In Chapter 7 we established that wh

In Chapter 7 we established that while performing their asset-transformation functions, FIs often mismatch the maturities of their assets and liabilities. In so doing,
they expose themselves to interest rate risk. For example, in the 1980s a large number of thrifts suffered economic insolvency (i.e., the net worth or equity of their
owners was eradicated) when interest rates unexpectedly increased. All FIs tend
to mismatch their balance sheet maturities to some degree. However, measuring
interest rate risk exposure by looking only at the size of the maturity mismatch can
be misleading. The next two chapters present techniques used by FIs to measure
their interest rate risk exposures.
This chapter begins with a discussion of the Federal Reserve’s monetary policy, which is a key determinant of interest rate risk. The chapter also analyzes
the simpler method used to measure an FI’s interest rate risk: the repricing model .
The repricing, or funding gap, model concentrates on the impact of interest rate
changes on an FI’s net interest income (NII), which is the difference between an
FI’s interest income and interest expense. Because of its simplicity, smaller depository institutions (the vast majority of DIs) still use this model as their primary
measure of interest rate risk. Appendix 8A, at the book’s Web site (www.mhhe
.com/saunders6e), compares and contrasts this model with the market value–
based maturity model, which includes the impact of interest rate changes on the
overall market value of an FI’s assets and liabilities and, ultimately, its net worth.
Until recently, U.S. bank regulators had been content to base their evaluations of
bank interest rate risk exposures on the repricing model. As explained later in this
chapter, however, the repricing model has some serious weaknesses. Recently, the
Bank for International Settlements (the organization of the world’s major Central
Banks) issued a consultative document 1 suggesting a standardized model to be
used by regulators in evaluating a bank’s interest rate risk exposure. Rather than
being based on the repricing model, the approach suggested is firmly based on
market value accounting and the duration model (see Chapter 9). As regulators
move to adopt these models, bigger banks (which hold the vast majority of total
assets in the banking industry) have adopted them as their primary measure of
interest rate risk. Moreover, where relevant, banks may be allowed to use their
own value-at-risk models (see Chapter 10) to assess the interest
convert