Modeling Interest Rate Risk in the Banking Book

Abstract: For a long time, being able to model and mitigate financial risk has been a key success factor for institutions. Apart from an internal incentive, legal and regulatory requirements continue to develop which increases the need for extensive internal risk control. Interest rate risk in the banking book ("IRRBB") alludes to the cur- rent or prospective risk to the bank’s earnings and capital emerging from adverse movements in interest rates that influence the bank’s banking book positions. When interest rates change, the value but also the timing of future cash flows are affected. Thus, the underlying value of a bank’s liabilities and assets and other off-balance sheet items change as a consequence, and therefore its economic value. In 2004, the Basel Committee on Banking Supervision published a paper Principles for the Management and Supervision of Interest Rate Risk which later lead the European Banking Authority ("EBA") to publish a renewed framework in 2016. In December 2021, the EBA published a draft of an updated version of this framework. This paper investigates how banks and risk managers should model IRRBB under these new guidelines. This is achieved by constructing an IRRBB model which is then evaluated to see whether the IRRBB framework provided by the EBA is adequate and comprehensive. The IRRBB model by the EBA is fundamentally constructed by creating six different shock scenarios where the yield curve is stressed (parallel- , short rate-, and long rate shifts). Thereafter, one measures risk by investigating how these shifts affect the bank’s or financial institutions’ economic value and net interest income. In this paper, additional stressed scenarios were produced through Principal Component Analysis and Monte Carlo Simulations. This paper found that the framework by the EBA is adequate and formulates good methods. However, the framework is not fully standardized and comprehensive, and some computations and methods are left for the institution to decide. This is most likely due to the uniqueness of each institution and that it is hard to formulate methods that are pertinent for all. A more complete, standardized framework would however be advantageous for, on the one hand, governing agencies which would benefit from decreasing the number of resources needed when supervising institutions’ internal models. On the other, institutions would benefit from decreasing the probability of potentially overlooking some risk. Furthermore, this would help companies de- crease their capital requirement, which is desirable.