Risk & Resilience Practice

Rate reset presents

banks with IRRBB
challenge
By focusing on six key areas, banks can more accurately manage
rising interest rates and credit spread risk across business lines, meet
regulatory demands, and create competitive advantage.
by Andreas Bohn, Marc Mitrovic, and Sebastian Schneider

March 2023
 Rising interest rates around the world can be a more intense competitive environment can
helpful to banks, but they come with challenges— cause individual players to see declines in liquidity
especially after an extended period of low coverage and gains in deposit beta—the percentage
borrowing costs. Aside from the direct impacts of of rate change passed on to customers.
monetary tightening, which may have positive or
negative effects, banks face increased uncertainty In Europe, many of these challenges are subject to
around customer behaviors, in both their loan books regulatory oversight through the European Banking
and deposits. Amid heightened regulatory risk, Authority’s (EBA) new guidelines for interest rate
leading institutions are now revisiting the impact risk in the banking book (IRRBB), published in
of these changes across data, models, and risk October 2022. The expanded framework motivates
management activities. banks to balance risks against key metrics,
including net interest income (NII) and economic
Fast changes in central bank interest rates can value of equity (EVE), which represents the net value
lead to significant shifts in customer behaviors and of assets and liabilities. It also provides rules and
bank risk exposures. In the loan book, drawing and recommendations on how to calculate key metrics,
repayment patterns may change, and there can be for example, with respect to the modeling and
significant disruptions in mortgage pipelines. There composition of balance sheet exposures, yield curve
is a higher risk of deposit decay-rate instability, scenarios, behavioral assumptions, and subrisk
which can require increased use of decay and categories (Exhibit 1). To meet IRRBB obligations,
hazard models to fix repricing tenors.1 Meanwhile, many banks are now abandoning the lens of the

Web <2023>
<IRRBB framework>
Exhibit 1
Exhibit <1> of <2>

Interest rate risk in the banking book framework balances net interest
income risk and economic value risk due to interest rate changes.

IRRBB1 key drivers

Risk to net interest and income Risk to economic value

Balance sheet exposure Yield curve scenarios Behavioral adjustments Subrisk categories
• Contractual cash flows and • Parallel shock up • Stability, tenor, and rate • Gap risks
margins • Parallel shock down elasticity of nonmaturing • Basis risks
• Contractual options and • Steepening deposits • Option risks
rights • Flattening • Termination and rollover • Credit spread risk
• Statutory rules and • Short rate up of term deposits
regulations • Short rate down • Mortgage prepayments,
• Implicit caps and floors and • Additional bank-specific pipeline risk, and drawing
statutory rules scenarios behavior
• Nonperforming exposure • Drawing of committed
• Hedging strategies and credit lines
instruments

1
Interest rate risk in the banking book.

McKinsey & Company

1
McKinsey Treasury Survey, January 2023.

2 Rate reset presents banks with IRRBB challenge

past 15 years—predicated on “lower for longer”— in turn, impacts how they should treat and interpret
and taking action to manage the impacts of higher behavioral models.
rates across the business.
To understand how best to manage IRRBB
exposure in the new regulatory environment,
IRRBB’s new definition of risk banks need to gauge trade-offs in the relationship
to net interest income between bank EVE and NII. The basic rule is that
The current test for IRRBB supervisory outliers is if a bank’s NII declines, it is less able to retain
focused on changes in banks’ EVE—the difference earnings. In a positive rate environment, an upward
in the value of assets and liabilities before and after shock to interest rates yields a negative delta EVE
hypothetical rates shocks. Going forward, however, and a positive delta NII. Therefore, a critical task
the EBA’s proposed test would equally assess the is to ensure that behavioral models can impart the
impact of shocks on NII. Methods for measuring NII insights into deposits to minimize NII volatility while
risk are evolving. The new supervisory outlier test remaining delta EVE neutral. In practice, this means
requires a calculation based on a static balance optimizing reinvestment and hedging activities.
sheet, but many banks (around one in three) are Ideally, then, it makes sense to agree on an optimal
starting to use the more realistic assumptions and delta EVE/delta NII position.
responses to market scenarios represented by a
dynamic balance sheet.2 Moreover, rising numbers McKinsey research shows that banks are taking a
of banks report that a combination of higher rates range of approaches to balancing delta EVE against
and the new methodology are causing them to delta NII in various rate scenarios. The differences
breach the test limit. are usually associated with variables that include
currency mix, yield curves, behavioral assumptions,
McKinsey’s most recent Treasury Survey also and pricing. However, the basic rule is that a bank’s
reveals some potentially damaging approaches ability to immunize NII across rate scenarios will be
to measurement of delta NII, with the majority contingent on its ability to manage EVE, as well on
of respondents applying floors on deposit and as the modeling choices it makes.
mortgage rates. This has the effect of producing
higher levels of variability when rates move up
or down. A minority of banks apply floors on A new approach to deposit
market rates.3 modeling and hedging
The EBA guidelines provide clarifications and
In calculating the impact of interest rate shocks, extensions for modeling, first relating to maximum
the EBA guidelines say banks should adopt an tenors and then to the scope of relevant deposits,
expanded definition of risk to NII that includes which have been expanded to include operational
market value changes in the other comprehensive deposits by financial institutions.
income (OCI) category (for example, revenues,
expenses, gains and losses), a correction position Best practices for deposits modeling and hedging
on a bank’s common equity tier-1 (CET1) capital. Just include the following:
56 percent of banks currently impose limits on OCI,
according to McKinsey’s survey. In addition, banks — Customer segmentation in line with regulatory
should consider increases or declines in profit or classifications. Balances should be assigned to
losses and capital over a longer time horizon. This, distinct segments. Behavioral and regulatory
features can be used for segmentation,

