Interest Rate Risk in Banking

We develop a theoretical and empirical framework to estimate bank franchise value. In contrast to regulatory guidance and some existing models, we show that sticky deposits combined with low deposit rate betas do not imply a negative duration for franchise value. Operating costs could in principle generate negative duration, but they are more than offset by fixed interest rate spreads that arise largely from banks’ lending activity. As a result, bank franchise value declines as interest rates rise, and this decline exacerbates, rather than offsets, losses on banks’ security holdings. We also show that in the cross section, banks with the least responsive deposit rate tend to invest the most in long-term securities, suggesting that they are motivated to hedge cash flows rather than market value. Finally, despite significant losses to both asset and franchise values stemming from recent rate hikes, our analysis suggests that most U.S. banks still retain sufficient franchise value to remain solvent as ongoing concerns.