Risk Management in Banking and Insurance · Interest Rate Risk Management

Interest Rate Risk in Banking: Meaning and Sources

Updated 11 October 2026 · Fact-checked

Interest rate risk is the risk that changes in market interest rates reduce a bank's earnings or the economic value of its capital. Its main sources are repricing risk, yield curve risk, basis risk and optionality risk. To answer questions, identify which rate mismatch or option feature is causing the loss.

Understand Interest Rate Risk: Meaning and Sources

A bank earns money by lending at one rate and borrowing at another. Its profit depends on the spread between what it earns on assets and what it pays on liabilities. When market rates move, that spread can shrink. This is interest rate risk.

Interest rate risk arises mainly in the banking book, which holds loans, deposits and investments the bank normally keeps to maturity. It is often called IRRBB (interest rate risk in the banking book). Trading book positions carry interest rate risk too, but that is treated as market risk.

There are two ways to look at the damage. The earnings view asks how changes in rates affect net interest income over the next year or so. The economic value view asks how changes in rates affect the present value of all assets, liabilities and off-balance sheet items, and so the bank's net worth.

The four main sources are these:

Repricing risk (also called gap risk): assets and liabilities reprice or mature at different times. A bank funded by short-term deposits and lending long at fixed rates loses when rates rise, because deposit costs go up first while loan income stays fixed.
Yield curve risk: the yield curve changes shape, by steepening, flattening or twisting, and not only by moving up or down in parallel. A bank positioned for a parallel shift can still lose.
Basis risk: assets and liabilities reprice on different benchmarks. For example, a loan is linked to the repo rate while a deposit is linked to a Treasury bill yield. The two benchmarks may not move together.
Optionality risk: customers or the bank hold options. Borrowers may prepay loans when rates fall, and depositors may withdraw term deposits early when rates rise. These actions work against the bank.

All four can arise together, so a good answer names the source and explains the mechanism.

Key rules to remember

Net interest income: NII = Interest income − Interest expense; The earnings view measures the change in this amount when rates change.
Repricing gap: Gap = Rate sensitive assets (RSA) − Rate sensitive liabilities (RSL); Calculated for each time bucket. A positive gap means the bank is asset sensitive.
Change in NII from a rate shift: ΔNII ≈ Gap × Δi; Δi is the change in rate. Use the gap for the period within which items reprice, and adjust for the part of the year remaining if asked.
Economic value of equity: EVE = PV of assets − PV of liabilities (including off-balance sheet items); The economic value view looks at the change in EVE when rates shift.

How to solve Interest Rate Risk: Meaning and Sources questions

Use this method for both theory and case-based questions on the meaning and sources of interest rate risk.

1Define interest rate risk in one line: exposure of earnings or economic value to adverse rate movements, mainly in the banking book.
2Read the case and list what reprices: assets, liabilities, benchmarks and customer options.
3Match each feature to a source: timing mismatch is repricing risk, change in curve shape is yield curve risk, different benchmarks is basis risk, and prepayment or early withdrawal is optionality risk.
4Explain the mechanism: say which side reprices first and whether rates rise or fall.
5State the impact on net interest income, economic value, or both.
6If numbers are given, compute the gap and multiply by the rate change, with the sign.
7Close with one control: gap limits, duration limits, hedging, or repricing of products.

Quickest way: Four-source tagging

When to use it: Use it for MCQs and short case questions that ask you to identify the type of interest rate risk.

Timing differs between assets and liabilities: repricing risk.
Curve shape changes (steeper, flatter, twist): yield curve risk.
Different benchmark rates for assets and liabilities: basis risk.
Customer or bank can prepay, withdraw or exercise a cap or floor: optionality risk.
If the case shows more than one feature, name the dominant one and mention the other.

Common mistakes in Interest Rate Risk: Meaning and Sources

Confusing repricing risk with basis risk
Both involve a mismatch between assets and liabilities.
Fix: Repricing risk is about when items reprice. Basis risk is about which benchmark they follow. Items can reprice at the same time and still have basis risk.
Treating yield curve risk as just a rise or fall in rates
Students think of rates moving in only one direction.
Fix: Yield curve risk is about a change in shape or slope. A parallel shift is the simplest case, and it is not the whole risk.
Saying a rate rise always hurts a bank
Students memorise the example of short deposits funding long fixed loans.
Fix: The effect depends on the gap sign. An asset sensitive bank gains when rates rise and a liability sensitive bank loses.
Ignoring optionality in deposits
Students think only borrowers hold options.
Fix: Depositors can withdraw term deposits early when rates rise, and borrowers can prepay when rates fall. Mention both.
Mixing interest rate risk in the banking book with trading book market risk
Both are rate related.
Fix: Banking book exposure is held for the long run and measured through earnings and economic value. Trading book positions are marked to market and treated under market risk.

Worked examples

Example 1

A bank funds a 5-year fixed-rate home loan portfolio with 1-year deposits that reprice annually. Market rates rise by 1% after the first year. Identify the source of interest rate risk and explain the effect.

Show the solution

The loans are fixed for five years, but the deposits reprice every year. The mismatch is in timing.
This is repricing risk.
When rates rise, the bank must renew deposits at higher rates, so interest expense increases.
Interest income from the fixed-rate loans does not change.
So the spread narrows and net interest income falls.

Answer: This is repricing risk. The bank is liability sensitive, so a rate rise reduces net interest income. Controls include gap limits, floating-rate lending or longer-tenor funding.

Example 2

In a time bucket, a bank has rate sensitive assets of ₹800 crore and rate sensitive liabilities of ₹1,000 crore. Rates rise by 0.50% across the board. Estimate the change in annual net interest income for this bucket, assuming all items reprice at the start of the year.

Show the solution

Gap = RSA − RSL = ₹800 crore − ₹1,000 crore = −₹200 crore.
Δi = 0.50% = 0.005.
ΔNII ≈ Gap × Δi = −200 × 0.005 = −₹1 crore.
The negative gap means the bank is liability sensitive, so the rate rise reduces income.

Answer: Net interest income falls by about ₹1 crore a year for this bucket.

Exam tips

MCQs often give a short scenario and ask for the source. Use the four-source tagging to answer quickly.
In descriptive answers, always give a one-line example for each source. It shows application.
Do not skip the sign of the gap in numerical questions. State whether the bank is asset or liability sensitive.
Link the sources to the earnings and economic value views in your conclusion.

Practice questions from Interest Rate Risk Management

Interest Rate Risk: Meaning and Sources in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Interest Rate Risk: Meaning and Sources: frequently asked questions

What is interest rate risk in the banking book?

It is the risk to a bank's earnings or economic value from changes in interest rates on positions held in the banking book, such as loans and deposits. It is also called IRRBB.

What is the difference between repricing risk and basis risk?

Repricing risk comes from differences in when assets and liabilities reprice. Basis risk comes from differences in the benchmark rates they follow, even if they reprice at the same time.

What is optionality risk in banks?

It is the risk from options embedded in products. Examples are borrowers prepaying loans when rates fall and depositors withdrawing term deposits early when rates rise.

Is yield curve risk the same as a rate increase?

No. Yield curve risk comes from a change in the shape of the curve, such as flattening or steepening, which affects items of different maturities differently.