Insight
Navigating rising inflation and interest rates
Relevant to: Bank Treasurers, ALCO members, ALM Model Development units and Model Validation.
At a glance
- In response to the rising inflation, central banks have embarked on historic tightening of their monetary policies. This is a game-changing event for banks raising questions as to how balance sheet risks should be managed going forward.
- Having a strong Risk Management framework and analytical capabilities will afford banks opportunities in the market, allowing for a proactive response to the current economic environment.
- In this article we highlight some key areas that banks’ ALM and Treasury departments need to address to future-proof their modelling. In our view, these areas are critical in that they all present certain challenges that directly impact decisions on how to preserve net interest income and economic value.
Inflation and interest rates have been a major storyline throughout 2022 and we can expect them to continue making headlines in 2023. The recent bank collapses, seen in the United States and Switzerland, have added a new layer of complexity. This uncertainty presents a significant challenge for banks and their treasury and asset-liability management functions. This article presents key considerations for leaders of banks on how to best navigate a new interest rate regime marked by resurging inflation and monetary policy response.
Tighter monetary conditions are impacting bank customers
2022 was characterized by the surge in inflation, both in the Nordic countries and in the eurozone as a whole, where inflation reached its highest level over the past 40 years ([1]). Amid uncertainty, the European Central Bank (ECB) had significantly revised up their year-end 2022 inflation forecasts, which showed the projected average inflation reaching around 6% in 2023 ([2]). The latest ECB macroeconomic projections in 2023 see inflation averaging 5.3% in 2023, 2.9% in 2024 and 2.1% in 2025 ([3]). Inflation, excluding energy and food, continued to increase in February, and ECB expects it to average 4.6% in 2023, which is higher than foreseen in the ECB December projections. Notably, the baseline projections for inflation have been revised down because of a smaller contribution from energy prices than previously expected – see Figure 1.
Figure 1 Inflation in the eurozone, measured by the Harmonised Index of Consumer Prices (HICP). Source: Eurostat.
In response to surging inflation, central banking institutions across Europe, including the Nordics, have started an interest rate hiking cycle. Disregarding the Norwegian central bank, who, in relative terms, has engaged in a more gradual hiking cycle, central banks have reacted with sharp increases to their key policy rates (Figure 2). The European economy is experiencing the most aggressive rate hike cycle in recent memory: in a year, the ECB Deposit facility rate increased about 350 basis points by the beginning of 2022 (Table 1).
Figure 2 Central banks’ policy rates. Source: Danmarks Nationalbank website; ECB website; Riksbank website; Norges Bank website.
Given most recent monetary policy actions of central banks and the elevated level of uncertainty further brought by the recent turbulent banking events – such as the collapses of the Silicon Valley Bank and of Credit Suisse – it has become even more difficult to project future economic development.
This complex landscape reinforces the importance for banks to revisit their internal modelling approaches used to support the decision-making process of Treasury departments. Many internal models, including behavioral and pricing models, have been calibrated in a persistent low interest rate environment. This could require enhancement of some of the model assumptions whose materiality is likely to increase as interest rates are no longer stable as well as integrating additional explanatory variables.
As an example, the Bank for International Settlements (BIS) states that “banks should distinguish between the stable and the non-stable parts of each Non-Maturity Deposit (NMD) category using observed volume changes over the past 10 years” ([4]) – the overarching argument for this being that 10-year time series should generally be deemed adequate to reflect a full business cycle. However, the past business cycle might not necessarily be representative of the next because the economy is structurally different, combining high inflation and lower growth outlook.
The speed with which inflation has increased, and the subsequent monetary policy response in terms of increasing central bank deposit rates, is having real economic consequences felt by bank clients. This in turn may trigger swift changes in the behavior of different customers, in both their loan books and deposits, which banks need to capture and counterbalance timely. Failure to understand and hedge the liquidity behavior of sources of funding, such as customer deposits, has proven to be critical in the failures of both Silicon Valley Bank and Credit Suisse, who had faced rapid and significant outflows of depositor funds.
Table 1 ECB Deposit facility rate levels (1999-present). The current pace of rate hikes is unusual in recent history.
Behavior of households around the Nordics is markedly impacted by high inflation. Inflation is hurting real income in the short term, coupled by falling house prices. This may create a pause for consideration in many households, which may be reflected by deteriorating consumer confidence indicators across the Nordics – as shown in Figure 3.
