4.2 Identification and management of IRRBB

Institutions should consider all interest rate sensitive instruments in the banking book in the context of the assessment and management of exposures to IRRBB, including assets, liabilities, interest rate derivatives, non-interest rate derivatives referencing an interest rate and other off-balance sheet items (such as loan commitments).

Institutions should consider non-performing exposures¹² (net of provisions) as interest rate sensitive instruments reflecting expected cash flows and their timing.

¹² Non-performing exposures as defined in Annex V of Regulation (EU) 680/2014.

Without prejudice to paragraph 10, small trading book business, as defined by paragraph 1 of Article 94 of Regulation (EU) No 575/2013, shall be included unless its interest rate risk is captured in another risk measure.

4.2.2 Capital identification, calculation and allocation for the purpose of IRRBB

When evaluating the amounts, types and distributions of internal capital pursuant to Article 73 of Directive 2013/36/EU, institutions should base the contribution of IRRBB to the overall internal capital assessment on the institution’s internal measurement systems outputs, taking account of key assumptions and risk limits. The overall level of capital should be commensurate with both the institution’s actual measured level of risk (inc luding for IRRBB) and its risk appetite, and be duly documented in its report on the Internal Capital Adequacy Assessment Process (ICAAP report).

Institutions should demonstrate that their internal capital is commensurate with the level of IRRBB, taking into account the impact on internal capital of potential changes in the institution’s economic value and future net interest income measures plus market value changes resulting from changes in interest rates. Institutions should evaluate IRRBB risk measures in their internal capital determination particularly noting that the IRRBB measures capture the risk in a complementary manner (e.g., considering IRRBB from a different time horizon). Institutions are not expected to double-count their internal capital for EV and net interest income measures plus market value changes, nonetheless the internal capital allocation methodology should consider both IRRBB risk measures and explicitly assess their potential impact on internal capital.

In their ICAAP analysis of the amount of internal capital required for IRRBB, institutions should consider:

• (a) internal capital held for risks to economic value that could arise from adverse movements in interest rates; and
• (b) internal capital needs arising from the impact of rate changes on future net interest income plus market value changes capacity, and the resultant implications for internal capital buffer levels.

Institutions should not only rely on the supervisory assessments of capital adequacy for IRRBB or on the outcome of the supervisory outlier test, but should develop and use their own methodologies for capital allocation, based on their risk appetite, level of risk and risk management policies. In determining the appropriate level of capital, institutions should consider both the amount and the quality of capital needed.

Capital adequacy assessments for IRRBB should take into account the following:

• (a) the size and tenor of internal limits on IRRBB exposures, and whether or not these limits are reached at the point of capital calculation;
• (b) the expected cost of hedging open positions that are intended to take advantage of internal expectations of the future level of interest rates;
• (c) the sensitivity of the internal measures of IRRBB to key or imperfect modelling assumptions;
• (d) the impact of shock and stress scenarios on positions priced with different interest rate indices (basis risk);
• (e) the impact on economic value and net interest income plus market value changes of mismatched positions in different currencies;
• (f) the impact of embedded losses and embedded gains;
• (g) the distribution of capital relative to risks across legal entities included in the group’s prudential perimeter of consolidation, in addition to the adequacy of overall capital on a consolidated basis;
• (h) the drivers of the underlying risk; and
• (i) the circumstances under which the risk may materialise.

The outcomes of the capital adequacy for IRRBB should be considered in an institution’s ICAAP and flow through to the assessments of capital associated with business lines.

To calibrate the amount of internal capital to be held for IRRBB, institutions should use measurement systems and a range of interest rate shock and stress scenarios, which are adapted to the risk profile of the institution in order to quantify the potential scale of any IRRBB effects under adverse conditions.

Institutions that operate internal capital models should ensure that the internal capital allocation for IRRBB is properly factored into the overall internal capital allocation and that any assumptions on diversification are documented and their reliability as well as stability is verified using historical data appropriate for the individual institution and the markets in which it operates. Internal capital costs may be allocated back to the business units and products to ensure that the full costs of the underlying business units or products are properly understood by those responsible for managing them.

In considering whether or not an allocation of internal capital should be made in respect of IRRBB to net interest income measures plus market value changes, institutions should take into account the following:

• (a) The relative importance of net interest income to total net income, and therefore the impact of significant variations in net interest income from year to year;
• (b) The actual levels of net interest income achievable under different scenarios (i.e., the extent to which margins are wide enough to absorb volatility arising from interest rate positions and changes in the cost of liabilities);
• (c) The potential for actual losses to be incurred under stressed conditions, or as a result of secular changes in the market environment – e.g., where it might become necessary to liquidate positions that are intended as a long-term investment to stabilise net interest income measures plus market value changes;
• (d) The relative importance of interest rate sensitive instruments (including interest rate derivatives) in the non-trading book, with potential effects shown either in the profit and loss account or directly in equity (e.g., via other comprehensive income); and
• (e) The fluctuation of net interest income measures plus market value changes, the strength and stability of the net interest income measures plus market value changes streams and the level of income needed to generate and maintain normal business operations. Institutions with a high level of IRRBB that could, under a plausible range of market scenarios, result in losses, in curtailing normal dividend distribution, or in a decrease in business operations should ensure that they have sufficient capital to withstand the adverse impact of these scenarios.

