For financial institutions, interest rate risk is a critical part of doing business, so it’s important for your institution to properly monitor it and take necessary steps to control it. The “right” level of risk depends on several factors, including the size and complexity of your institution’s operations, as well as the sufficiency of its capital and liquidity to withstand the potential adverse impact of interest rate fluctuations.Managing interest rate risk is particularly important in light of recent rate increases. The regulators have instructed examiners to determine whether financial institutions appropriately manage interest rate risk through “effective asset and liability risk management practices,” noting “rising rates may negatively affect asset values, deposit stability, liquidity, and earnings.”

Types of Interest Rate Risk

In simple terms, interest rate risk means risk to an institution’s financial condition or resilience (that is, its ability to withstand periods of stress) caused by movements in interest rates. There are several types of interest rate risk, including:Repricing risk. Credit unions and banks experience this risk when their assets and liabilities reprice or mature at different times. Suppose, for example, an institution makes a five-year, fixed-rate loan at 7% that’s funded by a six-month certificate of deposit (CD) at 3%. Every six months, when the CD renews, the institution is exposed to repricing risk. If the CD rate increases to 4% after six months, then their net interest income drops from 4% to 3%. Conversely, if the CD rate declines, their net interest income increases.To gauge repricing risk, financial institutions can compare their volume of assets and liabilities that mature or reprice over a given time period. The potential impact of fluctuating interest rates will depend in part on whether a bank or credit union is asset- or liability-sensitive. If it’s asset-sensitive — meaning assets reprice more quickly than liabilities — then its earnings generally increase when interest rates rise and decrease when they fall. If it’s liability-sensitive — meaning liabilities reprice more quickly than assets — then its earnings generally increase when interest rates fall and decrease when they rise. Some institutions are neutral — that is, their assets and liabilities reprice at the same time.Basis risk. This risk arises when there’s a shift in the relationship between rates in different markets or on different financial instruments. Suppose, for example, an asset and a related liability are tied to the prime rate and the one-year U.S. Treasury rate, respectively. If the spread between those two rates widens or narrows, it will affect the institution’s net interest margins.Yield curve risk. This risk arises from changes in the relationships among yields from similar instruments with different maturities. Suppose, for example, a bank or credit union funds long-term loans with short-term deposits. A typical yield curve reflects rates that rise as maturities increase. However, if market conditions cause the yield curve to flatten or even slope downward, the institution’s net interest margins can shrink or even turn negative.Options risk. Financial institution’s assets and liabilities often contain embedded options, such as the right to pay off a loan or withdraw deposits early with little or no penalty. The institution is compensated for offering members/customers this flexibility (typically in the form of higher interest rates on loans or lower interest rates on deposits). However, granting these options creates interest rate risk. For example, if interest rates go up, deposit holders will have an incentive to move their funds into investments that enjoy higher returns. If rates go down, many borrowers will pay off their loans so they can refinance at a lower rate.Another risk associated with rising interest rates is an increased risk of default by borrowers with variable-rate loans.

Managing the Risk

Banks and credit unions can apply financial modeling techniques to measure and monitor their interest rate risk. If your interest rate risk is unacceptably high, consider strategies for mitigating it, such as:

• Adjusting your institution’s mix of assets and liabilities to reduce interest rate risk.
• Increasing capital to help the institution absorb the impact of fluctuating interest rates.
• Reducing options risk by controlling the terms of loans and deposits.
• Using interest rate swaps or other techniques to hedge against interest rate risk.

Keep in mind, a key component of interest rate risk management is stress testing. In addition, the management of interest rate risk should also be incorporated into an enterprise risk management system.

Sidebar: Stressing Out About Interest Rate Risk

Each of the regulatory agencies provides guidance on managing interest rate risk. The guidance urges credit unions and banks to conduct periodic stress tests that include both scenario analysis and sensitivity analysis. Stress testing can help an institution manage risk by evaluating the possible impact of various adverse external events on their earnings, capital adequacy and other financial measures.Scenario testing examines the potential impact of various hypothetical or historical scenarios — such as rising or falling interest rates — on their financial performance. Sensitivity analysis estimates the impact of changes in certain assumptions or inputs into a financial model. It helps the institution determine which assumptions have the greatest influence on outcomes and fine-tune its assumptions accordingly.Gaining a clear understanding of what’s happening with interest rates and why is key to ensuring that you’re managing the risk that comes along with them appropriately. Need assistance with incorporating interest rate risk into your risk management system? Contact Doeren Mayhew’s Financial Institutions Group today for assistance.