Banks hedge interest rate risk by reshaping their own balance sheets, buying and selling derivatives like swaps, caps, floors, and futures, and moving loans off their books entirely through sales and securitization. Each technique attacks the same underlying problem: deposits reprice in weeks while fixed-rate loans lock in returns for decades, and that mismatch can crush the gap between what a bank earns on its assets and what it pays for its funding — its net interest margin — the moment rates move the wrong way.
Matching Assets and Liabilities
The first line of defense is structural. A bank tries to arrange its assets and liabilities so both respond to rate changes at roughly the same speed. On the funding side, that can mean pushing depositors toward two-year or five-year certificates of deposit, which lock in a cost for a known period. On the lending side, it can mean favoring adjustable-rate mortgages over fixed-rate ones. Adjustable-rate loans reprice at set intervals after an initial fixed period, so the interest they generate climbs when market rates climb.1Consumer Financial Protection Bureau. Consumer Handbook on Adjustable-Rate Mortgages
To know whether the mix is working, banks track exposure two ways. Net interest income (NII) sensitivity estimates how much short-term earnings would change if rates rose or fell by 100 or 200 basis points. Economic value of equity (EVE) takes the longer view, calculating how the present value of all future cash flows would shift under the same shock.2Federal Deposit Insurance Corporation. Section 7.1 Sensitivity to Market Risk A bank can look fine on the short-term measure while sitting on deep unrealized losses that only an EVE analysis exposes. That distinction proved catastrophic in 2023.
The Asset-Liability Committee
Most banks centralize these decisions in an Asset-Liability Committee, known as ALCO. Senior executives from treasury, lending, and risk management sit on it, set the bank’s tolerance for interest rate risk, review models and forecasts, and approve hedging strategies. ALCO also maintains the contingency funding plan that describes how the bank would access liquidity under stress.3Partnership for Progress. Asset/Liability Management Committee
Federal regulators expect this framework to be formal and documented. The Office of the Comptroller of the Currency requires national banks to establish risk governance frameworks with concentration limits and front-line risk limits covering interest rate exposure.4eCFR. 12 CFR Part 30 – Safety and Soundness Standards The OCC, Federal Reserve, and FDIC have jointly told banks to size those processes to their own complexity and risk profile.5Office of the Comptroller of the Currency. Interagency Advisory on Interest Rate Risk Management Banks that fall short face closer supervision and can be forced to hold more capital.
Interest Rate Swaps
When balance sheet adjustments alone are not enough, banks reach for interest rate swaps, the most widely used hedging derivative in commercial banking. In a typical swap, a bank holding 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 reflects 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 market rates. If rates climb, the bank collects larger floating payments that offset the rising cost of its deposits. No principal changes hands. The two parties settle only the net difference each period, so a bank can hedge a $500 million slice 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.7Office of the Law Revision Counsel. 7 U.S. Code 2 – Jurisdiction of Commission Central clearing reduces the risk that one party’s failure cascades through the system, and the trades are reported to repositories so regulators can watch for concentrated exposures.
Caps, Floors, and Collars
Where swaps lock in a fixed exchange, caps and floors work more like insurance with a defined trigger. A bank buys a cap by paying an upfront premium. If the reference rate rises above a set strike, the counterparty pays the bank the difference. The downside is limited to the premium, and the bank still benefits if rates stay low. Caps are especially useful for protecting against rising funding costs on short-term or variable-rate debt.
Floors run the other way. A bank holding adjustable-rate loans might buy a floor to guarantee a minimum return even if market rates fall sharply. If the benchmark drops below the strike, the counterparty pays.
Banks sometimes combine the two into a collar, buying one and selling the other. The premium received from selling the floor offsets part of the cost of the cap. The tradeoff is that the bank gives up some benefit if rates fall below the floor it sold.
Forwards 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 beginning three months from now. On the settlement date they compare the agreed rate to the actual market rate and one side pays the other the difference. FRAs give treasury teams precise control over future funding costs without committing to an actual loan or deposit today.
