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US Banks’ Interest-Rate Risk Reporting and Regulation: A Comparative Context

Managing assets, liabilities, and interest-rate risk is foundational to banking. Banks transform savings into longer-term lending and investments, a process called “intermediation” that permits higher levels of economic growth. But bank intermediation also can create asset-liability management (ALM) challenges and mismatches. Changes in the level of interest rates affect the size of a bank’s ALM mismatch.

The effect of changes in interest rates on banks’ financial performance can be non-linear because of the optionality enjoyed by bank customers, depositors, and some borrowers. For example, holders of non-maturity deposits can elect to withdraw their funds from the bank at any time; residential mortgage borrowers can choose whether or not to prepay their loans.

Recently, the significant tightening in US monetary policy has increased the importance of interest-rate risk at banks. Higher interest rates both reduce the value of banks’ fixed-rate assets and shorten the maturity of banks’ deposits. Quantitative tightening has reduced banking system reserves at the Fed and the total quantity of US banking system deposits in ways that some banks may not have anticipated.

Thus, it is important to understand how US banks’ interest-rate risk is measured, monitored, and controlled. Banks generally compute two measures of interest-rate risk: one that measures the short-term impact of potential changes in interest rates on the bank’s net interest income (NII) over the next year or two; and a second, economic value of equity (EVE), which is a long-term metric that computes the net present value of a bank’s total assets minus the net present value of total liabilities, including deposits.

In 2004, the Basel Committee on Banking Supervision (BCBS) developed a global standard for interest-rate risk management in the banking book (IRR-BB). It strengthened that standard in 2016 on the expectation that interest rates, then near all-time lows, would eventually rise. This revised IRR-BB standard includes five key features:

  • A framework for banks’ EVE calculation, including caps on the quantity of deposits they can assume to be core and caps on the average assumed maturity by deposit category.
  • A predefined set of six interest-rate-shock scenarios.
  • A test that establishes that a bank is an “outlier” if the worst impact of those shocks on its EVE would exceed 15% of tier 1 capital.
  • An expectation that supervisors will require outlier banks to hold more capital or take other mitigating actions.
  • Public disclosure of banks’ interest-rate sensitivity measures.

While other jurisdictions, such as Canada, the UK, and Euro-area, published rules to implement the Basel IRR-BB standard, there is no US rule that implements this standard. Next, we summarize several key aspects of banks’ reporting and the regulation of interest-rate risk in the US.

The quarterly filings that US bank regulators require do not include NII or a standard EVE calculation for the six BCBS interest-rate risk scenarios. Under a 1997 rule, the Securities and Exchange Commission does require all publicly listed US banks to disclose their sensitivity to interest-rate shocks in their annual 10-K filings. Data from these 10-K filings suggest that some US banks’ interest-rate risk metrics in 2021 surpassed the thresholds under the BCBS standard.

That said, US regulations don’t require banks to compute EVE data under the Basel Committee’s standardized framework. This means that banks may report different metrics and make different assumptions about their deposits in computing their EVE and other interest-rate risk metrics in 10-K filings. It’s possible that less conservative assumptions could be justified for some banks about the quantity of their core deposits and the assumed maturity of their deposits. But additional required disclosures about banks’ deposit assumptions would be helpful to identify and evaluate where banks’ assumptions are unusual. Without either more standardization of metrics or more disclosure of key assumptions, it can be challenging to draw accurate conclusions about a bank’s level of interest-rate risk.

Turning to regulation, the US has implemented some elements of the Basel IRR-BB standard for the largest banks through its supervisory processes, rather than through regulation. For example, the Office of the Comptroller of the Currency (OCC) Handbook advises examiners to make sure the largest banks run the Basel Committee’s six prescribed interest-rate scenarios, though neither the OCC nor any other  US regulator requires banks to make these calculations in a standardized manner.

Interestingly, the Handbook originally stated that for banks with more than $250 billion in assets, an EVE reduction in any scenario that exceeds 15 percent of the bank’s tier 1 capital would be considered an outlier and an examiner should take that into account in forming conclusions about the bank’s risk management. However, in 2019, the OCC revised the scope of its guidance on interest-rate risk as part of the regulatory tailoring initiative so that it only applies to banks with more than $700 billion in assets. Banks with between $250 billion and $700 billion in assets are still required to run the six Basel scenarios, but the OCC Handbook no longer applies the 15% outlier test or describes consequences for an examiner’s evaluation of risk management.

The Federal Reserve’s examination manual for commercial banks is even more limited in its discussion and states that Fed examiners may only focus on a bank’s compliance with “self-imposed parameters.”  Based on the Federal Reserve’s manual, it could be difficult to challenge a bank’s level of interest-rate risk as excessive if the bank is operating within the NII and EVE risk limits that the bank’s own board approved.

By contrast, the Basel standard requires supervisors to identify outlier banks that should be subject to review and/or should be expected to hold additional regulatory capital under Pillar 2 of the Basel II capital standard. US regulation does not establish a Pillar 2 charge for IRR-BB for US banks. The results of US bank stress tests can increase the largest US banks’ capital requirements through the requirement that covered banks hold stressed capital buffers. However, as highlighted in a recent Peterson Institute blog, since 2015, no US supervisory stress test has considered rising interest rates. Instead, US supervisory stress tests have focused on banks’ potential trading book and loan losses. Thus, in the US there are no incremental capital requirements for banks with high levels of interest-rate risk.

In sum, publicly listed US banks do face requirements to annually disclose their interest-rate sensitivity, but not to publish these metrics as part of their quarterly regulatory filings for bank regulators. These metrics and their calculation are not standardized per the BCBS methodology.

Most US banks are also not required to run all six BCBS-recommended interest-rate scenarios. For the largest US banks, some US supervisors apply the outlier test in evaluating these banks’ risk management. Nonetheless, no rule requires US banks to hold higher capital for elevated levels of interest-rate risk in the banking book, which may affect both US banks’ risk-taking and their resilience. Supervisory stress testing, which is intended to promote the largest banks’ resilience by requiring them to hold higher levels of capital, also does not evaluate interest-rate risk.

The lack of effective interest-rate risk regulation is a major gap in US prudential standards that has weakened supervision and contributed to current banking sector stress.

With thanks to contributions from an anonymous expert.