Addressing Interest Rate Risk in Banking

April 25, 2020

Addressing Interest Rate Risk in Banking

(Published in the Financial Express in 2018)

Dr. Shah Md Ahsan Habib[1]

Interest rate risk is one of the most important forms of risk that banks face in their role as financial intermediaries and thus, managing risk is a critical factor for the smooth running of any bank’s or a company’s operations. Normally, a sudden fluctuation in the interest rate would cause a decrease in interest income in the short term, while it also affects the assets of a company in the long term. In regard to short run earning prospects it involves change in future incomes being generated from interest which can be measured by comparing total interest income and total interest expenses. Using effective risk management, banks may optimally manage internal funds and debt capacity across periods to hold enough funds and be able to exploit lending opportunities as they arise. It is recognized that risk-neutral banks are effectively risk-averse in the face of financial frictions and optimally engage in risk management.

The most important interest rates from a macroeconomic perspective are interest rates that the government pays on the loans they use to finance the national debt. There are many other interest rates in a society, like rate of deposits of different types, bank lending rates of different types, bond rates etc., and all interest rates are visibly correlated, if market mechanism works. Monetary policy is the major driver of interest rates that has a direct effect because central banks tend to act upon those rates. They do so by setting their own discount rate and by lending or borrowing on such maturities. Public deficits are normally financed by debt. Government debt tends to be spread over all maturities, and higher deficits tend to raise the term structure of rates. For managing foreign exchanges, the differentials between interest rates across countries make investing in interest rate instruments relatively more or less attractive. For reducing the pressure on depreciation of the home currency, the central bank might increase interest rates, making lending in the home currency more attractive than in foreign currencies. The fundamentals of the economy also play a role- the better these are, the lower the interest rates should be. Expectations are a major driving factor. The yield curve is a very good indicator of interest rate that represents the relationship between short- and long-term interest rates, and serves a number of purposes for market analysts, but and also play role as a predictor.

All lenders and borrowers, whether at fixed or variable rates, are exposed to interest rate risk. Lending or borrowing at a fixed rate reduces the uncertainty on interest cost or revenue, but does not eliminate interest rate risk. A lender at a fixed rate faces the risk that rates could go up, in which case the lender has an ‘opportunity’ cost – the cost of not lending at a higher rate. The converse holds for a borrower on a fixed rate: should interest rates decline, the borrower would be better off by borrowing at lower rates. It is to be noted that for forecasted future exposures, such as future inflows or outflows, the exposures are identical to floating rate exposures because the future interest rate is uncertain, whether it is fixed or variable.

Fundamental changes in the regulatory and market environment have made interest rate risk a vital issue. Banks encounter interest rate risk in several ways. The primary and most often discussed source of interest rate risk stems from timing differences in the repricing of bank assets, liabilities and off-balance-sheet instruments. These repricing mismatches generally occur from either borrowing short-term to fund long-term assets or borrowing long-term to fund short-term assets.  Another important source of interest rate risk arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics. When interest rates change, these differences can give rise to unexpected changes in the cash flows and earnings spread among assets, liabilities and off-balance-sheet instruments of similar maturities or repricing frequencies.  An additional and increasingly important source of interest rate risk is the presence of options in many bank asset, liability and off-balance-sheet portfolios. Instruments with embedded options include various types of bonds and notes with call or put provisions, loans such as residential mortgages that give borrowers the right to prepay balances without penalty, and various types of deposit products that give depositors the right to withdraw funds at any time without penalty. If not adequately managed options can pose significant risk to a banking institution because the options held by bank customers, are generally exercised at the advantage of the holder. It is essential that banks accept some degree of interest rate risk. However for a bank to profit consistently from changes in interest rates requires the ability to forecast interest rates better than the rest of the market. The challenge for banks is not only to forecast interest rate risk, but also to measure and manage it in such a way that the compensation they receive is adequate for the risks they incur.

To measure and manage interest rate risk, various instruments, from gap management to derivative, can be used. A traditional measure of interest rate risk is the maturity gap between assets and liabilities, which is based on the repricing interval of each component of the balance sheet. Duration can also be used and is usually presented as an account’s weighted average time to repricing, where the weights are discounted components of cash flow. Some banks simulate the impact of various risk scenarios on their portfolios. In other words, simulation analysis involves the modeling of changes in the bank’s profitability and value under alternative interest rate scenarios. These measures of interest rate risk, while convenient, provide rough approximations at best and derivatives must be used in addition. The relatively recent ways to measure and manage interest rate risk in financial theory and increased computerization, along with changes in the foreign exchange markets, the credit markets and the capital markets over time, have contributed to the growth of financial derivatives.

Availability of benchmark rate is crucial for better interest rate risk management. Interest rate benchmarks play a key role in the financial system, the banking system and the economy. They are used by a variety of agents, ranging from banks that provide credit to businesses and households to derivatives market makers. And, the practices of market-based interest rate are an important component for benchmark rate and in enabling market allocation of resources. Meanwhile, interest rate also serves as a benchmark for pricing many other financial products. Market-based interest rate reform should reflect financial institutions’ autonomy to price their products.

[1] Professor and Director (Training), BIBM ([email protected]).

Leave a Reply

Your email address will not be published. Required fields are marked *