As the opportunity for simultaneous reductions in deposit and loan interest rates arises, there has been a noticeable surge in market attention towards the interest rate risks faced by banksAn impending major restructuring of bank assets is on the horizon, leading to an increase in repricing risks that are differentiated by duration structureThe correlation between repricing periods and interest rate decrease cycles means that banks with a negative sensitivity gap are poised to benefit moreThis raises an important question: what forms of interest rate risk will manifest in the banking landscape?

According to research by Kaiyuan Securities, a bank's trading book refers to the financial instruments and commodity positions held by banks for trading purposes or hedging risksThe bank's balance sheet is primarily engaged in on- and off-balance sheet operations to gain stable returns or offset risksIn terms of interest rate fluctuations, the risks associated with trading books are more overt, as seen directly reflected in the fluctuations of market value in FVTPL accountsConversely, the risks connected to the bank's balance sheet are more latent, requiring sophisticated management techniques and are subjected to strict regulatory constraintsThe interest rate risks from bank balance sheets manifest primarily as risks incurred from adverse changes in interest rate levels and duration structures, which can lead to losses in the overall yield and economic value of bank balance sheetsThese can be categorized into four specific types: basis risk, option risk, repricing risk, and yield curve risk.

Basis risk arises when the adjustments to pricing benchmarks for deposits and loans do not occur simultaneouslyMore specifically, it refers to the risk associated with assets in the bank's balance sheet where the benchmark interest rates of on- and off-balance sheet operations diverge despite having the same or similar terms

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This discrepancy is notable, especially as the Loan Prime Rate (LPR) faces continuous reductions while deposit rates remain relatively rigid, manifesting ongoing basis risksSince the reform in 2019, the LPR for one-year terms has seen eight cuts, cumulatively reducing more than the Medium-term Lending Facility (MLF), thus squeezing the margins banks can addHowever, the adjustment of deposit rates has relied more on self-regulatory mechanisms recently, keeping benchmark rates static for an extended periodSuch asymmetrical interest rate cuts result in increasingly evident basis risks and a continued compression of net interest margins.

The "linkage of deposit and loan rates" alleviates some degrees of basis riskIn April 2022, the central bank guided member banks to adjust deposit rates reasonably, referencing the yield of 10-year government bonds and one-year LPRThis market-oriented pricing mechanism for deposit rates has improved significantly, but the impact of adjustments in the deposit benchmark rate remains substantial, potentially stagnant for some timeIn the subsequent stages, deposit pricing will increasingly follow the framework of “benchmark rate plus adjustment,” being guided more by self-regulatory mechanismsIf the pricing of deposits and loans can effectively align, it will ensure net interest margins remain at reasonable levels, providing banks with a better opportunity to balance profit margins with their responsibilities to yield.

Option risk fundamentally concerns customers' rights in choosing financial instruments in conjunction with interest rate changesThis risk arises when customers exercise their options under declining deposit and loan rates, such as choosing to withdraw and re-deposit funds during rising deposit rates or refinancing loans when borrowing costs diminish.

Different banks are adjusting rates at varying paces, leading to a burgeoning trend of inter-provincial and cross-bank deposits

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The disparity in reduction levels across regions and between existing and new clients allows bank customers the flexibility to shift their deposit contracts through time and spaceFor instance, major state-owned banks and joint-stock commercial banks have brought their deposit rates for 1-5 year fixed terms down to below 3%. Meanwhile, certain urban and rural commercial banks still offer rates above 3% for similar terms, hesitating to drop their rates due to the risk of deposit outflow caused by their limited operational areas and singular business models.

For example, within the same banking institution, it is evident that branches in Jiangsu province offer lower rates compared to those in cities like Beijing, Shanghai, and Shenzhen, enticing some low-risk clients to move their deposits to those regions, thereby diminishing the effect of rate reductions on overall deposits.

The declining deposit rates have prompted some clients to reallocate their funds elsewhere, with low-risk financial products becoming an attractive alternativeHistorical data suggests there is often a seesaw effect between bank deposits and wealth management productsTraditionally, June tends to be a peak month for assessing bank deposits, with low-risk financial products generally seeing a negative growth trend during this periodHowever, in June 2023, cash management and fixed income products each registered a growth of approximately 0.12 trillion yuan and 0.13 trillion yuan respectively, which might correlate with the recent cuts in deposit rates.

