Risks Ahead for the Financial Industry in a Changing Interest Rate Environment pdf

OECD Journal: Financial Market Trends
Volume 2010 – Issue 1
© OECD 2010
Pre-publication version

OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010 1
Risks Ahead for the Financial
Industry in a Changing
Interest Rate Environment

Gert Wehinger
*

The current interest rate environment has been conducive to financial
institutions assuming exposure to interest rate risks. As interest rates are
expected to rise globally, albeit slowly, and current steep yield curves may
soon flatten, such risks may materialise in the near future. At the same
time, weaknesses in the banking sector still exist, especially for some
segments of the European banking sector. While the effects of changes in
interest rates and their structure on financial institutions differ, recent
changes in asset and funding structures of banks make them generally
more vulnerable to a changing interest rate environment. Currency risk
exposure has also grown, and regional concentration may pose specific
risks. An unravelling of carry trades will have a negative effect on some
institutions. Proper risk management can help during an adjustment
process, and regulatory reforms underway will better support risk
management functions in financial institutions that are, in any case,
already adjusting to the new environment.
JEL Classification: G01, G12, G15, G21, G32
Keywords: financial crisis, interest rate risks, sovereign risks, bond
markets, banks

*
Gert Wehinger is an economist in the Financial Affairs Division of the OECD Directorate for Financial and
Enterprise Affairs. This article is based on a background note prepared for the OECD Financial Roundtable held
on 15 April 2010 with participants from the private financial sector and members of the OECD Committee on
Financial Markets. The present version takes into account the discussions and comments made at that meeting
and selected developments that have taken place since. The author is grateful for additional comments from
Adrian Blundell-Wignall and André Laboul, as well as editorial assistance from Laura McMahon and Jane
Voros. The author is solely responsible for any remaining errors. This work is published on the responsibility of
the Secretary-General of the OECD. The opinions expressed and arguments employed herein do not necessarily
reflect the official views of the Organisation or the governments of its member countries.
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

2 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010
A. Current financial market outlook and risks
1. Selected recent developments
Financial markets
are searching for
direction, concerned
about sovereign risk
and the strength of
the recovery
Financial markets are searching for direction. While the global recovery is
ongoing, it is uneven across countries and regions, and investors still worry
about sovereign risk and the potential fallout from fiscal austerity programmes
and the gradual withdrawal of exceptional central bank support. Some
emerging markets are showing signs of overvaluation, especially in Asia, which

has received substantial capital inflows (Figure 1). Current weaknesses still
warrant fiscal and monetary policy support in most OECD economies, but
upward pressures on interest rates are increasing as public and corporate
financing needs are high, while central banks have started to withdraw from the
extraordinary policy measures they had taken in response to the financial and
economic crisis. Significant market pressures have accelerated fiscal
consolidation programmes in Europe. In emerging economies, most of which
have been less afflicted by the crisis than OECD countries, markets have picked
up more vigorously thanks to a relatively stronger recovery, and policy has
started to tighten.
Figure 1. Returns across a broad spectrum of asset classes
Selected investment alternatives, percentage changes over period, annualised, in US dollar terms
‐64.1%
‐49.0%
‐55.5%
‐53.7%
‐46.5%
‐40.5%
‐44.9%
‐50.4%
‐38.7%
‐38.6%
‐38.5%
‐43.3%
‐33.8%
‐28.7%
‐48.8%
‐28.2%
‐1.7%
‐6.7%

‐10.2%
‐10.9%
‐11.1%
30.0%
10.6%
21.2%
‐47.5%
‐42.8%
‐19.1%
12.3%
14.0%
12.7%
0.2%
49.9%
48.9%
45.5%
40.0%
33.7%
25.6%
19.5%
18.4%
16.2%
14.8%
13.5%
12.4%
11.9%
8.7%
6.7%
2.7%
29.2%

25.1%
24.8%
24.3%
21.9%
5.4%
1.2%
‐0.5%
49.7%
28.8%
19.5%
5.9%
1.3%
‐8.0%
‐13.6%
‐80% ‐60% ‐40% ‐20% 0% 20% 40% 60%
EQUITIES:
INDIA‐DS Market
LATINAMERICA‐DSMarket
EMERGING MARKETS‐DS Market
ASIAEXJAPAN‐DS Market
CHINA‐DS MARKET $
NASDAQCOMPOSITE
WORLD‐DSMarket
FTSE100
DJUSTOTALSTOCKMARKET
US‐DSMarket
S&P500COMPOSITE
DAX30PERFORMANCE
DOWJONES INDUSTRIALS
NIKKEI 225STOCKAVERAGE

