Chapter 5 – Interest Rate Risk-Management

Interest rate risk is the exposure of a bank’s financial condition to adverse- movements in interest rates. In other words, it means the volatility in net interest income (NII) or variations in net interest margin (NIM). The changes in interest rate affect a bank’s earnings by changing bank’s net interest income and the level of other interest sensitive income and operating expenses

Types of interest rate risk

It can be (a) mismatch or gap risk (b) basis risk (c) net interest position risk (d) embedded option risk (e) yield curve risk (f) price risk and (g) reinvestment risk.

  1. Mismatch or Gap risk : The gap is the difference between the amount of assets and liabilities, on which the interest rates are reset during a given period. It arises due to holding of assets and liabilities with different principal amounts, maturity dates or re-pricing dates as explained below: A bank has 8% liabilities of Rs.10 cc with one year maturity to fund a term loan of Rs.I0 cc with two years’ maturity at 10% interest. Hence, bank is earning a spread of 2% during the first year, but it is not certain for the 2″d year. Since deposits will have to rolled over at a new rate or new deposits have to contracted to fund the IL, the bank is exposed to interest rate risk.
  2. Basis risk : When the interest rates of different assets and liabilities change in different magnitude, it is called basis risk. Even when the maturity an asset and a liability falls at the same time interval, there could be risk, as the interest rates on liability and assets may change by different magnitude.
  3. Net interest position risk : Net interest position of the bank exposes the bank to additional interest rate risk. Bank having more assets on which it earns interest than the liabilities on which it pays interest, its interest earning will change with change in interest rate on assets without any change in interest rate on liabilities. Hence, with decline in interest rates. The bank having positive net interest position, will experience reduction in NII.
  4. Embedded option risk : When market interest rates change substantially, such situation leads to large scale prepayment of loans or pre-mature withdrawals of deposits. For example a bank funds a short term loan of 180 days with If% through a 180 days certificate of deposit at 9%. After 2 months, the borrower makes pm-payment of the Loan and the bank re-invests the repaid money at 10%. Hence, the bank get 2% spread for 2 months only, while for the remaining period, the spread is 1% only.
  5. Yield Curve Risk : Yield curve is a line on a graph that indicates (plots) the yield of all maturities of a particular instrument. For example Popular Bank used a 2 year floating rate FD for funding a 2 year corporate loan at floating rate (repricing done quarterly). Bank pays 100 basis points above the 182 days treasury bill rate of 7.5% on the deposit and recovers 300 basis points above the 364 days’ treasury bill rate of 7%, thus getting a spread of 2.5%. If the 364 treasury bill rate increases to 350 basis points, while the rate of 182 days TB remains constant, there will be change in the yield curve.
  6. Price Risk : When an asset (say a bond) is staid before maturity, the price risk arises. If the current interest rates go up, a bond will get lower price on sale if the coupon rate of the bond at the time of issue was lower than the presently prevailing interest rate.
  7. Reinvestment Risk : Uncertainty with regard to interest rate at which the future cash flows can be reinvested is called reinvestment risk.

Effect of interest rate risk

When interest rates change, these bring change in the (a) earning of the bank and (b) also the economic value.

  1. Effect on earning: Interest rate change affect the Net Interest Income and impact the overall earning. Similarly, there may be change in non-interest income from many activities that are based on fund based activities, when there is decline in fund based business due to change in interest rates_ For example, if there is decline in interest rates, the bank may experience fail in fund based business. In that case, the fee based business dependent on fund based business, may also experience decline and affect the earning.
  2. Effect on economic value : When there is change in the interest rate, the market value of existing asset (say a bond) may change. For example, if a bank has invested in 8% govt. bonds and current market rate of interest moves to 10%, the value of investment in 8% bond will decline, for which bank will have to make depreciation provision also.
  3. Embedded Losses : The earnings and economic value perspectives discussed thus far focus on how future changes in interest rate may affect a bank’s financial performance. When evaluating the level of interest rate risk, it is willing and able to assume, a bank should also consider the impact that past interest rates may have on future performance. In particular, instruments that are not marked to market may already contain embedded gain or losses due to past rate movements. These gain or losses may be reflected over time in the bank’s earning.

Interest Rate Risk Measurement

Degree of risk to which a bank is exposed can be measured only if the quantum of risk inherent in bank balance sheet is measured. For this purpose, the bank has to assess all material interest rate risk associated with a bank’s assets and liabilities and off-balance sheet position.

