Are banks prepared for interest rate and credit spread shocks?

17 August 2022

Across multiple currencies, including the euro, interest rates and credit spreads have reached levels not seen for a decade. Risk measurement tools and hedging strategies have been designed and calibrated in a “low for long” interest rate environment, and are already being tested to their limits by the changing conditions. Banks’ sensitivities to shocks in interest rates and credit spreads have been identified as a 2022 priority for European banking supervision. In this context, the ECB launched a review on interest rate and credit spread risks to assess banks’ exposures, risk appetite and the robustness of their risk management arrangements.

In a first phase, benefiting from both top-down and bottom-up perspectives, supervisors aimed to identify the most vulnerable supervised entities for a subsequent more targeted and qualitative assessment. The assessment was based on available supervisory data, such as sensitivities to various interest rate and credit spread shocks, and information regarding the impact of hedges on banks’ exposures or the modelled maturity of their assets and liabilities. This data was further complemented by the outcomes of a stress test (see the ECB Financial Stability Review from May 2022) and of an ad-hoc sensitivity analysis. The first phase produced a list of 31 banks which are now under closer scrutiny. Preliminary results included confirmation that banks had relatively limited exposure to interest rate and credit spread risk in the trading book at the end of 2021. However, credit spread risk in the banking book can be a material source of losses, especially in terms of sovereign and financial institution exposure. Regarding interest rate risk in the banking book, the net interest income perspective confirms that banks have a positive gap, which means their rate-sensitive assets exceed their rate-sensitive liabilities, so a rise in interest rates over a 12-month horizon would ensure returns on assets rise faster than the costs of liabilities. From an economic value of equity perspective, which takes a longer term look at interest rate risk, the picture is more nuanced with roughly as many banks set to benefit from a rate increase as to lose out from it. However, additional factors need to be taken into account for the assessment, such as hedging strategies and the modelling of customer behaviour. According to scenario-based sensitivity analyses, impacts on solvency ratios of higher rates and spreads appear negative but contained.

The second phase of the exercise, launched in May 2022, consists of a horizontal review across six modules:

• Non-linear interest rate derivatives in the trading book and inflation-linked products – interest rates and credit spreads are risk factors that drive the short-term price movements of trading book instruments. The review will focus on this specific aspect of banks’ risk management systems with a focus on interest rates and inflation derivatives.
• Asset and liability management and positioning – the review will analyse how banks respond to the yield curve and how they tackle increases in interest rates.
• Hedging derivatives – the team will assess banks’ hedging strategies and how robust they can be in a changing environment.
• Behavioural models – the review will focus on the behavioural modelling assumptions concerning (non-maturing) deposits and loan prepayments which have a significant impact on how the aggregated interest rate risk exposure of banks is measured.
• Credit spread risk in the banking book – taking advantage of the regulatory developments in this area, including the upcoming EBA Guidelines on interest rate risk and credit spread risk in the banking book, the review will focus on the current state of play regarding the identification, management and assessment of credit spread risk in the banking book.
• second-round effects – the focus of this module is on how banks are prepared to consider second-round effects, including changes in their asset quality, adjustments of their business model, for instance through possible competition for deposits, and impacts on their insurance and equity exposures.

The targeted review will be completed by the end of 2022. Joint Supervisory Teams will follow up on the bank-by-bank conclusions and fully factor findings into the 2023 Supervisory Review and Evaluation Process (SREP). The outcomes of the review will be taken into account when planning future on-site and off-site supervisory activities, and will contribute to defining further supervisory expectations.