Banks and their sensitivity to interest rate risk

Interest rates in the Eurozone have been low for almost a decade (Brei et al. 2020, Fell et al. 2021). However, following the increase in global inflation trends, central banks around the world began to tighten monetary policy in the first half of 2022. Despite the Russian invasion of Ukraine which clouded the economic outlook in 2022 For the Eurozone, expectations of a gradual normalization of monetary policy have started to drive up market interest rates.

Sudden changes in interest rates combined with inadequate management of interest rate risk can have unintended effects on financial stability. Banks perform maturity transformation and are therefore directly exposed to interest rate risk which can affect their net worth (Dries et al. 2022) and profitability. This concern has increased in recent years as eurozone banks have lengthened loan maturities and increased the share of fixed rate loans (mortgages).

A parallel shift and steepening of the yield curve

To assess the vulnerability of the euro area banking sector to changes in interest rates at the start of 2022, we examined the impact of two stylized interest rate scenarios. The ECB’s macroeconomic forecast for December 2021 set the baseline, with robust economic growth despite continued global supply constraints, growing stock markets and a slight increase in short and long-term interest rates with a roughly stable difference. The two stylized scenarios were based on this baseline but implied an alternative evolution of interest rates and financial variables over the three-year horizon. The first assumed a shift in the yield curve of around 150 to 250 basis points across all maturities from levels at the end of 2021; the second, a steepening of the yield curve, with its 10Y part rising 200 basis points, and its short end remaining solidly anchored at starting levels. Changes in interest rates have been accompanied by devaluation of equity and corporate bond prices, which has leveled country risk premiums on government bonds, especially in low-rated countries.

The two parts of the analysis

We used two ECB stress test frameworks, each constituting a level in the two-level analysis, and aiming to provide robust results by mitigating model risks. The first framework assumes a constant balance sheet and builds on top-down models used as part of the EU-wide stress tests, coordinated since 2011 by the European Banking Authority, to ensure the quality of banking projections ( Mirza and Zochowski 2017). These are reduced-form regression models employing various estimation techniques and exploiting macroeconomic, sectoral, banking or loan-level data to arrive at projections for credit, market risk parameters and risk components. net interest income. The second tier offers a dynamic balance sheet perspective and builds on a successful Macro-Micro Banking Euro Area Banking Sector Stress Test (BEAST) model (Budnik et al. 2020). This semi-structural model includes the representation of the Eurozone economies and about 90 individual banks. The model is regularly used for both policy assessment (e.g. Budnik et al. 2021a) and macroprudential stress testing (e.g. Budnik et al. 2021b). Conducive to our attempt to diversify model risk, BEAST often uses different data sets or empirical approaches than top-down models.

The constant balance sheet approach focuses on the impact of interest rates on the provisioning of loan losses, the valuation of assets in banks’ trading books and net interest income. Bank assets and liabilities that mature or amortize within a three-year horizon are replaced by similar financial instruments in terms of type, currency, geography, credit quality on the maturity date and original maturity. Banks’ balance sheets consist of loans to different economic sectors, equity and securities exposures on the asset side, and wholesale and retail funding on the liability side.

The dynamic balance sheet approach takes into account a larger number of channels, including changes in risk weights, other than the net interest income components of bank profitability, and endogenous reactions of banks. Bank balance sheets are represented with a level of granularity similar to that of top-down models. Part of the model’s equations associate macro-financial conditions with bank-level loan loss provisioning parameters, risk weights or funding costs, and other behavioral responses of banks such as adjustments to loan loss volumes. loans, interest rates, liability structure and profit distributions.

Positive profitability outlook…

It turns out that a sharp rise in interest rates, reflected by a parallel shift or steepening of the yield curve, could benefit banking sector profitability in early 2022 (see Chart 1). The return on assets (ROA) at the system level in the dynamic balance sheet approach increases mainly due to the positive impact of changes in interest rates on the net interest income (NII) and, to a lesser extent , on the income of customers benefiting from higher interest rate volatility. These more than offset the negative impact of the revaluation of fixed income securities and equities. Then come, in order of importance, credit risk and the negative impact of interest rates on the ability of certain borrowers to honor their obligations.

