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

5 ConclusionIn Section 4.1 we are able to show that large European banks tend to transform short term customerdeposits and amortised cost instruments at 1-5 year maturity like hybrid and subordinated debt intolong term loan assets, as expected. Given the earlier work discussed in Section 1, in which the effectivematurity of core deposits is estimated to be less than three years, the interest rate revaluation risk ofthese banks is significantly determined by their loan asset portfolios. Examining the loan asset valuesmore closely, we find in Section 2.3 that the banks with the largest loan asset porfolios in 2011 aredomiciled in the UK, France and Germany, and these banks extend loans primarily into Euro-areacountries and then into non-Euro European countries. Ranking the banks by their loan asset portfoliorepricing sensitivity to a 2% parallel shift in interest rates in Section 4.4, we find that the three riskiestbanks across most methods are Nykredit (DK), SNS Bank (NL) and Espirito Santo (PT). It mustbe emphasised that these rankings are independent of balance sheet size and do not account for offbalance-sheetinstruments like interest rate derivatives, but they provide a useful starting point for thebank analyst and supervisor.In measuring the interest rate repricing risk of these banks, we employ several methods and criticallyevaluate the Basel Committee guideline method for interest rate sensitivity. We show how thisguideline method is simplistic and we illustrate the size of the deviation from simple alternative pricingmodels through the use of examples. The guideline method is conservative for loan individual loan contractswith short maturities (less than 10-15 years) and in medium-to-high interest rate environments.However, the guideline method understates risk for portfolios of loans even at short maturities and forindividual loan contracts with longer maturities, and these understatements are exacerbated in lowinterest rate environments. Further work should be done to investigate the sensitivities of the BaselCommittee guideline method, and the simple alternative methods presented here for loan contracts,to the cashflow timing assumptions, and especially the timing assumption in the 5+ maturity bucket.Furthermore, we show that the 2% parallel shift in yield curves that is typically used as the socalled“standardised interest rate shock” is atypical of historical Euro yield curve movements. Morework should therefore be done to determine the appropriate shocks to apply to interest rates, especiallyfor supervisory purposes. In particular, it is inappropriate for supervisors to rely on monitoring onlyone interest rate scenario because it is fairly easy for banks to allocate their asset and liability maturitiesso that exposure to any one scenario is zero, while exposures to other scenarios might be large.ReferencesBasel Committee on Banking Supervision (2004): “Principles for the Management and Supervisionof Interest Rate Risk,” Discussion Paper July, Basel Committee on Banking Supervision, Basel,Switzerland.Czaja, M.-G., H. Scholz, and M. Wilkens (2009): “Interest rate risk of German financial institutions:the impact of level, slope, and curvature of the term structure,” Review of QuantitativeFinance and Accounting, 33(1), 1–26.English, W. B., S. J. van den Heuvel, and E. Zakrajsek (2012): “Interest Rate Risk and BankEquity Valuations,” FEDS Working Papers, (2012-26).Entrop, O., C. Memmel, M. Wilkens, and A. Zeisler (2011): “Estimating the Interest RateRisk of Banks Using Time Series of Accounting-Based Data,” Available at SSRN 982070.Federal Deposit Insurance Corporation (1994): “The Banking Crises of the 1980s and Early1990s: Summary and Implications,” Discussion paper, Federal Deposit Insurance Corporation.Flannery, M., and C. M. James (1984a): “The Effect of Interest Rate Changes on the CommonStock Returns of Financial Institutions,” The Journal of Finance, 39(4), 1141–1153.Flannery, M. J., and C. M. James (1984b): “Market Evidence on the Effective Maturity of BankAssets and Liabilities,” Journal of Money, Credit and Banking, 16(4), 435–445.Gorton, G., and R. Rosen (1995): “Banks and derivatives,” NBER Working Paper Series, 5100.29