Managing impact of continued volatility in markets and unprecedented rises in interest rates

Ian Broff, Head of Market RiskUSAA

Below is an insight into what can be expected from Henry’s participation at CeFPro’s Balance Sheet Management USA Congress.

The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.

What are the key considerations when conducting a review when there is an asset-liability mismatch?

A root cause analysis is critical to understanding what leads to an asset-liability mismatch observed in interest rate risk reporting.  Assessment of the inherent position between non-maturing deposits and direct CDs and the loan portfolio is important to understand the natural drift of the ALM position in the absence of mitigating actions or hedging.

Know what assumptions are embedded in your models and understand how those are supported and in what ways they could be wrong.  Do a sensitivity analysis of your assumptions (i.e. growth rates, Beta, decay, truncation, prepayment speeds, etc.)  and understand how it impacts your positioning against your limits if you are wrong in a certain direction.

It is critical to understand the direction of the mismatch (whether asset-sensitive or liability sensitive) and the magnitude of the mismatch as it compares to internal risk limits and risk appetite.

What are the potential implications when reviewing the impact of an inverted yield curve on earnings?

Inverted yield curves can be a pain trade for a traditional banking model normally designed to favor asset sensitivity and benefit from a rising rate environment or from the normal difference between longer-duration products and investments and less expensive demand deposit accounts.  In this environment, the competition for deposit funds against higher-yielding money market funds has become ferocious. It has forced many banks to replace those traditionally lower-cost deposits with higher-cost wholesale funding.

Conversely, it can be an opportunity for traditionally liability-sensitive institutions that may rely on higher-cost short-term funding to term out those borrowings at relatively favorable terms to support continued balance sheet growth or to enhance profitability on the back-book.

Asset-sensitive institutions will be tempted to term out borrowings to fuel growth, and institutions that have overextended balance sheets will be tempted to term out borrowings to improve liquidity buffers and boost earnings with higher short-term yielding assets.  But those temptations should be tempered by the need to manage downward rate risk that will be increasingly likely as implied by the inverted yield curve.

How can the balance between margin and risk be effectively maintained when making financial decisions?

In my experience, the most effective way to balance margin and risk is by having effective risk/reward frameworks like RAROC/SVA in place and part of the practice and culture of the firm.  From an interest rate risk perspective, the Funds Transfer Pricing (FTP) Framework plays a key role in this broader framework by assigning appropriate costs of funds.  To ensure effective decision-making on new loan production, it is important for the FTP to reflect the marginal cost of funding a new loan using wholesale funding, which will avoid eroding the value and margins of the deposit franchise.

On the liability side, it is important to provide stable FTP credits to the deposit business. Still, at the same time, the FTP framework should be flexible enough to allow for adjustments under changing market conditions.  The level of excess liquidity or liquidity needed at a particular time should be considered in the FTP crediting rates to drive the right behavior on pricing decisions.

The decision to favor margin over volume is a strategic decision that must be made oftentimes without a clear right answer. Still, without robust risk/return frameworks, those decisions will be poorly informed.

What are the key methods for measuring and effectively managing interest rate risk?

My preferred methods for measuring and managing interest rate risk are the Sensitivity to Net Interest Income (NII) and Economic Value of Equity (EVE), which can be augmented appropriately with a periodic interest rate repricing gap.  NII is useful in managing the short to medium-term earnings impact, while EVE is useful in managing longer-term exposures with optionality more appropriately accounted for.  The value that the interest rate gap views bring to augment this approach is to understand where significant concentrations of assets or liabilities are repricing at particular points on the yield curve horizon that are not visible in the EVE approach.

What are the key indicators to determine if interest rates are likely to change?

This is the multi-trillion-dollar question that many will pretend to know the answer to, but few will actually get it right, and generally, that will be by luck.  Forward-rate markets and models notoriously over-predict interest rate volatility in times of high-rate volatility and under-predict in times of low-rate volatility, and generally rely on mean-reversion assumptions towards a modeled unconditional long-term mean that can be easily biased based on the period of historical data used for calibration.

Alternatively, market participants can take a long time to accept macroeconomic data and signals. While prudent, interim positioning and hedging can become costly while waiting for the expected outcome to become realized.  For example, the increase in the money supply and expansion of the deficit occurred for more than a decade until the effects of core inflation finally took hold and ultimately led to a monetary policy response and consequent reaction from the interest rate markets.  If one was taking a rising rate view and favoring short-duration assets during that long period of time, the opportunity cost of interest income was quite significant and potentially in excess of the ultimate unrealized market value loss on longer-duration assets.

But there have been warning signs everywhere if the market chooses to see them; market participants often only choose to see what they want or what is most convenient for their incumbent position (i.e., confirmation bias).  The money supply could not be expanded forever, housing prices can’t increase faster than incomes forever, and interest rates can’t stay at or near zero forever either.  It is generally the time when the market decides to accept “there is a new normal” that the outlook shifts dramatically upon the realization of a shift in a fundamental assumption, like when Powell finally stated that inflation was no longer transitory.

So where does that leave us?  I would say, just don’t believe too much in any one thing or signal.  Stay focused on managing the risk; don’t leave yourself too exposed if you are wrong.  Because you are likely to be wrong, the question is how bad and how much it is going to cost you.  Make sure you can live to fight another day.