Interest Rate Risk

Interest Rate Risk:
Interest rate risk is the risk that an investment assets value will change due to the changes of the interest rate. Items like floating rate loans, variable rate deposits, loans maturing within the year, marketable securities within one year, money market deposits accounts are all considered as rate sensitive. According to the study from Fauziah (2009), they examined that impact on the financial risks on profitability of the conventional and Islamic banks in Malaysia for the period between 1996 and 2005. Based on the result they found, the relationship between Return on Assets (ROA) and interest rate risk has an significant impact while only has weakly significant on the Return on Equity (ROE).
Based on the research carried out by Albertazzi and Gambacarta (2009), they included interest rate as of the important macroeconomic factor to determine the profitability of bank. The result show that the bank’s profitability in Italy, Spain and Portugal is less affected by long term interest rate and they are more affected by the short term interest rate. In conclusion, interest rate has significant effect on the profitability of bank.
According to Hancock (1985), the profitability of bank is determined by the interest rate. He found that there is positive relationship between interest rate and bank’s profitability which means the increase in interest rate will lead to the increase in bank’s profitability.
A normal concept that commercial banks are “borrow short and lending long” implies that sharp interest rate increase may cause a number of bank failure. Flannery (1981) examined that does interest rate fluctuation have a significant on bank’s profitability. Based on the result he found, large banks have effectively hedged against the interest rate by assembling asset and liability portfolios with similar average maturities and thus the impact is minimal.
Demirguc-Kunt and Harry (2013) using bank-level data for 80 countries in the year’s 1988-95, to test the relationship between interest rate and bank’s profitability. They found that a larger ratio of bank assets to gross domestic product and a lower market concentration ratio lead to lower margins and profits, controlling for differences in bank activity, leverage, and the macroeconomic environment. (Demirguc-Kunt, & Harry, 2013)