INTEREST RATE RISK MANAGEMENT IN BANKS

Management Of Interest

Rate Risk In Banks

Presenter:

Dr. Vighneswara Swamy

What is Interest Rate Risk

What are the types of Interest Rate Risks

Effects of Interest Rate Risks

Measurement of Interest Rate Risks

Strategies for Controlling Interest Rate Risks

Basel Committee Recommendations

Sound Interest Rate Risk Management

Practices

Agenda Items

for the Session:

12/17/2009 2Presenter: Dr. Vighneswara

Swamy

Interest Rate Risk (IRR)

• Definition:

– It is the potential loss from

unexpected changes in interest rates

which can significantly alter a bank’s

profitability and market value of

equity.


Swamy

Interest Rate Risk .. explained

• The amount at risk is a function of the

magnitude and direction of interest rate

changes and the size and maturity structure

of the mismatch position.

• If interest rates rise, the cost of funds

increases more rapidly than the yield on

assets, thereby reducing net income.

• If the exposure is not managed properly it

can erode both the profitability and

shareholder value.


Swamy

Interest Rate Risks - Types

Interest Rate Risks

Repricing Risk Basis RiskYield Curve

RiskEmbedded Option Risk


Swamy

Repricing Risk

• Arises on account of mismatches in rates

• Can be measured by the measure of risk in different time buckets

• Information needed

– Balance sheet -on & off on a particular day

– Business plan & expected income/ exp. ignored

– Static vs Dynamic

Liabilities Assets Spread

Capital

(Crore)

@ ROI Maturity Investment

(Crore)@

ROI

Maturity

Scenario-1

Rs100 9% One year Rs100 10% Two year

Profit

1%(1crore)

Scenario-2

Rs100 11% 2nd year Rs100 10% Two year

Loss

1%(1crore)


Swamy

Mismatched Repricing Periods of Assets/Liabilities

Illustrations:


Capital

(Crore)

@ ROI Maturity Investment

(Crore)@ ROI Maturity

Scenario-1

Rs100 8% 91 days Rs100

Fixed Rate

10% 91 days

Profit

2%(0.49crore)

Scenario-2

Rs100 9% 91 days Rs100

Fixed Rate

11% 91 days

Profit

2%(0.49crore)

Scenario-3

Rs100

Asset

Sensitive

8% 91 days Rs100

Float Rate

10%(1st month) 30 days

Profit

2%(0.164crore)

Float Rate

11%(2nd month) 61 days

Profit

3%(0.5crore)

Total: 0.664 Crore

Scenario-4

Rs100

Liability

Sensitive

8% 91 days Rs100 Fixed Rate

10% 5 years

9% 91 days


Swamy

Basis Risk

• Interest rates on assets and liabilities do not change in thesame proportion.

• When Bank Rate was raised by 2%, PLR was raised by 1% anddeposit rates by 1.5%

• Interest rates movement is based on market perception of riskand also market imperfections.

• Therefore, basis risk arises when interest rates of differentassets and liabilities change in different magnitudes.

• The `basis’ form of IRR results from the imperfect correlationbetween interest adjustments when linked to different indexrates despite having the same re-pricing characteristics.


Swamy

Basis Risk – An Illustration

Repricing Liabilities (Rs Crores) Repricing Assets(Rs Crores)

Savings Deposit 50 Call Money 50

Fixed Deposit 50 Cash Credit 40

Total 100 Total 90

Gap(-) 10

Calculation of Standardised Gap Fall in Rates Fall in Amount

(Rs Crores)

Call Money 50 * 1.0% 0.50

Cash Credit 40 * 0.7% 0.28

A. Decrease in Interest Income (-) 0.78

Savings Deposit 50 * 0.5% 0.25

Fixed Deposit 50 * 0.4% 0.20

B. Decrease in Interest Expense (+) 0.45

Loss in Net Interest Income (A-B) (-) 0.33(Rs 33 Crores)12/17/2009 9Presenter: Dr. Vighneswara

Swamy

Embedded Option Risk

• Risks arising out of prepayment of loans and bonds (with

put or call options) and / or premature withdrawal of

deposits before their stated maturity dates.


