in a normalised rate environment”.

Even if rates had not risen, banks would still be more likely to fail the test now than when the EBA set the threshold, as they have further lowered the floor to be used in the EVE and NII tests. It will now be set at -1.5% for products with immediate maturities; this will rise by 3bp for each additional year until a 0% floor is set for products with maturities of 50 years or longer. The EBA did this because yields for euro bonds with maturities of five years or longer were below the old floor in March and December of 2020.

Adrian Docherty, head of bank advisory at BNP Paribas, has analysed publicly available figures in Pillar 3 reports to assess the likely impact of the test. “If you actually apply the 2.5% threshold, it means that about half of the banks in Europe are outliers,” he says. “Which is a bit of an odd thing to say, because they’re not really outliers then.”

The senior IRRBB specialist agrees that more banks will fail the test, as does Tim Breitenstein, director of financial services at consultancy KPMG. “It currently looks like there are a lot of banks that are either outliers or pretty close to this outlier threshold,” says Breitenstein. “It’s more than you would indeed expect from a typical criteria where you want to actually identify outliers.”

Contradiction in terms

The EBA has its own estimates of just how many more banks will be outliers, as it also calculated the decline in NII relative to Tier 1 capital without reference to the regulatory floor for 46 banks in its original analysis. This suggested at least 25%, but fewer than 50%, of banks would suffer a drop of at least 2.5% and therefore be classed as outliers. When the EBA applied the same analysis to 54 participating banks while taking the floor into account, the findings suggested only 5-10% would breach the 2.5% threshold.

“That‘s actually the reception I have currently [from banks], that indeed around 25% to 50% of banks would be outliers,” says Breitenstein. “So that fits to my observation.”

However, Dirk Jäger, head of banking supervision at the German Banking Industry Committee, cautions against relying on the results of a small sample of EU banks. According to data published by the ECB, there were 316 banking groups and 2,440 standalone credit institutions – including foreign-controlled subsidiaries – operating in the EU in November of last year. The sample used by the EBA, he says, may have been skewed towards a particular business model or geographic region.

“If the banks [in the sample] are in the same business models, then you will get the same results,” he says.

The senior IRRBB specialist at the European bank agrees: “Results may differ significantly from the ones used for the calibration.”

In its final report the EBA said it chose to apply the floor because of “current hedging strategies in place which might also be expected to adapt to the new regulatory framework”. Delphine Reymondon, the head of the authority’s liquidity, leverage, loss absorbency and capital unit, says she expects hedging strategies to change not as a result of the new test but because of the new interest rate environment; this, she believes, could mitigate NII risks as banks start to fret over the impact on their businesses of rates falling from their current heightened levels.

However, the senior IRRBB specialist says the significant increase in outliers means the test should be postponed until more data is available to recalibrate it. The EBA will soon undertake a further quantitative impact study using data from December 2022; this survey will ask for data for the NII outlier test, which the EBA urges banks to provide.

Reymondon says the test should still be implemented with the current threshold. She adds that the authority will consider revising the threshold, but only once changes in bank practices resulting from the surge in interest rates have become clearer.

“We probably have not yet seen the full effects of the increase in interest rates on assets and liabilities, in particular in terms of [the] pass through on the liabilities side, so the target is still moving,” she says. “This is why defining the right calibration today is still tricky.”

One behavioural change that could cause NII to fluctuate less would be if banks started to pass on more of the rate rises to depositors than they have done historically. If banks only raise rates for their assets, their NII will increase as they earn more money; but once rates fall, the banks will have to pass on more of the change to their assets, resulting in a decline in NII.

“If and when they start doing this more extensively – for example, if there is more competition in terms of remuneration of deposits – the impact on the decline of NII would be lower in a downward scenario compared to the baseline scenario of the banks,” says Reymondon.

Banks may not have to wait long before the EBA revises the technical standards – the legal instrument outlining the test. The Basel Committee on Banking Supervision announced on December 16 that it would review the shock scenarios used within its IRRBB standard as part of its two-year work programme for 2023 and 2024. The 2.5% threshold could be increased once the EBA revises the standards to incorporate any changes requested by the committee.

Normally, the outlier threshold would spell trouble for a bank, as its supervisor would begin to scrutinise the bank’s management of the risk as it approached the threshold.

“All of these things are looked at continuously as part of the supervisory dialogue,” says BNP Paribas’s Docherty. “So I wouldn’t make a big deal out of going from a 2.4% to a 2.6% share of Tier 1 capital. If you are at 2.4%, you get more attention than if you are at 0.2%. So all of these things have an increasing intensity as the scale of the decline gets bigger. Ultimately it will lead to [a Pillar 2 requirement] – and, for a bank with a significant interest rate risk, that could be a sizable add-on. So there are concrete outputs, but they are not automatic.”

The EBA expects that supervisors will not penalise those banks classified as outliers if there are significant numbers of them.

“We would strongly expect that the supervisors will exercise a reasonable supervisory judgment,” says Reymondon. “If everyone is an outlier, then there are no outliers anymore. The supervisor can target the ones which are still in the bucket of ‘real’ outliers, where they would need additional scrutiny and heightened supervisory dialogue.”

Too soon to revise?

The EBA’s efforts at reassurance have not stopped banks and advocacy groups from calling on lawmakers to not adopt the rules.

The senior IRRBB specialist says there is now “uncertainty” about whether supervisors will look favourably on banks’ explanations that they are not running significant risks.

Two sources say the European Banking Federation is lobbying the European Commission not to approve the EBA’s technical standards due to the test’s threshold. A third source, the senior treasury manager at the second European bank, says the EBF is lobbying for a higher threshold.

Before the technical standards become law, they must be approved by the commission, the Council of the EU (comprising the bloc’s elected heads of government) and the European Parliament. The commission must first adopt the technical standards – which it can adopt in part only or to which it may make amendments – according to the EU laws on delegated acts. The parliament and the council will have the chance to object to the rules within the first three months after the commission has adopted the standards, though they cannot make their own changes. If any of the legislators decide to halt the proposals, the EBA will be asked to make alterations that would satisfy the three legislative bodies’ concerns.

Risk.net did not receive comment from the EBF and the European Commission in time for the publication of this article.

It’s not all about EVE

The EVE and NII tests have a seemingly inverse relationship to each other. Under the former, banks with a greater proportion of longer-dated fixed-rate assets would find themselves at heightened risk during an upward rate shock as a result of their assets declining in value. Under the latter, banks with a greater proportion of short-dated fixed or variable rate assets would find themselves most at risk from NII volatility during a downward shock as their assets generated less income.

“In the UK, banks have in general more variable rate mortgages or at least shorter fixed period products compared to some countries in western Europe, like the Netherlands and Germany,” says Berend Ritzema, an IRRBB modelling specialist at Deloitte in the Netherlands. “In some southern European countries, like Portugal, banks on average also have more variable rate products, which could impact the sensitivity towards earnings-based metrics.”

KPMG’s Breitenstein says banks can find themselves having to balance their expected profits, along with EVE and NII. For example, a bank investing its capital in five-year fixed rate mortgages would face a risk to its EVE as the loans lost value when rates increased, but it would not face a risk to its NII. The bank could take out interest rate derivatives whereby it received variable payments to offset the value risk (as the contracts would increase in value according to the EVE calculation once rates had risen). However, variable paying products also lose income once rates decrease, and the bank would potentially pay out more on the fixed leg of the trades, thereby creating risk to its NII.

Editing by Daniel Blackburn

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