Interest rate risk and bank net interest margins

Abstract

Banks and their supervisors have spent considerable time and effort in recent years developing systems for monitoring and managing interest rate risk.2 This special feature examines that specific component of interest rate risk arising from the possible effects of changes in market interest rates on bank net interest margins. Such effects can be very large if interest rate risk is not managed carefully. For example, the secondary banking crisis in the United Kingdom in the 1970s reflected, at least in part, the funding of longer-term assets with short-term liabilities.3 Similarly, funding of long-term, fixed rate mortgages with savings deposits led to a very sharp drop in net interest margins at US thrift institutions in the early 1980s when interest rates rose to historic highs and the yield curve inverted. The result was actually negative net interest income for two years at US thrifts, after net interest margins had averaged nearly 1.5% over the preceding decade (FHLBB (1984)). By contrast, the results presented here suggest that commercial banks in the 10 industrial countries considered have generally managed their exposures to volatility in the yield curve in ways that have limited effects on their net interest margins. Thus, while fluctuations in net interest margins could be an important source of uncertainty in bank profitability – and could surely have adverse effects for particular institutions – changes in interest rates seem unlikely to undermine sharply the health of the banking sector through their effects on net interest income. The next section provides background on interest rate risk at banks, and discusses methods for assessing it. Given data limitations, the approach taken here focuses on the effects of market interest rates on the average yields on bank assets and liabilities and also on bank net interest margins. The subsequent section reports on the empirical findings. A final section provides some concluding remarks and caveats.

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