More EU banks will fail new IRRBB test as rates push upwards

Many more banks in the European Union are likely to be classified as outliers due to a new regulatory test that will check the amount of interest rate risk present in their loan and deposit books, according to bankers and consultants.

The European Banking Authority originally calibrated the rules for interest rate risk in the banking book (IRRBB) at a time when central banks were holding rates close to zero. The rule included a floor that assumed central banks would not cut rates below -1%.

That limited the size of a downward shock to net interest income (NII) – the interest banks receive on their assets minus interest paid on liabilities. But the calibration of a new regulatory test for NII proposed by the EBA last year could now collide with the rise in interest rates since mid-2022, triggering a sharp increase in the number of banks breaching the test threshold, according to five sources.

“When rates were 2% lower, the down shock banks were asked to calculate was probably limited due to the fact there was a model floor in the delta NII applied by many banks,” says Andreas Bohn, a partner in the risk team at consultancy McKinsey. “It basically improved the situation for banks, and now those banks are moving into a higher interest rate environment, the delta NII increases.”

The outlier test is part of the Basel Committee on Banking Supervision’s IRRBB standard, which was finalised in April 2016. The test helps supervisors identify banks most at risk from changes in interest rates.

Banks are required to measure hypothetical losses they would face following a dramatic change in interest rates. The Basel Committee outlined details of a test for measuring the economic value of banks’ assets and liabilities before and after a shock. Banks are considered outliers for the economic value of equity (EVE) test if their books drop in value by an amount equivalent to 15% of the bank’s tier 1 capital.

The Basel rules required banks to conduct a similar test for NII, but without an explicit outlier threshold – the text simply requires banks and supervisors to respond if the test results in a “large decline” in capital. In October 2022, the EBA therefore proposed a new quantitative definition for a “large decline” under NII. The outlier threshold was set at 2.5% of capital, which was designed to capture approximately the same number of banks as the 15% threshold under EVE.

No floor to stand on

However, when the EBA carried out its calibration for this 2.5% threshold, rates in the eurozone were at 0%. The original NII test includes a floor of -100 basis points applied to products with less than a year’s maturity. The floor incrementally increases by 5bp for each extra year of maturity on a product, up to 0% for products with maturities of 20 years or more.

This is important, because the NII test is more painful for banks in a downward shock, as profit margins can be sharply compressed if banks’ variable rate and short-term fixed rate assets reprice faster than liabilities. Since banks are usually unable to charge negative rates on retail deposits, when rates are very low, banks may not be able to offset the fall in interest income by repricing all their liabilities. This is why the floor on a down shock is crucial.

But with rates surging in Europe during 2022, banks will be able to apply the full 200bp down shock to assets without hitting the floor. As a result, far more banks are now likely to breach the 2.5% capital threshold for the NII test than the 15% threshold for the EVE test.

Christian Saß, an associate director in banking supervision for the Association of German Banks (Bankenverband), says the NII test might have led to “roughly” the same number of outliers as EVE if the floor were still binding: “So this is where I think the problem lies.”

Instead, Adrian Docherty, head of bank advisory at BNP Paribas, tells Risk.net that his analysis of bank Pillar 3 risk disclosures suggests around half of banks in Europe will be classed as outliers under the new NII test if the 2.5% calibration is retained. A senior risk manager at another European bank concurs: “We are implementing the new IRRBB outlier test and we agree that more banks could fail the test.”

Be reasonable

It would potentially make a nonsense of the concept of outlier status if too many banks cross the threshold. Outlier status doesn’t have automatic consequences, because supervisors have discretion on what actions to take. Still, it usually leads to heightened supervisory scrutiny and potentially higher Pillar 2 capital requirements.

Delphine Reymondon, head of the liquidity, leverage, loss absorbency and capital unit at the EBA, tells Risk.net the regulator will be closely monitoring the results of the NII test and will consider future revisions after it has been implemented.

She says the EBA will need to see how banks’ business models, modelling assumptions and strategies for lending and hedging change in the new interest rate environment before being able to recalibrate the test. All these factors could influence how sensitive banks’ NIIs are to downward shocks.

“This is also one of the areas where we said we would monitor the possible unintended effects of the lower bound precisely for this NII supervisory outlier test, because the interest rate environment has changed,” says Reymondon. “We knew when publishing that the calibration might need to be revised in the next few years.”

The EBA’s standard will take effect 20 days after it is published in the EU official journal of legislation, and banks will need to report the new NII test result for the first time at the end of the quarter in which that date falls. Bankers are calling for supervisors to respond pragmatically if large numbers of banks are indeed classified as outliers under the NII test.

“The supervisors have a certain degree of discretion here to deal with the outlier test,” says Saß of Bankenverband. “When they interpret the results, they need to do it cautiously and carefully.”

Update, January 26, 2023: This article was updated to put a background source on the record.

Editing by Philip Alexander