Managing interest rate risk in a rising-rate environment

Timothy Griffeth

We all know (sort of) what interest rate risk is, but many of us don't understand the tools available to mitigate it. This article, the second-place winner in the RMA 2004 Paper Writing Competition, provides an overview that both defines and gives strategies for managing interest rate risk in a rising rate environment.

Many banks are now looking at loan portfolios heavily populated with loans originated during a fairly lengthy period of low interest rates. A rising-interest-rate environment poses a challenge to these institutions, but there are a number of ways to mitigate interest rate exposure.

What It Is

Interest rate risk results from differences in the maturities of a bank's assets and liabilities. Typically, banks fund long-term loans with customer deposits and similar assets that are prone to periodic repricing due to market forces. As rates paid on customer deposits rise, the profit earned on the underlying loan, known as the net interest margin, erodes.

Gap analysis. Interest rate risk can be measured by using gap analysis. Dollar-value gap analysis--one of the simplest forms--measures the dollar value of those assets on a bank's balance sheet that are sensitive to changes in interest rates, less the bank's liabilities that are sensitive to interest rate changes. Therefore, a bank's interest rate gap would be the value of floating-rate loans on the bank's balance sheet less the value of customer deposits. A more sophisticated form of interest rate risk measurement is duration gap analysis. Duration is a measure of an asset s or a liability's sensitivity to a given change in interest rates. A bank's duration gap is the dollar-weighted duration of the bank's assets less the dollar-weighted duration of the bank's liabilities. Banks with a positive interest rate gap see net interest margins widen if interest rates were to rise (or to see net interest margin erode if rates were to fall). Banks with a negative interest rate gap would see net interest margin erode if rates rise (or would see net interest margin widen if rates were to fall) With a large number of loans set at a fixed interest rate during the recent period of low interest rates, many banks now face a negative interest rate gap in the face of a rising-interest-rate environment.

While rising interest rates can negatively affect a bank's net interest margin, rising interest rates correspond with improving economic and business conditions--a natural hedge against interest rate risk. As economic conditions improve, the expansion in lending opportunities is also priced at the new interest rate levels, and this expansion pricing partially offsets the risk associated with carrying assets whose interest rates were fixed during the low-interest-rate period. In particular, improving economic conditions lead to higher occupancy rates and rent revenues, which in turn help drive higher commercial real estate values. Therefore, the commercial real estate market should improve. Banks holding a portfolio of both commercial and residential real estate loans can, therefore, expect to mitigate the negative impacts of higher interest rates on residential real estate with improved lending conditions in the commercial real estate market.

Managing the Risk

Historically, banks have offset the risk associated with funding fixed rate loans with variable-rate assets, such as customer deposits, by lengthening the duration of the bank's assets. To do this, a bank would purchase fixed-rate government securities with maturities that correspond with the expected maturities of the bank's fixed-rate loans. Assets acquired to lengthen the duration of the bank's assets are commonly known as "balancing assets." However, many banks have realized that the same goal is achieved more efficiently by using derivatives to manage interest rate risk.

Collars. Another method to manage interest rate risk is the "costless" collar. A collar consists of an interest rate cap and floor, usually based on the London Inter-Bank Offered Rate (LIBOR). To enter into a collar, a bank would simultaneously purchase an interest rate cap and sell an interest rate floor in the derivatives market. An interest rate cap is a series of interest rate call options set at the same exercise rate and that have expiration dates at each point when the underlying liability (in this case, customer deposits) is expected to reprice. On the other hand, an interest rate floor is a series of interest rate put options with the same exercise rate that have expiration dates at each point when the underlying liability is expected to reprice. If interest rates rise, the interest rate cap calls for the seller of the cap to pay the bank the difference of LIBOR and the predetermined cap rate. If interest rates fall, the interest rate floor calls for the bank to pay the buyer the difference between the floor rate and LIBOR. Therefore, a bank knows its future interest rate expense regardless of whether interest rates rise or fall. The word costless means that the premium paid to purchase the interest rate cap is roughly equal to the premium received on the floor, excluding brokerage fees. By entering into a collar, a bank is in neither a short nor a long interest rate position in the derivatives market. In a rising-interest-rate environment, a bank that wants to offset only the interest rate risk associated with rising interest rates could take a long position in the derivatives market by purchasing only the interest rate cap. By having a negative interest rate gap, a bank would naturally be in a short interest rate position.

