Market risk refers to the risk that an institution’s earnings (income) and capital (operating funds) may be affected by changes in market rates or prices such as interest rates, securities prices, commodity prices and foreign exchange rates. For most institutions, the primary source of market risk is interest rate variability. For instance, when interest rates rose sharply in 1994, the value of bank securities holdings fell by more than $7.8 billion nation wide. It is this effect of rate changes on bank performance and condition that you’ll learn more about in this section.

In this course, the discussion of market risk is limited to the risk that interest rate movements will affect a bank’s earnings and capital position. There are four sources of interest rate risk, related to the terms on the loans a bank makes and the money it borrows.

The four sources of interest rate risk are:

• Repricing Risk - a risk that arises from mismatches in maturity and interest rate changes in a bank’s assets and liabilities.
• Options Risk - the risk that arises from implicit and explicit options in a bank’s assets and liabilities, such as prepayment of loans or early withdrawal of funds.
• Basis Risk - interest rates for various assets and liabilities may change at the same time, but not necessarily in the same amount.
• Yield curve risk - the risk that changes in market interest rates may have different effects on similar instruments with different maturities.

These four types of risk (repricing, options, basis and yield curve) will impact or influence net interest income when interest rates change. Recall that net interest income is the difference between interest income and interest expense. See the chart below:

In addition, interest rates can influence a bank’s non-interest income and expense. For example, as interest rates rise, a bank may see the number of loans it makes decline, reducing the number of loan origination fees that the bank receives.

Capital at Risk – the effects of market risk on capital

Banks are exposed to market risk on two fronts: through their earnings and through their capital. So far, we have focused on the shorter-term effects of interest rate movements on bank financial performance, that is, the effects on net interest income. However, there are longer-term effects of interest rate changes on capital.

One way to think about these effects is to think of them as the accumulation of the effects of interest rate changes on cash flows over time. The value of an asset depends on the stream of income it is expected to produce relative to market rates. Banks that are locked into long-term investments can see the value of their assets fall when interest rates rise. As with earnings, if liabilities are not matched appropriately to assets, this decline in value will be reflected in capital.

For example, if Bank A has extended a five-year fixed-rate loan on which it earns 8 percent interest, while current market interest rates are 10 percent for loans of similar risk, the Bank is missing the opportunity to earn at a higher rate. This lost income, over the five-year life of the asset, represents a loss of added capital that could have been accumulated over the life of the loan at the higher rate.

To the extent that a bank uses market-value accounting to evaluate its portfolio, these expected long-term changes in earnings can show up as short-term movements in capital. For example, increases in market rates cause the fair value of fixed-rate assets to fall, because the income streams they produce fall below what the market demands. If the fair value of a bank’s assets falls by more than the fair value of its liabilities following a rate increase, the fair value of its capital—also known as its Economic Value of Equity (EVE)—will fall. As discussed in the Board’s Response section, accounting standards for marking assets to their market value differ depending on their intended use.

For simplicity, we focus on the earnings implications of market risk and discuss capital at risk only briefly. In many banks—particularly smaller institutions—earnings models are the only tools used to evaluate interest-rate risk, and, because of the close relationship between earnings and capital, that is often sufficient. However, you should be aware that capital exposure is just as important as earnings exposure and cannot always be inferred from earnings models. Much of the basic information we will discuss regarding earnings at risk will carry over into capital analysis, should you choose to pursue that topic on your own.

Read more about Capital Adequacy. What do you know about your bank's capital adequacy position? Refer to the Try This at Your Bank exercise to learn more.

Repricing Risk

A financial contract is said to "reprice" whenever the interest rate that it pays changes. Instruments with fixed-interest rates do not reprice, by definition. Instruments with floating interest rates, such as variable-rate loans and CDs, reprice at a specified frequency, often once or twice a year. These contracts typically also specify a benchmark interest rate to be used for the repricing. For example, a variable-rate mortgage might reprice by changing its interest rate every six months to equal the long-term Treasury rate plus some spread (say 100 basis points, or 1 percent) to compensate the bank for the added credit risk associated with the mortgage. From an interest-rate risk standpoint, a repricing instrument is equivalent to a maturing instrument, because the interest rate that the bank pays or receives is updated to the prevailing market rate.

Repricing risk, then, is the risk that arises from timing differences or mismatches in the maturity and interest rate changes of a bank’s assets and liabilities. For example, if a long-term, fixed-rate asset is funded with a short-term deposit, interest income from the asset remains fixed over its life, while the interest expense changes each time the deposit is renewed. Because interest income is fixed and interest expense can move with market rate changes, net interest income and underlying economic value increase or decrease in response to market rates.

To make this example more concrete, suppose Bank A makes a five-year, 8 percent fixed-rate loan. The table below summarizes the effects of the interest rate rise on net interest income, the difference between what is earned on the loan and what is paid on the deposit to fund the loan.

