Are low interest rates firing back? Interest rate risk in the banking book and bank lending in a rising interest rate environment

Summary

Focus

Banks' engagement in maturity transformation, by borrowing short and lending long, allows them to earn the spread between the interest rates charged on longer-term assets and the interest rate paid on shorter-term liabilities. However, this exposes them to interest rate risk. Indeed, rapid and unexpected increases in interest rates can adversely impact the economic value of banks' equity due to changes in the present value and timing of future cash flows. Overall, increases in interest rates lead to a decline in a bank's net worth, as the value of assets declines more than the value of liabilities. This effect is most pronounced for banks that exhibit a large positive mismatch between the duration of their assets and liabilities, ie banks with a wider duration gap.

Contribution

Using extensive and granular euro area supervisory and credit register data, we analyse whether banks' exposure to interest rate risk affects the transmission of monetary policy to the supply of bank lending in an environment of rising interest rates. Since we have information on banks' derivative positions, we are able to measure their exposure to interest rate risk net of hedging. Furthermore, these data allow us to account for the behavioural assumptions that banks make when modelling the duration of their balance sheet. Our sample covers the period from 2021Q1 to 2023Q2 and 73 significant institutions in the euro area.

Findings

We find that, when interest rates increase by 100 basis points, a bank at the 75th percentile of the duration gap distribution reduces lending by 91 to 94 basis points more than a bank at the 25th percentile. Moreover, banks with a wider duration gap reallocate their loan portfolios away from fixed rate loans and loans with a longer duration. Micro, small and medium-sized enterprises are the most affected by the contraction in lending supply. As well, we show that firms cannot (fully) substitute the contraction in credit coming from banks with a wider duration gap with more borrowing from banks with a narrower duration gap. This results in an additional reduction in borrowing during a monetary tightening episode for these firms relative to other firms.

Abstract

We match granular supervisory and credit register data to assess the implications of banks' exposure to interest rate risk on the monetary policy transmission to bank lending supply in the euro area. We exploit the largest and swiftest increase in interest rates since the creation of the euro and find that banks with a higher exposure to interest rate risk, i.e., with a larger duration gap after accounting for hedging, curtailed corporate lending more than their peers. Ceteris paribus, greater interest rate risk entails closer supervisory scrutiny and potential capital surcharges in the short term, and lower expected profitability and capital accumulation in the medium to long term. We then proceed to dissect banks' credit allocation and find that banks with higher net duration reshuffled their loan portfolio away from long-term loans in an attempt to limit the increase in interest rate risk and targeted their lending contraction to small and micro firms. Firms exposed to banks with a larger exposure to interest rate risk were unable to fully rebalance their borrowing needs with other lenders, thus experiencing a relatively larger decrease in total borrowing during the monetary tightening episode.

JEL Classification: E51, E52, G21

Keywords: interest rate risk, duration gap, bank lending channel, financial stability