The present study aims to ascertain whether a relationship exists between liquidity risk and the interest rate risk of credit institutions. By analyzing the balance sheet of a small Italian bank during the years 2009 and 2010, its liquidity profile, the variables that influenced its dynamics and their effects on the bank’s global management, with particular attention to the interest margin and the interest rate risk in the Banking Book, were outlined. Gaps identified in literature were filled by shedding light on how a set of decisions designed mainly to reduce liquidity risk and comply with the new parameters established by the Basel III Framework enables a more effective management of the regulatory capital and helps the bank to achieve a solid balance between profitability and solvency. The main findings of the study demonstrate that the bank succeeded in modifying its liquidity profile in order to comply with the incoming constraints imposed by the Basel III framework; the actions taken to reduce the liquidity risk also lowered its interest margin, but also enabled the bank to reduce the amount of capital absorbed by the interest rate risk, giving rise to a globally positive effect.

Among the reasons for the failure of bank management models amply highlighted by the effects of the economic crisis and partly facilitated by the regulations imposed by the banking supervisors, there is also the lack of an integrated and overall approach to banking activities capable of simultaneously assessing the fallout of any choices made on different risk domains.

An example of this situation comes from the securitization processes that have often led to looser credit risk assessment methods due to the assumption of a transfer to the market of loans and the postponement to a subsequent measurement by the rating agencies. In addition, the fact of holding sizable ‘tranches’ of bonds deriving from these processes, i.e., of investing in securities of separate operations, has been discussed more often in terms of their market risk profile, neglecting the related credit risk, although this becomes fundamental in determining the value, for instance, of Collateralized Debt Obligations (CDO) and Asset- Backed Securities (ABS). The inclusion of these instruments in the sole trading book represents an example of such policies.

Much the same can be said about the liquidity risk. While banks are naturally liable to this risk, the availability of an enormous mass of funds, low interest rates and apparently ever more efficient markets have led to its underestimation and to an exposure that has gradually grown as the crisis has become more severe (BCBS, 2010). With an increasing internationalization of the financial system and a rising pressure of competition, every intermediary had been obliged to seek a delicate equilibrium between a prudent and balanced term structure of the assets and liabilities while pursuing higher and higher levels of profitability. The result has been very different at different levels of exposure to the liquidity risk (Tarantola, 2008).

Financial Risk Management Journal, Liquidity, Risk, Interest, Rate Risk, Banks, Are They Related.