The Basel Committee on Banking Supervision has issued a consultative document on the risk management, capital treatment and supervision of interest rate risk in the banking book. The consultative document expands upon and is intended to ultimately replace the Basel Committee’s 2004 Principles for the management and supervision of interest rate risk.

The Committee’s review of the regulatory treatment of interest rate risk in the banking book is motivated by two objectives, according to a release. First, to help ensure that banks have appropriate capital to cover potential losses from exposures to changes in interest rates. This is particularly important in the light of the current exceptionally low interest rate environment in many jurisdictions. Second, to limit capital arbitrage between the trading book and the banking book, as well as between banking book portfolios that are subject to different accounting treatments.

The proposal presents two options for the capital treatment of interest rate risk in the banking book.

A Pillar 1 (Minimum Capital Requirements) approach: the adoption of a uniformly applied Pillar 1 measure for calculating minimum capital requirements for this risk would have the benefit of promoting greater consistency, transparency and comparability, thereby promoting market confidence in banks’ capital adequacy and a level playing field internationally; alternatively,

An enhanced Pillar 2 approach: a Pillar 2 option, which includes quantitative disclosure of interest rate risk in the banking book based upon the proposed Pillar 1 approach, would better accommodate differing market conditions and risk management practices across jurisdictions.

An advantage of a Pillar 2 approach is that it can better accommodate differing market conditions and risk management practices across jurisdictions. Moreover, the required calculation of a standardised framework, embedded in a Pillar 2 approach, represents a new hybrid intersection between a capital requirement (Pillar 1) and a supervisory review process (Pillar 2) and would have served to promote greater consistency, transparency and comparability.

The proposal recognizes that not all banking book positions are easily amenable to standardisation, given uncertainty about the timing of cash flows due to behavioural aspects and embedded options (eg non-maturity deposits, loan prepayment). The proposal provides flexibility to allow banks to use internal parameter estimates for certain products – subject to constraints as well as supervisory review and approval.

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