While global economic activity remained subdued at the turn of year, near-term prospects have brightened, as highlighted in [3].
According to the International Monetary Fund (IMF) and the 2022 year-end ECB projections, growth was forecasted to be subdued in 2023 in the eurozone and across the Nordic countries, with the only exception of the Norwegian economy (cf. [3] and [5]). The prospect of a slowdown in the global economic activity, with potential “relatively short-lived and shallow” recession, had warned against increased unemployment and defaults among corporates. This sentiment was shared by the Financial Stability Review, November 2022 (cf. [7]), highlighting increasing vulnerability for corporates and households despite the policy support measures introduced in response to “the pandemic-induced disruption of economic activity “.
Latest ECB figures for growth in 2023 have been projected to come up to an average of 1.0% because of both the decline in energy prices and the economy’s greater resilience to the challenging international environment. ECB expects growth to pick up further in 2024 and 2025, however, at a weaker pace than predicted in December, owing to the tightening of monetary policy.
Figure 3 Consumer Confidence across the Nordics. Even though the baseline for consumer confidence is different, it is evident that there has been a general decrease in confidence over the last couple of years. Source: Statistics Denmark - statbank.dk; NIER (National Institute of Economic Research), Sweden; Statistics Finland; KANTAR TNS.
What should banks do?
Prudent Asset-Liability Management (ALM) and risk managers should in turn start contemplating how plausible macro-economic scenarios could be transmitted to banks’ balance sheet decisioning. By reassessing the macroeconomic assumptions into their ALM models, especially for stress testing, banks’ Asset Liability Management Committees (ALCOs) and executive management can make more informed decisions and better manage their risks in the current dynamic and uncertain environment. This can also help them to gauge the impact of rising interest rate risk across business lines under different circumstances, meet regulatory expectations ([4], [6]), and identify potential vulnerabilities under certain market conditions.
Another concern relates to behavioral models underlying both the strategic and tactical decision-making pertaining to ALM and hedging programs. Harboring back to our previous point, basing models on recent historical data will almost certainly create issues surrounding data representativeness. Modelling assumptions made in the past could introduce biases resulting in breaches of out-of-sample back testing, potentially even leading to erroneous decision-making. On the other hand, ALM functions who are on top of the impact of their modelling assumptions and are proactively assessing the appropriateness of their models should gain more insight into attractive risk/reward of the bank’s positioning. For this reason, we strongly encourage clients to reassess their behavioral models and place greater scrutiny on the underlying assumptions. Overly aggressive behavioral modelling that relies solely on historical data can be wildly off the mark in the current environment of increasing interest rates, which follows many years of flat and low interest rates. It is crucial for banks to have a flexible modelling framework that allows for the input of various assumptions and scenarios, so that they can more accurately gauge the potential outcomes under different circumstances. This approach can help banks gain a more comprehensive view of their risks and identify potential vulnerabilities before they become problematic, ultimately leading to better decision-making and risk management. Moreover, to ensure model transparency and comprehensibility, banks should strike a balance between complexity and ease of use. Excessively complex approaches can lead to opacity, which can obscure the underlying risks and potential outcomes.
Another fundamental question to reflect upon is whether banks have established strong governance around their models and are actively monitoring their performance over time. This is essential to ensure that they can identify any vulnerabilities or weaknesses in their models and perform mitigating actions in response to changing environments. Strong model governance also helps to ensure that the models are transparent, reliable, and consistent with the bank’s overall risk management strategy.
With the advanced analytics and data available to banks today, there is enormous potential for implementing a monitoring framework that includes early warning indicators directed towards specific vulnerabilities within the bank.
Some critical areas from a modelling point of view that should be addressed to future-proof banks’ modelling landscape are:
- Mortgage- and loan prepayment behaviors. Interest rate movement is typically a big driver of loan prepayments in the Nordics. Assessing customer incentives to refinance their mortgage and bank loans is crucial for the bank’s ALM profile and thus hedging decisions. Some banks might even want to entertain the possibility of proactively encouraging customers towards new loans through campaigns, whereby gaining certainty in their ALM profile as an alternative to predicting the speed at which loans will be prepaid.
