Bank ALM and Treasury Knowledge Series -How Banks Hedge Interest Rate Risk in the Banking Book, Closer Look at BCBS Guidelines

In an era of rising and volatile interest rates, the ability of banks to manage Interest Rate Risk in the Banking Book (IRRBB) has never been more critical. The Basel Committee on Banking Supervision (BCBS), in its landmark 2016 document BCBS d368, set out comprehensive principles and methodologies for identifying, measuring, and controlling IRRBB.

Here’s a practical and digestible walkthrough of the key components of this framework—perfect for professionals in ALM, risk, finance, and regulatory compliance.

-What is IRRBB?

Interest Rate Risk in the Banking Book (IRRBB) is the risk that changes in interest rates will adversely affect a bank’s:

• Economic Value of Equity (EVE) – the long-term value of assets minus liabilities.
• Net Interest Income (NII) – the short-term profitability from interest-earning assets vs. liabilities.

Unlike trading book instruments, IRRBB stems from on-balance sheet exposures such as loans, deposits, and held-to-maturity (HTM) securities.

-Key Components of IRRBB Management

1. Types of Interest Rate Risk

The BCBS identifies four core components of IRRBB:

• Gap Risk: Mismatched maturities or repricing periods between assets and liabilities.
• Basis Risk: Imperfect correlation between different interest rate indices (e.g., LIBOR vs SOFR).
• Option Risk: Optionality embedded in products (e.g., prepayment of mortgages).
• Yield Curve Risk: Changes in the slope and shape of the yield curve (e.g., flattening, steepening).

2. Measurement Approaches

Banks may adopt two frameworks to measure IRRBB:

A. Standardized Approach (SA-IRRBB)

Designed for comparability and supervisory review, it prescribes six interest rate shock scenarios, including:

• Parallel shift (up/down)
• Steepeners and flatteners
• Short rate up/down

Supervisory Outlier Test (SOT): A bank is flagged if ΔEVE > 15% of Tier 1 capital under any scenario.

B. Internal Models Approach (IMA)

Banks with advanced ALM practices may use internal models, provided they:

• Use robust behavioral assumptions (e.g., NMD stability)
• Capture all IRRBB types
• Include dynamic stress testing and scenario analysis

3. Behavioral Assumptions and Modelling

Banks must model the behavior of:

• Non-maturity deposits (NMDs): Often sticky and not rate-sensitive.
• Prepayment options: Found in retail and mortgage loans.
• Early withdrawals or term deposit breaks.

These assumptions significantly impact EVE and NII sensitivity.

4. Governance and Oversight

The BCBS outlines 12 high-level principles, emphasizing:

• Board & Senior Management involvement in setting risk appetite.
• Clear ALM policies and model validation practices.
• IRRBB integration into the ICAAP and stress testing programs.

5. Disclosure Requirements

To promote market discipline, banks must disclose:

• IRRBB risk appetite and limits
• ΔEVE and ΔNII results under standard shocks
• Assumptions for deposit behaviors and option modeling
• Governance structures

Why It Matters for Hedging

IRRBB isn’t just a theoretical concept—it shapes how banks hedge structural risk through:

• Interest Rate Swaps: To lock in NII or immunize capital.
• Term funding strategies: Aligning funding duration with asset maturity.
• Option overlays or macro hedges: To address behavioral risks.

The regulatory framework acts as both a guardrail and guidepost in this process.

Final Thoughts

Managing IRRBB is no longer a back-office concern—it’s now a core strategic pillar of modern bank treasury. Whether you’re a risk manager, regulator, or strategist, understanding the BCBS IRRBB principles equips you to navigate today’s volatile interest rate landscape with clarity and confidence.

If you'd like a deep dive into building internal models, structuring balance sheet hedges, or implementing stress testing, let’s connect or drop a comment below.

Resources: This article draws guidance and insights from the Basel Committee on Banking Supervision’s publication “Interest Rate Risk in the Banking Book (IRRBB)”, BCBS document d368, April 2016. Full document available at www.bis.org.

**Disclaimer** - This article's views, opinions, and information are solely for educational, personal, and informational purposes. They are entirely independent and do not reflect or relate, directly or indirectly, to my current or previous employers.

Babu Sathyanarayanan, Moorad Choudhry Prateek Yadav CFA Institute Global Association of Risk Professionals (GARP) Claire Trythall Beata Lubinska, Ph.D Utkarsh Jain Ganesh Nayak Priyanshu Pandey Govind Gurnani Jakob Lavröd Glenn Handley Priyanshu Pandey Aswath Damodaran Ife Osakuade, MSc