Interest Rate Risk and Bank Hedging

Abstract

This model concerns itself with how banks hedge their business risk, as composed of cash-flow risk and discount rate risk. In equilibrium, the two risks are intertwined as they are linked via the optimal hedging strategy. Ultimately, the bank stabilizes the marginal value of cash to trade off discount and cash flow effects. A regulator imposes a maximum leverage ratio, and the firm’s strategy is affected differentially depending on if the regulator imposes the limit on accounting or market variables. We show that when a bank’s deposit rate beta, loan beta, and deposit growth beta are zero that the bank optimally hedges away all interest rate risk. If not, then it retains some optimal net exposure to interest rate risk: A bank’s excess returns on loan and deposits, as well as equity and deposit flows, make up a bank’s investment opportunity set, and if this changes with r it is optimal to induce some state dependence of capital to r.