Interest Rate Risk Management in Today's Economy

Since early 2023, banks have lumbered through tough economic terrain. Liquidity and interest rate risk upsets from bank failures several months ago have increased regulatory oversight and furthered investor and depositor scrutiny. Meanwhile, the Fed’s fickle interest rate policy is creating uncertainty, forcing banks to closely watch their interest rate risks.

Banks can successfully tread the bumpy course if they rethink their interest rate risk operations. Below, we examine how banks can fortify their interest rate risk resiliency with enhanced modeling and leading technology.

Key discussion points

• New technologies can help leadership calculate bank interest rate risks and improve data governance
• Stress testing, hedging strategies, and contingency funding sources can quell interest rate threats
• Banks can correct model deficiencies with policy evaluations and regulatory reporting software
• Data aggregation challenges are a result of inaccurate mapping and outmoded processes
• Proper interest rate risk oversight prioritizes transparency and risk management in banking

Challenges of interest rate risks for banks

Rising interest rates have threatened bank earnings by impacting net interest income, a main source of revenue for banks. They’ve also dampened the underlying value of banks’ assets, liabilities, and off-balance sheet instruments against rising deposit fund costs. This has put pressure on liquidity and capital at some banks, requiring them to update and reinforce their resolution plans and capital levels. Banks are also evaluating their reporting infrastructure to ensure that their interest rate risk reporting is accurate and accessible.

As banks weigh options and restructure operations to better manage their interest rate risks, they may encounter these threats and obstacles:

Inaccurate modeling

Some banks may not refresh their models to capture all sources of interest rate risk exposures after changing their business strategies and products or completing merger and acquisition operations. If their assessments of new or modified products are deficient, as well as their models for new ventures, then banks may overlook hidden threats.

With a new operation or product, management may not entirely grasp a model’s methods and assumptions, or the chances that certain vulnerabilities could impact an organization and the consequences if they were to occur. This could also expose the bank to unexpected risks. To limit them, banks need to continually monitor and report on their interest rate risks associated with new activities that meet regulatory expectations.

Cloud technologies considerably help models adapt to changing business conditions. Gen AI’s advanced analytics can continuously monitor risk exposures and variations in key assumptions. They can also closely track capital adequacy levels and help optimize capital allocations to ensure reservoirs meet regulatory standards. Simultaneously, automated reporting can generate frequent reports on exposures. Leaders can then more effectively review threats underlying current risk limits and create a better review process.

With product changes, new decisions, or novel technologies, banks may fail to upskill current staff or recruit or retain needed talent. By doing so, they can provide employees with needed subject-matter expertise and, consequently, limit faulty models.

Banks can also curb impaired models by being more prudent. When they purchase them from third parties, banks should obtain current user guides and source documents that detail the model’s assumptions and calculation methods. This can reverse misinterpretations and difficulties with the model’s measurement system.

Key person risk

When a certain staff member who was critical to maintaining a bank’s risk management systems departs, the bank may be unable to fill this gap quickly and, thus, generate timely and accurate interest rate risk estimates. Meanwhile, the remaining personnel may have inadequate knowledge to cover the loss of a key person as result of talent shortages and continuing education inadequacies.

Requiring teams to track risks with legacy workflows adds to these troubles. Digitizing risk operations and moving data to a central cloud repository would reduce the need to train staff on various fragmented systems. Banks would also mitigate risks from missing information or documentation as a result of that key person’s exit.

Data hurdles

Banks cull, manage, and interpret vast troves of information used in interest rate risk assessments, which can introduce certain data risks, such as inaccurate mapping of data. Every product has specific data attributable to its profitability and risks to the firm and should correctly map to the product in the chart of accounts for accurate reporting and ongoing risk assessments. If it doesn’t, incomplete analysis and erroneous reporting could result. This could also happen if data is linked to the wrong product or if information is limited for caps and floors for loan and deposit products.

Interest rate risks can also be heightened if banks have limited data for off-balance-sheet positions, such as for loan commitments and credit guarantees. Or, more broadly, some banks may function without complete or quality data from their operations, portfolios, or branches.

Automating interest rate risk management in banks

Automation can greatly enhance the integrity of banks’ interest rate risk data and evaluations with real-time data gathering, dashboarding, and drill-down capabilities. Modernized management information systems and automated data mapping with extract, transform, and load (ETL) processes can easily transform the data into trusted resources and load it into the general ledger.

This granular reporting can help ensure that management’s strategies and risk thresholds align with the bank’s established risk tolerance levels and overall interest rate risk management approach. Nonetheless, a bank’s acceptable risk levels should be applied on a consolidated basis, and, if relevant, to individual affiliates.

While advanced tools can harness and analyze stores of financial data for modeling and risk calculations, they can’t always anticipate broader macroeconomic and financial market uncertainties. Automation technology’s powers have limits, so human observation is needed to effectively evaluate interest rate risk management strategies.

However, to solve an individual bank's interest rate risk challenges, leaders need to think holistically. This requires a culture that embraces a risk-conscious ethos and open, fluid communication with senior management and the board. As a best practice, leadership and board members (or a steering committee) should receive reports on a bank’s interest rate risk profile at least quarterly, but ideally, more frequently. With proper communication channels embedded, integrated and timely reporting aided by technology enables executives to be more effective risk management stewards.

Managing interest rate risks with stress testing

To thoroughly know their interest rate risk positioning, banks should use technology wherever possible in their frameworks along with consistent stress testing. Specifically, modeling of deposits is critical since they are banks’ primary source of funding. Without accurate planning for rising interest rates, banks may experience extensive losses. To prevent this, they should perform regular financial stress testing to not only inform leadership but also to continually gauge their financial safeguards to align with regulatory and stakeholder expectations.

Hedging interest rate risks

In this high-interest rate environment, banks should also optimize their hedging strategies. To do so, they need to integrate oversight of various figures and defenses, such as a bank’s liquidity profile, interest rate risk exposure, position on the interest rate curve, diversification of funding sources, and efforts to curb maturity cliffs—or when a bank’s assets or liabilities are set to expire. It is also recommended that banks develop a meticulous funding plan strategy, which should be precisely adjusted to moderate hedging expenses while reducing funding costs.

As a final measure, banks should also have a well-documented contingency funding plan. This ensures they have sufficient alternative sources of capital to cover losses from unforeseen threats. Banks should refresh it regularly in tune with current economic conditions.

Managing bank interest rate risks ahead

The 2023 banking disruption has magnified banks’ and regulators’ awareness of interest rate risk regardless if the Fed raises or steadies rates. To stay nimble, banks should redouble their preparations for variabilities by enhancing their interest rate risk monitoring with improved data quality. To achieve this in a frenetic financial ecosystem while avoiding tireless regulators, fleeing depositors, and demanding investors, they need to pivot to macroeconomic turns and keep pace with technological leaps.