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Few years ago, I was invited to lecture a selective group of people in a vendor forum at the beautiful Bogota Colombia. The topic of my presentation was dedicated to Asset and Liability Management and the relevance, particularly for a bank’s point of view to model and hedge the intrinsic interest rate risk on the balance sheet. By remembering the before mentioned beautiful and grateful experience, the main point is to emphasize the fact that interest rate risk management has represented an ancient and important topic for banks for a long while. Nonetheless, the failure of taking into account the asset and liability practice, more specifically, the interest rate risk management has been “THE DRIVER” associated with the SVB collapse.
As this article expresses in the head line, managing the risks on the balance sheet is a complex task. More than hard science, it also has to be with the art of measuring, modelling, and managing the risks associated with liquidity, capital, currency, and interest rate, among others. To capture and describe the complex art-science endeavor behind managing the above-mentioned risks would take more than a few pages. So, in the present dissertation, the focus is going to be interest rate risk, which in order to be properly hedged and managed requires as a minimum, the following items: 1. Characterization of the bank’s balance sheet The first and most important task when assessing interest rate risk is a proper characterization of the balance sheet. In this regard, knowing, for example, that the balance sheet is mainly comprised of fixed assets (which are vulnerable against the increase in interest rates, but defensive against the decrease in rates), is irrelevant if one does not have the complete picture on which liabilities are funding those assets. So, the first step for measuring interest rate risk is to have the big picture of assets and liabilities in the balance sheet of a bank. For example, in the case of SVB, the fact of the fixed rate asset side means nothing alone. The big problem arose when one took a look at the whole balance sheet, where fixed rate assets were mainly funded with floating rate liabilities, in the words of a famous Colombian writer “A chronicle of a death foretold.” In characterizing the balance sheet structure, there exists a well-known tricky part. It has to do with modelling the expected behavior of attrition, and/or optionality in some products, such as demand deposits with no contractual maturity or mortgages and a certain degree of prepayment intensity. By modelling the before mentioned characteristics, different conclusions from a simple view of the balance sheet may arise. For example, the expected duration of a fixed rate asset, which may or may not have a natural hedge with liabilities and, in the simple mirror have no contractual maturity, by modelling its behavior, its expected duration may match that of the before mentioned asset. Long story short, it is crucial to model and characterize the behavior of the balance sheet. “This might be used as a shield in both ways, to hedge against increases in interest rates in floating rate liabilities by paying the fixed rate in a swap and receiving the floating rate, used to honor the floating liabilities.” Finally, and only after a complete and robust characterization, it is possible to know which pieces of the Balance Sheet are at risk. For example x percent of fixed rate assets are unhedged with liabilities or derivatives against an increase in interest rates. Moreover, a complete assessment of the Balance Sheet may lead to conclusions on which pieces are structural and more complex to hedge or to change its underlying characteristics and the products that are much more dynamic, as tools to hedge or change the profile of the Balance Sheet. 2. Available and necessary tools to hedge interest rate risk There exists many tools to hedge against interest rate risk. Nonetheless, it is quite important to have a clear distinction between those structural and complex or dependent factors, but also those that are dynamic and represent a useful tool to change or hedge Balance Sheet characteristics or items. To discuss a few, in order to keep this dissertation as simple as possible, the asset side is quite relevant depending on the rates cycle. When assessing interest rate risk, the liability side is quite important as well. So, taking into account the structural tools, which are less dynamic, depend directly on the credit or deposit cycle in the economy, but also to the competitive landscape. Considering the latter, as said before, fixed rate assets are vulnerable against rate increases. Nonetheless, if fixed or stable portfolios of liabilities are well modeled and used to fund those assets, there exists a natural hedge and an important degree of interest rate risk mitigation. On the other side, floating rate assets are vulnerable against rate decreases. Nonetheless, if funded with variable liabilities, there also exists a natural hedge. However, in this last dissertation there might be controversy, because a bank would always prefer demand low-cost deposits vs. floating rate deposits. So, let’s say that the competitive landscape allows the bank to acquire an infinite amount of low cost fixed or stable demand deposits whereas, floating rate assets are being funded with fixed rate liabilities. The interest rate risk, which “EXISTS”, shall be hedged with other set of non-structural tools, which are the well-known hoomies, better recognized as financial derivatives. This might be used as a shield in both ways, to hedge against increases in interest rates in floating rate liabilities by paying the fixed rate in a swap and receiving the floating rate, used to honor the floating liabilities. This allows to effectively change the behavior of some floating liabilities into fixed rate liabilities, hedging at the end against increases in the rates. Taking the other side of the coin, the very same derivatives might be useful to hedge against decreases in rates on the floating rate asset side by effectively setting a floor (i.e. by paying the float of the loans in the swap and receiving the fix). 3. Timing for active management and hedging of risks Last but not least, especially when non-structural dynamic hedging tools are used, a clear, solid, and proactive timing is crucial. Let’s take the final example on the previous section and consider that after the recent volatility in markets, the decrease in rates, both in the US and Mexico is expected by the market and traders this year. If floating rate loans are funded with fixed rate liabilities, there exists an evident interest rate risk on the balance sheet. So, the financial derivatives might be used to effectively hedge the risk by exchanging the float rate of the loan portfolio for a fixed rate in a swap. At first sight, the trade seems simple. Nonetheless, two questions arise; the first is what should be the duration of the hedge and the latter, by intuition, should match the duration of the portfolio being hedged. But, perhaps, the most important question is the “WHEN”, because in order for the hedge to be efficient, the view on the rates has to be effective as well. So, if the hedge is performed on the 3-year tenor of the swap curve at 9 percent, in order for the hedge to be effective, the reference rate associated to that of the loan portfolio has to be less at some point in time vs that of the fixed leg of the swap. Long story short, timing is critical and represents most of the art in Asset and Liability management.