Interest rate risk could be seed of next crisis – economists

Fresh from fixing the last crisis, regulators may have begun to sow the seeds of the next one by encouraging financial firms to take on more interest rate risk, according to Srichander Ramaswamy and Philip Turner.

Writing in the latest edition of Central Banking journal, the authors – both formerly economists with the Bank for International Settlements – say the well-publicised fall in long-run interest rates across advanced economies appears largely down to drop in the real interest rate risk premium, not expectations of short rates. This implies firms are betting on rates staying lower for longer.

At the same time, post-crisis regulations have pushed financial firms to take on interest rate risk in the place of credit risk, they warn. Basel III encourages banks to hold large amounts of sovereign debt, and Solvency II likewise pushes insurers towards long-term bonds.

The combination means that firms are highly exposed to interest rate risk, and if their confidence in rates remaining low for a long time is misplaced, they could find themselves under serious stress.

Furthermore, Ramaswamy and Turner are sceptical that macro-prudential tools are currently up to the task of protecting the financial system – although they say some are more effective than others.

“How well do current macro-prudential policies deal with these new risks? The short answer is: ‘well for mortgage lending; work-in-progress for bank liquidity; and poorly for non-banks’,” they say.

The authors note with approval that limits on debt-to-income ratios for housing loans protect both households and banks from sharp increases in interest rates. They also say liquidity rules have curbed the worst excesses of maturity transformation by banks, but argue in favour of a mechanism for adjusting liquidity rules over the cycle, as is possible with capital requirements.

More problematic are macro-prudential tools for non-banks, to the extent they exist at all. “This is very serious when macro-prudential policies aimed at banks divert risks to non-banks,” they warn. Furthermore, issues of market functioning deserve further attention, the authors say. How asset managers’ reactions to shocks could destabilise markets “remains an unsolved question”.

As such, Ramaswamy and Turner urge policymakers to sharpen their focus on rate risks. Better data should help, and they note that the Basel Committee on Banking Supervision’s new rules on disclosure will generate data that supervisors should make use of. Supervisors should also monitor whether their “Pillar 2” – ie, firm-specific – rules are working, and make changes where necessary.

“Policy needs to address not only maturity mismatches and excessive leverage in non-banks, but also the threat that bond markets become illiquid in a crisis,” they say. “Because policies have so distorted the long-term rate, interest rate risk in financial institutions matters more than almost ever before.”