By Federico Galizia, CRO, Inter-American Development Bank.
Federico, can you tell the Risk Insights audience about your experience in the industry?
After a Ph.D. in Economics, researching financial crises and the credit cycle, I sank my teeth into risk management assignments at McKinsey. I have been working in Multilateral Development Banks for twenty years, the past ten as a Chief Risk Officer. The upcoming “insight into the day of a CRO” feature in CeFPro’s Issue Seven of Risk Insights Magazine will provide a detailed look into my role.
You will be speaking at the upcoming Risk Americas 2018 to discuss equity duration management in uncertain times. Why is this a key talking point in the industry right now?
After a decade of low and relatively stable interest rates, memory of the lessons learned back in the 1980s and 1990s is fading, and equity duration management may be taken for granted. In addition, bank balance sheets have lower leverage and higher equity levels than before the crisis, amplifying the impact of interest rate risk. As rate volatility returns, banks need to develop comprehensive models and robust analytics, taking into consideration stress test scenarios for net interest income (NII) generation.
What are the key considerations that need to be made when setting the appropriate policy band?
Maximizing NII may call for an increased equity duration, as longer-dated assets have higher yields than shorter term liabilities. There is, however, a trade-off between the level and the volatility of NII that needs to be considered in setting the appropriate policy band. New regulation and accounting standards may also play a role.
Can you provide a brief overview of the implications for an increasing rate environment?
As interest rates rise, placing equity duration at the upper end of the band may expose financial institutions to higher risk. On the other hand, by shifting to the lower end of the band, financial institutions may be sacrificing current income in expectation of future gains that may end up not materializing. The latter was indeed the case over the last few years.
What are the benefits of running key rate sensitivities for equity duration management, and how can uncertainties be accounted for in these calculations?
The underlying assumption in duration management is that yield curves shift in a parallel manner. Key rate sensitivity analysis helps to understand the implications of non-parallel shifts that are more common in periods of uncertainty about the future of interest rates. Furthermore, it may spot undue exposure to specific maturities of the yield curve.