The Basel Committee on Banking Supervision, with a consultative document released on Monday, is seeking public comment on proposals regarding what measures large baks should take, and how much reserve capital they should hold, to weather interest rate risks.
Since the global financial crisis that began in 2007, central banks throughout the world have set monetary policies that have kept interest rates at historic lows. As national economies recover, banks must be prepared for interest rates to once again be raised. “Although banks are expected to incorporate the effects of interest rate risk on earnings, guidance has so far been limited as to what supervisors expect,” the Basel Committee wrote.
The proposal presents two options for the capital treatment of interest rate risk: a uniformly calculation for minimum capital requirements (Pillar 1); and a quantitative approach that would accommodate differing market conditions and risk management practices across jurisdictions (Pillar 2).
“The Committee's review of the regulatory treatment of interest rate risk in the banking book is motivated by two objectives,” the proposal says. “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.”
“In theory, the design of a standardized capital framework should prescribe how to determine the risk across the entire banking book, including both on- and off-balance sheet instruments,” the consultative document adds. “In practice, this is not always straightforward…due to both continuing financial innovation and the nature of banking book products, where risks are not always amenable to standardized parameters or measurement techniques.” Given various complexities, the Basel Committee would allow a degree of internal modeling in the proposed Pillar 1 capital framework, subject to adequate controls on use and a demonstration of the accuracy of the metrics through independent validation.
Comments on the proposal must be uploaded by Sept. 11.