Regulation: Banks brace for Basel interest-rate risk push
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BANKING

Regulation: Banks brace for Basel interest-rate risk push

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.

Mayra Rodriguez Valladares, an independent New York-based risk-management expert and a supporter of Basel’s new push, says: “It will be very difficult to provide standardization in the banking book but banks need to be more transparent about their interest rate exposures. They publish very little, if at all, about the amount of assets in the banking book that fall under different maturity buckets, the stability of customer deposits by time-horizons, nor do they explain the models they use to manage interest-rate risk. By contrast, exposures in the trading book are now disproportionately more transparent than the banking book.”

Bankers say mandating lenders to hold capital against unrealized losses from interest-rate shifts ignores a profound difference between the trading and banking books, since in the latter case, banks typically hold assets to maturity. An effectively mark-to-market approach to assets held in the banking book, akin to derivatives in the trading book, through a Pillar 1 regime will challenge earnings, business models – potentially concentrating systemic risks if balance-sheet-structures are made too similar – and magnify interest-rate movements, says the ABA’s Carney.

Inaccurate assumptions

“The primary concern I have with a potential Pillar 1 approach to interest-rate risk in the banking book is that the Basel Committee could make uniform and simplifying assumptions about the characteristics of a typical bank’s assets and liabilities that may be inaccurate for a given institution,” Carney says. “Uniform assumptions could incentivize a bank to take positions they may not otherwise take.”

Investors in bank equity need to keep an eye on this. Colla says: “The main consequence of moving IRR to Pillar 1 would be on profitability. Banks would need to increase their capital but not have the opportunity to increase their revenue. The second consequence is that due to capital charge banks would need to reduce their IRR position. They would have to either increase the maturity on the deposit side, which they can’t directly control, reduce longer-dated risks and/or engage in pay-off swaps to hedge exposures.”

There are broadly two different ways of calculating interest-rate exposures and this is also a source of disagreement. The earnings-based approach measures the impact of a rates move on near-term net interest income, and the economic approach, sometimes dubbed the fair-value perspective, calculates the impact of a rates move by taking into account the present value of future cashflows. This latter framework attempts to generate a longer-term perspective on structural interest-rate risks and the results are largely comparable across banking groups.

Bankers say the economic approach rightly applies to trading assets, where the fixed-income exposures are for sale and financed by market-rate liabilities. However, they say it is not appropriate for banking-book assets given their buy-and-hold nature and would produce perverse results since an increase in rates typically appears detrimental to earnings under fair-value accounting, while in practice banks’ net interest income is boosted.

Colla at Avantage Reply adds that the earnings approach to the banking book also fails to capture market risks. “On a trading desk, banks can largely quantify information and risks attached to a transaction. But in the banking book, the real risk for fixed-rate mortgages, for example, is pre-payment and that’s determined by customer flows and deposit behaviour, which is complicated, outside banks’ control and will differ between lenders and countries.”

Maturity cap

Market players are concerned regulators might impose a maturity cap of five years on non-maturing deposits for regulatory-reporting purposes. Banks at present forecast deposit maturities based on their proprietary historic data. By potentially artificially shortening the maturity of liabilities, such as deposits, to finance longer-term assets, in any IRR banking book framework capital costs for banks would rise.

Carney at the ABA adds: “If the Basel Committee adopted assumptions that understated the effective maturities of a bank’s non-maturity deposits, it could induce a bank to inappropriately shorten its asset maturities, leaving the bank exposed to falling interest rates and unnecessarily reduce its net interest margins. If the Basel Committee overstated the maturity of these deposits, it could mistakenly lead banks to extend their asset maturities, leaving them exposed to rising interest rates and significant loss in economic value.”



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