The rise and fall in net interest income is the result of timing differences between when the interest rate on the asset (the loan) and the liability that funds the asset (the CD) can change (reprice). Net interest income declined because the bank is locked into an 8 percent rate for five years while the rate on its funding source can change annually.

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Options Risk

Options risk is the risk that arises from implicit and explicit options in a bank’s assets and liabilities, for instance, provisions in agreements that allow loan customers to prepay their loans or that allow deposit holders to withdraw their funds early, with little or no penalty. These options, if exercised, can affect net interest income and underlying economic value.

To see the effects of options risk, return to Bank A with its five-year loan. Assume, instead of funding the loan with a one-year CD, the bank funds it with a 4 percent five-year CD. In this case, the loan and CD agreements both have fixed interest rates for the same period, so repricing risk is a minimal. However, there is nothing that says the borrower can’t pay off the loan early or the CD holder can’t withdraw the funds ahead of the CD maturity date. In either case, the freed funds can be invested at the current market rate.

This ability to pay off or withdraw funds early is an option granted by the bank to the borrower and CD holder. The bank may charge for this option, levying a prepayment penalty on the loan or a penalty for early withdrawal on the CD, to provide it with a suitable return. However, in many instances banks forgo these penalties to stay competitive. As a result, loan customers have an incentive to prepay their fixed-rate loans when rates fall, refinancing at a lower rate, and to keep loans to contractual maturity when rates rise. CD holders on the other hand, will want to keep their CDs until they mature if rates fall and to move their deposits to obtain a higher yield when interest rates rise.

Bank A is caught in a vice. No matter which way interest rates move, the options in its loan and CD work to reduce its return. If a bank cannot adequately charge for the options in its products, those options will tend to favor the customer to the disadvantage of the bank, lessening its profitability.

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Basis Risk

Basis risk is the risk that changes in market interest rates may have different effects on rates received or paid on instruments with similar repricing characteristics (for example, a variable-rate loan whose rate is based on the three-month Treasury bill rate that is funded with three-month certificates of deposit). Because both instruments have a similar repricing interval, there is no repricing risk. History shows, however, that deposit rates and Treasury bill rates may not identically track market rate changes. To the extent the rates do not move in tandem, there are effects to net interest income and underlying economic values.

Suppose in this case that Bank A writes a variable rate loan that is “tied to” (or “priced off”) the three-month Treasury bill rate with 300 basis points (3 percent) added to compensate for the risk the customer presents. Also, suppose the bank funds the loan with a three-month CD, paying the national three-month CD rate. Note that, in this example, the loan reprices and the CD is renegotiated every three months. Because both rates change at the same time, there can be no repricing risk. Yet changes in the spread between the two market interest rates can cause Bank A’s net interest income to expand and contract.

All interest rates, in this case the Treasury bill and CD rates, do not necessarily move by the same amount. From the second quarter of 2000 to the first quarter of 2002, both the three-month Treasury bill rate and CD rate fell, but the CD rate fell faster (or the price that the bank had to pay to use the funds in the account).

Because the loan rate was based on the Treasury rate, Bank A’s cost of funds fell by more than its return, causing net interest income to rise. In other situations, the opposite outcome can occur, with the bank’s net interest income falling.

Even though Bank A worked hard to eliminate repricing risk by matching the repricing of the loan and the CD, it still faced interest-rate risk stemming from exposure to basis risk.

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Yield Curve Risk

Yield Curve Risk, another form of repricing risk, is the risk that changes in market interest rates may have different effects on yields or prices on similar instruments with different maturities. For instance, a change in market interest rates may affect the yield on a three-month Treasury bill more or less than on a one-year Treasury bill. Like other forms of repricing risk, this risk exposes a bank’s net interest income and underlying economic value to changes in market rates.

Just as interest rates on instruments issued by different parties don’t always move in tandem (Treasury securities and bank CDs, for example), interest rates on debt issues with different maturities don’t always move in parallel. In some instances, rates on shorter-term issues may move more or less than those on longer-term issues.

The charts below show the yield on various maturities of U.S. government debt issues—that is, the yield curve for these securities—in October 2000 and May 2001.

Normal Yield Curve	Inverted Yield Curve

Comparison of the two charts shows that the relative relationship of short- and long-term interest rates can vary significantly. Typically, banks exploit this relationship and lend for longer maturities than they borrow. (Longer-term rates are normally higher than shorter-term rates, and this difference contributes to banks’ net interest income. For more information about The Yield Curve [ “Borrow Short and Lend Long”], read Basic Investment Concepts for Banks.)

Thus, a bank may have loans with rates based on the longer-term end of the yield curve funded with deposits based on the shorter-term end of the curve. If the relationship between short- and long-term rates changes, the bank’s net interest income changes. For example, if the yield curve looked like the second chart, the interest rate on the short-term funding is above the rate received on the earning asset. Interest expense will be higher than interest income, resulting in a loss for the bank.