Summary
A sharp rate cycle was initiated in 2021 by central banks in a number of major economies which continued throughout 2022. In the case of the UK, this is the fastest that rates have risen in over three decades. As policy rates have fed through to deposits, banks’ balance sheets have been shifting.
The effects of rising rates will cause winners as well as losers. As long as assets can be re-margined faster than liabilities, upward rate cycles are generally good for banks’ net interest margin. However, internal procedures are being tested severely and more regulatory changes are likely; especially in light of the bank failures seen in Europe and the US in March this year.
It now looks like the peak of the cycle may have been reached. Whether rates might start to trend downwards is as yet unclear, but banks need to brace for the possibility that the volatility isn’t over.
The Macroeconomic Background
Rapidly climbing inflation leads to central bank intervention
The last few years for the UK economy, as with other major western economies, have been characterised by supply-side shocks. The post-pandemic reopening saw inflation in the UK start to climb and this was further exacerbated by price rises triggered by the Russian invasion of Ukraine.
Like many other central banks, the Bank of England targets an inflation level which they attempt to maintain through monetary policy; in the UK the target is set at 2%. As can be seen in the graph below, rapid price increases saw inflation climb above target at the start of 2021 and it has remained there since.
The central bank response was to wield the central bank base rate, a major tool in its monetary policy framework,
and interest rates started to climb.
Policy rates rise after a 15-year hiatus
Policy rates in the UK, US and Eurozone have not reached above 3% for over 15 years. This changed when policymakers in all three jurisdictions started raising rates to tackle the inflation described above; UK base rate reached 3.5% in December 2022.
However, it should be emphasized that rate levels are certainly notunprecedented, or even high in historical terms.
As can be seen by the graph in Figure 2, the low rate environment of the last decade cannot be characterised as
‘normal’. Generally then, banks shouldn’t be finding the current rate levels unexpected.
In fact it tends to be the case that when policy rates move upward, a bank can start pushing the rates on interest bearing assets (such as commercial loans and mortgages) up at a faster rate than it increases interest bearing liabilities (such as deposits) causing total net interest income (NII) to rise. This is generally the case for most banks’ balance sheets. There are always exceptions however alongside other significant balance sheet impacts caused by rate changes; such as the valuation of assets and liabilities shifting, which affects the bank’s economic value depending on the positioning of natural and derivative hedges.
The magnitude, if not the level, of rate rises has been significant. Given that the current level of rates is not unprecedented, why then have markets proven so volatile? The reason lies in the magnitude and speed of rate rises; this did take banks by surprise. The Bank of England increased base rate by 250 basis points in the 6 months to December 2022; similar increases were executed by the US Fed and the ECB.
Two examples illustrate how significant this is. The first can be seen in Figure 3, which illustrates the interest rate shocks mandated by the Basel Committee on Banking Supervision in their standards for Interest Rate Risk in the Banking Book1 . These standards, issued in April 2016, have been adopted by regulators globally and represent rate shocks against which all banks are mandated to display interest rate risk results for regulatory purposes.
As can be seen below, the levels for a parallel shift were set at 200bps for USD and EUR and 250bps for GBP. These rate shocks had been considered by most banks, and their regulators, to be feasible but fairly extreme. The fact that policy rate rises exceeded these shocks last year2 has highlighted the need for banks to run additional scenarios over and above those mandated by their regulators.
A further illustration of the magnitude of rate rises in 2022 is displayed in Figure 4. This displays the significance of the most recent rate tightening cycle when compared with historical central bank tightenings in the UK.
In fact, we have to look back over 30 years to find a cycle which took place with greater speed and magnitude. This was the cycle between 1988 and 1990, characterised as the Lawson Boom. In the Lawson Boom before Bank of England policymaking independence, the government showed reluctance to begin raising rates, with the result that the economy vastly overheated.
The outcome was that inflation reached over 8% in 1990, house prices were rising at an annual rate of over 30% and mortgage rates were in double digits. This was eventually tackled through extremely aggressive rate rises contributing to the UK recession of 1991-2.
