Interest Rate Risk in the Banking Book (IRRBB)

Interest rate risk in the banking book (IRRBB) is the risk that changes in interest rates reduce a bank's capital or earnings through the positions in its banking book: loans, deposits, investment securities, wholesale funding and the derivatives that hedge them. It arises because assets and liabilities reprice at different times and in different ways, so a move in rates changes the value of the balance sheet and the income it produces.

IRRBB is a specific case of general interest rate risk, separated from the market risk of the trading book because it is measured and capitalised differently. International expectations are set by the Basel Committee on Banking Supervision in a standard published in April 2016, which national supervisors apply through their own rules. The 2023 failure of Silicon Valley Bank put IRRBB at the centre of banking policy debates.

Imagine you lend a friend money for ten years at a fixed 2 per cent, using money you borrowed yourself on a rate that changes every year. If rates rise to 5 per cent, you are paying 5 per cent to borrow while earning only 2 per cent from your friend. The loan you made is also worth much less if you try to sell it.

Banks do this on a vast scale, funding long fixed-rate loans and bonds with deposits that can reprice or leave at short notice. IRRBB is the name for the danger that a change in rates makes that mismatch painful.

• Repricing or gap risk. Assets and liabilities reset their rates at different dates, so parallel or uneven shifts in the yield curve change the margin between them.
• Basis risk. Positions linked to different reference rates, such as a central bank rate and a market rate, may not move together.
• Option risk. Customers can repay loans early or withdraw deposits, and those choices tend to go against the bank when rates move, so behavioural assumptions, including deposit beta, matter a great deal.

Banks measure IRRBB in two complementary ways. Economic value of equity (EVE) looks at the present value of all banking book cash flows; net interest income (NII) looks at earnings over the next one to three years. The change in EVE under a rate shock is calculated as:

• $\text{CF}_t$ is the net banking book cash flow expected at time $t$, assets minus liabilities.
• $\text{DF}^{\text{base}}_t$ is the discount factor at time $t$ under current rates.
• $\text{DF}^{\text{shock}}_t$ is the discount factor under the shocked rate scenario.

A simple example uses duration. Suppose a bank has 1,000 million of assets with a duration of 4 years and 900 million of liabilities with a duration of 1 year, and rates rise by 2 percentage points. The approximate change in EVE is −(4 × 1,000 − 1 × 900) × 0.02 = −62 million. If the bank's Tier 1 capital is 100 million, that is a fall equal to 62 per cent of Tier 1.

The 2016 standard keeps IRRBB in Pillar 2, meaning supervisors assess it bank by bank rather than applying a single automatic capital charge. Banks must calculate EVE and NII effects under six prescribed shock scenarios: parallel up, parallel down, steepener, flattener, short rates up and short rates down, with sizes that differ by currency. A supervisory outlier test flags banks whose EVE would fall by more than 15 per cent of Tier 1 capital in any scenario, which can lead to demands for more capital, hedging or lower risk. Banks must also disclose their results publicly. The European Union added a separate outlier test on net interest income through European Banking Authority standards.

Banks manage IRRBB through an asset-liability committee that sets limits and approves strategy. The main tools are interest rate swaps, which convert fixed-rate assets or liabilities to floating, often under hedge accounting; changes in the mix and maturity of investment securities; product pricing; and funds transfer pricing, which moves interest rate risk from business lines to a central treasury that can hedge it. Behavioural models of prepayments and deposit lives are validated and stress-tested.

IRRBB results depend on assumptions about how long deposits stay and how much rates paid on them rise. In 2022 and 2023, banks that had bought long-dated bonds with deposits taken during the low-rate years saw large declines in economic value, often hidden in unrealised losses on securities held at amortised cost. At Silicon Valley Bank, deposits proved far less stable than assumed, and a large unhedged securities portfolio left little room when withdrawals began. Supervisors have since pressed banks to review deposit assumptions, test larger shocks and link IRRBB with liquidity risk, since rate losses and funding outflows can reinforce each other.

• Basel Committee: Interest rate risk in the banking book (2016)