Institutions should consider internal capital buffer adjustments where the results of their stress testing highlight the potential for reduced net interest income measures plus market value changes (and therefore reduced capital generation capacity) under stress scenarios.

4.2.3 IRRBB Governance strategy

The IRRBB strategy of the institution, including the risk appetite for IRRBB and IRRBB mitigation, should be part of the overall strategy, in particular the strategic objectives and risk objectives, which the management body must approve as laid down in subparagraph (2), letter (a) of Article 88(1) of Directive 2013/36/EU.

The institution’s risk appetite for IRRBB should be express ed in terms of the acceptable impact of fluctuating interest rates on both IRRBB measures should be reflected in limits. Institutions with significant exposures to gap risk, basis risk or option risk should determine their risk appetite in relation to each of these material sub-types of IRRBB.

The overall IRRBB strategy should also include the decision about the extent to which the business model relies on generating net interest income by ‘riding the yield curve’ – i.e., funding assets with a comparatively long repricing period with liabilities with a comparatively short repricing period. Where the business model relies heavily on this source of net interest income, the management body should explain its IRRBB strategy and how it plans to survive periods of flat or inverse yield curves.

Institutions should duly assess proposals to use new products, or engage in new activities, risk-taking or hedging strategies, prior to acquisition or implementation to ensure that the resources required to establish sound and effective IRRBB management of the product or activity have been identified, that the proposed activities are in line with the institution’s overall risk appetite, and that procedures to identify, measure, monitor and control the risks of the proposed product or activity have been established. It should be ensured that the IRRBB characteristics of these new products and activities are well understood.

Institutions using derivative instruments to mitigate IRRBB exposures should possess the necessary knowledge and expertise. Each institution should demonstrate that it understands the consequences of hedging with interest rate derivatives.

Institutions using models of customer behaviour as input for the measurement of their IRRBB should possess the necessary knowledge and expertise. Each institution should be able to demonstrate that it understands the consequences of modelling the behaviour of its customer base.

When making decisions on hedging activities, institutions should be aware of the effects of accounting policies, but the accounting treatment should not drive their risk management approach.

Consolidating institutions should ensure that internal governance arrangements and processes for the management of IRRBB are consistent and well integrated on a consolidated and a sub-consolidated basis.

4.2.4 IRRBB risk management framework and responsibilities

In view of having internal governance arrangements pursuant to Article 74 and 88 of Directive 2013/36/EU, institutions should, in relation to IRRBB, ensure the following:

• (a) That their management body bears the ultimate responsibility for the oversight of the IRRBB management framework, the institution’s risk appetite framework and the amounts, types and distribution of internal capital to adequately cover the risks. The management body should de termine the institution’s overall IRRBB strategy and approve the corresponding policies and processes. The management body may, however, delegate the monitoring and management of IRRBB to senior management, expert individuals or an asset and liability management committee under the conditions further specified in paragraph 42.
• (b) That they have in place an IRRBB management framework that establishes clear lines of responsibilities and that consists of a limit system, policies, processes and internal controls including regular independent reviews and evaluations of the effectiveness of the framework.
• (c) That the arrangements, processes and mechanisms referred for the assessment of IRRBB are comprehensive and proportionate to the nature, scale and complexity of the risks inherent in the business model and the institution's activities.

The management body should, in particular, be responsible for the following:

• (a) Understanding the nature and the level of the IRRBB exposure. The management body should ensure that there is clear guidance regarding the risk appetite for IRRBB in respect of the institution’s business strategies.
• (b) Establishing that the appropriate actions are taken to identify, measure, monitor and control IRRBB, consistent with the approved strategies and policies. In this regard, the management body or its delegates are responsible for setting:
• i. appropriate limits on IRRBB, including the definition of specific procedures and approvals necessary for exceptions, and ensuring compliance with those limits;
• ii. systems and standards for measuring IRRBB, valuing positions and assessing performance, including procedures for updating interest rate shocks, parameters and stress scenarios and key underlying assumptions driving the institution’s IRRBB analysis;
• iii. a comprehensive IRRBB reporting and review process; and
• iv. effective internal controls and management information systems (MISs).
• (c) Approving major hedging or risk-taking initiatives in advance of implementation. Positions related to internal risk transfers between the non-trading book and the trading book should be properly documented.
• (d) Carrying out the oversight of the approval, implementation and review of IRRBB management policies, procedures and limits. The level of and changes in the institution’s IRRBB exposure should be provided regularly to the management body (at least quarterly).
• (e) Ensuring that the validation of IRRBB measurement methods and assessment of corresponding model risk are included in a formal policy process that should be reviewed and approved by the management body or its delegates.
• (f) Understanding and assessing the functioning of its delegates in monitoring and controlling IRRBB, consistent with policies approved by the management body, on the basis of regular reviews of timely and sufficiently detailed information.
• (g) Understanding the i mplications of the institution’s IRRBB strategies and their potential linkages with market, liquidity, credit and operational risk but without requiring all the management body members to be experts in the area. Some of the members should have sufficient technical knowledge to question and challenge the reports made to the management body. The institution should establish that management body members are responsible for ensuring that senior management has the competence to understand IRRBB and that IRRBB management is provided with adequate resources.

