Kenneth R. Szulczyk
Interest-rate sensitive items are short-term securities, variable interest-rate loans, and short-
term deposits. When the interest rate varies, these items change almost immediately. On the
other hand, the fixed-rate assets and liabilities are not sensitive to interest rate changes. These
loans and securities are locked into one interest rate for a long time period. Banks consider
checking and savings accounts fixed-rate liabilities because these accounts pay little or no
interest.
If the interest rate increases from 10% to 15%, which equals a 5% interest increase, then the
income from interest-rate sensitive assets increases by $1 million (0.05 × $20 million = $1
million). Moreover, the cost of funds increases by $2.5 million (0.05 × $50 million = $2.5
million). Consequently, the bank’s profits decline by $1.5 million ($1 M - $2.5 M = -$1.5
million). Unfortunately, changes in the interest rates impact a bank’s profits significantly.
Three conditions occur as the interest rates fluctuate:
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If the interest-rate sensitive liabilities exceed the interest-rate sensitive assets, then rising
interest rates cause banks’ profits to plummet, while falling interest rates cause banks’
profits to increase.
If the interest-rate sensitive liabilities are less than interest-rate sensitive assets,
subsequently, increasing interest rates cause banks’ profits to soar, while declining interest
rates cause banks’ profits to plummet.
If the interest-rate sensitive liabilities equal the interest-rate sensitive assets, then
fluctuating interest rates do not affect bank profits.
For example, if the bank manager knows the interest-rate sensitive liabilities exceed the
interest-rate sensitive assets, and he believes interest rates will fall, then he will do nothing.
Bank manager expects the bank’s profit to rise. If a bank manager thinks interest rates will
increase, subsequently, he would boost interest-rate sensitive assets and decrease interest-rate
sensitive liabilities by manipulating balance sheet items.
During the last 20 years, four factors changed how a bank manages its balance sheet. First,
the U.S. federal government deregulated the financial markets, granting banks more flexibility
in acquiring assets and liabilities. Second, financial innovation created new, liquid financial
instruments, such as repurchase agreements, federal funds market, and securitization. Banks
securitized their bank loans and transformed them into liquid securities. Third, the high volatility
of interest rates during the 1980s contributed to the creation of new financial instrument, such as
the floating-rate debt. Some banks grant loans to borrowers with variable interest rates. If the
interest rate rises, subsequently, the banks increase the interest rate on the loans. For example, a
variable interest rate mortgage is an adjustable-rate mortgage (ARM). Finally, the derivatives
market expanded during the 1980s. Banks could buy futures and options to protect themselves
from changing interest rates and exchange rate. Therefore, banks learned to protect themselves
from interest rate fluctuations.