Question

The first half of 2020 has been very challenging for the Australian banking sector with major bush fires, then several severe storms (e.g. Canberra hailstorm) and now the COVID-19 outbreak and shutdown of the Australian economy. We have discussed, how the impact these events—particularly COVID-19—has had on the banks as well as how the banks and regulators have responded to the challenges.
You are the team leader of the Strategy and Operations team at the Commonwealth Bank of Australia. The CEO and Board has asked you to write a series of three short memos outlining the impact that COVID-19 has had on the bank and your recommendations for operations in the next 6 to 12 months. Each of the memos will focus on one fundamental risk and should be written independent of the other memos so that each memo is self-contained (e.g. when reading memo 1, you do NOT need to read the memos 2 and 4 to understand memo 1).

Question 1
Write a memo outlining the impact that COVID-19 has had on interest rate risk for the bank. Suggest some strategies the bank can use to manage this risk in the next 6-12 months.

Answer 1

Commonwealth Bank of Australia

COVID-19 and the economy

• The outbreak of COVID-19 is primarily a public health issue, but it is also having a major impact on the economy and the financial system. As the virus has spread, countries have restricted the movement of people across borders and implemented social distancing measures. The result has been major disruptions to economic activity across the world. This is likely to remain the case for some time yet as efforts continue to contain the virus.
• The primary response to the virus is to manage the health of the population, but other arms of policy, including monetary policy, play an important role in reducing the economic and financial disruption resulting from the virus.

Impact of COVID -19 on interest rate risk

• Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. The management of Interest Rate Risk should be one of the critical components of market risk management in banks.
• The COVID-19-induced market environment may negatively impact banks’ credit rating profile. New systemic, country, or other business risk factors may intensify and affect the creditworthiness of banks, counterparties, and borrowers, especially in the high-yield grade
• The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term impact of changing interest rates is on the bank’s networth since the economic value of a bank’s assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates.
• A sharp drop in interest rates and increased volatility in securities and FX prices increase banks’ market risk, potentially leading to losses

Strategies to manage the risks

• To implement strategies and policies with respect to interest rate risk management and ensure that senior management takes the steps necessary to monitor and control these risks. The board of directors should be informed regularly of the interest rate risk exposure of the bank in order to assess the monitoring and controlling of such risk.
• To hold capital commensurate with the level of interest rate risk undertaken.
• To estbalish appropriate hedging policies to manage interest rate risk.