The drawn-out death of a standard IRRBB charge

For 23 years, regulators have been trying – and failing – to standardise banking book rates risk

Catherine Contiguglia

Resolutions made in January are often destined for failure; they are too ambitious, out of touch with reality and require more effort than anyone is willing to put in. The same dynamics have ended plans for a standardised capital framework that would catch bank deposit and loan portfolios.

The latest attempt to apply a Pillar 1 treatment to interest rate risk in the banking book (IRRBB) got under way in 2012, as regulators tried to head off arbitrage between banking and trading books. But regulatory support quickly splintered and it took three years for the group to deliver its first consultation paper, which sketched out two contrasting paths.

As is the case with achieving rock-hard abs in three weeks, it is one thing to resolve banks will use a common approach to banking book rates exposure and another entirely to see it through.

The banking book includes non-traded items such as deposits and loans, for which estimating the impact of rate shocks is complicated. If rates rise tomorrow, will your grandmother empty her accounts and invest in foreign exchange? You don't know? Neither does the bank.

So, as with most New Year's resolutions, the most recent failure to standardise IRRBB capital came with a strong sense of deja vu. In 1993, the Basel Committee on Banking Supervision took a first stab at standardisation, eventually admitting "extensive discussion has not revealed a consensus on a standard approach or common set of assumptions which could be applied across all classes of instruments and across all countries". A US effort launched in 1992 later failed, largely for the same reasons.

As is the case with achieving rock-hard abs in three weeks, it is one thing to resolve banks will use a common approach to banking book rates exposure and another entirely to see it through

Basel released new guidance in 2004, for the first time recommending an outlier test based on the impact of a standard shock on economic value, but stopped there. Australia put IRRBB under Pillar 1 in 2008, but Australian banks still use internal models and some of the most contentious aspects of IRRBB standardisation are absent, such as prescribed slotting for non-maturity deposits and the overnight treatment of equity.

Fans of standardisation have a point: how banks measure IRRBB is opaque and there are plenty of opportunities to fudge the numbers. For example, more than one industry participant has let slip that modelling the duration of liabilities with no contractual maturity can be less than scientific – they are simply set off against whatever is on the asset side of the balance sheet.

But opponents have a point too. Standardisation could misrepresent risk and force institutions to run their business in line with unrealistic models, ignoring the real risks they hold in their books. And 23 years of debate seems a whole lot of work for what many see as a fairly benign risk in comparison with other exposures faced by the industry.

Also, trying to formalise an approach based on the impact of IRRBB on a bank's net interest income – as well as on economic value or the present value of future cashflow – is close to impossible. Side by side, they are meaningless. A rate rise could have a negative impact on the economic value of equity, but a positive effect on earnings. There is no magic model that captures the intricacies of each bank's book while also allowing meaningful comparison across them.

It isn't clear what the final Pillar 2 framework will look like – it could be far more standardised than the current framework. But the lack of regulatory consensus is likely to mean treatment of IRRBB remains fragmented.

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