SejrBank
▶ Play free
Interest-rate risk and duration: how rising rates can sink a bank
You can run a bank that never makes a bad loan and still lose it to interest rates. When rates rise, the value of assets that pay a fixed rate falls — and banks own a lot of fixed-rate assets.
Duration in one sentence
A bond's duration is roughly the percentage its price falls when interest rates rise by one percentage point. A bond with a duration of 7 loses about 7% of its value if rates rise 1 point, and about 21% if they rise 3 points. Short-dated bonds barely move; long-dated ones swing hard.
| Duration | Price change if rates rise 1pp | …if rates rise 3pp |
|---|---|---|
| 1 year | ≈ −1% | ≈ −3% |
| 3 years | ≈ −3% | ≈ −9% |
| 7 years | ≈ −7% | ≈ −21% |
Why banks carry this risk
Longer bonds and fixed-rate mortgages usually pay more, so reaching for duration boosts income when rates are low. But deposits are short: if rates rise, the bank must pay more to keep depositors while its long assets keep earning the old, low rate. Profits get squeezed and the market value of the assets falls.
The accounting trap
Banks can classify bonds as “held to maturity”, which means falls in market value do not hit reported capital. That is fine if the bank really can hold them to maturity. If it is forced to sell — because depositors leave — the hidden losses become real.
The SVB case
Silicon Valley Bank invested a large share of a deposit boom in long-dated US Treasuries and mortgage-backed securities at very low yields. When the Federal Reserve raised rates rapidly in 2022, the market value of those bonds fell sharply; by the end of 2022 the unrealised losses on SVB's held-to-maturity portfolio were roughly as large as its entire equity. When depositors ran, the losses could no longer stay hidden. The US savings-and-loan crisis of the 1980s was an earlier, slower version of the same mismatch.
How banks manage it
- Measure it: regulators require banks to report how their economic value of equity (EVE) and net interest income (NII) change under rate shocks such as ±2 percentage points.
- Match it: fund long fixed-rate loans with long funding — Danish banks famously use covered bonds that match mortgages.
- Hedge it: interest-rate swaps turn fixed-rate assets into floating ones, at a cost.
- Keep duration short when rates look likely to rise.
Frequently asked questions
What is duration risk?
The risk that rising interest rates reduce the market value of fixed-rate assets such as bonds and mortgages. The longer the duration, the larger the loss for a given rise in rates.
Why do rising interest rates hurt banks?
They reduce the value of fixed-rate assets and, if deposits reprice faster than loans, squeeze net interest income. Rising rates can also increase credit losses if borrowers struggle to pay.
How do banks hedge interest-rate risk?
Mainly with interest-rate swaps, by matching the maturity of assets and funding (for example with covered bonds), and by keeping the bond portfolio short-dated.