There are various techniques to measure the interest rate risk which include (a) repricing schedules (b) gap analysis (c) duration and (d) simulation approaches.

  1. Repricing schedules: It is the simplest form of measuring interest rate risk_ This schedule distributes interest sensitive assets, liabilities and off-balance sheet items into a certain no. of predefined time bands according to their maturity (if fixed rate of interest) and according to their repricing time (for floating rate of interest).
  2. Gap analysis: For evaluation of earning exposure, the interest rate sensitive liabilities in each band are subtracted from the corresponding interest rate-sensitive assets to produce a repricing gap for that time band. This gap can be multiplied by an assumed change in interest rates to yield an approximation of the change in net interest income that would result from such rate move. A liability sensitive (or negative) gap takes place when liabilities are more than assets in a given time band. In such situation, the increase in market interest rates can cause a decline in net interest income. An asset-sensitive (or positive) gap takes place when the assets are more than liabilities in a given. time band. In such situation, the decrease in market interest rates can cause decline in net interest income.
  3. Duration : Duration is a measure of the %age change in the economic value of a position that will occur given a small change in the level of interest rates. It reflects the timing and size of cash flows that occur before the instrument’s __contractual maturity. For a small payment, longer maturity instrument, the duration would be higher. The higher duration means that a given change in the level of interest rates will have a larger impact on economic value.
  4. Simulation : Banks using complex financial products, make use of advanced interest risk measurement techniques (rather than simple maturity schedule method). Simulation technique is an extension and refinement of simple analysis based on maturity schedule. But it involves a detailed breakdown of various categories of on and off-balance sheet position, with a view to incorporate assumptions about interest and principal payments. The simulation techniques could be static or dynamic.
    1. Static simulation : In this, the cash flows arising solely from bank’s current on and off-balance sheet positions are assessed. To make an estimate of exposure of earnings, simulations for cash flows and resulting earnings streams are conducted on the basis of different assumptions of interest rate. The change in the economic value can also be calculated by discounting those cash flows backto their present value.
    2. Dynamic simulation : This simulation is build with more detailed assumptions about future course of interest rates and expected changes in a bank’s business activity.
    3. Embedded assets / liabilities: Measuring interest rate risk may become difficult where there is no contractual maturity (like in cash of saving bank or current account) or demand loans or loans with prepayment facilities.

Strategies for controlling Interest Rate Risk

Banks follow various strategies to limit the shocks of interest rate volatility. But the basic strategy has been focusing on bridging the gap between rate sensitive assets and rate sensitive liabilities. Banks try to match the assets and liabilities maturities as closely as possible to reduce the gap to zero.

The strategy for reducing the sensitivity could be as under:

Asset sensitivity :

  • Extension in investment portfolio maturities
  • Increasing the floating rate deposits
  • Increasing the fixed rate lending
  • Selling the floating rate loans
  • Increasing the short-term borrowings,
  • Increasing the long term lending.

Liability sensitivity :

  • Reduction in investment portfolio maturities
  • Increasing the float rate lending
  • Increasing the long term deposits
  • Increasing the short term lending.

Other options :

  • Match long term assets with non-interest bearing liabilities
  • Match re-priceable assets with similar re-priceable liabilities
  • Make use of forward rate agreements, swaps, options and financial futures.
  • Sound loading policies and affective post sanction monitoring and recovery steps can contain the volume of NPAs. Large volume of NPA in the balance sheet entails carrying of non-interest earing assets, funded out of volatile liabilities.

Control and supervision of Interest Rate Risk management

An effective system of internal control for interest rate in a bank include

  • A strong control environment
  • Adequate process for identifying and evaluating risk
  • Establishment of control activities such as policies, procedures and methodologies
  • Proper information systems
  • Continuous review of compliance of policies and procedures.

Sound Interest Rate Risk management practices

It involves use of 4 basic elements

  • Proper Board and senior management oversight
  • Adequate risk management policies and procedures
  • Proper risk measurement, monitoring and control functions
  • Comprehensive internal controls and independent audits.

Role of Board : To approve strategies and policies and ensure that senior management takes steps necessary to monitor and control these risks in line with the approved policies.

Role of senior management : To ensure that the limits on risk taking are complied with, systems and standards for measuring risk-are put to place, there is effective review process, there is effective internal effective control.

Role of other functionaries : Individuals and committees should be clearly named and given responsibility for managing interest rate risk. There should be appropriate separation of their duties. Lines of authority and responsibility for developing strategies, implementing them and conducting the risk measurement and reporting functions should be clearly defined.

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