EMU‐DS Market
TOPIX
BONDS:
JPMEMBI
GLOBALMIDDLE EAST
JPMEMBIGLOBALASIA
JPMEMBIGLOBALAFRICA
JPMEMBIGLOBALCOMPOSITE
JPMEMBIGLOBALLATINAMERICA
JPBENCHMARK 10YEAR DSGOVT. INDEX
EMUBENCHMARK 10YR.DS GOVT.INDEX
USBENCHMARK 10YEAR DS GOVT.INDEX
OTHER:
EconomistCommodity Inds/All($)
S&PGSCICommodity Spot
DJCSHEDGE HEDGE FUND $
CarrytradeIndex‐ USD‐ AUD(a)
CarrytradeIndex‐ USD‐ NZ$(a)
CarrytradeIndex‐ Yen‐ AUD(a)
CarrytradeIndex‐ Yen‐ USD (a)
2008(1‐Jan‐08to 1‐Jan‐09)
From1‐Jan‐09to29‐Jul‐10 
(annualised)

Notes: a) The carry trade return index is calculated based on the assumption of one-month investments in the respective
currencies, borrowing in yen, applying one-month eurodollar interest rates and central exchange rates, without taking into account
bid/ask spreads and transaction costs.
Sources: Thomson Reuters Datastream and OECD.
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010 3
Most bond spreads
have narrowed,
reflecting relief
after the recent
turmoil, but specific
risks are still
apparent…
Bond markets are showing signs of relief after the recent sovereign
turmoil. Corporate and emerging market bond spreads have narrowed again
after some widening in the wake of the recent turmoil and are back in the range
of their longer-term averages (Figure 2). Some euro area government bond
yields are still unusually high, and spreads over German bunds have widened.
However, some recent sovereign bond issues by countries with large deficits,
including Greece, received an encouraging market reception. Weaknesses in the
banking sector are reflected in interbank market rates that are still relatively
elevated.
Figure 2. Have risk spreads narrowed too much?
High-yield and emerging market bond spreads
0
200
400
600
800
1000
1200
1400
Basispoints
Investmentgrade‐ US(Barclays)
Investmentgrade‐ Europe(JPM)

Highyield‐ US(BOFAML)
Highyield‐ Europe(JPM)
EMBIglobal(JPM)
Jul/Aug'07:
sev eresub‐
prime
effectson
money
markets
Mar‐08:
BearSterns
collapse
Sep08:GSE
takeover,
Lehman
collapse
April/May10:
EU sovereign
debtcrisis

Note: Daily data until 29 July 2010.
Source: Thomson Reuters Datastream.
Ample liquidity may
distort risk pricing
With still ample global liquidity, narrow spreads are also a reflection of
investors’ search for yield in the current low-interest-rate environment. While
the very low pre-crisis spreads have not been attained when measured against
the current background, risk spreads may have been lowered to unhealthy
levels, pricing risks again too low. Ample liquidity is also evident in other
market segments, in particular in certain commodities.

Carry trades are
starting to unwind
As interest rates and exchange rates are adjusting and global rebalancing is
expected to lead to further realignments, carry trades are likely to unwind. Thus
far these trades have been profitable in exploiting low US interest rates and
some fixed exchange rates in Asia. Should such adjustments happen abruptly,
the unwinding could be disorderly, jeopardising market stability.
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

4 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010
Figure 3. Interest rates are expected to rise
Interest rates as implied by futures markets
0.42
0.41
0.44
0.45
0.46
0.47
0.55
0.67
0.83
1.03
1.22
1.43
3.27
3.37
3.49
3.61
4.08
2.86

2.91
2.95
2.94
3.25
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Percent,perc entagepoints(ppt)
UnitedStates
Shortterm(1‐month) Shor tterm (3‐month) Longterm(1 0‐ye ar) Spread10y‐ 3m(ppt)
0.92
0.97
1.00
1.00
1.06
1.08
1.16
1.26
1.36
1.52
1.63
1.77

2.50
2.65
2.65
1.53
1.59
1.49
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Percent,per centagepoints(ppt)
Euroarea
Shortterm(3‐month) Long term(10‐year) Spread10y‐ 3m(ppt)
0.77 0.77
0.76
0.85
0.99
1.16
1.35
1.58
1.79
2.02
4.44

4.53
4.24
3.67
3.68
3.25
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Per cent,per c e ntagepoints(ppt)
UnitedKingdom
Shortterm(3‐month) Long term(10‐year) Spread10y‐ 3m(ppt)

Notes and Sources: see next page.
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010 5
Figure 3 (cont’d). Interest rates are expected to rise
Interest rates as implied by futures markets
1.10
1.18
1.28
1.31

1.46
1.61
1.79
2.01
2.21
2.45
3.27
3.39
3.49
3.58
2.09
2.08
2.03
1.97
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Per cent,per c e ntagepoints(ppt)
Canada
Shortterm(3‐month) Long term(10‐year) Spread10y‐ 3m(ppt)
0.36
0.34

0.33
0.32
0.30 0.30
0.31
0.33
0.34
0.36
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Per cent,perc entagepoints(ppt)
Japan
Shortterm (3‐month)