Impacts on Balance Sheets
The interconnectedness of interest rate risk and balance sheet
When rates move upwards, there are a number of balance sheet items which are heavily impacted. Major
ones include:
- Deposits- impacted in particular via movement from non or low interest bearing deposit accounts(current and savings accounts or CASA) to higher, usually fixed rate, products
- Loans- including products with loans underlying them (such as Mortgage Backed Securities), impacted by prepayments and, if rate moves are significant, or economic conditions are restrictive, by defaults,alongside valuation impacts
- Off balance sheet assets – such as revolvers, lines of credit, credit cards and mortgage pipelines, impacted by changes in drawdown and utilisation patterns
- Fixed rate securities – such as bonds; impacted by price movements and haircuts
- Derivatives – including Interest Rate swaps but also foreign exchange swaps, impacted by revaluation if there is a demand for safe-haven currencies leading to basis volatility
As has been seen by recent market events, these impacts can be significant for banks; however, covering all of them is out of the scope of this paper. Here, we will focus on movements in deposits portfolios and the passthrough from policy rates to deposit rates that characterises this part of banks’ balance sheets.
Focus on deposit books: Switching
Retail and commercial banks in the UK operate a number of deposit portfolios. Time deposits are offered at fixed rates, often with penalties for accessing funds early. Instant access accounts offer transactional features, such as the ability to make regular credit and debits and are often either non-interest bearing balances (NIBBS) or pay a low ‘managed’ interest rate that is controlled by the bank (known as interest bearing balances or IBBs).
Evidence of managed rates in action in recent years is illustrated in Figure 5; as policy and market rates rose, part of the rate rise was ‘passed through’ to IBBs.
Market rate rises are passed through to deposits in order to retain balances. This is because, when interest rates are generally low marketwide, customers do not have much incentive to place their funds outside of instant access accounts. However, if higher interest-bearing products appear, at a certain point it becomes attractive enough to forego the option of being able to access funds instantly; at this point customers will move balances out of low yielding accounts to earn higher returns in products such as fixed rate time deposits.
To prevent balances leaving IBBS accounts, banks have the option of increasing managed rates to try and retain funds. This can prove expensive however as repricing part of an instant access portfolio is not possible; the entire portfolio earns the same rate. Banks therefore often prefer to ‘passthrough’ only part of a market rate increase and concurrently encourage clients to ‘switch’ into products with higher rates that lock them in for a set term. Industry-wide, of the rate rises that took place in 2022, only 22% were passed through to household bank customers with interest bearing casa accounts (known as a
cumulative beta of 0.22).
The evidence of this movement between deposit portfolios or ‘switching’ happening at the end of last year in UK banks can be seen in below.
Figure 6 illustrates how, throughout 2022, balances in both NIBBs, IBBs and time deposits were generally rising industry-wide.
Between September and October 2022 there was a sudden flip; balances in IBBS, and to a lesser extent NIBBs, started to fall, concurrent with a rise in balances in time deposits.
What initiated this sudden deposit ‘switching’? We demonstrate below how the evidence seems to point to a tipping point caused by refinancing spread; the differential between what customers are earning in their instant access accounts versus an alternative, in this case term deposits.
Figure 7 displays how, as policy rates rose, despite some of this rise being passed to IBBs, the differential between rates paid for IBBS and time deposits started growing.
In October the differential reached 1% and this proved to be the trigger for a change in customer behaviour; suddenly clients were finding it worth the effort to move balances into term deposits and substantial balance sheet switching was the result.
Focus on deposit books: Total volume
Following on from our analysis above, it is important to keep in mind that term deposits are not the only alternative available to customers as rates rise. Other deposit and investment products can also become more attractive in a rising rate environment and/or be influenced by other factors. These alternatives can exist both inside and outside the traditional banking sector; the rise in popularity of crypto being one example of a new
innovation challenging the norms.
