It never rains, but it pours. Just as banks in the European Union are preparing for a new test of the interest rate risk embedded in their banking books, the Basel Committee on Banking Supervision is proposing an updated global standard to set parameters for testing the same risk.

Absent from the discussion are any estimates of the impact the Basel Committee’s proposed changes to global shock sizes will have on the test outcomes.

Risk.net has attempted to fill the void by using the prudential disclosures published by the banks themselves. These show that the new shock scenarios designed by the committee would cause more EU banks to fail the net interest income (NII) test. The test, which measures changes in cash flows from interest-bearing products that would be likely to follow a sudden and severe change in rates, is not only a novelty in the EU; it is virtually unknown in the world’s other developed economies, many of which only measure changes in the economic value of banks’ balance sheets.

Some sources in the banking industry say the results of our study, which combined the EU’s new test with the Basel Committee’s new shocks, are unsurprising. Others suggest there are limitations in the way our study can simulate the tests based on current disclosures, and that it may understate the impact of the new shocks on the existing economic value of equity (EVE) test. EVE is a single metric of interest rate risk in the banking book (IRRBB) that measures the gain or loss in the value of banks’ interest-bearing products following six scenarios of moving rates.

Crucially, banks will have to stay within the regulatory thresholds for both tests at the same time.

“It will be more challenging to avoid being an outlier in both perspectives,” says a senior risk manager at an EU bank. “At some point, you will start doing stupid things just in order not to be an outlier.”

Growing interest

Last December, the Basel Committee proposed updating the sizes of the shock scenarios within supervisory tests aimed at identifying those banks most at risk from sudden and severe changes in rates. The update would incorporate the sharp moves in interest rates seen since 2021 into the time series used to calculate hypothetical shock sizes. However, the effects of the update, should it be implemented, will be amplified because European regulators have also decided to increase the confidence level used to determine the severity of the shock relative to historical observations.

It will be more challenging to avoid being an outlier in both perspectives. At some point, you will start doing stupid things just in order not to be an outlier

Senior risk manager at an EU bank

Although the Basel Committee’s test relies on EVE, banks in the EU last month became subject to a new outlier test that relies on NII and which only uses two of the EVE test’s six scenarios. The European Commission published the technical standards detailing the NII test on April 24, which means banks had to begin complying with it in May.

If, in any scenario, a bank reports a decline in NII or EVE larger than a certain percentage of its total tier 1 capital, it will be deemed an outlier that is most at risk from changes in rates. Supervisors can then start to ask the bank to remedy the problem or increase its capital requirements.

According to available pillar 3 disclosures, 18 from a sample of 76 EU banks would have failed the NII test if it had been in force at the time of their most recent disclosures last December. The number would increase to 27 banks if the Basel Committee’s shock scenarios were used as well. Far fewer banks would fail the EVE test, and the new Basel shocks would generate a smaller increase in the number of outliers than would be the case if they were implemented in conjunction with the NII test.

“I’d say that’s somewhat in line with my expectation,” says a manager working in a second EU bank’s asset and liability management (ALM) team.

Not all of our sources agree that the proposed changes to the Basel Committee’s shock scenarios would have a greater impact if implemented alongside the NII test. These sources claim that increasing shock sizes could have an outsized impact on EVE – something it has not been possible for Risk.net to reflect in its results, given the limited nature of the data publicly disclosed by the banks. There are other limitations that affect how good a proxy pillar 3 results can provide (see box).

“This kind of proxy can suffer because there are a lot of devils in the details,” says the ALM manager at the second EU bank. “But that’s the best you can do with public information.”

Some countries would be more affected by the shocks than others. Jacek Rzeźnik, deputy director for ALM at Polish lender mBank, says the recalibration of the shocks will lead to a large increase in the size of the shock for the local currency. The Basel Committee only specifies shocks for currencies belonging to G20 countries. Banks in jurisdictions that do not use those currencies have to determine the shock sizes by using the committee’s methodology for calibrating shocks for G20 currencies.

“For the Polish złoty, it would go up to 400 basis points from 250bp,” says Rzeźnik. “If we increase the shock by 150bp, all the banks in Poland will be outliers.”

Time to adjust

There are various reasons why the updated shock sizes will have a greater impact if implemented in conjunction with the NII test rather than the EVE test. The senior risk manager at the large EU bank says European banks’ NII is more sensitive to rate changes owing to the way these firms typically invest in assets that reprice at the same time, or soon after, rates change.

“You have to decide how you want to invest your equity,” says the risk manager. “If you go for floating rate bonds, which most banks do, you’ll find with EVE there’s no problem with your equity investment. But with NII if the rates go down, you will earn less.”

EVE, on the other hand, exposes banks to risks if the rates on their assets are fixed for longer than the rates on their available funding. If rates rise, the fixed-rate assets lose value due to the higher discount applied to them.

Banks have had more time to get to grips with the EVE test, which two sources believe contributes to the Basel Committee’s proposed shocks having a greater impact when implemented in conjunction with the NII test. This is because many banks choose to stay well away from the EVE threshold. For NII, not only are many banks outliers, but many more are just under the threshold.

Tim Breitenstein, a director of financial services at KPMG, believes EU banks will become more accustomed to the NII test and reduce its impact over time.

“My forecast for the future is actually that banks will react to these new NII shocks,” he says. “They are able to manage their exposure. So personally, I expect that even if you now come up with, let’s say, 30 banks being NII outliers, the number will be lower in two years’ time or when the new Basel shocks apply.”