Notes: Data as of 29 July 2010. United States: Short-term future rates are calculated from CBT 30-day Fed Funds (sett. price) and
CME 3-month eurodollar (sett. price); long-term futures are CBT 10-year US T-note yields. Euro area: Short-term future rates are
calculated from LIFFE 3-month Euribor (sett. price); long-term futures are Eurex Euro Bund yields. United Kingdom: Short-term
future rates are calculated from LIFFE 3-month STERLING (sett. price); long-term futures are LIFFE Long GILT yields. Canada:
Short-term future rates are calculated from ME Bank Accept. 90-day (sett. price); long-term futures are ME 10Y Canadian govt.
bond yields. Japan: Short-term future rates are calculated from TIFFE 3-month euroyen Tibor (sett. price).
Sources: Thomson Reuters Datastream, OECD.
2. Interest rate outlook and risk premia

Interest rates are
expected to rise
globally, although
not very steeply
In this context, interest rates are expected to rise more globally, as judged
by futures markets (Figure 3). For most major economies, the very low short-
term rates are expected to rise only very slowly this year, with some slightly
more significant increases only as of next year. In Japan, short-term rates are
expected to fall well into next year. This sluggish development of short-term
rates mainly reflects the expectations that central banks will accommodate the
remaining weaknesses of these economies, while inflation pressures (as
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

6 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010
measured by nominal vs. real bond yield differentials) remain subdued, despite
the recent commodity price increases (Figure 4). Such increases, reflecting
actual and further expected rising demand mainly from emerging markets,
might forebode further upward price pressures that might not be adequately
reflected in behaviour underlying the market pricing of such inflation
expectation proxies.
Figure 4. Expected inflation still low despite increases in crude oil and commodities
Inflation expectations as implied by indexed bonds vs. price changes in crude oil and commodities
-150%
-100%
-50%
0%
50%
100%
150%
-1.5

-1
-0.5
0
0.5
1
1.5
2
2.5
3
3.5
Percentage points
United States breakeven inflation
Euro area breakeven inflation
%p.a. London BrentCrude Oil Index USD/BBL (r.h.s.)

Note: Daily data until 29 July 2010. Implied inflation expectations ("breakeven inflation") are differences in yields between 10-year
government benchmark bonds and inflation indexed bonds (BofA/Merrill Lynch government inflation-linked bond indices).
Source: Thomson Reuters Datastream.
The relatively
slower rise in long
rates may compress
term spreads
The expectations of only a weak rise in economic activity and no
significant increase in inflation expectations may be the main drivers behind the
equally lacklustre upward trend for long-term interest futures. In the United
Kingdom, futures markets even expect long-term rates to fall by the first
quarter of next year, reflecting more serious weaknesses of the economy. The
weaker (or downward) trend of long-term, as compared to short-term, rates is
resulting in falling term spreads between ten-year and three-month futures rates
in all cases shown, except the United States.

Feedback effects
from the real
It is also important to take into consideration that changes in interest rates
will themselves generate feedback effects that work through the real economy
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010 7
economy could
amplify or mitigate
interest rate
movements
and may mitigate or amplify interest rate movements. These changes are driven
primarily by spending and investment decisions by firms and households.
Important channels in this context are income and wealth effects. Regarding the
income effect, for example, household spending decisions will depend on
changes in the debt servicing burden. Likewise, investment decisions by firms
will depend on financing costs and the burden of servicing current debt, even
though firms tend to enjoy greater financing and risk hedging flexibility than
households. For the same reasons, small firms would be more affected than
large firms. Regarding the wealth effect, spending and investment decisions
may be sensitive to changes in net wealth incurred by changes in interest rates.
Both effects would then feed back into the financial sector in terms of credit
demand, default rates and the like, with perhaps significant second- and third-
round repercussions on interest rates and risk spreads (e.g. credit restrictions
leading to further default rates and lower spending).
3. Sovereign risk and some implications
Sovereign risk
premia and inflation
may not be
adequately reflected

in futures prices
Looking at current developments and the risks ahead, the projections, as
implied by futures markets and presented here, are highly uncertain. For one,
these futures refer to supposedly “riskless” government paper, and it is only
recently that the risk concept for government securities is being questioned (and
may lead to a major overhaul of models and concepts in finance). The Greek
crisis has shown that being part of a monetary union does not prevent
speculative attacks on a member of the union, and widening deficits in many
other OECD economies have put sovereign risks on top of risk watchers’ lists.
Sovereign credit default swap (CDS) spreads have been reflecting such trends
more strongly (Figure 5) – making some sovereigns look riskier than the
banking sectors in major economies. However, the EU-IMF rescue package for
Greece,
1
ECB interventions in the euro area secondary markets for public and
private debt securities, as well as the enhanced efforts for fiscal consolidation
made by many European governments, have calmed the markets, and risk
spreads have declined from their recent peaks.
Sovereign defaults
may become a
possibility
Even some large economies, whose market size and currency standing
gives them easy access to market financing, are on rating agency watch for
downgrades if their budget plans are considered to be unsustainable. For such
economies, the problem may be that their relatively good liquidity position is
hiding problems of a worsening, unsustainable solvency position. In the
absence of immediate market pressure, necessary adjustment may be further
delayed. While sovereign default is unlikely for large economies, a “quasi”
default via high inflation may be an option, even though not an immediate one
given the slack in most economies since the 2008 crisis. For smaller members

of the euro area (as for any fixed exchange rate regime economy) this option is
not available at a national level. As inflation cannot deviate too much from
euro-wide inflation, a real devaluation, i.e. deflation, would be warranted. But
this could trigger a detrimental debt-deflation spiral, in which the real value of
debt increases, with negative feedback from deflation and recession.
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

