Interest Rate Risk Management: CAIIB Paper 2 (Module D), Unit 8

Interest Rate Risk Management: CAIIB Paper 2 (Module D), Unit 8

Dear Bankers,
We all know that CAIIB exams are conducted by the Indian Institute of Banking and Finance (IIBF).  CAIIB is said to be one of the difficult courses to be cleared for the bankers. But we assure you that with the help of our “CAIIB study material”, you will definitely clear the CAIIB exam.
CAIIB exams are conducted twice in a year. Candidates should have completed JAIIB before appearing for CAIIB Exam. Here, we will provide detailed notes of every unit of the CAIIB Exam on the latest pattern of IIBF.
So, here we are providing “Unit 8: Interest Rate Risk Management” of “Module D: Balance Sheet Management” from “Paper 2: Bank Financial Management (BFM)”

Essentials Of Interest Rate Risk

Interest rate risk rates is the exposure of a bank’s financial condition to adverse movements in interest rates. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value. However, excessive interest rate risk can pose a significant threat to a bank’s earnings and capital base. Changes in interest rates affect a bank’s earnings by changing its net interest income and the level of other interest sensitive income and operating expenses. Changes in interest rates also affect the underlying value of the bank’s assets, liabilities, and off-balance-sheet (OBS) instruments because the present value of future cash flows (and in some cases, the cash flows themselves) change when interest rates change.

Interest rate risk refers to volatility in Net Interest Income (NII) or in variations in Net Interest Margin (NIM), i.e., NII divided by Earning Assets due to changes in interest rates. In other words, interest rate risk arises from holding assets and liabilities with different principal amounts, maturity dates or dates, i.e., ‘rollover rates’.

Sources Of Interest Rate Risk

Gap or Mismatch Risk

A gap or mismatch risk arises from holding assets and liabilities with different principal amounts, maturity dates or repricing dates, thereby creating exposure to changes in the level of interest rate. The gap is the difference between the amount of assets and liabilities on which the interest rates are reset during a given period. In other words, when assets and liabilities fall due to repricing in different periods, they can create a mismatch. Such a mismatch or gap may lead to gain or loss depending upon how interest rates in the market tend to move.

Example 1

  • A bank holds Rs. 100 crore liabilities at 9% of one year maturity to fund assets of Rs. 100 crore at 10% with two year maturity. Over the first year, bank is getting a profit spread of 1% amounting to Rs. 1 crore. However, its profits for second year are not certain. If interest rate remains unchanged, the profits will continue to be the same. However, since the liabilities are for one year and need to be rolled over for second year, bank is exposed to interest rate risk.
  • If the interest rate on liabilities increase to 11% in second year, bank would be incurring a loss of 1%, i.e., Rs. 1 crore in the second year. Conversely bank is again exposed to interest rate risk if it holds shorter term assets relative to liabilities, i.e., liabilities maturing in two years against assets maturing in one year. It then faces the uncertainty of interest rate at which it can reinvest funds after the first year for further one year matching the liabilities maturity.

Basis Risk

In a perfectly matched gap position, there is no timing difference between the repricing dates, i.e. the magnitude of change in the deposit rates would be exactly matched by the magnitude of change in the loan rate. However, interest rate of two different instruments will seldom change by the same degree during the same period of time. The risk that the interest rate of different assets and liabilities may change in different magnitudes is called basis risk. The under noted table shows how the basis risk occurs.

Gap Statement of XYZ Bank (Amt. In Crore of Rs.)

 

Repricing Assets   Repricing Liabilities  
Call Money

Cash credit

 

Gap (-)

 

50

40

90

10

Savings Deposit

Fixed Deposits

50

50

100

 

The bank as of now has a negative gap of Rs. 10 crore. In case the interest rate falls by 1%, then as per the traditional gap management (assuming rates on all assets and liabilities change by 1%- parallel shift), the bank’s NII should improve by Rs. 1 crore. Instead of falling in the same magnitude, assume that the rate on call money lending falls by 1%, the rate on cash credit falls by 0.7%, the rate on savings deposit falls by 0.5% and the rate on fixed deposits falls by 0.4%. The undernoted calculations indicate that the bank’s NII would deteriorate rather than improving in terms of the assumption of gap management.

Fall in Rates Fall in Amount
Call Money

Cash Credit

A. Decrease in interest income

Savings deposit

Fixed deposit

B. Decrease in interest expenses

Loss in Net Interest Income: A-B

50 x 1.0%

40 x 0.7%

(-)

50 x 0.5%

50 x 0.4%

(+)

(-)

Rs. 0.50 crore

Rs. 0.28 crore

Rs. 0.78 crore

Rs. 0.25 crore

Rs. 0.20 crore

Rs. 0.45 crore

Rs. 0.33 crore

 

Net Interest Position Risk

The bank’s net interest position also exposes the bank to an additional interest rate risk. If a bank has more assets on which it earns interest than its liabilities on which it pays interest, interest rate risk arises when interest rate earned on assets changes while the cost of funding of the liabilities remains the same.