Capital

(Crore)

@

ROI

Maturity Loan

(Crore)

@ ROI Maturity

Scenario-1

Rs100 8%

90

days Rs100 10%

90

days

Profit

2%(0.49crore)

Scenario-2

Rs100 8%

90

days Rs100 10%

90

days

2%(0.164crore)

for 30days

Int. Rates

decline after

30 days to 9%

60

days

1%(0.164crore)

for 60 days

Total 0.328 crore12/17/2009 10Presenter: Dr. Vighneswara

Swamy

Yield Curve Risk

• Risks caused due to the changein the yield curve from time totime depending on the repricingand various other factors.

Yield Curve is the relation between the

interest rate (or cost of borrowing) and

the time to maturity of the debt for a

given borrower in a given currency.


Swamy

What is

Yield Curve shape of

yield curveYield Curve Yield Curve

Risk

Yield Curve is

the relation

between the

interest rate

(or cost of

borrowing) and

the time to

maturity of the

debt for a

given borrower

in a given

currency.

The shape of the

yield curve is

influenced by supply

and demand. The

yield curve may also

be flat or hump-

shaped, due to

anticipated interest

rates being steady,

or short-term

volatility

outweighing long-

term volatility.

TEXT

The risk of

experiencing

an adverse

shift in

market

interest rates

associated

with

investing in a

fixed income

instrument.

Yield Curve Risk ..


Swamy

Yield Curve Risk – An Illustration

Date 91 T-Bill Deposit 364 T-Bill Loan Spread

22.05.2008 4.48% 5.48% 4.62% 7.62% 2.14%

08.08.2008 4.93% 5.93% 4.85% 7.85% 1.92%

08.12.2008 4.71% 5.71% 4.24% 7.24% 1.53%


Capital

(Crore)

@ ROI Maturity Loan

(Crore)

@ ROI Maturity

Scenario-1

Rs100Reference:

91 day T-Bill

@12.5%

13.5%

3 year fixed(quar

terly

repriced)

Rs100

Loan

16%Reference:

364 day T-Bill @13%

3 year float(qua

rterly

repriced)

Profit

2.5%(2.5crore)

Scenario-2

Rs100Reference:

91 day T-Bill

@14%

15%

90

days Rs100 16%Reference:

364 day T-Bill @13%

90

days

Profit

1.0%(1crore)


Swamy

Interest Rate Volatility

IMPACT OF INCREASE / DECREASE IN RATE OF INTEREST ON NII

COL1 COL2 COL3 COL4 COL5

Maturity pattern RSL - OUTFLOWS RSA - INFLOWS GAP - RSA - RSL CHANGE IN NII FOR

0.25 % DECREASE

1- 14 DAYS 18785.27 15920.09 -2865.18 7.16

15 - 28 DAYS 31772.55 31161.34 -611.21 1.53

29 DAYS - 3 MTS 68403.39 77914.78 9511.39 (-23.78)

3-6 MONTHS 87629.72 90673.27 3043.55 (-7.61)

6-ONE YEAR 101260.22 98917.23 -2342.99 5.86

ONE - 3 YEARS 108310.71 106316.51 -1994.2 4.99

3-5 YEARS 114558.21 124538.91 9980.7 (-24.95)

ABOVE 5 YRS 134964.33 137905.36 2941.03 -7.35

Impact of Interest Rate Volatility on the Net

Interest Income


Swamy

Approaches to Measure IRR

Maturity

Gap

Analysis

Simulation

Duration

Gap

Analysis

Value at

Risk

Measurement of IRR


Swamy

Maturity Gap Analysis

MGA distributesinterest rate sensitiveassets, liabilities and OBSpositions into a certainnumber of predefined timebands according to theirmaturity(if fixed rate) ortime remaining to their nextrepricing(if floating rate)


Swamy

Maturity Gap Analysis ..

