Maturity Transformation and Interest Rate Risk in Large European ...

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Committee method understates the revaluation sensitivity to interest rate increases. 29 Against the flatrate and Nelson-Siegel models, the Basel Committee method is prudent for maturities up to 30 years,in that it overstates the loan price sensitivity to interest rate increases. 30 This is comforting since wewould expect the remaining maturity of most loan contracts to be less than 30 years. However, whencompared to the Svensson model, the Basel Committee method is only prudent for loan contracts ofup to 10 year maturity, beyond which it understates the loan price sensitivity to interest rate increases.For banks with a substantial proportion of loans in the 10-30 year maturity category, we might expectthe Basel Committee method to understate the loan price sensitivity to interest rate increases.While prudential regulators presumably favour the conservativeness of a method, investors wouldlike an accurate assessment of the risk, with overstatements and understatements being equally harmful.Relative to the alternative loan models, the Basel Committee method overstates the revaluation gainsfrom interest rate decreases at shorter maturities and understates these revaluation gains at longermaturities. The Basel Committee method for interest rate revaluation sensitivity is therefore generallyconservative for shorter-maturity loans, and understates risk for longer-maturity loans.4.2.2 Effect of current yield curveThe Basel Committee guideline method for assessing interest rate revaluation sensitivity does not accountfor the prevailing yield curve at the time of the sensitivity estimate. For example, we mightintuitively expect a 2% change in interest rates to be more serious when interest rates are low; conversely,we might expect a 2% shock not to be very serious in a high interest rate environment. Weinvestigate this by comparing the sensitivities from the Basel Committee guideline method to the sensitivitiesfrom our simplest flat rate loan model of Section 3.2, noting that the latter does depend ona reference or prevailing rate of interest. We present a graphical summary in Figure 10.From the figure, we see that the Basel Committee method overstates the risk of a 2% parallelupward shift in the yield curve for loan maturities up to 27 years, relative to the simplest loan model.This observation agrees with those of the preceding section: although the Basel Committee methoddoes not take into account the specific form of the loan contract, it gives a conservative assessmentof the interest rate risk for loans with remaining maturity up to 27 years. However, we note that theprevailing level of the yield curve does noticeably affect the sensitivity of the price of a loan contract.When forward rates are flat and high, say 5%, the Basel Committee method conservatively assessesthe risk of a 2% parallel upward shift in yield curves (forward rates) for loans with remaining maturityup to 40 years. When yield curves are flat and low, say .1% or 1%, the Basel Committee methodunderstates the risk associated with 30-year loans.From the preceding section, we know that the Basel Committee guideline method is generallyconservative for shorter-maturity loans, and understated for longer-maturity loans. In addition tothese stylised facts, we also observe for interest rate increases that the Basel Committee guidelinemethod is less conservative, or more understated, when interest rates are low than when interest ratesare high. The Basel Committee method, which does not allow for the prevailing level of interest rates,is less appropriate for supervision in low interest rate environments.4.2.3 Effect of portfolio aggregationRegardless of the type of security and the current level of the yield curve, the Basel Committeeguideline method for interest rate revaluation sensitivity does not provide a unique method for portfolioaggregation. Suppose that a bank holds two loans of different remaining maturties, one with 1 year andthe other with 10 years. The Basel Committee method provides senstivities for each of these contractsindividually, but not uniquely for a portfolio of both. Two natural methods suggest themselves forcomputing the interest rate revaluation sensitivity of the portfolio with the Basel Committee method.29 We note in Section 4.1 that European banks’ on-balance-sheet positions in 2011 are net positive at long maturitiesand net negative at short maturities. This finding is very typical of banks’ role as maturity-transformers. However,it exposes them to increases in interest rates, since such increases would cause the value of (long-term) assets to dropby more than the offsetting rise in the value of (short-term) liabilities. Off course, the regulator might anticipate thatrational market participants should rationally compensate for overstatements/understatements in the Basel Committeeguideline method, and if there are no informational obstacles to the market participants doing so, such a regulator mightbe equally averse to both over- and understatements of interest rate sensitivity.30 This statement should be qualified by the specific parameter assumptions that have been made here on δ, β 0 , β 1 , β 2 , τ 1 .See the discussion of Figure 10.22
0Percentage change in price givena 2% parallel upward shift in interest rates−10percentage−20−30MethodBasel guidelineloan model 0.1%loan model 1%loan model 3%loan model 5%loan model 7%loan model 9%−400 10 20 30 40 50remaining loan maturityFigure 10: The effect of a 2% increase in interest rates at all maturities on the price of a loan contractwith remaining maturity between 1 and 50 years, according to the Basel Committee guideline and thesimple formula log p(δ + .02, τ) − log p(δ, τ) based on the present value function p(δ, τ) = (1 − e −δτ )/δ,where τ ∈ [1 : 50] is the remaining loan maturity and δ ∈ {.001, .01, .03, .05, .07, .09} is the level of theflat yield curve before the shock.23
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Page 6 and 7: paper.2.1 Accounting valuation meth
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Page 12 and 13: Table 3: Summary of the bank assets
Page 14 and 15: Eur billionsLoan asset exposures by
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Page 18 and 19: p({φ i }, {f(m)}, {τ i }) ∑ i
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Page 26 and 27: Table 8: Correlations between l−m
Page 28 and 29: Table 9: Rankings of the sample ban
Page 30: Hicks, J. (1939): Value and Capital

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