Interest rate risk exposures and hedging of euro area banks’ banking books

Prepared by Jonathan Dries, Benjamin Klaus, Francesca Lenoci and Cosimo Pancaro

Published as part of the Financial Stability Review, May 2022.

While rising interest rates should improve banks’ net interest income in the short term, it could also weigh on banks’ net worth in the medium term. Overall, euro area banks have a positive duration gap,[1] which implies that if interest rates rise, assets will lose more value than liabilities, thereby reducing the economic value of bank equity. After narrowing in 2020, the duration gap started to widen again from the first quarter of 2021 (Table A, panel a), signaling that banks were approaching pre-pandemic levels of interest rate risk. Over time, derivatives have, on the whole, played a clearing role; in other words, the banks’ exposure to interest rate risk (IRR) resulting from their non-derivative positioning was partly offset by their derivative positions in the banking book.

Table A

Eurozone banks’ duration gap has widened recently, increasing their interest rate risk

Sources: ECB (Supervisory Banking Statistics) and ECB calculations.
Notes: Panel a: The duration gap is calculated for the euro area aggregate based on Esposito et al.* and a sample of 62 SIs. Panel b: Change in banks’ net worth is calculated based on Esposito et al.* and a sample of 62 significant institutions. The graph on the left shows the development of the net worth of banks in the euro area at the aggregate level in the interest rate scenario considered, while the graph on the right plots the distribution between individual banks.
*) Esposito, L., Nobili, A. and Ropele, T., “Interest rate risk management during the crisis: evidence from Italian banks”, Journal of Banking and Finance, Flight. 59, October 2015, p. 10-11. 486-5

The overall impact of higher interest rates on banks’ net worth would be moderately negative, but large variations exist at the level of individual banks. The duration gap can be reflected in the sensitivity of the bank’s economic value to changes in interest rates. For example, a longer-term yield curve steepening of 200 basis points in Q3 2021 would have reduced banks’ aggregate net worth by about 4% of Common Equity Tier 1 (CET1) capital (Table Apanel b).[2] More than 60% of the banks analyzed would face a decline in their net worth in this scenario, while for 25% the net worth would decline by more than 7% of CET1 capital. This drop comes because, in the medium to long term, banks would have to pay higher funding costs to cover old, low-yielding assets. Changes in the economic value of banks’ equity do not always translate into book losses, but they do highlight banks’ resilience to changes in long-term interest rates.

An empirical analysis of bank characteristics and IRR indicates that the share of exposures with longer rate fixation periods plays a predominant role in this relationship and shows that derivatives are used to hedge IRR. Analysis[3] finds that the decline in banks’ net worth under a rate hike scenario is more pronounced when the share of loans with fixation periods longer than ten years is higher. In addition, large banks appear to be facing a smaller decline in their net worth, perhaps reflecting reduced hedging capabilities of smaller banks.[4]

Table B

Banks are actively managing interest rate risk exposures by changing the maturity profile of IRS transactions

Sources: ECB (Supervisory Banking Statistics and European Market Infrastructure Regulation) and ECB calculations.
Notes: Part a: “Basis swaps” are IRS on floating interest rates, “EONIA and €STR OIS” are overnight index swaps denominated in euros, “Other currencies OIS” are index swaps overnight indices denominated in other currencies, “Other LIBOR Currencies” includes LIBOR swaps denominated in GBP, JPY, CHF and USD, “Other IRS” includes Fixed-to-Fixed Swaps, Inflation Swaps and other IRSs. Right chart: the net notional amount is aggregated into four maturity bands. “SNF” stands for Non-Financial Corporations and “IRS” stands for Interest Rate Swaps. Panel b: ongoing transactions excluding intra-group transactions. Outstanding refers to contracts outstanding as of 31 December 2021, new refers to IRS transactions initiated after March 2021. Transactions with NCBs and counterparties with unidentifiable sectors are excluded and represent less than 2% of gross notional negotiated by euro area banks. Breakdown by sector: “IF” for investment funds, “MMMF” for monetary UCITS, “IC” for insurance companies, “PF” for pension funds, “NFC” for non-financial companies, “OFI” for other financial companies. establishments.

Eurozone banks have held an increased volume of interest rate swaps over the past two years, suggesting more active hedging of interest rate risk. Banks enter into interest rate swaps to supplement natural hedging, take on more risk through directional exposures, or provide liquidity through market making. When doing so to mitigate risk, banks transform future cash flows generated by assets or liabilities from variable rates to fixed rates, or vice versa. At the end of 2021, the gross notional outstanding amount of interest rate swaps held by banks had increased to €128 trillion, while that on the most liquid euro contracts (EURIBOR, EONIA OIS or €STR OIS swaps) had increased by 30% since the start of 2019 to €56 trillion (Table B, panel a). These contracts are better suited to reduce the volatility of banks’ balance sheets induced by the revaluation of cash flows denominated in euros. Over the past three years, banks have reduces their net notional amount[5] exposures to swap contracts with shorter maturities (less than one year), on which they pay fixed rates, and increased the volume of contracts with longer maturities, on which they receive variable rates (Table B, panel a). These elements are consistent with expectations of higher interest rates and the intention to protect low-yielding assets against rising rates.

Interest rate swaps are used to spread risk within the banking sector and transfer it to insurance companies and pension funds. Focusing only on euro-denominated interest rate swaps denominated on the euro interbank offered rate (EURIBOR), overnight index mid-rate (EONIA) or euro short-term rate (€ STR), euro area banks negotiate most of these swaps with other banks. With regard to risk transfers to other sectors, bank transactions are not evenly distributed over the maturity bands: insurance companies and pension funds receive fixed rate payments for maturities greater than ten years given their cumulative negative duration gap, making them a natural counterpart for banks. For contracts initiated after March 2021, when inflation started to pick up, investment funds took on more risk for short maturities while, for longer maturities, the share of insurance companies and pension funds in swap swaps doubled (Table Bpanel b).

Bank exposure to IRR appears moderate overall, but large variations exist between individual institutions. While a rise in rates would negatively affect the net worth of more than half of the banks analyzed, their exposure has decreased since 2017. Exposures to interest rate swaps, and in particular the volume of receiving floating swaps with longer maturity, have increased since inflation started to pick up in March 2021, suggesting that eurozone banks are using derivatives as hedging instruments. A normalization of monetary policy should not be a major concern in terms of the overall impact on the net worth of the Eurozone banking system, although it may have a negative effect on banks with large IRR exposures.

Leave a Reply