An analysis of commercial bank exposure to interest rate risk

Federal Reserve Bulletin, Feb, 1996 by David M. Wright, James V. Houpt

David M. Wright and James V Houpt, of the Board's Division of Banking Supervision and Regulation, prepared this article. Leeto Tlou and Jonathan Hacker provided assistance.

Banks earn returns to shareholders by accepting and managing risk, including the risk that borrowers may default or that changes in interest rates may narrow the interest spread between assets and liabilities. Historically, borrower defaults have created the greatest losses to commercial banks, whereas interest margins have remained relatively stable, even in times of high rate volatility. Although credit risk is likely to remain the dominant risk to banks, technological advances and the emergence of new financial products have provided them with dramatically more efficient ways of increasing or decreasing interest rate and other market risks. On the whole, these changes, when considered in the context of the growing competition in financial services have led to the perception among some industry observers that interest rate risk in commercial banking has significantly increased.

This article evaluates some of the factors that may be affecting the level of interest rate risk among commercial banks and estimates the general magnitude and significance of this risk using data from the quarterly Reports of Condition and Income (Call Reports) and an analytic approach set forth in a previous Bulletin article.(1) That risk measure, which relies on relatively small amounts of data and requires simplifying assumptions, suggests that the interest rate risk exposure for the vast majority of the banking industry is not significant at present. This article also attempts to gauge the reliability of the simple measure's results for the banking industry by comparing its estimates of interest rate risk exposure for thrift institutions with those calculated by a more complex model designed by the Office of Thrift Supervision. The results suggest that this relatively simple model can be useful for broadly measuring the interest rate risk exposure of institutions that do not have unusual or complex asset characteristics.

SOURCES OF INTEREST RATE RISK

Interest rate risk is, in general, the potential for changes in rates to reduce a bank's earnings or value. As financial intermediaries, 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 are fundamental to the business of banking and 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 (also referred to as "basis 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. In its formal sense, an option provides the holder the right, but not the obligation, to buy, sell, or in some manner alter the cash flow of an instrument or financial contract. Options may exist as standalone contracts that are traded on exchanges or arranged between two parties or they may be embedded within loan or investment products. 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, both explicit and embedded, are generally exercised at the advantage of the holder and to the disadvantage of the bank. Moreover, an increasing array of options can involve significant leverage, which can magnify the influences (both negative and positive) of option positions on the financial condition of a bank.

CURRENT INDICATORS OF INTEREST RATE RISK

The conventional wisdom that interest rate risk does not pose a significant threat to the commercial banking system is supported by broad indicators. Most notably, the stability of commercial bank net interest margins (the ratio of net interest income to average assets) lends credence to this conclusion. From 1976 through midyear 1995, the net interest margins of the banking industry have shown a fairly stable upward trend, despite the volatility in interest rates as illustrated by the federal funds rate (chart 1). In contrast, over the same period thrift institutions exhibited highly volatile margins, a result that is not surprising given that by law they must have a high concentration of mortgage-related assets.