Swaps. Another method of managing interest rate risk in a rising-rate environment is to create synthetic floating-rate loans by entering the derivatives market. To create a synthetic floating-rate loan, the bank enters into a fixed-to-floating interest rate swap, where the bank agrees to pay a counterparty a fixed rate (associated with payments from an underlying fixed-rate loan). In return, the bank receives a floating-rate payment based against an interest rate index, most likely LIBOR or the bank prime rate. Therefore, by substituting the floating-rate payment for the fixed-rate payment, the bank eliminates the interest rate risk associated with rising interest rates. In a period of falling interest rates, a synthetic fixed-rate loan also can be created by engaging in a floating-to-fixed-rate swap. In this swap, the bank agrees to pay a counterparty a floating rate in return for receiving a fixed payment.

The FAS 133 challenge. One drawback to using swaps is the potential accounting challenge for derivatives as outlined by FAS 133. First, swaps must be marked-to-market to reflect the fair market value of the swap. At the time the swap is engaged, no money changes hands (except for brokerage fees) and the swap has a market value of zero because it is simply an agreement for two parties to exchange cash flows. However, as the indexed interest rate changes, the swap creates value for one of the parties. If interest rates rise, the swap has value to the party receiving the floating rate. If interest rates fall, the swap has value to the party receiving the fixed rate. Thus, the value of the swap must be shown on the bank's balance sheet as either an asset or a liability. Second, the bank must determine how to account for payments received from the swap based on the "effectiveness" of the hedge. If the swap rate is directly linked to the interest rate index, the hedge is deemed "highly effective." If the correlation of the swap rate and the index rate is between 0.80 and 1.0, the hedge is deemed "effective." However, changes in the value of the swap that are not correlated with the index rate (that is, one minus the correlation) must be reported as either a gain or loss on derivatives. If the correlation between the swap rate and the index rate is less than 0.80, the swap is deemed "ineffective," and all changes in the value of the swap must be reported as either a gain or loss on derivatives.

Credit risk. Another drawback regarding swaps is the assumption of credit risk. When a bank engages in a swap, it is exposed to the risk that the counterparty may be unable or unwilling to fulfill its contractual obligations. Almost all bank failures are caused by credit risk, so regulators naturally are concerned about the credit risk assumed in such transactions.

The cap advantage. With the rapid increase in the popularity of swaps, there also is some concern that a major swap trader could default. However, the loss on a swap is limited to the difference between the variable payment and the fixed payment. Unlike a swap, which is typically a customized agreement between two parties, an interest rate cap (and floor) can be purchased in the market. Therefore, payment on the cap would be guaranteed by the clearinghouse of the exchange.

To terminate a cap, a bank simply resells the cap on the exchange or sells a series of interest rate puts that directly offset the cap. Terminating a swap is more difficult because the bank has to negotiate the termination with the counterparty. If an agreement cannot be reached, the bank can reenter the derivatives market and buy (or sell) an interest rate position that closely offsets the payments on the swap.

The swap advantage. Engaging in a swap requires no payment at the time of agreement, and purchasing a cap requires a relatively small up-front cost. Therefore, it is cheaper for a bank to manage its interest rate risk using derivatives rather than to purchase a series of government securities. Also, banks can better tailor their hedge position with their interest rate risks by using derivative-based tools. Furthermore, using derivatives does not require the bank to set aside a portion of the bank's capital, as is true when using balancing assets. These benefits have caused the use of derivatives to grow substantially. Forward and future rate contracts used by banks more than doubled from $98 billion in 1985 to almost $2.5 trillion by 1993. The notional principal underlying an interest rate swap grew from $186 billion in 1985 to nearly $3 trillion by 1993. In just three years, option contracts (such as caps, floors, and collars) grew from $697 billion in 1990 (the first year option contracts were included on the Call Report) to $1.77 trillion in 1993. Nearly 95% of banks with assets between $5 billion and $10 billion in 1993 used interest rate derivatives to manage interest rate risk, and 100% of banks with assets exceeding $10 billion used interest rate derivatives. Interestingly, only 6% of banks with assets between $100 and $300 million engaged in the interest rate derivatives market in 1993. The growth of derivatives used by the banking industry substantiates the use of derivatives as a viable and acceptable method for interest rate risk management. (1)

