Managing interest rate risk in a rising-rate environment

RMA Journal, The, Nov, 2004 by Timothy Griffeth

We all know (sort of) what interest rate risk is, but many of us don't understand the tools available to mitigate it. This article, the second-place winner in the RMA 2004 Paper Writing Competition, provides an overview that both defines and gives strategies for managing interest rate risk in a rising rate environment.

Many banks are now looking at loan portfolios heavily populated with loans originated during a fairly lengthy period of low interest rates. A rising-interest-rate environment poses a challenge to these institutions, but there are a number of ways to mitigate interest rate exposure.

What It Is

Interest rate risk results from differences in the maturities of a bank's assets and liabilities. Typically, banks fund long-term loans with customer deposits and similar assets that are prone to periodic repricing due to market forces. As rates paid on customer deposits rise, the profit earned on the underlying loan, known as the net interest margin, erodes.

Gap analysis. Interest rate risk can be measured by using gap analysis. Dollar-value gap analysis--one of the simplest forms--measures the dollar value of those assets on a bank's balance sheet that are sensitive to changes in interest rates, less the bank's liabilities that are sensitive to interest rate changes. Therefore, a bank's interest rate gap would be the value of floating-rate loans on the bank's balance sheet less the value of customer deposits. A more sophisticated form of interest rate risk measurement is duration gap analysis. Duration is a measure of an asset s or a liability's sensitivity to a given change in interest rates. A bank's duration gap is the dollar-weighted duration of the bank's assets less the dollar-weighted duration of the bank's liabilities. Banks with a positive interest rate gap see net interest margins widen if interest rates were to rise (or to see net interest margin erode if rates were to fall). Banks with a negative interest rate gap would see net interest margin erode if rates rise (or would see net interest margin widen if rates were to fall) With a large number of loans set at a fixed interest rate during the recent period of low interest rates, many banks now face a negative interest rate gap in the face of a rising-interest-rate environment.

While rising interest rates can negatively affect a bank's net interest margin, rising interest rates correspond with improving economic and business conditions--a natural hedge against interest rate risk. As economic conditions improve, the expansion in lending opportunities is also priced at the new interest rate levels, and this expansion pricing partially offsets the risk associated with carrying assets whose interest rates were fixed during the low-interest-rate period. In particular, improving economic conditions lead to higher occupancy rates and rent revenues, which in turn help drive higher commercial real estate values. Therefore, the commercial real estate market should improve. Banks holding a portfolio of both commercial and residential real estate loans can, therefore, expect to mitigate the negative impacts of higher interest rates on residential real estate with improved lending conditions in the commercial real estate market.

Managing the Risk

Historically, banks have offset the risk associated with funding fixed rate loans with variable-rate assets, such as customer deposits, by lengthening the duration of the bank's assets. To do this, a bank would purchase fixed-rate government securities with maturities that correspond with the expected maturities of the bank's fixed-rate loans. Assets acquired to lengthen the duration of the bank's assets are commonly known as "balancing assets." However, many banks have realized that the same goal is achieved more efficiently by using derivatives to manage interest rate risk.

Collars. Another method to manage interest rate risk is the "costless" collar. A collar consists of an interest rate cap and floor, usually based on the London Inter-Bank Offered Rate (LIBOR). To enter into a collar, a bank would simultaneously purchase an interest rate cap and sell an interest rate floor in the derivatives market. An interest rate cap is a series of interest rate call options set at the same exercise rate and that have expiration dates at each point when the underlying liability (in this case, customer deposits) is expected to reprice. On the other hand, an interest rate floor is a series of interest rate put options with the same exercise rate that have expiration dates at each point when the underlying liability is expected to reprice. If interest rates rise, the interest rate cap calls for the seller of the cap to pay the bank the difference of LIBOR and the predetermined cap rate. If interest rates fall, the interest rate floor calls for the bank to pay the buyer the difference between the floor rate and LIBOR. Therefore, a bank knows its future interest rate expense regardless of whether interest rates rise or fall. The word costless means that the premium paid to purchase the interest rate cap is roughly equal to the premium received on the floor, excluding brokerage fees. By entering into a collar, a bank is in neither a short nor a long interest rate position in the derivatives market. In a rising-interest-rate environment, a bank that wants to offset only the interest rate risk associated with rising interest rates could take a long position in the derivatives market by purchasing only the interest rate cap. By having a negative interest rate gap, a bank would naturally be in a short interest rate position.