Institutions should have delegation arrangements and procedures in place for any delegation by the management body of the monitoring or management of IRRBB, including, but not limited to, the following:

• (a) Persons or committees to which tasks of the management body are delegated for developing IRRBB policies and practices, such as senior management, expert individuals or an ALCO, should be identified and have objectives clearly set out by the management body.
• (b) The management body should ensure that there is an adequate separation of responsibilities in the risk management process for IRRBB. The IRRBB identification, measurement, monitoring and control functions should have clearly defined responsibilities, should be independent from risk-taking functions on IRRBB and should report IRRBB exposures directly to the management body or its delegates.
• (c) The institution should ensure that the management body’s delegates have clear lines of authority over the units responsible for risk taking on IRRBB. The communication channel to convey the delegates’ directives to these line units should be clear.
• (d) The management body should establish that the institution’s structure enables its delegates to carry out their responsibilities, and facilitates effective decision-making and governance. In this regard an ALCO, or its equivalent, should meet regularly and its composition should reflect each major department linked to IRRBB. The management body should foster discussion regarding the IRRBB management process, both between its members and its delegates and between its delegates and others in the institution. The management body should also ensure that regular communication between the risk management and strategic planning areas facilitate the monitoring of the risk arising from future business.

4.2.5 IRRBB risk appetite and policy limits

Institutions should articulate their risk appetite for IRRBB in terms of the risk to IRRBB measures in particular:

• (a) Institutions should have clearly defined risk appetite statements that are approved by their management body and implemented through comprehensive risk appetite frameworks – i.e., policies and procedures for limiting and controlling IRRBB.
• (b) Their risk appetite frameworks should:
• a. delineate delegated powers, lines of responsibility and accountability over IRRBB management decisions; and
• b. list the instruments, hedging strategies and risk-taking opportunities authorised for IRRBB.
• (c) In defining their risk appetites, institutions should take account of net interest income risks that may arise as a consequence of the accounting treatment of transactions in the non-trading book. The risk may not be limited to interest income and expenses: the effects of changes in interest rates on the market value of instruments that, depending on accounting treatment, are reflected either through the profit and loss account or directly in equity (via other comprehensive income), should be taken into account separately. Institutions should particularly take into account the impact related to embedded optionalities in fair value instruments under ongoing interest rate shocks and stress scenarios. Institutions should also take into account the potential impact on the P&L accounts of hedging interest rate derivatives if their effectiveness was hampered by interest rate changes.

Institutions should implement limits that target maintaining IRRBB exposures consistent with their risk appetite and with their overall approach for measuring IRRBB, in particular the following:

• (a) Aggregate risk limits that clearly articulate the amount of IRRBB acceptable to the management body should be applied on a consolidated basis and, as appropriate, at the level of individual affiliates.
• (b) Limits may be associated with specific scenarios of changes in interest rates and term structures, such as their increase or decrease or a change in shape of the yield curve. The interest rate movements used in developing these limits should represent sufficiently adverse shock and stress situations, taking into account historical interest rate volatility and the time required by management to mitigate those risk exposures.
• (c) Policy limits should be appropriate to the nature, size, complexity and capital adequacy of the institution, as well as its ability to measure and manage its risks.
• (d) Depending on the nature of an institution's activities and business model, sub-limits may also be identified for individual business units, portfolios, instrument types, specific instruments or material sub-types of IRRBB risk such as gap risk, basis risk and option risk.
• (e) Systems should be in place to ensure that positions that exceed, or are likely to exceed, limits defined by the management body or its delegates receive prompt management attention and are escalated without delay. There should be a clear policy on who will be informed, how the communication will take place and the actions which will be taken in response.
• (f) The reporting of risk measures to the management body or its delegates should have at least a quarterly frequency and should compare current exposure with policy limits.

A framework should be in place to monitor the evolution of hedging strategies that rely on instruments such as derivatives, and to control mark-to-market risks in instruments that are accounted for at fair-value. 4.2.6 IRRBB risk policies, processes and controls

Risk policies and processes

Internal controls

IRRBB IT system and data quality

Internal reporting

Model governance