A method for evaluating interest rate risk in U.S. commercial banks

Federal Reserve Bulletin, August, 1991 by James V. Houpt, James A. Embersit

When interest rates change, the economic values of the loans, securities, and deposits at banks also change, but not necessarily in offsetting ways. The net effect of these changes is reflected in a bank's earnings and net worth. The risk that changes in rates might adversely affect a bank's financial condition is referred to as interest rate risk.

As financial intermediaries, banks and other depository institutions accept interest rate risk as a normal part of their business. They assume the risk whenever the interest rates paid on their liabilities do not adjust in unison with the rates earned on their assets. Such mismatches often present institutions with opportunities to profit from favorable changes in interest rates, but they also expose a bank's capital and earnings to adverse changes. Effective management of interest rate risk is a fundamental element of the banking business.

Banks have many ways of managing their risk. Most banks change their exposures by altering the rates (or prices) and maturities at which they are willing to originate loans, buy or sell securities, and accept deposits. With the emergence of many new financial products and markets during the 1980s, banks have acquired even more alternatives for managing interest rate risk while meeting customer preferences on the terms of loans and deposits. Interest rate swaps and financial futures, forwards, and options are some of the growing number of tools banks now use to adjust their exposures.

In the United States, the combination of a volatile interest rate environment, deregulation, and the growing array of new on- and off-balance-sheet products has made the management of interest rate risk a growing challenge. Accordingly, bank supervisors are placing increased emphasis on evaluating the interest rate risk of banks. This focus has become particularly sharp in light of the current implementation of risk-based capital charges. The 1988 international agreement on capital standards known as the Basle Accord represents an important milestone in supervisory policy by making a bank's minimum capital requirements sensitive to the credit risk of its assets and off-balance-sheet positions.(1) The agreement, however, focuses primarily on credit risk; it does not impose an explicit capital charge tied to interest rate risk.

One possible effect of this focus is that banks may have an incentive to substitute interest rate risk for credit risk in structuring their balance sheets. Indeed, this may already be happening. The emergence of large positions in mortgage-backed securities is particularly noticeable. At the end of 1988, these securities accounted for 17 percent of the aggregate securities portfolio of the commercial banking industry and less than 3 percent of its total assets; by early 1991 these shares had doubled, to 35 percent of all bank securities and 6.5 percent of total banking assets. Although the share of mortgage-backed securities in total assets is still small, the rapid growth within such a short period may be an indication of increasing interest rate risk exposure among banks. Regardless of whether banks are increasing their exposure, interest rate risk is a fundamental element of the business and should be considered in assessing the adequacy of bank capital.

CURRENT RISK GUIDELINES

The Basle Accord tailors a bank's minimum capital requirement to the credit risk embodied in the institution's assets and off-balance-sheet instruments. Under the agreement, those balances perceived to carry greater credit risk must be backed by levels of capital higher than those required for lower-risk positions. Overall, the standard requires internationally active banks to have total capital (including equity, reserves, and subordinated debt) equal to at least 8 percent of their fisk-weighted assets by the end of 1992.2 The capital treatment of interest rate risk was deferred in the construction of the existing agreement and is now being addressed by another international committee working, once again, under the aegis of the Bank for International Settlements (BIS).

The Federal Reserve System is actively participating in the work of the BIS committee. However, several reasons suggest the need for simultaneous steps to supplement the current "domestic" approach to the supervision of interest rate risk. One reason is that the time required to develop and implement an international standard is uncertain. Moreover, the international approach under development is aimed primarily at the largest and most internationally active banks, which conduct activities in a variety of currencies (each with its own interest rate exposure) often involving complex transactions. An approach for incorporating interest rate risk into the risk-based capital standard developed for them may have to be modified for application to many of the 12,000 small and medium-size U.S. banks. Indeed, once an international framework emerges for the assessment of interest rate risk, every country may need to tailor that framework to the specific characteristics and structure of its own banking system.