- Stable funding from non-maturity deposits. Banks tend to rely on historical data to model NMDs. Due to low yielding investment environment over the past 10-15 years, there has been a propensity by depositors to accumulate excess liquidity on NMDs. Therefore, funds covering transactional or operational needs have become indifferentiable from excess liquidity/cash, and, as such, would be less stable given that excess liquidity is “masquerading” as stable funding. The fundamental question from a modelling point of view thus becomes: How can banks distinguish between stable and non-stable funding in the short and medium terms in this new interest rate environment?
- Non-maturing deposit migration incentive increases. Over the years, customers have earned almost no interest in their savings accounts. Therefore, the incentive for customers to migrate their money from current accounts to savings accounts has been limited. In fact, many savings products have been retired from the banks’ product offerings. In conjunction to the ECB raising the deposit rates, we expect saving products to have an increasing share and importance in the market, the underlying rationale being that customers are incentivized to migrate excess liquidity to higher yielding account types or fixed-income securities (e.g., from current accounts to savings accounts, term deposits or even fixed-income securities). Not only does this have a real impact on cost of funding, but also from a risk modelling perspective, it is important to assess this migration effect, as required by regulators ([6], article 112(c)).
- Deposit Pricing Strategy. As interest rates rise, pressure will increase on banks’ pricing committees to evaluate deposit pricing framework and strategy going forward. From a risk management perspective, banks are challenged with the adjustment speed of deposit rates and how much to pass through to customers. It is fair to assume that if the gap between market rates and banks’ administrative rates becomes too wide, there will be a run-off of the deposit base, which in turn will lead to an increased liquidity risk. Additionally, banks that rely heavily on deposits as their main source of funding might start to face excessive profitability in their deposit base (from an internal pricing point of view) as market rates have increased faster than administrative rates. It is important that banks address this development as it could potentially create misleading incentives towards business activities.
How future-proofing behavioral models impacts decision-making
While the above-mentioned areas are important now, it should also be mentioned that they should/could not be assessed individually. An example of this is the re-introduction of savings products and how to model migrations between various deposit types (i.e., the latter three bullet points mentioned above). One thing to hypothesize is that an attractive deposit rate on term deposits, enticing customers to migrate funds from their current accounts, could also start revealing a prevalence of yield-chasing segments in a bank’s customer base. Furthermore, the stability of this funding source might also be predicated on the repricing speed. This means that yield-chasing customers withdraw funds from the bank entirely and place them with competitors. On the other hand, aggressive repricing speeds and attractive rate setting could potentially also drive-up cost of funding and impact the ALM profile, hedging decisions (trading costs) and creating wrong incentives. These are some of the intricacies at play that we envision banks will need to balance going forward. Furthermore, banks also need to consider their business models and strategic positioning in the market. In other words, an informed funding strategy is imperative for navigating the turbulent macro-economic and geo-political landscapes to preserve net interest income margins. Naturally, in conjunction to the liability side, banks should always have considerations pertaining to assets. It is important that banks be mindful of their loan portfolio growth expectations. A shrinking loan portfolio resulting from a recessionary environment might be offset by a reduction in stable funding. The more general point to be made here is asking whether banks and ALCO have adequate tools and models in place that would allow them to anticipate and project correctly into the future.
Briefly, successfully managing the geo-political and macroeconomic contexts is thus predicated on understanding a confluence of factors which can be ambiguous territory. However, it is also herein banks can uncover opportunities, by being proactive rather than just reacting to what is occurring.
Interested in discussing further?
Our network of Treasury & ALM specialists provides expert guidance and support to clients throughout the Nordics and Europe as a whole. At Deloitte, we have a proven track record of success in helping Nordic and European banks build robust ALM and behavioral modelling frameworks and navigate the complex regulatory environment. With our extensive experience and deep understanding of the financial landscape, we are a trusted partner of choice for those seeking to stay ahead of the curve and achieve success in today’s dynamic banking environment, particularly in the face of rising inflation and interest rates.
References
[1] Danmarks Nationalbank (2023). Inflation – why did it rise and what are the drivers ahead?
[2] Economic Bulletin Issue 8, 2022
[3] Economic Bulletin Issue 2, 2023
[4] BIS (2016). Standards on Interest Rate Risk in the Banking Book.
[5] International Monetary Fund (2022). World economic outlook, October 2022.
[7] ECB (2022). Financial Stability Review, November 2022.
