Latin American banking systems are facing a new challenge: the management of interest rate risk.
Banks are inherently exposed to interest rate risk on all their interest rate-related assets and liabilities; their liabilities typically have short maturities, while their assets are usually long-term. However, these risks may not affect all banks in the same way and might be heightened in a period in which monetary policy is difficult to predict. For example, European banks can better withstand interest rate risks than their US peers, as reported previously.
The world was reminded of the importance of managing interest rate risk during the banking turmoil triggered by high interest rates in March 2023 which saw the collapse of Silicon Valley Bank and other US-based regional banks.
However, compared with peers in advanced economies, Latam banks have reasons to be particularly cautious.
To begin with, they make less use of interest rate derivatives to hedge against interest rate risk. For the median banking system in advanced economies, the gross market value of interest rate derivatives was almost 7% of total assets in 2022, a higher proportion compared with emerging market banks, according to a BBVA report.
Moreover, net interest income, more sensitive to interest rates, is greater than in other regions as a percentage of total revenue, reported the Bank for International Settlements (BIS) in a September paper. In 2022, net interest income made up 65% of total income in the region, compared with less than 55% at the median bank in advanced economies.
Instead, banks in the region mitigate the impact of rate changes by minimising repricing gaps between assets and liabilities, BBVA Group chief economist Jorge Sicilia told the Regional Policy Dialogue for the Financial Sector conference organised earlier this month by the Inter-American Development Bank.
If a bank has a high proportion of its liabilities at a fixed rate, it cannot adjust quickly when there is a change in interest rates, says Larisa Arteaga, director, Latin America Financial Institutions at Fitch Ratings.
The greater exposure on consumer loans increases credit risk and the mismatch of assets and liabilities.
“Many banks in Latin America are underpinning their growth on short-term consumer loans while most of their customers are migrating from sight deposits to term deposits as they look to get high interest rates. Therefore, they have a higher proportion of liabilities in fixed rates and longer-term than assets, which makes managing interest rate risk more challenging,” Ms Arteaga says.
The risk of increased sovereign debt holding
In the past decade, Latam banks have doubled the size of their fixed-income portfolio while lenders in advanced economies have moved in the opposite direction. Such increases also change the nature of their exposure to interest rate risk.
In 2022, securities accounted for almost 30% of assets at banks in Latin America, compared with 17% in advanced economies, says the BIS.
Fixed-income securities reached 29.3% of total assets in 2022, says the BIS. The same indicator was 17.5% for banks in advanced economies at the end of last year. The duration of these portfolios increased, which is exposing lenders to greater impacts from changes in interest rates.
Holdings by banks of domestic sovereign debt surged in emerging markets during the Covid-19 pandemic. The larger holdings of domestic sovereign debt by emerging market banks have strengthened the ties between the sovereign and banking sectors, the so-called sovereign-bank nexus.
Because public debt is at historically high levels, with the sovereign credit outlook deteriorating in many emerging markets, a deeper nexus poses risks for lenders, says the International Monetary Fund (IMF) in a report. The problems for banks will arise if a sovereign struggles to service its debt and/or banks face widespread defaults from other borrowers in a context of high interest rates.
Other risks
Latin American banks have heavier cost structures than other regions, explains Mr Sicilia. Their financial position is sound, but with room for improvement in asset quality and operational efficiency, he adds.
Total operating expenses is close to 4% of total assets on average in the region, higher than other regions.
Other risks for the sector include partial dollarisation in some countries, liquidity tensions in some markets, and the growth of some credit portfolios including consumer lending following the pandemic.
Finally, economic growth in the region is expected to slow this year and in 2024. The Latam and Caribbean region is expected to see growth decline from 4.1% in 2022 to 2.3% this year, according to the IMF. Banks will find it difficult to increase appetite for lending, as previously reported by The Banker.
