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Focus: Interest rates
Higher for longer? - What bankers should keep in mind about rising interest rates
Patrick Akiki
Partner Financial Services Markets Leader, PwC Switzerland
Matthieu Patrice
Director Treasury Consulting, PwC Switzerland
Kuchulain O`Flynn
Manager Liquidity and Funding, PwC Switzerland
Clemens Fessler
Senior Associate Consulting Financial Services, PwC Switzerland
Lilia Mukhlynina
Senior Associate Consulting Financial Services, PwC Switzerland
If you'd started working at a bank ten years ago, you'd probably consider yourself an experienced professional by now. But the economic changes we've seen this last year can make even seasoned bankers feel like they have to learn everything again from scratch. After more than a decade of zero-interest rates, many bankers have never worked in an environment – previously regarded as normal – when rates were significantly above zero. This, paired with unusually high inflation, a land war in Europe and an energy crisis, has banks rushing to react to a new reality. In the following article, we highlight three key channels through which we believe banks will be affected by these changes. We also point out which measures need to be taken to minimise risk and how financial institutions can use the current situation to their advantage.
IRRBB
The first channel we wish to highlight is banks’ Interest Rate Risk in the Banking Book (IRRBB). When interest rates change rapidly, banks can experience a mismatch of the rates they set on customer loans and those on deposits. This risk is generally referred to as the IRRBB. High and rising interest rates present tough challenges to banks’ IRRBB models because of changes to the maturity profile of assets and liabilities. If a bank has to reprice its deposits before its loans, it can run into problems. Suddenly, the bank might have to pay out more in interest on deposits than it takes in from loans. This will subsequently hurt the bank’s net interest income as well as impacting the Economic Value of Equity (EVE), which is derived by discounting future cash inflows and outflows.
If not managed properly, IRRBB can become a serious threat to banks' capital bases and earnings since it can negatively affect the underlying value of banks' assets and liabilities. The risk is particularly high when interest rates change rapidly within a short timeframe as happened over the last year.
In addition to preparing for the direct effects on their balance sheets, banks should also brace themselves for a wave of new regulation concerning IRRBB. In 2016, the Basel Committee on Banking Supervision (BCBS) issued new standards on IRRBB, subjecting banks’ balance sheets to stricter control. In Switzerland, the Financial Market Supervisory Authority (FINMA) adapted the Basel IRRBB guidelines in January 2019 and therefore expects Swiss banks to identify, measure and control IRRBB risks.
The recent dramatic changes in the macroeconomic environment have led regulators to revisit the topic of IRRBB in their attempts to prepare the financial sector for more turbulent times. As recently as December 2021, the European Banking Authority (EBA) launched three consultations with the aim of specifying technical aspects of their IRRBB guidelines. In October 2022, the regulator published the final set of guidelines and two Regulatory Technical Standards (RTS) that specify technical aspects of the new framework. Further underscoring the significance of this topic, the European Central Bank also stated in its supervisory objectives for 2022 to 2024 that addressing sensitivity in interest rates and credit spreads is a major priority for the upcoming years.
Intermediation margin
In contrast to concerns over heightened IRRBB risks, banks have fewer reasons to worry when it comes to their intermediation activities – at least in the short term. This will come as a pleasant surprise for most bankers after years of dealing with zero-interest rates. Since the financial crisis of 2008, record low rates have put pressure on margins and kept revenues low. Even though demand for loans was strong, banks were unable to pass on negative interest rates to their customers on ever increasing deposits. The result has been a significant deterioration of their intermediation margins and pressure on profits.
In 2022, this trend basically reversed due to the rapid policy changes of central banks. Banks were able to charge high rates for loans while keeping deposit rates low. The record high deposits that banks had accumulated in recent years meant that losing out (to some extent) to competitors who paid more was not the end of the world. Net interest income increased significantly, which boosted banks’ profits in 2022. In the EU, year-on-year growth of quarterly net interest income accelerated to nearly 9% in the second quarter of 2022[1].
Banks shouldn't get too accustomed to this, however. In the US, where both inflation and interest rates increased earlier than in the EU, total deposits have decreased for the first time since World War II. European banks should expect similar developments as depositors start to demand some return on their cash and are willing to move it elsewhere if they receive a better offer.
It is important that banks are aware that they are in a rather fortunate position at the moment, but it won't last forever. The key question is how their funding structure and the composition of their lending book will interact given further rate hikes and a potential economic slow-down. It's important that banks evaluate their balance sheets and assess those areas where they could be especially at risk. Generally, though, the end of negative interest rates on reserves at central banks should continue to support profitability as the marginal return on lending remains high. Even with demand for loans falling, higher rates for existing assets should provide some more breathing room for banks’ intermediation business.
Credit risk
So far, we have focussed on how changes in the interest rate affect banks directly and in the near term. However, high interest rates will also have an indirect effect over a longer time horizon on banks. Because these rates have a strong influence on the economy as a whole, they also change the conditions for each bank’s customers, both households and companies.
One sector that is already showing signs of stress is commercial real estate. As a result of the pandemic and the shift to remote work, office space occupancy in the US came down from as high as 95% to under 50%.[2] Banks will need to respond to this by changing their risk assessments for loans that could be affected by this. Further, they need to account for second-order effects as many businesses that rely on office workers are also struggling to get back to pre-pandemic revenues. In Manhattan alone, economists estimate that workers are spending at least US$ 12.4 billion less every year as a result of a 30% reduction in the time they spend working at the office.[3]
Banks will feel the heightened credit risk either through erosion of their borrowers’ disposable income or increased debt-servicing costs. Both can have a negative impact on banks' performance as higher provisioning may be needed in anticipation of potential defaults.
If inflation and interest rate growth do not slow down soon, the situation may get worse as aggregate demand falls further, ultimately weakening the labour and housing markets. There are numerous examples from the past showing how sudden and large changes in the interest rate can cause solvency problems for entire industries and lead to significant credit risk exposure for banks.
Conclusion
Rising interest rates, increased economic uncertainty and emerging regulatory demands are challenges for the economy overall and banks in particular. Sophisticated strategies and solutions will be required if financial institutions are to navigate this uncertain environment and gain a competitive edge.
Banks will need to revise their stress scenarios and make sure these are not entirely based on pre-pandemic conditions. The benefits of the interest rate floor are no longer felt and stress from a sharp decline in interest rates is once again a possibility.
At the moment, banks typically assess the IRRBB risk appetite annually. The increased market volatility brought on by both economic and political events means that more frequent assessments will be required. This should help banks make adjustments quickly as the economic situation changes and lower the risk of facing a stress scenario.
Finally, banks should also keep an eye on regulatory developments. Containing IRRBB risks in the financial sector is high on the agenda of regulators, but it is not the only item of concern by far. Organisations should expect even more regulation relating to capital requirements, climate reporting and data governance.
More positively, the zero-interest years are now over and it's unlikely we'll see something similar soon. This provides some relief for banks because their core business becomes more profitable and they get a break from constantly looking for other ways to make money. Nevertheless, caution is advised not to become too accustomed to high intermediation margins. If too many customers start taking their cash elsewhere, banks might become concerned that they haven’t raised their deposit rates sooner.
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