Patrick Akiki
Partner, Financial Services Market Leader, PwC Switzerland
After years of zero-interest rates, even experienced bankers have never worked in an environment that was previously seen as normal, with rates significantly above zero. In this article, we highlight three key channels through which we believe banks will be affected.
Interest rate risk in the banking book (IRRBB)
The first channel we’d like to highlight is banks’ 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 impact 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.
Banks shouldn’t get too accustomed to this though. 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’s important that banks are aware they’re 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 the 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 extra breathing space for banks’ intermediation businesses.
Credit risk
So far, we’ve focused 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 on banks over a longer time horizon. 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’s already showing signs of stress is commercial real estate. As a result of the pandemic and the shift to remote working, office space occupancy in the US came down from as high as 95% to under 50%. Banks will need to respond by changing their risk assessments for loans that could be affected by this drop. What’s more, 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.
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 don’t 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.
The winning formula
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. Even though the zero-interest years are now over and it’s unlikely we’ll see something similar soon caution is advised against becoming 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. The winning formula to navigate the challenging period ahead will be a mix of business strategy, resilience, and appropriate risks and control frameworks, led by experienced teams with strong business acumen and the willingness to adapt.
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