Regulation: Banks brace for Basel interest-rate risk push

By:
Sid Verma
Published on:

Fears of Pillar 1 capital charge; Rules may hit earnings and concentrate risk.

The Basel Committee on Banking Supervision’s (BCBS) bid to standardize the treatment of interest-rate risk in lenders’ banking books – the first-ever attempt to set a capital regime for interest-rate risk internationally – is encountering a wall of technical and principles-based resistance.

A consultation document, set to be unveiled in April, has been delayed amid a disagreement that has pitted the US and Japan against the UK and Germany, according to reports, with the former group arguing rate-risk rules should remain in the hands of local regulators.

Mayra Rodriguez Valladares
It will be very difficult to provide standardization in the banking book but banks need to be more transparent about their interest rate exposures

  Mayra Rodriguez Valladares

The BCBS first announced in March 2013 its intention to introduce capital charges to cover interest-rate fluctuations in the banking book, which, in theory, would cover a diverse group of assets from floating-rate loans, bonds, derivatives to sight deposits.

Sources now reckon that the proposals could be published in the third quarter of the year, or possibly in time for the June meeting of the BCBS, before a quantitative impact study – originally due at the end of 2014 – is conducted later in 2015. Bankers are drawing comfort from the delays since entrenched divisions suggest any Basel IRR framework could be watered down.

Intentions

The intention behind the proposal to standardize IRR is twofold: firstly, to limit arbitrage opportunities between banks’ trading and their banking books; and secondly to boost lenders’ structural interest-rate risk management to reduce exposure to the volatility of interest-related margins during shifts in the cycle.

Basel’s fundamental review of the trading book, which has imposed new, big rate-risk, credit and liquidity charges, has increased the incentive, in theory, for banks to shift assets, such as high-rated government bonds, to the banking book for capital relief, say regulators, since the latter imposes no interest-rate-risk charges.

Banks, of course, have plenty of previous form with this kind of manoeuvre. However, some bankers say there should be a comprehensive study on whether lenders are gaming the banking/trading books in practice before regulatory redress, akin to the Basel study in 2013 into the divergence between lenders’ risk-weighting of similar assets that came from tweaking their internal models. This subsequently formed the basis of the BCBS’s proposal in late 2014 for a capital floor for lenders using an internal ratings-based approach to calculate capital requirements.

In addition, the suggestion senior bankers see their balance sheet as fair game to be traded at will with the aim of achieving capital relief is a distorted view of how operational controls work in practice, say risk analysts.

Hugh Carney, senior counsel at the American Bankers’ Association, says: "The Basel Committee is dealing with a lot of moving targets. The concern about arbitrage between the trading book and banking book, in principle, is not apparent since we don’t know what the former, and associated capital and regulatory requirements, will end up looking like in the future."

Bernard Colla, senior manager at financial risk-management consultancy Avantage Reply, adds: "Risk management is subject to independent reviews by risk departments and submitted to approval to the management board. The latter tend not to take short-term views akin to traders."

Aside from arbitrage fears, supervisors are concerned that the prolonged period of historically low rates, combined with the lack of binding capital charges for interest-rate fluctuations, is creating systemic risks. HSBC, for example, introduced the UK’s lowest-ever five-year fixed-rate mortgage at 1.99% in April, even as the Bank of England eyes a rate hike next year. This is one small example that speaks to regulators’ concerns about the challenges facing banks to both reduce the sensitivity of earnings and ensure shifts in the interest-rate cycle do not erode the value of fixed-rate loans en masse.

Public comment

In one of the few public comments on the IRR push, William Coen, then the deputy secretary general of the Basel committee and now secretary general, told Euromoney in March 2013: "There is a wide range of views over how to measure interest-rate risk in the banking book and there are considerable complexities around interest-rate modelling that need to be considered before any specific proposal could be put forward." Two years later, the committee remains divided over how to measure interest-rate risk.

US regulators in the early 1990s and the early drafts of the Basel II accord in 2004 flirted with imposing a capital requirement to address interest-rate risk in the banking book. In the end, US and Basel regulators opted for the supervisory approach rather than a capital rules-based one, given the challenges in establishing unifying assumptions about liabilities, assets and customer behaviour. Australia, though, is one jurisdiction that has imposed an IRR charge in the banking book.

Currently, Pillar II of the Basel framework captures interest-rate risk. Banks are required to maintain internal systems to manage rate fluctuations under a set of qualitative principles, backed by stress-testing and internal audits. The Fed stress test, for example, includes a 500 basis point interest-rate shock on banking-book assets. The BCBS is now considering including interest-rate risk under Pillar 1, which mandates capital buffers for individual categories of risk, including credit, market, operational, counterparty and securitization risks.