Managing Interest Rate Risk: Strategies for Banks

Managing Interest Rate Risk

There are two primary ways to manage interest rate risk:

Commercial banks focus solely on interest rates (expenses & income).
It is the most popular interest rate management strategy.
This technique focuses on protecting or maximizing a financial institution’s net interest margin (spread), which is the difference between interest income and interest expense.
The bank’s assets and liabilities are divided into interest rate sensitive and non-sensitive items.

This management tool focuses on protecting the financial institution’s net worth (the value of stockholder’s investment).
Banks and competitors learn how to avoid duration gaps in their asset portfolios compared to their liability portfolios.

Unit banks are one of the oldest kinds of banking, offering all services from a single office.
Some services (like deposits, cashing checks, paying bills) may be offered from limited service facilities such as drive-in windows and ATMs linked to the bank’s computer system.
Unit banks are independent and do not have connecting branches in other areas.
The rapid formation of new banks contributes to the comparatively large number of unit banks, even in the age of electronic banking consolidation and mergers.
Customers often prefer small banks that know their customers well and provide personalized services.
Most new banks start as unit organizations due to limited capital, management, and staff until they can grow and attract additional resources and professional staff.
Many banks create multiple service facilities, branch offices, electronic networks, websites, and other service outlets to open new markets and diversify geographically to lower overall risk exposure.
Bankers understand that relying on a single location for customers and income can be risky if the surrounding economy weakens and people and businesses move away.

As a unit bank grows larger, it may establish a branch banking organization, especially if it serves a rapidly growing region and faces pressure to follow its business and household customers as they move or lose them to more conveniently located competitors.
Branch banking organizations offer a full range of banking services from several locations, including a head office and one or more full-service branch offices.
They offer services through ATMs, computers electronically linked to the bank’s computer, mini-branches, point-of-sale terminals in stores and shopping centers, telephones, fax machines, and the internet.
Senior management of a branch banking organization is usually located at the home office, though each full-service branch has its own management team with limited authority to make decisions on customer loan applications and other daily operations.
Some services and functions in a branch banking organization are highly centralized, while others are decentralized at the individual service facility level.