Ensuring effective management of liquidity risk in a rising rate environment to minimise impacts

Ensuring effective management of liquidity risk in a rising rate environment to minimise impacts

By Brandon Davies, Board Director, Obillex Limited, Former Head of Market Risk, Barclays.

Brandon, can you please tell the Risk Insights readers a little bit about yourself, your experiences and what your current professional focus is?

The major part of my executive career consisted of 32 years spent with Barclays Bank. I was seconded to work in Sydney and New York, where I was seconded to Salamon Brothers, structuring and dealing Mortgage Backed Securities.

Very soon after my return to the UK I was appointed a Managing Director and head of Financial Engineering for the newly created BZW, later becoming the head of Debt Structured Products for Barclays Capital. Somewhat to my surprise I was subsequently asked to become the treasurer of the retail banking operations of the group, the surprise being due to there not being such a treasury, I had to create it. After 7 years in that and its successor roles I retired from Barclays some 14 years ago.

My next career was with the Global Association of Risk Professionals where I wrote and implemented banker training programmes for Indonesia and China. After leaving GARP I took a series of Non Executive Director roles in financial services becoming the Chairman of a private equity company and today serve on the board of two FinTech companies and am advisor to a Shariah Bank. I have also just completed my first term of teaching the Finance masters course at Buckingham University. I am an economist by background and a member of the Financial Markets Group at the London School of Economics.

At the Liquidity Risk Management Forum, you will be sharing your insight on ensuring effective management of liquidity risk in a rising rate environment to minimize impacts. Why do you believe this is a key talking point in the industry right now and what can risk professionals gain from this insight?

There is a tendency to think that liquidity management is primarily about meeting regulatory requirements, it is not, liquidity is endogenous to markets though markets for many assets, notably bonds have become very dependent on Central Bank intervention through their Quantitative Easing operations. The gradual withdrawal from QE and the likelihood that rising interest rates is likely to create challenging markets as many market professionals have very little experience of dealing in rising interest rate environments. The chart below is either interesting or chilling depending on your point of view what it shows is that US interest rates have not risen for a decade and indeed have been generally on the decline for 35 years.

Just how much market liquidity is “one way liquidity” is something we are likely to find out over the next year or so.

Can you explain some of the challenges of managing liquid asset portfolios in a rising interest rate environment and the best ways to handle them?

Perhaps the biggest change in the structure of bank liquid assets holdings over the last 40 years has been the demise of the bills market, these were very short term trade related assets (mostly around 30 days but up to 90 days term) which qualified as the then equivalent of HQLAs (know as Eligible Liabilities {ELs}). In the late 1970s some 22% of the ELs of the UK banks were comprised of bills. The natural interest rate sensitivity of these bills was very low, compare this to the natural interest rate sensitivity of UK Gilts which have an average term of around 15 years. Derivatives provide one way to hedge this risk but the capital costs of hedging are much higher than they were just a few years ago and the liquidity of derivative contracts in many currencies may prove far more challenging than has been the case as it will potentially be a market with significantly skewed demand. There is in my view a need to find new asset classes to assist interest rate risk for balance sheet management.

Please can you provide an overview of the importance of stress testing interest rate risk?

Stress Testing is now fully established as the main test for the sensitivity of all aspects of bank balance sheet risk, including interest rate risk. There is good reason for this, VaR or Expected Shortfall have their uses but rely on an assumed distribution of future outturns. But just how predictable are interest rates? Looking at the passed decade of QE affected rates may not give a good guide to future rates. It is very important not to think the immediate passed indeed even the last decade is a guide to the future. Predictability is not a feature of the world we now live in.

How might depositor behavior change in a rising rate environment?

One of the features of to days retail banking market is the potential for competition in deposit gathering, not only do we have a number of new competitor banks and price comparison sites but also PSD2 and particularly open banking. The combination of these factors is something we have never experienced before so again the passed is not a guide to the future, especially if that future includes a rising interest rate environment. We simply do not know how depositors will react to these changes so will stable retail deposits remain stable? Possibly or possibly not, having a planned out reaction function to whatever happens is going to be a necessity. One more set of scenarios we need to be running.

What, in your opinion does the future hold for liquidity risk professionals, and how can they keep up with the increasing change?

The need for professionalism in managing balance sheet risks including liquidity risk is only going to grow and that means a very close alignment with market professionals is going to be required. Not only do we need to keep abreast of market developments we need to consider how we might build new products to manage our balance sheet risks in what may well be a very challenging decade.

Want to know more? 

The Center for Financial professionals will address several of these key areas and more at the upcoming 7th Annual Liquidity Risk Management Forum taking place on 12 June in London. The forum will provide an exclusive platform for the industries finest to discuss the current liquidity risk landscape including regulatory requirements, markets trends and more. The event will include vital insight from leading CROs, Heads, Managing Directors and regulating bodies such as the European Central Bank. To view the full speaker line up, agenda and more please visit www.cefpro.com/liquidity.

Additionally for more information on registration please call +44 (0) 207 164 6582 or email us at marketing@cefpro.com.