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We were approached by a large municipality in the Netherlands with a long-term loan portfolio of about EUR 400 mln. Municipalities have a continuous budget cycle looking 4 years ahead. They therefore want to obtain a realistic projection of their future financing costs. As organisations typically refinance their loans at maturity, there is a financial risk in case of adverse interest rate movements. Therefore, on would want to know what the loan portfolio interest refinancing risk would be in a negative scenario. And how likely this would be.
It is not always straightforward for a public institution to balance budget, keep costs low while not compromising on programs with a social impact. Large buffers mean that we need to put money aside to prepare for higher interest rates at time of refinancing. However, it would also mean that money would stay idle in case the interest rate risk did not materialise.
What is a proper method to estimate loan portfolio interest rate risk?
Although multiple models are available to estimate the risks given a certain confidence interval, it makes sense to leverage expertise from the insurance sector. This is a sector that by nature relies on having a proper, balanced calculation of it’s risks. It relies on EU-wide Solvency II regulations that provide concrete guidance on risk management practices for Value at Risk estimations. For this exercise we therefore applied the Solvency II standard formula for interest rate risk used by the insurance sector.
The calculated interest rate component consists of two underlying risk-factors.
1) a risk-free base rate (with forward expectations into the future) and
2) a credit spread that depends on the rating of the organisation.
We derive the interest and credit spread shocks by applying the Solvency II methodology. These shocks enable us to obtain the loss (or gain) relative to the current interest rate under a given confidence interval. Essentially, we calculate negative, expected, and positive monthly scenarios for the interest rate in the next four years. For one of the loans, we obtained the following estimations using publicly available historical DNB swap rates and the derived credit spread:
Once we have created the three scenarios, we are better able to estimate the amount due for each loan based on its refinancing date. As a result, we have an exact estimation of differences in payments due between expected and negative scenarios. For example, for loan 2 below, we estimate the additional interest up to 2025 in a negative VaR90 scenario to be 91,5k Euro.
Total interest risk on the loan portfolio
Perhaps not that detrimental if you look at one loan. But, taking the full refinancing portfolio into account until 2025 provides a different perspective. In that case we observe a total additional costs of 876k in the event of a negative interest scenario.
What is the best certainty level for a negative scenario
Overall impact varies substantially depending on the confidence interval (80, 90, 95 or 99% VaR) we choose to use. A 80% VaR means that in 20% of the years we expect to have higher costs than the calculated number. And a confidence interval of 99% means that there is a 1% chance that the costs are higher.
The confidence level we choose depends a lot on the risk appetite an organisation can or wants to take. In case a scenario materialises that is worse than the selected confidence level, the corresponding buffer will not suffice. To maintain a balanced budget would inherently lead to successive cost-cuts or halt of other activities.
So, one could say that it is a trade-off. A low certainty level would mean a high chance of overruns and frequently occurring cost cuts. A high certainty level on the other hand means low probability on overruns and cost cuts. However this would also imply a higher buffer which could be considered redundant or ‘idle’ in quite and stable periods.
Benefits of a reproducable proces
After implementation of the methodology we obtain a manageable and repeatable process. This enables us to project the future financing costs for the loan portfolio and the interest rate risk involved. It can become a simple as uploading a file with the current loan portfolio.
To illustrate how the method works we have created a tool that helps understand this methodology:
We provide various interest rate risk reports to our clients. These can include the interest risk of the long-term and short-term loan portfolio and the pension provisions. In the case above we did so for a municipality, however we can apply the same process of course to any other organisation.
Data analytics and automation will help you to get proper and timely insight in the probability and impact. This will give you more control and makes it a lot easier to communicate with all stakeholders about adverse events.
If you want to receive more information about our risk reporting services please feel free to contact us. We would be happy to tell you more about these risk reports and what they contain.