Navigating interest rate resets: The latest IRRBB hurdle for banks
Banks worldwide face a series of challenges with rising interest rates. In addition to the direct impact on monetary tightening, there is the increased uncertainty around customer behaviors, with banks needing to revisit the impact of changes across data, models, and risk management activities. As banks face regulatory risk, many are reviewing the impact of these changes across data, models, and risk management activities. Regulations are subject to the European Banking Authority’s new guidelines for interest rate risk in the banking book (IRRBB), which pushes banks to balance risks against key metrics, including net interest income (NII) and economic value of equity (EVE). It provides rules and recommendations on how to calculate key metrics, for example, with respect to the modeling and composition of balance sheet exposures, yield curve scenarios, behavioral assumptions, and subrisk categories.
Banks face increased risk due to deposit decay-rate instability, which can require increased use of decay and hazard models to fix repricing tenors. In addition, a more intense competitive environment can cause individual players to see declines in liquidity coverage and gains in deposit beta—the percentage of rate change passed on to customers. To manage interest rate risk in the new regulatory environment, banks need to gauge trade-offs in the relationship between bank EVE and NII. McKinsey’s research shows that banks are taking a range of approaches to balancing delta EVE against delta NII in various rate scenarios.
The EBA guidelines provide clarifications and extensions for modeling, first relating to maximum tenors and then to the scope of relevant deposits, which have been expanded to include operational deposits by financial institutions. Best practices for deposits modeling and hedging include customer segmentation in line with regulatory classifications, core balance modeling, deposit volume modeling, deposit beta calculation, and hedging strategy. With the updated guidelines and new approaches to deposit modeling and hedging, banks must also pay attention to how they treat and interpret behavioral models, as this will impact capital over a more extended period.