Rising Interest Rates Bring Opportunities and Risks for Banks

This post is part of a series titled “Supervising Our Nation’s Financial Institutions.”

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One of the challenges U.S. banks—and community banks, in particular—have faced over the past decade is downward pressure on net interest margins. Increased competition, low interest rates and often tepid loan demand have made it increasingly difficult for banks to generate earnings from their core business of making loans, with the COVID-19 pandemic adding additional strain.

The Federal Reserve’s continuing moves this year to raise interest rates to cool stubborn inflation could help ease some of that pressure on banks, as rates charged on loans and earned on investment securities also increase. Banks by and large still have a large cushion of low-cost deposits that accumulated during the pandemic that could be deployed into higher-yielding assets. However, some institutions are beginning to observe declines in deposit levels as customers withdraw funds to cover rising expenses or seek higher yields elsewhere. Banks may be reluctant to make investments now over concerns about maintaining deposits along with the prospect of yet higher rates in the future. Rising interest rates—and interest rate changes in general—create risks for banks that must be managed well to protect earnings and capital, thereby ensuring safe and sound depository institutions.

Interest Rate Risk Basics

Interest rate risk (IRR) is the risk to a bank’s earnings and capital that occurs when interest rates change. For community banks, IRR arises primarily because the rates on and prices of assets and liabilities change by different amounts or at different times. IRR is comprised of four types of risk:See this FDIC document for numerical examples of how the different types of IRR affect net interest margins (PDF).

• Repricing risk occurs when assets (loans and investments) mature or reprice at different times than liabilities (deposits and other borrowings).
• Basis risk arises when interest rate changes lead to a difference in how a bank’s assets are repriced versus its liabilities.
• Yield curve risk arises from nonparallel changes in the yield curve. The rate change on a two-year Treasury bond, for example, may differ from that on a 10-year Treasury bond.
• Option risk happens when the timing or amount of a bank’s cash flows changes because of a decision by a bank borrower (e.g., a loan customer) or lender (e.g., deposit customer).

For many community banks, repricing risk is of the most concern. They must be constantly aware of the mix of fixed-rate and floating-rate assets and liabilities on their balance sheets, as well as when those assets and liabilities mature or reprice and to what magnitude.

The Supervision Perspective

While the effects of changes in interest rates have always been monitored by banks and regulators alike, the significant interest rate increases this year have resulted in potential IRR exposures not seen in quite some time. Moreover, the industry’s lack of recent experience with rising and more volatile interest rates, coupled with material levels of market uncertainty, presents challenges for all banks, regardless of size or complexity.

The federal bank regulators—the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency—issued guidance on IRR for all banks in 2010 (PDF), as the economy and banking industry were recovering from the financial crisis and the Great Recession, and it remains in effect today. This guidance sets forth expectations for measuring, monitoring and mitigating IRR exposures.

Managing Interest Rate Risk

Banks are expected to measure the effects of changing interest rates on earnings, liquidity and capital. Methods to measure IRR vary but should be appropriate for the bank’s size, complexity and inherent level of IRR. Most banks use a combination of stress simulations to measure their exposure to earnings in the short term (one to two years) as well as the long-term impact to the bank’s capital position.

Banks can measure the impact of a variety of stress scenarios including interest rate shocks and changes in the shape of the yield curve. Bank management should understand assumptions used in the IRR models and how they affect the forecasted outcomes. A well-managed bank will then compare the results against the tolerances for IRR adopted by senior management and the board of directors.

A bank could mitigate its IRR by altering its balance sheet, with the goal of reducing mismatches in the maturities and repricing schedules of assets and liabilities. Hedging IRR with derivatives such as interest rate swaps is one possible option for banks with the knowledge and expertise needed to use these instruments appropriately. If IRR management is deemed inadequate by regulators, they will likely require enhancements to a bank’s IRR policies and procedures to more effectively measure, monitor and then control IRR exposures. Bank regulators may recommend or direct a bank to raise capital or take other actions if IRR management is deemed inadequate.

The banking industry’s IRR exposure warrants increased attention both by bank management and by regulators at this time. This closer look is needed because of the significant interest rate increases this year and because of the challenges of accurately measuring IRR exposures given persistent volatility and potential uncertainty in the path of interest rates, evolving consumer behaviors and other economic variables. As always, banks are expected to establish appropriate risk tolerances and develop effective methods to measure, monitor and control exposures to IRR in a manner consistent with the size and complexity of the bank.

Despite the challenges, some banks may be well positioned to benefit from the opportunities created by this year’s sizable rate increases, thus improving earnings and capital positions.

Note

1. See this FDIC document for numerical examples of how the different types of IRR affect net interest margins (PDF).