Banks hedge interest rate risk by reshaping their own balance sheets, entering derivatives contracts like swaps and caps, and selling or securitizing loans to move the exposure elsewhere. The core problem is a duration mismatch: deposits reprice in weeks, while fixed-rate mortgages lock in returns for decades. When rates shift, that gap can compress the margin between what a bank earns on loans and what it pays for funding. Every commercial bank has to actively manage it.
Measuring the Exposure First
Before choosing a hedge, a bank measures how sensitive it is to a rate move. Two metrics do most of the work. Net interest income (NII) sensitivity estimates how short-term earnings would change if rates rose or fell by a set amount, typically 100 or 200 basis points. Economic value of equity (EVE) takes the longer view, calculating how the present value of the bank’s future cash flows would shift under the same shock.1Federal Deposit Insurance Corporation. Section 7.1 Sensitivity to Market Risk
The two can tell very different stories. A bank can look healthy on NII while sitting on deep unrealized losses that only EVE would surface. That distinction matters because federal regulators expect institutions to run both, with governance frameworks and risk limits scaled to the bank’s size and complexity.2eCFR. 12 CFR Part 30 – Safety and Soundness Standards3Office of the Comptroller of the Currency. Interagency Advisory on Interest Rate Risk Management Most banks route those decisions through an Asset-Liability Committee (ALCO), which sets tolerances, reviews forecasts, and approves hedging strategy.4Partnership for Progress. Asset/Liability Management Committee
Reshaping the Balance Sheet
The most fundamental hedge is changing the mix of what the bank owns and owes so that assets and liabilities respond to rate changes at similar speeds. On the funding side, that can mean pushing depositors toward two-year or five-year certificates of deposit, converting short-term liabilities into longer-term ones with fixed cost. On the lending side, it can mean prioritizing adjustable-rate mortgages over fixed-rate loans. Adjustable-rate loans reprice at set intervals, so interest income rises alongside market rates.5Consumer Financial Protection Bureau. Consumer Handbook on Adjustable-Rate Mortgages
These adjustments are slow. They work at the pace new deposits are gathered and new loans are booked, which is why banks rarely rely on balance sheet changes alone.
Interest Rate Swaps
When balance sheet work isn’t enough, swaps do most of the heavy lifting. In a typical swap, a bank with a large book of fixed-rate loans agrees to pay a fixed rate to a counterparty and receive a floating rate in return. The floating leg is usually tied to the Secured Overnight Financing Rate (SOFR), which tracks the cost of borrowing cash overnight against Treasury collateral.6Federal Reserve Bank of New York. Secured Overnight Financing Rate Data
The effect is to convert a fixed-rate asset into one that tracks the market. If rates climb, the bank receives larger floating payments that offset rising deposit costs. No principal changes hands; the parties settle the net difference each period. A bank might use a swap with a notional amount of $500 million to hedge part of its mortgage portfolio without selling a single loan.
Federal law requires most standardized swaps to be submitted for clearing through a registered derivatives clearing organization, and the trades must be reported so regulators can watch for concentrated exposures.7Office of the Law Revision Counsel. 7 U.S. Code 2 – Jurisdiction of Commission
Basis Risk
No hedge is perfect. Basis risk is the chance that the hedge and the exposure don’t move together, usually because they reference different rate indexes or because the spread between those indexes shifts. A bank funding itself with deposits that track the prime rate but hedging with a SOFR-based swap faces basis risk if the two rates diverge. Hedging converts one type of risk into a smaller, more manageable one; it does not eliminate it.
Caps, Floors, and Collars
Where swaps lock in a two-way exchange, caps and floors behave like insurance with a defined trigger. A bank buys a cap by paying an upfront premium. If the reference rate rises above a preset strike, the counterparty pays the difference. The downside is capped at the premium, and the bank keeps the benefit if rates stay low. Caps are useful for protecting against rising funding costs on short-term or variable-rate debt.
Floors run the other direction. A bank holding adjustable-rate loans might buy a floor to guarantee a minimum return if market rates fall sharply. Both contracts run under the standardized documentation of the International Swaps and Derivatives Association (ISDA) Master Agreement, which sets the legal framework, default protections, and netting rules.8SEC.gov. ISDA 2002 Master Agreement
A bank can also combine a cap and a floor into a collar, buying one and selling the other. The premium from the sold leg offsets part of the cost of the bought leg. The tradeoff is giving up some upside on whichever side was sold.