Interest rate futures serve the same purpose but trade on public exchanges. The Chicago Mercantile Exchange lists Treasury bond futures, federal funds futures, and SOFR futures.8CME Group. Interest Rates Products Because the exchange guarantees every trade and requires daily margin settlements, futures carry far less counterparty risk than over-the-counter forwards. A bank expecting rates to rise can short Treasury futures, profiting as bond prices fall and offsetting losses in its existing bond portfolio. The tradeoff is customization: futures come in standard sizes and maturities, so the hedge rarely matches the exposure exactly.
Selling the Risk Away
The most direct way to eliminate interest rate risk on a specific asset is to move it off the balance sheet. In a loan sale, a bank sells existing loans to another institution or investor for immediate cash. The buyer takes on the long-term rate exposure, and the bank frees up capital for new lending. Banks often keep the servicing rights, collecting fees for processing payments without bearing the underlying risk.
Securitization scales that idea up. A bank pools thousands of loans, usually mortgages, into an investment vehicle, slices the pool into tranches with different risk profiles, and sells the resulting securities to institutional investors. Fannie Mae and Freddie Mac, the two government-sponsored enterprises that dominate the secondary mortgage market, buy qualifying mortgages from lenders and package them into mortgage-backed securities with a guarantee of timely principal and interest.9Federal Housing Finance Agency. About Fannie Mae and Freddie Mac That guarantee widens the pool of investors willing to buy mortgage debt and lets banks recycle their lending capacity.10Freddie Mac. Understanding Mortgage-Backed Securities
A bank that securitizes loans cannot simply walk away, however. 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 it cannot hedge away or transfer that retained slice.11Office of the Law Revision Counsel. 15 USC 78o-11 – Credit Risk Retention The “skin in the game” rule, enacted after the 2008 financial crisis, keeps the bank’s interests aligned with the investors buying the securities.
The Limits of Hedging
No hedge eliminates interest rate risk. It converts one kind of risk into a smaller, more manageable one. The residual is called basis risk: the chance that the hedge instrument and the hedged exposure do not move in lockstep. It appears when a bank’s assets and its swap reference different rate indexes, or when the spread between those indexes shifts unexpectedly. A bank funded by deposits tied to the prime rate and hedged with a SOFR-based swap faces basis risk if the gap between prime and SOFR widens.
Hedging also depends on the people using it. Silicon Valley Bank’s 2023 collapse showed what happens when governance breaks down. SVB had poured depositor funds into long-duration government bonds and mortgage-backed securities while rates were low, then removed the interest rate hedges that would have protected it and adjusted internal model assumptions so the exposure looked smaller without any actual reduction in risk. Management focused on short-term NII sensitivity, which showed the bank as “asset sensitive” and positioned to gain from rising rates, and ignored the EVE metric that would have exposed deep unrealized losses. SVB had breached its own long-term interest rate risk limits repeatedly since 2017, and management loosened the limits rather than cut the exposure.12Federal Reserve Board. Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank The tools work only when the ALCO process, independent risk review, and board oversight enforce them.
Stress Tests and Tax Rules That Shape Hedging
Large banks face annual stress tests that check whether their hedges would hold up under extreme scenarios. Banks with more than $250 billion in total consolidated assets must complete the Dodd-Frank Act Stress Test and report results to the OCC every year.13Office of the Comptroller of the Currency. DFAST14A 2026 Reporting Instructions The Federal Reserve publishes the scenarios they must model, and a bank whose hedging leaves it dangerously exposed under a severely adverse scenario can be forced to restrict dividends, halt share buybacks, or raise more capital.14Federal Reserve Board. 2026 Stress Test Scenarios
Tax rules push in the same direction: hedge properly or lose the treatment. Under federal tax law, gains and losses on qualifying hedging transactions are treated as ordinary income or ordinary loss rather than capital. To qualify, the transaction must be entered into in the normal course of business primarily to manage risk on borrowings or ordinary property like loans.15eCFR. 26 CFR 1.1221-2 – Hedging Transactions The identification requirement is strict. The bank must clearly designate a transaction as a hedge before the close of the business day on which it is entered into.16Internal Revenue Service. PLR 202601013 A transaction undertaken for speculation, even one that happens to offset a balance sheet risk, does not qualify and gets capital treatment instead. Same-day documentation and clear risk-management policies are part of the hedge, not paperwork after it.