Personal Opinion Piece: The Regulator's Response to Recent Bank Collapses

For the past few years, I have consistently highlighted the concerning challenges faced by banks due to the optimistic biases in their economic value of equity calculations. These issues primarily arise from over-estimated assumptions related to current account spreading, prepayment rates, and capital assumptions.

While individually these assumptions might not present a significant risk if they align with the bank's risk appetite and maintain a semblance of realism, a worrisome trend has emerged. It appears that banks have been leveraging these assumptions to minimise their hedging requirements, thereby increasing their exposure to risk.

Recent communications suggest that regulators are now finally recognising that mismanagement of Interest Rate Risk in the Banking Book (IRRBB) could be a fundamental factor behind the latest spate of bank failures and the ongoing issues with capital erosion. Although this insight is a step in the right direction, it seems there is still a lack of comprehensive understanding of the situation. Below, I delve deeper into how a confluence of factors, primarily rooted in assumption-based mismanagement, has contributed to the banking sector's current predicament.

Current Account Assumptions: Silicon Valley Bank's Collapse

Silicon Valley Bank serves as a stark illustration of the risks involved when banks overly optimise their liability assumptions to curtail or eliminate the need for hedging. During the COVID-19 pandemic, a period marked by global lockdowns and a heightened propensity for saving among individuals, the bank witnessed a surge in current account balances. This temporary boost in their funding base led them to hedge their actual fixed assets, primarily government bonds, against a hypothetical duration they attributed to their current account balances. Given the extended period of stable interest rates, the assumption that current accounts would consistently maintain a 0% interest rate seemed plausible at the time.

However, this assumption proved to be critically flawed, significantly undermining the bank's capital and liquidity positions and precipitating its downfall. The detailed analysis of Silicon Valley Bank's collapse has been addressed in a previous webinar, the link to which is provided below for further insight.

Silicon Valley Bank represents an extreme case where reliance on assumptions rather than concrete hedging strategies led to rapid failure in the face of rising interest rates (hence the speed of collapse following interest rates increasing). It is crucial to remember that hedging functions as a form of insurance against fluctuations in interest rates. Without adequate hedging, banks are exposed to the full brunt of cost increases. Despite Silicon Valley Bank's dramatic example, it is important to note that numerous other banks have also relied on less drastic but still significantly harmful assumptions, adversely affecting their capital positions.

Challenges with Prepayment Assumptions

The inherent issue with prepayment assumptions lies in the methodology of extrapolating future behaviour from the previous 12 months' data to forecast prepayment rates over the next five years, for instance, in the context of a five-year mortgage. This approach is relatively unproblematic in a stable, Business-As-Usual (BAU) interest rate environment. However, the landscape has shifted dramatically from a period of unusually high prepayment rates—fuelled by incentives such as the stamp duty holiday in the UK and historically low-interest rates—to a markedly lower prepayment frequency in a higher interest rate environment.

Many banks have continued to extend the prepayment rates observed during the COVID-19 pandemic, including the stamp duty holiday period, across the next five years. This projection assumes that mortgages will experience consistently high rates of prepayment throughout their duration. Yet, the reality is likely to diverge significantly from this forecast. With current interest rates approximately 5% higher than during the pandemic, borrowers who secured mortgages at around 1% are less inclined to prepay early. The favourable terms of their existing mortgages, combined with the opportunity to allocate surplus funds into higher-yielding investments such as bonds or savings accounts, diminish the likelihood of prepayment. Consequently, the prepayment rates are anticipated to be considerably lower than initially projected at the inception of these mortgages.

Capital Spreading Assumptions

Observations indicate that numerous financial institutions have adopted capital allocation assumptions as a strategy to hedge against the inherent risks associated with fixed assets, such as mortgages. For example, within the framework of a five-year mortgage, these institutions posit that a certain proportion of the asset's value is counterbalanced by the bank's capital reserves. This approach is predicated on the assumption that the bank possesses sufficient capital to absorb any potential loss in value across various segments of the asset's lifespan.

This method essentially allows banks to manage their risk exposure by aligning open asset positions with corresponding capital reserves, effectively acknowledging the bank's tolerance for potential losses within its asset portfolio. However, this strategy appears to overlook the fundamental principle of hedging. The primary objective of a hedge is to provide a financial safeguard against depreciation in asset values—specifically, in scenarios where the interest rate secured on a mortgage falls below prevailing market rates. In such cases, a well-structured hedge or swap agreement should ideally result in an appreciable gain, offsetting the loss in asset value through an increase in the swap's value, particularly the payment received from the floating leg of the swap as market rates rise.

Conversely, capital reserves do not exhibit an increase in value as a direct response to a decrease in the value of mortgage assets on the balance sheet. Therefore, banks that rely on capital allocation assumptions as a means to mitigate changes in the valuation of fixed assets need to critically evaluate their balance sheet strategies. The misconception that capital can serve as an effective hedge against fluctuating asset values necessitates a thorough reassessment of risk management practices within these institutions.

