Optimal Management of the Interest Rate Risk in the Banking Book

Bogie Ozdemir

Following the 2007–08 financial crisis, continuous monetary stimulus resulted in very low, even negative, interest rates and a flat yield curve, a fundamental challenge to the operating models of banks and the insurance companies. Banks require a positively sloping yield curve to pick up net interest income by maintaining a positive target duration for their equity. Insurance companies need high-enough interest rates as they use the interest income generated from fixed income assets to back up their insurance liabilities.

Neither a sufficient slope nor sufficient level has been available to them, significantly reducing their interest income and increasing capital requirements. While the income impact is more immediately obvious for the banks, insurance companies have had an additional hit: the present value of their very long-dated insurance liabilities increase significantly when these future liabilities are discounted at a very low (even negative) discount rate, forcing an increase in their best value of liabilities,11 The expected or mean value (probability weighted average) of the present value of future cashflows for current obligations, projected over the contract’s run-off

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