Introduction
Banks continuously borrow and lend money at different:
interest rates;
maturities;
repricing dates;
benchmarks; and
contractual terms.
Because these characteristics do not perfectly match, changes in market interest rates can affect a bank’s income and economic value.
This is Interest Rate Risk.
For banking-book positions, Interest Rate Risk in the Banking Book (IRRBB) is the current or prospective risk to a bank’s earnings and capital arising from adverse movements in interest rates. RBI issued final guidelines on governance, measurement and management of IRRBB on February 17, 2023.
An important CAIIB point is that the 2026 IIBF BFM syllabus still uses the wording “RBI’s Draft Guidelines on Interest Rate Risk in Banking Book” under Module D. However, the current regulatory position is that final RBI IRRBB guidelines have already been issued.
Learning Objectives
After studying this topic, you should be able to:
explain Interest Rate Risk in the Banking Book;
identify gap, yield-curve, basis and option risk;
understand how fixed and floating-rate products create IRR;
distinguish the earnings and economic-value effects of rate changes;
interpret asset-sensitive and liability-sensitive balance sheets; and
identify common CAIIB traps involving interest-rate movements.
Why Banks Face Interest-Rate Risk
Banks perform maturity and repricing transformation.
For example, a bank may:
accept deposits repricing after three months;
provide a fixed-rate loan for five years;
grant floating-rate loans linked to an external benchmark;
hold long-duration securities;
issue deposits at fixed rates;
receive deposits withdrawable before contractual maturity; and
enter into interest-rate derivatives.
The rates received on assets and the rates paid on liabilities therefore do not necessarily change:
at the same time;
by the same amount; or
according to the same benchmark.
This creates IRR.
The Basel framework identifies three major sources of IRRBB:
Gap Risk
Basis Risk
Option Risk
Gap risk also contains risks arising from changes in the shape of the yield curve.
Gap or Repricing Risk
Gap risk arises because assets and liabilities do not mature or reprice at the same time.
Consider a bank that has:
floating-rate loans repricing every six months; and
deposits repricing every three months.
If market interest rates suddenly rise, the deposit cost may increase before the lending rate increases.
For several months:
Interest Expense may rise faster than Interest Income.
The bank’s Net Interest Income can therefore fall.
The opposite timing structure produces a different result.
Basel describes gap risk as risk caused by differences in the timing of interest-rate changes across banking-book instruments.
Fixed-Rate Assets and Liabilities
Fixed-rate products create interest-rate sensitivity because their contractual cash flows remain fixed while market rates change.
Fixed-Rate Loan
Suppose a bank holds a long-term fixed-rate housing loan.
If market rates rise:
the bank continues receiving the old fixed rate;
new loans may be priced at higher rates; and
the economic value of the old fixed-rate loan generally falls.
The longer the remaining maturity and duration, the greater the potential sensitivity.
Fixed-Rate Deposit
A fixed-rate deposit works differently.
If market rates fall while the bank continues paying an old higher fixed deposit rate, the bank may remain locked into an expensive liability.
Therefore, both assets and liabilities can create IRR.
Floating-Rate Exposures Do Not Eliminate IRR
A common misconception is:
“Floating-rate loans have no interest-rate risk.”
That is incorrect.
A floating-rate asset may reprice:
quarterly;
monthly;
half-yearly; or
after another specified period.
Meanwhile, the liability funding that asset may reprice on another date.
Even if both are floating, their benchmarks may also differ.
Therefore, floating rates reduce some fixed-rate exposure but can still create:
repricing risk;
basis risk; and
earnings volatility.
Asset-Sensitive and Liability-Sensitive Balance Sheets
A useful conceptual approach is to compare the volume of assets and liabilities that reprice within a particular horizon.
Asset-Sensitive Position
If more assets than liabilities reprice in the relevant period, the bank is broadly asset-sensitive for that horizon.
When rates rise, asset yields may generally increase faster than funding costs.
This can improve NII.
When rates fall, asset yields may decline faster, which can reduce NII.
