Interest Rate Risk Management by EME Banks

After completing this reading, you should be able to:

• Describe the mechanisms through which changes in market interest rates affect a bank’s economic value and the key methods banks use to manage interest rate risk.
• Compare the methods banks in emerging market economies (EME) and banks in advanced economies have historically used to manage their interest rate risk and how these methods affected their vulnerability to changes in interest rates.
• Explain the recent changes in EME banks’ exposure to interest rate risk and the importance of hedging this risk.

Mechanisms Through Which Changes in Market Interest Rates Affect a Bank’s Economic Value

Changes in market interest rates can significantly impact a bank’s economic value through two primary channels: net interest income and valuation of financial instruments.

Net Interest Income (NII)

Fluctuations in market interest rates directly affect a bank’s profitability by altering its NII. NII, the difference between interest earned on assets and interest paid on liabilities, is highly sensitive to rate movements. The relative sensitivity of asset and liability yields to these movements is crucial. This, in turn, depends on how quickly assets and liabilities reprice. For instance, if a bank’s loan portfolio reprices more frequently than its deposit base, rising market rates will initially expand the bank’s net interest margin (NIM). However, if deposit rates also adjust rapidly, the increased cost of funds can offset this benefit. Empirical evidence suggests that changes in short-term rates have a positive but often limited impact on NIMs, while the effect of changes in the yield curve’s slope is more variable. A 100-basis point increase in short-term rates typically translates to a less than 20 basis point change in NIMs over a year. It’s also worth noting that NII often constitutes a larger portion of total income for banks in emerging market economies (EMEs) compared to those in advanced economies (AEs).

Valuation Effects

Interest rate movements also influence the valuation of assets and liabilities, particularly fixed-income instruments. The duration of an instrument, a measure of its sensitivity to interest rate changes, determines the magnitude of the valuation impact. Longer-duration instruments experience larger price swings for a given change in interest rates. For example, a bank holding a portfolio of long-term government bonds will see a substantial decline in their market value if interest rates rise. Beyond the direct impact on valuations, rising rates can also indirectly affect valuations by increasing credit risk. Higher interest burdens can lead to increased default rates among borrowers, impacting the value of loan portfolios. This valuation channel is becoming increasingly relevant for EME banks as they hold a higher proportion of securities, often with longer maturities, on their balance sheets. Accounting practices also play a role, as unrealized losses can accumulate if assets are not marked to market. These losses can materialize if assets are sold, for instance, to cover deposit withdrawals.

Key Methods for Managing Interest Rate Risk

Matching Interest Rate Sensitivity (Repricing Gap Management)

This strategy focuses on aligning the interest rate sensitivity of assets and liabilities within specific repricing timeframes. This involves managing the repricing gap, the difference between the value of assets and liabilities that will be repriced within a given period. This approach is prevalent among EME banks. They achieve this by:

• Focusing on short-term, floating-rate lending: This ensures that asset yields adjust quickly to market rate changes. Business loans, which are typically floating-rate, form a significant portion of EME banks’ loan portfolios. A considerable proportion of these loans also have maturities of less than one year.
• Utilizing time deposits as a primary funding source: Time deposits have fixed maturity dates, and their interest rates adjust with market rates, making them suitable for matching with short-term loans. While time deposits are generally more expensive than demand deposits, they offer greater funding stability due to restrictions on early withdrawals, which is particularly important in EMEs.

Hedging with Derivatives

A more holistic approach to managing IRR involves matching the interest rate sensitivity of the entire asset portfolio with that of the liability portfolio to minimize the impact on the bank’s overall economic value. This can be achieved through the use of derivative instruments like interest rate swaps. However, the use of derivatives is generally more common among AE banks compared to EME banks.

Management of Interest Rate Risk in Emerging Market Economies (EME) vs. Banks in Advanced Economies

A key difference in how EME and AE banks manage IRR stems from the composition of their balance sheets and their access to and use of derivatives. This has led to different vulnerabilities to interest rate changes.