8 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010
Figure 5. Selected credit default swap (CDS) spreads
0 100 200 300 400 500 600 700 800 900 1000
Greece
Hungary
Portugal
Ireland
Spain
Italy
Belgium
Slovenia
Austria
France
UnitedKingdom
Netherlands
Germany
UnitedStates
Norway
Sectors(memo):
USInsurance
EUBanks
UKBanks
EUInsurance

USBanks
UKInsurance
Basispoints
28/07/2008
28/07/2009
29/07/2010

Notes: Senior five-year credit default swap premiums (mid) for sovereign bonds, senior five-year credit default swap premium index
(mid) for banking sector.
Sources: Thomson Reuters Datastream and OECD.
Steep yield curves
due to low policy
rates may soon
flatten…
Thus far, long-term benchmark rates for major economies have remained
rather low, and steepening yield curves in most economies were thus the result
of short-term policy rates being lowered to unprecedented levels (Figure 6). If
insights can be gained from experience, the relationship between policy rates
and the steepness of the yield curve in the United States was especially strong
in the 1980s (Figure 7). While term spreads are still at historically high levels,
they have recently come down and are expected to decline further as monetary
policy tightens.
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010 9
Figure 6. Long-term rates are still low
(A) Ten-year government benchmark bond yields and US-euro yield spread
‐150
‐100
‐50

0
50
100
150
200
250
300
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
01/01/2004
01/03/2004
01/05/2004
01/07/2004
01/09/2004
01/11/2004
01/01/2005
01/03/2005
01/05/2005
01/07/2005
01/09/2005
01/11/2005
01/01/2006

01/03/2006
01/05/2006
01/07/2006
01/09/2006
01/11/2006
01/01/2007
01/03/2007
01/05/2007
01/07/2007
01/09/2007
01/11/2007
01/01/2008
01/03/2008
01/05/2008
01/07/2008
01/09/2008
01/11/2008
01/01/2009
01/03/2009
01/05/2009
01/07/2009
01/09/2009
01/11/2009
01/01/2010
01/03/2010
01/05/2010
01/07/2010
Percent
UnitedState s
EuroArea

Japan
SpreadUS‐EMU
(r.h.s.,b.p.) 

(B) Term spreads between ten-year and two-year government bond yields
‐50
0
50
100
150
200
250
300
350
01/01/2004
01/03/2004
01/05/2004
01/07/2004
01/09/2004
01/11/2004
01/01/2005
01/03/2005
01/05/2005
01/07/2005
01/09/2005
01/11/2005
01/01/2006
01/03/2006
01/05/2006
01/07/2006

01/09/2006
01/11/2006
01/01/2007
01/03/2007
01/05/2007
01/07/2007
01/09/2007
01/11/2007
01/01/2008
01/03/2008
01/05/2008
01/07/2008
01/09/2008
01/11/2008
01/01/2009
01/03/2009
01/05/2009
01/07/2009
01/09/2009
01/11/2009
01/01/2010
01/03/2010
01/05/2010
01/07/2010
Basispoints
Unite dStates
EuroArea
Japan

Source: Thomson Reuters Datastream.

RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

10 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010
Figure 7. US monetary policy impact on yield curves
Term spread of ten-year minus two-year benchmark yield vs. Fed funds target rate
0
2
4
6
8
10
12
14
16
18
20
‐200
‐150
‐100
‐50
0
50
100
150
200
250
300
Jan‐1980
Oct‐1980
Jul‐1981

Apr‐1982
Jan‐1983
Oct‐1983
Jul‐1984
Apr‐1985
Jan‐1986
Oct‐1986
Jul‐1987
Apr‐1988
Jan‐1989
Oct‐1989
Jul‐1990
Apr‐1991
Jan‐1992
Oct‐1992
Jul‐1993
Apr‐1994
Jan‐1995
Oct‐1995
Jul‐1996
Apr‐1997
Jan‐1998
Oct‐1998
Jul‐1999
Apr‐2000
Jan‐2001
Oct‐2001
Jul‐2002
Apr‐2003
Jan‐2004

