What Is Interest Rate Risk?

Interest rate risk is the danger that shifts in market interest rates will negatively affect a bank's financial position. This risk operates through two primary channels: asset values (existing fixed-rate loans and bonds decline in market value when rates rise) and net interest margin (the spread between earning rates and funding costs can compress in rising or falling rate environments depending on the bank's asset-liability mix).

The 2022-2023 rate hiking cycle by the Federal Reserve provided a dramatic illustration of interest rate risk. Banks that had invested heavily in long-duration bonds (10-30 year maturities) during the 2020-2021 low-rate era saw the market value of those securities decline sharply — by 20-30% in some cases. Silicon Valley Bank held approximately $91 billion in bonds with an unrealized loss of $15 billion, which became a real loss when it was forced to sell to meet deposit withdrawals.

Banks manage interest rate risk through asset-liability management (ALM), which involves matching the duration and repricing characteristics of assets and liabilities. A well-managed bank ensures that rate increases on its loans roughly offset rate increases on its deposits, keeping margins stable. Banks also use interest rate derivatives (swaps, caps, floors) to hedge mismatches.

For depositors, interest rate risk is largely invisible in normal times but can become acute during periods of rapid rate changes. On BankHealthData, interest rate risk surfaces indirectly through the liquidity ratio (banks with large unrealized bond losses may have impaired liquidity) and return on assets (margin compression reduces profitability). If you are concerned about your bank's exposure to rate risk, look for declining trends in these metrics during periods of rising rates.