The Evolution of IRRBB

There are dozens, if not hundreds, of active regulations, guidelines, and frameworks globally that address capital and liquidity requirements. In the United States, the Federal Reserve deployed the Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act stress tests. The European Banking Authority (EBA) implemented the Capital Requirements Directive (CRD) and the Capital Requirements Regulation (CRR). Hong Kong Monetary Authority (HKMA) and the Monetary Authority of Singapore (MAS) have their own sets of capital and liquidity requirements. 

What brought us to this current landscape of such extensive banking regulation? 

Interest rate risk in the banking book (IRRBB) has been a prominent topic in the banking sector for decades, its evolution driven by the ever-shifting financial landscape. Since its inception in the 1970s, IRRBB guidelines and frameworks have continually pushed banks to enhance transparency and risk mitigation strategies. But why the constant change? Could the initial approaches have been more comprehensive, or should we expect continuous change? And how do you stay ahead of a moving target? 

The journey began in the 1970s, with seminal events like the Herstatt Bank collapse¹ serving as a wake-up call for the need for stringent risk management. Since then, the complexity of financial markets and the exposure of vulnerabilities during crises have necessitated ongoing reforms. Banks today must harness advanced technologies and data analytics to navigate this terrain effectively. 

The Basel Committee as a beacon of stability in an era of turbulence 

The 1970s was a period of profound societal and cultural shifts. Post-Vietnam War, the world witnessed significant social movements and activism; cultural milestones including Star Wars, Saturday Night Fever, and The Godfather; and global political turmoil from Chilean President Salvadore Allende’s assassination to US President Nixon’s resignation post-Watergate.  

But the decade wasn’t just pivotal for broad societal changes; it specifically marked a turning point for the financial markets and banking industry. 

Amidst these transformations, one event stands out as a catalyst for regulatory reform: the Herstatt Bank collapse. This banking crisis reshaped the landscape of financial regulation, setting the stage for many of the robust frameworks we see today.  

Herstatt Bank, then West Germany’s largest private bank¹, engaged in aggressive foreign currency speculation, leading to significant foreign exchange exposure. On June 27th, 1974, with FX exposure triple the size of its capital², the bank faced an insurmountable challenge exacerbated by technological limitations: time zone differences. Unable to complete the proper transfers to meet its obligations, Herstatt Bank collapsed, sending shockwaves through the global economy and triggering a liquidity crisis. The following morning the New York Times reported the bank’s estimated losses at around $200 million, equivalent to over $1 billion today¹.  

The aftermath memorialized Herstatt with the newly introduced term “Herstatt risk,” synonymous with FX settlement risk³.  

In response, the Group of Ten (G10) countries formed the Committee on Banking Regulations and Supervisory Practices, now known as the Basel Committee⁴. This committee was tasked with enhancing supervisory practices and improving banking supervision worldwide. 

 Early milestones 

• In 1975 the Committee published the “Concordat,” principles for sharing supervisory responsibility 
• In the early 1980s, the Committee’s concerns about deteriorating capital ratios amidst a highly turbulent international risk environment grew, particularly with the dawn of the Latin American debt crisis⁴.This marked the beginning of what would become the Basel I accord, a pivotal step towards strengthening the stability and resilience of the international banking system. 
• Basel I, the Basel Capital Accord, was released in 1988, setting a minimum capital ratio of 8% to be implemented by 1992. The Accord was always intended to be updated, and has been amended several times since then. 

The Committee calls attention to the banking book 

• In 1999 the Committee proposed Basel II with a new framework adapted to more complex banking practices, intending to replace the Accord, and was later released in 2004. This new capital adequacy framework was based on three pillars: minimum capital requirements, supervisory review, and market discipline. 
• 2004 also saw the Committee’s publication of "Principles for the management and supervision of interest rate risk." This document established foundational guidelines and laid the groundwork for IRRBB. 
• Continuing to enhance guidelines around capital and liquidity, and in response to the 2007-09 financial crisis, Basel III was developed to address weaknesses in the Basel II framework. 
• The Committee completed Basel III reforms in 2017, focusing on capital requirements for credit risk, operational risk, and a revised leverage ratio. 

