3 minute read 16 May 2023
RBI guidelines

Navigating the latest RBI guidelines on Interest Rate Risk in the Banking Book

By Subrahmanyam Oruganti

EY India Business Consulting Partner and Financial Services Risk Quant Leader

Subrahmanyam is a partner with the financial services consulting team. With 17 years of experience, he leads capital markets modelling, regulatory transformation, and automation.

3 minute read 16 May 2023

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  • Navigating the latest RBI guidelines on Interest Rate Risk in the Banking Book (IRRBB) a perspective

IRRBB is a strategic measure to manage balance sheet and profitability.

In brief

As per new guidance :

  • Banks must measure their interest rate risk exposures only for the banking book as against the total book.
  • Banks must also move to a full revaluation-based standardized approach.
  • It is imperative that banks consider the impact of macro-economic variables in behavioral models.

The Reserve Bank of India (RBI) on 17 February 2023 issued the final guidelines on Interest Rate Risk in the Banking Book (IRRBB). The enhanced guidelines require banks to measure, monitor and disclose their exposure to IRRBB based on a set of prescribed interest rate shock scenarios and assumptions on the underlying balance sheet that may impact the capital base and future earnings of banks.

One of the most important aspects which the regulator has emphasized is for banks to model the behavior of assets and liabilities for cashflow profiling by considering the impact of macro-economic variables. 

In India, deposits are the significant portion of the liability portfolio. In light of the global events (the collapse of SVB) and the rapid rise in interest rates, it is imperative for banks to evaluate the behavior of such products in relation to macro-economic factors1 . We have historically observed in other regions as well that non-maturing deposits are typically sensitive to macro-economic factors2. Therefore, every Indian bank needs to evaluate this sensitivity for their own portfolio and start this process by developing a macro-sensitive behavioral models for deposit segments3 .

On the other hand, the majority of loans (asset side) in India are of floating nature, resulting in lower prepayment risk. Hence, the macro-sensitivity on the assets side will be much lower, and building macro-sensitive models is not expected to yield significant outcomes. However, banks need to do analysis to evidence the macro-sensitivity is not high for their loan portfolio.

Evolution of IRRBB landscape

Banks should approach the latest guidance with the intent of developing a robust and strategic framework for balance sheet management over a long term. Accordingly, they may consider the following:

Book separation: Banks must undertake a clinical process to capture only their banking book exposures for IRRBB measurement and management. The boundaries between the banking and trading books, the extent, and restrictions on moving instruments across regulatory books are provided in the draft guidelines. While banks are expected to follow the existing guidelines for book segregation as of now, they would need to revisit this classification in light of the new guidelines again in the future. The delineation between banking book and trading book should be clear.

Data granularity: Banks will need to evaluate their existing data management and governance framework to ensure they are able to provision and store appropriately granular historical data including contractual maturity, associated optionality, early maturity dates, other attributes as required for behavioral modeling etc., while also meeting expected data quality requirements.

NII stabilization: IRRBB can be used to achieve Bank’s Board of Directors (BoD) targeted Net Interest Income (NII) stabilization. This should be mapped according to an optimal level of NII required to achieve an expected interest rate outlook over the next one to two years. Furthermore, residual interest rate risk can be hedged by using interest rate swaps (IRS) or other derivative instruments.

Measurement approach: Banks may adopt standardized approach (SA) in accordance with the directive from RBI. The SA technique is expected to assist banks with benchmarking their internal models. Basel standard and revised RBI guidelines expect IRRBB to be measured across three risk types — gap, basis, and options. Banks would need to attribute and identify how each risk type is contributing to a bank’s interest rate risk.

Model validation: Banks should ensure that any existing IRRBB models are identified and validated in line with the firm’s risk management policy. New model requirements or their enhancements should be inventoried and mitigating actions, until such models are in production, should be identified and implemented. Their integration with bank’s IRRBB framework is expected to capture deposit repricing and early redemption, prepayment of assets and other optionality. This will need stronger scrutiny and validation support on an ongoing basis.

Contributors: Abhijit Pingle, Partner, Business Consulting.

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Summary

The new requirement for behavioral modeling may become a major concern for banks as there may be significant data challenges in building the models for non-maturing deposits and other products. Therefore, banks need to first identify a comprehensive list of gaps against the latest regulatory requirements before considering any tactical or strategic solutions. 

About this article

By Subrahmanyam Oruganti

EY India Business Consulting Partner and Financial Services Risk Quant Leader

Subrahmanyam is a partner with the financial services consulting team. With 17 years of experience, he leads capital markets modelling, regulatory transformation, and automation.