Interest Rate Risk in the Banking Book (IRRBB) – and specifically the net interest income (NII) measure – has entered a new phase, driven by two key developments. First, after years of low and even negative rates, banks have returned to operating in a positive interest rate environment. The rapid rise in rates initially triggered significant losses in securities portfolios, but enabled banks to rebuild their margins. When rates decline, these margins are put at risk and their preservation poses new challenges for banks.
Second, the regulatory framework for NII has reached maturity in the EU. The European Banking Authority (EBA) finalized its IRRBB/CSRBB package (including the Guidelines on IRRBB and CSRBB [1], the Final Draft RTS on Standardized and Simplified Standarized Methodologies [2] and on Supervisory Outlier Tests [3], and the Final Draft ITS on Supervisory Reporting [4]) which have been transposed into international and national frameworks and law (see [5], [6], [7], and [8]). With the IRRBB reporting live since September 2024, the regulatory expectations for measurement methodologies and reporting frameworks are now in place.
Looking ahead, the pace of regulatory rulemaking is likely to slow down. On-Site Inspections (OSIs), however, may surface supervisory findings that require enhancements to models, data, and processes. This forces a strategic question on banks: will they approach IRRBB NII purely as a compliance exercise, meeting regulatory minimum requirements – or will they leverage their NII simulations as a management tool to generate actionable insights for balance sheet steering, margin preservation across rate cycles, and multi-year planning?
Answering this question requires a solid understanding of the methodological foundations. At the heart of IRRBB NII lies the simulation framework that enables banks to project earnings under various interest rate scenarios. Central to any such simulation are the assumptions regarding the development of the balance sheet. For the supervisory outlier test (SOT), the regulator requires a constant balance sheet (CBS) where the balance sheet structure remains unchanged as positions mature – an assumption that enables comparability across institutions by isolating the interest rate and behavioral effects on NII.
At first glance, the definition of the CBS appears straightforward. As we will see, however, realistic implementation examples reveal considerable complexity. While the regulatory framework for the SOT does specify implementation requirements for the CBS, these provisions fall short of a fully unambiguous definition – leaving room for interpretation that has given rise to divergent market practices.
This whitepaper examines these practices and provides a comparison of different CBS simulation approaches. We assess each approach through various lenses: aggregation level, number of newly generated instruments, consistency with dynamic simulations, complexity, flexibility and treatment of hedges. By illuminating strengths and limitations, we offer a framework for making informed choices about IRRBB NII simulation infrastructure. Our objective is not to prescribe a single “correct” approach, but rather help to enable informed discussions within banks on what IRRBB NII should accomplish –and which simulation approach best serves that purpose.
Approaches to simulating a constant balance sheet
IRRBB NII is strongly influenced by bank-specific balance sheet structures, behavioural assumptions and modeling choices. As a result, it is not a standardized risk measure. This is supported by regulatory requirements which are principles-based and allow for considerable flexibility – a point we discuss in this section, focusing on NII’s key modeling assumption: the constant balance sheet (CBS).
Regulatory baseline for CBS models
In its Guidelines on IRRBB and CSRBB [1] the European Banking Authority (EBA) sets out general principles for the modeling of NII. These include that NII calculations be currency-specific (GL 91); adequately model embedded options and non-maturity deposits (NMDs) (GL 108–112); follow strict guidelines when modeling equity (GL 113 –116); consider the various types of interest rate risk; and ensure that model complexity reflects the institution’s Supervisory Review and Evaluation Process (SREP) category.
EBA’s “Final Draft RTS on Supervisory Outlier Tests” [3] provides more details but still allows for a considerable degree of interpretation regarding the CBS implementation. In particular:
- Article 5 (d), definition of CBS: “Institutions shall compute the change in the net interest income under the assumption of a constant balance sheet, where its total size and composition, including on- and off-balance sheet items, shall be maintained by replacing maturing or repricing cash flows with new instruments that have comparable features with regard to the currency, amount and repricing period of the instruments generating the repricing cash flows.”
- Article 5 (e), margins of simulated new business: “Margins of the new instruments shall be based on the margins from recently bought or sold products with similar characteristics. In the case of instruments with observable market prices recent market spreads shall be used and not historical market spreads.”
We use these provisions as the baseline to examine various CBS modelling approaches. In simple cases, their interpretation is straightforward: a bullet instrument with no interim redemptions that repays its principal at maturity should be replaced with another bullet of equal time to maturity and principal. […]
To continue reading, please download the full whitepaper.
Authors
Dr. Christian van Enckevort, Principal and Expert in ALM and Liquidity Risk
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Matthias Mrozek, Manager and Expert in ALM and Bank Management
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