Why European banks can better withstand interest rate risks than their US peers

A succession of central bank interest rate rises — and the US banking failures that followed — brought the management of interest rate risk in the banking book (IRRBB) under increased scrutiny. 

Now a new report, published by rating agency Moody’s, lifts the lid on why US regional banks were the most affected by rapidly rising interest rates earlier in the year, while European banks emerged largely unscathed. 

According to the report, loose regulation and light supervision has contributed to smaller US banks becoming increasingly exposed to interest rate risk, while tighter regulation and active supervision helps — and in fact compels — European banks to take steps to manage it. 

IRRBB arises from mismatches in the repricing of interest-bearing assets such as loans and securities, and liabilities like deposits, in line with interest-rate movements. Managing IRRBB means predicting, identifying and then taking action to reduce these mismatches. But if a bank cannot adequately manage its IRRBB, sharp movements in interest rates can cause its capital levels and earnings to drop — or even be wiped out. 

However, Moody’s report highlights how regulation strongly influences banks’ management of interest rate risk, and the vastly different regulatory environments of Europe and the US, which mean equally divergent management of IRRBB. 

“In Europe, supervisors can require corrective measures or impose additional capital requirements. European banks are also subject to a supervisory outlier test [SOT] that benchmarks a bank’s exposure to IRRBB against their peers. In practice, this means most banks have low appetite for interest rate risk,” says Simon Ainsworth, associate managing director at Moody’s Investors Service, and one of the authors of the report. 

European banks are subject to regulatory guidelines issued by the European Banking Authority (EBA). Last October, the EBA published a tougher set of regulatory requirements for IRRBB, which are applicable to all banks in the EU. 

The updated 2022 guidelines include new criteria for regulators to identify non-satisfactory internal models for IRRBB management and closer scrutiny of the five-year repricing maturity cap of non-maturity deposits. 

US supervisors don’t follow Basel guidance on IRRBB

Mr Ainsworth says US regulation and supervision have been more limited, contributing to weaker IRRBB management at some US banks. 

In the US, regulations essentially call for supervisors to judge whether a bank’s IRRBB management conforms with its own internal IRRBB policy. Supervisors do not assess risk against a bank’s peers. 

This is in direct contrast to advice given by the Basel Committee on Banking Supervision. In fact, one of the key Basel principles is for an SOT to identify banks with excessive IRRBB exposures in the context of its peers. 

For Tim Breitenstein, director of financial services at KPMG Deutschland, the SOT is vital to European banks’ ability to withstand the recent run of rate rises. “One tool that really worked in Europe is the supervisory outlier test. Each and every bank measures interest rate risk according to prescribed scenarios. It is then reported, every quarter, to supervisors. Supervisors can quickly see whether risks are emergent. Consistent application of these outlier tests was missing in the US for mid-size and smaller banks.” 

But pointing out supervisory gaps between the EU and the US is nothing new. In 2020, the International Monetary Fund (IMF) offered a number of recommendations to enhance the rigour of the US regulation and supervision of IRRBB. 

“The IMF called this out in 2020,” says David Aikman, director of the Qatar Centre for Global Banking and Finance at King’s College. “It said that IRRBB was an area [in which] the US authorities weren’t taking a sufficiently quantitative approach. And because the US has very long-term mortgages, this is a big deal.” 

It is an even bigger deal for the smaller US banks, which have smaller capital requirements. The Moody’s report points to another paper: the 2023 Spring interest rate risk report from the Office of the Comptroller of the Currency. The report looked at approximately 900 banks and found that the median for both small and mid-size supervised banks (with assets of $115bn or less) has, in a shock scenario, a 20% economic value of equity (EVE) risk of Tier 1 capital. The regulatory limit for EU and UK banks is 15%.

The worst US banks had an EVE risk as high as 68%. EVE is a long-term indicator of net cash flow and helps banks determine the impact of changes in interest rates on their equity. 

More US regional banking failures could be on the cards

“Given the current level of unrealised losses, I expect that there’ll be more US failures,” says Giorgio Bou-Daher, author of ‘Banking in the Age of the Platform Economy’ and a lecturer in banking, fintech and finance at EM Normandie Business School. “Likely, the failures will be smaller regional banks that aren’t household names,” he says. He also predicts some consolidation: “The small banks, if anything, will become fodder for the large ones.” 

While the outlook for European banks is potentially rosier than for some in the US, European banks are not equally exposed within the region. 

“It mostly comes down to risk appetite, which is reflected in their business model and the different nature of the assets and liabilities a bank has on its balance sheet,” says Mr Ainsworth at Moody’s. The Moody’s report reveals that the characteristics of a bank’s housing loans are a key driver. 

French banks’ exposure to the national housing market is highlighted as a particular vulnerability, since this form of lending, unlike in the UK and Spain, for example, is typically over longer periods. In France, mortgage terms can be from five to 25 years, and fixed-rate mortgages permit borrowers to fix the rate for the lifetime of the loan. 

While Mr Bou-Daher does not see catastrophe ahead in terms of European banks’ management of IRRBB, for him the picture is somewhat mixed. “On the face of it, Europe is okay; there are no expected collapses. However, when you delve deeper, several nuances emerge. When interest rates go up, it’s especially risky if you’ve got a lot of fixed-rate, long-term lending — as we can see with several French banks, especially the more local ones who derive most of their revenues from France.”

So what tools do banks have to mitigate IRRBB? Essentially, it boils down to reducing asset and liability mismatches by using interest-rate derivatives and, in the case of non-linear risks, altering the mix of assets and liabilities.

“Interest rate risks stemming from structural gaps are relatively linear, which means that downward and upward interest rate scenarios of the same magnitude would result in broadly similar value impact [but in opposite directions]. This type of risk is therefore generally hedged with interest rate swaps,” says Mr Ainsworth. 

More capital needed to mitigate interest rate risk

However, some assets and liabilities, namely fixed-rate mortgages and customer deposits, behave differently, depending on the magnitude of the change in interest rates and on whether rates rise or fall, creating non-linear interest rate risk, such as the existence of options to redeem a mortgage early, or to withdraw deposits. 

“Because of these non-linear features, these risks cannot be fully hedged with swaps. It is therefore important that banks and regulators understand the degree to which the business model exposes them to risk, to what extent linear risks are hedged and the potential risk and impact of non-linear risks crystallising, as well as other structural mitigants that can be employed [such as redemption penalties for mortgages], or a change to the mix or types of assets and liabilities on balance sheet,” he says. 

Mr Aikman, who was previously an economist at the Bank of England, believes tougher capital requirements will ultimately serve to best mitigate risk. He urges the consideration of moving the capital charge for IRRBB from the Basel regulation’s pillar two, where national supervisors have vast discretion, to pillar one, which covers the main capital requirements and has clear global standards. 

“We had guidance for what pillar two should look like from the Basel Committee and it just wasn’t implemented in many countries. So you can’t rely on that to ensure we get coverage of these rules across countries. It has to be a pillar one charge,” he asserts. 

But the real key, says Mr Aikman, is more capital. It is an unpopular measure but one, he believes, that is achievable. “I fundamentally reject the idea that banks can’t increase their capital levels.” He concedes it would take years, but the rewards are clear. “Increased capital means it doesn’t matter so much about spotting little pockets of risk here or there, or playing catch-up. You get a more resilient system, full stop.”