Objective:To improve the

net interest

income in the

short run over

discreet periods

of time called the

gap periods.

How is it done?The risk sensitive

assets and risk

sensitive liabilities

are grouped into

‘maturity buckets’

based on maturity

and the time until the

first possible

repricing due to

change in the interest

rates

What is the Gap?The gap is then

calculated by

considering the

difference between

the absolute

values of the RSAs

and RSLs.

RSG=RSAs-RSLs

Relative differences in each maturity bucket – represents the sensitivity in

that band.12/17/2009 17Presenter: Dr. Vighneswara

Swamy

Maturity Gap Method (IRS)

Three Options:

• A) RSA>RSL= Positive Gap

• B) RSL>RSA= Negative Gap

• C) RSL=RSA= Zero Gap


Swamy

Maturity Gap Analysis … Option-1

Liabil

ity(Crores)

Rate

%

Increase

d

Rate%

Decreased

Rate%

200

1800* 10 11 9

3000 11 11 11

5000

Int

Expe

nse

510 528 492

NII=

Asset(Crores)

Rate

%

Increase

d

Rate%

Decreased

Rate%

200

800* 12 13 11

1000* 14 15 13

1000* 16 17 15

2000 18 18 18

5000

Int

income

756 784 728

246 256 236

A case of Positive Gap:

RSAs= Rs2800, RSLs=Rs1800 GAP=Rs2800-RS1800=Rs100012/17/2009 19Presenter: Dr. Vighneswara

Swamy

Liabil

ity(Crores)

Rate

%

Increase

d

Rate%

Decreased

Rate%

200

1800* 10 11 9

3000 11 11 11

5000

Int

Expe

nse

510 528 492

NII=

Asset(Crores)

Rate

%

Increase

d

Rate%

Decreased

Rate%

200

800* 12 13 11

1000 14 15 13

1000 16 17 15

2000 18 18 18

5000

Int

income

756 784 728

246 256 236

A case of Negative Gap:RSAs= Rs800, RSLs=Rs1800 GAP=Rs800-Rs1800=(-)Rs1000



Swamy

Liabil

ity(Crores)

Rate

%

Increase

d

Rate%

Decreased

Rate%

200

1800* 10 11 9

3000 11 11 11

5000

Int

Expe

nse

510 528 492

NII=

Asset(Crores)

Rate

%

Increase

d

Rate%

Decreased

Rate%

200

800* 12 13 11

1000* 14 15 13

1000 16 17 15

2000 18 18 18

5000

Int

income

756 784 728

246 256 236

A case of Zero Gap:

RSAs= Rs1800, RSLs=Rs1800 GAP=Rs1800-Rs1800=0



Swamy

Inferences from above options:

Rising Interest Rates

Declining Interest

Rates

Uncertain situation

(May not occur in reality)

Maintain a positive gap

Maintain a Negative gap

Maintain a Zero gap

No benefits

SCENARIO STRATEGY


Swamy

Factors Affecting Net Interest Income: An Example

• Consider the following balance sheet:

Assets Yield Liabilities Cost

Rate sensitive 500$ 8.0% 600$ 4.0%

Fixed rate 350$ 11.0% 220$ 6.0%

Non earning 150$ 100$

920$

Equity

80$

Total 1,000$ 1,000$

GAP = 500 - 600 = -100

NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)

NIM = 41.3 / 850 = 4.86%

NII = 78.5 - 37.2 = 41.3

Expected Balance Sheet for Hypothetical Bank


Swamy

24

Factors Affecting Net Interest Income

• Changes in the level of interest rates

• Changes in the composition of assets and liabilities

• Changes in the volume of earning assets and

interest-bearing liabilities outstanding

• Changes in the relationship between the yields on

earning assets and rates paid on interest-bearing

liabilities

12/17/2009 Presenter: Dr. Vighneswara

Swamy

25

Examine the impact of the following

changes

• A 1% increase in the level of all short-term rates?

• A 1% decrease in the spread between assets yields

and interest costs such that the rate on RSAs

increases to 8.5% and the rate on RSLs increase to

5.5%?

