In America, banks operate in an open market where they are allowed to set their interest rates. In deciding what rates to charge a borrower, the bank considers the credit-worthiness of the customer. Interest rate risks (IRR) occur when banks give long-term loans that are funded by short-term deposits. The higher the risk, the higher the possibility of the bank collapsing. It is essential for any bank to manage the risk. Banks depend on interest paid by its borrowers to make profit. Therefore, changes in interest rates affect the bank's earnings and can disrupt its business. Banks must measure its IRR to know which action to take. Some banks employ risk managers while others outsource the services. The first thing that any bank must do is to analyse the impact of the interest rate on their business and then model the bank's business strategy in response to the changes. The policy should aim at reducing the bank's exposure while maximising the benefits to the bank. Economic growth often poses an increased interest rate risk (Begenau, Piazzesi, " Schneider, 2015).
All bankers seek to remain competitive by offering attractive interest rates. Higher rates for deposits or lower rates for loans are likely to attract clients to the financial institution. The setting of interest rates is, however, not entirely within the powers of the banks. The Federal Reserve influences the interest rates charged by banks through its monetary policies such as setting federal funds rates and also giving stipulations on the minimum reserves that banks should have. The Federal Reserve also sets the Federal fund rate which forms the basis for the interest rates set by banks. Banks cannot fix their rates below the benchmark set by the Federal Reserve. Banks can prepare for the interest rate risks through gap analysis. Under this method, the bank categorises its assets and liabilities based on their maturity period or the expected periods of interest changes. Where a bank has more liabilities than assets, the bank will be exposed to an increase in interest rates. However, if it has more assets than liabilities, a decline in interest rates would negatively impact on its fortunes.
Economic growth and inflation affect interest rates. The Federal Reserve uses interest rates as a way of controlling inflation. During slow economic growth, it lowers the rates to encourage borrowing while during higher economic growth, the Fed increases the interest rates to prevent inflation. For instance, during the 2007 - 08 financial crisis, the Fed increased the interest rates to manage the rising inflation. It also uses policies such as buying and selling of securities in the open market as a means of controlling interest rate Through the policies; the Fed can control the interest rates set by banks. Poor policies by the Fed can result in an economic recession as was the case in the 1980s. It is therefore essential for the Fed to consult the bankers before reviewing the interest rates to avoid market shocks. Banks depend on interest rates to earn a profit. To maintain profitability, the net interest rate on assets should be higher than that of liabilities. Shocks in interest rate changes can affect the bank stock, primarily where the bank heavily relies on deposits (English, Van den Heuvel, " Zakraj\u0161ek, 2018). When lending, banks can either set permanent interest rates or rates that are subject to review over time. Where the interest rates are subject to review, banks are better capable of responding to fluctuations.
References
Begenau, J., Piazzesi, M., " Schneider, M. (2015). Banks' risk exposures (No. w21334). National Bureau of Economic Research.
English, W. B., Van den Heuvel, S. J., " Zakrajšek, E. (2018). Interest rate risk and bank equity valuations. Journal of Monetary Economics.
