New Look at Global Banks Highlights Risks From Higher-for-Longer Interest Rates
IMF Blog, October 16, 2023
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Bibliographic details
- Authors: Charles Cohen, Srobona Mitra, Fabio Natalucci
- Published: October 16, 2023
Context and overview
- Central banks could keep interest rates higher for longer to curb inflation that remains stubbornly high in many countries, which may slow economies.
- This interest-rate environment is unprecedented in a generation for global financial markets and requires sharpened analytical tools and regulatory responses.
- IMF enhancements: stress-testing tools focused on rising interest rates and funding pressures; a new surveillance tool using analyst forecasts and traditional bank metrics; these tools use public data to complement supervisory stress tests and IMF-World Bank Financial Sector Assessment Programs.
How rising rates affect banks
- Banks can benefit by collecting higher interest rates from borrowers while keeping deposit rates low.
- Risks:
- Loan losses may increase as consumers and businesses face higher borrowing costs, especially if they lose jobs or revenues.
- Banks’ holdings of bonds and other debt securities lose value when interest rates rise, potentially forcing sales at a loss under sudden deposit withdrawals or funding pressures.
- The failure of Silicon Valley Bank exemplified the bond-loss channel.
- Central bank lending facilities, such as the Federal Reserve’s discount window, can reduce losses from forced securities sales under deposit-run scenarios.
Global stress-test findings
- Scope: almost 900 lenders across 29 countries.
- Baseline scenario (aligned with the latest IMF World Economic Outlook) identified:
- 30 banking groups with low capital levels, together accounting for about 3 percent of global bank assets.
- Severe stagflation scenario (high inflation with a 2 percent global economic contraction and even higher central bank interest rates) results:
- 153 weak institutions, accounting for more than a third of global bank assets.
- Geographic pattern:
- Excluding China, there are many more weak banks in advanced economies than in emerging markets.
Surveillance tool and back testing
- Tool inputs: traditional supervisory metrics (e.g., ratio of capital to assets) and market indicators (e.g., market price to book value of bank equity).
- Flagging rule: banks flagged for further review if outliers across three or more of five risk metrics—capital adequacy, asset quality, earnings, liquidity, and market valuation.
- Back testing outcomes:
- Surge of potentially vulnerable institutions at the onset of the pandemic.
- Sustained rise in late 2022 as higher interest rates began to bite; this latter group included the four banks that either failed or were taken over in March.
- Current indicators (market data and consensus analyst forecasts) point to:
- A substantial group of smaller banks at risk in the United States.
- Concern for some lenders in Asia, including China, and Europe as liquidity and earnings pressures persist.
Policy implications and recommendations
- Stress testing:
- Supervisory stress tests should include market-based analysis.
- Tests should include smaller lenders.
- Scenarios should be more severely adverse yet still plausible.
- Supervisory capacity:
- Bank supervisors need to be proactive and ready to address identified weaknesses.
- More than half of economies do not have independent bank supervisors with adequate resources (per IMF Financial Sector Assessment Program findings).
- Regulatory standards:
- International standards need raising to manage liquidity and interest rate risks in banks.
- At least one-fifth of economies have weak supervisory and regulatory practices to monitor and address these risks.
- Central bank access:
- Banks should be better prepared to access central bank lending facilities.
- Banks should periodically test such access while supervisors assess whether weaker lenders can easily tap emergency assistance.
Near-term priorities
- Use the current lull in banking strains to increase resilience in banks, regulators, and supervisors.
- Prepare for a possible resurgence of banking risks if interest rates stay higher for longer than currently priced in markets.
—This blog is based on Chapter 2 of the October 2023 Global Financial Stability Report, “A New Look at Global Banking Vulnerabilities.”