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IRRBB (2/3): Regulation

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Executive summary

The Basel Committee set 12 Principles in which to regulate IRRBB. The first 9 are meant to regulate banks’ non-trading activities. Principles 10-12 focus on a supervisory approach to banks.

Key learning objectives:

  • Analyse the 12 Principles of IRRBB regulation set by Basel III

What are The Principles of IRRBB Regulation?

Principle 1:

  • IRRBB is an important risk for all banks that must be specifically identified, measured, monitored and controlled. In addition, banks should monitor and assess Credit Spread Risk in the Banking Book. Credit spread risk in the banking book refers to any asset/liability spread risk of credit-risky instruments that is not explained by IRRBB and the expected credit/jump to default risk

Principle 2:

  • The governing body of each bank is responsible for oversight of the IRRBB management framework, and the bank’s risk appetite for IRRBB. Monitoring and management of IRRBB may be delegated by the governing body to senior management, expert individuals or an asset and liability committee. Banks must have an adequate IRRBB management framework, involving regular independent reviews and evaluations of the effectiveness of the system

Principle 3:

  • The banks risk appetite for IRRBB should be articulated in terms of the risk to both economic value and earnings. Banks must implement policy limits that target maintaining IRRBB exposures consistent with their risk appetite

Principle 4:

  • Measurement of IRRBB should be based on outcomes of both economic value and earnings-based measures, arising from a wide and appropriate range of interest rate shock and stress scenarios

Principle 5:

  • In measuring IRRBB, key behavioural and modelling assumptions should be fully understood, conceptually sound and documented. Such assumptions should be rigorously tested and aligned with the  bank’s business strategies

Principle 6:

  • Measurement systems and models used for IRRBB should be based on accurate data, and subject to appropriate documentation, testing and controls to give assurance on the accuracy of calculations. Models used to measure IRRBB should be comprehensive and covered by governance processes for model risk management, including a validation function that is independent of the development process

Principle 7:

  • Measurement outcomes of IRRBB and hedging strategies should be reported to the governing body or its delegates on a regular basis, at relevant levels of aggregation (by consolidation level and currency)

Principle 8:

  • Information on the level of IRRBB exposure and practices for measuring and controlling IRRBB must be disclosed to the public on a regular basis

Principle 9:

  • Capital adequacy for IRRBB must be specifically considered as part of the Internal Capital Adequacy Assessment Process approved by the governing body, in line with the bank’s risk appetite on IRRBB

Principle 10:

  • Supervisors should, on a regular basis, collect sufficient information from banks to be able to monitor trends in banks IRRBB exposures, assess the soundness of banks IRRBB management and identify outlier banks that should be subject to review and/or should be expected to hold additional regulatory capital

Principle 11:

  • Supervisors should regularly assess banks IRRBB and the effectiveness of the approaches that banks use to identify, measure, monitor and control IRRBB. Supervisory authorities should employ specialist resources to assist with such assessments. Supervisors should cooperate and share information with relevant supervisors in other jurisdictions regarding the supervision of banks IRRBB exposures

Principle 12:

  • Supervisors must publish their criteria for identifying outlier banks. Banks identified as outliers must be considered as potentially having undue IRRBB. When a review of a bank’s IRRBB exposure reveals inadequate management or excessive risk relative to capital, earnings or general risk profile, supervisors must require mitigation actions and/or additional capital
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