2
The static balance sheet assumption, a key component of the European Union–wide stress tests, means that the balance sheets of
participating banks are assumed to remain constant over the stress test horizon in terms of total volume, maturity, and product mix.
3
McKinsey Treasury Survey, 2021–2022.

Rate reset presents banks with IRRBB challenge 3

 complemented by advanced analytics and rates may become more volatile due to changing
expert judgment. prepayment behavior, as can loan life spans.

— Core balance modeling. Banks must determine Best practices on quantification, hedging, and pricing
their long-term stable balances, taking into of prepayment risks are evolving. They include:
consideration migration between current
accounts, term deposits, and savings deposits. — Customer segmentation. Banks can divide the
mortgage portfolio into customer segments
— Deposit volume modeling. Efforts should be through analysis of behavioral features.
made to measure the evolution of deposit
volumes. Industry best practice is to use the — Prepayment behavior. Banks should quantify
age-period-cohort model, taking into account “constant” prepayments and prepayments
the survival rate and expected volume. subject to specific criteria, such as interest rate
level, prepayment penalties, age of mortgage,
— Deposit beta. This is defined as the sensitivity and additional borrower background. They
of client rates to changes in market rates or should adjust expectations to reflect likely
the pass-through rate. There is a trend toward shorter tenors.
regime-based deposit betas to better capture
the variability of market rates being passed — Interest rate scenarios. Banks should model
through to customers in different interest rate a range of scenarios and simulate potential
regimes. Calculation of deposit beta should prepayment behavior for each scenario.
inform hedging strategy.
— Hedging ratios and strategy. Banks should
— Hedging strategy. Risk profile of modeled evaluate the value of mortgages under various
liabilities can be covered by different hedging rate scenarios and derive sensitivities to
instruments. The hedging strategy can focus on economic value and P&L. They should select
economic value or net interest margin, or it can hedging instruments reflecting fair value and
target the optimization of the risk-return profile. P&L changes.
An increasing number of institutions are using
stochastic models to test hedge ratios in the — Pricing. Institutions should adjust pricing
presence of convexity and optionality. based on analysis of maturities and
prepayment behaviors.
An increasingly common approach is to apply
advanced analytics to the modeling task, for In a more volatile rate environment, pipeline risk
example, by using machine learning to estimate increases, with acceptance rates tending to be less
classification probabilities and predict allocations as predictable as prices move between first lock and
rates and regulatory treatments change. A random full drawing. In fixed-rate mortgages, meanwhile,
forest model, for example, creates multiple binominal prepayment rights can lead to significant reductions
regression-based decision trees and simultaneously in repricing tenors. At the time of writing, average
selects variables. Often the analytics will point to repricing tenors are well below the regulatory cap.
previously unconsidered drivers, leading to higher- Meanwhile, just a quarter of banks hedge pipeline
than-expected prediction accuracy. risk, our most recent Treasury Survey shows.

The current rate environment also requires There are related uncertainties around the quantum
heightened attention to modeling and management and timing of drawdowns. Again, some banks are
of mortgages and other term loans. Acceptance tackling the challenge with advanced analytics, which
they apply at each step in the process, from the initial

4 Rate reset presents banks with IRRBB challenge

It is not always the case that credit
spread volatility is directly correlated
to credit rating, and higher-rated
companies are often more volatile.

lock, through client acceptance, and at full approval. to credit spread risk and should be appropriately
Early indications are that use of supervised and documented and justified (Exhibit 2).
unsupervised learning provides powerful insights into
acceptance rates, contingent on the banks’ ability to It is not always the case that credit spread volatility
marshal sufficient data across financial, behavioral, is directly correlated to credit rating, and higher-
and macroeconomic dimensions. The analytics can rated companies are often more volatile, McKinsey
also provide vital insights into potential hedging research shows. A key but sometimes ignored driver
ratios and hedge timing. is debt tenor. To offset the risks associated with
the above approaches, the EBA has introduced
an idiosyncratic component to measures of credit
Focusing on credit spread risk spread risk in the banking book.
The new IRRBB guidelines expand the perimeter for
credit spread risk in the banking book (CSRBB) and With banks starting to implement the CSRBB
set higher expectations for bank governance with alongside IRRBB rules, some have adopted
respect to credit decisions. CSRRB is defined as a strategic change programs, allowing them to
combination of two elements: changes in “market simulate CSRBB for the entire balance sheet,
credit spread” and changes in “market liquidity including issuances. Consequently, they can
spread,” representing the liquidity premium that measure the full impact of changes in market
sparks market appetite for investment and creates liquidity and credit spread for both assets and
willing buyers and sellers. liabilities. This helps them reflect a more dynamic
view of the impact of changes to funding spreads
There is still uncertainty regarding the scope of in internal risk management frameworks and make
CSRBB. However, the guideline asks banks to economic capital calculations that go beyond the
consider all instruments that may be subject to regulatory interpretation of the EBA guideline.
credit spread risk, including off-balance-sheet Currently, just 28 percent of banks measure the
items such as loan commitments. Assets at fair risk of variation in their funding rates over time,
value should always be included, while changes in McKinsey’s Treasury Survey shows.
the institution’s own funding rate cannot be used
to offset credit risk. Indeed, institutions should not
exclude any instrument in the banking book from Balancing the framework with
the perimeter of CSRBB ex ante, including assets, six priorities
liabilities, derivatives, and other off-balance- The EBA’s new standards for managing IRRBB
sheet items. Potential exclusion of instruments are designed to help banks navigate the impacts
should only be done in the absence of sensitivity of shifting rate environments on securities