I expect that even if you now come up with, let’s say, 30 banks being NII outliers, the number will be lower in two years’ time or when the new Basel shocks apply

Tim Breitenstein, KPMG

The ALM manager at the second EU bank says the findings also indicate that the NII threshold for identifying outliers is, in practice, stricter than the EVE threshold. The European Banking Authority (EBA) had intended to set the NII threshold to result in the same number of outliers as under the EVE test. The outlier thresholds are set at 15% of tier 1 capital for EVE and at 5% for NII.

“It’s totally arbitrary,” says Christian Saß, an associate director at the Association of German Banks. “It’s all about how the threshold is set in the end.”

History lesson

The NII threshold has a tainted history. The EBA had to revise it after a rise in rates by the European Central Bank could have caused half the banks in the EU to be designated as outliers.

After EU banks sounded the alarm on the proposals, the European Commission – which needs to adopt technical standards from the EBA before they can enter into law – sought ways to address the banks’ concerns. The EBA then stated that the threshold should be set at 5%.

“It shows that our concerns that were raised back then were very valid,” says Saß.

Before the rate rises, the EBA’s original analysis found 8.7% of banks to be outliers under the EVE test with the threshold at 15%. A 5% threshold for the NII test was estimated to result in between 10% and 25% of banks being classified as outliers; the estimate was between 5% and 10% of banks if the threshold was 7.5%. After the rate rises, using data from December 2023, Risk.net found that 6.85% of banks would be outliers under the NII test with a threshold set at 7.5%, while 56.16% would be outliers if the threshold were 2.5%.

The ALM manager at the second EU bank says this suggests the threshold is still not being set reasonably. The EBA has committed to altering the threshold once the EU implements the Basel Committee’s update.

“The supervisory outlier test NII threshold is, let’s say, calibrated not so well,” says the ALM manager. “With a reasonable calibration you should have 7.5%.”

However, the NII threshold’s history also shows how different points of the rate cycle can affect the number of outliers in the two respective tests. If rates were to return to 0%, far fewer banks would be outliers on the NII test even if the Basel Committee’s proposed shocks were incorporated.

Current accounts make up a large part of banks’ funding, and these accounts often pay nothing to the depositor. The margins banks earn from investing these deposits rise as rates move higher, which means a downward shock in the outlier test will have a more severe effect on NII. If rates were closer to 0%, the reduction in interest margins from a decline in rates would be smaller.

“In the supervisory outlier test, when rates are assumed to go down by 2% you will just make less,” says the senior risk manager at the first EU bank.

Parallel lines

However, there is another possible reason why the simulated results look worse for the NII test than for EVE.

To determine whether banks were outliers, Risk.net increased their disclosed test results by the difference between the old and new shocks for the parallel shock scenarios – whereby the whole curve of an interest rate shifts up or down by the size of the shock. These scenarios are applied to both EVE and NII, and typically catch most banks out.

A limitation of simply scaling results is being unable to account for non-linear effects, which means larger shocks can have a disproportionate impact on banks’ results.

This can occur if products have built-in optionality – which customers exercise differently, depending on the level of rates as well as the direction and size of rate moves. Mortgages, for example, can have early repayment options, which are exercised less when rates increase and more if rates fall. When a bank uses linear hedging of its mortgage portfolio, such convexity effects remain unhedged, and more extreme interest rate shocks can lead to relatively bigger losses.

A senior risk manager at a large EU bank says they have found that this has a greater impact on EVE than on NII. KPMG’s Breitenstein says non-linearity can affect both measures, though “in practice, the non-linearity effect on the economic value side might be bigger”. There are two reasons for this.

The first is that EVE is not time-bound and assesses the total future value of all assets once they reprice. By contrast, NII only assesses the effect on cash flows over a one-year period, which means any assets and deposits repricing after the observation window will not have an impact on the results.

Secondly, if banks use simple discounting of cash flows in the EVE measure, this can also lead to non-linear effects. Assets fixed for longer face larger discounts than shorter-dated products, and the change in the valuation discount is greater than the move in interest rates.

“You have this whole future basically in your economic value, and not just the NII of the next year,” says KPMG’s Breitenstein. “It makes a big difference. In fact, discounting of future cash flows leads to non-linearities, and the effect is bigger the further away the cash flow is – even if there are just plain cash flows without optionality.”

It is unclear what further impact non-linearity would have on the results. The senior risk manager at the first EU bank says it can have a doubling effect, which would lead to 20 of the 85 banks being deemed as outliers under the EVE test. That would still be fewer than under the NII test, though it would be far more than the single outlier under the current EVE test. The size of the non-linearity may not be the same for all banks, which makes it impossible to come up with a precise number to scale all results by.

“It really depends on individual banks,” says Breitenstein. “Bank with lots of options will have big non-linearity. The bank with just straight positions like fixed-rate bonds, fixed-rate loans and maybe swaps will have less non-linearity. In addition, non-linearity depends on the term structure of the bank and will be different if interest rates go up or down.”

It is also unclear what the Basel Committee will do next. Banks have complained that the increase in the shock sizes for some currencies was mainly due to regulators upping the confidence level of the test, rather than being driven by the inclusion of recent rate changes into the time series.

“It’s a dangerous path,” says the ALM manager at the second European bank. “If you tend to be too strict, you will leave little option to ALM for positioning.”

Editing by Daniel Blackburn