Interest Rate Risk Management

Module D: Balance Sheet Management

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CAIIB Super-Notes

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Bank Financial Management: Interest Rate Risk Management

CAIIB SUPER NOTES

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Contents
Coverage:
1. 2. 3. 4. 5. 6. 7. 8. Essentials of Interest Rate Risk Sources of Interest Rate Risk Effects of Interest Rate Risk Measurement of Interest Rate Risk Interest Rate Risk Measurement Techniques Strategies for controlling Interest Rate Risk Controls and supervision of Interest Rate Risk Management Sound Interest Rate Risk Management Practices

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CAIIB Super-Notes

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1.

ESSENTIALS OF INTEREST RATE RISK

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Essentials of Interest Rate Risk

Interest Rate risk is the exposure of a banks financial conditions to adverse movements in interest rates Though this is normal part of banking business, excessive interest rate risk can pose a significant threat to a banks earnings and capital base Changes in interest rates affect
Banks earnings by changing its Net Interest Income and level of other interest sensitive income and operating expenses The underlying value of the banks assets, liabilities and off-balance-sheet instruments
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Interest Rate Risk

Interest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM) Therefore, an effective risk management process that maintains interest rate risk within prudent levels is essential to safety and soundness of the bank

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2.

SOURCES OF INTEREST RATE RISK

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Types of Interest Rate Risk

Gap Risk Arises from holding assets and liabilities with different principal amounts, maturity dates or repricing dates Bank is asset sensitive if assets are repriced much more rapidly than the liability during the period Liability sensitive if interest paid on its deposit is reset more rapidly than the rate being charged on the loan Basis Risk Risk that interest rates of different assets and liabilities may change in different magnitudes Fairly high in respect of banks which create composite assets out of composite liabilities Net Interest Position Risk Interest rate earned on assets changes while cost of funding of liabilities remains the same Embedded Option Risk Prepayment of loans/bonds and/or premature withdrawal of deposits Yield Curve Risk Yield of all maturities of a particular investment Price Risk Assets are sold before maturity dates Reinvestment Risk Uncertainty with regard to interest rate at which the future cash flows can be reinvested

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3.

EFFECTS OF INTEREST RATE RISK

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Effects of Interest Rate Risk

Earnings Perspective
Focus is impact of interest rate change on accrual or reported earnings particularly NII Traditional approach Economic Perspective Impact on Economic value of banks assets, liabilities and off balance sheet positions A view of the sensitivity of the net worth of the bank to fluctuations in interest rates Provides a more comprehensive view since it considers effect on present value of all future cash flows Embedded Losses Impact of past interest rates on bank performance Gains or losses reflected over time Instruments that are not marked to market

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4.

MEASUREMENT OF INTEREST RATE RISK

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Measurement of Interest Rate Risk

Before management, risk has to be identified and quantified Measurement systems should
Assess all interest rate risk associated with Banks assets, liabilities and OBS positions Utilise generally accepted financial concepts and risk management techniques Have well documented assumptions and parameters

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CAIIB Super-Notes

Sirf Business

5.

INTEREST RATE RISK MEASUREMENT TECHNIQUES

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Interest Rate Risk Measurement Techniques

Repricing Schedules Simplest Technique Maturity/Repricing Schedule that distributes interest sensitive assets, liabilities and OBS positions into a certain no of predefined time bands based on maturity or time remaining to next repricing Gap Analysis When repricing schedules are used to assess the interest rate risk of current earnings A negative or liability sensitive gap occurs when liabilities exceed assets (RSA<RSL) in given time band increase in market interest rates could cause a decline in NII. A positive or Asset sensitive gap Occurs when assets exceed liabilities (RSA>RSL) in a given time band decrease in market interest rates could cause a decline in NII. Duration A measure of the percentage change in economic value of a position that will occur given a small change in the value of interest rates Higher duration implies that a given change in the level of interest rates will have a larger impact on economic value Simulation Approaches Detailed assessments of the potential effects of changes in interest rates on earnings and economic value by simulating the future path of interest rates and their impact on cash flows M S Ahluwalia CAIIB Super-Notes Sirf Business

