In anticipation of rising interest rates, it seems like a no-brainer: Banks should hedge this interest rate risk and thereby at least try to avoid the prospect of going belly-up. Interest rate derivatives serve exactly this purpose. A variety of derivatives could be used, but the most ubiquitous choice for bankers is the interest rate swap, which permits them to lock in rates for the replacement funding when existing liabilities mature.

By way of a simple example, suppose a bank has a single six-month asset earning 7 percent, funded by three-month liabilities costing 5 percent. The bank thus earns a 2 percent spread for the initial three months. At the end of that time, the original three-month deposit matures, and the bank has to replace it with a new deposit. The new three-month liabilities must pay the prevailing interest rate as of the rollover date; in a rising-rate environment, that may be well above 5 percent, for a spread well below 2 percent.

The bank could use a swap to lock in the cost of funds for the second three-month interval. The challenge with this approach is that the rate which the swaps market allows it to lock in for that period is market-determined. If the consensus forecast predicts that deposit rates will be higher by the time the deposits roll over, the swaps market will build this expectation into pricing. Put another way, while the swaps market permits the bank to eliminate the uncertainty associated with future rollover pricing, hedging could potentially lock in a seemingly unattractive spread—i.e., a spread that ends up causing a hit to earnings.

This example assumes the original maturity of the asset is just six months, but the problem multiplies as the maturity of the asset extends for longer durations. The bigger the discrepancy in the respective maturities, the more severe the risk exposure. Given that commercial loans and mortgages can cover periods as long as 30 years, the associated risks can be quite substantial.

In the real world, banks face three alternatives: first, hedging and locking in known but potentially unattractive (or even negative) spreads for the horizon covered by the maturities of their assets; second, remaining unhedged, hoping that the actual interest rate changes that arise won't be as adverse as those implicitly expected based on the swaps' pricing; or third, taking some middle-ground position by hedging only a portion of the exposure.

Of course, the source of the original risk is the propensity of banks to take on the higher-yielding longer-term assets, funded by lower-cost shorter-term liabilities. In theory, instead of relying on interest rate derivatives, banks could simply match the maturities of their assets with those of their liabilities such that both reset their respective interest rates (nearly) simultaneously. But that's easier said than done. Matching 30-year mortgages with 30-year deposits isn't going to happen.

And, ultimately, even if banks could hedge away all of their yield-curve risk, that risk wouldn't go away. Rather, it would be shifted to the banks' derivative counterparties—often major financial institutions that act as derivatives dealers. When derivatives are "paying off" to the banks that use them to hedge, the banks' counterparties are losing on those positions. Sustained market movement could still have a destabilizing effect, albeit to a different population of derivatives market participants.

One of the relatively recent market developments is the move toward cleared derivative contracts. Historically, most swaps were bilateral contracts between two market participants, where swap settlements were made periodically (e.g., monthly or quarterly) over the life of the exposures being hedged, accrual period by accrual period. But that's changing. Increasingly, the market has been transitioning to cleared swaps, where transactions are registered with an exchange clearing house and the full value of any gain or loss on the registered contract is accelerated, paid, and received daily, instead of being spread out over the term of the swap.

This process of daily settlements ensures that losses won't accumulate to the point where a derivative counterparty cannot meet its obligation. In other words, the daily settlement process effectively guarantees that winners will get paid. However, it does so at the cost of requiring that participants maintain a higher volume of liquid assets than they would likely do using traditional bilateral derivative instruments. This liquidity consideration, by itself, is a bit of a disincentive for banks to enter into derivatives positions, as it may require some substitution of lower-yielding, more-liquid assets for higher-yielding assets that may be less readily convertible to cash.

The recent spate of bank failures and takeovers notwithstanding, the fundamental economic precursors to these developments haven't really changed all that much. Given the Fed's charge to counter inflation, the risk of interest rates continuing to rise is very much alive. With that, we can expect pressure on bank profitability to persist, whether or not banks put on additional hedges. We can also expect that, for the foreseeable future, the Fed and the administration will be challenged by having to battle inflation while at the same time bolstering confidence in our banking system, even as some less-well-capitalized banks may be forced to shut down.

See also:

• What Happened to Credit Suisse?
• U.S. Banks on a Bumpy Path
• U.S. Studies Ways to Insure All Bank Deposits
• U.S. Backstops Bank Deposits to Avert Crisis

Ira Kawaller holds a Ph.D. in economics from Purdue University and has held adjunct professorships at Columbia University and Polytechnic University. Derivatives have been a consistent area of interest for most of his career. Kawaller contributes frequent blog postings on topics related to politics and economics at igkawaller.medium.com.