The Great Unwind: What Will Rising Interest Rates Mean For Bank Risk Exposures?

by: Market Integrity Insights

By Vincent Papa, PhD, CFA

Excess liquidity and relaxed monetary policy in the buildup to the financial crisis and central bank interventions to ease the economic meltdown that followed have fueled low interest rates in most advanced economies. But this low interest rate environment can't last forever, and a growing stable of research points to rising interest rates placing significant strain on bank profitability and capital adequacy levels. That's because interest rate risk management is at the heart of a bank's business model, after all.

Indeed, the 2013 IMF Global Financial Stability Report cites as an example the erosion of regulatory capital that would occur among Italian banks (7.7%) in response to a 200-basis-point increase in interest rates. Prudential regulators include rate sensitivity in their stress tests. Hence, it is worth examining the following two questions:

  1. How will the inevitable rise in interest rates impact bank performance and capital levels?
  2. How well do bank financial statements communicate the effects of possible interest rate changes on profitability and equity?

Effects of Interest Rate Changes on Bank Performance and Capital Adequacy

Both the IMF report and a 2012 Federal Reserve paper comprehensively outline the possible effects of interest rate increases, including changes to net interest margin, balance sheet structure, and values of interest-sensitive assets and liabilities. We would expect the following:

  • Changes in net interest margins: The bank financial intermediation business model entails maturity transformation (i.e., borrowing short term and lending long term); thus, interest rate assets have a longer maturity than liabilities. In other words, bank balance sheets are typically characterized by a maturity mismatch. If there is a steepening of the yield curve, the net interest margin would be expected to increase due to the maturity mismatch. Meanwhile, long-term assets have higher incremental returns than the incremental costs of short-term liabilities.
  • Potential changes in balance sheet structure and maturity mismatch: Increases in interest rates can alter the loan/deposit composition. For example, deposit disintermediation, or reduced deposit funding, tends to occur whenever interest rates rise because the opportunity cost of depositors saving in low-yield assets increases. In turn, a change in the balance sheet structure impacts the net interest margin.
  • Effect on hedging instruments and interest rate derivatives: Interest rate increases can lead to changes in the value of interest rate derivatives. The net effect on net interest income, profit, and capital will depend on whether these derivatives are applied as either fair value hedges or as trading instruments.
  • Effect on real economy and credit risk: Higher interest rates can result in slower economic growth because of higher capital costs and defaults by individuals and firms who borrow from banks. Low interest rates also enable banks to have higher levels of forbearance than in a high interest rate environment. Hence, the level of loans that are classified as nonperforming could potentially increase if interest rates were to rise.
  • Effect on available-for-sale (AFS) assets including debt securities and cash-flow hedging instruments: Interest rate increases can reduce the value of debt securities. The reduced value of long-term interest rate sensitive assets can offset any increases in net interest margin arising from the maturity mismatch of bank balance sheets and resulting in the reduced book value of equity. Under Basel II regulatory capital rules, prudential filters could be applied on unrealized gains or losses to avoid capital erosion. However, these filters will not be allowed under Basel III, which will make regulatory capital a lot more sensitive to changes in the value of AFS securities in response to interest rate increases.

The above effects can either individually increase or decrease the book value of equity. In other words, there can be offsetting impacts that make it difficult to generalize the overall effect of interest rate increases, making the disclosure of bank-specific anticipated impacts all the more important.

Analyzing the Potential Risks

We examined the market-risk disclosures of nine leading banks in the United States, United Kingdom, France, Germany, and Switzerland. Though useful, different components of market-risk disclosures (for example "value at risk," or VAR) often is difficult for investors to decipher because of incomparability across banks and difficulty linking VAR to financial statement line items. That said, a useful disclosure that gives a clear view of bottom-line effects is interest rate sensitivity analysis. However, we found that the value of this disclosure varied across banks. Some banks did not have a sensitivity analysis due to immateriality (Deutsche). Many other banks (HSBC, UBS, BNP Paribas, Crédit Agricole, JPMorgan, and Bank of America) only provided either one line item (net interest rate margin) or aggregated the impacts of different line items. And only two banks disaggregated the impacts of "other comprehensive income," or OCI (Barclays and Citigroup) in a manner that informs on the impact of rate rises on different line items. In the illustrative sensitivity analysis table below, we show examples of the desirable level of disaggregation that was not common with the other banks that we reviewed.

As shown above, the interest rate sensitivity analysis disclosures can be very useful in conveying to investors a "bottom-line" view of the impact of interest rate increases on bank profitability and capital adequacy. These are particularly useful when they sufficiently detail and differentiate the effects on net interest margin, changes in the value of securities, and the effects of hedging strategies. There is also need for further enhancement of interest rate disclosures to provide necessary context on the elements that drive interest rate sensitivity (e.g., precisely judge the maturity mismatch). For example, an expected/behavioral maturity analysis of assets and liabilities is a useful disclosure for investors. In sum, enhancing interest rate disclosures is an area that warrants standard-setter and regulator attention.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.