Definition of credit spread risk unclear in EBA proposals

Market participants say banking book guidelines will be difficult to follow

Lack of direction: if proposals are not clarified, participants say they will not be able to monitor risk as required

Draft European guidelines on managing interest rate risk in bank deposit and loan books do not define credit spread risk clearly, a conference in London has heard. If the proposals are not clarified, market participants claim they will not be able to monitor the risk as required.

“The definition of credit spread risk in the banking book is not as clear in the guidelines from the European Banking Authority as it is in the Basel Committee on Banking Supervision’s standards. We are missing this definition,” said Roberto Virreira, a London-based manager of IRRBB policy at Standard Chartered, speaking at the Banking Book Risk Summit in London on November 28.

On October 31, the European Union’s banking legislator, the EBA, published draft guidelines setting out how banks should manage interest rate risk in the banking book. The draft proposal will update existing guidelines on IRRBB to incorporate new principles set out by the Basel Committee, which were published in April 2016.

One of those principles includes the need to monitor the risk of declining credit quality on bonds held in the banking book, known as CSRBB. The EBA guidelines state that banks must monitor credit spread risk, but do not provide a clear definition of what the regulator is trying to capture.

“There isn’t much regulatory clarity in terms of the paper and in Basel it is quite clear what the regulator is after,” said Virreira.

He continued: “We are missing this definition to make a clear distinction of what is [credit] spread [risk] and what is [credit] margin. Those are clearly distinguished [in the Basel Committee’s final standards] and we can infer that spreads are relevant for price risk. With EBA, it is not quite clear, so it needs to be incorporated.”

We are missing this definition to make a clear distinction of what is [credit] spread [risk] and what is [credit] margin… With EBA, it is not quite clear

Roberto Virreira, Standard Chartered

The final standards from the Basel Committee define CSRBB as any kind of asset or liability spread risk of credit-risky instruments that is not explained by IRRBB or jump-to-default risk. It explains that changes to the underlying credit quality could amplify the risk of increases or decreases in the price of bonds once market interest rates change.

The EBA guidelines, on the other hand, only define CSRBB as “any kind of spread risk of interest rate-sensitive instruments that is not IRRBB or credit risk”.

IRRBB specialists argue the EBA’s guidelines need to provide more clarity on the definition of credit spread risk so as to be able to identify exactly what the regulators want banks to monitor.

Virreira believes capturing credit spread risk in IRRBB is not the most appropriate way to assess the risk and that it should instead be captured as a market risk.

“I don’t think credit spread risk is IRRBB, but it has to be there. It is probably more amenable to market risk,” said Virreira.

Outlier banks

By and large, market participants have responded positively to the EBA’s draft guidelines on IRRBB as it is not as prescriptive as previously envisaged. One element that market participants are pleased with is the clarification that an outlier test will not result in immediate supervisory action.

“We welcome the approach to the outlier test, as it is seen as more of a warning signal than needing some prescribed action,” said Warsaw-based Jacek Rzeznik, head of market risk and liquidity risk at Polish universal bank Mbank, speaking at the Banking Book Summit.

The outlier test is designed for regulators to identify banks that have undue interest rate exposure and whose internal models designed to capture the risk are not up to scratch.

The test compares the bank’s economic value of equity, a cashflow-based calculation, against six prescribed interest rate shock scenarios, and sets the threshold of EVE at 15% of the bank’s Tier 1 capital. Banks that could see a greater than 15% drop in EVE are considered to be outliers and subject to supervisory review.

According to the Basel Committee’s guidelines, if the review shows a bank to have undue interest rate risk or inadequate management, then “there is a strong presumption for supervisory and/or regulatory capital consequences”.

Market participants had feared this could bring a Pillar 1 charge through the back door, but the EBA’s guidelines state the 15% threshold will act as an “early warning signal”. If a bank’s EVE breaches this threshold, the guidelines state it “should inform the competent authority”.

Rzeznik said there is, however, a possibility for national regulators to still use the outlier test as a signal for immediate supervisory action rather than an early warning signal envisaged by the EBA.

“This is where local regulators could read differently, but it shouldn’t be automatic action because then it becomes Pillar 1,” he said.

The EBA’s draft guidelines are currently being consulted on and this discussion will close on January 31, 2018. Following the conclusion of the consultation, the EBA will publish final guidelines, which – apart from the assessment of credit spread risk and an outlier test – will apply to banks on December 31, 2018. Banks will have a longer transition period to implement the assessment of credit spread risk and the outlier test, but the guidelines do not define how long that will be.