Sources of Market Risk

Assessing and managing market risk is complicated, but the idea is to structure the balance sheet—and perhaps use off-balance-sheet instruments such as interest rate derivatives—in such a way that moderate, unexpected changes in rates will minimally affect income and capital. This is much easier said than done, however, especially when profitability concerns are taken into account.

Click to view the definition of each of the four sources of interest rate risk:

  • Repricing Risk
  • A risk that arises from mismatches in maturity and interest rate changes in a bank’s assets and liabilities. A financial contract is said to reprice whenever the interest rate it pays changes.

  • Options Risk
  • The risk that arises from implicit and explicit options in a bank’s assets and liabilities, such as prepayment of loans or early withdrawal of funds.

  • Basis Risk
  • The risk from unequal movements in interest rates on a bank’s assets and liabilities with the same maturity.

  • Yield Curve Risk
  • The risk that changes in market interest rates may have different effects on similar instruments with different maturities.

These risks will impact or influence net interest income when interest rates change. Generally, changes in interest rates can affect banks in three main ways.

  1. Bank liabilities tend to reprice faster than assets, which means that in an increasing-rate environment, the increase in interest expense will usually outstrip any increase in interest income, potentially squeezing profits. In a declining-rate environment, the opposite is true, potentially improving bank profits.
  2. Changes in interest rates affect the market value of interest-bearing assets, particularly investment securities that are held as either trading securities or available-for-sale securities under FAS 115. Such securities must be reported at fair value, which means they will be marked to market value on at least a quarterly basis for Call Report purposes. The value of these securities is inverse to the direction of interest rates, i.e., as interest rates rise, these securities will fall in value.
  3. Banks are subject to a risk known as “basis risk,” in which not all interest rates will move together. The impact of rate changes on capital and earnings will then depend upon what types of assets and liabilities a bank has on its books and how the rates on these instruments change relative to one another.