Basis risk in the banking book

Basis the price an investor pays for a security plus any outofpocket expenses. These securities are accounted for in a different way than those in the trading book, which are traded on the market and valued by the performance of the market. Basel committee on banking supervision consultative. Guidelines on the management of interest rate risk arising. Credit default risk is the primary focus of such exposures. Due to the heterogeneous nature of this risk, it is captured in pillar 2. The management of interestrate risk in the banking book irrbb has been increasing in importance since 2004, shown by the increased frequency and scale of regulatory requirements. The book considers the aspects key to these issues. Basis risk arises since different curves and indices do not move in a uniform manner. However, it does not set any specific requirements with respect to the valuation of banking book positions in the context of the calculation of the own funds requirements for market risk associated to those positions.

In response to the new standards, the hkma published a consultation paper regarding the proposal to update the current spm module ir1 interest rate risk management and the return of mabs12 interest rate risk exposure in june 2017. Draft rts on the treatment of nontrading book positions. Basel iv revised trading and banking book boundary for. This booklet provides an overview of interest rate risk comprising repricing risk, basis risk, yield curve risk, and options risk and discusses irr management practices. Interest rate risk in the banking book irrbb is currently part of the basel. Apg 117 interest rate risk in the banking book advanced. Interest rate risk in the banking book irrbb refers to the current or. The bcbs published its final standards on interest rate risk in the banking book irrbb in april 2016, with guidelines set to be implemented by 2018. Describes the impact of relative changes in interest rates for.

The trading book is required under basel ii and iii to be markedtomarket on a daily basis. Any changes in interest rates have an impact on the present value of future cash flows on the bank. The handbook of alm in banking 2 nd edition provides a comprehensive overview of stateoftheart asset and liability modelling, risk management techniques and transfer pricing. Interest rate risk in banking book irrbb refers to the current or prospective risk to a. The european banking authority eba launched today a consultation on draft regulatory technical standards rts on how institutions should calculate the own funds requirements for market risk for their nontrading book positions that are subject to foreignexchange risk or commodity risk under the frtb standardised and internal model approaches. The standards revise the committees 2004 principles for the management and supervision of interest rate risk, which set out supervisory expectations for banks identification, measurement, monitoring and control of irrbb as well as its supervision. Basis is the total cost of buying an investment or other asset, including the price, commissions, and other charges. In fact, the overnight federal funds rate experienced a change of 300 basis points or more over a 12month period 15 percent of the time between 1955 and 2008. This includes gap risk, which arises from the term structure of banking book instruments, basis risk, which describes the impact of. Basel iv revised trading and banking book boundary for market. Three subtypes external basis, currency basis and tenor basis will be. Banks with significant exposures to gap risk, basis risk or positions with explicit or embedded options should establish risk tolerances appropriate for these risks. Historically, interest rate risk in the banking book irrbb has been a risk to which many in the market have paid less attention compared to liquidity risk and credit risk. The industry must take into account more extensive.

Interest rate risk in the banking book interest rate risk in the banking book irrbb can be a significant risk for banking institutions and new regulations will have a significant impact on their risk management frameworks. Revised trading and banking book boundary for market risk 11 total sample. Interest rate risk in the banking book irrbb is the risk to earnings or value and in turn to capital arising from movements of interest rates that affect banking book positions. These guidelines on managing interest rate risk in the banking book are intended to provide guidance on designing the strategies and processes required for identifying, measuring, controlling and monitoring interest rate risks in the banking book. Nevertheless, in view of the importance of interest rate risk in the banking book, this directive specifically includes. Interestrate risk in the banking book irrbb regtech. The basel committee on banking supervision has today issued standards for interest rate risk in the banking book irrbb. Basis risk is the risk of loss in earnings or economic value of the banking book arising from imperfect correlation in the adjustment of the interest rates earned and paid on different. Interest rate risk management at community banks community.

Interest rate risk is a banks exposure to adverse movements in interest rates. Deutsche bank annual report 2017 nontrading market risk. Basis risk is defined as the inherent risk a trader the winning mindset of a trader being a master trader is not just about formulating better strategies and analysis but is also about developing a winning mindset. It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge, or because of a mismatch between the expiration date of the hedge asset and the actual selling date of the asset calendar basis risk, oras in energydue to the difference in the. It is used to determine capital gains or losses for tax purposes when the stock is sold. Article 105 requires institutions to revalue trading book positions at fair value at least on a daily basis. Each position on an asset belongs to a book, being trading or a banking book. Interest rate risk in banking book irrbb refers to the current or prospective risk to a bank s capital and earnings arising from adverse movements in interest rates that affect banking book positions. This book does not contain the value at risk var methodology for measuring interest rate and liquidity risk exposure in the banking book, but aims to give practical advice to managers of small and mediumsized banks so that they can develop a sound. This chapter describes requirements on assessing interest rate risk in the banking book, ie the current or prospective risk to a bank s capital and to its earnings, arising from the impact of adverse movements in interest rates on its banking book. Interest rate risk has the potential to create adverse effects on the financial results and capital of the bank arising from positions in the banking book. Basis risk in finance is the risk associated with imperfect hedging.

