Some large European banks may be unprepared to deal with the effect of interest rate rises, the European Central Bank has concluded after a stress test, owing to miscalculations of derivative exposures, depositor loyalty or the estimated value of their own assets in changing market conditions.
The regulator might go as far as demanding additional reserve capital from the banks it deemed the least ready for possible hikes in base rates, Korbinian Ibel, the ECB's director general of microprudential supervision, told journalists Oct. 9.
He said: "What we do is identify the risks and go into in-depth discussions with the banks to check, are they aware of the risks and is it proactively and consciously managed or do they basically tumble into that kind of risk? If you find the bank tumbling into it and realizing the risks only in our discussions, then of course, yes, it can be that we also demand additional capital."
The stress test analyzed the possible consequences of six different types of sudden interest rate changes in the currencies to which the 111 banks in the sample are exposed. In the most extreme scenario, the test assumed an increase of 200 basis points in the base central bank rate.
The ECB put the banks into four categories, according to their preparedness for increases in interest rates. Without revealing names, the Frankfurt-based institution said the 12 banks in the first category were found to be neutral to rate shocks, while the 17 lenders in the fourth category were the most sensitive. The second and third categories, which sit between neutral and most sensitive, contained 48 and 34 banks, respectively.
"The grade-four banks are banks who do not, let's say, manage their [interest rate risk in the banking book] positions in different ways. Here what we need to do is have intense discussions and check with the banks if they are aware of their model risk, if they are aware of their positioning risk, if they are aware of their derivatives risk and if they really want to take it as part of their strategy, and if they have enough capital to cover it if things go wrong," Ibel said.
Eye on derivatives
The ECB will also scrutinize more carefully those banks that use the derivatives market to speculate rather than protect their portfolios from possible downturns, said Ibel.
If the ECB were to increase interest rates by 200 basis points in one go, the test found, the 55% of banks sampled that use derivatives to shorten the duration of their banking book would benefit by an average of 14% of their common equity Tier 1 capital. The 45% that use derivatives to increase duration would lose an average of 8% of their CET1 capital.
Additionally, some lenders might be overly optimistic in relying on the loyalty of a "core" group of current account holders, Ibel added, warning that online rivals known as fintechs are increasingly pushing the customers of traditional banks to switch brands.
In the extreme scenario, aggregate CET1 dropped by 28.1% on average among the 87 banks that use nonmaturing deposits (such as current accounts) to model customer behavior, owing to the increased cost of holding on to deposits in a more competitive market, the data published by the ECB showed.
"Only 7% out of €4.3 trillion of modeled deposits take into account the possibility that deposit stability may decrease with an increase in interest rates," the ECB said in its report.
Meanwhile, the estimated values of bank holdings such as bonds could tumble in a higher-rate economy, leading in the worst case to a drop in CET1 of as much as 2.7%. However, net interest income would rise for 76% of the banks sampled, the ECB said, with 57% seeing a dip in so-called economic value of equity and 19% seeing a rise. Some 4% of banks would see net interest income fall and economic value of equity rise, while 20% would see both figures decline.
The 19% of banks that would see both figures rise are characterized by high proportions of floating-rate loans in their asset mix, while the 20% where both would drop comprises primarily banks that have long asset durations, for example through holdings of fixed-rate mortgages.
Another consequence of the stress test is that the ECB will start to have higher expectations of banks that lag behind when it comes to modeling interest rate risk, Ibel said. "Now we will say, we know of X, Y, Z, banks who do it. They are in the same environment, so there's no reason why you shouldn't. You are a big bank so we expect the same level of sophistication."
The ECB is expected to lay out a path for tapering its so-called quantitative easing program later in October. It has said rate rises would come only "well past the horizon" of its asset purchases, which are currently due to run through at least the end of December.
Elsewhere, the U.S. Federal Reserve has raised rates three times since December 2016, and Bank of England policymakers have made increasingly strong suggestions that they are considering boosting rates in November.
The ECB's deposit rate is set at negative 0.4%, meaning that banks have to pay the central bank to store funds with it.
Click here to access the SNL worldwide bank ranking template and view key balance sheet figures, performance and capital adequacy ratios for individual European banks.