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Banks and Their Regulators: The Road Ahead

How rising rates precipitated the bank failures of the past few weeks, and how institutions are trying to avoid becoming the next to collapse.

By Ira Kawaller | March 30, 2023 at 12:08 PM
Stock illustration: Business moving forward

Along with the heightened sensitivity about the health of the banking sector, business media have begun reflecting a heretofore underappreciated recognition of the importance of interest rate risk management in banking. Recent reporting and editorializing leaves the impression, however, that we wouldn’t be facing this onslaught of failures and rescues if only these troubled institutions had managed their risks better. There’s a certain truth to that, but it’s not quite that simple.

Like all commercial enterprises, banks operate in a world of uncertainty. But for banks, the realm of interest rate uncertainty is paramount because banks function both as borrowers and lenders at the same time. They borrow largely from their depositors, whom they pay interest, and they lend to individuals and companies by initiating and buying loans or other securities, thereby earning interest. Thus, they bear interest rate sensitivity on both their assets and their liabilities.

Having both interest revenues and interest expenses, banks pay particular attention to the spread between the yields earned on their assets and the interest costs they pay on their liabilities. Generally, banks can widen that spread by taking yield curve risk. Interest rates are usually higher for longer-term instruments (i.e., the yield curve is upward-sloping), so banks can typically goose their earnings by structuring their portfolios with shorter-term liabilities and longer-term assets.

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