EME Banks

Reliance on Repricing Gap Management

EME banks have traditionally focused on managing the repricing gap to mitigate IRR. This involves matching the interest rate sensitivity of assets and liabilities within specific repricing buckets. This is a shorter-term, NII-focused approach.

Asset Structure – Short-Term, Floating-Rate Loans

A defining characteristic of EME banks is their reliance on short-term, often floating-rate loans, especially to businesses. Business loans typically have floating rates and form the largest share of EME banks’ outstanding loans. Further, a significant portion of their loan portfolio has a remaining maturity of less than one year (e.g., over 40% in emerging Asia and Latin America). This composition makes their assets highly sensitive to short-term interest rate movements, ensuring that their yields adjust quickly to changes in market rates.

Liability Structure – Time Deposits

EME banks rely heavily on time deposits as a primary funding source. Time deposits have historically accounted for a substantial portion of EME banks’ liabilities (e.g., around 35% in emerging Asia). Time deposits have defined maturity dates, and their interest rates adjust with market rates, making them suitable for matching the short-term nature of their loan portfolios. This matching of repricing characteristics between assets and liabilities is the core of their repricing gap management strategy. While time deposits are more expensive than demand deposits, they offer greater funding stability due to restrictions on early withdrawals. This stability is particularly valuable in the more volatile macro-financial environments of EMEs.

Limited Use of Interest Rate Derivatives

A critical difference is the limited use of interest rate derivatives by EME banks compared to AE banks. Data shows that the gross market value and notional value of interest rate derivatives as a percentage of bank assets are significantly lower for EME banks. This implies that EME banks have historically relied less on sophisticated hedging strategies involving derivatives.

Resulting Vulnerabilities

By focusing on managing repricing gaps, EME banks have been relatively successful in mitigating the impact of short-term interest rate changes on their NII. The matching of asset and liability repricing minimizes the direct impact of rate movements on their margins. However, this approach has limitations, particularly with the increasing holdings of securities by EME banks. These securities, especially longer-maturity ones, expose EME banks to valuation risks arising from interest rate changes, a risk that repricing gap management does not directly address. This growing exposure creates a need for more comprehensive IRR management, potentially involving greater use of derivatives.

AE Banks

Portfolio Approach and Use of Derivatives

AE banks generally adopt a broader, portfolio-based approach to IRR management. This involves managing the interest rate sensitivity of the entire balance sheet, considering both NII and the economic value of equity (MVE). A key component of this approach is the more extensive use of interest rate derivatives.

Asset Structure – Longer-Term, Fixed-Rate Loans

AE banks typically have a larger proportion of longer-term, fixed-rate loans in their portfolios, such as mortgages. Lending to households, often in the form of mortgages, constitutes a larger share of AE banks’ loan books compared to EME banks. These longer-term, fixed-rate assets are more sensitive to changes in long-term interest rates and create a greater need for hedging strategies.

Liability Structure – Diverse Funding Sources

AE banks tend to rely on a more diverse mix of funding sources, including demand deposits, wholesale funding, and other liabilities, which may have varying repricing characteristics. This diversity can create mismatches in interest rate sensitivity between assets and liabilities. AE banks rely less on time deposits.

Extensive Use of Interest Rate Derivatives

The use of interest rate derivatives is much greater among banks in AEs than among those in EMEs. This allows AE banks to more effectively manage complex interest rate exposures arising from their diverse balance sheets and their holdings of longer-term assets.

Resulting Vulnerabilities

While the use of derivatives allows for more sophisticated hedging, it also introduces other risks, such as counterparty risk and basis risk (the risk that the hedge is not perfectly correlated with the underlying exposure). AE banks are, therefore, more vulnerable to these types of risks. Their performance can also be more sensitive to changes in the shape of the yield curve and the effectiveness of their hedging strategies.

Direct Comparison and Key Takeaways

• Focus: EME banks focus on managing repricing gaps to protect NII, while AE banks take a broader portfolio approach, often using derivatives to manage overall interest rate sensitivity.
• Asset and liability structure: The prevalence of short-term, floating-rate loans and time deposits in EMEs, compared to longer-term, fixed-rate loans and more diverse funding in AEs, shapes their respective IRR management strategies and resulting vulnerabilities.
• Derivatives usage: The greater use of derivatives by AE banks allows for more sophisticated hedging but also introduces counterparty and basis risk. EME banks’ limited use has simplified their IRR management historically but leaves them more exposed to valuation risk with increasing securities holdings.

