Regulation > Does liquidity risk overshadow market risk?

Published: 23rd January 2010 by William Webster

In a world where regulators are focusing on liquidity and capital it's easy to overlook market risk. In many firms this means interest rate exposure. In the UK with Bank Rate at an all time low it's tempting to think that hedging fixed rate assets is just a waste of money. After all why pay 3.25% on a 5 year swap when 3 month Libor is only 51 basis points?  Surely matching the interest basis on assets and liabilities ends up costing you 274 bps doesn't it? 

Well, yes it does. Many firms play the yield curve for this very reason. It's been encouraged by the Bank of England keeping Bank Rate so low to help recapitalise commercial banks. But you don’t want to run this carry trade without asking a few questions about the risks too.

Can rates remain this low?

Futures markets currently indicate forward Libor rates between 1.50% and 1.75% by the year end. But will this come to pass?

Maybe. Forward rates are an observable market price but they aren’t cast in stone. That's why just being reliant on forward rates can lead to a false sense of security. The actual rates in a years time could be very different. So what else can you do?

You could sound out market opinion. That's quite popular and if my straw poll is anything to go by there appears to be two divergent views.

First, rates will remain low as central banks continue to support the financial system. Second, rates will increase as central banks act to dampen inflationary pressures. It's easy to alter your opinion depending on who you've just listened to. Could history help us instead?

Since 1975 Bank Rate averaged over 8% and in the 70s, 80s and 90s reached peaks well over 10%. Forward Libor rates have been even higher and during certain periods exceeded 30%. Furthermore between 2008 and 2009 Bank Rate fell 4.5% in a 10 month period. Importantly this was at a time when rates were already low. Does this tell us that rates are destined to increase? Possibly but there's no certainty, think of Japan. Should we stop trying to guess and ask .......

Could you get caught out?

Banks limit their interest rate risk by using a number of measures. They include gaps, basis point value, value at risk and earnings at risk. Often risk limits are applied to these measures in accordance with the firm's risk appetite (that's the theory).

What would happen if Bank Rate (or market rates) increased by 4.5% in a 10 month period or by even more? Would the risk measures you use show you the impact?

They probably would. But there is a big difference between seeing the potential for risk and actually dealing with it. Part of this difficulty occurs because the outside chance of a large and rapid increase in rates is often treated as a remote event that can be dealt with when the time comes, if it ever does.

Our limits will protect us won't they?

That depends on how good your limit structure is and how well it is managed. Consider the following:

1. Is there as much luck as judgment? Interest rate risk can lead to losses either through the position you run and/or by the magnitude of the change in rates. Are your interest limits just based on an amount of risk? For example a maximum gap or basis point value. What happens if there is a large adverse change in rates, does this lead to a substantial mark-to-market loss or a diminution in net interest income? Is there any limit in place that forces senior managers to "close out" the risk after a certain level of loss has been incurred? Or having missed the opportunity to hedge can they hold on and hope it will all come good in the end?
2. When did you review your limits? In times of increased risk the same limit can lead to greater losses. This is particularly the case in illiquid or discontinuous markets. A gap, delta or basis point value limit before the crisis was presumably put in place because it was appropriate at that time. We need to ask if that limit is still suitable.
3. Are your limits stress tested? If large changes in rates do damage, stress testing should show you how bad it can be. Do you know what happens to the value of your balance sheet or net interest margin?

Let's put this into perspective. Consider the impact stress testing has had on liquidity. Translate this approach to your market risk and you can't help but think that many firms need to reconsider their market risk limits.

It is surprising that the regulator hasn’t taken this view too. Surely it's only a matter of time. Be prepared to justify what you do or running the carry trade may cost you more than 274bp.

Summary

Interest rates are notoriously difficult to predict but historically they are very low. Banks tend to have long asset positions so rate rises will hurt. This will be felt through mark-to-market losses or reductions in net interest margins. Swift rate changes and changes of great magnitude can catch you out. The temptation is to continue to back a losing horse. Limits don’t always protect against loss particularly when markets lose liquidity. In the current environment you need to consider how market risk has increased. Stress testing interest rate risk could reveal that your limits are too high. That's a conclusion the regulator may take too.

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