Editor's Note: As the savings and loan crisis of the 1980s
showed, taxpayers can end up paying when banks engage in excessive
risk taking. And there are a large number of ways that banks can
take on too much risk. They might make speculative loans, for
example. The savings and loan industry engaged in speculative
lending but also was exposed to risks by making long-term mortgages
that were funded by short-term deposits. This creates what is
called interest rate risk, which is discussed below in more detail.
It is clear why taxpayers should care about bank risk taking,
but why should the Federal Reserve?
As one of its duties, the Fed regulates the safety and soundness
of certain banking organizations. This means the Fed monitors
the riskiness of these banking organizations, examines them and
takes steps to prevent them from taking risk in excessive levels.
As a result, the Fed has a strong interest in topics such as interest
rate risk. The Minneapolis Fed not only devotes considerable resources
to regulating banks, but it also gives serious attention-in the
fedgazette and other publicationsto the effect of regulatory
policy on bank risk taking.
All banks face interest rate risk (IRR) and recent indications
suggest it is increasing at least modestly. Although IRR sounds
arcane for the layperson, the extra taxes paid after the savings
and loan crisis of the 1980s suggests there is good reason to learn
at least a little about IRR.
Think of IRR as blood pressure for banks. It can increase or decrease
without obvious outward signs, and such changes can cause failure.
At the same time, regulators and banks can monitor it and detect
changes. Finally, banks can take preventative steps to manage IRR
but they do not want to eliminate it completely as it, like blood
pressure itself, is vital for survival.
In general, IRR is the potential for changes in interest rates
to reduce a bank's earnings and lower its net worth. IRR manifests
in several different ways but we will provide a simplified example
to illustrate the general issue. The most common manifestation of
IRR occurs because the assets of the banks, such as the loans it
holds, come due or mature at a different time than the liabilities
of the bank, such as deposits.
Take, for example, a bank that funds itself only with certificates
of deposit that have a maturity of two years. This bank also only
makes mortgage loans with a maturity of 15 years. Should interest
rates rise in the future, the bank would face a decline in its expected
income. Why? The monthly inflow of cash to the bank from the mortgages
are fixed for 15 years. When the certificates of deposit come due
before the mortgages, the bank will have to pay more to receive
funding so cashflows out of the bank will increase.
Clearly IRR holds the potential to have a negative impact on earnings
and net worth of a bank. So why don't banks try to eliminate it
by ensuring that all of its assets and liabilities have exactly
the same maturities? Banks would earn less money without taking
on this risk. By earning the difference between long-term and short-term
rates, for example, banks are getting paid to assume IRR and meet
the demands of customers for deposits and loans. The challenge for
banks is to measure IRR and manage it such that the compensation
they receive is adequate for the risks they incur.
Focusing on risk management of banks in this case is particularly
important because, as has been pointed out in many Minneapolis Fed
publications, some of the risk taking of banks is borne by the taxpayers
who support the safety net for banks. These concerns are always
heightened in periods such as the current one where IRR is on the
Measurements of interest rate risk: Going up
Regulators and banks employ a variety of different techniques to
measure IRR.A relatively simple method used by many community banks
is gap analysis, which involves grouping assets and liabilities
by their maturity period, or the time period over which the interest
rate will change (the "repricing period"), such as less than three
months, three months to one year, etc. The "gap" for each category
is then expressed as the dollar value of assets minus liabilities.
A large, negative gap would indicate that the bank has a greater
amount of liabilities that are repricing during that time than assets,
and therefore would be exposed to an increase in rates. A negative
gap would suggest an exposure to a decline in rates.
Regulatory agencies often employ a slightly more complex version
of gap analysis to estimate the level of IRR for a bank and for
the entire banking industry. This technique involves estimating
the change in the value of assets and liabilities within each time
band at a given institution for a change in interest rate (for example,
up 2 percentage points) and then calculating the aggregate difference
between the two. This amount roughly represents the loss in net
worth a bank would suffer if interest rates moved unexpectedly.
Consider a hypothetical bank with $80 million in assets, $60 million
of it in liabilities and $20 million in equity capital. Following
a 2 percentage point increase in interest rates, the asset value
of the bank drops to $70 million while the value of liabilities
falls to $55 million. The change in net worth for this bank would
be negative $5 million, implying that equity capital is worth only
$15 million. Typically, the net change in economic value is expressed
as a percentage of assets.
Graph 1 below shows the distribution of changes in economic value
for an immediate 2 percentage point increase to interest rates for
all commercial banks in the nation at the end of 1999 and 1998.
The distribution has shifted to the left from year-ago levels, suggesting
that IRR has increased for the industry.
For example, in December 1999 the percentage of banks whose economic
value would decline by more than 1.5 percent of assets increased
from 25 percent to 33 percent. Ninth District banks have witnessed
similar shifts in their distribution over the past year, although
the aggregate levels are lower. Currently, 24 percent of banks within
the district would see their economic value shrink by more than
1.5 percent given a 200 basis point increase in rates, compared
to just 13 percent one year ago.
These results are reinforced by findings from recent bank examinations.
In addition to assessing things like capital adequacy, asset quality
and earnings performance, regulators also rate the sensitivity of
a bank to market risk arising from their exposure to foreign exchange,
commodities, equities, and interest rates. (For more information
on examination ratings see the January 1999 fedgazette
article, "What Are CAMELS
and Who Should Know.")
While the vast majority of commercial banks in the nation received
one of the two highest ratings, the percentage of banks whose sensitivity
ratings were downgraded from their last exam has been climbing steadily,
and actually exceeded the percentage of banks that were upgraded
during the last two quarters (see graph 2). Similar results are
found in Ninth District exam ratings.
Two likely culprits behind the recent increases in IRR at commercial
banks are lengthening asset maturities and a greater reliance on
short-term, volatile liabilities. Banks have changed the composition
of their asset portfolios to include larger holdings of both residential
mortgages and mortgage-related securities, two asset categories
that typically have longer maturity periods. Additionally, the percentage
of such assets that mature or reprice in less than one year has
been declining in favor of assets that mature in over 15 years.
At the same time that their asset portfolio maturity has been rising,
banks have been forced to rely more heavily on volatile liabilities
due to sluggish deposit growth. Examples of volatile liabilities
include fed funds purchased, other borrowed monies (like advances
from the Federal Home Loan Banks), and time deposits over $100,000.
These instruments typically mature in a very short period (often
under a year), exposing banks to higher interest expenses if market
rates are rising when these funds are being replaced. Together,
these trends are resulting in the asset side of the balance sheet
becoming less interest-sensitive while the liability side is becoming
Response to heightened levels of interest rate risk
Commercial banks can take several steps to manage IRR. The first
step in management is measurement. In addition to some of the techniques
described above, banks have much greater access over the last several
years to advanced forms of computer models that allow them to determine
their IRR on a real-time basis.
Banks can also avail themselves of asset/liability management firms
to get expert advice on controlling their IRR. In addition to directly
changing the types of assets and liabilities they hold, banks can
enter into financial contracts to shift some of the IRR they have
to other parties who are better able to manage it. Finally, regulators
closely scrutinize the systems used by bank managers to measure
and identify their interest rate risk to ensure that banks are not
taking on undue levels of such risk.