12.4 Evaluating Interest Rate Risk
Matched rate transfer pricing divides the net interest income of your institution into three components: Lending, Deposit, and the Rate Risk Profit (or loss). The Rate Risk Profit is derived by subtracting all credits for funds (Funding Center Expense) from all charges for funds (Funding Center Income).
A net positive number implies that part of your interest margin is a result of any rate bets (or rate risk) your institution has taken. A negative number implies that you have incurred a loss due to rate risk.
Current and Embedded Rate Risks: The total rate risk profit (or loss) figure is made up from two sources:
- Current Rate Risk Profit: The result of the rate risk inherent in your current exposure. You can actively manage this profit through effective Asset/Liability management.
- Embedded Rate Risk Profit: The result of interest-rate bets. You can no longer manage this component of earnings because the relationships are contractual. All you can do is wait it out.
Embedded Rate Risks Example
Suppose a bank, on day one, raises $1,000 in the form of a one-year certificate of deposit at 4%. If the wholesale (open market) alternative to one-year funds costs 5% then, the matched transfer rate is 5%.
The bank then lends the $1,000 in the form of a five-year non-amortizing (bullet) loan at 10%. If the cost of five-year wholesale funds is 8% then the matched transfer rate for five-year funds is 5%.
This table shows the components of the bank's interest rate margin on day one:
Table 12-2 Bank’s Interest Rate Margin on Day One in case of Embedded Rate Risk
| Income Statement Component | Rate | Transfer Rate | Spread |
|---|---|---|---|
| Asset | 10.00% | 8.00% | 2.00% |
| Liability | 4.00% | 5.00% | 1.00% |
| Funding Center Spread | 3.00% | ||
| Net Interest Margin | 6.00% |
Over the next year, interest rates rise by 200 basis points. Now, the bank, eager to eliminate future rate risk, issues a new four-year $1,000 CD at 8.5%. However, the four-year transfer rate is now 9.5%.
This table describes the components of the interest margin for the bank after one year:
Table 12-3 Bank’s Interest Rate Margin after One Year in case of Embedded Rate Risk
| Income Statement Component | Rate | Transfer Rate | Spread |
|---|---|---|---|
| Asset | 10.00% | 8.00% | 2.00% |
| Liability | 8.50% | 9.50% | 1.00% |
| Funding Center Spread | -1.50% | ||
| Net Interest Margin | 1.50% |
Although the bank is now perfectly matched from a current rate risk perspective (a four-year bullet loan funded by a four-year CD), it is losing 150 basis points at the funding center.
On day one, the bank took a rate bet by funding short. The bet was that one year from the loan origination date the bank would be able to raise four-year funds at less than the cost of funding the original five-year loan, or 8%. Since the four-year transfer rate on day one was 7%, when interest rates went up by 200 basis points, the bank was badly hit.
Although the net interest margin of the bank is still 150 basis points, the bank could have locked in a 300 basis point net interest margin for five years on day one if it had not taken a rate bet by issuing a five-year CD.
The loss of 150 basis points on the $1,000 loan is a result of the embedded rate risk taken by the bank. The bank can do nothing to eliminate embedded rate risk, except wait.
- Measuring Current and Embedded Rate Risks: Even though
nothing can be done about Embedded Rate Risk, it is important to identify the
impact of Embedded Rate Risk for planning ahead. For example, if a bank had a
large profit in the funding center owing to Embedded Rate Risk, and was unaware
of this, it can be lulled into a false sense of security. That bank might be
surprised when this source of profit evaporates.
Conversely, if a bank is experiencing a large loss in the funding center due to Embedded Rate Risk, and it can measure it, the bank might choose to wait it out rather than taking drastic and immediate actions.
- Measuring Current Rate Risk: You can measure Current Rate Risk by Transfer Pricing your entire balance sheet as if it were originated today. Everything should be Transfer Priced based on its remaining term. Under this method, a five-year CD with one year until maturity would receive the same Transfer Rate as a three-year CD with one year left.
- Measuring Embedded Rate Risk: The total rate of risk profit is made up of Embedded Rate Risk and Current Rate Risk. Embedded Rate Risk = Total Rate Risk Result - Current Rate Risk Result