Interest Rate Risk: Lessons from the 2023 Silicon Valley Bank Collapse and the 2022 UK Pension Fund Crisis

The recent financial disruptions, including the 2023 Silicon Valley Bank collapse and the 2022 UK pension fund crisis, have highlighted a critical issue that affects various sectors of the economy: interest rate risk. This risk arises from significant asset-liability mismatches, where entities such as pension funds, insurers, and banks face challenges in managing their short-term cash flows against long-term liabilities. In this article, we will delve into how interest rate swaps (IRS) play a crucial role in hedging this risk and explore key findings from a recent study by the economists of the Bank of England.

The Role of Interest Rate Swaps

Interest rate swaps are financial derivatives that allow firms to exchange fixed-rate payments for variable-rate payments based on prevailing interest rates like SOFR (Secured Overnight Financing Rate) or SONIA (Sterling Overnight Index Average). With a market worth over $500 trillion in outstanding gross positions as of 2022, IRS are a vital tool for managing interest rate risk.

Hedging Strategies

Firms can hedge interest rate risk through internal rebalancing or by using synthetic instruments like IRS. For instance:

Pension Funds: These entities need to pay fixed incomes to policyholders in the future. To insulate their assets against interest rate movements, they typically receive fixed payments in IRS agreements, thereby increasing their duration.

Banks: Banks often follow a lend-long-borrow-short approach. They may use IRS to pay fixed rates and decrease their duration, closing the mismatch between their assets and liabilities.

Sectoral Participation and Risk Sharing

The BoE economists identifies four main end-user segments in the swaps market: funds (including hedge funds and asset managers), pension and liability-driven investment funds and insurers (PF&I), banks, and corporations.

Below are a summary of facts about sectoral participation:

• PF&I vs. Banks and Corporations: PF&I typically receive fixed payments, while banks and corporations generally pay fixed rates. This complementary nature makes these sectors natural counterparties in the swaps market.
• Maturity Segmentation: There is significant maturity-based market segmentation. PF&I tend to hold long-term swaps (10 years and above), while banks predominantly engage in short to intermediate maturities (three months to five years).
• Responses to Interest Rate Changes: When interest rates fall, PF&I increase their net receive positions, while banks and corporations increase their net pay positions. This behavior reinforces their roles as natural counterparties.

The Role of Dealers

Dealers play a critical role as intermediaries in the swaps market. Despite offsetting positions between sectors, dealers still bear significant imbalances: dealers receive fixed rates in short maturities and pay fixed rates in long maturities, resulting in a net negative duration. This highlights their crucial function in maintaining market stability.

The study also explores how demand and supply dynamics affect swap spreads—the difference between the swap rate and a similar maturity bond yield.

• Demand Pressures: Increased hedging demand from banks can substantially raise long-term swap spreads, making it cheaper for PF&I to hedge their positions. Conversely, increased demand from PF&I has the opposite effect but with different magnitudes.
• Sectoral Spillover Effects: Changes in hedging demands due to regulatory changes or market shocks can have broader implications for asset pricing. For example, heightened regulation or responses to changes in interest rates can affect swap spreads significantly.

Key Takeaways

The findings from the study offer a few takeaways:

• Risk Sharing: Different sectors act as natural counterparties due to their complementary hedging needs, contributing to the overall stability of the market.
• Dealer Intermediation: Dealers act as shock absorbers, absorbing large imbalances and maintaining market stability, highlighting their systemic importance.
• Asset Pricing: Sector-specific demand shocks can significantly impact swap spreads and have broader implications for the financial system, emphasizing the interconnected nature of financial markets.