Monitoring Bank Interest Rate Risk

Once the board has established interest rate risk boundaries, it is important that appropriate risk measurement systems are put in place to monitor policy compliance. You should receive reports, at least quarterly, that allow you to judge: the level and trend of interest rate exposure, determine whether that exposure is within the risk tolerances you set, and if the bank has adequate capital for that exposure.

A basic method of monitoring your bank’s interest exposure is through a gap analysis or report. “Gap” refers to a the difference, or gap, between the value of a bank’s assets that mature or reprice over a certain period of time and the value of its liabilities that mature or reprice during that same period. A gap report, then, reports these differences at various points in time, which reveals the exposure of earnings to changes in interest rates and constitutes the heart of gap analysis. This is important information for directors and management to know, because of how interest rate changes can impact a bank’s income and capital.

  • If assets are repricing faster than liabilities, for example, an increase in interest rates will affect interest income before it affects interest expense, leading to a short-term rise in earnings.
  • If liabilities are repricing faster, the same interest rate rise will cause earnings to fall.

To see how a gap can affect net income, click on "Effect of a Gap" in the Learn More column.

While gap analysis is a basic method, banks often use a more sophisticated method to monitor interest rate risk: interest rate risk models. These models combine bank financial data, interest rate assumptions, behavioral assumptions for the bank and its customers, and finance concepts to judge a bank’s potential interest rate exposures. These models can, generally, be grouped into two broad categories:

Earnings-at-Risk (EAR) models focus on possible changes in a bank’s net interest income, noninterest income and bottom-line profitability from interest rate movements. This risk assessment approach is sometimes referred to as a “short-term view,” “accounting approach” or “earnings perspective” to judging interest rate risk. Banks may develop their own EAR models or purchase models developed by others. The models they use vary with respect to their features and what they will allow you to include, assume and change in the model. Two EAR models commonly used by banks are Gap Analysis and Income Simulation.

Capital-at-risk, or economic-valuation and duration models, the second category of models, focus on possible changes in the market value of a bank’s assets, liabilities and off-balance-sheet items due to interest rate movements and the impact these changes have on the bank’s equity capital position. This approach is sometimes referred to as a “long-term view” or an “economic approach” for determining interest rate risk. Economic valuation focuses on possible changes in the market value of a bank’s assets, liabilities and off-balance-sheet items due to interest rate movements and the impact these changes have on the bank’s equity capital position. Like EAR models, banks generally use two broad categories of models to judge their equity exposure to interest rate changes: Duration and Economic Value of Equity Simulation (EVE).