Analysis of Cumulative Assumption Risks

The critical issue with the current application of assumptions within economic value modelling is twofold. Not only are these assumptions frequently overstated, as demonstrated through the various examples above, but they also uniformly influence the repricing gap in a particular direction. Specifically, these assumptions tend to generate a perceived "fixed" liability stance within the repricing gap, effectively diminishing the apparent net exposure to fixed assets. This results in a portrayal of the net position that is significantly less substantial than its actual contractual obligations, absent any assumptions.

To illustrate, consider a scenario where a bank secures ￡100 million in five-year mortgages, which would traditionally be allocated within the five-year liability bucket. If the bank anticipates a certain percentage of these mortgages will be prepaid, it might adjust the value of this portfolio down to ￡80 million. Subsequently, the bank may apply a ￡20 million capital allocation assumption and a ￡20 million current account assumption against this adjusted figure. This manoeuvre ostensibly reduces the net exposure to a mere ￡40 million, before even executing any genuine swap agreements!

Therefore, from an initial stance of ￡100 million in mortgages, the financial modelling suggests that only ￡40 million necessitates hedging. This substantial reduction—effectively obscuring ￡60 million from immediate view—potentially leads committee members to a misleading perception of security regarding the bank's repricing gap or net economic value assessments.

The Impact of Insufficient Hedging on Banking Stability

The rationale behind the recent spate of banking collapses is straightforward: an extensive portion of unhedged fixed asset positions significantly heightens the risk of capital losses in the event of rising interest rates. This vulnerability was not a concern during periods of stable, Business-As-Usual (BAU) interest rates. However, the landscape has shifted markedly due to the steep interest rate hikes observed in recent years.

Banks found themselves inadvertently positioned for a rate down scenario (to gain from an increase in economic value had interest rates decreased). Conversely, the opposite materialised, with interest rates actually increasing. This positioning has precipitated substantial losses, triggered bank failures, and led to notable issues in capital sufficiency.

The Evolving Regulatory Perspectives on Banking Failures and Interest Rate Risk

Regulatory authorities have begun to acknowledge that the series of bank failures can be attributed to interest rate risk. This development may seem expected, as substantial increases in interest rates naturally lead one to consider interest rate risk as a primary concern. However, the initial diagnosis by many was focused on liquidity risk, only to later understand that liquidity issues were merely a symptom of the deeper problem, not the cause itself.

For a detailed exploration of how Interest Rate Risk in the Banking Book (IRRBB) influences liquidity, and the connections between IRRBB, capital, and liquidity, please refer to the webinar linked below.

Nonetheless, it has come to my attention that the regulator's primary concern appears to be singularly focused on the capital allocation assumption. While, as previously discussed, this assumption indeed poses potential risks, it is essential to acknowledge that a range of other factors also warrants consideration.

However, a point of particular frustration is the apparent lack of regulatory concern regarding the capital allocation assumption, provided that banks do not engage in swap transactions against this capital position (i.e. not assuming a ￡10m capital position in the 5 year bucket, and taking out a ￡10m receive-fixed swap to hedge it).

Thus, according to this perspective, there is a significant distinction between offsetting a capital assumption with a swap in relation to an asset!

However, it is crucial to remember that the primary objective of hedging a fixed asset with a swap lies in the expectation that the asset's value will move in a direction nearly opposite to that of the swap, with a close magnitude of change. Consequently, the differential in value change between a swap and an asset is often minimal.

In essence, employing capital assumptions, whether for a mortgage or a swap, results in a comparable adverse effect on your capital during critical situations.

For the time being, we can appreciate the fact that attention is being directed towards the appropriate area of IRRBB and assumptions. However, there seems to be a focus on identifying commonalities among failing banks, notably the capital allocation assumptions, rather than a comprehensive understanding of how improperly utilised assumptions can lead to significant capital losses.

Conclusion

In conclusion, the recent turmoil within the banking sector, underscored by a series of collapses, has illuminated the critical vulnerabilities embedded within the industry's operational and strategic frameworks. Central to these challenges is the reliance on overly optimistic assumptions related to current account spreading, prepayment rates, and capital allocation. These assumptions, while seemingly benign in stable economic environments, have proven to be the Achilles' heel of financial institutions in the face of rapidly changing interest rates.

The regulatory response, albeit a step in the right direction, highlights the need for a more nuanced and comprehensive approach to oversight. The focus on capital allocation assumptions, while important, should not overshadow the broader spectrum of risks associated with mismanagement of interest rate risks and the intricate web of assumptions that underpin the banking book.

This analysis calls for a paradigm shift in both banking strategy and regulatory oversight. Banks must adopt more conservative and realistic assumptions, enhance their risk management frameworks, and cultivate a culture of continuous evaluation and adaptation to economic indicators. Similarly, regulators must broaden their lens to capture the full panorama of risks, ensuring that their guidance and interventions address the root causes of instability, not just its symptoms.

As the banking sector navigates through these turbulent times, the lessons learned from recent failures must pave the way for a more resilient and prudent banking system. A system where strategic foresight, robust risk management, and regulatory acumen converge to safeguard the industry's integrity and stability. Through collaborative efforts between banks and regulators, the industry can aspire to not only withstand the ebbs and flows of economic cycles but to emerge stronger, more agile, and better equipped to serve the needs of the global economy.

Webinar Link:

Nothing New Under the Sun: Silicon Valley Bank – What Went Wrong and Lessons (Re)Learned (youtube.com)