Any financial institution aims to make a profit with minimum cost possible. Banks and other lending agencies get a lot of profit from the interest they charge their customers who borrow money from them. Interest rate is the percentage of additional cash that a borrower should pay on top of the actual amount of cash borrowed over a specified period (Hilliard and Jordan, 356). The higher the interest rate charged by a bank, the higher the profit the bank gets. However, many individuals and organizations prefer borrowing money from banks and other lending agencies that offer low-interest rates (Corwin and Phelim, 39). Various risks are associated with interest rates. The risks may be on either the lenders or the borrowers. This piece of work analyses the interest rate risks.
Interest rate risk is simply described as a risk to earnings that may arise as a result of changes in interest rates. Interest rate risks arise from several factors such as changes in the activities of a bank and changes in options that are related to interest rates (Cooper and Weston, 379). The underlying economic value of any bank is usually affected by the changes in interest rates offered by the bank. The present value and future cash flow are usually affected by the changes in interest rates. Banks and other financial institutions have to take risks when they anticipate high income from the interest rates they offer to their customers (Cooper and Weston, 380).
Entrepreneurs and business individuals must be risk-takers to excel in their business ventures. This is because there are risks in every business but what differs from one business to the other is the magnitude of the risks.
What every bank should do is to put in place proper measures of managing interest rate risks. This is because it has been established that it is impossible to eliminate risks that are associated with interest rates (Akella and Stuart, 30). If the management team of a bank is not ready to take risks associated with interest rates, it implies that such a bank can not lend money to customers and hence it cannot fully sustain its activities in the current competitive business environment.
Banks differ from one another in the sense that the level of interest rate risk one bank is willing to take is not the same level of interest rate risk another bank is willing to take. Some banks try as much as possible to minimize risks associated with interest rates. Such banks are likely not to get involved in activities with particular changes in interest rates and hence they are likely to lose opportunities that could have benefited them more (McLean and Tobin, 128).
On the other hand, some banks are willing to assume high risks associated with interest rates. Such banks can decide to take interest rate positions and in some cases, they may decide to leave their interest positions open. Strategies of pricing, lending, and even funding by a bank can be changed to alter the bank’s interest risk exposure (McLean and Tobin, 118).
If interest rates on loans increase, the number of customers who borrow loans from banks decreases. This means that the number of problems associated with loan repayment also increases. In such cases, only banks that are in positions of obtaining other funds from various sources can effectively sustain their operations. On the other hand, banks that solely rely on wholesalers for funding may find it very difficult to find extra cash to replace the loans that have not been repaid. When interest rate risk profiles for banks are being developed, the managers of the banks need to consider and even understand the liquidity of the banks. At the same time, various sources of funds for the banks should be explored to ensure the sustainability of the banks even when customers have problems in repaying their loans (Akella and Stuart, 40).
Effective management of risks that arise from interest rates requires comprehensive processes to be put in place by banks and other financial institutions. This can ensure timely identification and appropriate measurement of the risks. If comprehensive processes for managing risks are put in place, monitoring and control of interest rate risks become very effective (McLean and Tobin, 132). It is therefore very important for banks to establish policies that can be used to control interest rate risks and communicate them to bank workers in writing. This is a sure way of creating awareness among the workers on how they can reduce the interest rate risks.
In conclusion, the management of every financial institution should be able to assess and know the interest rate risk exposure of their institutions. If the risk exposure of a bank is known, the identification of interest rate risk becomes a bit easier. Management of the risks that are identified early can also be effective before their adverse effects are felt by a bank. Bankers should not be afraid of interest rate risks but they should view them as challenges that must be faced.
Akella, Srinivas and Stuart, Greenbaum. Innovations in Interest Rates, Duration Transformation, and Bank Stock Returns. Journal of Money, Credit, and Banking, Vol. 24, No. 1 (1992), 27-42.
Cooper, Shelley and Weston, Stephanie. The Pricing of Over-the-Counter Options. Bank of England Quarterly Bulletin, 1995, 375-381.
Corwin, Joy and Phelim, Peter. Quasi-Monte Carlo Methods in Numerical Finance. Houston, Texas: Enron Corporation, 1995.
Hilliard, Johnson. and Jordan, Susan. Hedging Interest Rate Risk Under Term Structure Effects: An Application to Financial Institutions. The Journal of Financial Research, Vol. XV, No. 4 (1992), 355-368.
McLean, John and Tobin, George. Animal and Human Calorimetry. Edited by K. A. Johnson and D. E. Johnson. New York: Cambridge University Press, 1997.