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The Interest Rate Risk

of Mortgage Loan Portfolio of Banks

A Case Study of the Hong Kong Market

Jim Wong

Hong Kong Monetary Authority

Paper presented at the Expert Forum on Advanced Techniques on Stress Testing: Applications for Supervisors Hosted by the International Monetary Fund

Washington, DC– May 2-3, 2006

The views expressed in this paper are those of the author(s) only, and the presence of them, or of links to them, on the IMF website does not imply that the IMF, its Executive Board, or its management endorses or shares the views expressed in the paper.

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The Interest Rate Risk of Mortgage Loan

Portfolio of Banks

A Case Study of the Hong Kong Market

Jim Wong

Market Research Division Hong Kong Monetary Authority

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3

Content

Market and Interest Rate Structures

Interest Rate Risk

Stress-testing Framework and Model

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Mortgage Market in Hong Kong

• Primarily adjustable rate mortgages, with

pricing mainly referenced to prime rate (P)

• The cost of fund is determined by a mix of

interest rates

• Dominated by major retail banks

- not only by market shares

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5

Interest Rate Structure of Hong Kong

• Under the Linked Exchange Rate system, interest rates in

Hong Kong tend to track closely their US counterparts • Major local interest rates are:

- Prime rate (P, this is also named as the best lending rate) - Savings deposit rate (SR)

- Interbank rates (HIBORs) - Time deposit rates (TDRs)

- Others (such as interest rates on negotiable certificates of deposit and debt instruments)

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Prime rate

• Set by major retail banks and followed by other banks

• normally adjusts when there is a change in the US Federal funds target rate (FFTR), or when pressures from changes in the cost of funds are built up to a certain level

0 2 4 6 8 10 12

Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 % p.a.

Average P 3-month LIBOR

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7

Savings deposit rate

• Normally adjusts in tandem with P

• Traditional practice, not required by regulation

0 2 4 6 8 10 12

Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 % p.a.

Average P

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Interbank rates

• Normally track closely US interest rates, but may deviate from the US rates with a risk premium due to liquidity conditions and other factors

0 2 4 6 8 10 12

Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 3-month HIBOR

3-month LIBOR % p.a.

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9

Risk premium

• HIBOR minus LIBOR

• Short-term deviations in interest rates of the Hong Kong dollar over the US dollar. The mean level over the past 17 years is close to zero

-300 -200 -100 0 100 200 300 400 500 600 700

Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Bps

Historical mean 95% confidence band

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Reasons for the narrowing of

spread

Balance sheet positions of banks

Assets Liabilities

Fixed-rate assets Fixed-rate liabilities Variable-rate assets

(mostly HIBOR-based lending)

Variable-rate liabilities

(mostly HIBOR-based borrowings) P-based assets

(largely priced with reference to P)

P-based liabilities

(largely savings deposits, the interest rates of which move in tandem with the P)

Non-interest bearing assets

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11

0 2 4 6 8 10 12

Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Average P

Weighted average mortgage rate % p.a.

P + 1%

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• This was made possible by the extraordinary low funding cost with the HIBOR being at an usually deep discount to LIBOR of 200 bps.

0 2 4 6 8 10 12

Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 3-month HIBOR

3-month LIBOR % p.a.

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13

Stress-testing framework and model

• An error correction model is established to examine how P and other interest rates may move in response to changes in FFTR (and LIBOR) and risk premium.

• With the estimation results, we could stress test and assess the potential impact on interest margin of banks’ existing mortgage portfolio under an interest rate shock of a possible sharp reversal of the risk premium.

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Stress-testing framework and model

Model specification: t t t t

t R X DS e

P = + + + +

∆ α0 α1 1 α2 1 (1) where Xt is

1 ratio L/A based -P with ns Observatio 1 ratio L/A based -P with ns Observatio when 0 8 0 7 4 3 0 6 0 5 2 1 < ≥ ⎪ ⎪ ⎩ ⎪ ⎪ ⎨ ⎧ ∆ + ∆ + ∆ + ∆ ∆ + ∆ + ∆ + ∆ = ∑ ∑ ∑ ∑ = − − = + − − + = − − = + − − + M l l t M l l t t t M l l t M l l t t t t prem prem FFTR FFTR prem prem FFTR FFTR X φ φ φ φ φ φ φ φ (2) with t t

t P FFTR

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15

Stress-testing framework and model

• The error correction model studies the situations (total

4 situations) :

– FFTR/Risk Premium are increasing or decreasing

– P-based L/A ratio is greater than or less than 1

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Stress-testing framework and model

Estimation Results

Dependent Variable : P Jan 95-Jan 05

Selected Variable Coefficient

Short run (1)

RtA1 -0.09 *

L/A ratio 1

+

∑∆premt 0.12 **

∑∆premt 0.54 **

+

FFTRt 0.16 *

FFTRt 0.74 ***

Long run (2)

FFTR 0.89 ***

Adj. R-squared 0.69

Q(6) 11.75 Q(12) 17.83 DW 1.82

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17

Scenario analysis

The scenario that the risk premium increases by 200 bps (back to its historical mean level), while US interest rates remain unchanged, is examined. The effects in three months’ time are as below:

Risk Premium Reversal of 200 bps (back to the mean level)

Changes (bps)

P +24

HIBOR +200

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Scenario analysis

The impacts on net interest margin of HIBOR-based mortgage loans priced in January 2005 are simulated.

Risk Premium Reversal of 200 bps

(back to the mean level)

Mortgage Pricing 200

Funding Cost -65

Current Gross Mortgage Margin 135

Operating Cost -30

Credit Cost -10

Current Net Mortgage Margin 95

Estimated Reduction of Mortgage

Margin -176

Simulated Net Mortgage Margin

References

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