Australia’s interest rate risk environment is set to change dramatically in the next two years. Among the most significant of the infrastructural changes are the Fundamental Review of the Trading Book (FRTB), a new prudential standard for Interest Rate Risk in the Banking Book (IRRBB), and the Interbank Offer Rate (IBOR) transition. All three will make heavy demands on budgets and management time ahead of a planned common start date of 2022.
In this article, we outline the main changes. A common theme is that all of these developments will require a degree of system reconfiguration, as regulators shift the way that the industry thinks about interest rate risk in its various forms. Beyond the technical challenges, there will also be changes to the governance of risk. Senior managers will need to review the content on the changes to the interest rate risk management framework, in order to be ready on time.
The Fundamental Review of the Trading Book (FRTB) has now been finalised by the Basel Committee, and it is due for implementation globally from the beginning of 20221. FRTB will replace the current standard for measuring market risk in the trading book with approaches that are more comprehensive, refined, elaborate and demanding.
Australian banks are likely to migrate to FRTB on Basel’s timetable. Publicly, APRA has been reserved about its plans, and a draft on prudential standard has not yet been released. However it has been discussing its approach with industry, and KPMG understands that it intends to move trading books on to the standardised method for risk measurement as a first step.
Reaching the advanced levels of accreditation required by the standard will take more time. Data and computational requirements are intense, and an extended period of testing is necessary. Local banks which currently operate with advanced model accreditation may well still be on the standardised approach when the new regime takes effect.
1 Europe now seems likely to move in 2023 at the earliest.
Several of the major banks have either started planning for, or begun, market risk engine replacement projects. Although these installations will need to adhere to the existing prudential regulations as a baseline requirement, current investments are typically on a no-regrets basis with respect to impending FRTB requirements.
For the Internal Modelling Approach (IMA), those requirements are formidable. IMA for FRTB entails very long histories of high-integrity input data, as well as a high degree of consistency between modelled and actual profit and loss. Even trading desks which clear the bar need to be able to switch back to the standard method, if APRA deems that they are not up to par.
APRA may use its national discretion to ease some of the more onerous requirements around IMA and provide the banks with some relief. Industry is now very interested in whether, and how, any such relief might be offered. For example, APRA could conceivably relax the requirements around the modellability of risk factors, or it may choose to relax requirements around profit and loss attribution.
Even for those banks that are not contemplating IMA, there will still be much to do in relation to FRTB. The standard method is very different to, and much more elaborate than, the existing regulations. In addition to rebuilding some of their infrastructure, banks will also need to address a probable change in demarcation between the banking and trading books.
These are all topics that we expect APRA to detail in, or before, the first quarter of next year.
In September 2019, APRA released a draft standard (APS117) for Interest Rate Risk in the Banking Book (IRRBB). This new Standard would apply to all ADIs – not just those for which it currently imposes an interest rate risk capital charge. Globally, the equivalent standards come into effect in 2022, and APRA is aligned with this timetable.
APRA has several good reasons to revise the Standard. First, Australia – a leading country in the adoption of RWA measures for IRRBB – needs to align itself with new global regulations. A second imperative is the harmonisation of capital measures across banks. Greater comparability of risk models and their output has been one of APRA’s aspirations over recent years, and IRRBB is not exempt. Finally, APRA is seeking to temper volatility in measured IRRBB risk. IRRBB volatility has far exceeded that of other forms of risk-weighted assets, despite low and stable interest rates. APRA has indicated that some of this volatility needs to be eradicated.
The capital impact of the changes is not clear-cut but, taking the likely effects of all changes into account, KPMG expects system capital to rise from its average of about 3% of risk-weighted assets. We also suspect that APRA’s changes will succeed, both in suppressing volatility in RWA and in raising comparability of IRRBB risk measures across banks.
For the many smaller ADIs that are not yet subject to APS117, the draft Standard means a raft of qualitative changes. Some of these are arguably implied under the more general provisions of APS110 and CPS220. Nevertheless, by making them explicit, the new Standard will instil greater clarity in relation to APRA’s expectations of qualitative risk management at smaller institutions.
For our more detailed analysis of the draft standard, you can download our summary below.
Benchmark interest rates around the world are changing. Following a series of scandals involving the setting of interbank rates a few years ago, regulators initiated a transition to new, higher integrity benchmark rates. These rates are based on actual transactions, rather than quotes and estimates, and they are relatively risk-free.
The transition is due for completion at the end of 2021, at which time panel banks submitting quotes on interbank rates in the five major currencies in London will no longer be compelled to do so. This timetable for transition has since been taken up in many other jurisdictions, whose benchmark rates (so-called “IBORs”) are not set in London.
Much has to be done for this transition to succeed. To name a few of the major tasks: banks need to identify and remediate legacy contracts referencing the old rates; customers need to be engaged in renegotiation; new products have to be developed; risk, trading and accounting models need to be remediated; systems have to be upgraded; and, tax arrangements need to be reconsidered.
IBOR replacement is a fast moving industry process. In just a few weeks in 2019: European interest rate benchmarks have changed; US guidance has been issued on replacement programs; and, international accounting authorities have provided guidance on the transition for legacy products.
Within financial markets, there has also been much activity. Open interest in risk free rate products in sterling and US dollar continues to grow, and a recent bout of extreme volatility in short-term US dollar interest rates has highlighted the challenges that lie ahead.
For further information, and a subscription to our regular IBOR newsletter, please contact: AU-FMLIBOR@kpmg.com.au