• Changes in the relationship between short-term

asset yields and liability costs

• A proportionate doubling in size of the bank?


Swamy

1% increase in short-term rates

Assets Yield Liabilities Cost

Rate sensitive 500$ 9.0% 600$ 5.0%

Fixed rate 350$ 11.0% 220$ 6.0%

Non earning 150$ 100$

920$

Equity

80$

Total 1,000$ 1,000$

GAP = 500 - 600 = -100

NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)

NIM = 40.3 / 850 = 4.74%

NII = 83.5 - 43.2 = 40.3

Expected Balance Sheet for Hypothetical Bank

With a negative GAP, more liabilities than assets reprice higher; hence NII

and NIM fall12/17/2009 26Presenter: Dr. Vighneswara

Swamy

Maturity Gap Method – Mathematical

Expressions

RSG = RSAs - RSLs

Gap Ratio = RSAs / RSLs

NII = Gap x rWhere,

NII = Change in Net Interest Income

r = Change in Interest Rates

NII = Earning Assets x NIM

1

2

3

4


Swamy

• NII = Earning Assets x NIM x C

• Where, C = % change in NIM

• Since, NII = Gap x r

• Gap x r = Earning Assets x NIM x C

• Therefore,

• Earning Assets x NIM x C

• GAP = -----------------------------------------------

• r• Where; Earning Assets = Total Assets of the Bank

• NIM = Net Interest Margin

• C = Acceptable Change in NIM

• r = Expected Change in Interest Rates


Expressions ..

5


Swamy

• Bharat bank has earning assets worth Rs. 3000 crores and a Net

Interest Margin(NIM) of 3%. In a swift move Bharat Bank decided

that a 2% increase/decrease in the NIM can be the acceptable limit.

It further forecasts that a 0.75% increase in the interest rate. Now

you are required to calculate the target gap which the bank can

maintain to remain within the acceptable limits of NII.

• Answer:

• Earning Assets x NIM x C

• GAP = ------------------------------------------------------

• r

• 3000 x 0.03 x 0.02 1.8

GAP = --------------------------------------------- = ----------- = Rs. 240 Crore

0.0075 0.0075

Maturity Gap Method –

Illustration


Swamy

• Consider the Following Illustration of two banks which have a same Gap

Ratio;

• Inference: Gap level is more helpful than the Gap Ratio in taking

Positions


Expressions .. Gap Ratio

Parameters Bank A Bank B

RSA 2900 1005

RSL 2000 695

GAP 900 310

GAP Ratio 1.45 1.45

NII 830 390

Decrease in Interest 0.5 0.5

Change in NII (GAP * Change in R) 4.5 1.55

%change in NII (Change in NII /NII) 0.54% 0.40%


Swamy

Rate Adjusted Gap = ( RSA1 * WA1 + RSA2 * WA2 + ……. )

• - ( RSL1 * W1 + RSL2 * W2 + ……. )

• Where,

• WA1 , WA2, …. are Weights of the corresponding RSAs

• WL1 , WL2, …. are Weights of the corresponding RSLs

• Illustration: The case of a Positive Gap turning Negative

• Rate Adjusted Liabilities = 1800 x 0.75 = 1350

• Rate Adjusted Assets = [(800 x 0.5) + (1000 x 0.25) + (1000 x 0.5)] = 1150

• Rate adjusted Gap = 1150 – 1350 = (-) 200

• Inference: By assigning weights the Positive Gap has actually become Negative


Expressions .. Rate Adjusted Gap

Liability Rate% Weight

Increased

Rate% Assets Rate% Weight

Increased

Rate%

200 200

1800 10 0.75 10.75 800 12 0.5 12.5

3000 11 11 1000 14 0.25 14.25

1000 16 0.5 16.5

2000 18 18

6


Swamy

Statement Of

Interest Rate Sensitivity

• Generated by grouping RSA,RSL & OFF-Balance sheet items in to various (8)time buckets.

