Tag: Interest Rate Policy

Are Small Business Bearing Some Of The Bank’s Interest Rate Risk?

An interesting working paper from the IMF was released today. Why Do Bank-Dependent Firms Bear Interest-Rate Risk? looks at the link between bank funding, floating rates and how this is transmitted to firms who borrow on variable rate terms. The paper concludes that banks do indeed transfer interest rate risks to firms, and this is especially so when banking regulation tightens.

Here is the summary:

I document that floating-rate loans from banks (particularly important for bank-dependent firms) drive most variation in firms’ exposure to interest rates. I argue that banks lend to firms at floating rates because they themselves have floating-rate liabilities, supporting this with three key findings. Banks with more floating-rate liabilities, first, make more floating-rate loans, second, hold more floating-rate securities, and third, quote lower prices for floating-rate loans. My results establish an important link between intermediaries’ funding structure and the types of contracts used by non-financial firms. They also highlight a role for banks in the balance-sheet channel of monetary policy.

Here is the full conclusion from the report:

Bank lending is in large part funded with floating-rate deposits. As hedging is costly, banks avoid mismatch with the interest-rate exposure of their liabilities, in part, by making floating-rate loans to firms. To establish this link between the structure of bank liabilities and the floating-rate nature of bank lending, I examine the cross section of banks. Banks with greater interest rate pass-through on their deposits hold more floating-rate assets: both loans and securities. In the cross section, these floating fractions are positively correlated with each other. I show that if banks were responding to demand for floating-rate debt from firms instead of their own liabilities, this correlation would be negative.

Moreover, while banks with more deposit pass-through hold more floating-rate loans, they quote lower interest rates for ARMs relative to FRMs. The combination of higher quantities and lower prices points to variation in supply rather than demand. I also present time series and historical evidence supporting the supply-driven view of floating-rate bank lending to firms.

This paper therefore highlights an important consequence of banks’ short-term funding: the potential for interest-rate mismatch. While standard models do analyze maturity mismatch created by short-term funding, they typically do not consider uncertainty in interest rates and interest-rate mismatch.

This paper shows that the structure of banks’ funding has important implications for the choices banks make about interest-rate risk on the asset side of their balance sheets. More broadly, my results establish an important link between intermediaries’ funding structure and the types of contracts used by non-financial firms. My results suggest that tighter regulation of banks’ exposure to interest rates might lead banks to pass on more risk to firms, which is particularly relevant given renewed regulatory focus on banks’ exposure to rates.

Bank-dependent firms, i.e. poorly rated firms and smaller firms, are more exposed to interest rates than firms with better access to capital markets. While these firms do use interest-rate derivatives to hedge this exposure, they do so only partially. I show that this exposure is a component of the Bernanke & Gertler (1995) balance-sheet channel of transmission of monetary policy. Banks therefore play a role in the transmission of monetary policy to firms beyond the usual bank lending channel; here the effect is based on existing rather than new bank lending.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Another Perspective On Rate Sensitivity

Yesterday we took a deep dive looking at how sensitive borrowing households are to a prospective rise in their owner occupied mortgage rates. A fundamental, though valid assumption we made was to look at the relative number of households impacted. This distribution led the analysis.

However, we can look at the data through a lens of relative mortgage value, not household count. This changes the perspective somewhat and today we explore this additional dimension.

We use the same movement in rate scenarios, from under 0.5% up, to more than 7% and show the relative portfolio distribution by value of outstanding loans and the tipping point where the household would fall into mortgage stress.

Using this lens, we immediately see that from a value perspective, a significant proportion of value resides in NSW (larger home prices, bigger loans). Within the NSW portfolio, more than 20% of the value would be impacted by a small incremental rise in mortgage rates. We also see some value impacted in VIC and WA, but to a lessor degree. In other words, the more highly leveraged state of households in NSW means a small rise in real mortgage rates will bite hard here. This despite all the focus in the press on WA and QLD!

Another interesting view is created by using our geographic zoning definitions, radiating from the central business district (CBD) in the middle, in concentric rings, out to the suburbs, and into the regions beyond. The areas where sensitivity is highest to small rate rises are the inner and outer suburbs, plus the urban fringe. This is because mortgages are quite large, relative to incomes. In other words, there is a geographic concentration risk which needs to be taken into account.

Our household segmentation models highlights that from a value perspective, young affluent and exclusive professionals have a dis-proportionally large share of value, and a significant proportion of this would be at risk from even a small rise.

