Interest Rate Risk – Protecting Net Interest Margin (NIM)

Preface

We have observed significant market volatility due to the current economic and geo-political climate. Numerous economies are under external market pressure with high and rising inflation levels. Interest rates continue to remain a key topic of focus globally. Central banks in all major economies are in the process of increasing interest rates – where a rise of 50 bps or more has become the norm. Several financial institutions perceive current and near-term future scenarios as a positive for them in generating higher interest income and margins. In this blog, we seek to evaluate some particular focus areas that are likely to have great importance in near future.

• Increasing Interest Rate Scenario: Shouldn’t it improve Net Interest Margin (NIM)?

Net interest margin (NIM) is the core contributor for profitability of banks and building societies (i.e., financial institutions (FIs)) – mainly from retail, commercial and wholesale lending operations. Over the past decade, the average NIM for UK FIs has seen positive  movements i.e., reaching (approx.) 1.9% in 2019.  However, near zero interest rates implemented by Central Banks around the world during the COVID period drove the average NIM for UK banks close to lows of 1.2%.  This impact was driven from a higher proportion of reduced interest rates and income on the lending portfolios, combined with a marginal reduction in the cost of liabilities.

• However, with Central Banks rapidly increasing interest rates to mitigate the current inflation shock, there is an opportunity for banks’ NIM to improve, if banks are successful at risk managing the interest rate risk in their loan books and in their liabilities.

With markets now moving away from the prolonged low-interest environment, it gives rise to several uncertainties, from consumers and banks’ behaviour to future rate rises and knock-on impacts to other sectors such as housing – all of which may impact NIMs in the short to medium term. Following Bank of England (BoE) rate increases, NIMs have started slowly improving with large banks benefitting the most, mid-sized banks benefitting moderately and building societies with only a marginal positive impact. Cost of funds for FIs may rise either faster or slower than its yield on earning assets, and is ultimately influenced by wider macroeconomic conditions. Accordingly, the impact of rate rises on NIMs remains somewhat uncertain. While the general expectation is for a short-term increase, it is critical to manage and maintain NIMs throughout this period of uncertainty, to ensure stable earnings.

• But what about the further rate increases expected by the central banks? Shouldn’t it further enhance the NIM levels?

Theoretically yes, however, there are several factors operating simultaneously in the world of economics and geo-politics. Liquidity generated in the last couple of years has started heating up the economy, forcing central banks to increase interest rates. Further, the Russian invasion of Ukraine resulted in a sharp increase of commodity prices – which has amplified the cost of living crisis in the UK. With latest inflation figures reaching double digits and expected to rise further, it is highly likely that interest rates may reach upwards of 3% in 2023. At least nine banks and building societies have increased rates following the 25bps rise in June, with the rise being passed on to variable rate mortgages immediately, and fixed rate mortgages being priced on market expectations of the interest rate trajectory. All this has led to mortgage rates rising at their fastest pace for a decade in the six months to May 2022, and it is expected to continue to increase to levels of high significance over the near term. This could lead to a further slowdown and possible recession in the economy amid the cost of living crisis. The UK economy has seen contraction of 0.1% in Q2 and is likely to continue to contract further in H2 2022, squeezing household disposable incomes and increasing cost of living crisis. FIs need to be wary of a possible rise in non-performing loans (NPLs), provisions and defaults as a direct result of the increased cost of living and reduction is disposable household incomes, which may impact overall NIMs adversely (and may also lead to higher capital requirements and potentially elevated cost of funds in the current macroeconomic scenario).

• What about the support from the Central Bank and Government? We have seen in the past that their measures effectively support the wider economy under financial crisis. However, it may not be so clear this time.

In the current inflationary regime, BoE monetary policy levers may not be available as in the past. Additionally, expansive fiscal measures may be constrained by the increased yields on new government debt issuance. Banks should consider this uncertainty and assess potential impacts on NPLs, provisioning or defaults on NIM with different macro-economic scenarios.

• What should exactly be done to protect or stabilise NIMs?

