1) A. Mechanisms Through Which Interest Rates Affect Economic Value Of A Bank

Changes in market interest rates directly impact a bank’s economic value by influencing its net interest income (NII) and the valuation of its assets and liabilities. The following are the key mechanisms in this context:

1. Effect on Net Interest Income (NII): Changes in market interest rates significantly impact a bank’s net interest income (NII) by altering the difference between interest earned on assets and interest paid on liabilities. The extent of this impact depends on the repricing sensitivity of both.
   • Repricing Sensitivity and Timing: Banks earn income from interest-earning assets (loans, securities) while paying interest on liabilities (deposits, borrowings). If the assets and liabilities have different repricing frequencies, changes in market interest rates can either increase or erode net interest margins (NIMs). The effect of rate changes is dictated by the time until the next repricing of assets and liabilities. Floating-rate assets adjust immediately, while fixed-rate assets only reprice upon maturity.
   • Sensitivity of Yields: If loan rates adjust faster than deposit rates, higher interest rates typically boost NIMs. However, if funding costs rise at the same pace as asset yields, the benefit is diminished.
   • Empirical Impact: It has been observed that short-term rate changes often have a positive but relatively modest effect on NIMs (eg, a 100 bp rise might translate into a <20 bp change in margins over four quarters).
   • Share of Total Income: NII typically represents a larger proportion of total income for EME banks than for banks in advanced economies (AEs), amplifying the significance of rate changes for EME profitability.
   • Deposit Rate Sensitivity: The more closely deposit rates track market rates, the greater the rise in funding costs, which can erode net interest margins (NIMs).
   • Regional Differences: In emerging market economies (EMEs), NII forms a larger portion of total income (~65%) than in advanced economies (AEs) (~55%).
   • Yield Curve Slope Effects: The steepness of the yield curve influences NII but in a less predictable manner than short-term rate shifts.
2. Valuation Effects on Assets and Liabilities: Changes in market interest rates also affect the valuation of assets and liabilities, especially fixed-income instruments.
   • Duration Sensitivity: Longer-duration instruments undergo larger price swings when rates shift. If rates increase, present values decline, which can erode a bank’s net worth.
   • Indirect Effects via Credit Risk: Higher interest burdens for borrowers may spur increased default rates, negatively affecting loan portfolios’ values.
   • Accounting Treatment Matters: Unrealized losses accumulate if assets are not marked to market, becoming an issue if assets must be sold to meet liquidity needs (e.g., deposit withdrawals).
   • Emerging Market Banks’ Vulnerability: EME banks hold a growing share of longer-duration securities, increasing their exposure to rate-driven valuation losses.
   • Demand deposits (which often pay no or low interest) become more expensive as rates rise, potentially causing outflows to higher-yielding alternatives.
3. Economic Value of Equity (EVE) and Solvency Risks Fluctuations in interest rates affect not only profitability but also economic value.
   • Impact of Duration Gaps: If a bank’s assets have a longer duration than its liabilities, rising rates reduce net worth, since asset values decline faster than liability values.
   • Example – Silicon Valley Bank (SVB) Collapse: The SVB crisis illustrated how large unrealized losses on securities could trigger liquidity crises, deposit withdrawals, and solvency concerns.
   • Regulatory Response: Supervisors increasingly require banks to evaluate their interest rate risk (IRR) exposure through economic value models, beyond just net interest income analysis

1) B. Key Methods Banks Use To Manage Interest Rate Risk (IRR)

