Cleveland Fed researchers examine rising bank interest rate risk; credit default swap reforms; European inflation

Interest rate risk at commercial banks is climbing, particularly at small banks, say Cleveland Fed researchers

Average interest rate risk in the US banking system has been increasing since the end of the financial crisis, and the increase has been particularly steep at small banks, say Federal Reserve Bank of Cleveland researchers William Bednar and Mahmoud Elamin. While big banks’ interest rate risk exposure is being driven mainly by their liabilities, Bednar and Elamin say at small banks, it is coming from both their assets and their liabilities.

Banks run the risk of losing money if unexpected differences arise between the long-term interest rates at which banks lend and the short-term rates at which they borrow. Using data from bank “call reports” and an economic value model, Bednar and Elamin assess the current level of interest rate risk borne by banks. They find that the average interest rate risk at the 50 largest U.S. commercial banks has risen since 2011, but remains significantly below than the pre-crisis peak. However, the researchers find a much greater increase in interest rate risk at smaller banks, noting a very steep ascent after 2009.

Bednar and Elamin say the uptick in average interest rate risk at the 50 largest banks is being driven by the banks’ liabilities. Looking at big banks’ assets, they say the declining contribution of loans to interest rate risk is being offset by the increasing contribution of security holdings.

At small banks, both liabilities and assets – including both loans and securities -- are contributing to increased interest rate risk.

Bednar and Elamin say banks and regulators need to closely monitor the higher level of interest rate risk, which could be a problem once interest rates start rising.

Read Rising Interest Rate Risk at US Banks.

Reforms are likely to improve transparency in the market for credit default swaps, say Cleveland Fed researchers

Credit default swaps (CDSs) are a form of insurance against default on a credit, such as a bond or loan, and they play an important role in managing the risk exposures of financial institutions and asset management firms. But a key shortcoming of the over-the-counter (OTC) market infrastructure for CDSs -- lack of transparency-- contributed to the severity of the recent financial crisis. Federal Reserve Bank of Cleveland researchers John Carlson and Margaret Jacobson say reforms being implemented under the authority of Dodd-Frank should improve transparency and make CDS pricing more competitive.

According to Carlson and Jacobson, by 2007, CDS counterparty risk exposures had become embedded in a tangled network of bilateral connections. A buildup in systemic risk went unchecked largely because neither regulators nor market participants could follow the risks being transferred.

Reforms agreed to by the G-20 nations and incorporated into the Dodd-Frank Act aim to improve market transparency. OTC contracts that can be standardized are now required to be cleared at a central counterparty; standardized CDS contracts must trade on regulated exchange-like platforms called swap execution facilities (SEFs); all CDS trade information is required to be reported to a central data repository; and CDS market participants must hold cash in margin accounts as a buffer against changes in CDS valuations.

The researchers say these reforms will allow market participants to see pre- and post-trade pricing. In addition, regulators will have access to information that will allow them to follow the risks as they are transferred and to monitor risk concentrations as they develop.

Read New Rules for Credit Default Swap Trading: Can We Now Follow the Risk?

The European Central Bank recently eased monetary policy because inflation had drifted well below the ECB’s target, according to Cleveland Fed researchers Owen Humpage and Jessica Ice.

Read more in European Inflation.