Managing interest rate risk in the banking book using an optimisation framework

The art of managing interest rate risk in the banking book is becoming topical again with the recent release of the Basel Consultative document as well as the banks’ need to generate interest income in a persistently low and flat interest rate environment. Interest rate risk in the banking book is traditionally managed by considering the tradeoff between short-term income volatility and the longer-term economic value of equity (EVE) volatility: the tradeoff between risk (of earnings and/or EVE decline due to adverse interest rate movement) and return (of net interest rate income and potential increase in EVE due to favourable interest rate movements). Although these are old and well-understood concepts, these risk vs return frameworks are at best implicit in many organisations, leaving room for suboptimisation. Another area of improvement is with respect to simplistic risk appetite frameworks, in many cases limited to sensitivity analysis (eg parallel shocks, etc), which can neither capture the true variety of interest rate movements nor be conceptualised. In this paper, we introduce a dynamic optimisation framework for explicitly managing interest rate risk and the return in the banking book. We also define the risk appetite in a manner that can be conceptualised and directly calibrated to an organisation’s risk preferences and tolerances.