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Schmalenbach Business Review

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25.05.2018 | Original Article

Why Do Banks Bear Interest Rate Risk?

verfasst von: Christoph Memmel

Erschienen in: Schmalenbach Business Review | Ausgabe 3/2018

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Abstract

This paper investigates determinants of banks’ structural exposure to interest rate risk in their banking book. Using bank-level data for German banks, we find evidence that a bank’s exposure to interest rate risk depends on its presumed optimization horizon. The longer the presumed optimization horizon is, the more the bank is exposed to interest rate risk in its banking book. Moreover, there is evidence that banks hedge their earnings risk resulting from falling interest levels with exposure to interest rate risk. The more a bank is exposed to the risk of a decline in the interest rate level, the higher its exposure to interest rate risk.

Vorheriger Artikel Bid-Ask Spread Patterns and the Optimal Timing for Discretionary Liquidity Traders on Xetra

Nächster Artikel Individuals’ Perception and Processing of Risk Information: Exploratory Evidence from Germany

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Note that whenever we refer to banks’ interest rate risk exposure in this paper, we have their interest rate risk in the banking book in mind, i.e. the interest rate risk resulting from the banks’ traditional business and not from their trading activities.

See Vuillemey (2016) for an overview of the interest rate risk bearing in banking from a macroeconomic point of view.

The concept of the so-called “pull-to-par” effect (in the context of bonds) is closely related to the reasoning above.

In Appendix 1, we show how a bank optimizes its exposure to interest rate risk if the optimization horizon is continuous, and not discrete with only two possible values as in the case above. However, as we have only dummy variables in the empirical study to characterize the optimization horizon, we concentrate on the model above.

This approximation corresponds to the first-order Taylor approximation of the term \(1/a\) at \(a=1\).

The hedging component in the case of investors maximizing their wealth \(t=2\) is zero.

In Table 2 in Sect. 4.2, it is shown that the share of the serial variation of the variable \({IRR}\), the exposure to interest rate risk, is much higher than the share of the variable \(\theta\), namely 24% (= 100% – 76%) vs. 6% (= 100% – 94%). This finding supports the assumption that the exposure to interest rate risk (\({IRR}\)) is much easier to alter than the long-run pass-through \(\theta\) of the bank’s assets and liabilities.

Busch and Memmel (2017) find a long-run effect on the net interest margin for the small and medium size banks in Germany of 8 bps per 100-bp shift in the term structure, while the effect for the more wholesale oriented large banks amounts to 3 bps.

In addition, English (2002) argues that, in theory, the change in economic (or present) value should be equal to the present value of the changes in the stream of future net interest incomes.

Note the resemblance to the theoretical concept of the variance decomposition (see, for instance, Greene (2012)): \(var(x)={var}(E(x|y))+E({var}(x|y))\) where \(y\) contains the bank-specific information.

Note that the duration is defined as a positive number.

Memmel and Schertler (2013) find for the German banks not using derivatives that, for the median bank, 92.1% of the assets and 89.8% of the liabilities (including some parts of equity) are interest bearing.

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Titel: Why Do Banks Bear Interest Rate Risk?
verfasst von: Christoph Memmel
Publikationsdatum: 25.05.2018
Verlag: Springer International Publishing
Erschienen in: Schmalenbach Business Review / Ausgabe 3/2018
Print ISSN: 1439-2917
Elektronische ISSN: 2194-072X
DOI: https://doi.org/10.1007/s41464-018-0051-5