What is Interest Rate Exposure?
Interest rate exposure can be defined as the potential loss that banks may incur due to fluctuations in interest rates. This risk arises as the bank’s assets, such as loans and bonds, generally have a longer matu- rity than the bank’s liabilities (like deposits). This risk may be conceptualised in two ways. If interest rates rise, the value of long-term assets would fall more than the value of short-term liabilities, thereby reducing the bank’s equity.
On the other hand, if interest rates fall, the bank would be forced to pay greater rates on deposits much before its long-term loans mature and it would be able to replace these loans with those that would give higher interest rates.
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Let us take an example to understand the concept of interest rate risk. Suppose a bank accepts only the certificates of deposits having maturity periods of two years. Also, suppose that the bank makes only mortgage loans of maturity of 15 years. Now, if interest rate rises, the expected income of the bank would decline. The reason behind the decline income of the bank is that it receives fixed inflow for 15 years from the mortgages.
However, when the certificate of deposits becomes due before the mortgages, the bank will have to pay more. Therefore, you can see internal rate of return (IRR) can have very serious financial repercussion on a bank. Let us take another example.
American Savings and Loans (S&L) are mortgage lenders. They collect deposits and underwrite mortgages. In the 1980s and 1990s, the American S&L system faced a major crisis when several thousand deposits failed due to interest rate risk. Many of these deposits were underwritten long-term fixed-rate mortgages backed by variable-rate deposits.
The variable rate deposits paid interest rates based on the market interest rates. As market interest rates increased, so did the deposit rates. As a result, the interest payments that the deposits were bound to receive exceeded the interest payments they were actually receiving on their fixed-rate mortgages. This resulted in large losses and eventually wiped out thousands of S&L.
Change in interest rate affects the value of foreign currency assets and liabilities of banks. For example, the interest rate differential be- tween two currencies determines the forward rates. Similarly, the value of foreign currency assets and liabilities acquired from money market operations can change when the interest rates change leading to pricing and reinvestment risks applicable to any fixed income securities.
The banks also undertake several other interest rate-dependent transactions like foreign currency swaps, interest rate swaps, forward rate agreements, etc. The changes in the interest rate affect the valuation of these instruments. In addition, any mismatch between foreign currency assets and liabilities in terms of maturity dates can lead to potential losses when inter- est rates change.
For example, banks cannot always ensure the exact matching of maturity of assets and liabilities as these are acquired as a part of business operations. The re-financing of assets/liabilities may have to be done at different interest rates leading to losses. The maturity mismatch between assets and liabilities is known as gap. These gaps are filled by banks through making transaction by paying/ receiving appropriate forward differentials, which are functions of interest rates.
Any adverse movement in interest rates impact forward differentials which affect the cash flows underlying the assets/liabilities due to gaps. The interest rate risks are managed through dealers by undertaking money market operations to match the assets and liabilities, using swaps and through other interest rate derivative products. To conclude, a bank can have interest rate exposure when its earnings are sensitive to changes in the interest rate.
Instruments, such as loans, investment, deposits, etc. generate the revenue of costs for banks. These revenues or costs are driven by interest rate. Therefore, any change in the interest rate would result in changes in the revenues and costs of a bank.
Sources of Interest Rate Exposure
The major factors that give rise to interest rate exposures in banks are explained as follows:
- Timing difference in pricing bank assets, liabilities and off-balance-sheet items: Interest rate exposure fundamentally originates from the timing difference in pricing. A bank is exposed to interest rate risks when it borrows short-term to fund long-term assets or borrow long-term assets.
- Imperfect correlation: Banks are exposed to interest rate risks when they establish imperfect correlations in the adjustments of interest paid and interest earned from different instruments. Therefore, with changes in the interest rate, these differences result in unforeseen changes in the cash flows and earnings that are spread among assets, liabilities and off-balance-sheet items.
- Options contracts: Options refer to the financial contracts that provide the holder a right but not an obligation to buy or sell the underlying asset. Options can cause significant amount of interest rate exposure to banks. If the options are not properly managed, bank customers can exercise the options for their advantage (and for the disadvantage of the bank).
Forms of Interest Rate Risk
Following are the major forms of interest rate risk faced by banks:
Repricing risk
This risk arises due to changes in fixed-income term structure. Mainly, maturity mismatch contributes to repricing risk. For example, suppose a bank is earning 5% interest on an asset that supports a liability for which the bank is paying 4% interest rate. The maturity period of the asset is three years; whereas, the maturity period of the liability is 12 years.
In this case, the firm needs to reinvest the proceeds from the asset every three years. Now, if the interest rate declines to 3%, the bank will only earn 3% on the asset for the remaining 9 years; whereas, it will have to pay at the rate of 4% for the liability. This situation will result in significant loss for the bank.
Basis risk
This type of interest rate risk arises when interest rate on assets and liabilities do not change in the same proportion. For, example if interest rate on assets increase by 1% and interest rate on liabilities increase by 1.5%, it can give rise to basis risk for a bank.
Yield curve risk
This type of risk arises when a bank is invested in fixed income instrument and the interest rate moves in the adverse direction. This type of change either flattens or steepens the yield curve of an asset.
For example, suppose a bank has invested in bonds (fixed income securities). Now, if interest rate or yield increases, the price of the bond will decrease and vice versa. Therefore, the yields for comparable bonds with different maturities will be different.
Embedded option risk
A bank is exposed to embedded option risk due to prepayment of loans and immature withdrawals of deposits. For example, When a customer having a fixed deposit with a maturity period of 5 years withdraw the deposit, for say, after 2 years, the bank is exposed to option risk as the bank now have to reinvest the money in another avenue that will pay at least equal amount of interest to avoid loss in interest earnings.