Recent Changes in EME Banks’ Exposure to Interest Rate Risk

EME banks’ exposure to interest rate risk (IRR) has been evolving in recent years, primarily due to changes in the composition of their asset portfolios. This evolution necessitates a re-evaluation of their traditional IRR management strategies and highlights the growing importance of hedging.

Historically, EME banks have effectively managed IRR by focusing on minimizing repricing gaps between assets and liabilities. This was achieved through a combination of short-term, floating-rate lending (primarily to businesses) and reliance on time deposits for funding. This strategy primarily addressed the impact of interest rate changes on net interest income (NII).

However, a significant shift has occurred: EME banks’ holdings of securities have been increasing. This trend has been particularly pronounced since the Covid-19 crisis. Several factors have contributed to this increase. For instance, EME banks stepped in to absorb the increased supply of government debt. This increase in securities holdings, especially those with longer maturities, represents a fundamental change in their IRR profile.

This change is significant for several reasons:

• Increased Exposure to Valuation Risk: Unlike short-term loans that reprice quickly, securities, especially those with longer maturities, are subject to significant valuation changes in response to interest rate movements. A rise in interest rates leads to a decline in the market value of these securities, directly impacting the bank’s economic value. This type of risk, known as market value risk or economic value of equity (EVE) risk, was less of a concern when EME banks’ balance sheets were dominated by short-term loans.
• Shift from NII Focus to Overall Portfolio Management: The traditional focus on managing repricing gaps is primarily designed to mitigate the impact of interest rate changes on NII. However, with the growing presence of securities, the focus needs to shift towards managing the interest rate sensitivity of the entire portfolio, encompassing both NII and the market value of assets. This requires a more comprehensive approach to IRR management.
• Interaction with Funding Risk: Valuation losses on securities can interact with funding risk. As seen in recent banking stress events, large unrealized losses on securities can trigger concerns about a bank’s solvency, potentially leading to deposit withdrawals. This interaction underscores the need for proactive risk management.

Importance of Hedging Interest Rate Risk

Given these recent changes, hedging has become increasingly important for EME banks. The traditional strategy of minimizing repricing gaps is no longer sufficient to manage their overall IRR exposure effectively. Hedging strategies, such as the use of interest rate derivatives, become crucial to mitigate the valuation risk associated with their growing securities portfolios. These strategies allow banks to manage the interest rate sensitivity of their entire portfolio, protecting both NII and economic value from adverse interest rate movements.

Question

Regarding the impact of interest rate changes on a bank’s economic value, which of the following statements is correct?

A) Changes in short-term interest rates have a substantial and consistent impact on net interest margins (NIMs) of over 50 basis points per 100 bps change in rates.

B) The impact of interest rate changes on a bank’s net interest income is primarily determined by the overall volume of lending activity.

C) Rising interest rates can indirectly affect valuations by increasing credit risk and potentially leading to higher default rates.

D) Net interest income (NII) is generally a smaller proportion of total income for banks in emerging market economies (EMEs) compared to those in advanced economies (AEs).

Correct Answer: C

When interest rates rise, borrowing becomes more expensive for individuals and businesses, which can lead to increased credit risk as some borrowers struggle to meet higher interest payment obligations. This can result in higher default rates, negatively impacting the valuation of a bank’s loan portfolio and overall financial stability.

A is incorrect: Empirical evidence suggests that a 100 bps change in short-term rates typically leads to a less than 20 bps change in NIMs, not over 50.

B is incorrect: While lending volume matters, the impact of interest rate changes is more directly determined by the interest rate sensitivity and repricing characteristics of a bank’s assets and liabilities.

D is incorrect: NII typically constitutes a larger proportion of total income for EME banks compared to AE banks, as EME banks rely more on traditional lending activities and less on fee-based or investment banking services.