Interest Rate Risk in the Banking Book (IRRBB) refers to the potential impact that changes in market interest rates can have on a bank's earnings and its overall capital. This risk arises from the core business of banking: taking in deposits and lending money out, often over different timeframes and at different types of rates (fixed vs floating).
We can break down the main
effects into three key areas:
1. The Funding Side: The Cost of Deposits
A bank's primary source of funding is customer deposits. The risk here is that the cost of these deposits can change unexpectedly. When market interest rates rise, banks may need to increase the interest they pay to depositors to prevent customers from moving their money to higher-yielding investments. If the bank has to raise its deposit rate quickly, its cost of funding goes up, which squeezes the profit margin it earns from lending. Conversely, when rates fall, if the bank cannot lower its deposit rates proportionally (perhaps because they are already near zero), its profit margin is also compressed.
2. The Asset Side: The value of Loans and Mortgages
This is the risk associated with the money the bank has already lent out, especially long-term, fixed-rate loans like mortgages. Consider this example: If a bank has issued a 30-year mortgage at a fixed rate of 3%, and market rates then rise to 5%, the bank is stuck earning a below-market rate for years. The economic value of that 3% loan decreases because it's less profitable than a new loan issued today. We refer to this economic relationship as 'duration' risk.
If market rates fall significantly, homeowners with those 3% mortgages will likely refinance to get a new, lower rate. They pay back their loans to the bank early. The bank now has its cash back, but must lend it out again at the new, lower market rate, earning less income than it had originally planned. This is known as Prepayment Risk.
3. The Impact on Capital: The Investment Portfolio
This is a direct and significant impact on the bank’s balance sheet and net worth, separate from its day-to-day earnings. Banks hold large portfolios of high quality securities (like government treasuries) as a way to store liquidity. When interest rates rise, the market value of existing, lower-yielding bonds falls. There is a negative relationship between market interest rates and the price of fixed-income securities. This “paper loss” doesn’t immediately hit the bank’s income statement. Instead, it is recorded in a special section of shareholder’s equity called Accumulated Other Comprehensive Income (AOCI). A negative entry in AOCI directly reduces the bank’s total equity, thereby lowering its book value and shrinking its capital base.
Putting the Pieces Together
Let me give you a brief example. Take a look at the interest income and interest expense behavior based on data available in the St. Louis FED FRED Tool.
It is clear that around 2Q2022 to about 3Q2024 interest expense increased faster than interest income, leading to a compression in bank’s net interest income. This particular time was when we had higher market interest rates.
Conclusion:
Interest rate risk can materially affect a bank's earnings, liquidity profile, and capital position. Depending on the structure of its assets and liabilities, rising interest rates may initially benefit or hurt net interest income. However, as funding costs adjust and securities portfolios experience valuation pressure, many banks face net interest income margin compression and reductions in economic capital. While banks actively hedge these exposures, hedging involves costs and may not fully offset the effects of large interest rate movements.
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