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David Renz - SunGard

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Balance Sheet Stewardship: Why Interest Rate Risk Matters

29 May 2014  |  984 views  |  0

While interest rates have been low since 2008, they won’t stay that way forever. For banks, the inevitable rise of interest rates will have both negative and positive effects. We need to look at two separate effects – market value losses and changes in interest income – to understand how treasurers can minimize the negative aspects of rising interest rates.

Market value changes

Market value changes on the overall balance sheet may be of some importance from a capitalization perspective. However, they only produce losses if the resulting market value change is booked against capital or the interest income.

Against held-to-maturity banking book assets, the market value change from rising interest rates represents the future earnings potential of the balance only if the balance sheet remains constant. Market value changes for the entire banking book do not represent the single comprehensive measure for interest rate risk.

For the trading book, Value at Risk (VaR) and expected shortfall provide insight alongside scenario-based stress tests. Considering the liquidity buffers mandated by the liquidity coverage ratio (LCR), this perspective should be reflected in selected portfolios of the banking book, too. If one measures the economic value of equity sensitivity of a balance sheet of a bank that funds short term and lends long term, the loss against rising rates stems from assets losing more value than liabilities. Since banks are highly leveraged, economic capital is hampered.

Away from pure interest rate risk and looking at the LCR and trading book positions, the only thing that counts is the actual market value of the positions. Unless their funding was perfectly correlated with the position itself, the liability side does not matter at all. Therefore, market risk methodologies that are known from the trading book ought to be applied to the liquid asset portfolio, too. As they seek to avoid losses on their LCR-eligible assets, treasurers are more akin to a long-term bond investor than a rates trader. But the strategy has to work repeatedly, which is why the treasurer needs to keep the long run in sight.

Changes in interest income

Income volatility may be the single biggest direct threat from a rate hike. First, the dynamics within the balance sheet should be projected into the future under different rate scenarios. While in some scenarios this may have an upside, the treasurer’s contribution needs to be analyzed in terms of stability and correlation with the margin income generated at the front. Not only does this serve as a valuable clue to the viability of treasury’s current position in the interest rate risk space, but it helps to formulate coherent policies for hedging the banking book and future positioning on the rate curve.

This process, known as a tenor mismatch strategy, helps banks to avoid the pitfalls in using pay fix positions. While they may be perfectly correlated to fair value losses in terms of mark-to-market in a world of rising rates, their performance is far from guaranteed from an income perspective. In a world where hedging of rates requires ever more skill – and more liquidity – the use of these tried and tested derivatives deserves special attention.

Second, there are considerable interactions between interest rate movements and booking fair-value changes either to trading income (trading book assets) or into capital, where banks typically have longer-dated securities in the liquidity buffer.

Why not just look at the duration risk or a VaR? While these numbers may cover the initial loss, the actual problems in these assets are part of a repeating interaction of the bank with the market. In addition, liquidity buffers are here to stay, so re-investment needs to be simulated, too. Furthermore, as with any shock, the exact term structure behind the scenario is also important. Considering the LCR, there may be certain periods where this ratio is depressed, and if rates bite at this point, it gets even nastier.

Dynamic simulation techniques, where the balance sheet and isolated portfolios are simulated into the future, allow treasurers to determine the effects of their tenor mismatch strategy and interactions between market value losses and income/capital. Based on this, natural and synthetic strategies can be devised to counter any negative effects or boost positive impacts. Natural strategies consist mainly of incentivizing or pushing existing instruments or slightly altering known positions. Derivative-driven strategies are mainly based on interest-rate derivatives.

Attaining empirical validity and accommodating reverse stress testing may be done in this framework by basing simulation on a large number of Monte Carlo scenarios or on an isolated portfolio. This gives the numbers a new dimension with estimated empirical probabilities, which allows banks to quantify different hedging strategies. Given that the exact sequence of events around a rate hike is shrouded in mystery, this additional dimension may come in handy, particularly when it comes to avoid over-hedging.

With simulations based on realistic and plausible rate scenarios and known and well-understood instruments, banks are relying on existing “technologies” to avert the danger. Therefore, the key to managing interest rate risk does not lie in a relentless round of costly innovation, but in combining insights that are already found in the risk management space with actual operational items. Successful treasurers will combine an analytical view of the balance sheet with operations.

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David Renz

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