Bank regulators may be called upon to adopt a more interventionist supervisory approach to assessing banks’ liquidity positions in the wake of the failure of banks that were reliant on unstable funding and rate-sensitive assets. A paper prepared by the Bank for International Settlements’ Financial Stability Institute has raised the prospect of widening the scope of stress tests to focus more on the interplay of capital and liquidity. It also suggests that business model analysis could be used to assess banks’ ability to address changes in their operating environments, including rising interest rates. The FSI paper, Rising Interest Rates and Implications for Banking Supervision, says the largest, quickest and broadest rise in interest rates since the 1980s has posed substantial challenges for banks. Rate rises over the past year have exposed heightened vulnerability for banks with material exposures to long-term fixed-rate assets. “A long period of exceptionally low interest rates encouraged some banks to take on greater risk in search of yield. This involved banks holding a significant proportion of longer-term fixed-rate assets that are supported by shorter-term less stable funding,” the paper said. “As interest rates rise, such banks may incur significant declines in asset values, while also being exposed to volatile fund providers that may flee from the first sign of trouble.” In essence, that was story behind the failure of Silicon Valley Bank in March.  The paper says banks with core deposits have a natural hedge against rising rates, since they may pay below market rates of interest and still retain those funding sources. But banks that rely on less stable funds providers are subject to elevated liquidity risks, which are amplified when interest rates rise or their credit conditions deteriorate. If large depositors withdraw funds, banks may be forced to sell depreciated fixed income assets and crystallise losses. The magnitude of the impact depends on the composition of banks’ balance sheets and their business models. The magnitude of the deposit runs observed during recent banking market turmoil suggests that the assumptions around the stickiness of deposits embedded in liquidity coverage ratio and net stable funding ratio standards may not always hold. “That does not necessarily imply that runoff rates applicable to all banks need to be recalibrated. Instead, it may indicate that supervisors should require individual banks to hold additional HQLA if they deem that risks faced by such banks are not sufficiently captured by LCR and NSFR rules. “This would be the case, for example, if excessive concentration of deposits from a few sources would make funding more unstable that what is implied by standard runoff rates.” Supervisors could also require specific banks to hold additional HQLA depending on the characteristics of their assets. While long-term, fixed-rate government securities are often eligible to be included in the stock of HQLA without any haircut, such assets have a high sensitivity to interest rate changes. In practice, this means that the stock of longer-term HQLA falls when interest rates rise, regardless of their accounting classification.