Thus, the bank with a positive net interest position will experience a reduction in NII as interest rate declines and an expansion in NII as interest rate rises.

A large positive net interest position accounts for most of the profit generated by many financial institutions.

Embedded Option Risk

Large changes in the level of market interest rates create another source of risk to banks profit by prepayment of loans and bonds (with put or call options) and/or premature withdrawal of deposits before their stated maturity dates. In cases where there is no penalty for prepayment of loans, the borrowers have a natural tendency to pay off their loans when a decline in interest rate occurs. In such cases, the bank will receive only a lower NII.

Example

Take the case of a bank which has disbursed a 90 days loan at the rate of 10% which is funded through a 90-day CD at the rate of 8%.

In case the rate of interest decline to 9% after 30 days and the borrower prepays his loan immediately and the bank receives only 200 basis points NII for 30 days rather than the anticipated 90 days. In the remaining 60 days of the 90 days term, the NII will be only 100 basis points, as the Bank would be reinvesting the funds at 9%.

The embedded option risk is becoming a reality in India and is experienced in volatile situations. The faster and higher the magnitude of changes in the interest rate, the greater will be embedded options the risk to the bank’s NII.

Yield Curve Risk

An yield curve is a line on a graph plotting the yield of all maturities of a particular instrument. Yield curve changes its slope and shape from time to time depending upon repricing and various other factors. As the economy moves through the business cycle, the yield curve changes rather frequently. At the intervention of Reserve Bank of India, the yield curve can be twisted to the desired direction by altering the yields on government stocks or different maturities by RBI.

Example

  • To illustrate how a change in the shape of yield curve affects the bank’s NII, let us assume that XYZ Bank, used 3 years floating rate fixed deposits for funding 3 year floating rate loans (the deposits and loans are repriced at quarterly intervals). If the bank pays 100 basis point above the 12.50% (91 days Treasury Bills rate), i.e. 13.5% to fixed deposits and charges 300 basis point, above the 364 days Treasury Bills rate of 13%, i.e., 16% on its loans, a NII of 250 basis points is produced.
  • If the yield curve turns inverted during the next repricing date with the 91 days TBs rate increasing to 14% and 364 days TBs rate remaining at 13% and the spread relationship or deposits and loans to TBs remains constant, the NII will be reduced to 100 basis points, i.e.,( 16% -14% +1%= 1%).

Price Risk

Price risk occurs when assets are sold before their maturity dates. In the financial market, bond prices and bond yields are inversely related. For example, the price of 10-year 14% Government of India stock will receive only lower price than originally paid for, when coupon or stocks of similar maturity has gone up to 15% in the market. The price risk is closely associated with the trading book which is created for making profit out of short-term movements in interest rates,

Reinvestment Risk

Uncertainty with regard to interest rate at which the future cash flows can be reinvested is called reinvestment risk.

Example

  • Suppose, XYZ Bank has a zero coupon deposit of Rs. 10,000 and it promises to double the amount with 7 years and uses the funds for investing in a 7-year bond at an annual coupon of 12%.
  • In case, the interest rate falls to 10%% after one year, the bank could reinvest the coupon cash flows only at 10% against the anticipation of reinvesting the coupon at a fixed rate of 12%. Due to this reinvestment risk, the bank will find it difficult to pay the interest on deposit on maturity.

Effects Of Interest Rate Risk

As the discussion above suggests, changes in interest rates can have adverse effects both on a bank’s earnings and its economic value. This has given rise to two separate, but complementary, perspectives for assessing a bank’s interest rate risk exposure, i.e.,

  • Earnings perspective
  • Economic perspective
  • Embedded losses

Earnings Perspective

In the earnings perspective, the focus of analysis is the impact of changes in interest rates on accrual or reported earnings. This is the traditional approach to interest rate risk assessment taken by many banks. Variation in earnings is an important focal point for interest rate risk analysis because reduced earnings or outright losses can threaten the financial stability of an institution by undermining its capital adequacy and by reducing market confidence.

Economic Value Perspective

Variation in market interest rates can also affect the economic value of a bank’s assets, liabilities and off-balance-sheet (OBS) positions. Thus, the sensitivity of a bank’s economic value to fluctuations in interest rates is a particularly important consideration of shareholders, management and supervisors alike.

Embedded Losses

The earnings and economic value perspectives discussed thus far focus on how future changes in interest rates 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 gains or losses due to past rate movements. These gains or losses may be reflected over time in the bank’s earnings.

