The Basel Committee is proposing changes to the regulatory capital treatment and supervision of interest rate risk in the banking book (IRRBB) in order to help ensure that banks have enough capital to cover potential losses from exposures to change in IR and to limit incentives for capital arbitrage between the trading and the banking book. The committee has therefore submitted to the financial institutions, two alternative solutions: a standardised Pillar I ( Minimum Capital Requirements) approach and an enhanced Pillar II approach ( Market Discipline, which includes elements of Pillar III).
Briefly, within Pillar I approach IRR is measured, through an EVE measure, against several IR shock scenarios (parallel shifts, flattening, steepening etc…). These scenarios must reflect global economic conditions and IR volatility. Obviously not all banking book positions are amenable to standardisation, given uncertainty about the timing of cash flow due to behavioural aspect and embedded options like NMDs and loan prepayment for which flexibility is provided to allow banks to use internal parameter estimates.
Within Pillar II approach, instead, banks are allowed to use Internal measurement system (IMS) for assessing their capital adequacy. This approach includes standardised disclosure of both bank’s IRRBB risk profile and IRRBB metrics ( including standardised calculation framework), key measurement assumptions, quali-quantitative assessment of IRRBB levels.
Which of the two should be adopted?
Certainly a Pillar I approach could promote greater comparability and more level playing field, however, it does probably not reflect banks’ current levels of IRR for example because of their customised approach to cater for different product offerings, regulatory environments and business models that can affect assumptions, measurement techniques and risk management. Furthermore the maturity transformation service that banks provide will be drastically curtailed and rate variability transferred to the public (retail costumer especially) who are least able to manage this risk thus creating potential credit risk for banks.
A Pillar II approach could instead increase transparency and encourage greater understanding of the drivers of IRR. Under the enhanced Pillar II approach, however, banks are subject to additional standards regarding the calculation and supervisory reporting. Within this approach, the standardised framework calculation act as fallback for assessing banks’ capital levels.
Probably the right approach to use should be the second one but few comments on standardised disclosure are necessary. In fact Financial Institutions might prefer a “true” Pillar II approach that does not uses the standardised approach intended for Pillar I in order both to avoid constraints on banks’ internal modelling of IRRBB and problems for certain financial institutions, like French one, which used to hedge NMDs with an excessively long duration.