On the flip side, reduced loan rates have led to rises in early repayments, which is another area of concern for financial institutionsThe phenomenon of early repayments is expected to impact bank operations in the short termOn the asset side, when LPR enters a downward trend, the repayment pressure for fixed-rate housing loans rises significantly

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Without a switch to a floating rate system, borrowers tend to pay off existing fixed-rate loans early or refinance their loans with lower rates.

Meanwhile, on the liability side, the demand from the real economy is slowly recoveringWith high-yield quality assets being scarce, the use of idle funds to repay loans is seen as a rational choice for individualsEarly repayment rates for residential mortgage-backed securities have soared, reaching the highest recorded index since observation began, while new medium to long-term loans to residents showed no significant increase in MayThe inclination of residents to reduce their leverage remains strong, suggesting that early repayments may continue to hinder banks' net interest income.

If banks were to offer discounts on existing mortgages, state-owned and joint-stock banks are likely to experience significant pressures on their margins in the short termIn the first quarter of 2023, new mortgage rates stood at 4.14%, which is below the peak observed since early 2016 (5.75% in the fourth quarter of 2018). combined with a decline in 5-year LPR by 10 basis points in June 2023, existing mortgage rates appear quite high, making early repayments more appealing.

Kaiyuan Securities conducted a rough study assessing how discounting existing mortgages affects bank interest marginsSeveral assumptions underpin this analysis: First, the volume of high-rate loans within the existing mortgage loans of listed banks ranges from 10% (conservative) to 20% (neutral) to 30% (aggressive); secondly, the average decline space for existing mortgage rates is estimated at 100 basis points; lastly, the average balance of high-rate assets and growth of net profits in 2023 are expected to align with those of 2022.

Calculated results indicate that should average mortgage rates decline by 100 basis points, the drag on net interest margin across listed banks would be approximately 1.5 basis points (conservative), 3.0 basis points (neutral), and 4.5 basis points (aggressive). Notably, state-owned banks would suffer the most pronounced impact, with joint-stock banks following close behind.

Given the current net interest margins of state-owned banks generally sitting below the warning line of 1.8% and the LPR being on a downward path, there will be demands for adjustments to savings rates through reductions in deposit interests among other measures to alleviate the pressure on margins

With the prospect of extensive reductions on existing high-rate mortgages, the pressure on banks’ net interest margins could be further heightened, making widespread adjustments in existing mortgage rates unlikely in the near term.

On the other hand, repricing risks incurred due to the variation in duration structures will impact banks differentlyBanks with sensitivity to declines in rates typically find benefitting conditions more favorableIn instances where deposit and loan rates are reduced simultaneously, banks typically see an advantage if their loan repricing cycle is longer than the deposit cycle, resulting in a negative sensitivity gap impacting net interest income positively.

An historical comparison indicates that when deposit and loan rates decreased in 2015, we can refer to the duration of repricing for that year in analyzing the impacts on margins for banks during a similar interest rate cut situationThe four banks that experienced an increase in net interest margin during 2015—China Merchants Bank, Ping An Bank, Nanjing Bank, and Suzhou Bank—all had longer average loan repricing durations compared to their deposits from the previous yearThis indicates that beneficial outcomes often arise from timely adjustments to deposit and loan rates in prior cycles of interest dropping.

In the current context of simultaneous drops in interest rates, banks characterized by longer loan repricing durations relative to their deposit repricing durations are likely to see lesser pressures on their net interest margins due to favorable repricing structuresUrban commercial banks alongside rural banks strongly exhibit this pattern of balance.

The simultaneous fall in deposit and loan rates is expected to drag down the overall net interest margins of listed banks by approximately 1 basis point from 2023 to 2024, indicating relatively modest negative impacts amid increasing differentiation among regional banks

As per Kaiyuan Securities’ projections, the onset of falling deposit rates continues to widen gaps in repricing associated with drops in LPR observed since the start of 2023.