Finally, again using our value lens, we can see that the largest segment which would be impacted by a 0.5% or less rate rise are soloists (see our earlier post for definitions) who got their mortgage via mortgage brokers. In comparison, delegators who get their loans direct from the bank, without an intermediary, are least exposed.

So, we conclude it is essential to look at the mortgage portfolio both from a value AND count perspective. But in fact, it is the value related lens which provides the best view of relative risk. This is how risk capital should be allocated.

Larger loans, via brokers are inherently more risky in a rising rate environment.

Are Interest Rates Stuck At Historic Lows?

In a speech at the Open University, The Bank of England’s Chief Economist, Andy Haldane explores why interest rates in advanced economies have got “stuck” and how policymakers should respond. Highly relevant given the recent BIS report which said there was too much reliance on risky low interest rate monetary policy.

Official interest rates in the major economies remain stuck at unprecedentedly low levels. Central banks have made vigorous attempts to dislodge them, including through special liquidity schemes, asset purchases and forward guidance. Yet interest rates remain stuck. This stickiness in interest rates has surprised both policymakers and financial markets. After they hit their floor, financial markets expected official rates in the US to unstick in 6 months, in the UK in 10 months, in Japan in 13 months and in the euro-area in 14 months. But they have remained stuck: in Japan for over 20 years and in the US, the UK and the euro-area for over 6 years. Indeed, the expected time to lift-off remains as many months away today as when rates first hit their floor: in the US 9 months, in the UK 10 months, in the euro-area 34 months, in Japan 72 months. In Australia, rates are as low as they have been in living memory, and some advocate further cuts still.

Real-Interest-RatesAndy explores two possible factors that may have contributed to current low levels of interest rates: “dread risk and recession risk. The first generates an elevated perception of risk, the second an asymmetric balance of risk. Both are relevant to explaining the path of interest rates, the likely fortunes of the economy and the optimal setting of monetary policy.”

The effects of dread risk have, Andy argues, “proved lasting and durable.” The fear of a further financial crisis and the risk-averse behaviours that follow help “explain the sluggishness of the recovery, and the adhesiveness of interest rates, since the crisis.” And, “if the past is any guide, these scars may heal only slowly.”

In a discussion of recession risk, Andy considers what we can expect for future growth on the basis of past trends. He finds that “the probability of an expansion lasting for longer than 10 years is, on past evidence, less than 10%.”

“If a recession were to strike in the period ahead, a relevant question for monetary policy is how much room for manoeuvre might be necessary to cushion its effects.” Comparing the magnitude of previous loosening cycles to the current path of the yield curve Andy finds, “recession probabilities exceed interest rate threshold probabilities by a factor of anywhere between 1.5 and 4.”

“Put differently, based on these estimates there is a considerably greater chance of interest rates needing to be cut to their floor to meet recessionary needs than of them gliding back to levels that could safely cushion a recession. Even after interest rates have lifted off from their floor, it is more likely than not they may return there over a ten-year horizon.”

What, therefore, are implications for monetary policy of continued dread and recession risk? Using the forecast from the May Inflation Report Andy has updated the interest rate trajectories he produced earlier this year. “As then, they suggest the optimal path for interest rates involves an immediate cut in rates for about a year, which pushes inflation back to target and closes the output gap. Thereafter, interest rates rise gradually in line with the market curve.”

However, the trajectories are illustrative and may “underplay the effects of risk” such as the dread risk and recession risk he has focused on here. He argues these risks have led to a cautious response to the recovery by both households and, to some extent, businesses which may “skew growth risks to the downside”. As a result, while April’s wage data was “encouraging news… one swallow does not a summer make.” “Wage growth is causing some fluttering, but not in this dovecote.”

This, in combination, with the downside risk to the MPC meeting its 2% inflation target two years hence, gives Andy “considerable sympathy” with the argument that interest rates should be “lower for longer” to manage the risks from raising rates too soon. A rate rise “however modest” would be a further example of bad news to already cautious consumers: “A policy of early lift-off could be self-defeating. It would risk generating the very recession today it was seeking to insure against tomorrow.”

This leads Andy to conclude: “my judgement on the appropriate monetary stance in the UK is relatively little altered from earlier in the year. The current level of interest rates remains, in my view, appropriate to assure the on-going recovery and to insure against potential downside risks to demand and inflation. Looking ahead, I have no bias on either the size or direction of future interest rate moves.”