The COVID19 crisis combined with low interest rate environment for a sustained long period has created the perfect storm which, left unmanaged, could have significant impacts on banks’ earnings and capital. Interest Rate Risk in the Banking Book (IRRBB) is an area that is becoming increasingly important for banks to proactively monitor and manage in the current environment. In this article, we discuss the key considerations for Australian banks during and post the crisis for prudent IRRBB management ultimately ensuring banks remain profitable and stable institutions while playing a key role in the economic recovery.
During a crisis like the one we are in; stability of the banking industry will be a crucial factor for a sustained recovery of the overall economy. Banks will play a major role by lending to businesses and households at lower interest rates to stimulate economic activity and also by partnering with the government in implementing some of its relief schemes. However, at the same time it is very likely that the bad debts will increase to historical levels in the coming months and years. Therefore, issuing credit to stimulate the economy will become a delicate balancing act for banks.
Australian banks are relatively in a strong position compared to other banks in advanced economies globally going into this crisis.
This is due to number of factors such as:
Increase in deposits in 2019 and relatively lower accumulation of assets leading to higher LCR. Also, reduced reliance on replacing maturing bonds for funding in the current environment
Historically low bad debt, most likely correlated to continued growth, wealth creation, immigration, mining, tourism & education boom
ROE of Australian banks has been higher when compared to other international banks over the past few years. It was also significantly above their cost of equity (estimated to be around 9–10 per cent), despite the gap between the two narrowing as ROE drifted down over the past five years
The narrowing of the NIM due to low interest rate environment has had less of an effect on Australian banks’ profitability compared to other advanced economies. This is because funding costs in Australia have been relatively cheaper than other economies. Funding costs on retail deposits are nearing zero. At the same time, wholesale funding has tended to go down below the cash rate. Wholesale funding in Australia is largely based on the BBSW rates. BBSW has been trending below the cash rate (cash rate represented in grey in Graph 2) recently.
However, COVID19 has undoubtedly made it more challenging than ever to assess risks in the financial services sector. The macro economic conditions evolving out of the crisis have never presented themselves in the past and as a result modelling risk based on historical data and assumptions is generating limited confidence amongst risk management professionals and in the industry as a whole. The word “unprecedented” has been used time and again in the past few months and banks have had their fair share of this reflection in almost every facet of risk management as well. For example, credit risk provisioning (with limited relevance of historical PDs) OR operational risk assessment (due to extended remote working environment) has never been more challenging.