As inflation is increasing throughout the economy, central banks have begun raising interest rates. Since community bank assets are loan heavy, it is generally assumed that rising interest rates will have a positive impact on community banks.
But this is not typically the case.
What risks do community banks face with higher interest rates?
Community banks often manage as if they are asset sensitive and will have earnings pressure when interest rates rise. When funding costs increase faster than asset yields, it is known as liability sensitivity. The biggest risk comes from deposits if bank liabilities reset faster than assets grow.
However, risks can also come from loans and investment portfolios for several reasons.
- As rates rise, fixed-rate loans, especially those with long terms, can negatively affect the loans’ value.
- Loans with higher interest rates have a higher default risk.
- If interest payments to community bank customers do not rise as fast as the interest rates in the market, depositors may withdraw money, heightening the need for new business.
- Since community banks often hold large amounts of government debt that they use for collateral with low or negative interest rates, the value of this debt can fall when interest rates rise.
How can a community bank combat the risks of higher interest rates?
Interest rate risk, or IRR, measures a community bank’s risk based on these and other factors. A proper assessment of a community bank’s risk includes more than an analysis of the effect Risk A has when Condition X changes. When Condition X changes, it can also affect Risk B, C, D, or more, either directly or indirectly.
The risks and interrelationships between economic and financial conditions need to be assessed, measured, and reported by community banks. A comprehensive approach that looks at the functions of a community bank and the connection with the various risks is fundamental.