How Do Banks Manage Interest Rate Risk?

How Do Banks Manage Interest Rate Risk?
How Do Banks Manage Interest Rate Risk? (Image:

Matching Assets and Liabilities

Interest rate risk is the difference in time, credit, and rate between an asset and the liability used to fund the asset. In the case of a bank, the primary liability is its deposit base, the certificates of deposits it issues and savings accounts, among other items. Certificates of deposit and savings accounts are interest-rate sensitive items for which the bank must be prepared to offer competitive rates. The deposit pool is a function of the size of the bank. Banks are continually adjusting the optimum number of outstanding liabilities and the maturity structure based on the amount of new loans made each day. The issue of what structure the maturity of liabilities must be is also important because the bank must be ready for immediate line of credit commitments. These are agreements that banks hold with individuals and businesses to prearrange lending if needed. These agreements are usually written for a fee and a 1-year time frame. The funding is variable draw downs and repayments can only be estimated.

Asset Matching Considerations

Asset collection has its complications as well. After writing loans, banks must determine a hard estimate of ability to pay, whether there might be delays in payments and whether credit quality might change thus changing the pricing of the loan. On this basis, a bank will determine how much of the loan to fund. Rarely are loans funded to their precise maturity but are funded short of the maturity to gain additional spread advantages between the asset and liability. Importantly, banks will often tie certificates of deposit, which rarely are redeemed early, to the purchase of United States Treasury bonds. These bonds can be traded for capital gains or used for liquidity.

Making the Interest Rate Balance Work

When banks see slacking loan demand, management will lower their interest rate outlook. This implies that the nature of the business cycle is changing and that liquidity will be increasing and borrowers will want to extend their loan maturities to take advantage of lower rates. Conversely, when rates rise it means loan demand is rising and more customers need to be accommodated with more money at higher rates. Complicating the matter is the seasonality of loans. Seasonally, the spring and early summer and post-Thanksgiving periods require banks to keep higher levels of liquidity. Conversely, months with lower loan demand result in greater payments of debt. The important issue is that the balance of assets and loan demand and the accurate prediction of interest rates will greatly impact the earnings of the bank. While banks must meet regulatory issues over loan making, liquidity and loan diversification, these concerns must be weighed against the banking profitability. Asset allocation is a fluid and complicated dynamic process that must be regularly reviewed.

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