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Why does managing interest rate risk in the banking book matter more now?

Photographic portrait of Thor Boon Lee
Thor Boon Lee

Associate Partner, Risk Consulting, Ernst & Young Consulting Sdn. Bhd.

5 minute read 23 Jan 2026

Bank Negara Malaysia’s IRRBB Exposure Draft signals a shift in how banks manage interest rate and liquidity risk.

In brief

  • Bank Negara Malaysia’s IRRBB framework strengthens oversight of interest rate risk across the banking book.
  • Liquidity and IRRBB are closely linked through funding structure, deposit behavior and balance sheet composition.
  • Banks must enhance governance, data quality and behavioral modeling to meet new regulatory expectations.

The Exposure Draft for Interest Rate Risk in the Banking Book (IRRBB) has been released by Bank Negara Malaysia (BNM) as part of the Basel III reforms. The IRRBB assesses interest rate risk across the entire banking book, which includes assets and liabilities. It impacts all Malaysians, directly or indirectly, as the IRRBB guidelines look at how interest rates impact a bank’s balance sheet, including held-to-maturity assets, current accounts, savings accounts (CASA) and fixed deposit rates.

To safeguard financial stability, BNM has issued detailed guidelines on liquidity risk management and aligned with international standards under the IRRBB framework. This article explores the relationship between liquidity, the banking book and regulatory requirements in Malaysia.

Liquidity and interest rate risk management are fundamental pillars of a sound banking system. In Malaysia, the banking book primarily consists of loans, deposits and long-term funding. Unlike the trading book, which focuses on short-term positions and is marked-to-market, the banking book is held for accrual and long-term value creation.

Liquidity in the banking book

Liquidity risk occurs when a bank cannot meet its cash flow obligations as they arise. This can happen if the bank struggles to liquidate assets quickly or secure funding at reasonable cost. In the banking book, liquidity risk primarily arises from mismatches between the maturity of assets (like long-term loans) and liabilities (such as shorter-term deposits), as well as concentration risks related to a narrow depositor base and behavioral assumptions regarding deposit stickiness and prepayment patterns.

Effective liquidity management is crucial for banks to withstand funding shocks and continue supporting the economy, particularly in Malaysia’s deposit-driven financial system. BNM’s Policy Document on Liquidity Risk aligns closely with Basel III liquidity standards while addressing local market nuances.

Key features of the policy document

  1. Liquidity coverage ratio (LCR): Banks must hold sufficient high-quality liquid assets (HQLA) to cover net cash outflows over a 30-day stress scenario. Malaysian banks are required to maintain an LCR of at least 100%.
  2. Net stable funding ratio (NSFR): this ratio promotes stable, long-term funding for banking book exposures, also requiring a minimum of 100%.
  3. Internal liquidity stress tests: Banks must conduct regular stress tests to assess funding and market shocks, while considering factors like retail deposit run-offs and wholesale funding withdrawals.

BNM has introduced updated guidelines that include measures for intraday liquidity, collateral management and contingency funding plans. These updates emphasize the importance of managing payment obligations in real-time and having clear contingency measures in place during stress scenarios.

With these new guidelines, banks must carefully manage loan growth, deposit reliance and HQLA holdings to comply with LCR and NSFR requirements, reducing the risk of sudden funding gaps.

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Understanding IRRBB in Malaysia
 

IRRBB arises from changes in interest rates that affect the economic value of equity (EVE) and net interest income (NII) in the banking book.
 

Common sources of IRRBB for Malaysian banks include repricing mismatches, where the differences in the timing of interest rate changes between loans and deposits. There is also the basis risk to consider, where variations from different reference rates, such as the transition from Kuala Lumpur Interbank Offered Rate (KLIBOR) to alternative rates. Another source to consider is the optionality risk, where risks associated with prepayments of housing loans and early withdrawals of deposits.
 

The Exposure Draft outlines that banks will have approximately two years to implement these changes. However, gathering clean and accurate data for behavioral modeling can be time-consuming and will depend on each bank's historical data collection practices.
 

Key elements of the IRRBB framework include:

  • Standardized shocks, where banks must measure EVE and NII sensitivity under six prescribed interest rate shock scenarios.
  • Supervisory outlier test, where a decline of more than 15% of Tier 1 capital in EVE under stress indicates elevated IRRBB exposure.
  • Behavioral modeling of non-maturity deposits (NMDs), where banks must justify assumptions on deposit stickiness and repricing behavior.
  • Malaysian retail deposits, typically stable, may mitigate volatility compared to wholesale funding markets.

 

Effective governance is essential, with the Board and senior management accountable for risk appetite, monitoring and model validation. The Asset-Liability Committee (ALCO) plays a crucial role in this oversight.
 

The interplay between liquidity and IRRBB

Liquidity and IRRBB risks are interconnected in Malaysia. Funding choices, such as reliance on short-term deposits, influence both liquidity ratios and IRRBB sensitivity. Assumptions about deposit behavior affect compliance with LCR and NSFR, as well as IRRBB modeling. BNM expects banks to adopt an integrated risk management approach so that measures to strengthen liquidity do not inadvertently increase IRRBB vulnerabilities.
 

Liquidity and IRRBB are core risks that Malaysian banks must manage prudently. BNM’s guidelines create a regulatory framework consistent with Basel III while catering to local market dynamics. By emphasizing robust liquidity buffers and sensitivity to interest rate shocks, the guidelines enhance the resilience of the banking sector.
 

For banks, success lies in balancing profitability with regulatory compliance and systemic stability. The banking sector must be prepared to comply with these guidelines and strategically utilizing IRRBB through gap analysis, behavioral modeling and validation.

Summary

Bank Negara Malaysia’s Exposure Draft on IRRBB reinforces the need for stronger risk management across balance sheets. The framework highlights the interconnected nature of liquidity and interest rate risk, particularly in a deposit-driven banking system. As banks prepare to meet new expectations around stress testing, behavioral modeling and governance, success will depend on integrating IRRBB considerations into liquidity planning while maintaining regulatory compliance and financial resilience.

About this article

Photographic portrait of Thor Boon Lee
Thor Boon Lee
Associate Partner, Risk Consulting, Ernst & Young Consulting Sdn. Bhd.
Helping organizations make sense of risk through clear and practical advice. Enjoys spending quality time with family outside of work.
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