Global footprint 

Over time the Basel Committee expanded from the G10 to 45 institutions from 28 jurisdictions⁴ and global adoption rates of IRRBB and credit spread risk in the banking book (CSRBB) have been steadily increasing. Some jurisdictions have fared better than others in terms of bank adoption and compliance. 

European Union (EU) 

The EU has been proactive in implementing IRRBB and CSRBB, with the European Banking Authority (EBA) providing detailed guidelines and supervisory expectations.  

In 2022, the EBA published its regulatory technical standards on IRRBB, which were subsequently adopted by the European Commission. The EU has also introduced the Capital Requirements Directive V (CRD V) which includes provisions for managing interest rate risk in the banking book⁵. This directive requires banks to have a comprehensive IRRBB framework in place and to regularly report their IRRBB metrics to the relevant authorities⁶.  

As a result, EU banks have made significant progress in implementing IRRBB and CSRBB, with many institutions now having dedicated teams and systems in place to manage these risks. 

 A 2023 KPMG benchmarking analysis found below 60% of EBA-regulated banks prepared for the complexities of IRRBB – read our Data Principles of Mastering IRRBB Guide to learn about data readiness and the oversight framework that can help. 

United States (US) 

In the US, the Federal Reserve has incorporated IRRBB and CSRBB into its stress testing and capital planning processes, emphasizing the importance of these risks in the banking sector. The Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) program includes IRRBB as a key risk factor⁷.  

The implementation of IRRBB and CSRBB has also been a priority for US regulatory agencies, such as the Office of the Comptroller of the Currency (OCC)⁸ and the Federal Deposit Insurance Corporation (FDIC)⁹. These agencies have issued guidance and regulations for banks to manage and report on these risks effectively.  

The OCC, for example, requires banks to have a robust IRRBB program that includes stress testing, scenario analysis, and risk management strategies.  

Additionally, the FDIC has issued regulations that require banks to have an effective CSRBB program, which includes monitoring and measuring the liquidity risk associated with their funding activities.  

Overall, the incorporation of IRRBB and CSRBB into regulatory frameworks in the US demonstrates the recognition of these risks as crucial factors in ensuring the stability of the banking system. 

Nonetheless, about 80% US banks surveyed by Wolters Kluwer in 2023 feel their current systems can’t handle the complexities of IRRBB – access our guide to Data Principles of Mastering IRRBB to read about data readiness and the data framework that can help. 

United Kingdom (UK) 

The UK's Prudential Regulation Authority (PRA) has also adopted these guidelines, with a focus on ensuring that banks have robust risk management frameworks in place¹⁰.  

The PRA issued a supervisory statement on IRRBB several years ago and updated it as recently as May 2023¹⁰, outlining its expectations for banks' risk management practices. The PRA has also incorporated CSRBB into its regulatory framework through the Liquidity Coverage Ratio (LCR), which requires banks to hold enough high-quality liquid assets to withstand a 30-day stress scenario¹¹. This highlights the importance of managing both interest rate and liquidity risks in the UK banking sector.  

Outcomes 

Changes in risk management and capital allocation 

The introduction of IRRBB and CSRBB has led to significant changes in risk management and capital allocation practices. Banks are now required to conduct more sophisticated risk assessments, stress tests, and scenario analyses. This has resulted in a more granular understanding of risk exposures and the need for higher capital buffers to absorb potential losses. 

Effects on lending and investment activities 

The enhanced risk management frameworks have also influenced lending and investment activities. Banks are more cautious in their lending practices, particularly in sectors and regions with higher interest rate and credit spread risks. This has led to a shift in investment strategies, with a greater focus on risk-adjusted returns and diversification. 

