Measurement & Management of IRRBB

Effective management of Interest Rate Risk in the Banking Book (IRRBB) requires the employment of sophisticated tools and methodologies to assess and mitigate potential vulnerabilities. Below are some of the pivotal tools utilised by financial institutions:

• Gap Analysis: a foundational tool to identify and measure the mismatches between rate-sensitive assets and liabilities over specified time bands. By assessing the gaps, banks can pinpoint periods where they may be exposed to interest rate risks. A positive gap indicates more rate-sensitive assets than liabilities, making a bank potentially vulnerable to declining interest rates. Conversely, a negative gap suggests the opposite, posing a risk in a rising rate environment.

• Duration Analysis: a measure of the price sensitivity of a bank's positions relative to changes in interest rates. It offers insight into the weighted average time until a bank's cash flows, both assets and liabilities, are received. Duration Analysis aids banks in understanding how their overall portfolio might change in value for a given shift in interest rates. Longer durations indicate higher sensitivity, implying greater potential changes in value with rate shifts.

• Earnings at Risk (EaR): provides an estimation of the potential adverse impact on a bank's future earnings due to changes in interest rates. Typically evaluated over a one-year horizon, it helps institutions gauge the effect of interest rate shifts on their net interest income, offering a short-term perspective on IRRBB.

• Economic Value of Equity (EVE): captures the long-term effects of interest rate changes, representing the present value of future cash flows from assets minus the present value of future cash flows from liabilities. Changes in interest rates can significantly impact EVE, and tracking this measure offers insights into the long-term resiliency and health of a bank's balance sheet in the face of interest rate fluctuations.

These tools allow banks to develop a comprehensive understanding of their exposure to IRRBB, ensuring they are well-equipped to make informed decisions and employ effective risk management strategies.