Bank Interest Rate Risk Management and Valuation of Earnings

Abstract

This paper examines banks’ interest rate risk management and its effects on the persistence and valuation of banks’ earnings. We construct a novel measure to capture the extent to which a bank is able to generate persistent net interest income (the primary component of a bank’s earnings) by changing interest rates on assets and liabilities in response to market interest rate changes. This measure builds on traditional maturity gap, but in explaining changes in net interest income, our model takes into consideration asymmetrical changes in the interest rates of rate sensitive liabilities and assets. We hypothesize that banks with the ability to enhance yields on assets and reduce funding costs through interest rate risk management strategies are more likely to have persistent net interest income and, thus, higher valuation of net interest income. Using a sample of bank holding companies from 1997 to 2011, we find evidence supporting our hypotheses. Our study enhances our understanding of banks’ interest rate risk management and can help investors and bank regulators assess banks’ interest rate risk management and earnings sustainability.