Forward Rate Agreements and Futures
Forward rate agreements (FRAs) let a bank lock in a borrowing or lending rate for a specific future window. Two parties agree today on a fixed rate for, say, a three-month period starting three months out. On the settlement date, they compare the locked rate to the actual market rate and settle the difference in cash. FRAs give treasury teams precise control over future funding costs without committing to an actual loan or deposit today.
Interest rate futures do similar work but trade on public exchanges like the Chicago Mercantile Exchange, which lists Treasury bond futures, federal funds futures, and SOFR futures.9CME Group. Interest Rates Products The exchange guarantees each trade and requires daily margin settlement, so counterparty risk is far lower than in over-the-counter forwards. A bank that expects rates to rise can take a short position in Treasury futures, gaining on those contracts as bond prices fall and offsetting losses on its own bond holdings. The tradeoff is standardization: futures come in fixed sizes and maturities, so the hedge rarely lines up exactly with the exposure.
Loan Sales and Securitization
The most direct way to eliminate rate risk on a specific asset is to move the asset off the balance sheet. In a loan sale, a bank sells existing loans to another institution or investor for immediate cash. The buyer takes the long-term rate exposure; the seller frees up capital for new lending. Banks often keep the servicing rights, collecting fees for handling payments without carrying the underlying risk.
Securitization scales the same idea. A bank pools thousands of loans, typically mortgages, into a single vehicle, slices the pool into tranches with different risk profiles, and sells the resulting securities to institutional investors. Fannie Mae and Freddie Mac dominate the secondary mortgage market, buying qualifying mortgages from lenders and packaging them into mortgage-backed securities with a guarantee of timely principal and interest.10Federal Housing Finance Agency. About Fannie Mae and Freddie Mac That guarantee widens the investor base and lets banks continuously recycle their lending capacity.11Freddie Mac. Understanding Mortgage-Backed Securities
Banks that securitize can’t walk away entirely. Federal law generally requires the securitizer to retain at least 5 percent of the credit risk on assets that are not qualified residential mortgages, and the retained slice cannot be hedged away or transferred.12Office of the Law Revision Counsel. 15 USC 78o-11 – Credit Risk Retention This “skin in the game” rule, enacted after the 2008 crisis, keeps the bank’s interests aligned with those of the investors buying the securities.
What Happens When a Bank Doesn’t Hedge
The 2023 collapse of Silicon Valley Bank showed how the tools fail without governance behind them. SVB had put depositor funds into long-duration government bonds and mortgage-backed securities while rates were low. When the Federal Reserve began raising rates aggressively in 2022, the market value of that portfolio dropped by billions. Management had actually removed the interest rate hedges that would have cushioned the loss, and adjusted internal model assumptions to make the exposure appear smaller without reducing it.13Federal Reserve Board. Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank
The Federal Reserve’s post-failure review found that SVB focused almost entirely on short-term NII sensitivity, which showed the bank as positioned to benefit from rising rates, while ignoring the EVE metric that would have revealed the deeper losses. SVB had breached its own long-term rate risk limits repeatedly since 2017, and management responded by loosening the limits rather than cutting the exposure.13Federal Reserve Board. Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank
Tax Treatment of the Hedge
How a bank documents a hedge affects how it is taxed. Under federal tax rules, gains and losses on qualifying hedging transactions are treated as ordinary income or ordinary loss rather than capital. To qualify, the transaction has to be entered into in the normal course of the bank’s business, primarily to manage risk on its borrowings or on ordinary property like loans.14eCFR. 26 CFR 1.1221-2 – Hedging Transactions
The identification rule is strict. The bank must designate the transaction as a hedge before the close of the business day on which it is entered.15Internal Revenue Service. PLR 202601013 A trade undertaken for speculation, even one that happens to offset a balance sheet risk, does not qualify and gets capital treatment instead.14eCFR. 26 CFR 1.1221-2 – Hedging Transactions Same-day documentation and clear risk-management policies are therefore part of any real hedging program, not paperwork bolted on afterward.