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Interest Rate Risk

Interest Rate Risk (IRR) is the possible loss that can occur from sudden and unexpected changes in interest rates. This can significantly alter a bank’s profitability and market value of equity. A bank’s interest rate risk reflects the extent to which its financial condition is affected by changes in market interest rates.

Net Interest Income

The income risk measure is employed to assess the impact of a change in overall interest rate level to the net interest income from the banking book. The investment risk measure is employed to assess changes in the market value of the trading portfolio in response to interest rate changes.

Net interest income is the difference between interest income and interest expense. It is the principal determinant of the profitability of banks. Net interest income is determined by interest rates on assets and paid for funds, volume of funds and mix of funds (portfolio).

Fluctuations in the interest rate affect the net interest income. Whenever rate of interest situation related to assets and liabilities differ, then changes in market interest rates will affect bank earning. If a bank tries to organise its assets and liabilities to remove interest rate risk, the profitability of the bank would be harmed.

Factors Affecting Interest Rate Change

Various economic forces affect the level and direction of interest rates in the economy. Inflation is one of the most influential forces on interest rates.

Interest rates usually climb when the economy is growing, and fall during economic downturns.

• Rising inflation leads to rising interest rates
• Moderate inflation leads to lower interest rates

Affects of Interest Rate Change

Change in the interest rate has certain affects on a bank with regard to various risks.

• Basis risk: assets and liabilities are based on different rates moving in different direction
• Yield curve risk: bank earnings by taking advantage of difference in short term and long term rates do not follow the market expectancy principle
• Reinvestment risk: related to the cost of capital of bank, like bank can borrow when rates are high, but when it lends prevailing rates become low
• Option risk: prepayment options associated with a loan, similar to a putable bond

An increase in the demand for credit will raise interest rates and vice versa. An increase in the supply of credit will reduce interest rates and a decrease in the supply of credit will increase them.