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ABSTRACT
This paper examines the role interest rate risk played in the performance of financial institutions during a period of financial crisis in the Jamaican economy in the late 1990s. The economic environment during this period was characterized by highly volatile interest rates, liberalization of the foreign exchange market and deregulation in the banking sector. We examine the changes in net interest margin and the market value of equity of the commercial banks. We find that changes in net interest margin and changes in market value of equity are positively related to changes in market interest rates. These results partially explain the severe profitability and solvency problems that the commercial banks experienced in the late 1990s, after the government drastically reduced market interest rates. We also find that bank management moved, to alleviate pressure on solvency by adjusting the asset and liability mix but was not able to effect a significantly positive outcome for bank profitability and solvency.
Research into the management of financial institutions focuses on theories that explain the use of actions that identify and minimize risks related to interest rates, liquidity, technology and operational events (Sinkey 2002). Larger financial institutions in developed economies use a range of sophisticated, off-balance sheet techniques, such as interest rate swaps, forwards, futures and derivatives. Smaller banks in developed economies and banks in developing countries, with less access to off-balance sheet, techniques, rely on the management of assets and liabilities to minimize risk (Lai and Hassan 1997).
The focus of this paper is the effect of interest rate risk on banks in an emerging economy, answering the question "can the management of interest rate risk alleviate pressure on the financial sector of an emerging economy at risk?" The failure to manage and monitor risk can lead to profitability and solvency problems (Lai and Hassan 1997), Given the restricted access to financial tools available to management in an emerging economy, the potential for system-wide effects is greater than in developed countries, which can put fragile economies at greater risk. Financial institutions in developing countries play a larger role in the economy when gross domestic product (GDP) has a comparatively low base and a low growth rate. In order to examine the research question we set our study...