1. Balance Sheet Management
   • Repricing Gap Management: Banks match the timing of asset and liability repricing to mitigate interest rate fluctuations.
   • Loan Composition Strategies:
     • EME banks favor floating-rate loans, ensuring asset sensitivity aligns with deposit sensitivity.
     • Advanced Economy banks rely more on fixed-rate mortgages and demand deposits.
   • Deposit Structure Optimization:
     • EME banks rely heavily on time deposits (~35% of liabilities in some regions), which stabilize funding costs.
     • Demand deposits, though cheaper, pose a higher risk of outflows during rate hikes.
2. Use of Interest Rate Derivatives
   • Swaps and Futures: Convert fixed-rate exposures to floating (or vice versa), mitigating interest rate volatility.
   • Options and Caps/Floors: Offer protection by ensuring rates remain within predefined limits.
   • Derivatives Usage Disparities:
     • AE banks: Hold significantly larger derivative positions (~7% of total assets).
     • EME banks: Use derivatives far less frequently, except in certain markets (e.g., Czechia, South Africa).
3. Economic Value Hedging
   • Duration Matching: Aligning asset and liability durations stabilizes economic value against rate shifts.
   • Repricing vs. Duration Gap Hedging:
     • Short-term IRR management relies on repricing bucket alignment.
     • Long-term IRR management focuses on minimizing duration mismatches.
4. Diversification of Income Streams 
   • Reducing Reliance on NII: By expanding fee-based services (e.g., asset management, payments, insurance), banks buffer themselves against interest rate volatility.
5. Regulatory and Supervisory Measures
   • Supervisory Mandates: Regulators now require banks to measure IRR using both NII and economic value models (Basel IRRBB framework).
   • Capital Reserves for IRR: Banks must maintain buffers to absorb potential interest rate shocks

2) Comparison of IRR Management Methods In EME And AE

• A. Differences in IRR Management Approaches
  • Banks in emerging market economies (EMEs) and advanced economies (AEs) historically adopted different strategies to manage interest rate risk (IRR) due to differences in financial market development, business models, and regulatory environments.

• B. How These Methods Affected Vulnerability to Interest Rate Changes
  The effectiveness of these approaches determined how vulnerable each group of banks was to market interest rate changes.
  • Emerging Market Economy (EME) Banks
    • Strengths:
      • Floating-rate loan dominance meant interest income adjusted with market rates, reducing earnings volatility.
      • Time deposits’ stability prevented sudden liquidity crises, unlike more volatile wholesale funding used by AE banks.
      • Lower historical securities exposure limited direct valuation losses from rising interest rates.
    • Weaknesses:
      • Limited use of derivatives left EME banks exposed when interest rate risks increased.
      • Recent rise in securities holdings increased valuation risk, particularly if bonds are longer-duration.
      • Higher credit risk sensitivity: Rising interest rates directly impacted borrowers, increasing default risks and credit losses.
  • Future Outlook and Adaptation Needs
    • Advanced Economy (AE) Banks
    • Strengths:
      • Widespread use of derivatives helped stabilize earnings by hedging against interest rate fluctuations.
      • More diversified funding sources included market-based instruments, allowing greater flexibility in IRR management.
      • Well-developed stress testing frameworks enabled proactive risk identification and mitigation.
    • Weaknesses:
      • Greater reliance on fixed-rate loans and securities meant AE banks were more exposed to duration risk.
      • Dependence on wholesale funding and demand deposits created a higher risk of liquidity crises when interest rates spiked.
      • Mark-to-market exposure: Many AE banks had large unrealized losses on securities portfolios when rates rose (e.g., Silicon Valley Bank collapse).
• C. Case Study: March 2023 Banking Stress (SVB & EME Banks) The collapse of Silicon Valley Bank (SVB) in March 2023 revealed critical differences in how AE and EME banks managed IRR.
  • SVB’s Downfall (AE Bank)
    • Held long-duration securities (~50% of assets), which lost value when rates rose.
    • Failed to hedge interest rate risk effectively, despite access to derivatives.
    • Faced massive deposit withdrawals as corporate clients withdrew uninsured deposits.
      • Forced to sell assets at a loss, triggering a liquidity crisis.
  • EME Banks’ Resilience
    • Minimal impact from March 2023 crisis as EME banks had lower reliance on securities holdings.
    • Floating-rate loan models helped maintain profitability despite rising rates.
    • Stable deposit base (time deposits) reduced outflow risks.
    • However, rising securities exposure in EMEs suggests future vulnerabilities.
• D. Future Outlook and Adaptation Needs
  • EME banks must enhance risk management by developing derivative markets and adopting economic value hedging to mitigate increasing securities exposure risks.
  • AE banks need to reassess funding structures to reduce dependency on wholesale deposits and enhance capital buffers against interest rate shocks.
  • Regulators globally are emphasizing stress testing that combines NII and economic value approaches to ensure IRR resilience.

