Interest rate risk and its measurement techniques [This purpose of the Annex is to provide a set of terminology and definitions that will provide a better understanding of IRRBB to both banks and supervisors.]

1. Definition of IRRBB

1.1 What is IRRBB?

IRRBB refers to the current or prospective risk to a bank’s capital and to its earnings, arising from the impact of adverse movements in interest rates on its banking book.

Excessive IRRBB can pose a significant threat to a bank’s current capital base and/or future earnings if not managed appropriately. Changes in interest rates can affect the underlying economic value of the bank’s assets, liabilities and off-balance sheet instruments, because the present value of future cash flows (and, in many cases, the amounts of cash flows themselves) change when interest rates change. Changes in interest rates also affect a bank’s earnings by increasing or decreasing its NII and the level of other interest rate-sensitive income and operating expenses.

1.2 Accounting and IRRBB

Fundamentally, there are two distinct methods for valuing banking book items, namely:

(a) "amortised" (or "historical") cost, where values are based on initial cost less accumulated depreciation, taking account of the expected life/maturity of the item; and

(b) "fair" (or "market") value, where values are based on market prices (where available) or on the net present value of expected cash flows, discounted at the prevailing rate (where no market price is available).