Interest Rate Risk

A bank's main source of profit is converting the liabilities of deposits and borrowings into assets of loans and securities. It profits by paying a lower interest on its liabilities than it earns on its assets—the difference in these rates is the net interest margin.

However, the terms of its liabilities are usually shorter than the terms of its assets. In other words, the interest rate paid on deposits and short-term borrowings are sensitive to short-term rates, while the interest rate earned on long-term liabilities is fixed. This creates interest rate risk, which, in the case of banks, is the risk that interest rates will rise, causing the bank to pay more for its liabilities, and, thus, reducing its profits.

For instance, if a bank has a loan for $100 for which it receives $7 annually in interest, and a deposit of $100 for which it pays $3 per year in interest, that is a net interest margin of $4. But if current market interest rates for deposits rises to 4%, then the bank will have to start paying $4 for the $100 deposit while still receiving 7% on the long-term loan, decreasing its profit in this scenario by $1.

All short-term and floating-rate assets and liabilities are interest-rate sensitive—the interest received on assets and paid on liabilities changes with market rates. Long-term and fixed-rate assets and liabilities are not interest-rate sensitive. Interest-rate sensitive assets include savings deposits and interest-paying checking accounts. Long-term CDs are not interest-rate sensitive.

So for a bank to determine its overall risk to changing interest rates, it must determine how its income will change when interest rates change. Gap analysis and duration analysis are 2 common tools for measuring the interest rate risk of bank portfolios.

Gap analysis is the difference between the value of the interest rate sensitive assets minus the value of the interest rate sensitive liabilities (the gap) multiplied by a change in interest rate of 1%.

Gap = Value of Interest Rate Sensitive Assets – Value of Interest Rate Sensitive Liabilities.

Gap x Change in Interest Rate = Change in Bank's Profit.

More sophisticated gap analysis takes into account the different terms of the different assets and also convexity, but the calculations are far more complicated.

Since interest rates affect the prices of bank assets and liabilities in the same way that they affect bonds, bankers also use a tool commonly used in bond portfolio analysis—duration analysis.

Duration measures the change in the price of a bond when the interest rate changes by 1%. A bank calculates its duration gap by subtracting the weighted average duration of its assets minus the weighted average duration of its liabilities.

Reducing Interest Rate Risk

Banks could reduce interest rate risk by matching the terms of its interest rate sensitive assets to it liabilities, but this would reduce profits. It could also make long-term loans based on a floating rate, but many borrowers demand a fixed rate to lower their own risks. In addition, floating-rate loans increase credit risk when rates rise because the borrowers have to pay more each month on their loans, and, thus, may not be able to afford it. This is best exemplified by the many homeowners who defaulted because of rising interest rates on their adjustable rate mortgages (ARMs) during the 2007 – 2009 credit crisis.

Increasingly, banks are using interest rate swaps to reduce their credit risk, where banks pay the fixed interest rate they receive on their assets to a counterparty in exchange for a floating rate payment.

Trading Risk

Generally, greater profits can be made by taking greater risks. A bank's leverage ratio is limited by law, but it can try to earn greater profits by trading securities. Although United States banks cannot, by law, own stocks, they can buy debt securities and derivatives. For this, banks hire traders for a separate department that specializes in trading securities.

The risk of trades is measured by standard statistical tools for measuring investment risk: standard deviations and value at risk (VaR). However, many banks use more sophisticated financial models to gauge risk and to increase their profits, but the 2007 – 2009 credit crisis showed that many of these models were faulty.

Also, rogue traders can cause stupendous losses for banks, even causing their bankruptcy. Consider Barings Bank that started in 1762, and was considered to be the most stable and safest bank for centuries. In 1995, Nick Leeson lost more than 860 million pounds trading Japanese equities in Singapore. Barings was unable to provide the cash to cover the losses, so it collapsed.

The 2007 - 2009 credit crisis has also shown the tremendous risks presented by derivatives, which are securities whose value depends on an underlying asset or index. The most common derivatives bought and sold by banks are mortgage-backed securities (MBS), interest-rate swaps, and credit default swaps (aka credit derivatives).

Graph spanning 2000 - 2007 showing the exponential growth of the notional value of credit derivatives held by banks, either as beneficiaries or as guarantors.

Source: http://www.federalreserve.gov/pubs/bulletin/2008/articles/bankprofit/default.htm

Foreign Exchange Risk

International banks trade large amounts of currencies, which introduces foreign exchange risk, when the value of a currency falls with respect to another. A bank may hold assets denominated in a foreign currency while holding liabilities in their own currency. If the exchange rate of the foreign currency falls, then both the interest payments and the principal repayment will be worth less than when the loan was given, which reduces a bank's profits.

Banks can hedge this risk with forward contracts, futures, or currency derivatives which will guarantee an exchange rate at some future date or provide a payment to compensate for losses arising from an adverse move in currency exchange rates. A bank, with a foreign branch or subsidiary in the country, can also take deposits in the foreign currency, which will match their assets with their liabilities.

Sovereign Risk

Many foreign loans are paid in U.S. dollars and repaid with dollars. Some of these foreign loans are to countries with unstable governments. If political problems arise in the country that threatens investments, investors will pull their money out to prevent losses arising from sovereign risk. In this scenario, the native currency declines rapidly compared to other currencies, and governments will often impose capital controls to prevent more capital from leaving the country. It also make foreign currency held in the country more valuable; hence, foreign borrowers are often prohibited from using foreign currency, such as U.S. dollars, in repaying loans in an attempt to conserve the more valuable currency when the native currency is declining in value.

Operational Risk

Operational risk arises from faulty business practices or when buildings, equipment, and other property required to run the business are damaged or destroyed. For instance, banks in the vicinity of the World Trade Center suffered considerable losses as a result of the terrorist attacks on September, 11, 2001, which knocked out power and communications in the surrounding area. Barings Bank collapsed because its audit controls did not detect the calamitous losses suffered by its rogue trader, Nick Leeson, early enough to prevent its collapse.

Many types of operational risk, such as the destruction of property, are covered by insurance. However, good management is required to prevent losses due to faulty business practices, since such losses are not insurable.