RSA:

• MONEY AT CALL

• ADVANCES ( BPLR LINKED )

• INVESTMENT

RSL:

• DEPOSITS EXCLUDING CD

• BORROWINGS


Swamy

Balance Sheet looked at from Interest Rates:

Balance Sheet Items

Whether Interest

bearing

Fixed / Floating

Rate Remarks

Liabilities

Capital No

Reserves & Surplus No

Deposits

- Current Deposits No

- Savings Deposits Yes Fixed

- Term Deposits Yes Fixed

Discretionary pricing for High

Value deposits & Inter bank

items

Borrowings

- From within India Yes Fixed

- From Outside India Yes Generally Fixed

Sometimes, floating, linked to

LIBOR

Other Liabilities

- Interest Payable Yes Fixed

- Subordinated Debts Yes Fixed

In a few cases, this is floating

rate item

- Others NO

Balance Sheet looked at from Interest Rates:


Swamy

Impact of Interest Rate Changes on NII

Rising Interest Stable Interest Falling Interest

Rate Scenario Rate Scenario Rate Scenario

Negative Mis Matches in IRS Adverse No Impact Favourable

Mis Match in IRS is NIL No Impact No Impact No Impact

Positive Mis Matches in IRS Favourable No Impact Adverse

IRS & Interest Rate Scenario


Swamy


Swamy

35

To a larger extent depends on the accuracylevel of the forecasts made regarding thequantum and the direction of the interestrate changes

While gap measurement is easy,gap management is quite difficult.

It assumes that change in interest rates

immediately affects all RSAs and RSLs

Ignores Time Value

of

Money

Limitations of Maturity Gap

Analysis

Duration Gap Analysis

Duration

Analysis:

Duration is a

measure of the

percentage

change in the

economic value

of a position that

occurs given a

small change in

level of interest

rate.

Duration

Analysis:

It concentrates

on the price risk

and the

reinvestment

risk while

managing the

interest rate

exposure.

Duration

Analysis:

It also measures

the effect of rate

fluctuation on

the market value

of the assets and

liabilities and

NIM with the help

of duration.


Swamy

Duration Gap Analysis – What is it?

Duration Gap Analysis ..Illustration

Assets and Liabilities chart of Bharath Bank is presented here below along

with their durations and interest rates. Based on the information, identify the

RSG and the NIM. During the forecasting period of one year, if the interest

rates rise/fall by 2%, what would be its implication on the NIM of Bharath

Bank?

Liabiliti

es

Amount

(Crore)

Duration

(months)Int. Rate

(%)

Assets Amount

(Crore)

Duration

(months)Int. Rate

(%)

Equity 200 Cash 200

ST

Depo 1800 5.5 11.5

ST

Loans 1800 2.75 12.5

LT

Depo 2500 23.7 15

LT

Loans 2000 23 16.5

Others

500 11.5 11

Invest

ments 1000 10.5 13.5

5000 500012/17/2009 37Presenter: Dr. Vighneswara

Swamy

Duration Gap Analysis …

Liabilities

Amount Duration Interest Increased Decreased Assets Amount Duration

Interest Increased Decreased

(crore) in MnthsRate(%) Int. Rate(%)

Int. Rate(%)

(crore) in Mnths

Rate(%) Int. Rate(%)

Int. Rate(%)

Equity 200 Cash 200

ST Depos 1800 5.5 11.5 13.5 9.5

ST Loans 1800 2.75 12.5 14.5 10.5

LT Depos 2500 23.7 15 15 15

LT Loans 2000 23 16.5 16.5 16.5

Others 500 11.5 11 13 9 Investm 1000 10.5 13.5 15.5 11.55000 5000

Int. Expe

637 683 591 IntIncome

690 746 634

NII 53 63 43NIM 0.010

60.0126 0.0086

Answer:RSG = RSAs – RSLs = (1800+1000) – (1800+500) = 500


Swamy

• Using the Duration analysis to assess the sensitivity of

the market value of Assets and Liabilities.

