banks and interest rate risk

8/14/2019 Banks and Interest rate risk

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Broad issues

Banks and interest rate risk p. 2/


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Interest rates dropped dramatically...

10-09-1997 25-05-1998 28-01-1999 05-10-1999 17-06-2000 03-03-2001 10-11-2001 19-07-2002

Time

6

8

10

12

14 10 years



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NPV of a bank

We convert assets into cashows a i and liabilities intocashows li . Then:

A(0) =N

i=1

a i

(1 + z(t i))t i

L(0) =N

i=1

li

(1 + z(t i))t i



5/42

If interest rates went up?

If we get a parallel shift of the yield curve of :

A() =N

i=1

a i(1 + + z(t i)) t i

L() =N

i=1

li(1 + + z(t i)) t i

The impact upon equity capital is(A() A(0)) (L() L(0)) .



6/42

Think NPV, think MTM!

A great deal of confusion comes out of the earningsperspective.

In terms of core economics, we need full MTM of both assets and liabilities.In India, banking regulation, and many bankingprofessionals, do not yet think MTM, do not yetthink NPV.



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Problem 1: Reduce a bank into a setof cashows



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Imputation of cashows

Life would be very easy if:1. The banking regulator asked banks to report

cashows for assets and liabilities in timebuckets, and2. Made these disclosures public.



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Repricing date versus maturity

If a loan to a company is PLR-linked, its really sixmonth maturity, regardless of the loan duration.

Assets and liabilities can be classied by time torepricing or time to maturity.



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r v r u v m n -posits

Technically, savings accounts and current accountsare maturity 0.

In practice, there is a lot of stability.One can own some long assets, backed by demanddeposits, and be safe.How much is core? How much is volatile?


t


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ere we stan n n a on sc o-sure

Banks are required to classify assets by time tomaturity (but not repricing), and show this in the

annual report.Banks are required to classify assets by time torepricing, and submit this to RBI, but this is not

publicly released.NYSE has superior disclosure standards, so ICICIBank and HDFC Bank release good data.

There is no attempt at disclosing cashows .



12/42

How to make progress?

Complicated algorithms to impute cashows out of public domain disclosure.

500 lines of perl.See Interest rate risk in the Indian banking system ,by Ila Patnaik and Ajay Shah.

http://www.mayin.org/~ajayshah/PDFDOCS/PatnaikShah2002_banks_irates.pdfhttp://www.mayin.org/~ajayshah/PDFDOCS/PatnaikShah2002_banks_irates.pdf


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xamp e o cas ows or(31/3/2002)

(Rs. crore)

Bucket Assets Liabilities

Zero 12409 342620-1mth 41659 8053

1-3mth 18382 51133-6mth 21927 74836-12mth 87411 154211-3yrs 43282 1742293-5yrs 31882 55414

> 5yrs 80285 9944Banks and interest rate risk p. 13/


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Problem 2: What shocks to worryabout?



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BIS Proposal

Look at ve years of daily data for the long rate.Compute the time-series of change-over-one-year

Take the 1th and 99th percentile of this distribution.



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Using Indian data

The NSE ZCYC database allows us to do this.We use 1/1/1997 - 31/7/2002.

In India, there are 288 days per year.The shock to worry about is 320 bps.



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One of the worlds highest IR vol

Rank Country Volatility

1 Turkey 32.932 Chile 1.743 India 1.72

4 Mexico 1.365 U.K. 0.916 Indonesia 0.887 Poland 0.818 Philippines 0.77

Source: Baig (2001), IMF Working Paper, out of list of 25 countries.Banks and interest rate risk p. 17/


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Method 1: Casual perusal of gaps



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Look at them:

Note: these are cashows.(Rs. crore)

Bucket Assets Liabilities

Zero 12409 34262

0-1mth 41659 80531-3mth 18382 51133-6mth 21927 74836-12mth 87411 154211-3yrs 43282 1742293-5yrs 31882 55414> 5yrs 80285 9944



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Does not get the job done

Is SBI carrying a signicant risk?What would happen if interest rates went up by 320

bps?Does SBI have enough equity capital to absorb this?

A casual perusal of gaps does not convey the materialityof mismatches (if any).



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Method 2: Measure the NPV impactof a shock



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Method 3: Duration



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Fisher-Weil duration

The sensitivity of PV to a parallel shift of :

P () =N

i=0

cie (r i + )t i

P ()

= N

i=0

t icie r i t i

1P (0)

P ()

= D FW

where D FW = ( t icie r i t i )/ PV.Banks and interest rate risk p. 24/

ur n r r r y r p-


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ur n r r r y r pproximation

For small shocks it gives a reasonable predictionof what will happen to PV.



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A bad idea for us

-40

-30

-20

-10

0

10

20

30

40

50

60

-400 -300 -200 -100 0 100 200 300 400

I m p a c

t u p o n

S B I ( b i l l i o n r u p e e s

)

ExactDuration-based



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Method 4: The stock market



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e-express t e ong nterest rate as


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p greturns

On the ZCYC, the long rate goes up from r 1 on day1 to r 2 on day 2.

The log returns on the bond, where the bond pricegoes from p1 to p2 is:

log( p2/p 1) =

T (log(1 + r 2)

log(1 + r 1))


A d k d l


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Augmented market model

(r j r f ) = + 1(r M r f ) + 2(r L r f ) +



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SBI

0.108(0.218)

1 0.8369(6.402)

2 0.8359(2.316)R2 0.3732T 104

Speculative position on core business of SBI:long SBI futures, short Nifty futures, short 10-yearbond futures. Banks and interest rate risk p. 31/


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Results


u y u n v x-


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yposure

BIS says that we should worry about banks whereover 25% of equity capital would be gained/lost inthe +320 bps move.Our results use accounting data for year ended31/3/2002.

This holds for 33 of 42 banks in our sample. SBIand ICICI are not in this group.7 have reverse exposures, 26 have normal

exposures.



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Policy issues


d l


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Poor disclosure

RBI rules require valuation at min(MTM, purchaseprice).

Hidden reserves.Source of fog and confusion.Banks may not hedge a security at book value of Rs.110 and market value of Rs.120.


Di l f h


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Disclosure of cashows

Fixed income analytics starts from cashows.It shouldnt be a struggle to get to cashows.


Frequency


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Frequency

Annual disclosure is highly unsatisfactory.We should have daily MTM and daily disclosure.


IFR


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IFR

Hierarchy:

Natural hedges,

Derivatives,Equity capital.

IFR ignores the larger context and assumes thesecurities portfolio is the only thing.IFR thinks all banks are alike.

IFR is to be built up in ve years.


Better tools for supervision


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Better tools for supervision

Do such computations to isolate weak banks.Use stock market coefcients to isolate weak banks.


IRD k t


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IRD market

We need an interest rate derivatives market.Modern architecture: Bank owns the customer, lays

off the interest rate risk.



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Also see


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Also see

Web page on Indian xed income:http://www.mayin.org/~ajayshah/FIXEDINCOME/index.ht

http://www.mayin.org/~ajayshah/FIXEDINCOME/index.htmlhttp://www.mayin.org/~ajayshah/FIXEDINCOME/index.html

banks and interest rate risk

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