Interest Rate Risk in the Banking Book – Preparing the European Banking System for a Sudden Upward Shift in Interest Rates

It is widely acknowledged that the current low interest rate environment and intense competition in several countries have resulted in rather subdued revenues of European banks. In particular Net Interest Income (NII), which still accounts for 70% of European bank revenues, is under pressure as net interest margins continue to shrink. Continuously low interest rates in the wake of the COVID-19 pandemic significantly affect banks’ profitability and capital position. The current environment increases the risk that sudden upward changes in market interest rates will negatively impact a bank’s net interest income and the fair value of a bank’s future cash flows or its equity value.

An important question is whether the regulatory approach of the Single Supervisory Mechanism (SSM) is tight enough to assess banks’ exposure to Interest Rate Risk in the Banking Book (IRRBB). In this unprecedented low interest rate environment and given the economic impact of the COVID-19 pandemic, it is imperative that IRRBB be measured and managed adequately, including both from an Economic Value of Equity (EVE) and NII perspective. However, bank regulators and the banking sector have failed to agree on common standards for modelling IRRBB and especially Non-Maturity Deposits. The SSM stopped short of including IRRBB in Pillar I of the Basel III framework, so regulation under Pillar II continues, under which banks are required to conduct supervisory outlier tests of the EVE, which identifies high-risk banks under six standard interest rate shocks. 

In our research paper, we suggest that the current SSM’s regulation of IRRBB modelling and mitigation might not be tight enough and discuss improvements to ensure bank solvency and financial stability. We assess the adequacy of the supervisory outlier tests by conducting an empirical analysis of historical interest rate changes and comparing those with the standard interest rate shocks of the supervisory outlier tests. We focus in particular on the variation of historical interest rates within the current low interest rate environment. Our results reveal that the standard interest rate shocks are conservatively calibrated and adequately reflect current interest rate changes, which ensures that the supervisory outlier tests can appropriately capture banks with heightened interest rate risk under the EVE perspective. The detailed empirical analysis can be found in our research paper.

Nevertheless, we recommend introducing an earnings perspective in the supervisory outlier tests, since low interest rates exert high pressure on banks’ interest earnings, which is not explicitly addressed under the EVE perspective. Keeping in mind that earnings can act as a critical buffer against IRRBB, we advise EU banking regulators to similarly identify banks whose NII is at risk. Further, we consider minimum capital requirement regulation under Pillar I as a way to increase capital buffers and improve banks’ resilience to interest rate-related stress. To improve resilience against IRRBB, we recommend implementing a standardised approach to calculating minimum capital requirements as a prudent supervisory measure because high uncertainty around future interest rates and customer behaviour may bias the results of internal IRRBB measurement models.  

While our empirical analysis of changes in the yield curve relied on a linear regression analysis, future research should assess these interest rate changes using more sophisticated approaches, eg, via stochastic processes, to enhance the simulation of interest rate changes. In addition, future research should consider the behaviour of depositors in various interest rate stress and shock scenarios to broaden the empirical foundations of how to deal with Non-Maturity Deposits in the Basel framework. 

Recovering from the pandemic with the help of unprecedented levels of fiscal stimulus and monetary easing might well lead to the return on inflation in the medium term. This will require the ECB and other central banks to react by limiting tender operations, tapering and stopping bond purchase programs and raising interest rates. To avoid collateral damage in banks’ balance sheets we need to prepare the banking system today for a rapid upward shift in interest rates, by further improving risk management practices and tightening the regulatory approach to IRRBB.

Axel Wieandt, former CEO of HRE and Valovis Bank, is a Finance Professor at WHU Otto-Beisheim School of Management.

Marc Wambold is a Banking Supervisor at Deutsche Bundesbank.

The views expressed are those of the authors and do not necessarily reflect the opinion of Deutsche Bundesbank or the Eurosystem.