The rise in the use of derivatives results from the increase in interest rate volatility during the 1970s and early 1980s, along with the banking industry's sophistication in measuring interest rate risk. The increased interest rate volatility especially the spike in interest rates caused by the second oil shock in the late 1970s, forced banks to better understand and manage the interest rate risk carried on their balance sheets. Besides its use as a tool for managing interest rate risk, derivatives may have other positive impacts. Banks that use interest rate derivatives have seen significantly stronger growth in their commercial loan portfolios, possibly because of enhancements in the borrowing relationship resulting from the banks being able to offer customers other risk management tools, such as derivatives. The reduced interest rate risk may also allow banks that use interest rate derivatives to offer more competitive loan rates than banks that do not use interest rate derivatives. Second, the use of derivatives for interest rate risk management allows banks to hold less capital, as the risk of insolvency related to a dramatic change in interest rates is largely reduced. Interestingly banks that use derivatives to manage interest rate risk appear to be no more or no less efficient than banks that do not use derivatives. However, banks that do not use derivatives appear to have wider net interest margins than banks that do use derivatives, which implies that banks not using derivatives to manage interest rate risk must be compensated for the higher level of interest rate risk, which in turn may explain part of the stronger loan growth generated by banks that do use derivatives. This result's significance is that it counters public and regulator sentiment that perceives derivatives as overwhelmingly risky

Summary

The consensus market perspective is that interest rates will rise in the near future, perhaps significantly, as the economic recovery gains traction. There are a number of ways banks can mitigate their interest rate exposure. First, rising interest rates generally correspond to improving business conditions, so a natural hedge exists in the form of improved lending opportunities, particularly in commercial real estate. Historically, banks have managed interest rate risk by purchasing "balancing assets," such as government securities, to match expected cash inflow and cash outflows. Since the 1980s, institutions have found derivatives more effective from both a risk and cost standpoint. The two most common forms of interest rate derivatives used to manage risk are collars and swaps. Banks that use derivatives to manage interest rate risk can offer borrowers lower loan rates and enhance the borrowing relationship by offering other risk management tools. These institutions experience narrower net interest margins, but generate stronger loan portfolio growth.

 5/00    6.27
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10/00    6.51
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12/00    6.40
 1/01    5.98
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 7/01    3.77
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 9/01    3.07
10/01    2.49
11/01    2.09
12/01    1.82
 1/02    1.73
 2/02    1.74
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 4/02    1.75
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 7/02    1.73
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 9/02    1.75
10/02    1.75
11/02    1.34
12/02    1.24
 1/03    1.24
 2/03    1.26
 3/03    1.25
 4/03    1.26
 5/03    1.26
 6/03    1.22
 7/03    1.01
 8/03    1.03
 9/03    1.01
10/03    1.01
11/03    1.00
12/03    0.98
 1/04    1.00
 2/04    1.01
 3/04    1.00
 4/04    1.00
 5/04    1.00
 6/04    1.03
 7/04    1.26
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Federal Funds Rate, Federal Reserve System

Notes

(1) As of June 30, 2004, the notional principal underlying forward and future rate contracts used by banks had grown to over $12.2 trillion and the notional principal underlying interest rate swaps used by banks had grown to $49.7 trillion. From the OCC Bank Derivatives Report, Second Quarter 2004, www.occ.treas.gov/ftp/deriv/dq204t.xls.

Sources

Brewer, Elijah III; Jackson, William E. III; Moser, James T; "The Value of Using Interest Rate Derivatives to Manage Risk at U.S. Banking Organizations," Economic Perspectives, Third Quarter 2001, Vol. 25, Issue 3, pp. 49-66.

Bodi, Zvi; Kane, Alex; Marcus, Alan J.; Investments, Fifth Edition, McGraw-Hill Irwin, 2002.

Calva, Jeremy, "Improving Economy Puts New Emphasis on Managing Risk," American Banker-Bond Buyer, Vol. 7, No. 49, December 8, 2003, p. 6.

Chance, Don M., Analysis of Derivatives for the CFA[R] Program, AIMR, 2003.

Cornwell, Ted, "Rising Rates Threat to REITs," American Banker-Bond Buyer, Vol. 28, No. 32, May 3, 2004, p. 1.

Simons, Katerina, "Interest Rate Derivatives and Asset-Liability Management by Commercial Banks," New England Economic Review, January/February 1995, p. 12-17.

Contact Tim Griffeth by e-mail at Timothy.Griffeth@Mercantile.net.

Tim Griffeth is a senior credit analyst at Annapolis Bank & Trust, Annapolis, Maryland. Annapolis Bank & Trust is a subsidiary of Mercantile Bankshares Corporation. The opinions expressed in this article are those of the author alone and do not necessarily represent the position of Mercantile Bankshares Corporation or its affiliates.

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