• Banks use interest rate swaps.bank image by Pefkos from Fotolia.com
  
  Interest rate swaps, if used correctly, are a method by which financial institutions can manage risk and gain access to otherwise-inaccessible markets. However, by incurring debt obligations and introducing random variables, they do introduce new risks, which is of particular import considering the interest rate swap was designed for risk management in the first place.
  
  

Unpredictable Income

• If a bank pays a lot of its liabilities based on a fixed interest rate, but its assets are paying on a floating interest rate, this can create problems, as the cash flow from the assets is not always going to match the amount of cash owing on the liabilities. A bank can match its obligations with its income by swapping interest rates with another bank with the converse problem.
  
  So, if it swaps its fixed interest rate liabilities with another bank's floating interest rate liabilities, it is then paying off the other bank's debtors while the other bank pays off its debtors.
  
  The risk involved in this is the fact that the bank is now both paying and being paid according to floating interest rates. This means that rather than have the uncomfortable situation of substantially higher income than expenses one year followed by the converse in the next, it can have both at the same steady level.
  
  

Predictable Income Not So Good

• The bank that took on the fixed interest rate has the opposite problem. While its costs and income are now fixed, this means that should interest rates dramatically rise over time, the bank will lose out on profit. While it is shielded from the problems associated with interest rate fluctuations, it also loses out on the ability to capitalize on them. Risk is reduced in this case, but so is potential profit.
  
  

Other Party Failure

• Finally, interest rate swaps are agreements between two financial institutions. Since they are essentially agreeing to pay one another's bills, this means that should one party make some bad financial decisions and go bankrupt, the other party will lose a substantial portion of its income.
  
  The risk involved here is the fact that two or more banks are essentially tying their fortunes together. If one bank fails, the effects can be felt by every other bank it has interest swaps with.