Operational complexities and data requirements 

Implementing IRRBB and CSRBB presents several operational challenges. Banks must invest in advanced risk management systems, data analytics, and reporting tools to meet regulatory requirements. The need for high-quality, granular data adds to the complexity, as banks must ensure data accuracy, completeness, and timeliness. 

Potential unintended consequences 

While IRRBB and CSRBB aim to enhance risk management, there are potential unintended consequences. For instance, the increased capital requirements may lead to higher costs for banks, which could be passed on to customers through higher interest rates or fees. Additionally, the focus on risk mitigation may limit banks' ability to support certain sectors or regions, potentially impacting economic growth. 

What the future holds for IRRBB and CSRBB 

Looking ahead, regulatory bodies are likely to continue refining the guidelines for IRRBB and CSRBB. We can expect further clarifications, adjustments to capital requirements, and enhanced supervisory expectations. Additionally, the integration of climate-related risks into these frameworks is a growing trend, reflecting the increasing focus on sustainability in the financial sector. 

Implications for banks and the financial industry 

For banks, the path forward involves ongoing investment in risk management capabilities, technology, and data infrastructure. Banks that proactively adapt to these regulatory changes will be better positioned to manage risks and capitalize on opportunities. The financial industry as a whole will benefit from a more resilient and stable banking sector, capable of withstanding market volatility and supporting economic growth. 

Conclusion 

The evolution of Interest Rate Risk in the Banking Book (IRRBB) reflects the dynamic nature of the financial landscape and the continuous efforts to enhance risk management practices. From its origins in the 1970s, driven by significant financial events like the Herstatt Bank collapse, to the comprehensive frameworks established by the Basel Committee, IRRBB has become a critical component of banking regulation.  

The global adoption of IRRBB, alongside CSRBB, underscores the importance of managing interest rate and credit spread risks to ensure financial stability. As regulatory bodies continue to refine these frameworks, banks are compelled to invest in advanced risk management systems and data analytics to meet evolving requirements.  

While these changes present operational challenges and potential unintended consequences, they ultimately contribute to a more resilient banking sector. Looking forward, the integration of climate-related risks and further regulatory adjustments will shape the future of IRRBB, emphasizing the need for banks to remain agile and proactive in their risk management strategies. The ongoing evolution of IRRBB not only safeguards the banking industry but also supports broader economic stability and growth. 

To learn more about best practices around data optimization, please read our guide, "Data Principles for Mastering IRRBB."

Sources

• 2.https://www.nytimes.com/1974/06/29/archives/failure-of-herstatt-disturbs-banking-herstatt-failure-disturbs.html 
• 4.https://www.bis.org/publ/bcbs_wp13.pdf 
• 6.https://osttra.com/articles/fx-settlement-risk/ 
• 8.https://www.bis.org/bcbs/history.htm 
• 10.https://kpmg.com/de/en/home/insights/2021/12/new-eba-consultation-package-on-irrbb-and-csrbb.html 
• 12.https://www.eba.europa.eu/sites/default/files/document_library/Publications/Guidelines/2022/EBA-GL-2022-14%20GL%20on%20IRRBB%20and%20CSRBB/1041754/Guidelines%20on%20IRRBB%20and%20CSRBB.pdf 
• 14.https://www.federalreserve.gov/supervisionreg/ccar-2020-archive.htm 
• 16.https://www.occ.gov/publications-and-resources/publications/comptrollers-handbook/files/interest-rate-risk/index-interest-rate-risk.html 
• 18.https://www.fdic.gov/resources/resolutions/resolution-authority/resplans/plans/wbc-165-1412.pdf 
• 20.https://www.bankofengland.co.uk/prudential-regulation/publication/2013/the-internal-capital-adequacy-assessment-process-and-supervisory-review-ss 
• 22.https://www.bankofengland.co.uk/-/media/boe/files/paper/2020/december/guidelines-on-the-management-of-interest-rate-risk-arising-from-non-trading-activities.pdf