What’s the right level of interest rate risk for a community bank — and what’s the right way for your bank to manage that risk? To answer these questions, it’s necessary to analyze your bank’s comparative size, its operational complexity and whether it has sufficient capital on hand to maintain profitability despite interest rate fluctuations. Based on your circumstances, management also needs to develop sound asset and liability risk management practices that hold up over time.
What’s interest rate risk?
Interest rate risk means risk to a bank’s financial condition or resilience (that is, its ability to withstand periods of stress) caused by movements in interest rates. There are several types of interest rate risk, including:
Repricing risk. Banks experience this risk when their assets and liabilities reprice or mature at different times. Suppose, for example, that a bank makes a five-year, fixed-rate loan at 7% that’s funded by a six-month certificate of deposit (CD) at 3%. Every six months, when the CD renews, the bank is exposed to repricing risk. If the CD rate increases to 4% after six months, then the bank’s net interest income drops from 4% to 3%. Conversely, if the CD rate declines, the bank’s net interest income increases.
To gauge repricing risk, banks can compare their volume of assets and liabilities that mature or reprice over a given time period. The potential impact of fluctuating interest rates will depend in part on whether a bank is asset- or liability-sensitive. If it’s asset-sensitive — meaning assets reprice more quickly than liabilities — then its earnings generally increase when interest rates rise and decrease when they fall. If it’s liability-sensitive — meaning liabilities reprice more quickly than assets — then its earnings generally increase when interest rates fall and decrease when they rise. Some banks are neutral — that is, their assets and liabilities reprice at the same time.
Basis risk. This arises when there’s a shift in the relationship between rates across markets or financial instruments. Suppose, for example, that an asset and a related liability are tied to the prime rate and the one-year U.S. Treasury rate, respectively. If the spread between those two rates widens or narrows, it will affect the bank’s net interest margins.
Yield curve risk. This risk arises from changes in the relationships among yields from similar instruments with different maturities. Let’s say that a bank funds long-term loans with short-term deposits. A typical yield curve reflects rates that rise as maturities increase. However, if market conditions cause the yield curve to flatten or even slope downward, the bank’s net interest margins can shrink or even turn negative.
Options risk. Bank assets and liabilities often contain embedded options, such as the right to pay off a loan or withdraw deposits early with little or no penalty. The bank is compensated for offering customers this flexibility (typically with higher interest rates on loans or lower interest rates on deposits). But granting these options creates interest rate risk. For example, if interest rates rise, deposit holders will have an incentive to move their funds into investments that enjoy higher returns. If rates go down, many borrowers will pay off their loans to refinance at a lower rate.
How can you manage your risk?
Banks can apply financial modeling techniques to measure and monitor their interest rate risk. If your interest rate risk is unacceptably high, consider strategies for mitigating it, such as:
- Adjusting your bank’s mix of assets and liabilities to reduce interest rate risk,
- Increasing capital to help absorb the impact of fluctuating interest rates,
- Reducing options risk by controlling the terms of loans and deposits, or
- Using interest rate swaps or other techniques to hedge against interest rate risk.
Keep in mind that a key component of interest rate risk management is stress testing.
Be risk-averse
Community banks face many interrelated and evolving issues, including risk management. Whether that risk involves interest rates, rapidly changing AI and technology, or issues related to liquidity vs. capital, an ongoing, integrated risk management system can support your bank’s profitability and long-term success.