Rate reset presents banks with IRRBB challenge 5

 Web <2023>
<IRRBB framework>
Exhibit 2
Exhibit <2> of <2>

Credit spread risk in the banking book is increasingly in focus.

Scope of CSRBB1

Items at amortized cost Items at fair value (market to market)

IRRBB3
Idiosyncratic credit spread2
Administered rate Credit margin CSRBB
Market credit spread
Core element
Market liquidity spread
Out of scope
Funding margin
Funding rate Market duration spread

Reference rate ‘Risk free’ rate

Eg, consumer loans Eg, corporate loans Eg, bonds/interest earning securities

Instruments No instrument Exclusions from Assets at fair value Own credit spread
generally included excluded ex-ante scope to be justified always included A worsening of credit
Instruments sensitive Includes assets, Any potential exclusion Assets at fair value worthiness of the
to volatility in credit liabilities, derivatives, of instruments should should always be institution should not
spreads that may and other off-bal- be done in the case included have any positive
impact the institution’s ance-sheet items such of the absence of impact on the credit
income and/or capital as loan commitments, sensitivity to credit spread risk measure
irrespective of their spread risk and should
accounting treatment be appropriately
documented and
justified

1
Credit spread risk in the banking book.
2
Instrument/borrower specific.
3
Interest rate risk in the banking book.
Source: Consultation on draft Guidelines on IRRBB and CSRBB, (EBA/CP/2021/37), European Banking Authority, December 2021; Standards: Interest rate risk
in the banking book, Basel Committee on Banking Supervision, April 2016.

McKinsey & Company

portfolios, pensions, and fair-value accounting. against peers. A common action is to review
Meanwhile, the new supervisory outlier test organizational capabilities (size, skills, mandates)
threatens to capture many more banks than the and responsibilities. For processes, some leading
existing method. banks apply a twin strategic risk management
and operational risk management lens, taking into
To tailor the operating model to the demands of account escalation processes and remediation
IRRBB, we recommend an approach focused playbooks. Another common strategy is to apply
on governance, organization, and processes. dedicated KPIs to process efficiency, again
As a first step, many banks review committee ensuring alignment with peer groups.
structures, and terms of reference, benchmarked

6 Rate reset presents banks with IRRBB challenge

 Once a baseline is established, banks should seek interest income, including sensitivity and
Find more content like this on the
out ways to manage changes in NII, including using scenario analyses
McKinsey Insights App
advanced analytics and potentially switching to
fair-value accounting for securities. It is increasingly 4. Business and hedging strategy: reviewing
common to fully integrate credit spreads into the repricing profile of assets, liabilities, and off-
steering process, with the focus on fair-value balance-sheet position, aligning average tenors,
securities, while refining behavioral models to as well as considering application of derivatives
reflect higher levels of rate elasticity. It will also and hedge accounting
be imperative for banks to measure and manage
operational deposits. All of this will best be achieved 5. Credit spread risk: allowing for calculation
Scan • Download • Personalize
under a holistic governance framework that CSRBB for a wide range of balance sheet
balances delta NII and EVE through six key priorities: items, which can also be leverage for a broader
management of spread risk, including funding-
1. Data integrity: ensuring completeness of data, spread risk
exhaustive and correct data attribution, reliable
data transfer, and central storage 6. Reporting: establishing a flexible and dynamic
reporting framework that is easily accessible for
2. Behavioral models: employing a full suite of multiple users and allows for drill downs
behavioral models for deposits, mortgages, and
committed credit lines to capture changes to By paying close attention to management of these
client behavior in different rate scenarios six areas, leading banks have shown that they can
more accurately gauge the impact of rising interest
3. Supervisory outlier test: allowing for rapid rates and credit spread risk across key business
and frequent calculation of supervisory lines, meet regulatory expectations, and create the
outlier testing for economic value and net impetus for competitive advantage.

Andreas Bohn is a partner in McKinsey’s Frankfurt office, where Marc Mitrovic is an expert; Sebastian Schneider is a senior
partner in the Munich office.

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Rate reset presents banks with IRRBB challenge 7