EBA Guidance: Banks to Rethink Credit Spread Risk Coverage – Risk.net

European Union lenders are bracing for a potential expansion of their credit spread risk management practices following recent guidance from the European Banking Authority (EBA). The updated recommendations, issued in late December 2023 and detailed in EBA guidelines, are prompting banks to reassess the scope of their Credit Spread Risk in the Banking Book (CSRBB) perimeters.

A senior risk modeller at a European bank told Risk.net, “We at least need to either put more products into the perimeter or revise our argumentation.” This suggests banks may need to include a wider range of banking book products in their CSRBB calculations, or strengthen the justification for their current approach.

What is CSRBB and Why the Change?

Credit Spread Risk in the Banking Book (CSRBB) refers to the risk of losses stemming from changes in credit spreads – the difference in yield between a debt instrument and a benchmark – for non-trading book exposures. These exposures typically include loans and other assets held by banks on their balance sheets. The EBA’s focus on CSRBB is part of a broader effort to enhance the resilience of the banking sector to financial shocks, particularly those related to credit market fluctuations.

The current guidance replaces the 2018 guidelines on interest rate risk in the banking book (IRRBB) and CSRBB, aiming to provide more specific criteria for assessing and monitoring CSRBB. The EBA’s updated approach specifically identifies criteria to determine when internal models used for CSRBB management are no longer considered satisfactory. This increased scrutiny comes as regulators globally seek to improve risk management practices in the wake of recent banking sector stresses.

Impact on Banks: Expanding the Perimeter

The core of the issue lies in defining the “perimeter” – which banking book products are included in CSRBB calculations. Banks have historically had some discretion in determining this perimeter. The EBA’s new guidance appears to be narrowing that discretion, potentially requiring banks to incorporate a broader range of assets. This could include retail loans, corporate loans, and other fixed-income instruments.

Expanding the perimeter would necessitate banks to invest in more sophisticated modeling and data analysis capabilities. It would also likely increase the capital requirements for these exposures, as CSRBB is a key component of banks’ risk-weighted assets. The European Banking Federation (EBF) has been actively engaged with the EBA on these issues, seeking clarity on the practical implications of the new guidance.

The Liability Side of the Equation

Interestingly, the definition of CSRBB has been a point of contention. While the EBA initially focused on the asset side of the balance sheet – the loans and investments held by banks – some argue that CSRBB should also consider the impact of credit spread changes on a bank’s liabilities. A report by the European Banking Federation highlights this debate, referencing the Basel Committee on Banking Supervision’s (BCBS) standards. The EBF notes that while the EBA previously limited CSRBB to assets, a “gradient approach” could apply to all banking book items, including liabilities.

Considering liabilities would add another layer of complexity to CSRBB calculations, as changes in a bank’s creditworthiness can affect the cost of funding. This represents particularly relevant in the current environment, where interest rates are volatile and credit spreads are widening.

Compliance Timeline and Next Steps

The EBA’s guidelines on IRRBB and CSRBB were initially applicable from December 31, 2023, with a compliance deadline of April 28, 2022. However, the recent guidance issued in December 2023 necessitates a re-evaluation of existing frameworks. Banks are now actively working to understand the implications of the new recommendations and adjust their CSRBB models accordingly.

The immediate next steps for banks involve a thorough review of their current CSRBB perimeters, data quality, and modeling methodologies. They will need to assess whether their existing models adequately capture the potential impact of credit spread changes and, if not, develop and implement revised models. Ongoing monitoring and reporting to regulators will also be crucial to demonstrate compliance with the EBA’s guidelines.

The EBA’s focus on CSRBB underscores the importance of robust risk management practices in the banking sector. As credit spreads remain volatile and economic uncertainty persists, banks must proactively address this risk to ensure their financial stability and protect their stakeholders.