Impact of interest rate risk on the Spanish
banking sector
Laura Ballester, Rom ́an Ferrer, and Cristobal Gonz ́ alez ́Abstract.This paper examines the exposure of the Spanish banking sector to interest rate
risk. With that aim, a univariate GARCH-M model, which takes into account not only the
impact of interest rate changes but also the effect of their volatility on the distribution of bank
stock returns, is used. The results show that both changes and volatility of interest rates have a
negative and significant impact on the stock returns of the Spanish banking industry. Moreover,
there seems to be a direct relationship between the size of banking firms and their degree of
interest rate sensitivity.Key words:interest rate risk, banking firms, stocks, volatility1 Introduction
Interest rate risk (IRR) is one of the key forms of financial risk faced by banks. This
risk stems from their role as financial intermediaries and it has been attributed to two
major reasons. First, in their balance sheets, banks primarily hold financial assets and
liabilities contracted in nominal terms. Second, banks traditionally perform a matu-
rity transformation function using short-term deposits to finance long-term loans. The
resulting maturity mismatch introduces volatility into banks’ income and net worth
as interest rates change, and this is often seen as the main source of bank IRR. In
recent years, IRR management has gained prominence in the banking sector due to
the fact that interest rates have become substantially more volatile and the increasing
concern about this topic under the new Basel Capital Accord (Basel II). The most
common approach to measuring bank interest rate exposure has consisted of estimat-
ing the sensitivity of bank stock returns to interest rate fluctuations. The knowledge
of the effect of interest rate variability on bank stocks is important for bank managers
to adequately manage IRR, investors for hedging and asset allocation purposes, and
banking supervisors to guarantee the stability of the banking system. The main ob-
jective of this paper is to investigate the interest rate exposure of the Spanish banking
industry at a portfolio level by using the GARCH (generalised autoregressive condi-
tional heteroskedasticity) methodology. Its major contribution is to examine for the
first time in the Spanish case the joint impact of interest rate changes and interest rateM. Corazza et al. (eds.), Mathematical and Statistical Methodsfor Actuarial Sciencesand Finance
© Springer-Verlag Italia 2010