Eba consults on rts on the treatment of nontrading book. Interest rate risk in the banking book is the current or prospective risk, to both the groups capital and earnings, arising from movements in interest rates, which affect the groups banking book exposures. Sep 17, 2004 over the past 20 years, financial institutions have made significant efforts to establish and improve their procedures for interest rate risk management, including using economic models of interest rates and related models of credit risk lopez 2001a, b. The analytical var for interest rate risk in the banking book can be calculated as follows. This risk category is closely associated with interest rate risk in the banking book as basis risk describing the impact of relative changes in interest rates for financial instruments that are priced using product specific curves. Interest rate risk an overview sciencedirect topics. The authors of the article state that the source of the basis risk is the mismatch between the reference rate used to define the interest flow of loans.

A trading book is the portfolio of financial instruments held by a brokerage or bank. Basis risk is the financial risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite. Interest rate sensitive instruments assets, liabilities and offbalancesheet items in the nontrading book, excluding assets deducted from cet1 capital, e. From the risk management perspective, the principal difference is how profit is recognised. They claim that the proposed combination of value and earnings based required capital is not consistent with the measurement of available regulatory capital, which only reflects value losses gains on banking book positions to a minor extent i. As a result, institutions are now in the process of finding ways to comply with impending regulations whilst seeing what the most effective ways of calculating, and minimising, risk are. The banking book is a term for assets on a bank s balance sheet that are expected to be held to maturity, usually consisting of customer loans to and deposits from retail and corporate customers. Nov 21, 2017 the analytical var for interest rate risk in the banking book can be calculated as follows. At the same time, bank supervisors worldwide, including the federal reserve, have been expanding their.

In may 2015, the european banking authority eba published an. In the banking book, the profit is recognised on the accrual basis i. Basis risk is the financial risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This impacts the underlying value of the banks assets. The handbook of alm in banking 2 nd edition provides a comprehensive overview of stateof the art asset and liability modelling, risk management techniques and transfer pricing. Jun 07, 2019 each position on an asset belongs to a book, being trading or a banking book. As expected, the monitoring of fixed rate gap is done by most of the banks 92%. Interest rate risk in the banking book irrbb can be a significant risk for banking institutions and new regulations will have a significant impact on their risk. Definition of interest rate risk in the banking book. The way ahead executive summary interest rate risk in banking book irrbb refers to the current or prospective risk to a banks capital and earnings arising from adverse movements in interest rates that affect banking book positions. One of the fundamental objectives in banking is to borrow funds at a lower rate and lend them at a higher rate, thereby making profits.

Aps 117 includes basis risk as one of the four components of irrbb. This reflects the different notions of risk between positions in the two books. Now in its fourth edition, this useful guide has been updated with the latest information on alm, basel 3, derivatives, liquidity analysis, market risk, structured products, credit risk, securitizations, and more. The purpose of calculating ir risk in the banking book is to assess the impact on future earnings as well as the impact on shareholders equity. The basel committee on banking supervision bcbs issued new standards on irrbb in april 2016. Nov 28, 2016 banking book instruments are accounted for on an amortized basis. The interest rate risk in banking book refers to the risk to a banks capital and earnings arising from adverse movements in interest rates that affect banking book positions.

Interest rate risk in the banking book in 2015, two documents were published that will have a significant impact on the risk management framework of banking institutions. Interest rate risk is the risk to current or anticipated earnings or capital arising from movements in interest rates. Interest rate risk in the banking book capital requirement. Trading book assets are traditionally markedtomarket on timely basis whereas the banking book assets are held until. Basis risk unexpected changes in the basis between the placing and the lifting of a hedge. When interest rates change, the present value and timing of future cash flows change. The handbook of alm in banking 2nd edition risk books. Basis risk, risks arising from hedging exposure to one interest rate with exposure to a rate which reprices under slightly different conditions yield curve risk, risks arising from changes in the slope and the shape. The financial crisis which saw many banks suffer from basis risk crystallisation and the subsequent extended period of low to negative. Its aim is to identify earnings volatility over a 12monthhorizon against the two. It generally arises from repricing risk, risks related to the timing mismatch in the maturity and repricing of assets and liabilities and off. What is interest rate risk in the banking book irrbb. Calculating interest rate risk in the banking book. The banking book is a term for assets on a banks balance sheet that are expected to be held to maturity, usually consisting of customer loans to and deposits from retail and corporate customers.