Oct‐
2004
Jul‐2005
Apr‐2006
Jan‐2007
Oct‐2007
Jul‐2008
Apr‐2009
Jan‐2010
Basispoints
memo:USrecessions(NBER) UnitedStates
EuroArea Japan
USFedfundstargetrate(r.h.s.,inverted)

Source: Thomson Reuters Datastream.
…but fiscal
pressures and
corporate financing
needs may lift rates
at the long end
But further fiscal pressures will keep government financing needs at high
levels and add to inflation risks further down the line. Paired with competition
for financing from the corporate sector, in particular from financial institutions
that have to roll over massive amounts of debt in the near future, this should
raise rates at the long end, likely more than futures markets currently expect.
Should monetary policy react to such pressures, raising rates more than markets
currently predict, this could counterbalance the rise at the long end and flatten
yield curves even more. All this will also depend on the impact of inflation and
inflation expectations on the short and the long end of the curve, and how much
monetary policy will “lean against the wind”.

B. Financial sector soundness, risk exposures and risk management
1. Current weaknesses
Weaknesses in the
banking sector are
still pertinent
The banking sector is still fragile. While banks are preparing for tighter
capital and liquidity requirements that are likely to be required when Basel III
concludes at the end of 2010 (although phase-in periods will apply), many
weaknesses remain. Exposure to commercial real estate risks (small banks in
the US and some regional banks in Europe) and sovereign risks (in Europe) are
of major concern, and so is funding. While major US banks have been enjoying
solid profits and deleveraging for some time, the process of deleveraging is
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010 11
lagging in Europe. However, profit reports of major European banks for the
first half of 2010 have been rather positive, mostly due to falling loan losses.
The results of Europe’s stress-testing of 91 banks announced on 23 July, found
that (only) seven banks need more capital. This has boosted confidence and
calmed the markets.
especially for
some segments of
the European
banking sector
Despite the relatively comforting results of the European banking sector
stress tests, the aggregate results illustrate, according to the Committee of
European Banking Supervisors (CEBS), “the continued reliance on government
support for currently 38 institutions participating in the exercise. Consequently,
it seems too early to speak about a generic ‘forced’ withdrawal. Any
considerations of possible exit strategies should rather take into account

detailed case-by-case analysis in order to ensure banks’ long-term viability
after an exit from government support has taken place.”
2
Moreover, observers
have commented on the weaknesses in the German Sparkassen sector, which
was not part of these stress tests.
Table 1. Banks’ market value losses and gains
Change in market value of largest G20 banks, in USD billion
a)

2010
b)
2009 2008 2007 2006 2005
memo:MV
(latest)
e)
memo:
recovery
f)
United States 72.8 220.1 - 338.0 - 295.2 175.0 - 19.9 811.5 86.7
United Kingdom 41.4 179.3 - 256.7 - 72.8 109.0 - 19.1 421.8 86.0
Italy - 28.5 40.0 - 177.8 73.2 61.4 47.1 142.3 6.5
France - 27.5 107.4 - 157.6 - 31.6 108.6 13.4 184.3 50.7
China - 6.5 136.4 - 124.3 60.1 82.3 - 347.3 104.5
Australia - 6.7 139.7 - 110.9 43.7 38.9 18.2 258.1 119.9
Japan 27.0 - 40.5 - 107.6 - 111.8 - 48.6 204.0 283.6 - 12.5
Russian Federation 8.6 61.4 - 107.5 24.7 45.3 17.1 99.0 65.1
Canada 16.8 112.2 - 97.4 12.2 31.1 37.2 261.6 132.4
Brazil 1.7 150.8 - 88.1 60.6 37.8 29.9 299.7 173.1
Germany - 0.2 28.0 - 80.0 - 3.7 34.1 14.8 68.1 34.8

Turkey 18.7 49.9
- 67.6 39.6 - 4.0 25.7 112.6 101.5
South Korea - 0.6 38.2 - 63.8 - 0.0 11.9 39.1 71.2 59.0
India 15.9 45.5 - 59.3 56.5 16.7 11.6 113.9 103.7
South Africa 8.6 22.4 - 22.3 - 0.2 6.8 7.9 70.9 138.8
Indonesia 17.9 24.2 - 16.2 7.6 14.1 - 1.4 66.0 259.9
Mexico 4.0 7.2 - 8.9 5.6 6.6 0.8 28.4 125.9
Argentina 1.2 2.8 - 3.2 - 1.2 2.3 0.2 6.5 121.8
G20 countries' total 164.7 1 324.9 -1 887.3 - 132.6 729.2 426.5 3 646.8 78.9
memo item:
Euro area
total
c)
- 120.6 304.0 - 788.0 81.6 379.2 105.4 711.6 23.3
memo item:
G7 total
c)
101.8 646.5 -1 215.1 - 429.6 470.5 277.5 2 184.5 61.6
memo item:
Global
d)
130.5 1 710.6 -2 787.4 - 49.8 1 138.8 504.2 4 888.1 66.1

