Interest Rate Risk in the Banking Book (IRRBB) represents a major structural risk for commercial banks. IRRBB occurs due to timing mismatches between the maturity and repricing dates of a bank’s assets (loans) and its liabilities (deposits) within its non-trading books.
Primary Drivers of IRRBB Exposure
- Gap Risk: Mismatches in the maturity and repricing timings of assets and liabilities. For example, if a bank funds long-term, fixed-rate mortgages using volatile, short-term variable deposits, its net interest margin will drop if market interest rates rise.
- Basis Risk: Occurs when assets and liabilities are priced using different interest rate indexes that do not move perfectly together.
- Option Risk: The risk that customers exercise embedded options within loans or deposits, such as borrowers prepaying fixed-rate mortgages early when market rates drop.