How do banks manage interest rate risk

Banks use these instruments like duration matching and interest rate swaps as the primary ways of managing that risk. Duration matching lets banks control the duration of their bond portfolio to mitigate interest rate risk on their balance sheet. During usual times, major global banks have kept the duration of their bonds within a range of 3-5 years. Moreover, it is a frequent strategy to convert fixed-rate assets into floating rates through interest rate swaps in order to avoid the risk of rising short-term European interbank offered prices Euribor and Libos themselves. During 2023, the volume of global interest rate derivatives trading, as reported by The Bank for International Settlements (BIS), rose to US$583 trillion, making it the most heavily traded form of financial derivative in terms of use during that period.

Sources of Interest Rate Risk and Fundamental Impact

Interest rate spreads, a classic deposit-based lending service, fund banks’ core business model. Banks take the deposits made by savers and then make loans to borrowers, with their income being largely determined by how wide each spread is. However, its spread may narrow or expand when market interest rates are volatile, and it will have implications on the profitability of the bank as an entity. It’s no news that market-driven activities like interest rate volatility can have a strong influence one way or another on the key financial matrix for a bank, such as capital adequacy Ratio (CAR) and Net Interest Margin.

The management of interest rate risk using fundamental analysis is absolutely crucial. Banks can anticipate upcoming interest rates. Macroeconomic environment, inflation and money market, and change their asset-liability structure. Higher inflation or more restrictive monetary policy by the central bank could lead banks to expect rising interest rates, causing them to charge higher loan rates and only issue fixed-rate debt instruments.

Management of Bond Investment Portfolios

Banks generally have substantial holdings of bonds, such as government and corporate bonds, as well as mortgage-backed securities (MBS). Bond Prices This is the most important concept to learn. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise; therefore, if the bond recordings are composed of an important part of that balance sheet and profit.

To manage interest rate risk, banks generally employ the following strategies:

• Duration Matching: Banks can insulate themselves against interest rate fluctuations on both the asset and liability sides of their balance sheets by moving funds between long-term financing (bonds) matched with short-term debt (deposits). If banks are expecting interest rates to rise, they may cut bond duration in order to offset the effect of rising rates on bond prices.

• Interest Rate Swaps: The most common use of interest rate swaps is in the form of banks converting their fixed-rate assets (like loans and securities) into a floating rate or turning their variable debt, such as deposit liabilities, into a fixed rate. This is to hedge against the interest rate risk.

Hedging Interest Rate Risk in the Stock Market

Interest rate levels are key to a bank’s stock price and subsequent changes in the expected profitability of the bank. Banks suffer because when interest rates go up, they are forced to pay more on their borrowing (because savers demand higher returns), which eats into net interest margins and hurts stock prices. Moreover, bank stock investors pay a lot of attention to changes in monetary policy and interest rates, which have serious effects on the volatility of equity markets.

To hedge against the impact of interest rate fluctuations in the stock market, banks may adopt the following measures:

• Capital Structure Optimization: They can do that by fine-tuning capital structure so as to make themselves better shielded against interest rate risk. Banks can respond by issuing floating-rate debt rather than reducing high-cost fixed-rate debt, thereby relieving the pressure of rising interest rates.

• Hedging in the Derivatives Market: Banks can hedge the interest rate risk of their stock positions using derivatives like options and futures. These tools enable banks to protect their short-term profits or minimize losses when the market anticipates a rate increase.

Management of Loan and Deposit Rates

Not only bank investment but also its core business, that is, loans and deposits, are affected by interest rate risk. Banks must also be able to rapidly modify loan and deposit rates in line with movements of market interest rates, given the need for their competitive positioning as well as performance.

• Floating-Rate Loans: In an effort to hedge a future interest rate increase, they can lend more instruments based on floating rates. This allows the bank to increase its spread when market rates rise, as it will push up its loan rates.

• Interest Rate Corridor Management: With these rising and falling interest rates, banks can use the corridor between loan and deposit rates as a flexible rate range while keeping some spread. This allows banks to hedge interest rate risk without significantly raising costs.

Use of Derivative Instruments

In order to effectively hedge interest rate risk, banks widely employ derivative instruments like interest rate options, Interest futures and IlleUest rater swaps. By offering these tools, banks are able to hedge interest rate volatility without altering their business model. Banks can use interest rate swaps to turn fixed-rate debt (highly sensitive to rising rates on the yield curve) into floating-rate debt that is not so closely tied.