Current & potential developments
Adding to the adverse economic impact of COVID-19 lockdowns on the topline revenues, banks and financial institutions are experiencing widespread margin compression from the recent volatility of interest rates. The Treasury yield curve (representing the distribution of yields or interest rates on Treasury debt across all tenors, from the short term T-Bills to longer term T-Bonds) has been flattening and even at times becoming inverted, i.e., low Treasury rates across all maturities, or higher interest rates on short term bonds than on longer term bonds. Banks, lenders and financial institutions typically rely on the spread income derived from using short term funding sources to fund long term assets, which yields a positive differential under normal conditions, but is currently under pressure of declining, and possibly even turning negative.
The extent of a bank’s earnings vulnerability to interest rate volatility is dependent on its funding mismatch gap profile, balance sheet liquidity, and contingency funding resources, all of which typically are detrimental to banks’ net interest margins when the yield curve becomes flat or inverted.
The challenging yield curve environment may lead to other ripple effects beyond interest rate risk exposures, ranging from resulting stresses to your institution’s clients, productivity of your staff, and threats posed to the larger community and local government.
As the unfavorable yield curve environment prolongs, the erosion of bank earnings may further threaten bank’s capital to fall below the minimum capital level required under Basel.
Key questions you should consider
- Is your institution’s interest rate vulnerability and response plan accurately assessed and stress tested?
- Are your institution’s overall interest rate risk management program and liquidity risk management program effective under the current crisis, and incorporating the appropriate risk factors? Or should they be revisited and updated for the current environment?
- What options in banks’ asset-liability management tool kit are available to best protect their Net Interest Margin or Spread Income?
How Accume can help
An organization-wide and comprehensive risk assessment will help to identify all short term and longer-term areas of risk exposures, as well as uncover any emerging or hidden risks that emanate further from margin compression. This basic action step, done right, will enable management to stay ahead and respond proactively to a fast-changing crisis environment as a result of rate volatility.
Specific risk management program reviews and retooling are advisable to adapt model assumptions and stress test scenarios to better capture risk exposures and their corresponding potential impact on earnings and capital, as well as to engage discussions about re-designing or adding any new risk mitigating controls, if needed.
A fresh and critical new pair of eyes to a bank’s asset-liability management toolkit is essential to enhance its capability to protect margins and earnings. Management is advised to consider a wide variety of financial asset classes, funding strategies, and simple hedging strategies that can be deployed specifically for interest margin protection.