books about online stock trading, forex, futures, stock investing, market, trading systems
Managing Interest Rate Risk
Back to contents page

This is the third main type of risk faced by banks. If there's a reservation that investors frequently harbor about investing in banks, it's that earnings can be squeezed by interest rates, which are completely outside banks' control.

The impact of rates on banks is often oversimplified to "Higher rates, good; Lower rates, bad." But there are more nuances to interest rate management than this. For instance, at any point, banks can be either asset sensitive or liability sensitive. Asset sensitivity means that the interest rate on assets (like loans) will change more quickly than the interest rate on liabilities. In this situation, rising rates will be profitable—at least for a while. But when banks are liability sensitive and rates start to rise, the interest rate on liabilities will change faster than the interest rate on assets, pinching margins.

However, banks aren't nearly as interest rate sensitive as they used to be. Banks try to closely match the life of their assets to their liabilities. And big banks have additional risk management tools at their disposal that small banks don't.

To understand why banks aren't entirely at the mercy of prevailing interest rates, consider how banks report their revenue and income. Unlike traditional firms, there is no explicit "revenue" or "sales" line. Instead, there are four major components to examine: (1) interest income, (2) interest expense, (3) noninter- est (or fee) income, and (4) provisions for loan losses. Here's an example of how the top of a bank income statement will look

For now, let's ignore the noninterest income component because this is generally steadier than interest income and interest expense. When we do this, we see that banks have a natural hedge built into their business. Consider the following as a base case for a bank operating in a strong economy

Suppose now that the Federal Reserve cuts rates. Because the Fed understands the benefit of maintaining a strong banking system, subtle cues are generally communicated before any cuts. In the meantime, banks reposition their balance sheets so that they're liability sensitive, thus allowing net inter­est income to widen. However, if a cut happens, it's for a good reason. A re­cession might be causing unemployment to rise and bankruptcies to increase. That, in turn, leads to higher provisions for loan losses for banks. Here's "what might happen in a weak economy

Have interest rates impacted the bank? Yes and no. Sure, net interest income widened, but this number is meaningless in isolation. After all, the weak economy caused provisioning to double, thereby wiping out the wider interest spread. In the real "world, this relationship doesn't come out to the perfect round numbers laid out here, but it can be close. From 2OOO to 2001, for example, FDIC data shows that net interest income grew S16.1 billion for the banking industry, mostly because of lower rates. However, the weakening economy caused banks to give most of that benefit back in the form of $13.8 billion of increased provisioning. 2

Virtually all banks can benefit in this type of scenario. However, big banks also have additional tools at their disposal. For starters, the breadth of their business lines makes it easier for them to reposition their balance sheet to focus on one sector versus another, depending on the operating environment. Perhaps most importantly, big banks have the ability to access the capital markets to pass the buck by letting investors purchase the loans (much like a bond) and assume the interest rate risk. Then banks—which still service the loans and collect a fee doing so—can focus on their strengths: credit and liquidity risk management.

At the end of 2OO2, for example, Bank One owned just S11.6 billion of credit card loans—those it held on its balance sheet—yet it managed a total card portfolio of $74 billion. This has happened industrywide and highlights the strength of larger lenders. For instance, although commercial banks and savings banks held 56 percent of all U.S. consumer loans on their balance sheets in 1990, that number had fallen to 37 percent by the end of 2OO2. Why? Because securitized assets—those that are sold off to investors and that banks continue to service—had risen from 6 percent of loans outstanding to 35 percent, according to the Federal Reserve.

Thus, while margins can be impacted by interest rates, large financial insti­tutions are making progress toward managing the interest rate cycle. As you're thinking about interest rate risk, remember that the impact it has on a bank's balance sheet is complex, dynamic, and varies from institution to institution.

Smarter trading The art of day trading Trading Chaos Sane Investing In An Insane World
Beat The Odds In Forex Trading