Stefano Chiarlone, CFO Italy, UniCredit

Below is an insight into what can be expected from Stefano’s session at Risk Evolve 2024.

The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.

In what ways can firms adapt business strategies to a changing interest rate environment?

Firms should already take interest rate evolution into consideration when performing forecasts and planning by using a series of levers. The exposure to rates needs to be mitigated by accurate risk management practices via derivatives or other hedging techniques. At the same time, it is important to have proper monitoring of the evolution of rates, also relying on market consensus or forward, in order to manage the financing strategy and the deployment of excess liquidity according to rate evolutions. Finally, the working capital should be planned accurately to avoid unnecessary financial costs related to short-term borrowing.

How can financial institutions adapt to navigate the ripple effects of interest rate changes on credit and liquidity risk?

There are different levers to be activated by financial institutions. But there is a precondition: there should always be an overview of the potential impacts of interest rate changes on both portfolios and liquidity profiles. This requires scenario planning and simulations of the impact of rate changes on the riskiness of clients (by portfolios for more granular segments) in order to assess potential LLPs evolutions on NII to manage top-line and liquidity KPIs. Once simulations are defined, the following step is to design mitigating strategies and enact dedicated actions. The toolbox to be utilized to manage interest rate fluctuations allows a variety of choices. It requires a proper asset and liability management strategy to reduce vulnerability to rate changes via potential hedging and replicating strategies, and it also necessitates a diversification of exposures via a careful limit definition strategy on the asset side. A constant market focus and appropriate monitoring approach are key to taking appropriate preemptive positions exploiting the evolution of market conditions.

What are some of the specific dynamics that arise in credit and liquidity risk when interest rates fluctuate?

Overall, the fluctuations of rates can impact in a significant way the dynamics of credit and liquidity risk of a bank. Hence, banks have an articulated set of KPIs that are used to monitor closely such risks in order to maintain financial stability. Just to name a few related to credit risk, interest rates impact borrowers’ ability to service their debt if they are exposed to floating rates (and are not hedged), leading to increased risk of delinquencies and fluctuations in credit quality. Such impact can also pass through an increase in the refinancing risk of specific term exposure for borrowers or via a reduction of the value of specific collaterals. All in all, this might end up worsening borrowers’ ratings and hence increasing the RWA related to such a position, thus hitting the capital ratios of banks. As far as liquidity risk is related, the increase in rates might negatively impact the funding costs of banks, either direct funding via deposits or market funding or might impact the investors’ appetite. Such impact may affect the market liquidity pool for various asset classes and hence the capability of banks to execute specific transactions. For deposits, the evolution of market rates can impact the cost of deposits for banks, but also their overall stock if clients look for alternative investment strategies for their “non-core” cash and shift their money from the current account to other financial instruments.

What considerations should financial institutions take into account when analyzing the impact of interest rate fluctuations on earnings and profitability?

Further to the impact on the value of assets, liabilities, and equity, there are various factors to be considered when analyzing the Interest Rate Sensitivity of earnings and its impacts on the profitability of a financial institution. First and foremost, the effect on the net interest margin, looking at both assets and liabilities. This analysis needs to be performed preemptively and regularly, with a focus on rate expectations also based on consensus and forwards. Such assessment is needed to envisage appropriate smoothing strategies and revise dynamically the pricing to be applied to loans and deposits, also considering the profitability targets and the competitive pressures. This also requires a constant focus on potential influences of rates on customer behavior, including deposit flows, loan demand, and investment preferences. Obviously, banks also need to consider the potential mismatch between the maturities and the repricing characteristics of the various assets and liabilities. The shape and movements of the yield curve, to assess the profitability of different financial products and strategies and the related earnings volatility should be taken into consideration as well. Banks need to regularly assess the effectiveness of their hedging strategies. Finally, the impact on regulatory requirements must remain at the forefront of the analysis.

How can firms prepare for economic uncertainty and financial shocks in a changing risk environment?

it’s crucial to have an appropriate planning function regularly monitoring economic indicators and performing scenario analysis in order to identify potential economic and financial shocks. Such data are needed to adjust strategies and plans accordingly and to develop contingency plans to mitigate their impact. Performing stress tests to assess the resilience of the firm’s financial position under such scenarios, and to identify pain points and vulnerabilities to be addressed is also fundamental to increase the resilience and increase the financial buffers. In this case, cash reserves can be built up to maintain sufficient actual or contingent liquidity to withstand periods of financial stress and uncertainty. Companies should consider appropriate insurance and hedging strategies to protect against specific risks, like currency fluctuations and commodity price volatility. Also, implementing robust risk management practices, including credit risk, market risk, operational risk, and liquidity risk is key and should include appropriate measures to withstand supply chain disruptions. Finally, cost-efficiency improvements to enhance cost resilience can help to maintain profitability during challenging economic conditions. By proactively implementing such steps, firms can enhance their resilience to economic uncertainty and financial shocks in a changing risk environment.