ALM in a world of falling interest rates
09 October 2019
Interest rates have been falling worldwide since November 2018, due to concerns about the global economy and trade (as illustrated in Figure 1). A low rate environment presents challenges to both banks and insurers, with a different impact on each industry.
Figure 1: UK 10 year Gilt rates and LIBOR Swap Rates (6m LIBOR)
Source of data: Refinitiv (Eikon)
Looking at insurers, this is felt through the impact on firms’ solvency ratios, which dropped sharply in many cases during H1 2019. However, the future impact of interest rates on firms’ balance sheets could be far greater if rates continue to fall. This reflects the nature of interest rate hedging undertaken in the market; many insurers do not hedge the interest rate exposure of their entire Solvency II balance sheet. While this may reflect a desire to focus on other metrics such as IFRS, liquidity constraints or indeed a view that interest rates may rise over the longer term, the impact is nevertheless clear. There is also a risk that insurers are forced to hedge interest rates as they fall further, to ensure that solvency ratios do not fall too low.
Turning to banks, the fall in interest rates is reflected in the Net Interest Margin (NIM), a phenomenon commonly referred to as “margin compression”. In Europe, where rates are already negative, banks have generally been reluctant to charge retail customers interest for holding deposits; implying an effective customer rate floor at (or near) 0%. But since a corresponding floor has not been observed on the asset side, NIM becomes compressed. Given most banks have historically not felt it appropriate to hedge their NIM, margin compression presents a significant issue for the sector’s profitability. Most banks have responded by examining their product mix to improve profitability, and when required by upgrading their Fund Transfer Pricing ‘FTP’ processes to ensure that product level NIM is measured accurately.
Whatever the nature of the institution, the interest rate movements observed in 2019 highlight that interest rates can continue to move significantly lower, and indeed become negative across the curve. Firms need to have strategies in place to cope with such movements, no mean undertaking given the complexity of interest rate risk management and the need for engagement and debate across the organisation, from board level downwards.