EBA Proposals Eye Enhanced Credit Spread Risk and Standardized NII


Friday, February 25, 2022 | By Luis Matias, Associate Director, WW Pre-Sales, Technical Pre-Sales

EBA Proposals Eye Enhanced Credit Spread Risk and Standardized NII

With interest rate hikes now almost a given in the medium-term horizon as a result of increasing inflationary pressure, European regulators are shifting their focus to ensure financial institutions are prepared to weather associated impacts. In December 2021, the European Central Bank (ECB) announced its supervisory priorities for the triennium of 2022-2024 where “Sensitivities and shocks to interest rate and credit spreads” are clearly identified as a key vulnerability for the European banking sector, and therefore, a supervisory priority for the period.

Paving the way for this increased scrutiny, on December 2, 2021, the European Banking Authority (EBA) proposed a revision of the guidelines for identification, evaluation, management and mitigation of Interest Rate Risk in the Banking Book (IRRBB) and Credit Spread Risk in the Banking Book (CSRBB) of financial institutions’ non-trading book activities.

The shift in monetary policy together with the new guidelines will certainly keep bankers and supervisory authorities busy for the foreseeable future, ensuring the European banking sector manages through the increasing interest rate cycle while protecting their margins, earnings and capital.

So, what’s new in the proposed revision of IRRBB and CSRBB guidelines?

  1. Notable updates:
    1. Credit Spread Risk in the Banking Book: The proposed guidelines establish CSRBB as a distinct risk category that should follow similar standards as IRRBB regarding its identification, measurement and management. CSRBB is defined as the risk that economic value or net interest income changes due to the shocks to market-wide spread, excluding changes to the credit quality of underlying debtors. EBA leaves the perimeter of application of CSRBB quite open while setting assets recognized at fair value as the minimum perimeter; it expects financial institutions to justify the exclusion of all other on and off-balance sheet exposures from CSRBB scope. Identification and measurement of CSRBB should be taken into consideration both from the Economic Value of Equity (EVE) as well as from a Net Interest Income (NII) perspective.
    2. EBA’s definition of NII has been expanded to focus on total earnings rather than just interest income and expense, therefore accommodating the inclusion of both CSRBB and IRRBB on earnings-based measures. Consequently, the valuation effects of financial instruments classified at fair value must now be included while measuring NII risk.
    3. On the matter of modeling non-maturity deposits, more restrictive caps are introduced for weighted average maturity of retail deposits and an outright no-maturity assumption is to be applied to wholesale deposits. Maturity transformation of funding from non-maturity deposits continues to be a key driver of banks’ profitability, and regulatory bodies have elevated their concerns on potential risks arising thereof.
    4. Minimum specific criteria have been set forth to determine non-satisfactory IRRBB internal systems, and where required, set the application of standardized approaches for IRRBB and CSRBB.
  2. Standardized approaches for EVE and NII calculations
    An updated standardized approach for Economic Value of Equity and a new standardized approach for Net Interest Income measurement are set forward in the proposed guidelines. While banks running internal models are not mandated to also apply standard approaches, these will certainly be used by supervisory authorities as challenger models and used as fallback approaches when internal models are not present or deemed inappropriate.
  3. Supervisory Outlier Tests (SOT)
    1. While leaving the SOT for Economic Value of Equity almost unchanged, the proposed guidelines introduce a new Outlier Test for Net Interest Income sensitivity.
    2. Two alternative approaches of SOT for NII are put forward for consultation. These are based on a 1-year horizon and constant balance sheet approach, with the inclusion of valuation effects for fair value financial instruments also under consideration.
    3. EBA recognizes the need to further decrease floor levels for stressed interest rates during EVE and NII SOT calculations; lower bounds have been decreased to -150 basis points from -100 basis points prescribed in the current standards.

The proposed guidelines apply to all banks in the European Union, regardless of the size and complexity of their operations. While larger banks are likely to already be running internal models sophisticated enough to avoid also having to run standardized approaches, the changes to CSRBB, NII models and SOTs will impact all, regardless of size, and are expected to have a significant impact on banks’ existing balance sheet risk management processes.

Increased supervisory scrutiny and market volatility will push financial institutions to adopt novel Asset Liability Management (ALM) systems, with the capacity to run more comprehensive EVE and NII stress testing frameworks and the ability to provide results in almost real-time.

For more information about how to enhance your Asset Liability Management analytics, explore our SS&C Algorithmics Balance Sheet Risk Management product page.

 

Sources



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