Liability-Sensitive Position
If more liabilities than assets reprice in the relevant period, the bank is broadly liability-sensitive.
When rates rise, funding cost may increase faster than asset income.
This can compress NII.
When rates fall, liability costs may decline faster, potentially improving NII.
Balance-Sheet Position | Rates Rise | Rates Fall |
|---|---|---|
Asset-Sensitive | NII generally tends to improve | NII generally tends to weaken |
Liability-Sensitive | NII generally tends to weaken | NII generally tends to improve |
These are directional relationships. Actual outcomes also depend on:
size of rate changes;
timing;
benchmark behaviour;
customer options;
pricing floors;
deposit behaviour; and
management actions.
Yield-Curve Risk
Interest rates of different maturities do not always move together.
For example:
short-term rates may rise sharply;
medium-term rates may rise only slightly; and
long-term rates may remain unchanged or even decline.
Such changes alter the shape of the yield curve.
Basel treats this as the parallel or non-parallel dimension of gap risk.
Parallel Shift
Rates across maturities move broadly by the same amount.
Non-Parallel Shift
Different portions of the curve move differently.
Examples include:
steepening;
flattening; and
inversion-related changes.
A bank whose assets and liabilities appear matched under one parallel-rate assumption may still have risk when different maturities move by different amounts.
Basis Risk
Basis risk arises when an asset and liability have similar repricing periods but are linked to different interest-rate benchmarks.
Basel defines basis risk as the effect of relative changes in rates on instruments having similar tenors but priced using different indices.
Practical Banking Situation
Suppose:
a floating-rate loan is linked to one external benchmark; while
the deposit or borrowing funding it follows another market rate.
Both may reprice frequently.
But if:
Loan Benchmark rises by 0.25%
while
Funding Benchmark rises by 0.75%
the bank’s spread can compress.
This is basis risk.
The important point is:
Same Repricing Date ≠ Same Rate Movement
Option Risk
Option risk arises when either the bank or the customer can alter the timing or amount of cash flows because of an explicit or embedded option.
Basel separates this broadly into:
automatic option risk; and
behavioural option risk.
Loan Prepayment
Suppose a bank has granted long-term fixed-rate housing loans.
Market interest rates fall.
Borrowers may:
refinance elsewhere; or
prepay existing loans.
The bank loses an attractive high-yielding asset and must reinvest the money at lower current rates.
This creates interest-rate option risk.
Premature Deposit Withdrawal
Suppose deposit rates rise significantly.
Some depositors may prematurely close existing low-rate deposits and move into higher-rate products, subject to contractual conditions.
The bank’s expected liability cash-flow pattern changes.
Deposit Persistence
Even accounts technically withdrawable on demand may display stable behavioural patterns.
If customer behaviour changes sharply when rates move, assumptions about the effective maturity and repricing behaviour of those deposits can become inaccurate.
The Basel framework therefore highlights behavioural assumptions for non-maturity deposits and prepayable loans as important to IRRBB measurement.
Automatic vs Behavioural Option Risk
Type | Meaning | Example |
|---|---|---|
Automatic Option | Exercise is strongly linked to economic value and contractual terms | Interest-rate cap, floor or explicit option |
Behavioural Option | Depends on how customers actually respond | Loan prepayment or deposit withdrawal |
Customer behaviour can make interest-rate risk non-linear.
A bank may expect one set of cash flows when rates are stable and a very different set when rates move sharply.
How Interest Rates Affect Bank Earnings
One important perspective is the earnings perspective.
RBI describes IRRBB as affecting a bank’s future earnings as well as capital, while the Basel framework explains that changes in rates can alter Net Interest Income and other interest-sensitive income and expenses.
The earnings effect depends mainly on:
how quickly assets reprice;
how quickly liabilities reprice;
the direction of rate movement;
benchmark differences;
pricing floors or caps;
deposit behaviour; and
customer options.
Margin Compression
Suppose funding costs rise immediately but lending yields rise only after several months.
During the lag:
Interest Expense rises faster than Interest Income.
Net Interest Margin can compress.
