Interest rates have been at top of mind for many financial professionals in recent years. Interest rate fluctuations can significantly affect a bank’s deposit stability, earnings and asset values, for better or worse. Banks need to control their interest rate risk to ensure their capital and liquidity remain stable through the ups and downs.   

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. Examples of this risk include: 

Repricing risk. Banks experience this risk when their assets and liabilities reprice or mature at different times. Suppose 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, 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, compare the volume of assets and liabilities that mature or reprice over a given time period. The potential impact of fluctuating interest rates depends in part on whether your 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 risk arises when there’s a shift in the relationship between rates in different markets or on different 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. For instance, 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 in the form of higher interest rates on loans or lower interest rates on deposits). But these options create interest rate risk. For example, if interest rates go up, deposit holders will have an incentive to move their funds into investments that enjoy higher returns. If rates go down, many borrowers will refinance at a lower rate. 

Another risk associated with rising interest rates is an increased risk of default by borrowers with variable rate loans. 

What steps should your bank take? 

Banks can apply financial modeling techniques to measure and monitor their interest rate risk. If your risk is unacceptably high, consider strategies for mitigating it, such as: 

• Adjusting your bank’s mix of assets and liabilities, 

• Increasing capital to help the bank absorb the impact of fluctuating interest rates, 

• Reducing options risk by controlling the terms of loans and deposits, and 

• 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.  

One piece of the risk-management puzzle 

It’s important not only to address interest rate risk, but also to understand how it relates to other risks your bank is facing. This provides context for improving your entire risk-management system going forward.