Prudential Regulation Authority Rulebook

7.1

This chapter sets out the methodology the PRA uses to inform the setting of a firm’s Pillar 2A capital requirement for interest rate risk in the non-trading book, commonly known as interest rate risk in the banking book (IRRBB).

7.2

IRRBB is the risk of losses arising from changes in the interest rates associated with banking book items.

7.3

For larger or more complex firms the PRA employs a comprehensive approach to its IRRBB risk assessment that reviews duration risk, basis risk and, as necessary, optionality risk.

• Duration risk arises when the re-pricing of banking products (assets and liabilities) is mismatched across time buckets. Firms generate these positions via the normal running of their banking book and manage the resultant risks through their internal management processes and hedging activities.
• Basis risk is generated by banking book items that re-price in relation to different reference rates. The most common and material basis risks seen within UK banks derive from products re-pricing against policy rates (eg Bank Rate) and market rates (eg SONIA). As part of the review of basis risk the PRA also considers asset swap spread risk, which typically arises when firms hedge the duration risk associated with fixed rate securities using derivatives (typically interest rate swaps).
• Optionality risk arises from the discretion that a bank’s customers and counterparties have in respect of their contractual relations with the bank in the form of financial instruments. Embedded options are diverse and firm-specific and include prepayment risk on fixed rate loans and deposits and switching risk on non-interest bearing current accounts. Optionality risk is considered separately when material.

7.4

Smaller and less complex firms are subject to a standard approach which is based on reviewing their own policy limits for interest rate risk and, where appropriate, basis risk. A proportionate approach is applied where a firm demonstrates some aspects of complexity with a detailed review undertaken of the policy limit-setting approach, the potential for any breaches and the ability of the firm to manage the associated risks.

7.5

Large firms or those with more complex IRRBB risk exposures are subject to a comprehensive risk assessment process. This assessment involves the collection and processing of granular risk data provided by the firm and a review process including firm meetings and discussion. Together this ensures that the PRA has the appropriate information to understand and evaluate the firm’s IRRBB risks and management processes.

7.6

The data for this process are collected in a standard data report from the firm. The data are processed using internal PRA systems. A range of value-at-risk and earnings-at-risk based measures are used to calculate capital requirements. The FSA017 regulatory return, which provides more aggregated re-pricing information, can be used to validate the data provided.

7.7

The methodology with respect to duration risk, basis risk and optionality risk is detailed below.

7.8

To assess duration risk, firms are first requested to allocate all items to the relevant time bucket and to report their exposure in each time bucket, as follows:

• fixed-rate assets or liabilities are allocated to the time bucket corresponding to their maturity (allowing for behavioural prepayment adjustments);
• floating-rate assets or liabilities are allocated to the time bucket corresponding to the frequency of re-set, with behavioural adjustments for administered rate products;
• derivatives are allocated according to their contractual re-pricing dates; and
• non-determinate items (ie those that do not have a pre-set contractual maturity, such as sight deposits and current accounts) are allocated to time buckets based on firms’ assumptions. The PRA expects firms to justify these assumptions and any changes to them.

7.9

Second, the net interest rate gap of the firm for each time bucket is calculated for each material currency.

7.10

A shock is then applied to the net interest rate position for each respective time bucket. The methodology uses a range of currency-specific yield curve volatility parameters and a set of different interest rate shocks.

7.11

The VaR model is calibrated to a 1-in-100 year confidence level and uses a one-year holding period to reflect the potentially illiquid nature of banking book positions. Historical observations normally include ten years of yield curve data and are designed to capture stressed market conditions.

7.12

For each significant currency, the different interest rate shocks are applied to the net interest rate gaps in each time bucket. The methodology uses both government yield curves and swap rate curves by material currency in order to calculate the potential impact of the interest rate risk shocks.

7.13

Economic value (EV) changes are then summed up across all time buckets in order to assess the change of the firm’s EV due to its IRRBB exposure to an interest rate shock. Basis risk.

7.14

The review of basis risk concentrates on net policy rate and net market rate (contractual and behavioural) exposures including on-and off-balance sheet positions. The assessment is designed to capture the risk of market funding costs rising relative to a more stable policy benchmark.

7.15

The assessment process involves collecting information on variable rate re-pricing in order to calculate the net policy rate position by currency. These positions include: customer products linked contractually to policy rates; customer products that are expected to price in line with policy rates behaviourally; balances held with central banks that are currently priced in line with policy rates; and derivative hedges based on policy rates or correlated indices.

7.16

The PRA measures basis risks by applying to each firm’s nominal exposure a change of the spread between the two reference rates on which the bank incurs basis risk exposure. The potential movement between the reference rates employs a statistical approach based on historical observations, at a 1-in-100 year confidence level.

7.17

The PRA measures how the price of hedging market versus policy rate exposures for a one-year period can move over a three-month timeframe. This is likely to involve the use of relevant swap curves, eg Overnight Indexed Swaps.

7.18

The approach generates a one-year earnings at risk (EaR) measure to assess the capital requirement for basis risk. The calculation considers the net Bank Rate position exposed to a funding shock.

7.19

Swap spread risk arises when firms hedge the duration risk associated with fixed rate securities using derivatives (typically interest rate swaps). This generates a valuation risk through asymmetric movements between the value of the bond (eg gilt) and the derivative (eg swap). The ongoing valuation risks should be managed within appropriate risk limits and capitalised.

7.20

The PRA considers relative movements in the value of securities, eg gilts versus swaps (of similar maturities) over a ten-year period via a Value at Risk (VaR) model calibrated at a 1-in-100 year confidence level assuming a one-year holding period.

7.21

In the United Kingdom, prepayment risk on lending is limited by the typically short re-pricing duration of fixed-rate products (retail mortgages and unsecured lending are typically fixed for terms not exceeding five years).

7.22

The impact of behavioural factors on certain non-determinate liabilities such as current accounts (eg customer switching) should be considered by firms. The behaviour of some components of these current account balances remains uncertain and may be affected by a change in interest rates.

7.23

The comprehensive approach involves discussing optionality risks with the firm during the risk assessment process in order to understand the materiality (or otherwise) of embedded option features. Dependent on the nature of a firm’s business this could include non-UK products that have material embedded option features for which additional information may be requested.

7.24

Other IRRBB risks that may be considered, if material, include the risks arising from legacy market rates, hedge accounting operations and structural foreign exchange exposures. The PRA monitors these and other emerging risks to ensure such risks are capitalised adequately.

7.25

Individual capital requirements for the different sub-components of IRRBB referenced above are then summed to calculate a firm’s IRRBB capital requirement based on the data provided.

7.26

The process also assesses the quality of the firm’s management, data and governance of IRRBB under the comprehensive approach and considers any additional capital required to reflect failings in a firm’s practice.

7.27

The PRA reviews the internal policy limits used by a firm. If appropriate (and these are most usually based on the economic impact of a 200 basis point shift in interest rates) the policy limits are used as the basis for determining IRRBB.

7.28

Under the standard methodology, the PRA does not assess Pillar 2A for basis risk. Nevertheless, the PRA expects that a bank or building society mitigates its basis risk by setting limits on:

• its exposure to basis risk for each type of basis risk mismatch; and
• the sensitivity of its net interest margin to basis risk.

7.29

The PRA may allow firms, on a case-by-case basis, to allocate maturities based on behavioural assumptions.

7.30

The PRA uses existing data reports, such as the Stress Testing Data Framework (STDF) programme for larger firms, or FSA017 for smaller firms, and works with individual firms to set out additional bespoke data requirements where needed for the IRRBB assessment. The PRA may also ask firms to submit internal management information relevant to IRRBB.