Central idea: Finance Minister urged banks to remain vigilant about “interest rate risks” and undertake regular stress tests during a review of public sector banks’ (PSBs) performance on March 25.

Why in news?

• Inflation-led rising interest rates across the world have caused concerns of contagion effects from banking crises in the US and Europe.

What is Interest Rate Risk?

• Interest rate risk refers to the possibility that a loss could happen as a result of a fluctuation in interest rates.
• A bond’s or another fixed-income security’s value will decrease if the rate rises.
• Interest rate movement typically has an inverse relationship with the market value of fixed-income assets.
• In general, the values of currently issued fixed income instruments decrease when interest rates rise and rise when interest rates decrease.

How does it affect banks?

Interest rate risk affects banks in several ways-

1. Interest yields: Banks earn interest income by lending out funds to borrowers at a higher rate than the cost of borrowing those funds. When interest rates rise, the cost of borrowing funds for banks increases, thereby decreasing their net interest margins (NIMs) and profitability.
2. Bond yield: Banks also hold a large amount of fixed-income securities in their portfolios, such as government bonds, corporate bonds, and mortgage-backed securities. These securities generate a fixed interest income, which can be affected by changes in interest rates. When interest rates rise, the value of fixed-income securities held by banks decreases, leading to a potential loss in the value of their investment portfolio.
3. Liabilities burden: Banks’ liabilities, such as deposits, often have short maturities, while their assets, such as loans, have longer maturities. When interest rates rise, the cost of funding short-term liabilities increases, while the interest earned on longer-term assets remains fixed. This can negatively impact banks’ profitability and cash flows.

Why do banks resort to interest rate increases?

Banks resort to interest rate increases for several reasons-

• Combat inflation: When the economy experiences a rapid increase in prices, the central bank may raise interest rates to discourage borrowing and spending, thereby cooling down the economy and reducing inflationary pressures.
• Attract deposits: Banks may raise interest rates to attract more deposits from savers, which in turn allows them to lend more money and earn more profits.
• Protection against risks: banks may also raise interest rates in response to changes in the global financial market or to protect their own financial stability in the face of potential risks or shocks.

Try this MCQ:

Which of the following best describes interest rate risk in banking?

(a) The potential loss of income due to changes in interest rates

(b) The risk that borrowers will default on their loans due to high-interest rates

(c) The risk that banks will become insolvent due to low-interest rates

(d) The potential loss of value of a bank’s assets due to changes in interest rates

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