Mitigating and managing concentration risk in a volatile interest rate environment

Dimitris Papathanasiou, Head of Global Funding and International Treasury Risk, Credit Suisse

Below is an insight into what can be expected from Volker’s session at Balance Sheet Management Europe 2023.

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 impact has concentration risk had on the recent banking crisis?

The most well-known case of concentration issues in the recent crisis was the failure of Silicon Valley Bank. There were two separate concentration issues:

  1. As of the end of 2022, SVB had 37,466 depositors, each holding over $250,000 per account. Given that $250,000 is the limit for deposit insurance, that can be a material issue. In aggregate, those customers with balances greater than this amount account for most of SVB’s deposits. Out of its total $173bn deposits at the end of 2022, $152bn were uninsured. But this was not the only problem. SVB’s business model was focused on serving entrepreneurs and their businesses in Silicon Valley. That means that the customers were concentrated in the exact geographic location and primarily active in the same sector. Apparently, they were talking to each other and receiving financial consultation from the same person. SVB had $42bn of outflows, a death blow pushing the bank to receivership.
  2. SVB allocated too much of its available liquidity to purchasing government bonds (with the wrong timing) and didn’t have a conservative split between cash and securities. Its AFS book grew from $13.9bn at the end of 2019 to $27.3bn in the first quarter of 2022. At the same time, the longer-duration HTM portfolio grew from $13.8bn to $98.7bn. When the interest rates started rising, those bonds lost some of their value. Given the accounting treatment, that wouldn’t be a big problem as the losses were not recorded in the P&L.. Still, when its depositors who are active in the tech business (which is also negatively correlated with interest rates) needed their cash, SVB had to unwind part of its securities portfolio and recorded material losses in its P&L. There are questions about the interest rate risk management and the lack of regulation of IRRBB but I won’t comment here.
What can financial institutions do to ensure they stay ahead of concentration risk?

Every financial institution should have a framework for concentration risk monitored by the second line of defense. Considering these types of risks, the framework should be based on the long-term funding strategy. Every Board should have approved a plan on how they want the Bank to get funded. Simple questions include what products should be used and what is the range as a percent of the liabilities, for which tenors take into account the refinancing risks, etc. Then, a risk appetite should be built to ensure the strategy is implemented. Regarding liabilities, the main areas to look out for are product, tenor, and counterparty concentrations. On the asset side, I would highlight concentrations in the HQLA portfolio.

However, liquidity risk managers should be aware of other concentrations within the bank similar to those in SVB and appropriately adjust their limit frameworks.

How can financial institutions overcome a concentrated environment within the banking sector?

After defining the long term funding strategy each institution should make in order to understand how stable is its funding base. A risk assessment of its funding providers has to be performed. For example, the money market funds who are the main buyers of CDs and CPs have a very low risk appetite. Apart from monitoring the credit spreads they are very sensitive to short term credit ratings. If there is a downgrade this market is completely closing. That means that if the financial institutions decide to include this type of funding in their liabilities they should consider if they can withstand a sudden removal of this funding base. Thus, a mitigating strategy would be to ensure no over-reliance, have longer maturities and avoid tenor concentrations in this product.

Other areas that the financial institutions should pay attention is to other types of funding such as TRS or upgrades that sometimes are not managed directly by Treasury.

How can financial institutions overcome concentration risk from deposits withdrawal?

Deposits is a very broad category that includes different type of customers with completely different risk appetite. There are a number of areas that the risk managers should focus.. First of all is what type of customers does the bank have. Large corporates are usually the most sensitive to the credit profile of the financial institutions and they usually have very short tenors. Thus they are the most risky from the depositors. A long term relationship with the financial institution is a small mitigant but definitely not enough to avoid withdrawals if a crisis happens. Thus I would say that the financial institutions should try to have limited  high risk deposits and concentrate on bringing in lower risk deposits.  Pricing is extremely important in order to achieve this objective.

Then given that the deposits are usually short term banks should look into diversifying to other types of funding as well. For example secured funding can be an excellent and cheap way  to increase the funding sources. Bonds and private placements even though they are a bit more expensive provide longer term funding and thus reducing tenor concentrations to short term funding. Securitization and covered bonds is another good way to fund and can provide access to markets in more turbulent days.

Why is it important to understand the concentration risk of government bonds that banks are facing?

I think this risk is higher  to regional banks that include large portfolios of  government bonds of their countries even though theses countries have high credit risk. This can become a big issue as during global or country specific crises the banks which will need additional liquidity will see their HQLA securities portfolios losing value.

Regarding large international banks they should have a framework defining the risk appetite on concentrations of HQLA. Usually, there are 2 ways of monetizing HQLA: selling and repoing. The risk manager should examine the access to the markets and understand the liquidity and the potential price fluctuations of the securities as well as a number of other factors (eg signalling, percentage ownership of issuance, sourcing of securities etc.) before they define their risk appetite.