From compliance to insight: Why prepayment modelling matters now

Navigating IRRBB: Smarter prepayment models for a volatile rate environment

In today’s dynamic asset liability management landscape, accurately modelling prepayment behaviour is essential for managing risk and optimising asset valuation – particularly for fixed-rate mortgages and term loans. Selecting a modelling approach aligned with your institutions balance sheet is critical to strengthening performance across three key dimensions: Risk Management, Valuation, and Regulatory Compliance.

KPMG’s latest thought leadership examines how smarter prepayment models can enable banks to anticipate cash flow volatility, strengthen ALM strategies, and transform compliance into a source of resilience and competitive advantage.

IRRBB Series: Prepayment Modelling

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The rising importance of prepayment modelling

In today’s volatile interest rate environment, prepayment behaviour has become a critical factor influencing liquidity, profitability, and risk management. Unexpected prepayments alter projected cash flows, potentially resulting in surplus funds that require reinvestment and rendering existing hedges less effective. Enhanced modelling of prepayment risk allows for more precise asset valuation, particularly in volatile economic conditions.

Regulatory expectations under Basel

The Basel Committee, through SRP31, places strong emphasis on understanding and managing prepayment risk as part of IRRBB. Banks are required to understand and prudently estimate prepayment risk across their portfolios. Failure to do so may result in regulatory scrutiny and findings. Incorporating sound modelling practices supports compliance and demonstrates a proactive risk management posture.

Static vs dynamic modelling approaches

Static models effectively overlooking external financial incentives influencing borrower decisions. These models are easy to implement and understand, but are far too simplistic for today’s bank with a significant lending business.

Dynamic models, on the other hand, offer a more sophisticated approach to forecasting prepayment behaviour by incorporating both real-time market conditions and borrower-specific characteristics. Basel guidelines support the use of these factors to enhance predictive accuracy and align modelling practices with regulatory expectations.

Addressing prepayment risk within IRRBB

Banks routinely simulate various economic scenarios to evaluate how shifts in conditions, such as interest rate volatility or macroeconomic shocks, may influence prepayment behaviour. Scenario analysis and stress testing helps identify vulnerabilities and supports more resilient balance sheet management.

Your business, our focus

KPMG has extensive experience in assisting domestic and international banks in the development and implementation of robust prepayment models tailored to their portfolios and regulatory environments. We offer strategic insights into how behavioural modelling can enhance balance sheet optimisation and hedging strategies.

KPMG, with a wider view of the market, can assess fixed vs. floating rate product mix, FTP methodologies, and ALM strategies. Our behavioural modelling team also supports scenario analysis and stress testing, aiding banks in understanding shifts in prepayment behaviour under adverse rate environments, giving you a view of your position in relation to your peers.