Banks' Interest Rate Risk: Pricing and Risk Management

This thesis covers an extended overview about interest rate risk (IRR) in general and two essays on theoretical and empirical financial intermediation covering the pricing and risk management of banks' IRR exposure. It investigates how banks should optimally price the IRR stemming from maturity transformation into loan and deposit rates and whether such optimal behavior can be found in bank interest margins. Moreover, it addresses the question of how IRR hedging off the balance sheet affects banks' maturity transformation. The first essay makes a twofold contribution to the extent to which IRR is priced in bank margins: First, the thesis presents an extension of the Ho and Saunders (1981) model to capture IRR and expected returns from maturity transformation. Banks price IRR according to their individual exposure separately in loan and deposit intermediation fees, but reduce (increase) these charges for loans (deposits) when positive excess holding period returns from long-term exposures are expected. Second, using data for the German universal banking sector between 2000 and 2009 the thesis tests the model-derived hypotheses not just for the commonly investigated net interest margin but also for interest income and expense margins separately. Banks price their individual IRR and corresponding expected excess holding period returns in their interest income and net interest income. For interest expenses, IRR exposure is only priced by smaller, local banks. In the second essay, financial intermediaries' IRR management is investigated as the simultaneous decision to manage on-balance-sheet exposure and to use interest rate swaps. Both decisions are substitute risk management strategies. For banks with trading activity, the maturity gap and the decision to use interest rate swaps are exogenous to one another. For banks without trading activity, the decision to use interest rate swaps is exogenous to the maturity gap, but the reverse relationship is endogenous. The magnitude of the maturity mismatch is, however, always an endogenous determinant of the extent of derivatives use. These findings provide support for the maturity gap being largely determined by customer liquidity needs, whereas the decision to use interest rate swaps relies on compliance with IRR regulation. Exploiting the time-series variation in panel data, the thesis presents evidence of selective hedging behavior in the use of interest rate swaps driven by the slope of the yield curve as well as by funding uncertainty