4.2 Capital identification, calculation and allocation

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 (including 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 earnings resulting from changes in interest rates. Institutions are not expected to double-count their internal capital for EV and earning measures.

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 earnings 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 (see section 4.5.), 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 earnings (including effects on the fair value through other comprehensive income (FVOCI) portfolio) 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 economic capital models should ensure that the internal capital allocation for IRRBB is properly factored into the overall economic 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. Economic 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 earnings, 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 earnings;
• (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, the strength and stability of the earnings stream 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 earnings (and therefore reduced capital generation capacity) under stress scenarios.