Shortcomings of GAP Analysis

Does not take account of variation in characteristics of different positions within a time band Ignores differences in spreads between interest rates due to change in market interest rates Does not take into account changes in timing of payments that might occur as a result of changes in the interest rate environment Only a rough approximation Fail to capture variability in non-interest revenue and expenses
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Duration based Measurement

Average duration is assumed for positions that fall into each time band Average durations multiplied by assumed change in interest rates to construct a weight
Different weights may be used for different positions that fall within a time band Different interest rate changes may also be used

Weighted gaps are then aggregated across time bands

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Shortcomings of Duration approach

Focus on just one form of interest rate risk exposure repricing risk Since average durations are used the differences in actual sensitivity positions arising from differences in coupon rates and timing of payments will not be reflected Risk of options may not be adequately captured

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Types of Simulation
Static Simulation Cash flows arising solely from banks current on and off balance sheet positions are assessed Dynamic Simulation More detailed assumptions about the future course of interest rates and expected changes in banks business activity over that time More sophisticated techniques allow for dynamic interaction of payments streams and interest rates, and better capture the effect of embedded or explicit options

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Additional Issues
Declines in interest rates result in increasing levels of prepayments Non-maturity deposits may be withdrawn without penalty Treatment of positions with embedded options Inputs from managerial and business units

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6.

STRATEGIES FOR CONTROLLING INTEREST RATE RISK

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Ways to Reduce Sensitivities

Reduce Asset Sensitivity Extend investment portfolio maturities Increase floating rate deposits Increase fixed rate lending Sell floating rate loans Increase short term borrowings Increase long term lending Reduce Liability Sensitivity Reduce investment portfolio maturities Increase floating rate lending Increase short term lending Increase long term Deposits

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Other options available for managing interest rate risks

Match long term assets preferably with non-interest bearing liabilities Match repricable assets with similar repricable liabilities Use Forward Rate Agreements, Swaps, Options and Financial Futures to construct synthetic securities Sound loaning policies and effective post-sanction monitoring and recovery steps to contain NPAs
Full match in repricing assets and liabilities is not prudent even if it was feasible. Appropriate tolerance limits should be placed on interest rate sensitivity gaps.
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7.

CONTROLS AND SUPERVISION OF INTEREST RATE RISK MANAGEMENT

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Effective Internal Control System includes

A strong control environment Adequate process for identifying and evaluating risk Establishment of control activities such as policies, procedures and methodologies Adequate information systems

Continual review of adherence to established policies and

procedures
Banks should have their measurement, monitoring and control functions reviewed on a regular basis by an independent party
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8.

SOUND INTEREST RATE RISK MANAGEMENT PRACTICES

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Basic Elements
Board and Senior Management oversight of Interest Rate Risk Adequate Risk Management policies and procedures Appropriate risk measurement, monitoring and control functions Comprehensive internal controls and independent audits

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Roles and Responsibilities

Board of Directors Approve Strategies and policies Ensure action by Senior Management in line with the above To be informed regularly of interest rate risk exposure Senior Management Management of structure of banks business and level of interest rate risk To ensure that appropriate policies and procedures are established to control and limit the risks To ensure that resources are available for evaluating and controlling interest rate risk Periodic review of organisations interest rate risk management policies and procedures Also responsible for maintaining: Appropriate limits on risk taking Adequate systems and standards for measuring risk Standards for valuing positions and measuring performance Comprehensive interest rate risk reporting and interest rate risk management Review Process Effective internal controls Should define lines of responsibility and authority for developing strategies, implementing tactics and conducting the risk measurement and reporting functions of the interest rate risk management process

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M S Ahluwalia, amongst other things, is a visual artist, blogger, blog designer and of course an MBA and Banker from New Delhi, India.
To know more about him you may visit his blog-site: Estudiante De La Vida

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