Sorted by 2008 losses.
a) Based on banks contained in respective countries' Datastream bank indices.
Note that such data are not available for Saudi Arabia.
b) From 1-Jan-10 to 29-Jul-10.
c) Based on banks contained in respective countries' Datastream bank indices.
d) Based on banks in Datastream worldwide bank index.
e) Memo item: Market valuation as of 05-Apr-10.

f) Ratio of sum of change in 2009 and 2010(b) over the negative change in 2008, in per cent.
Sources: Thomson Reuters and OECD.
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

12 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010
Favourable profit
conditions for banks
are waning and
bank share prices
have been declining
in many cases
While financial institutions have been profiting from improving and
favourable conditions over the last year, earnings reports as recently released
by some major banks for the second quarter of 2010 show that these conditions
are waning. Over the past year and well into 2010, share prices of the sector
have improved to an extent that by now most banking sectors have recuperated
most or even overcompensated previous (2008) losses in market value (based
on sectoral indices for G20 economies; Table 1). However, more recent
developments led to year-to-date (end-of-July) declines in market value in
several cases, and these declines were particularly strong for banks in France
and Italy. If measured against broad stock market developments (and looking at
a slightly different sample highlighting some more European banking sectors),
the situation for the banking sectors in several countries looks even gloomier
(Figure 8).
Figure 8. Weaknesses in the banking sector still pertinent
Year-on-year growth of selected banking sector equity indices relative to total stock market
8.7
‐2.6
‐3.3
‐7.2

‐8.7
‐9.7
‐10.8
‐12.5
‐13.2
‐13.6
‐16.6
‐21.3
‐29.5
‐32.0
‐34.0
‐100 ‐80 ‐60 ‐40 ‐200 204060
Canada
UnitedKingdom
Australia
Spain
Germany
UnitedStates
Sweden
France
Japan
Italy
Switzerland
EuroArea
Netherlands
Belgium
Greece
Percent
Year‐to‐date(asof29‐Jul‐2010, annua lised) 2009 2008

Note: Sorted by year-to-date declines.
Sources: Thomson Reuters Datastream and OECD.
Many smaller US
banks are affected,
and important risks
remain to the US
financial system
overall
In the United States, defaults among smaller banks reached record levels
in 2009, affecting 140 banks; this is almost triple the total of 53 failed banks in
the period 2000-2008 as a whole (26 failed banks in 2008 already having been
the record of that period). Government support (liability guarantees and capital)
will still be needed, as vulnerabilities remain high and low capital levels may
be squeezed by further losses, stemming from commercial property and
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010 13
consumer loans, for example, as well as by feedback effects from lower
economic activity. The fragility of the current situation has also been noticed by
the IMF in its recent Financial System Stability Assessment of the United
States, which found that bank balance sheets “remain fragile and capital buffers
may still be inadequate in the face of further increases in nonperforming
loans.”
3

2. Interest rate risk, exchange rate risk and sovereign exposures
Interest rate risks
are related to
repricing risk, yield
curve risk, basis risk

and optionality
In addition to the current weakness and vulnerability of the financial sector
rooted in the crisis, a changing interest rate environment and exchange rate
adjustment are posing specific, additional risks further down the line. The key
elements of interest rate risk for banks include repricing risk, yield curve risk,
basis risk and optionality.
4
Repricing risks arise from timing differences in the
maturity for fixed-rate and repricing for floating-rate bank assets, liabilities and
off-balance-sheet positions. Yield curve risks cover adverse effects on a bank's
income or underlying economic value stemming from unanticipated shifts of
the yield curve. Basis risks are rooted in an imperfect correlation in the
adjustment of the rates earned and paid on different instruments with otherwise
similar repricing characteristics. Optionality has become an increasingly
important source of interest rate risk, arising from the options embedded in
many bank assets, liabilities and off-balance-sheet portfolios.
The current interest
rate environment
has been conducive
to assuming interest
rate risk exposure
The currently low short-term (policy) rates and steep yield curves (see
above), paired with relatively stable or fixed exchange rates (especially in
Asia), have been providing incentives to profit from positive carry in fixed
income and foreign exchange markets. This will typically add to investors’
holdings of long-term assets and tilt funding profiles towards shorter maturities,
thus potentially adding to maturity mismatches.
Effects of changes
in the interest rate
structure on

financial
institutions differ
The effects of changes in the interest structure differ across financial
institutions. In general, banks and other institutions that engage in positive
maturity transformation (borrowing short and lending long), and thus profit
from the steepness of the yield curve, will suffer from any flattening of the
curve, irrespective of whether this has been brought about by higher short-term
rates or by lower long-term rates. More broadly, “asset sensitive” institutions,
i.e. those whose assets are expected to re-price faster than their liabilities,
would be positively affected by a rise in interest rates because their net interest
margins increase. Conversely, “liability sensitive” institutions will profit from a
fall in interest rates.
5

