Always consider hidden risks
How Sensitive we are to Interest Rates: A Scary Picture ?
( From FRED, IMF,BIS, BOE, BOJ )
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Many like to argue that their economy is healthy and well-balanced in terms of indebtedness, unlike Japan's in the late 1980s. But we must realize that since the financial crisis in 2007, huge pile of debt is still being add to the system again.
And that pile of debt means a lot in terms of interest rates risks. How sensitive we became since the big spike in interest rates in 1994?
Well, we tried to grab some interesting numbers for you. Some results that can keep Central Banks awaken at night !
Banks Holdings of Government Debt
The value of banks’ fixed-income assets would be particularly
affected if global interest rates were to rise sharply. Sovereign
bond holdings of some banking sectors have increased in
recent years ( see graph below).
In Japan, these holdings comprised
around 25% of banks’ assets in 2012 Q3, compared with less
than 2% of UK banks’ assets.
The Bank of Japan has estimated
that a 100 basis point increase across the yield curve would
cause mark-to-market losses of 10%
of Tier 1 capital for major
Japanese banks and even more for regional banks. A sharp rise
in global interest rates would also affect a number of other
real and financial asset values.
As governments responded quickly to the financial crisis with bank bailouts and fiscal
stimulus to avoid the implosion of the financial system, their indebtedness explode to new highs. And in countries that experienced a
housing bubble in the run-up to the crisis, households had already accumulated
In the half-decade since the peak of the crisis, the hope was that
significant progress would be made in the necessary deleveraging process, thereby
enabling a self-sustaining recovery.
Instead, the debt of households, non-financial corporations and government
increased as a share of GDP in most large advanced and emerging market
economies from 2007 to 2012.
For the countries in the chart below taken
together, this debt has risen by $33 trillion, or by about 20 percentage points
GDP. And over the same period, some countries, including a number of emerging
market economies, have seen their total debt ratios rise even faster. Clearly, this is
unsustainable. Overindebtedness is one of the major barriers on the path to growth
after a financial crisis and will explain why we will have a prolonged slow growth period...
The Broad Picture
In several economies, and especially in the advanced ones, low interest rates spark an explosion of credit borrowing.
The financial system’s massive holdings of government bonds leave it exposed to a spike in yields. While the large public financing
needs have been fully absorbed by the market thus far, the willingness of market participants to continue to do so at low yields is contingent on sustaining confidence in long-term fiscal sustainability and growth, and on corporate and household savings trends.
Sensitivity to a rise in interest rates have more than triple on average compare to 1994 for the G7 countries. And this is only Government bonds excluding Central Banks. I do not want even to figure out what s the result if we add Corporate debt and Consumer debt.
Worrisome indeed !
Have we learned something since the financial crisis ?
Holders of Government Bonds : Sensitivity to an Interest Rates Shock
Consider what would happen to holders of US Treasury securities (excluding
the Federal Reserve) if we have a paralell yield shift of a rise by 3 percentage points: they would lose more than $1 trillion, or almost 8% of US GDP
( see chart below,
The losses for holders of debt issued by France, Italy, Japan and
the United Kingdom would range from about 15 to 35% of GDP of the respective
countries. Yields are not likely to jump by 300 basis points overnight; but the
experience from 1994, when long-term bond yields in a number of advanced
economies rose by around 200 basis points in the course of a year, shows that a big
upward move can happen relatively fast.
And while sophisticated hedging strategies can protect individual investors,
someone must ultimately hold the interest rate risk. Indeed, the potential loss in
relation to GDP is at a record high in most advanced economies. As foreign and
domestic banks would be among those experiencing the losses, interest rate
increases pose risks to the stability of the financial system if not executed with great
Clear central bank communication well in advance of any moves to tighten
will be critical in this regard. We already saw a missperception of Central Bank communication with the markets with the Federal Reserve on June 19.
Japanese Banks and Government Bond Holdings
JGB market exposures represent one of the central macrofinancial risk factors. This risk reflects the possible impact on public debt sustainability of changes in yields and related effects on investor confidence; the increased role of the private financial sector in
covering government borrowing needs; the prospect that ongoing demographic shifts will reduce private saving; and growing household interest in investing abroad.
Interest rate risk sensitivity is especially prevalent in regional banks and insurance companies (JGBs representing about 70 percent of life insurers' securities holdings and 90 percent of insurance cooperatives’ securities holdings). In addition, the main public pension scheme, as well as Japan Post and Norinchukin bank, also have large JGB exposures as shown by the charts below...
As expected, JGB market exposures constitute one of the central macrofinancial risks for the system. Tests including market yield shocks (i.e., the macro scenario with a 100 bps shock and the sensitivity test for a larger shock) reduce aggregate capital ratios in the first two years more than other scenarios.
Banks in Japan have a larger exposure to domestic sovereign debt than those in any other advanced economy. The BOJ (2012) notes that regional banks in Japan in particular are especially vulnerable to the risks of these large holdings: according to the BOJ, a 100-basis-point increase in interest rates across the yield curve would lead to mark-to-market losses of 20 percent of Tier 1 capital for regional banks and 10 percent for the major banks.