With the introduction of negative interest rates by ‘Swiss National Bank’ the interest rate business of banks has been put under margin pressure. Banks with predominate balance sheet business need to adjust their balance sheet structures by correctly allocating hedging costs and adjusting client pricing in the lending business. Three approaches can be observed today: (1) increase of term transformation, (2) charging of fixed add-ons in lending business and (3) charging of true hedging cost in lending business. These mitigate interest rate risk only partially and do not necessarily provide sufficient accruals from current windfall profits for the future. Banks should consider hedging cost allocation to client prices, adjusted replication approaches and product redesign to reduce future interest rate risks and to mitigate P/L impacts. Based on our observations even mid-size retail banks with a balance sheet size of e.g. CHF 10bn will have opportunities to enhance their interest rate income by approximately CHF 5 to 10mn p.a. by applying above considerations.

It has been more than two years since the European Central Bank (ECB) introduced negative interest rates and Quantitative Easing measures to support economic development through an expansion of lending activities. The Swiss National Bank (SNB) followed the ECB in January 2015 and introduced negative interest rates, mainly to stabilise the Swiss currency.

These macro prudential measures affect the refinancing and replication activities of all banks with traditional balance sheet business. The natural floor of non-negative interest rates in the deposit business with private and smaller corporate clients constrains the ability of banks to achieve past profitability targets. Only the SNB thresholds of 20 times the banks’ reserve requirements at SNB help to partially reduce adverse effects on banks. Costs of swapping fixed loans and mortgages, however, have increased directly through negative Libor rates.

How sustainably can banks mitigate the adverse effects of negative interest rates on their profitability in the medium term?

This situation raises two vital questions for banks, which need to be carefully reflected upon and answered:

1. What is the right way and level of pricing logic adjustments in the balance sheet business to best mitigate adverse effects of negative interest rates?
2. To what extent do the current activities of banks already sufficiently accommodate these developments?

Not finding the correct answers to these questions can leave huge revenue potentials untapped and shift competitive positions, mainly for smaller and medium-sized retail banks, in the Swiss market.

In a working paper on banking profitability the International Monetary Fund (IMF, 2016) confirms banks in the Euro zone have compensated a decline of their interest incomes through a lending volume increase and revenue diversification. According to SNB, the lending volumes of Swiss banks have also increased by approx. 3% since the introduction of negative interest rates. Additionally, the widened lending margin has had a positive impact on the profitability of banks. This short-term view of the IMF, however, still excludes the mid- and long-term effects of a potential interest rate lift on banks’ interest rate expenses.

With rising interest rate levels at the short end of the interest rate curve, the currently perceived interest rate advantages (windfall profits) will fall away. Thus, the windfall profits in the newly priced lending business have potentially not provided sufficient leeway (SNB, 2016) to temper all the effects on the already existing loan deals.

Management of interest rate risks through Asset Liability Management as key factor to preserve banks’ interest income

The obligation to respond to these timing and pricing challenges appropriately lies with the Treasury department and the Product Management units of banks. Apart from the correct anticipation of term-out costs in the lending business, the replication of the deposit business and product portfolio steering is of utmost relevance.

Charging term-out costs

Banks currently apply three different steering mechanisms to manage their interest rate and profitability risks, which enable them to temper profitability forfeits in the short-term:

1. Refinancing of the longer-term lending business through the short-term deposit business to enhance replication yields through term transformation. This approach does not suitably address margin risks.
2. Charging of fixed price add-ons in the lending business, which do not adequately compensate interest rate risks in the medium-term. They usually do not address differences of asset and liability volumes across term bands in the balance sheet.
3. Quantification of the real, term-congruent hedging cost along the interest rate curve and its term-congruent charging on the respective loan positions. This approach is not yet widespread.

Depending on the banks’ balance sheet structures, these approaches do not necessarily ensure sufficient accruals until interest rates might go up again. The current windfall profits serve rather to enhance today’s profit and loss statements.

_{Image 1: Illustrative CHF interest rate mechanisms}

Following the assessment of real term-out costs, the term structures of assets and liabilities need to be aligned in a way that additional interest revenues serve to compensate for margin pressure on the existing, not yet repriced loan portfolio. Furthermore, an appropriate term structure of the lending portfolio should be pursued. Therefore, banks should analyse the term structure of their balance sheet for non-compensated opportunity costs and refine the margin logics of their balance sheet products. The ultimate goal of such an analysis is to ensure adequate provision for any uncompensated costs of swapping the loan portfolio through appropriately priced hedging costs in their client rates for new or extended business.

Restructuring of the replication approach

Depending on the banks’ refinancing strategy, the replication approach of the deposit business and product terms should be reconsidered, both aiming for a limitation of the interest rate risks derived from the term structure of the balance sheet. Moreover, non-interest dependent income should be strengthened, not purely by introducing higher account or service fees, but by releasing some replicated volumes in certain term bands of the banks’ balance sheets.

_{Image 2: Effects of negative interest rates on deposit replication depending on client rate strategy (illustration)}

Change of product design

An adjustment of the overall product assortment can finally allow for a suitable mix of balance sheet and non-balance sheet products with an enlarged fee component, a more attractive risk-return profile for clients and an adjusted term structure of the product and replication portfolios of banks. A pure shift of the client’s investment risks, however, should not be the consequence. There is also a need to re-allocate customers’ investments purely from a real-return standpoint (IMF, 2016) (BOE, 2015), still considering their risk-return profile, investment objectives, investment horizon and risk-carrying capacity.

Opportunities to stabilise the interest business

According to our estimates and market observations, the costs of non-optimised balance sheet structures in certain term bands can account for 5 to 30 bps of lending products and 5 to 10 bps of deposit products. Even a medium-sized retail bank with an assumed lending volume of e.g. CHF 10bn and a refinancing rate through deposits of e.g. 70% would have an annual revenue enhancement opportunity of approx. CHF 5 to 10mn. The opportunities through not fully charged term-out costs amount to a comparable sum. An analysis and implementation of these potentials should ideally be conducted as early as possible and sufficiently prior to an expected interest rate rise.

_{Image 3: Opportunities in interest bearing business (illustration)}

Overall, it seems prudent for Swiss banks to identify their real exposure to low interest rates and its significance for their profitability. A still-low interest rate level provides some leeway to master these challenges. Interest rates rising later than expected, however, do not necessarily mitigate the adverse impact on the interest income sufficiently.

Dieter Klein - Director, Monitor Deloitte

Dieter leads the Pricing Offering for Financial Institution at Deloitte’s strategy practice Monitor Deloitte in Switzerland. He has been working as a strategy consultant for many years and has more than 15 years of professional experiences in the banking industry, primarily in balance sheet product management and credit risk management. Dieter studied Investment Theory, Finance, Banking, Marketing and Computer Science at university and holds a master degree in business administration.

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Bibliography

BoE. (2016). Staff Working Paper No. 571. London; Great Britain: Bank of England.
IMF. (2016). Negative Interest Rate Policy: Implications for Monetary Transmission and Bank Profitability in the Euro Area. Washington, USA: International Monetary Fund.
SNB. (2016). Presentation of the Swiss National Bank's Financial Stability Report. Bern, Switzerland: SNB.