HOW BANKING WORKS · INTEREST AND PRICING 25
A fixed rate does not remove interest-rate risk. It decides who carries more of it.
Borrowers often frame the choice as simple: fixed means safe, floating means risky. Banking sees a more precise question. Interest rates can change whether the customer’s contract changes or not. If the borrower’s rate is fixed while the bank’s funding cost rises, the borrower is protected for that fixed period and the bank carries more repricing risk. If the borrower’s rate floats with a benchmark, more of the rate movement passes through to the borrower.
The important idea is allocation. A contract can move risk between parties, but it cannot make the economic uncertainty disappear.
This article begins Batch 07 under the canonical How Banking Works hub: interest and pricing.
What a fixed rate actually fixes
A fixed-rate loan sets the contractual interest rate for a defined period. That period may be the entire loan or only an initial segment.
If a borrower signs a five-year loan at 4 per cent fixed for all five years, the contractual rate does not move merely because market rates rise to 6 per cent or fall to 2 per cent. The borrower gains payment predictability. The bank gives up the ability to reprice that asset during the fixed period unless the contract contains specific reset or prepayment terms.
Fixed therefore means fixed according to the contract for a stated horizon, not “immune from every financial consequence.”
What a floating rate actually floats against
A floating-rate loan usually combines a reference rate or benchmark with a contractual spread.
customer rate = reference rate + contractual spread
The benchmark can change over time. The spread may remain fixed unless another contractual condition changes. As the benchmark moves, the borrower’s interest expense generally moves with it according to the reset schedule.
The exact benchmark, observation method, floor, cap, reset frequency and fallback rules all matter. “Floating” describes a family of structures rather than one universal product.
The borrower’s risk corridor
| Rate structure | Borrower benefit | Borrower risk |
|---|---|---|
| Fixed | Predictable contractual rate during fixed period | May pay above market if rates fall; refinancing or early repayment may have costs |
| Floating | Can benefit if benchmark rates fall | Payment burden can rise if benchmark rates increase |
The right structure therefore depends on the borrower’s cash-flow resilience, horizon and tolerance for uncertainty. This article explains the mechanism; it does not recommend one product over another.
The bank’s risk corridor is the mirror image
Suppose a bank makes a five-year fixed-rate loan at 4 per cent. If the bank funds itself with deposits that reprice quickly and deposit costs rise from 1 per cent to 4 per cent, the loan still earns 4 per cent while funding becomes much more expensive.
The borrower’s payment stability has become the bank’s margin compression.
By contrast, a floating-rate loan can reprice upward when benchmarks rise. That can protect part of the bank’s interest income—but it also increases the borrower’s debt-service burden and can raise credit risk.
Risk therefore moves rather than disappears.
A simple fixed-rate example
A bank lends S$1 million at 4 per cent fixed. At origination, its effective funding cost for the relevant horizon is 2 per cent. Ignoring other costs, the initial interest spread is 2 percentage points.
One year later the bank’s funding cost rises to 3.5 per cent while the loan remains fixed at 4 per cent. The spread has narrowed to 0.5 percentage points before operating cost, credit risk and capital cost.
The customer’s contract worked exactly as designed. The bank’s balance sheet is where the rate movement appears.
A simple floating-rate example
Now imagine a S$1 million loan priced at a reference rate plus 1.5 percentage points. The benchmark begins at 2 per cent, giving the borrower a 3.5 per cent rate. Later the benchmark rises to 4 per cent, so the customer rate becomes 5.5 per cent at the next contractual reset.
The bank has passed through much of the market-rate increase. But the borrower’s payment rises. If the borrower had little cash-flow headroom, the bank has reduced interest-rate margin risk while increasing the probability of credit deterioration.
That is why banking risk cannot be managed one label at a time.
Fixed-rate loans create economic value changes even before cash flows change
When market rates rise, the present value of a fixed stream of lower-rate cash flows generally falls. The borrower may still pay every instalment exactly on time, but the economic value of the asset changes relative to current market yields.