Margin Expansion
If earning assets reprice upward faster than liabilities, the opposite may occur.
The bank may temporarily earn a wider spread.
Economic-Value Effect
The second major perspective is the economic-value perspective.
Changes in interest rates alter the present value of future cash flows from:
assets;
liabilities; and
off-balance-sheet instruments.
The Basel framework therefore treats changes in earnings and changes in economic value as complementary ways of assessing IRRBB.
Rising Rates and Fixed Cash Flows
When market yields rise, the present value of existing fixed future cash flows generally falls.
Therefore, a long-duration fixed-rate asset can lose economic value when rates increase.
But liabilities also change in economic value.
The effect on the bank’s economic value depends on the relative sensitivity of assets and liabilities, not merely the fall in asset value.
Earnings Effect vs Economic-Value Effect
Basis | Earnings Perspective | Economic-Value Perspective |
|---|---|---|
Main focus | Future income | Present value of future cash flows |
Key concern | NII and earnings volatility | Economic value of equity/capital |
Horizon | Usually shorter-term earnings focus | Longer-term balance-sheet effect |
Sensitive to | Repricing timing and rates | Duration and cash-flow sensitivity |
Typical question | What happens to margin? | What happens to economic value? |
RBI’s IRRBB framework requires attention to both current/future earnings and capital.
Effect on Securities and Investment Holdings
Interest-rate changes also affect fixed-income securities.
When market yields rise:
prices of existing fixed-rate bonds generally fall.
When market yields decline:
prices generally rise.
The sensitivity is greater for instruments with longer duration, other things being equal.
For banking-book interest-rate management, the important point is the underlying economic sensitivity of future cash flows.
Accounting treatment and economic value are not always identical. The Basel framework notes that instruments held at amortised cost may not show the full market-rate effect immediately in accounting carrying values, even though their underlying economic value changes.
Effect on Loans
Interest-rate changes can affect loans through:
repricing of floating-rate loans;
value changes in fixed-rate loans;
borrower prepayments;
customer demand for new credit;
refinancing behaviour; and
repayment capacity.
A rapid rise in interest rates can also increase borrowers’ debt-servicing burden where lending rates reset upward.
This can create an interaction between:
Interest Rate Risk and Credit Risk
Basel specifically expects banks to consider interactions between IRRBB and related risks such as credit and liquidity risk.
Effect on Deposits and Funding
Interest-rate movements influence both the price and behaviour of liabilities.
When rates rise:
depositors may demand better returns;
wholesale borrowing costs may increase;
low-rate deposits may move into higher-yielding products; and
funding may reprice faster than some assets.
When rates fall:
the bank may benefit from lower funding costs;
but some fixed-rate liabilities may remain expensive until maturity.
Therefore, liability pricing is a major component of interest-rate-risk management.
Off-Balance-Sheet Exposures
Interest-rate risk is not confined to visible balance-sheet items.
Off-balance-sheet instruments may:
create IRR;
reduce IRR through hedging; or
change the timing and sensitivity of future cash flows.
Examples include:
interest-rate swaps;
Forward Rate Agreements;
futures;
options; and
other interest-rate derivatives.
A derivative may reduce one risk while creating another, such as:
basis risk;
valuation risk;
counterparty risk; or
imperfect hedge risk.
Therefore, the complete interest-rate-risk position should include both balance-sheet and relevant off-balance-sheet exposures. RBI’s IRRBB framework expressly addresses interest-rate effects across banking-book exposures.
Banking Book vs Trading Book
CAIIB learners should distinguish these concepts.
Banking Book
Generally contains positions arising from normal banking activity that are not held principally for short-term trading.
IRRBB focuses on the effect of changing interest rates on the banking book’s earnings and economic value.
Trading Book
Positions held for trading are exposed to market-price risk and are governed through the market-risk framework.
An interest-rate movement can therefore affect both books, but the risk-management and regulatory treatment are not identical.
Practical Banking Application
Consider a bank with:
long-term fixed-rate housing loans;
floating-rate corporate loans linked to an external benchmark;
short-duration wholesale deposits;
retail savings deposits;
fixed-rate term deposits; and
Government securities.
