Recalibration of IRRBB Shock Scenarios
In December 2023, the Basel Committee on Banking Supervision (BCBS) published a Consultative Document on the recalibration of shocks for the measurement of IRRBB. Following the consultation period, on 16 July 2024, the BCBS published the final Recalibration of Shocks in the Interest Rate Risk in the Banking Book Standard. The indicative timeline for implementation is 1 January 2026; however, the changes shall only apply in the UK subject to their formal adoption by the Prudential Regulation Authority.
Purpose of interest rate shock scenarios
Yield curve shocks are utilised as part of the process of measuring exposure to interest rate risk. Shocks are applied under both of the primary methods for quantifying IRRBB, i.e., Economic Value of Equity (EVE) measures, and earnings-based measures. The quantification (i.e., size) and nature (i.e., distribution over the term structure) of the shocks are acutely relevant to the overall measurement process, with a range of shocks required to identify all potential aspects of banks’ IRRBB.
A set of standardised shocks has been prescribed by regulators, which banks are required to apply as part of their IRRBB measurement processes - in the UK, these are set out in the Internal Capital Adequacy Part of the PRA Rulebook and include parallel, rotational, and short-rate shocks.
To find out more about IRRBB generally, including application of shocks and IRRBB measurement processes, see our earlier article.
Recalibration of shocks
The BCBS’s original calibration approach considered a data period of 3 January 2000 to 31 December 2015 and was based on the application of a series global shock parameters, themselves derived using weighted averages of currency-specific shocks calibrated to a 1-in-100-year confidence level; the shocks were rounded to 50 basis point intervals.
With a number of years having passed since the original analysis, the BCBS sought to extend the period of assessment from December 2015 to December 2022, which would increase the number of data points and bring the calibrations up-to-date with more recent developments in interest rates across economies globally.
As part of this process, the BCBS observed some limitations with respect to its original methodology, in particular that the calculation could produce significantly different results depending on the actual level of interest rates. Global factors could also overshadow shocks at a individual currency level.
As such, the BCBS has adjusted its methodology, replacing global factors with local shock factors calculated directly for each currency, and moving from a 99th centile to a 99.9th centile when considering changes in interest rates for shock calibration to maintain sufficient conservatism. Finally, the BCBS refined the outputs by reducing the level of rounding to 25 basis points. Floors and caps applicable within the purview of shock calibration remain in force, to ensure a level playing field.
The table shows the original and recalibrated shock factors, in basis points, for the major currencies Sterling, Euro and US Dollar.
Overall, the recalibrations have resulted in significant uplifts for both Euro and Sterling.
Effect of the recalibrations
Using overnight index swap data published by the Bank of England, and applying the recalibrated shock scenarios from the BCBS, we estimate the following impacts to shocked interest rates.
The chart shows the effect (increase or decrease) to the shocked yield curve at the tenor midpoint for each prescribed shock scenario and in Sterling. All changes are shown in percentage points (pp).
llustrative impacts of proposed changes in shock calibration. Source: Bank of England OIS data and Katalysys calculations
Impacts with respect to the parallel scenarios are straightforward: with the parallel shock factor for Sterling increasing from 250bps to 275bps, the net effect at all points is an increase of 25bps in the level of shock applied to the input yield curve (yellow and red bars above).
Considering the short-rate shocks, which are by design intended to taper towards nil impact at the longest tenor points, the result of the upwards recalibration of 125bps in the short shock factor has the effect of increasing the shocks by approximately this level in the shortest tenor bucket, tapering to a nil effect at >20-years (orange and purple bars above).
Lastly, for the rotational shocks, which are a function of both the long and short shock factors - both of which have been recalibrated upwards (by 125bps and 100 bps respectively) - the extremities of the rotations are now more pronounced, i.e., the swings around the shortest and longest repricing time buckets are now larger (blue and green bars above).
At an overall level, with an upwards recalibration of all inputs, the shocks to the yield curve are generally higher across the entire term structure.
Implications for banks
Banks are already encouraged by the PRA to incorporate additional IRRBB scenarios beyond those prescribed into their risk analysis (see, Supervisory Statement SS31/15 ‘The Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP)’, 2.9D). As such, banks may already be measuring their IRRBB under more pronounced shocks than the standard list of six.
Notwithstanding, we would recommend banks consider applying the recalibrated shock scenarios set out by the BCBS when evaluating their IRRBB exposures. This would allow a bank to pre-empt the implementation of the proposed changes and understand any implications for their activities far in advance. This approach would also be of particular importance to firms whose IRRBB exposures:
are spread across multiple currencies all of which could be impacted by the proposed changes;
are already approaching internal risk limits, or indeed the PRA’s Supervisory Outlier Test of 15% of Tier 1 Capital under an EVE calculation, since the larger shocks could result in increased exposure values; and,
are or may increase in the coming years as part of planned growth or the evolution of the balance sheet.
How We Can Help
Banks may face a variety of challenges when meeting the extensive and detailed requirements set out in the UK IRRBB Rules (including in relation to CSRBB). At Katalysys, we have a deep understanding of IRRBB from the perspective of regulatory rules, modelling and measurement, and in terms of practical management. We also offer a cloud-based IRRBB measurement and reporting solution – k-ALM® IRRBB.
Our team has supported a range of clients in this area, from those seeking first authorisation to well-established institutions. Whether you need:
a cloud-based IRRBB solution;
support in defining an IRRBB Risk Management Framework including risk appetite;
assistance embedding policies relating to IRRBB;
guidance on modelling of behavioural assumptions, including non-maturitydeposits (NMD);
an independent review of your existing IRRBB frameworks, models or processes.
We have the subject matter expertise and technical skills to help.
For more information, please contact:
Josh Nowak
Managing Director, Risk & Regulatory Consulting
T: +44 (0)7587 720988