3) Recent Changes In EME Banks Exposure To IRR Importance Of Hedging

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1. Recent Changes in EME Banks’ Interest Rate Risk Exposure:
   Historically, emerging market economy (EME) banks had lower exposure to interest rate risk (IRR) than their advanced economy (AE) counterparts due to their loan structures and funding composition. However, recent changes in market conditions and banking practices have increased EME banks’ exposure to IRR in several
   • Rising Securities Holdings
     • EME banks significantly increased their holdings of securities, particularly government bonds, in response to economic policy shifts, liquidity injections, and regulatory changes.
     • Since the COVID-19 crisis, EME banks’ securities portfolios have grown to absorb large-scale government debt issuances, often at longer maturities.
     • This shift increases valuation risk because bond prices decline when interest rates rise, leading to unrealized losses.
   • Longer Duration of Government Bond Holdings
     • The average maturity of government bonds held by EME banks has increased from less than six years (2010) to more than seven years (2021).
     • Longer bond duration = Higher sensitivity to interest rate changes → Small rate hikes cause larger declines in bond prices.
     • This marks a structural shift in IRR exposure, making EME banks more vulnerable to valuation losses than before.
   • Reduced Reliance on Floating-Rate Loans
     • Traditionally, EME banks issued floating-rate loans, meaning interest income adjusted automatically when rates changed.
     • However, loan structures are diversifying, and some banks are increasing exposure to fixed-rate lending, reducing their ability to naturally hedge against rate fluctuations.
   • Liquidity Risks and Rising Funding Costs
     • EME banks still rely heavily on time deposits (~35% of liabilities in some regions), which remain relatively stable.
     • However, if rates rise sharply, funding costs increase, and banks may be forced to pay higher rates to retain deposits, further pressuring margins.
   • Greater Link Between Sovereign and Banking Sector Risks
     • Higher government debt holdings increase the sovereign-bank nexus, where rising sovereign risks (e.g., higher government bond yields or credit rating downgrades) translate into greater banking system vulnerabilities.
     • This tightens funding conditions and exposes banks to simultaneous market and funding shocks.
2. Importance of Hedging Interest Rate Risk in EME Banks
   Given these structural changes, hedging interest rate risk has become more critical for EME banks to maintain financial stability and profitability.
   • Preventing Large Valuation Losses
     • Bond price volatility due to interest rate changes can lead to unrealized or realized losses if banks need to sell securities to meet liquidity needs.
       • Example: Silicon Valley Bank (SVB) Collapse
         • SVB faced massive unrealized losses on its long-term securities.
         • When customers withdrew deposits, SVB had to sell bonds at a loss, triggering a liquidity crisis and failure.
         • Reducing Net Interest Margin (NIM) Volatility
           • As EME banks’ loan portfolios diversify, floating-rate assets alone may not provide sufficient protection against rate fluctuations.
           • Hedging through derivatives (e.g., interest rate swaps) helps stabilize earnings by protecting against unexpected rate hikes
         • Managing Liquidity and Funding Risks
           • Rising rates increase the cost of deposit retention as banks must offer higher rates to prevent deposit outflows.
           • Hedging mitigates sudden funding shocks, allowing banks to manage liquidity needs without fire sales of securities.
         • Aligning with Global Regulatory Expectations
           • Basel III and other international frameworks emphasize economic value hedging to ensure banks remain resilient under stress scenarios.
           • Many advanced economy banks use derivatives extensively, while EME banks lag behind. Expanding the use of interest rate hedging strategies can help EME banks meet evolving regulatory standards.
3. Future Outlook: How EME Banks Can Strengthen IRR Management
   To address rising IRR exposure, EME banks should:
   • Expand the use of derivatives (interest rate swaps, futures) to actively hedge against duration risk.
   • Diversify funding sources beyond deposits, incorporating market-based instruments that provide flexibility.
   • Reduce reliance on long-duration securities unless adequately hedged.
   • Enhance internal risk modeling to include both net interest income (NII) sensitivity and economic value stress tests.
   • Align risk management practices with Basel IRRBB recommendations to meet regulatory expectations.