What can banks do to address the challenges posed by rising interest rates?

Banks’ economic values of equity (EVE) are most likely negatively affected by the rise in rates. The impact is dependent on the duration of equity taken by the bank; the higher the equity duration, the larger the decline in EVE when rates rise (and hence a higher EVE risk). On the other side, choosing a high equity duration would lock in consistent income over a longer period of time (lower earnings risk), whereas a low equity duration results in earnings fluctuating with market rates (high earnings risk). As a result, eliminating both EVE risk and earnings risk at the same time is hard to achieve. Selecting the appropriate equity duration (or more in detail, key rate durations) is a balancing act between acceptable levels of EVE risk versus earnings risk. This decision depends on the bank’s risk appetite, internal risk limits and regulatory limits (SOT limits). Finally, due to EBA’s introduction of the NII SOT (supervisory outlier test on earnings risk), banks will need to put more emphasis on earnings risk, by assessing the impact of mitigation measures on the size of earnings risk relative to capital.

Levers to consider

Since today’s rate environment is materially different from years past, banks should re-evaluate their ALM strategy and, in particular, actively manage residual interest rate risk going forward. For banks, the following levers are important to consider:

• Adapting the interest rate risk limit framework to the new reality. This includes an assessment whether or not it is necessary to amend the overall equity duration and corresponding key rate durations. Especially, the introduction of the NII SOT by EBA will incentivize banks to amend existing limits on earnings risk or set new ones. The preferred target equity duration and corresponding key rate duration profile will be the result of a study where the impact of alternative equity durations is assessed against the bank’s risk appetite, and EVE and earnings risk limits. Once decided, it will be necessary to [i] adapt the hedge (derivative overlay) according to the new equity duration and key rate duration profile set as targets and [ii] manage the overlay over time in such a way that the realized key rate duration profile remains within the limits set around the target key rate profile and equity duration. Since the risk limit framework is part of the broader ALM framework, the ALM framework could be subject to a review as well.
• Reassessing key behavioral assumptions in the banking book. Although behavioral models are reviewed periodically, banks should consider recalibrating the behavioral models, especially after a shift in paradigm from negative to positive interest rates. Since behavioral assumptions are used to forecast cashflows, they should be set in a forward looking way (possibly using an expert overlay) and thus reflect the new rate environment. In this way, banks will understand how their behavioral models for mortgage pre-payments and non-maturing deposits impact the IRRBB key metrics and resulting equity duration going forward. Amendments in behavioral models can alter the size and structure of a derivative overlay.
• Brushing up the product palette and reviewing the range of banking products. Banking products that have not been attractive in a low and/or negative interest rate environment during the past years could very well become more attractive again for clients in a different (high) interest rate environment. At certain interest rate levels and steepness of the yield curve, clients could favor floating rate over fixed term instruments, short-term over long-term instruments, or vice versa. Volume shifts between banking products can gradually alter the balance sheet composition over time and materially change the interest rate risk profile of the banking book. Therefore, banks should consider adapting their product palette (and corresponding price setting) to the new interest rate environment. Also, banks should consider offering alternative banking products to clients to be able to benefit from risk offsets between assets and liabilities. This can be done by e.g. refurbishing specific products that have been on the shelf for a while now.
• Managing the duration of the liquidity buffer portfolio (more) actively in conjunction with the desired interest rate risk profile set by the revised ALM strategy. Investments in bonds with maturities consistent with the ALM strategy can bring the equity duration closer to the desired level and reduce the size of a potential derivative overlay.
• Strengthening the risk system capabilities to be able to provide management the requested transparency in a timely manner. It requires scenario analyses to determine the impact of strategic ALM decisions on the key risk metrics, both internal and regulatory risk limits and SOTs as well as other balance sheet metrics (e.g. capital and capital ratios). Scenario analyses include the roll-over of the bank’s balance sheet and hedges for a certain period (e.g. 1-5 years) under various scenarios regarding market rate, client rate (commercial margins) and balance sheet assumptions.

How can Zanders support banks in meeting these challenges?

Zanders is a trusted advisor in helping banks review their ALM/hedge strategy. Drawing on expert knowledge in ALM, we help banks conduct strategic ALM studies and holistic balance sheet management assessments using our proprietary tooling. These typically include impact studies of:

• alternative hedges (derivative overlays);
• changes in key behavioral assumptions;
• changes in balance sheet composition or
• other possible measures to mitigate the residual interest rate risk.

Using our holistic approach, we provide transparency and support banks in understanding the impact on future EVE risk, earnings (NII) and earnings risk, as well as other key metrics such as capital ratios, leverage, liquidity and funding (LCR and NSFR) ratios under different scenarios.

Are you interested in Strategic ALM and Holistic Balance Sheet Management? Contact Jaap Karelse, Erik Vijlbrief (Netherlands, Belgium and Nordic countries) or Martijn Wycisk (DACH region) for more information.