Management of interest rate risk in banks

MeaningInterest rate risk: It is the chance that an unexpected change

in interest rates will negatively effect the value of an investment.

A bank main source of profit is converting the liabilities of deposits and borrowings into the assets of loans and securities. It profits by paying a lower interest on its liabilities than it earn on its assets.

The difference in these rates is the net interest margin.

Sources of Interest Rate Risk

Re-pricing risk

Basis risk

Embedded option risk

Yield curve risk

This risk arises from holding the assets and liabilities with different principal amounts, maturity, or re-pricing dates, there by creating exposure to unexpected changes in the interest rates.

Example:Liability Asset Result3 month deposits

5 year bonds Liability sensitive

3 years deposits

3 year bond with 6 month reset

Asset sensitive

2 year deposit 364 days treasury bills

Asset sensitive

5 year deposits 5 year term loan

Neutral

Re-pricing risk:

Basis risk arise when interest rate of different assets and liabilities changes in different magnitudes.The basis form of IRR results from the imperfect correlation between interest adjustments when linked to different index rates deposits having the same re-pricing characteristics.

Example:

Re-pricing liabilities

Re-pricing assets

Result

90 days certificate of deposits

90 days commercial paper

At re-pricing certificate of deposit rates may fall by just 0.5% p.a. while interest rates on C.P. may fall by 1% p.a.

Basis risk

This risk arise by prepayment of loans and bonds(with put or call option) and/ or premature withdrawal of deposits before there stated maturity dates.

Holder will like to exercise put option if interest rates in the meantime have edged up while issuer will exercise call option if interest rates have fallen.

Every time a deposit is withdrawn or, a loan is prepaid, it creates a mismatch and gives rise to re-pricing risk.

In order to protect themselves from this risk, bank impose penalties on premature withdrawal of deposits

Embedded option risk

Risk caused due to the change in the yield curve from time to time depending upon re-pricing and various other factors.

Yield curve is the relation between the interest rate and the time of maturity of the debt for a given borrower in a given currency.

Yield curve risk

Effect of interest rate risk

•Earning perspective

•Economic value perspective

•Embedded losses

Approaches of IRR

Gap analysis

Duration model

Rate shift scenarios

Simulation methods

Gap analysis

Gap analysis is a tool used by credit unions to analyze the match between rate sensitive assets (RSA) and rate sensitive liabilities (RSL). If RSAs and RSLs are evenly matched the effects of interest rate changes will be minimized while profitability is maximized.

RSG= RSAs-RSLsGap ratio= RSAs/RSLs

NIM= Net Interest Margin

Simulation model

The purpose of using simulation methods is to test the non-linear effect with many complex rate scenarios and obtain a probabilistic measure of the economic capital to be held against ALM interest-rate risk.

Simulates the performance under alternative interest rate scenarios and assesses the resulting volatility in NII/NIM/ROA/ROE.

Computer generated scenario about future and response to that in a dynamic way.

SimulationAdvantages-•Forward looking•Dynamic•Increase the value of strategic planning•Enhance the capability of analysis•Interpretation easy•Timing of cash flows captured accurately

Disadvantage-Accuracy depends on quality

of data, strength of the model and validity of assumptions.

Time consumingHuge investment in computerRequires highly skilled

personnel

Rate shift scenarios

It attempt to capture the non linear behavior of customers. A common scenario test is to shift all rates up by 1%. After shifting the rates the cash flows are changed according to the behavior expected in the new environment.

The analysis is used to show the changes in earnings and value expected under different rate scenarios.

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