Types of IRRBB

Interest Rate Risk in the Banking Book (IRRBB) is a complex area that can be broken down into specific categories. These categories help banks understand and plan their risk management strategies more effectively. Here are the main types of IRRBB:

Repricing Risk

This risk comes from the differences in the timing of rate changes for a bank's assets and liabilities. Imagine a bank has assets set to change rates in two years, but its liabilities change rates in one year. If interest rates go up in that first year, the bank might face higher borrowing costs without seeing higher returns from assets, leading to smaller profit margins.

Yield Curve Risk

Banks often look at the yield curve, which shows interest rates for different loan durations, to make decisions. However, this curve can change in shape, which is defined as yield curve risk. If the curve becomes flatter than expected, banks might not benefit as much from borrowing short-term and lending long-term.

Basis Risk

Basis risk arises from the imperfect correlation between the proportional increase/decrease on assets & liabilities that reprice against different benchmarks. For example, an asset and liability may reprice by the same amount and at the same date on the repricing gap, but reprice against different benchmark rates (such as LIBOR vs SONIA).
Essentially, it is the risk associated with the unforeseen alteration in the spread between two reference rates. The risk crystallises when the differential between the rate at which an institution borrows and the rate at which it lends varies unpredictably.

Optionality Risk

Certain banking instruments have inherent options. These can be explicit, such as the option for a depositor to withdraw funds prior to maturity, or implicit, manifesting in behavioural tendencies. Optionality risk arises when such options are exercised in reaction to interest rate changes, leading to unanticipated discrepancies in an institution's cash flows and interest receipts.