This is an important point, because if banks focus only on switching, then they could fall into the trap of assuming
that balances will simply switch from one portfolio to another but be retained inside the bank. Figure 8 illustrates
the fallacy of doing this.
Deposits in banks during the pandemic increased dramatically. Figure 8 is evidence that this deposit glut is now unwinding as debt is paid down, or perhaps as mentioned, deposits move to options outside the banking system. This is happening across all three of the UK, Euro area and USA, but in the US in particular, the deposit pool has actually begun shrinking.
It is difficult to predict what will happen next; although what is fairly certain is that balance sheet impacts have not yet fully played out.
Implications
Internal implications
When moving from a steady rate environment, which has existed for over 15 years, to a volatile rateenvironment, internal procedures are sorely tested. Internal procedures that need reviewing include, but are not limited to:
Pricing strategies- both external and via internal funds transfer pricing
Plans, policies and metrics – including interest rate risk, hedging and hedge accounting policies and metrics, funding plans and metrics, liquidity policies and metrics, the annual planning cycle, capital plans, policies and metrics and recovery and resolution and contingency funding plans
Stress testing practices – for interest rate, liquidity, capital and credit purposes
In particular, any key behavioural assumptions in the above which rely on historical data must come under scrutiny. In the case of non-maturing deposits, if these have been assumed to hedge fixed rate asset portfolios but balance switching, outflows or passthrough rates prove to be higher than modelled, the financial impact for the bank can be significant. Due to the fact that these are large portfolios, unexpected rate shocks can cause havoc if the valuations of back book assets drop concurrent with a scramble to replace back book liabilities with new, costly funding.
Historical data is the only data that we have, but it is likely to be more valuable to compare recent data to historical datasets in order to demonstrate changes in patterns and behaviours than to use averages calculated over long periods. Any modelling recalibrations should also take into account the innovations that have occurred since the last rate cycles took place; considering technology changes and other recent innovations such as crypto and central bank currencies.
Regulatory Implications
Finally, we turn to the regulatory implications of the recent rate environment and the impacts it has wrought. The bank failures in March 2023 have yet to fully play out, so we will focus on three regulatory changes which were already in play before this that may affect the UK:
1. Changes to Basel regulatory rate shocks
As discussed above, policy rate rises last year exceeded the highest shocks mandated under the Basel IRRBB standards. The BCBS has already stated that it will review the shock scenarios set out in the April 2016 IRRBB standards in its work programme for 2023/244. We expect that local regulators may pre-empt this.
2. Changes to Standard Outlier Tests
The current outlier test, adopted by nearly all regulators, compares the results of Economic Value of Equity stress tests against Tier 1 capital. The EBA has proposed adding a second test against Net Interest Income stress tests5. Although this is not currently being adopted in the UK, the PRA has
stated that it will consider whether it should adopt a test against NII in the future6
3. Alternative approaches for non-systemic UK banks
Proposals are underway in the UK to establish a tiered system for bank regulation, known as the ‘Strong and Simple’ regime. It has been proposed to add variation to capital standards and liquidity standards; it is yet to be revealed if interest rate risk in the banking book will feature in this7
Conclusion
The fastest rate tightening cycle in three decades has had a significant impact on bank balance sheets. In this paper we focussed on the transmission mechanism from policy rates to deposits. We have demonstrated the interplay between passthrough rates on instant access accounts and customer switching to fixed rate deposit accounts.
Banks have only passed a proportion of rate rises through to interest bearing balances in the UK. They have seen significant shifts on their balance sheets to fixed rate deposit accounts as a result. In addition, aggregate bank deposit balances are no longer rising, as the effects of the pandemic unwind.
Inflation in the UK, alongside the US and the Eurozone, has now started to ease. However, core inflation is proving stubborn and policymakers now have to decide whether to halt or even reverse rate rises without doing so too early in order to combat this. If rates move downward again, will balance sheet impacts reverse or will customer behaviour show inertia? Banks must execute scenarios for all and any of these eventualities.
