Interest Rate Risk for Banks and Credit Unions: A Beginner's Guide

Now Is the Time to Do Our Homework on Deposits

Interest rate risk is a fundamental concept in banking, but for those new to the industry, it can seem overwhelming. This Guide summarizes the basics of interest rate risk, how to measure it, and how to manage it strategically.

What Is Interest Rate Risk?

Interest rate risk is the potential for an institution’s earnings or capital to be negatively affected by changes in interest rates. Because banks and credit unions earn money by lending at higher rates than they pay on deposits, changes in interest rates can impact profitability significantly.

Monitoring and appropriately managing interest rate risk may help institutions maintain stable earnings, plan strategic growth, remain compliant with regulators, and serve customers reliably.

There are two primary ways to evaluate interest rate risk:

Earnings at Risk (EaR): Focuses on the short-term impact of interest rate changes on an institution’s net interest income.

Economic Value of Equity (EVE): A long-term view that looks at how much the institution would be worth (market value of assets minus the market value of liabilities) in different shocked interest rate environments.

Types of Interest Rate Risk

Mismatch Risk: Happens when assets (like loans) and liabilities (like deposits) don’t reprice at the same time. For example, if an institution holds long-term fixed-rate loans but has to frequently reprice short-term deposits, it might earn less as rates rise.
Option Risk: Refers to borrowers or depositors changing their behavior when rates change – e.g., refinancing loans when rates fall or withdrawing money early from a low-interest deposits to reinvest at higher rates.
Yield Curve Risk: Comes from changes in the shape of the yield curve (which plots interest rates across different time horizons). A normal yield curve slopes upward, meaning long-term interest rates are higher than short-term rates because investors demand more return for lending money over a longer period. If short-term rates rise faster than long-term rates (flattening or inverting the yield curve), the cost of funding increases while loan income stays the same or decreases, squeezing profits.
Basis Risk: Arises when financial instruments (including indices that are usually highly correlated) react differently to changes in interest rates. Banks often hedge interest rate risk using financial instruments like derivatives (e.g., swaps, futures), assuming different rates will move in sync. If they don’t, the institution may earn less or pay more than expected.

How to Measure Interest Rate Risk

Institutions use several tools and models to understand how their balance sheets will react to interest rate changes:

GAP Analysis. This analysis compares the timing of repricing dates and cash flows for assets and liabilities over various time periods. It gives a snapshot of whether an institution is “asset-sensitive” (benefits from rising rates) or “liability-sensitive” (is hurt by rising rates). If an institution has more assets repricing or maturing in a certain period, it is said to have a positive gap. This generally benefits an institution if interest rates rise, as asset cash flows will earn higher returns while liabilities may remain at lower rates. If the institution has more liabilities maturing or repricing in a certain period, rising interest rates have the opposite effect on earnings as it pays higher rates on liabilities while earning lower rates on assets.
Net Interest Income (NII) Simulations. These simulations project how interest income and expenses may change over time in various interest rate scenarios. The “base case” assumes a "static" balance sheet (no growth) to isolate inherent risk exposures. From there, institutions run dynamic scenarios to measure the influence of proposed strategies.
Economic Value of Equity (EVE). This calculates the value of a bank if all assets and liabilities were sold today (a hypothetical liquidation value). It is useful for understanding long-term risk but doesn’t reflect the institution as a “going concern” entity (i.e., new loan or deposit activities).

Assumptions Matter

Every model is only as good as the assumptions behind it. Key assumptions include:

Prepayment rates (how fast loans get paid off early)
Deposit decay (how long customers keep their money with the bank)
Pricing behavior (how much rates on loans or deposits change when the market changes)

Bad data or unrealistic assumptions can skew results, so institutions often work closely with consultants and internal teams to fine-tune these inputs.

Key Takeaways

Interest rate risk is about how changes in rates affect an institution’s income and value.
It’s not about predicting interest rates, but being prepared for different scenarios.
“Listening to your balance sheet” (i.e., objectively considering asset/liability data) is more important than trying to guess what will happen to the ‘market’.
Better strategic decisions come from understanding one’s risk profile and running what-if scenarios to optimize strategic efforts.

Interest rate risk management is both an art and a science. The key is to build a foundation of understanding and work with experienced colleagues to learn how strategy and analysis go hand in hand. Managing risk isn’t about avoiding risk, rather it’s about understanding it, planning for it, and using it to make smarter decisions.

For more insights from Darling Consulting Group, click here.

ABOUT THE AUTHOR

Geof Kelly is a Director at Darling Consulting Group. In his role, he partners with banks and credit unions throughout the country to improve the effectiveness of their asset/liability management (ALM) process. He collaborates with management teams to craft institution-specific strategies designed to enhance financial performance, while navigating interest rate, liquidity, and capital risk management within the dynamic economic and regulatory landscape.

Geof joined Darling Consulting Group in 2024 with over a decade of industry experience in senior management capacities at banking and consulting institutions. He earned a B.S. in Accounting & Business Management and an M.S. in Accounting from the University of Massachusetts-Amherst.

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