There are numerous ways depending on the bank’s overall asset-liability profile for protecting or stabilising NIMs as illustrated below:

Interest Rate Risk Management: FIs should embed their interest rate profile and associated risks in their business strategy & planning. They should emphasise the need for a policy framework focusing on optimal asset-liability mix and cost of funds structure for current portfolios and for any future business expansion and projections in order to have a healthy ALM profile with minimal interest rate risk. FIs should define relevant Early Warning Indicators (EWIs) and review their limit framework for effective risk management. These measures will help stabilise NIMs. Further, it will provide a clear view of interest rate sensitivity in the financial plan, including both upside and downside risks.

ALM and Funding Profile: To achieve stability in earnings and NIM, FIs need to strengthen their ALM and funding profile. Non-maturing deposits (NMDs) are the cheapest and most stable source of funding available. Firms should focus on enhancing its NMD base with optimal interest rate offerings to the customers, SMEs and corporates. FIs may also look for enhanced offerings for mid-to-long term savings products at optimal and attractive interest rates to minimise any interest rate gap risk and achieve balanced ALM & funding profile.

Interest Rate Derivatives: To hedge interest rate risk arising from the origination of customer products such as fixed rate loan products where cash funding is unlikely to be available at the same re-pricing maturity as the customer product.

Mitigation for potential loan losses: FIs should conduct an impact assessment for loan losses while passing on higher interest rates to customers and conduct suitable measures such as reducing the increase in interest rates for lower income group borrowers and increasing the repayment period whilst maintaining the same monthly repayments.

Behavioural Analysis: Provides useful insights for any potential shifts in a firm’s ALM profile such as early prepayment of loans, early withdrawal of time deposits and stability of funding through NMDs. Behavioural analysis also helps in shaping future business planning and strategy. Firms may update product offerings with relevant terms and conditions to minimise relevant interest rate risks.

Along with effective NIM management, the above measures also help FIs to effectively manage regulatory capital requirements for interest rate risk.

• It is great to understand that the above measures help to manage NIM effectively, but how does it help to manage regulatory capital requirements?

While considering measures for improving, protecting or stabilising NIMs, it is important for FIs to focus on regulatory capital requirements due to interest rate risk. Integrated interest rate risk management framework serves a well-rounded purpose i.e., identification of interest rate risk sources, necessary measures (as illustrated above), protecting NIMs and optimising regulatory capital requirements.

• That’s Interesting. What should be done to develop an integrated Interest Rate Risk Management (IRRM) Framework?

Banks should establish integrated an IRRM framework aligning first and second lines of defence activities – business plan, strategy and goals aligned with effective risk management practices. With the latest, more stringent regulatory requirements, an integrated framework becomes of utmost importance. For example, higher interest income through fixed rate loans may help to increase NIMs but may result in higher capital charge if ALM repricing profile is not managed effectively.

Deloitte helps FIs to develop an integrated IRRM framework, aligning business plan, strategy and goals with risk management strategy and framework. This framework is aligned with regulatory requirements and includes policies and procedures, governance and controls framework, risk appetite, systems and data framework, behavioural analysis, regulatory and internal metrics, EWIs, scenario analysis, mitigation action plan, capital assessment and so on.

• Where do the firms stand on Integrated Interest Rate Risk Management framework?

Certain firms face challenges (and are still in the process) for compliance with the latest regulatory guidance (SS31/15 and PRA Rulebook – applicable from 31st Dec 2021).

Deloitte has been supporting numerous financial institutions and; has significant industry wide experience and market insights in the interest rate risk management domain. Our upcoming publication “A Glance at the Industry Position in the first 6 months of new IRRBB guidance” will illustrate the common challenges faced by financial institutions and how Deloitte is best placed to support with enhanced interest rate risk management through numerous accelerators developed over a number of years.

“ With the current inflation shock forcing Central Banks for rapid increase in interest rates, there is an opportunity for financial institutions to improve their Net Interest Margins, if they are successful at managing the risk associated with the uncertainties of the implications on their assets, liabilities and ultimately their clients."