Interest rate risk is a crucial risk faced by banks that can lead to losses resulting from unfavorable movements in interest rates in both the banking book and the trading book. In the banking book, this risk arises due to the maturity mismatch between assets and liabilities and changes in the yield curve.
To manage interest rate risk effectively, banks must have a robust governance, measurement, and management framework in place. This framework should include clear policies and procedures, adequate resources, and regular monitoring and reporting to ensure that banks can take proactive measures to mitigate potential risks and maintain a sound financial position.
The governance framework for interest rate risk management should include board and senior management oversight, risk management policies and procedures, risk appetite and limits, and robust reporting mechanisms to ensure that the board and senior management receive timely and accurate information on the bank's interest rate risk exposure.
Banks should measure interest rate risk using a range of techniques, including gap analysis, duration analysis, and scenario analysis. Asset and liability management (ALM), hedging, stress testing, and reporting and monitoring should be used for managing interest rate risk.
Banks are required to prepare regular reports detailing their interest rate risk in the banking book (IRRBB) exposures to assess and manage the risks associated with fluctuations in interest rates. These reports include interest rate risk reports, gap reports, duration reports, stress testing reports, ALCO reports, and regulatory reports.
Under the Basel III framework, Pillar 2 requires banks to perform a comprehensive assessment of their IRRBB and hold sufficient capital to cover the risk. The capital assessment for IRRBB under Pillar 2 involves several steps, including IRRBB identification, scenario analysis, stress testing, and capital adequacy assessment.
Factors to consider for IRRBB capital adequacy assessments include internal limits, hedging effectiveness and cost, sensitivity to modeling assumptions, basis risk, currency mismatches, embedded losses, capital distribution, underlying risk drivers, and risk crystallization circumstances.
The board should receive semi-annual reports on the bank's IRRBB exposures, compliance with policies and limits, key modeling assumptions, stress test results, reviews of IRRBB policies and adequacy of measurement systems, and periodic model reviews and audits. A validation framework includes three core elements: evaluation of conceptual/methodological soundness, ongoing model monitoring, and outcomes analysis including back-testing of key parameters.
Banks should consider several factors when developing interest rate shock and stress scenarios. These include identifying risks, evaluating concentration in certain instruments/markets, assessing interactions with related risks, measuring potential impact on net interest income, accounting for option risk, specifying the term structure of interest rates, estimating changes to administered or managed interest rates, measuring time needed to reduce or unwind unfavorable exposures, and incorporating changes to portfolio composition due to external or internal factors.
The Board/ALCO must set IRRBB limits, establish systems for measuring IRRBB, and implement reporting and review processes, performance assessment, and effective internal controls and MIS.
In conclusion, to manage interest rate risk effectively, banks must have a robust governance, measurement, and management framework in place, including appropriate limits, measurement systems, and reporting and review processes. This will ensure that banks can take proactive measures to mitigate potential risks and maintain a sound financial position.