Introduction

Interest Rate Risk in the Banking Book (IRRBB) has become a hot topic over recent years and there is a clear trend towards standardisation of the IRRBB approaches for measurement, modelling and monitoring in the banking industry. From a regulatory perspective, the journey started in April 2016 when the Basel Committee on Banking Supervision (BCBS) published the final Standards (BCBS Standards) on IRRBB that replaced the 2004 Principles. The new standards set out the Committee's expectations on the management of IRRBB in terms of identification, measurement, monitoring, control and supervision, and reflect changes in supervisory practices due to the exceptionally low interest rates, whilst providing methods and models to be used by banks in a wider and enhanced risk management framework. BCBS Standards had an important impact on the global adoption of standardised metrics and emphasised a clear difference between market risk (inherent in the trading book) and IRRBB (inherent in the banking book). However, IRRBB is not only a regulatory term. It has an impact on the profitability of financial institutions and its mismanagement leads to losses. There are many cases where banks have suffered from margin compression in the aftermath of the financial crisis when interest rates started going down. These banks failed to hedge the banking book against rates going down and, consequently, Current Accounts and Saving Accounts (CASA) and equity liabilities were reinvested at lower rates. Additionally, a non-transparent and deficient internal transfer pricing framework from business to the central unit caused open positions and margin at risk. The robust balance sheet management presupposes that customer business and financial risks are clearly separated with sound methodology. Therefore, the understanding of the interrelation between IRRBB and Funds Transfer Pricing (FTP) is an imperative in order to ensure effectiveness in the risk management process and allocation of clear responsibilities between stakeholders within the financial institution.

Without any doubt, the main driver for IRRBB evolution is a persistent low-rate environment. In some locations rates even moved into negative territory. The concept of negative rates is against a fundamental paradigm in finance that money has a time value that results from different investment opportunities. A fixed income security bought today for a specified term will return the payoff or future value that is dependent on both the compounding method and interest rate employed. Interest rates paid or charged for money depend, to a great extent, on the length of the term of investments. Therefore, the interest rate represents the price paid to use money for a period of time, which is commonly referred to as the time value of money.

In recent years, central banks in Europe have employed negative rates as an unprecedented measure to combat recession and foster recovery. The idea of being charged for lending is counter-intuitive and puts into question the concept of time value of money described above. Such a move is viewed as controversial by economists as there is a clear impact on the banking system. One of the primary concerns over negative rates is fuelling of cash hoarding behaviours as depositors are penalised instead of being compensated. Consequently, they are incentivised to hold cash. There is also a clear impact on the banks' profitability. Negative rates increase costs for banks with excess liquidity, resulting in a search for ways to offset these costs through raising account fees and charges and, in extreme cases, cutting back lending to the real economy. Indeed, the interest rates concept is extremely important because changes in interest rates affect a bank's earnings and its risk situation in different ways. This is exactly the reason why the regulator advocates the need for appropriate and precise methods for the measurement of the interest rate risk which enable the revelation of all its significant sources and the evaluation of its impact on the operative profile of the bank.

The regulatory aspect which reflects the changes in the market landscape is an important driver for IRRBB evolution and enhanced framework. However, the author believes there is another reason for the change in approach for the management of financial risks, in particular IRRBB and liquidity risk. It is beneficial for banks to adopt holistic and proactive management of financial risks. In her book Asset Liability Management Optimisation (Lubinska, 2020), the author examined the interrelation between interest rate risk and liquidity risk and quantified the benefits in terms of the reduced cost of funding achieved by the optimisation exercise and the holistic management of both risk categories.

The first attempts to integrate the interest rate risk and another type of risk (credit risk) has been proposed by Drehmann et al. (2010), and Alessandri and Drehmann (2010). The work performed by Drehmann et al. constructs the general framework for measuring the riskiness of banks, which are subject to correlated interest rate and credit shocks. The results show a strong interaction between credit risk and interest rate risk, sufficient to influence net profitability and capital adequacy: in particular, the magnitude of each risk component and the speed with which profits return back to equilibrium after the hypothesised shocks depend, among other things, on the re-pricing characteristics of the positions in the banking book and the cost of funding (Baldan et al., 2012).

The literature has thoroughly debated both the liquidity risk and interest rate risk and, until the regulatory updates on stress testing, IRRBB and liquidity, there seems to be little contribution from scholars on the integrated management of these types of risk. The link between financial risks can be seen in one of the main functions of credit institution, i.e., maturity transformation. Banks finance their investments by issuing liabilities with a shorter maturity than that of their investments; the resulting imbalance between the terms for the assets and liabilities means that they take on the interest rate risk and liquidity risk (Resti and Sironi, 2007). Baldan et al. (2012) launched the hypothesis that there is a direct relationship so that reducing the exposure to the liquidity risk induces a reduction in the interest rate risk as well. Their study analysed a small Italian bank during the years 2009 and 2010 which had to modify its liquidity profile in order to comply with the Basel III requirements. As a result, it generated the simultaneous reduction in its exposure to the interest rate risk. The authors conclude that there is a need to arrive at integrated risk management in which the control of each of these risks is placed in relation to the bank's different functions and influences its strategic decisions (Baldan et al., 2012).

After the regulatory updates, the silo basis approach is being slowly replaced by more integrated management of ALM risks. This is because profitability remains a key concern for the banking sector. The low profitability and widespread dispersion for some countries, along with high operating costs, continues to dampen the profitability prospects, especially for the European banking sector. Thus, there is a need to come up with new approaches which could address shrinking profitability, a heavily regulated landscape and exposure to financial risks. This necessity has been highlighted by Choudhry (2017) in "Strategic ALM and Integrated Balance Sheet Management: The Future of Bank Risk Management". In this article Choudhry suggests that the discipline of ALM, as practised by banks worldwide for over 40 years, needs to be updated to meet the challenges presented by globalisation and Basel III regulatory requirements. In order to maintain viability and a sustainable balance sheet, banks need to move from the traditional "reactive" ALM approach to a more proactive, integrated balance sheet management framework. This will enable them to solve the multi-dimensional optimisation problem they are faced with at present. In his book The Moorad Choudhry Anthology: Past, Present and Future Principles of Banking and Finance (2018), Choudhry describes a "vision of the future" with respect to a sustainable bank business model. This vision of the future contains the concepts of strategic, integrated and optimised ALM. The need for integration is now getting recognition from treasurers, risk managers and regulators. It is also starting to be considered among the ALM systems providers. They are attempting to build ALM solutions which focus on the integration between IRRBB, liquidity and FTP, supporting the view that, today, more holistic balance sheet risk management is required. Interest rate risk in banking cannot be viewed in isolation from liquidity risk, funds transfer pricing or capital management. Balance sheets have become more volatile - a result of changing term structures, optionality, better informed customers and the use of derivatives.

The objective of this book is to serve as a practical support in the daily management of IRRBB through the examples, case studies and solutions which have been developed during the author's career. It is a summary of many practical ideas related to hedging of the exposure to IRRBB subcategories, i.e., yield risk, option risk, gap risk and basis risk. The book represents the author's attempt to provide an insight into the practical aspects of IRRBB management along with the description of the main metrics and their calculation methods. It presents the concept of immunisation and natural hedging strategy...