It’s been a decade since the financial crisis brought the global economy scarily close to total collapse. Since then, risk management has been bolstered to prevent another crash. Are those measures enough? Six students looked into a standard recently implemented by the Basel Committee, which requires banks to use standardized methods to measure their exposure to interest rate risk. Risk manager and Tilburg University professor Marco Folpmers graded the students’ research with a 9. So what exactly did they find out? In a guest post for Univers, the students explain what they did and what they found—and why it matters.
By: Kevin de Veer, Thomas Kerkhofs, Hans-Peter Hiddink, Dimana Ivanova, Maartje Schriever & Jack Arkesteijn
September 2008. Starting with the Lehman Brothers, the accumulation of unsafe mortgage-backed securities got the better of the US market and economy, leaving a global financial meltdown behind. Simply said, if the banks made a mistake back then, they would not make that same mistake again, right?
Probably not, at least not exactly. However, in such a complex environment, where so much is at stake, mistakes are easily made and risks are easily overseen. There is one complex part of the economy, which was of major importance during the 2008 crisis as well, which is of major importance to all financial markets, from governments to banks and private investors: everyone is concerned with interest rates.
The interest rate is the rate which one party asks in exchange to loan money. In recent weeks, Turkey has increased its interest rate to 17.75%, Argentina’s central bank keeps interest rates at 40%, while in the meantime, European interest rates are unprecedentedly low: the rate on an average Dutch savings account is around 0.05%. For the average Joe, this interest rate landscape is rather hard to understand. And even for experts in risk management, this field remains complex with many stakeholders affected by these rates.
One of the parties heavily dependent on interest rates are banks, as their business model consists of earning and paying interest. As history has shown, shifts in the interest rates can have a major impact for banks and all subsequent parties involved. As our economic system is built around financial institutions, it is fair to say that proper interest rate risk management is of crucial importance.
The 2008 financial crisis took the world by surprise and caused severe damages on most economies. The main reason for its occurrence was the loss in faith in the banking institutions. Their credibility went down drastically during the housing bubble, when many irrational mortgages were lent out. Such a situation, when people’s trust in banks declines and they move their deposits away while the loans remain in place, is known as a banking crisis. It is very dangerous because it is contagious and has severe consequences such as sharp inflation increases, threatening the whole economy. In an attempt to keep their depositors and, at the same time, avoid taking more loans, banks start increasing their interest rates. This, in turn, makes it harder for people to repay their existing loans, only deepening the crisis. This vicious circle was the cause of the second largest financial crisis the world has known.
It became evident that more regulations need to be put forward in order to prevent reoccurrence. Ever since, banks and other financial institutions have been subject to a lot of monitoring, supervision, tightening and implementation of new rules and requirements. Their exposure to risk is limited to certain bounds and frequently measured and reported to ensure that they do not exceed it. The types of risk banks face are many, according to the reason they arise from: credit risk, liquidity risk, market risk, interest rate risk. Banks make money by borrowing money short term, and lending long term. Typically, long term interest rates are higher than short term interest rates, providing banks with a profit. From this, you can see that a bank is exposed to risk arising from changes in the interest rate. In our research we specifically focus on interest rate risk, how it is measured, and which regulations are issued to avoid the negative consequences arising from it.
The international organization responsible for determining the guidelines of risk measurement and risk handling is the Basel Committee. It sets global standards for regulation and supervision of banks, and revise these if necessary—for instance following major financial events like the crisis of 2007-2009. Lately, they implemented a new standard, Basel #368, demanding banks to use standardized methods to measure their exposure to interest rate risk.
These standards are once more an attempt to make banks less vulnerable, which, in light of our saving accounts, is a good thing. Still, after looking through these new standards, there are both pros and cons which one could underline when comparing it to the previous version. The most important new aspects of this publication includes six standardized shocks, among which a 200bp (200 basis points, which equals 2 percentage points) parallel shock, against which banks can measure their interest rate risk. Shortly stated, it seems as if the new standards went from complex to more simple and comparable. This appears to be a clear trade-off and we asked ourselves: are these new standards still accurate enough to capture the risk at stake?
As part of the Outreaching Honors Program, we, all second year bachelor students from TiSEM, were given the opportunity to look into Basel standard #368, and research whether the newly proposed standardized methods are good enough, or whether in fact more standardized scenarios are needed. We conducted this research under the guidance of professor Marco Folpmers, who is Managing Director Finance & Risk Benelux for Accenture, as well as a professor at TIAS business school.
Important to understand is that banks are affected by interest rates in two distinct ways, leading to two different approaches to interest rate risk. Firstly there’s the earnings approach, where the banks’ earnings are affected by the interest rate, as they earn and pay interest to realize a profit. The second approach is the value approach, which looks at a bank’s balance sheet. Many assets and liabilities are financial instruments whose value is stated as their present value (future value of cash flows discounted against a discount rate). As the applied discount rate is heavily dependent on the interest rate, so are the assets, liabilities and thus the equity. As companies often prioritize maximizing the shareholder/equity value, it is of utmost importance for banks to manage the risk coming from the value approach, and to keep this risk within the limits of their risk appetite. Since the interest rate is sensitive to risk, it’s important to measure this risk. In other words, it must be determined how large the swings in interest rates are.
To get to a conclusion regarding the trade-off between comparability and accuracy, we conducted interviews and statistical analyses. First, we conducted interviews with two professionals in the field: Mr. Versendaal (ALM manager at ABN AMRO) and Mr. Baalhuis (Senior Pricing Analyst at de Volksbank). They explained that a 200bp instantaneous shock is only realistic on a one-year horizon. Moreover, they both stated that the six standardized measures as suggested by Basel make banks more comparable, but the measures are not fully representative of real life scenarios.
Following our field research in the form of the two interviews, we can now look more in depth at the risk exposure of the interest rate, as stated previously, to look at how big the swings of the interest rate really are.
With the help of a PCA analysis, we find that 98% of the variation in interest rates correspond with the six standardized shocks. Moreover, a 200bp (basis point) shock is very unrealistic for an instantaneous shock as it only corresponds to time frames of a quarter of a year or longer.
The PCA gave us good insights into the accuracy and the complexity of using and finding standardized measures, based on data from the past. To provide a more solid support of the findings we have found so far, we conducted another data analysis on historical interest rate movements.
We find that on a monthly basis a 200bp shock is almost impossible to occur. However, with respect to yearly shocks, the probability of a shock in short term interest rate being higher than 200bp is quite substantial, around 8%.
To conclude, we hypothesized that there would be a trade-off in accuracy and comparability between the new standardized measures and the previous measures. This trade-off was confirmed during the interviews with Mr. Baalhuis and Mr. Versendaal, as the standardized measures are not representative of real life scenarios. The PCA as well as our own data analysis pointed out how instantaneous shocks of 200bp are unrealistic, as seem monthly shocks of 200bp, while yearly 200bp shocks do occur, making the monthly shift of 200bp a safe bet to hedge against. Consequently, when using the standardized measures, there is still a small chance that not all risk is captured by these methods, possibly leading to improper risk management. However, reducing these odds will be costly in terms of time and money.
Taking into account that Basel #368 was published with the intention to make banks more comparable, we conclude that it is advisable to use the standardized scenarios as easy, cost efficient measures increasing the comparability.