Figure 1 System-wide return on assets (ROA), 2021-2024

Remarks: The results presented are based on the dynamic balance sheet approach.
Sources: ECB.

…and barely affected system-wide solvency forecasts

The impact on solvency of the two stylized scenarios is negative but very contained. The CET1 ratio increases from 15.5% in 2021 to 14.5% in 2024 in the lag and steepening scenarios compared to 14.7% in the reference scenario. The right panel of Figure 2 decomposes the cumulative change in the CET1 ratio into CET1 capital losses that result from revaluation losses entering the capital calculation directly and not via profit and loss, a slight increase in the effective risk weight , and the mitigating impact of deleveraging. In the constant balance sheet approach and in the absence of the last two adjustments, the difference between the CET1 ratio in the interest rate change scenario and the reference becomes 1.4 percentage points, and 0.5 percentage point for the steepening scenario. Nevertheless, there is a strong correlation (81%) of solvency results at bank level between the dynamic approach and the constant balance sheet approach. The two approaches also provide a similar correlation of bank-level results for NII devaluation losses (85% correlation coefficient) (52%) and loan loss provisioning (36%).

Figure 2 System-wide CET1 ratio, 2021-2024 (left); Cumulative change in the components of the CET1 ratio (right)

Remarks: The results presented are based on the dynamic balance sheet approach.
Sources: ECB.

Winners and losers

Although the average effect on system solvency is slightly negative, there will be losers and winners among institutions. About half of the banks experience losses and the other half benefit from a sharp rise in interest rates in the dynamic and constant balance sheet approaches (see chart 3). Among the banks with the strongest negative impact of rising interest rates are development and promotion lenders, universal banks and diversified lenders.

picture 3 End of the horizon (2024) Differences in CET1 ratio between alternative scenarios and reference scenario for the constant balance sheet (left) and dynamic balance sheet (right) approaches

Remarks: TD – ECB top-down models and constant balance sheet approach; BEAST – dynamic balance sheet approach.
Sources: ECB.

What are we learning?

Overall, the euro area banking system at the start of 2022 was well equipped to weather rising interest rates, ending a decade of historically low interest rates. However, some banks appear to be somewhat vulnerable to a sharp change in interest rates and are at risk of substantial capital losses, and it remains essential to ensure that they are closely monitored and prepared to deal with sharp changes in interest rates. The last few months have started to test the robustness of this conclusion, with a gradual increase in market interest rates, especially on the long end of the yield curve. So far, the Eurozone banking sector has weathered these increases against a much bleaker economic backdrop than our baseline scenario, marked by the Russian invasion of Ukraine. Overall, while there are limits to how our stylized analysis can help the current monetary policy debate, it is reassuring that the resilience of the banking system does not appear to be threatened by the normalization of the Monetary Policy.

References

Brei, M, C Borio and L Gambacorta (2020), “Banking intermediation when interest rates are very low for a long time”, VoxEU.org, 7 February.

Dries, J, B Klaus, F Lenoci and C Pancaro (2022), “Interest rate risk exposures and hedging of banking books of euro area banks”, Box 5, ECB Financial Stability ReviewMay.

Fell, J, T Peltonen and R Portes (2021), “Lower for longer – macroprudential policy issues during the low interest rate environment”, VoxEU.org, 2 June.

Budnik, K, M Balatti, I Dimitrov, J Groß, M Kleemann, T Reichenbachas, F Sanna, A Sarychev, N Siņenko and M Volk (2020), “Banking Euro Area Stress Test model (BEAST)”, ECB Working Paper No 2469.

Budnik, K, I Dimitrov, C Giglio, J Gross, M Lampe, A Sarychev, M Tarbe, G Vagliano and M Volk (2021a), “The growth-at-risk perspective on the system-wide impact of Basel III finalization in the euro area”, ECB Occasional Paper Series, n° 258.

Budnik, K, L Boucherie, M Jancokova, M Borsuk, J Karmelavicious, I Dimitrov, M Lampe, G Giraldo, G Vagliano, J Groß and M Volk (2021b), “Macroprudential Stress Test of the Euro Area Banking System in pandemic coronavirus (COVID-19) environment”, ECB.

Mirza, H and D Zochowski (2017), “Stress test quality assurance from a top-down perspective”, ECB Macroprudential Bulletin, Flight. 3.


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