Now assume market rates rise sharply.
Several effects may occur together:
Housing Loans
Existing fixed-rate loans do not immediately generate higher income, while their economic value may fall.
Floating Corporate Loans
These may reprice upward, but only according to the contractual reset frequency.
Wholesale Funding
Short-term borrowings may reprice almost immediately, increasing funding cost.
Deposits
Customer expectations for higher deposit rates can raise liability costs.
Securities
Fixed-rate bond values can fall as yields rise.
Customer Behaviour
Borrowers and depositors may alter their behaviour according to relative market rates.
The final effect on the bank cannot be determined by saying simply:
“Rates rose, so bank income rose.”
Management must examine the entire repricing and cash-flow structure.
CAIIB Exam Focus
1. IRRBB Affects Both Earnings and Capital
Do not restrict interest-rate risk to NII alone.
2. Remember the Three Core Sources
Gap Risk – Basis Risk – Option Risk
3. Yield-Curve Risk Is Closely Linked to Gap Risk
It arises when different maturities do not experience the same interest-rate movement.
4. Same Repricing Period Does Not Eliminate Basis Risk
Different benchmarks can move differently.
5. Floating-Rate Assets Are Not Risk-Free
Repricing lags, benchmark differences and embedded options remain relevant.
6. Asset-Sensitive and Liability-Sensitive Positions React Differently
Do not assume every rate rise has the same effect on every bank.
7. Customer Behaviour Can Change Cash Flows
Prepayments and deposit withdrawals create option risk.
8. Earnings and Economic Value Are Complementary Perspectives
A position that appears manageable from short-term NII may still create substantial long-term economic-value sensitivity.
9. Balance-Sheet and Off-Balance-Sheet Positions Both Matter
Derivatives can hedge or create interest-rate exposure.
10. Current RBI Position Is Final IRRBB Guidelines
Although the 2026 IIBF syllabus wording still mentions “Draft Guidelines”, RBI issued final IRRBB guidelines on February 17, 2023.
Common Exam Traps
Trap 1: “Interest Rates Rising Is Always Bad for a Bank”
Wrong. The impact depends on whether assets or liabilities reprice faster and by how much.
Trap 2: “Asset-Sensitive Banks Lose When Rates Rise”
Generally the opposite for the earnings perspective: if rate-sensitive assets reprice upward faster than liabilities, NII tends to benefit.
Trap 3: “Floating-Rate Loans Eliminate Interest-Rate Risk”
Wrong. Repricing gaps and basis risk may remain.
Trap 4: “Assets and Liabilities Repricing on the Same Day Means No IRR”
Not necessarily. They may be linked to different benchmarks and therefore create basis risk.
Trap 5: “Interest-Rate Risk Affects Only Profit”
Wrong. It can also affect the economic value of the bank’s assets, liabilities and capital.
Trap 6: “Yield-Curve Risk Exists Only When All Rates Rise”
Wrong. It is particularly important when different points on the yield curve move by different amounts.
Trap 7: “Loan Prepayment Is Only a Credit Issue”
Wrong. Prepayment changes the timing and amount of cash flows and can create option risk.
Trap 8: “Demand Deposits Have No Interest-Rate Behaviour”
Wrong. Customer behaviour and deposit pricing can change as market rates move.
Trap 9: “A Fixed-Rate Liability Has No Interest-Rate Risk because Its Rate Cannot Change”
Wrong. Its relative economic cost can become unfavourable when market rates move.
Trap 10: “IRRBB and Trading-Book Interest-Rate Risk Are the Same”
Wrong. They relate to different books and are treated through different risk-management frameworks.
Memory Technique
Remember the main sources as:
G – B – O
G = Gap Risk
B = Basis Risk
O = Option Risk
For balance-sheet effects, remember:
E – V
E = Earnings effect through NII/NIM
V = Value effect on assets, liabilities and economic equity
So the complete idea is:
Rates Change → GBO Risks → Earnings + Value Effects