In the US, a 2018 law--passed with bipartisan support--rolled back some of the stringent rules to determine liquidity risks set in the Dodd-Frank financial reform act for banking companies with assets below $250bn, up from $50bn. More specifically, those institutions do not have to undergo stress tests or submit so-called living wills. $250bn was the new threshold under which banks are deemed too important to the financial system to fail. The decision also increased the risk of more taxpayers’ liabilities upon larger potential bank failures. Banks such as Silicon Valley Bank were not covered under the new relaxed threshold.
In Europe, “contrary to the US, the regulatory rules on liquidity such as the Liquidity Coverage Ratio and the Net Stable Funding Ratio apply to all banks, whatever their size”, said Jerry Grbic, CEO at the ABBL. The objective of the LCR is to promote short-term resilience by ensuring that banks have enough liquid assets, whereas the NSFR aims at stable funding structure. In other words, the LCR addresses the asset side of the balance sheet, and the NSFR addresses the liability/equity profile.
Moreover, “the analysis and the stress tests on Interest Rate Risk in the Banking Book (IRRBB), must be achieved annually so that the regulator can observe the evolution for various banks coupled with the review of the 10 largest credit commitments”, said Grbic. The IRRBB refers to the current or prospective risk to the bank’s capital and earnings arising from adverse movements in interest rates that affect the bank’s banking book positions. “The exercise includes also the small banks”, he said. “Should risk indicators are increasing, the regulators will ask questions”.
“The management of maturities and interest rate have been catastrophic at SVB”, said Grbic. “The banks in the best position nowadays are the those that implemented hedges, a costly initial decision, but one that do not have to sell positions with a loss”.
The euro has simplified hedging decisions
Grbic believes that the arrival of the euro has helped the domestic banks in the management of their hedges, as the Belgian and Luxemburg francs had nowhere near the volume nowadays accessible with the euro at much cheaper levels. In addition, “the euro has also enabled the banks to offer much larger bonds with fixed rates in a deeper and liquid market”. He added: “the asset-liability management has strongly progressed in Luxembourg whereas these operations used to be maintained in large centres, such as in London”. Depending on their “buffer over the required capitalisation” some banks may decide to hedge all or 80% of their interest rate risk depending on their risk appetite, their capacity, but also on the nature of the bank’s business.
On asset quality, Grbic does believe that the domestic markets will not generate an important level of default as Luxemburg banks “have always had a conservative approach”. Despite complaints from real estate promoters “that the banks never offer enough credit”, the “general rule for the local banks”, according to Grbic, is “not to finance more than 80% of the asset value”.
There are exceptions. “The regulator authorises the first-time buyers to finance up to 100% of the value of the property”, he said. “However, the mortgage repayments should not exceed more than one-third of the net revenues of the client or the couple”. Historically, domestic banks have offered mainly variable rates, until 3-4 year ago. Since then, only one-third of new loan originations were still at variable rates, making those clients and banks most exposed to higher interest rate resets but also to the recent decline in real estate prices should the sale of the house become necessary.
Yet, Grbic does not believe that the rising rate environment will change the banks’ approaches in providing mortgages, but he expects them to be more conservative in assessing properties’ valuation.
This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .