Interest Rate Risk Management

Interest Rate Risk Management

This report aims to discuss the volatility of interest rates and how that issue is important for insurance companies, especially those underwriting premature death risks and selling annuities. The report also presents insights into why interest rates are important for other financial institutions such as banks and corporations who hold interest related securities throughout their accounting processes. Finally, the essay offers a status of the interest rate risk management processes utilized by different corporations and the types of risk management throughout the market. When interest is involved, a major aspect is handled by banks.

Banking is a business that deals with money and other instruments of credit. By money and instruments of credit we mean that although anything can function as money such as dollars, pennies, checks, sea shells and even rocks, it is the process of buying and selling. The idea of money presents an ideal solution for piano salesmen who no longer have to carry around their product for barter. Banks became middlemen in sales transactions in our modern way of thinking to replace the barter systems of old. The real genius in the idea of banks is the concept of interest. Banks created a new way to profit from their middle man status and these concepts arte the foundation of the credit process where banks and other institutions extend loans for longer periods of time in exchange for a payment in the form of interest. There are well over 25,000 banks and near-banks in the United States alone.

Throughout America's history there were a number of financial panics that plagued our nation. In the early 19th century for example, bank failures, business bankruptcies, and long-term economic downturns can be traced to the non-regulated banking systems and because there was little flexibility in the monetary supply. Thus, in 1907 the United States Congress established the National Monetary Commission in an effort to deal with the banking system's issues. Eventually, the Congress passed the Federal Reserve Act around Christmas in 1913. The act established the Federal Reserve Banks and established a more elastic currency that allowed for rediscounting of commercial paper and also establishing new controls over the commercial banking system. The Federal Reserve Act was not a perfect legislation because even today we still see the occasional deficiency such as the International Banking Act of 1978 also called the Humphrey-Hawkins Act which attempted to provide updates such as objectives for the Federal Reserve. These new objectives were efforts to spur economic growth that was more in line with the modern economy's potential to expand and also add stability to the U.S. dollar as well as moderate long-term interest rates.

A major aspect of interest rate risk management stems from the Federal Reserve. The Federal Reserve is actually a Board of Governors in Washington D.C. And also twelve individual regional Federal Reserve Banks. These aspects of the system have a responsibility to conduct our nation's monetary policies by influencing both the money and credit scenarios of the United States economy. There is also an underlying responsibility to regulate commercial banking institutions to ensure the soundness in our overall banking and financial system. The Federal Reserve conducts this risk management through three major tools:

Open market operations to control the level of reserves in the depository system

Setting reserve requirements for depository institutions

Setting the discount rate for lending reserves

The Federal Reserve drives how much it will cost organizations to borrow money. By raising and lowering interest rates for example, the Federal Reserve dictates whether industry players will have the resources to borrow the cash they need to run their daily operations and this includes all aspects of the national and global economy such as insurance companies, banks, investors and every other type of business entity. The management of interest rates is more than managing inflation -- through interest rate manipulation, the Federal Reserve controls outcomes such as mergers, bankruptcies, overcapacity, relocation abroad, state and federal subsidies, competition, taxes, and many other business needs and trends. When businesses need to borrow money, the Federal Reserve's actions are paramount to the overall process.

The risk associated with interest in both the public and the private sector is controlled by these banking institutions including the Federal Reserve Bank. Consider that there are both banks and non-banks that participate in the United States. Banks are made up of commercial banks, savings & loan associations, mutual savings banks, and credit unions. The majority of the lending and credit surprisingly is not handled by banks.

One of the biggest stakes in interest rate risk management in the United States is actually handled by institutions considered to be non-banks. These consist of finance companies, mortgage companies, insurance companies, pension funds, and investment banks. The difference between banks and non-banks is that non-banks do not accept demand deposits and therefore do not participate in the United States Payment System. This distinction is mute because these non-banks success is vital to our way of life in regard to interest rate risk management because they hold nearly eighty percent of all lending opportunities. Consider the impact of insurance companies who underwrite premature death risks and are selling annuities. The interest rates are a major aspect of their business and demand may be changing in the future.