Market risk with bonds 325
POSITIVE INTEREST
FROM A LOAN
PROFIT MARGIN
RESERVE REQUIREMENTS
NON-INTEREST
BUDGET CHARGES
NEGATIVE INTEREST -
COST OF MONEY
MONETIZATION OF
CREDIT RISK
TRANSACTION
COSTS
200 bp vs.
50 bp IN CAPITAL MARKET
Figure 14.4 The difference between cost of money and interest from a loan is by no means
net profit
correlation in the adjustment of the rates earned and paid on different instruments
with otherwise similar repricing characteristics.
14.8 Hedging interest rate risk in a commercial bank
The preceding sections have explained that interest rate risk is inherent to most busi-
nesses, and it is arising from a variety of factors: fixed rate bonds and loans whose
servicing becomes too expensive when interest rates fall, mismatch between loans and
deposits, differences in the timing between contractual maturity or repricing of assets,
the nature of outstanding liabilities, obligations derived from derivative financial
instruments and other reasons.
Net interest income can also be affected by changes in market interest rates. One of the
reasons not often talked about is that of banks that provide servicing and loan adminis-
tration functions for mortgage loan pools in return for a fee. When interest rates fall, the
servicing bank experiences a decline in its fee structure as the underlying mortgages repay.
Moreover, as far as a credit institution’s bottom line is concerned, a good deal of dif-
ference is made by the pattern of the interest rate spread. Chapter 6 has made reference
to positive and negative interest rates. Based on my experience as a consultant to the
boards of financial institutions, Figure 14.4 emphasizes five main allocation channels
of the margin which exists between the two. Rare is the case of a credit institution that
proactively assigns part of the margin between positive and negative interest as if it
were buying reinsurance against interest rate risk.
This is an expensive oversight because even floating rate assets and liabilities are
exposed to basis risk. The reason is the difference in repricing characteristics of relevant
pairs of floating rate indices, such as the savings rate and 6-months Libor. Furthermore,
a growing range of financial products have embedded options that affect their effective
duration and pricing.

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