Assuming a steady duration structure for deposits and loans akin to that at the end of 2022, we observe that deposit structures are evenly distributed among various tenors, with those under 3 months, between 3 months and a year maintaining shares of approximately 17%. Furthermore, within the 1 to 5-year segments, segments such as 1-year and 2-year carries 25% eachOn the loan side, the tenors similarly show an even distribution with shorter terms under 1 year being predominant.

To understand the differences seen in net interest margin impacts requires a holistic view across quantity, pricing, and tenure aspects as analyzedIn 2023, the repricing effects on both deposits and loans exhibit an impact of 3 basis points and -3.4 basis points respectively, combining to yield a total drag on net interest margin of about 0.4 basis pointsThe slower pace of rate reductions undertaken by certain urban and rural commercial banks leads to a net interest margin being unilaterally impacted by reductions in LPR.

Yield curve risks are also notable, as divergences in rates catalyze arbitrage opportunitiesYield curve risk relates to the unfavorable effects resulting from asymmetrical repricing which leads to non-parallel movements within the yield curve, typically seen in shifts between short-term and long-term rates.

Divergence in loan rates also emphasizes concerns over the short term, as loans become increasingly short-term focusedSince the beginning of 2019, the LPR one-year has primarily been guided by the central bank's monetary policy, alongside supply and demand factors that collectively resulted in an aggregate drop of 60 basis points

Should this variation persist, it might reinforce a trend wherein short-term loans take precedent over longer-term solutions.

Moreover, there has been growing phenomena of "loans-for-deposits" arising from instances where certain private banks offer higher rates for 5-year large deposits exceeding 3.65%, contrasting with the decreasing rates of consumer loans which have fallen below 4%. This rollercoaster in loan and deposit interest rates leads to greater arbitrage opportunities, adding an unprecedented layer of complexity to the loan management strategies employed by banks.

Under these conditions, bond investments may also gain moderate advantagesWith the parallel drop in both earnings from lending and deposit rates, the market is expected to attract influxes of funds trickling into the bond market, negating some negative pressures on margins as a result of falling LPRsThus, banks invested heavily in bonds could also benefit from these dynamics.

Increased valuation insights within bank investment accounts could lead to boosted capital reserves or profitsIf a bond bull market is catalyzed due to lower deposit and loan rates, investment accounts dominating the financial strategy for banks could see considerable capital appreciation returns that directly augment profit levels in financial statements.

The introduction of new regulatory standards has heightened the requirements for banks in managing interest rate risks on their accounts, particularly in relation to asset-liability "duration management." Since 2018, the CBRC has enforced more stringent regulations on managing interest rate risks, including the monitoring of repricing gaps and the absolute levels of duration gaps.

Banks have typically developed a comprehensive internal risk management framework, featuring decision-making and execution procedures encompassing board members alongside operational divisions

As the dual interest rate reduction creates ripples through the industry, banks can adapt their management strategies to mitigate the risks tied to asset balance sheets.

Firstly, controlling repricing gaps is crucial to minimizing the fluctuations in net interest income stemming from annual rate adjustmentsObserving the proportion of interest rate risks that fall within the one-year period can aid in this control.

Secondly, effective duration management through controlling the relative percentages of long-term deposits within total deposits can decrease costs amidst a rate drop, thereby distributing debt efficiently across the portfolio.

Thirdly, balancing mismatched term earnings via treasury management models has become essential to neutralizing the effects of rapid fluctuationTransaction performance hinge significantly on structuring borrowing and lending optimally across differing interest rate regimes.

Lastly, the automation of monitoring and refinement of calculations related to future cash flows can provide essential insights into static and dynamic simulations of interest rate risks.

Banks with a negative repricing gap will be among the principal beneficiaries when interest rates declineThe repricing gap reflects the difference in assets and liabilities that will expire or have their rates reset over a defined periodWith both lending and deposit rates decreasing, banks with such negative gaps will see a reduced impact on revenues compared to their expenditures on interest, allowing relative financial gains.

Overall, analyzing the impact of simultaneous rate reductions, it is crucial to assess net interest margins under different conditionsBanks with larger bases of savings and lower lending ratios will likely benefit as lower deposit rates shield against LPR cuts.

Moreover, in terms of financial strategies, banks that maintain robust investments in trading sectors will also glean advantages from falling interest rates

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