by Ioannis Akkizidis
It has been years since banks have faced these conditions, but solutions have improved greatly since then
Authorities tried for months to talk down the threat of inflation, but consumers and homebuyers had other ideas. Now that inflation has reached multi-decade highs in some jurisdictions and central banks have embarked on programs to raise interest rates to combat it, financial institutions suddenly find themselves in a real-time, real- world test – maybe a stress test. It is still too early to tell – of the robustness of their processes for assessing interest rate risk and other risks connected with it.
It has been many years since bankers have had to contend with rising interest rates. For much of the time since the global financial crisis, the yield on government debt issued in many mature economies had at most a 1 to the left of the decimal point, and often a 0 or even a minus sign.
But central bankers have begun to refer to inflation as “persistent” rather than “transitory,” and the Federal Reserve has made plain, even if it continues to use Delphic-like utterances to communicate its thinking, that four quarter-percentage-point increases in its key policy rate – maybe more hikes, and maybe more than a quarter-point for some of them – are on the way in 2022.
The Bank of England, Bank of Canada and their peers in places as far flung as Brazil, the Czech Republic and New Zealand have followed suit. The European Central Bank and Reserve Bank of Australia are expected to continue to hold rates steady, and the People’s Bank of China cut a key rate in January to ease pressure on its struggling property market, but the global trend for rates is clearly higher.
A new, and more complex, normal
Much has changed since the last time interest rate risk was a major consideration. That will make assessing and managing it more challenging this time around. For one thing, the industry is out of practice. Interest rates have been stable and very low for many years, making the calculations and analysis simple.
Another challenge is that during earlier significant tightening cycles, determining rate risk involved static analysis that relied on data that was current or from not long before. No dynamic analysis – no forecasting or consideration of second- or third-order effects, no need to weave together views from different departments within an institution – was required. The process was simple for that reason, too. It reflected an innocence among regulators and bankers about interrelationships among risk factors, something that went hand in hand with the limited technological sophistication of risk management systems of the day.
The necessary analysis is much more complicated today, and the economic and financial backdrop presents more threats for financial institutions. The risks are greater, and the assessment of them is going to be more difficult. Here are some potential sources of heightened interest rate risk in a rising-rate environment:
- Declining values on fixed-rate loans. As rates rise, the increasingly meager interest payments on fixed-rate loans, especially with long terms, reduce the loans’ value. Banks have high volumes of these loans on their books because rates depressed by central bank policies increased their attractiveness to borrowers. Banks can employ various hedging strategies to mitigate their losses, though.
- Increasing default risk. One saving grace of loans with very low fixed rates is that it is easy for borrowers to make payments. As customers take out new loans at higher rates, that ability declines.
- Rising loan prepayments. The volume of customer deposits has increased substantially, from 7 trillion to 17 trillion euros just in the euro zone in the last decade. Banks have paid little or no interest on those deposits, but they will have to adjust the rates to a higher degree. If interest payments do not rise as fast as market interest rates, depositors are likely to withdraw large sums and pay down floating-rate loans, exacerbating the urgency to generate new business.
- Reduced collateral. Banks are forced to hold large amounts of government debt issued with very low, often negative, interest rates. This debt is used as collateral on interbank loans. As rates rise, the value of this debt, and therefore banks’ collateral, falls.
Accounting fully for interest rate risk will take more than simply estimating values for these factors – decreased loan values, amounts prepaid, default probabilities and so forth – based on a given increase in rates across the yield curve over a certain period of time. An institution’s model also must reckon with rates of change in the impact of risks. Levels of certain risks tend to rise and fall in a nonlinear fashion as other factors change. There are accelerations and tipping points to consider.
Then there are the interrelationships among risks and the developments that influence the interrelationships. A proper assessment of interest rate risk involves not just determining the change in some Risk A as an input Condition X changes. Often – and this is a point that regulators have emphasized since the financial crisis, and especially in the last few years – a change in Condition X can affect Risk A, and it can also affect Risks B, C and D, either directly or through the effect that a change in Risk A can have on those other risks.
As an increase in rates lowers the market value of long- dated government bonds held on the books as collateral, for example, the market value for such paper may become thin; in this case greater interest rate risk means greater liquidity risk, too. Or say there is a decrease in profits, or an accumulation of losses, by a bank’s proprietary trading desk as rising interest rates send stock and bond prices lower, something that has occurred recently amid central bank hawkishness; here, rising interest rate risk is heightening market risk.
Rising to the challenge of rising rates
These economic and financial conditions, and their attendant risks and the interrelationships among them, need to be assessed, measured and reported, and the recent rise in interest rates, with more apparently to come, makes the task more urgent. Accomplishing it demands a holistic approach supported by an integrated data solution that facilitates connections among functions within an organization, echoing the connections among different risk sources.
An integrated solution is the only way to capture and act on these intricate and changing connections – through complex scenario analysis, for instance, or modeling new business strategies – in a way that assures accurate measurement, consistent results and effective planning and decision making. The alternative is to maintain a hodgepodge of systems scattered across different departments. That might have been good enough to manage interest rate risk in the simpler precrisis years, but the more challenging conditions that banks face today require more sophisticated methods to understand and manage them.