Interest Rate Risk Case Study - 1980s savings and loan crisis in the U.S

Interest Rate Risk

  • Interest rate risk is the potential for loss due to fluctuations in interest rate levels. 
  • The degree of sensitivity to interest rate risk is classically measured with duration.

1980s savings and loan crisis in the U.S

  • All commercial banks, S&Ls included, accept short-term demand deposits from customers and use those funds to make long-term loans. 
  • Their goal is to capture the spread between the rate paid for short-term deposits (liabilities from the bank’s perspective) and the rate received on longer-term loans (assets from the bank’s perspective). 
  • During the late ‘60s and early ‘70s, the yield curve was upward sloping, which meant that short-term rates (a cost for S&Ls) was much lower than longer term rates (a profit center for S&Ls).
  • In the late 1970s, inflation surged and the Federal Reserve responded by raising interest rates. This reality weakened strong lending margins to the point where losses began to mount.
  • This situation could not be directly addressed because a large proportion of the loans were fixed-rate mortgages (a problem that is known as an asset-liability mismatch). 
  • Savings and loan operators accounted for this negative profit spread by lower lending standards and getting into some very risky loans. 
  • They ended up losing so much money that the American taxpayers had to engage in a $160 billion bailout of the industry and roughly 35% of the S&Ls were immediately out of business
  • Regulation Q - created in 1933, with the goal of prohibiting banks from paying interest on deposits in checking accounts. It also enacted ceilings on the interest rates that could be paid in other types of accounts.
Lessons learned - Hedging Interest rate risk
  • One option is to match the duration of their short-term liabilities and their long-term assets. If the assets and liabilities are correlated and they have an approximately similar duration, then their movements will offset each other as interest rates fluctuate. 
  • Another option is to hedge known interest rate risk using a derivatives product (e.g., caps, floors, swaps).

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