Banks’ recent
changes in asset and
funding structures
make them more
vulnerable to a
changing interest
rate environment
Generally, the impact of interest rate changes will depend on the maturity
and re-pricing structure of institutions’ balance and off-balance-sheet items,
and are complex to analyse. Also, complexity of this structure has increased as
financial institutions have been assuming more complex exposures to interest
rate risk through structured products, with an embedded interest rate risk that
has not always been fully understood. More recently, during the crisis, many
banks have significantly increased their holdings of excess reserves and other
short-term liquid assets, suggesting their ability to benefit from increases in
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

14 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010
short-term rates. At the same time, increased reliance on wholesale funding
(instead of deposits with low and relatively stable interest rates) has rendered
banks more sensitive to interest rate changes.
Proper risk
management can
help during an
adjustment process
Adjustments to changes in the interest rate structure will depend not only
on the risk exposure of financial institutions (which is hard to monitor based on
public disclosures), but also on the way in which risk embedded in these
exposures is managed. Adjustment processes can be abrupt, as feedback effects
may be at work that amplify the speed and extent of rebalancing. Work by the
Basle Committee
6
has looked at these issues well before this financial crisis and
has proposed principles to be used in evaluating a bank’s interest rate risk
management and interest rate risk exposure, and in developing a (supervisory)
response to that risk. At the core of these principles is the involvement of the
board and senior management in the oversight of interest rate risk, and the
responsibility of senior management in ensuring that the structure of the bank's
business and the level of interest rate risk it assumes are effectively managed,
evaluated and controlled. In order to perform these tasks, banks must have
adequate information systems in place, and reports, independent reviews and
evaluations should result in revisions where necessary, and be made available
to the relevant supervisory authorities. Banks must also hold capital
commensurate with the level of interest rate risk they undertake, and should
release information on the level of interest rate risk and policies for its
management.

Currency risk
exposure has grown,
and regional
concentration may
pose specific risks
The profitably of carry trades as well as the increased globalisation of the
financial industry has substantially increased banks’ foreign currency exposure
(Figure 9). Profit opportunities arising from, among other factors, relatively
stronger growth in certain regions as well as specific country contexts and
relations (e.g. between Spain and Latin America) have favoured foreign
exchange exposure of major OECD banks to emerging European and other
developing regions (Figure 10). If such exposure becomes too concentrated, i.e.
if not diversified over a wider range of countries and regions, this could pose
risks. For example, observers have warned of the exposure of some European
banks to Eastern Europe, where some economies are weakened and many
financial institutions have been hit hard by the crisis. And, more recently,
sovereign exposures to some countries on the euro area periphery have come
into the focus.
How the unravelling
of carry trades
affects a given
institution depends
on the type of
institution and the
types of trades it
does
The effects of exchange rates and unwinding of carry trades on financial
institutions is more difficult to predict. First, the foreign exchange market is
rather opaque, as participants know their positions relative to a given
counterparty, but not the aggregate position of a given counterparty. Second,

how the unravelling of carry trades affects a given institution depends to a large
extent on the type of trades that an institution engages in. For example, for
institutions that are using foreign exchange primarily to trade their proprietary
books, a rapid rise in the rate of their short currencies could have significant
negative effects. On the other hand, for clearing banks, an increase in volume
and volatility on FX markets is likely to prove highly profitable. Overall, how
currency movements affect a bank’s exposure depends primarily on the nature
of the institution and the currency of its home market.
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010 15
Figure 9. Banks’ foreign currency exposure vis-à-vis non-banks has grown significantly
External positions of banks in foreign currencies vis-à-vis the non-bank sector: assets minus liabilities
‐100
400
900
1,400
1,900
2,400
Dec‐95
Mar‐96
Jun‐96
Sep‐96
Dec‐96
Mar‐97
Jun‐97
Sep‐97
Dec‐97
Mar‐98
Jun‐98

Sep‐98
Dec‐98
Mar‐99
Jun‐99
Sep‐99
Dec‐99
Mar‐00
Jun‐00
Sep‐00
Dec‐00
Mar‐01
Jun‐01
Sep‐01
Dec‐01
Mar‐02
Jun‐02
Sep‐02
Dec‐02
Mar‐03
Jun‐03
Sep‐03
Dec‐03
Mar‐
04
Jun‐04
Sep‐04
Dec‐04
Mar‐05
Jun‐05
Sep‐05

Dec‐05
Mar‐06
Jun‐06
Sep‐06
Dec‐06
Mar‐07
Jun‐07
Sep‐07
Dec‐07
Mar‐08
Jun‐08
Sep‐08
Dec‐08
Mar‐09
Jun‐09
Sep‐09
Dec‐09
Mar‐10
USDbillion
Other
Swissfranc
Poundsterling
Yen
Euro
U.S.dollar

