Introduction: A financial institution’s balance sheet is more than just a static snapshot of assets and liabilities. When viewed through the lens of risk management, it holds the key to understanding a bank’s exposure to interest rate and liquidity risks. By segmenting and reorganizing the balance sheet, institutions can uncover insights that drive strategic decisions, protecting equity and managing risks in a dynamic market.

In this article, we’ll explore some practical tips on redesigning balance sheets to better identify and measure interest rate risk (IRR) and liquidity risk, while highlighting key metrics that can be leveraged for a more accurate risk assessment.

1. Breaking Down Interest Rate Risk (IRR): Earnings at Risk and Economic Value at Risk

Interest rate risk is a critical component of a bank’s overall risk profile. Two key metrics used to measure this risk are Earnings at Risk (EaR) and Economic Value at Risk (EVaR).

• Earnings at Risk (EaR): This metric focuses on the potential changes to the bank's net interest margin (NIM) as a result of interest rate shocks. It’s derived from the institution’s run-in balance of fixed and variable rate loans and advances. EaR essentially helps forecast how much of the bank’s current earnings are vulnerable to changes in market interest rates.
• Economic Value at Risk (EVaR): EVaR, on the other hand, examines the long-term impact of interest rate movements on the economic value of equity. It considers yield curve risks and focuses on the impact of shocks on run-off balances of assets and liabilities. This metric is vital for assessing how interest rates beyond a 12-month horizon could affect the bank’s capital position.

2. Liquidity Risk: Understanding Key Liquidity Metrics

Liquidity risk is equally important, and its mitigation lies in understanding the institution’s ability to meet short-term obligations under different market conditions. The best sources for liquidity metrics are the institution’s high-quality liquid assets (HQLA) and cash flows.

While we won’t delve into the technicalities of stress testing, the key is to separate assets and liabilities into fixed and variable rate segments, and to classify liquidity assets by their levels. This helps in determining the store of liquidity available and the exposure to volatility in market rates.

3. Restructuring the Balance Sheet for Risk Insights

Now that we’ve established the key metrics, let’s look at how the balance sheet can be redesigned to better expose interest rate and liquidity risk.

• Loans and Advances: Separate these into fixed rate loans (which provide run-in balances) and variable rate loans. This segmentation allows for a clearer understanding of which assets are most sensitive to interest rate fluctuations.
• Funding: The funding side should similarly be segmented into fixed rate/fixed term funding and those with indeterminate maturities. Slicing the funding maturities into granular profiles provides a more accurate picture of the institution’s cash flow needs and risk exposure.

By organizing assets and liabilities into distinct categories (fixed, variable, and liquid), banks can more easily calculate the weighted average rate for each pool. This can then be used to perform run-in and run-off tests, mapping to yield curve nodes. Though typically assessed through key rate duration (KRD), mapping maturity profiles to yield curve nodes can simplify long-term interest rate exposure analysis.

4. Conducting Risk Exposure Tests

With this restructured approach, financial institutions can now conduct interest rate risk and liquidity exposure tests that, while not perfectly precise, can offer valuable insights. For example, by analyzing the sources of time decay, banks can ensure that their portfolios maintain positive duration, which protects earnings from sudden rate drops—a common vulnerability for institutions with negative exposure to falling rates.

5. Adapting to Changing Market Conditions

In today’s economic environment, particularly in emerging markets, many banks are funded through both the short and long ends of the maturity spectrum. In cases of an inverted yield curve, this can significantly impact profitability. Traditional "borrow short, lend long" strategies may need to be revisited.

To optimize the balance sheet, institutions should consider building a long-end funding term structure while keeping loan portfolios relatively short. This strategy can help navigate periods of market volatility while preserving earnings stability.

Conclusion: A Strategic Approach to Risk Management

By redesigning the balance sheet into segmented profiles and applying tailored risk metrics, financial institutions can gain a clearer understanding of their interest rate and liquidity risk exposures. This structured approach empowers banks to optimize their balance sheets in line with current market conditions, protect their equity, and navigate complex financial environments with greater confidence.

Call to Action: Have you revisited your balance sheet design recently? If not, now might be the time to ensure your institution is equipped to handle future market fluctuations. Let’s discuss how to tailor your balance sheet for optimal risk management.