An Analysis of Commercial Bank Exposure to Interest Rate Risk

Banks earn returns to shareholders by accepting and managing risk, including the risk that borrowers may default or that changes in interest rates may narrow the interest spread between assets and liabilities. Historically, borrower defaults have created the greatest losses to commercial banks, whereas interest margins have remained relatively stable, even in times of high rate volatility. Although credit risk is likely to remain the dominant risk to banks, technological advances and the emergence of new financial products have provided them with dramatically more efficient ways of increasing or decreasing interest rate and other market risks. On the whole, these changes, when considered in the context of the growing competition in financial services have led to the perception among some industry observers that interest rate risk in commercial banking has significantly increased. This article evaluates some of the factors that may be affecting the level of interest rate risk among commercial banks and estimates the general magnitude and significance of this risk using data from the quarterly Reports of Condition and Income (Call Reports) and an analytic approach set forth in a previous Bulletin article.1 That risk measure, which relies on relatively small amounts of data and requires simplifying assumptions, suggests that the interest rate risk exposure for the vast majority of the banking industry is not significant at present. This article also attempts to gauge the reliability of the simple measure’s results for the banking industry by comparing its estimates of interest rate risk exposure for thrift institutions with those calculated by a more complex model designed by the Office of Thrift Supervision. The results suggest that this relatively simple model can be useful for broadly measuring the interest rate risk exposure of institutions that do not have unusual or complex asset characteristics. SOURCES OF INTEREST RATE RISK