• Ds x S = ( D x A ) - ( DL x L ) • Where,

• Ds = Duration Gap / Duration of Surplus

• DA = Duration of Assets, DL = Duration of

Liabilities A = Assets L = Liabilities

• S = Surplus / Gap


Swamy

39

7

Duration Gap Analysis …

Duration Gap Analysis ….

9

Substituting L = A – S in the above eqn. We get

Ds = DL + ( A / S ) x ( DA - DL )

When there is a market fluctuation,

-D( r) x Current MV

MV = ------------------------------------------

( 1 + r )Where, MV = Change in the market value

D = Duration of assets or liabilities

r = Change in the interest rate

r = Current interest rate

MV = Market Value

Then,

New MV = Current MV + MV 9

8


Swamy

Duration Gap Analysis …..

Then, -D( r) x Current MV

MV = -----------------------------------

( 1 + r )An Example:

The following is the information about Bharath Bank. Market value of

liabilities is Rs1800 crores, MV of Assets is Rs2000 Crores, Duration of

Assets is 5 years, Duration of Liabilities is 4 years, the ROI is 10% and

Change in the ROI is +2%. You are required to asses the change in the MV of

the bank whose Equity is currently Rs200 crore.

Answer:

Parameter Change in MV Original MV New MV

Assets -5(0.02) x2000

(1+0.1)

182 2000 1818

Liabilities -4(0.02) x1800

(1+0.1)

131 1800 1669

Equity 182 – 131 51 200 149


Swamy

Simulation


Swamy

42

What is it?Simulates performance underalternative interest ratescenarios and assesses theresulting volatility in NII / NIM/ ROA / ROE / MVE

A financial modelincorporating inter-relationship of assets,liabilities, prices, costs,volume, mix and otherbusiness related variables

Computer generatedscenarios about future andresponse to that in a dynamicway

Data Requirement

Maturity and repricing

Rate scenarios

Alternative management

response under different

scenarios

Yield curves

Prepayment tables

Behavioural pattern of assets

and liabilities

Consistency of assumptions

Simulation- other information

• Risk-Return policies - management appetite for risk taking

• Regulatory framework – Ward against practices which are considered unsafe and unsound

• Capital strength and profitability

• Experience and track record of management

• Other risks embedded in the balance sheet - Liquidity / Credit / Forex risks

• Business plan


Swamy

Simulation


Swamy

44

-AdvantagesForward looking

Dynamic

Lessens the role of crisis management

Increases the value of strategic planning

Enhances capability of analysis

Interpretation easy

Timing of cash flows captured accurately

-Disadvantages

Accuracy depends on quality of data, strength of the model and validity of assumptions

Time consuming

Huge investment in computer

Requires highly skilled Personnel

Analysis paralysis

Interest Rate Risk Management


Swamy

INTEREST RATE RISK MODELS

Risk Measurement Systems

GAP

REPORT

EARNINGS

SIMULATION

ECONOMIC VALUATION

Short-Term

Earnings

Exposure

Yes Yes Generally does not distinguish short-term

accounting earnings from changes in

economic value.

Long-term

Exposure

Yes Limited* Yes

Repricing Risk Yes Yes Yes

Basis Risk Limited* Yes Limited*

Yield Curve

Risk

Limited* Yes Yes

Option Risk Limited* Limited* Yes

* The ability of these types of models to capture this type of risk will vary with the

sophistication of the model and the manner in which bank management uses

them.

Interest Rate Risk Management


Swamy

Benefits from IRR management

•Defined financial targets based on corporate risk

tolerances

•Reduced earnings volatility

•Improved cash flow forecasting

•Improved corporate credit ratings

•Defined risk management and hedge methodologies


Swamy

Conclusion

• Based on the quantity of interest rate risk

and quality of interest rate risk management,

we can evaluate the adequacy of the bank’s

capital.

• Determine the component rating for

sensitivity to market risk.

• Determine further the effect of interest rate

and earnings on the business in a

macroscopic view.


Swamy

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INTEREST RATE RISK MANAGEMENT IN BANKS

Economy & Finance