Note: March 2010 data are provisional (Locational Banking Statistics, Preliminary Report 21 July 2010).
Source: BIS Quarterly Review, Banking Statistics.
Regulatory reforms
to better support risk

management are
underway , and
financial
institutions are
adjusting to the new
environment
Some support for financial institutions in their efforts to cope with all
these risks will come from regulatory reforms currently envisaged by policy
makers worldwide. Many banks are already reacting by building up capital
buffers to the proposed Basel III rules
7
for which broad agreement was reached
end of July,
8
and which are expected to be finalised by the end of 2010. These
rules will impose tighter regulatory requirements in terms of capital and
liquidity, including those attenuating pro-cyclicality inherent in the current
rules. In terms of corporate governance and risk management, there is some
evidence that banks have been improving their risk management and corporate
governance more generally. For example, remuneration schemes have been
reformed in line with official as well as industry proposals
9
in order to make
them more risk-compatible and to avoid excessive risk-taking. There is also
evidence that risk assessments and stress tests are becoming more
comprehensive, and risk officers are being given a more prominent role in the
corporation, and are encouraged to think about extreme risk and rely less on
theoretical models.
10
Furthermore, risk control and management could be

enhanced by separating bank business, as foreseen by the recent reforms
(“Volcker rule”) in the United States
11
or the firewalled Non-Operating Holding
Company Structure (NOHC) proposed by the OECD.
12
Finally, measures to
strengthen the market infrastructure (including exchange trading and disclosure
requirements) could enhance transparency, the pricing of risk, and help
financial companies to better manage risks exposures.
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

16 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010
Figure 10. Banks’ foreign currency exposure is substantial in some countries
Consolidated foreign claims of reporting banks vis-à-vis selected countries and regions, ultimate risk basis.
Amounts outstanding as of end-March 2009, in USD billion
0 500 1,000 1,500 2,000 2,500 3,000 3,500
Other(a)
OtherEuropeanbanks
France
German
y
Italy
Spain
Switzerland
UnitedKingdom
Japan
UnitedStates
USDbillion
Otherdeveloping countries

Lat inAmerica/Caribbean
Emerging Europe
Asia&Pacific
Otherdeveloped countries
UnitedStates
WesternEurope

a) The rest of a total of 24 reporting countries (reporting countries are: Austria, Australia, Belgium, Canada, Chile, Chinese Taipei,
Finland, France, Germany, Greece, India, Ireland, Italy, Japan, the Netherlands, Norway, Portugal, Singapore, Spain, Sweden,
Switzerland, Turkey, the United Kingdom and the United States).
Note: Data are provisional (Consolidated Banking Statistics, Preliminary Report 21 July 2010).
Source: BIS Quarterly Review, Banking Statistics.

RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT

OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010 17
NOTES

1
Following the tensions on European sovereign issuers, the Ecofin Council and the EU Member States agreed on
10 May on a comprehensive package of stability measures, including a European Financial Stabilisation
Mechanism. This arrangement will provide up to EUR 500 billion of funds committed by euro area
members to members in difficulty, subject to strong conditionality. The IMF is participating in the
financing arrangements with EUR 250 billion. EUR 60 billion of the EU commitment draws on an
existing facility, and EUR 440 billion will be sourced through a special purpose vehicle (SPV).
2
CEBS et al. (2010).
3
IMF (2010).
4

For more details see BCBS (2004).
5
For this and the following paragraph, see also Kohn (2010).
6
BCBS (2004).
7
BCBS (2009a, b).
8
On 26 July 2010 the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee
on Banking Supervision, reached broad agreement on the Basel Committee's capital and liquidity reform
package; see the BIS press release at /> and its annex

9
For industry recommendations to reform remuneration policies, see IIF (2008).
10
It is also interesting to note that JPMorgan Chase has put aside USD 3 billion of “model-uncertainty reserves” to
cover losses related to mishaps of quantitative models (see The Economist, “Number-crunchers
crunched”, February 13, 2010).
11
The so called Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President
Obama on 21 July 2010 and should “promote the financial stability of the United States by improving
accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American
taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other
purposes.”
12
See OECD (2009), and Blundell-Wignall et al. (2009).
RISKS AHEAD FOR THE FINANCIAL INDUSTRY IN A CHANGING INTEREST RATE ENVIRONMENT
18 OECD JOURNAL: FINANCIAL MARKET TRENDS – VOLUME 2010 ISSUE 1 © OECD 2010
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Basel Committee on Banking Supervision (BCBS) (2004), Principles for the Management and Supervision of Interest

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consultative document, December, available at www.bis.org/publ/bcbs164.htm
.
Basel Committee on Banking Supervision (BCBS) (2009b), International framework for liquidity risk measurement,
standards and monitoring, consultative document, December, available at www.bis.org/publ/bcbs165.htm
.
Blundell-Wignall, Adrian, Gert Wehinger and Patrick Slovik (2009), “The Elephant in the Room: The Need to Deal
with What Banks Do”, OECD Journal: Financial Market Trends, vol. 2009/2.
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(2010), Questions & Answers: 2010 EU-wide stress testing exercise, available at
/>.
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