However, this is being offset by by the higher market risk capital requirements. Risk management in banking is a comprehensive reference for the risk management industry, covering all aspects of the field. How bcbs 368 will affect alm 3 distinction is useful from a management and treasury perspective too see below. This describes the impact of relative changes in interest rates for financial instruments that have similar tenors but are priced using different interest rate. Basel committee on banking supervision consultative document. This booklet applies to the occs supervision of national banks and federal savings associations. Jun 16, 2019 basis risk is the financial risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. The measurement of basis risk will also require assumptions to be made about the variation of the adis customer product rates around the implied cost of funds. Interest rate risk in the banking book irrbb more specifically refers to the current or prospective risk to the banks capital and earnings arising from adverse movements in interest rates affect the institutions banking book that positions. Interest rate risk in the banking book irrbb is the risk to earnings or capital arising from movement of interest rates. It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge, or because of a mismatch between the expiration date of the hedge asset and the actual selling date of the asset calendar basis risk, oras in.

Basis risk arises since different yield curves and indices do not move in a uniform manner. Basis risk can be measured by designing a scenario under which there is a divergence in the different base rates to which a bank is specifically sensitive. The banking book can also include those derivatives that are used to hedge exposures arising from the banking book activity, including interest rate risk. An accounting book that includes all securities that are not actively traded by the institution, that are meant to be held until they mature. Deutsche bank is exposed to credit spread risk of bonds held in the banking book. Within nontrading market risk the basis between a product specific bond curve and a risk free interest rate curve. Interest rate risk in the banking book irrbb irrbb overview interest rate risk in the banking book irrbb is the risk to earnings or capital arising from movement of interest rates. Differences between interest rate risk irr in the banking. Guidelines on the management of interest rate risk arising from nontrading book activities 5 instruments, including gap risk, basis risk and option risk.

Basis risk the risk that a change in prevailing interest rates will change the price of a companys or investors interestbearing liabilities disproportionate to the price of interestbearing assets. Banks with significant exposures to gap risk, basis risk or positions with. Banking book instruments are accounted for on an amortized basis. Financial instruments in a trading book are purchased or sold for reasons including to. Banking book instruments are generally intended to be held to maturity, with changes in market value not necessarily reflected in financial accounts or capital requirements. These types of assumptions must be clearly documented by the adi, including reference to the data on which the assumptions rely. The management of interestrate risk in the banking book irrbb has been. Basis risk can be a significant risk for many banks, but is one that standard gap and value approaches will usually miss as, in effect, they focus solely on the date when items will reprice as opposed to how much they might reprice on that date. Interest rate risk in the banking book irrbb due to different fixed interest rates of assets and liabilities allocated to the banking book, credit institutions are exposed to a risk of changing interest rates on the money and capital markets. This risk category is closely associated with interest rate risk in the banking book as basis risk describing the impact of relative changes in interest rates for financial instruments that are priced using product specific. Ev is a technique that can also be used to estimate basis risk in the banking book, either in isolation, or when combined with a general yield curve shift or with a change in assumed parameters. The way ahead executive summary interest rate risk in banking book irrbb refers to the current or prospective risk to a banks capital and earnings arising from adverse movements in interest. These risk types will be capture by a combination of quantitative tools captures and stress scenario 2. It is important to note the advantage of using independent principal components.

Differences between interest rate risk irr in the banking and. The seminal guide to risk management, streamlined and updated. If you sell the asset, you subtract your basis, also known as your cost basis, from the selling price to determine your capital gain or capital loss. Jun 29, 2015 risk management in banking is a comprehensive reference for the risk management industry, covering all aspects of the field. Also, for a futures contract, the difference between the cash price and the futures price observed in the market. A bank buying such an instrument can effectively lock into the current level of the tenor basis spread it is paying or receiving and thus immunise itself from further changes, but, as will be explained in the next section, mechanically hedging this, or indeed any form of basis risk, can in a banking book be problematic unless there is. At the same time, bank supervisors worldwide, including the federal reserve, have been expanding their knowledge and oversight of interest. Over the past 20 years, financial institutions have made significant efforts to establish and improve their procedures for interest rate risk management, including using economic models of interest rates and related models of credit risk lopez 2001a, b. Deutsche bank annual report 2016 nontrading market risk. The valueatrisk var for assets in the trading book. Now in its fourth edition, this useful guide has been updated with the latest information on alm, basel 3, derivatives, liquidity analysis, market risk, structured products. Rajesh kumar, in strategies of banks and other financial institutions, 2014. Nii, on the other hand, is always based on cash flows at client rates and thus represents total nii. The irrbb measure is a key input to the asset liability committee alco.