This is one reason banks monitor both accounting income and economic-value sensitivity. A loan can be performing perfectly and still contribute to interest-rate risk.
Prepayment creates another layer of rate risk
If market rates fall, a borrower with a fixed-rate loan may want to refinance at a lower rate. If prepayment is allowed cheaply, the bank can lose a valuable higher-yielding asset precisely when rates have fallen.
If rates rise, the borrower is less likely to refinance, so the bank remains locked into the lower fixed rate for longer.
This asymmetry is called optionality. It means the borrower’s behaviour changes the effective maturity of the bank’s asset.
Floating-rate loans can contain floors and caps
A floor can prevent the contractual rate from falling below a defined minimum even if the benchmark falls further. A cap can limit how high the rate can rise.
Those features alter who carries extreme rate movements. A floor protects part of the lender’s income. A cap protects the borrower from unlimited contractual increases above the cap. Both have economic value and can affect pricing.
Reset frequency matters
A loan that resets every month responds to market rates much faster than one that resets every six or twelve months. Even two floating-rate loans can therefore carry different repricing risk.
The bank looks not only at whether an instrument is fixed or floating but at when its next price change can occur.
Funding has its own repricing clock
Assets and liabilities rarely reprice together perfectly. A bank can hold mortgages that reset annually while deposits reprice in days. Or it can hold short-term floating loans funded by longer-term fixed debt.
The difference between those clocks creates repricing risk. Article 28 in this batch follows that mechanism across the whole balance sheet.
Rate risk can become credit risk
A floating-rate structure can protect the bank’s asset yield as rates rise. But if borrower instalments rise too far, delinquency and default risk can increase.
This creates a trade-off:
more repricing passed to borrower → less immediate margin pressure for bank → potentially more borrower cash-flow pressure.
Interest-rate risk management therefore cannot ignore underwriting quality.
Rate risk can become liquidity risk too
When market rates rise sharply, depositors can move money toward higher-yielding accounts or competing institutions. The bank may need to raise deposit rates to retain funding. That increases funding cost quickly.
If the bank’s assets are long-term and fixed-rate, income may adjust slowly while liability costs adjust rapidly. Margin pressure can then combine with deposit outflow risk.
This is why rate risk sits inside a larger funding and liquidity system.
Hedging can move the risk again
Banks can use derivatives such as interest-rate swaps to transform fixed-rate exposure into floating exposure or vice versa. A fixed-rate loan can therefore be economically hedged even though the customer’s contract remains fixed.
But hedging creates its own basis, counterparty, collateral, valuation and operational risks. The bank has not erased uncertainty; it has transferred and reshaped it.
Why the borrower’s horizon matters
A borrower expecting to repay or refinance in one year may value certainty differently from one carrying debt for twenty years. A household with very stable income may tolerate floating-rate variation better than one with thin monthly surplus.
The product name therefore cannot answer the suitability question. The rate structure must be read against the borrower’s cash-flow horizon and contractual flexibility.
Four misconceptions to remove
| Misconception | Better model |
|---|---|
| “Fixed rates eliminate rate risk.” | They stabilise the borrower’s contractual rate while moving more repricing risk to the bank for the fixed period. |
| “Floating rates are always cheaper.” | The outcome depends on benchmark movements, spread, floors, caps and timing. |
| “A performing fixed-rate loan creates no interest-rate risk.” | Its economic value and relative yield can change as market rates move. |
| “Passing rate changes to borrowers makes the bank safer.” | It can reduce margin risk while increasing borrower credit risk. |
A mastery test
- What exactly is fixed in a fixed-rate loan?
- What components usually form a floating customer rate?
- Why can a bank lose margin on a fixed-rate loan when market rates rise?
- How can floating rates turn rate risk into credit risk?
- Why does prepayment make the effective life of a fixed-rate asset uncertain?
If those answers connect, fixed versus floating stops being a prediction game about where rates will go. It becomes a question about where rate uncertainty lives inside the contract and balance sheet.