Interest rate risk in the French banking system.

Abstract

Although most bank failures and banking problems historically have been attributable to poorly managed exposures to credit risk, inadequate management of interest rate risk can give rise to the same types of problems, as illustrated by the U.S. 'savings and loan crisis' of the early 1990s. Interest rate risk is one of the principal risks inherent in the maturity transformation activity of banks. Excessive or poorly managed exposure to interest rate risk can menace both the financial balance of specific credit institutions and the overall stability of the financial system. The current environment of low interest rates, ongoing developments in regulatory and accounting standards, and the structural burden of the fixed-rate investment strategy of French banks – and of continental European banks in general – all combine to make exposure to and management of interest-rate risk a leading concern of the different actors involved in ensuring financial stability. In this environment, prudential authorities, along with other authorities responsible for overall financial stability, need to have accurate indicators of levels and trends in exposure to interest rate risk in the financial system. However, the diversity of this risk makes it very difficult to select such indicators. The choice depends heavily on the nature of the interest rate risk – in particular, on the volume of assets and liabilities containing embedded options –, on the financial structure of the specific institution, and on its overall strategy. This explains the diversity of practices observed today in the monitoring and management of interest rate risk. The same factors also make it extremely difficult to establish a harmonised system of quantitative reporting. As with other types of risk, the first line of defense against the vulnerabilities associated with interest rate risk is the soundness and robustness of internal management and control systems. The new capital framework envisages a tailored supervisory review.