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Capital Question

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Published: 6th October 2020 by William Webster

Capital isn't gold bars

Capital adequacy is right up there in terms of importance and quite rightly too as it’s a measure of the ability to absorb losses. What’s a lot harder to nail down is the way we manage the interest rate risk on capital and that is what this article addresses.

The capital or reserves arise from the net value of the firm’s assets and liabilities. In theory it’s what would be available for distribution if we liquidated the business. 

In the normal course of things capital isn’t identifiable as gold bars sitting in the safe or as an investment in Gilts it’s just used in what we do. But on paper we can isolate it and when we do, we appear to have two businesses, not one.

The first is borrowing and lending, the second is asset management - that’s about getting a return on the owner’s wealth. The two are normally linked together by calculating the return on capital.

By way of example, a balance sheet of £100m, of which £10m is capital, with a net profit of £1m has a 10% return on capital. Very good in the current environment but should this return fall beneath the rate on safe investments you are subtracting from the owner’s wealth not adding to it. 

Capital therefore belongs to the shareholders or members and although not specifically identifiable it is deployed in the business. It should provide a return and that return should exceed what is obtainable from passive investment - otherwise why not close the business and hand back the money?

Interest rate risk

In managing our first activity, borrowing and lending, we limit the mismatch between fixed and variable interest rates in the balance sheet. Without appropriate hedging, changes in interest rates would affect valuations and earnings. 

One of the main tools we use to monitor this risk is an interest rate gap report. In this, both assets and liabilities are placed into time buckets dependent on when the interest rate is repriced. So, a three-month deposit goes into the three-month bucket, a five-year gilt into the five-year bucket and a five-year variable rate mortgage in the three-month bucket, (because it’s capable of being quickly repriced) and so forth.

The gap report shows how much risk we take when the yield curve moves and from here, we appreciate the gains and losses we may face if and when interest rates change. When the risk is considered too large interest rate swaps are used to manage things.

If you take a close look at the gap you will see the capital position and it’s my bet that it’s treated differently and doesn’t have a specific time bucket allocated to it. In effect it’s treated as an overnight risk. Is this the right thing to do? Let’s consider the implications. 

The capital could be placed in one of three time buckets:

  • Overnight
  • 30 years, (representing a long way into the future)
  • Anywhere in between

The overnight position would lead to no apparent interest rate risk and wouldn’t need hedging. The 30-year position would lead to a much greater risk and would need to be hedged. Since the capital is a liability the hedge would require a receive fixed swap of a similar maturity. 

Does this mean that overnight is the correct place? 

As I discussed earlier the balance sheet can be thought of as two businesses and by excluding the reserves, the day-to-day interest rate risk is all about that arising from borrowing and lending not that from the capital itself. This has implications for earnings.

By putting the capital in the one-day bucket it earns the overnight interest rate and by putting it out longer you get the 30-year yield. 

The decision on what to do must therefore depend on:

  • The interest rate risk appetite on the capital itself, (how far do you want to invest it).
  • Your expertise and judgement on the level of interest rates and the shape of the yield curve.
  • How your balance sheet responds to higher and lower interest rates.

It should also be noted that the default position of placing capital in an overnight bucket may appear risk free but is nevertheless at one end of the spectrum.

At the time of writing receiving at 0.54% on a 30-year GBP swap doesn’t feel a great place to be in hedging the interest rate risk on capital (but then I remember rates in double digits, and this must affect my opinion).

Consideration also needs to be made to the effect of any further falls in rates and their potential to compress margins further.

Balanced approach

It may therefore be worth evaluating a more balanced approach, for example, spreading equal quantities of capital across some of the shorter dated time buckets, say 20%, 1-5 years. 

If interest rates increase you are in effect investing capital at rates beneath the market rate and if rates fall further, you are investing capital above the market rate.  This could be beneficial if negative rates lead to further margin compression. With both scenarios the investment horizon is sufficiently short to see a fifth of it rolling off each year.

What I find surprising, is that, presumably most firms see their business as long term but invest their capital as if it’s going to disappear tomorrow. I suspect this is largely due to the fact that this is a difficult topic to “nail-down” and by doing nothing you appear not to lose money, well not unless rates go down further. Therefore, it’s something that should be on the Board agenda.

Summary

  • Capital is the net value of assets and liabilities - the owner’s funds;
  • It’s normally invisible and is used in the business;
  • For banks and building societies when you separate the capital you have two businesses – borrowing/lending and capital investment;
  • We limit the interest rate risk on our balance sheet;
  • Where is the capital in the interest rate gap?
  • It could be overnight, 30 years or in between;
  • Where should it be?
  • What are the implications in terms of hedging and earnings?
  • How does this fit in with your earnings profile and risk appetite?
  • It’s something the Board should have an opinion on.

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