After three years of negative interest rates, three out of four Swiss banks manage only to a limited extent the interest rate risks in their balance sheet.
A Treasury pulse check by Deloitte Switzerland has revealed that only a few banks factor interest rate risk in by adjusting short-term tenors or variable interest rate products in their lending business or by offering off-balance sheet products to offset the impact of low or negative margins on their deposit business.
Most banks put short-term profitability ahead of mitigating medium-term interest rate risks despite expecting interest rates to rise
More specifically, banks do not anticipate interest rate risk extensively through price differentiation based on hedging costs across loan maturities and therefore do not manage mid- to long-term interest risk in a systematic way. Those that do are focusing more on shorter loan maturities and are willing to give away market share in their lending business.
However, swapping the asset side and pricing hedging costs carefully into lending rates is vitally important, as the accumulation of client CHF deposits with low profitability and rather low stability of deposit volumes (in the replication portfolio) are affecting refinancing and the associated interest rate risk from liabilities.
Figure 1. Volume development of variable rate loans by banks’ interest rate expectations
Loan pricing does not fully reflect inherent interest rate risks
Overall, observed pricing measures taken by banks to stabilise profitability in their lending business appear inconsistent and unsystematic. The wider and more unspecific the variety of applied pricing measures has been the more the volume of the loan portfolio has grown. This indicates an insufficient provision for risk in the balance sheet.
Only one in eight banks factors hedging costs in their loan prices to evade a risk-inadequate increase of the lending business; weighting long-term profitability over short-term growth.
Almost no bank prices loans against the market trend, and 40 per cent of banks are following their peers and realising short-term profits from not pricing respective hedging costs in their loan rates. Only one in six banks manages interest rate risks through a higher proportion share of variable rate products to mitigate the longer-term interest rate risks.
However, it is unlikely that rising interest rates will improve lending margins immediately, which differs from the view of most participants in the market. Banks may overestimate the effect on their lending business because they anticipate equal upward movements in asset and liability margins, as well as minimal differences in interest rate changes along the yield curve.
Nevertheless, the windfall profits on their lending business from hedging respectively the cost of swapping (mistakenly perceived as additional margin) will start to fade away first. Compared to the gains on shorter deposit income, the longer tenors of the mortgage or loan portfolio will weaken overall lending profit increase, and lending earnings will react later than those on deposits. This does not contradict any effect that short-term rate movements have on long-term yields (Grisse & Schumacher, 2017). The effects of short-term rates could potentially even increase the margin stress on lending business, as the steepening of the yield curve is more likely to limit the ability of banks to roll over their real hedging costs to their clients when long-term swap rates already react positively and short-term rates remain still significantly negative. Adequate pricing of lending business is therefore more imperative in a negative interest rate environment the longer the normalisation of interest rates takes.
Figure 2. Short-term effect and direction of an interest rate rise on lending profitability vs. deposit profitability
Conditions in the deposit business remain demanding
The more that clients are charged with negative interest rates on their deposits, the more growth of unprofitable deposits in the balance sheet is avoided.
One quarter of banks approach the management of deposit profitability through an extension of the duration of their replication portfolio, even though they expect rising interest rates - as 75 per cent of them do from the end of 2018 onwards. However, according to the Deloitte’s ‘CFO-Survey in Autumn 2017’ only ten per cent of banks’ CFOs expected higher interest rates before the end of 2018.1
As charging negative deposit rates is not yet an option for most Swiss retail banks, margin pressure remains strong, and service fees and off-balance sheet offerings can only reduce but cannot offset fully the profitability impact – leaving clients with a free-of-charge hedge position against the bank.
According to survey participants, any further material reduction in interest rates would lead to a comprehensive extension of negative deposit rates to all client segments, including retail clients. Those banks with significant growth in deposits over the past three years would be more willing to charge negative interest rates to their clients in these circumstances.
Figure 3: Expected change in interest rates and time horizon - no short-term increase in interest rates expected across banks
How to navigate balance sheet business through the negative interest rate environment?
The observed market mechanism in a negative interest rate environment and the current pricing practice of banks indicate room for improvement in four areas:
- Swap the asset side appropriately and price respective hedging costs in the lending business to avoid risk-unadjusted volume growth.
- Align the margins across various maturities in the lending portfolio to level the term structure and related risks in accordance to the structure of the replication portfolio and refinancing conditions.
- Retain and accrue windfall profits from negative refinancing conditions in the lending business according to the specific term risks in the lending portfolio.
- Align the replication approach of non-maturing products in the light of interest rate expectations and refinancing conditions in CHF and foreign currencies.
In summary, interest risk management should consist of four components and should be tailored to the specific products and interest rate exposure of the bank (Klein, 2017).2
1For short-term interest rate expectations see also ‘Deloitte CFO Survey – Autumn 2017 Results’: https://www2.deloitte.com/content/dam/Deloitte/ch/Documents/finance/ch-en-cfo-survey-autumn-2017.pdf
2For further details on interest rate management see also ‘Deloitte Banking Blog 20/02/2017 – How to tackle negative interest rates right?’: https://blogs.deloitte.ch/banking/2017/02/negative-interest-rates-the-real-challenges-are-still-to-come.html