Measurement Of Interest Rate Risk

Before risk can be managed, it must be identified and quantified. Unless the quantum of risk inherent in a bank’s balance sheet is measured, it is impossible to measure the degree of risk to which the bank is exposed. It is also equally impossible to develop effective risk management strategies/techniques without being able to understand the correct risk position of the bank.

In general, but depending on the complexity and range of activities of the individual bank, banks should have interest rate risk measurement systems that capture all material sources of interest rate risk and that assess the effects of rate changes on both earnings and economic value. Measurement systems should:

  • Assess all material interest rate risks associated with a bank’s assets, liabilities, and OBS positions
  • Utilise generally accepted financial concepts and risk measurement techniques
  • Have well-documented assumptions and parameters

Interest Rate Risk Measurement Techniques

Banks use various techniques to measure the exposure of earnings and of economic value to changes in interest rates. The variety of techniques ranges from calculations that rely on simple maturity and repricing tables, to static simulations based on current on- and off-balance-sheet positions, to highly sophisticated dynamic modelling techniques that incorporate assumptions about the behaviour of the bank and its customers in response to changes in the interest rate environment.

  • Repricing Schedules
  • Gap Analysis
  • Duration
  • Simulation Approaches

Strategies For Controlling Interest Rate Risk

Interest rate risk management process should begin with strategies which change the bank’s interest rate sensitivity by altering various components of the balance sheet. The actual management of banks’ assets and liabilities focuses on controlling the gap between Rate Sensitive Assets and Rate Sensitive Liabilities. Some banks pursue a strategy of matching assets and liabilities maturities as closely as possible to reduce the gap to zero and insulate the NII from the volatility of interest rate. Aggressive bankers, however, vary the gap in tune with their interest rate forecasts. If they expect increase in interest rates, they widen the gap by repricing the assets more frequently than their liabilities.

The banks have been following various balance sheet strategies to limit the shocks of interest rate volatility. The basic strategy of the banks is focussed on bridging the gap position. The strategies for reducing the assets and liabilities sensitivity are:

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 lendings
  • Reducing investment portfolio maturities
  • Increase floating rate lendings
  • Increase long-term deposits
  • Increase short-term lendings

The other options with available to the banks for managing interest rate risks are:

  • Match long-term assets preferably with non-interest bearing liabilities.
  • Match repriceable assets with a similar repriceable liabilities.
  • Use Forward Rate Agreements, Swaps, Options and Financial Futures to construct synthetic securities and thus hedge against any exposure to interest rate risk.
  • Maturity mismatch is accentuated by proliferation of Performing Assets (NPAs) and loan renegotiations. Sound loaning policies and effective 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 earning assets, funded out of volatile liabilities.

Controls and Supervision Of Interest Rate Risk Management

Banks are required to have adequate internal controls to ensure the integrity of their interest rate risk management process. These internal controls should be an integral part of the institution’s overall system of internal control. They should promote effective and efficient operations, reliable financial and regulatory reporting, and compliance with relevant laws, regulations, and institutional policies. An effective system of internal control for interest rate risk includes:

  • A strong control environment
  • An adequate process for identifying and evaluating risk
  • The establishment of control activities such as policies, procedures, and methodologies
  • Adequate information systems
  • Continual review of adherence to established policies and procedures

Sound Interest Rate Risk Management Practices

Sound interest rate risk management involves the application of four basic elements in the management of assets, liabilities and OBS instruments:

  • Appropriate board and senior management oversight
  • Adequate risk management policies and procedures
  • Appropriate risk measurement, monitoring, and control functions
  • Comprehensive internal controls and independent audits

Board and Senior Management Oversight of Interest Rate Risk

Effective oversight by a bank’s board of directors and senior management is critical to a sound interest rate risk management process. It is essential that these individuals are aware of their responsibilities with regard to interest rate risk management and that they adequately perform their roles in overseeing and managing interest rate risk.

Board of Directors

In order to carry out its responsibilities, the board of directors in a bank should approve strategies and policies with respect to interest rate risk management and ensure that senior management takes the steps necessary to monitor and control these risks consistent with the approved strategies and policies. The board of directors should be informed regularly of the interest rate risk exposure of the bank in order to assess the monitoring and controlling of such risk against the board’s guidance on the levels of risk that are acceptable to the bank.

Senior Management

Senior management must ensure that the structure of the bank’s business and the level of interest rate risk it assumes are effectively managed that appropriate policies and procedures are established to control and limit these risks, and that resources are available for evaluating and controlling interest rate risk.

Senior management is also responsible for maintaining:

  • Appropriate limits on risk taking
  • Adequate systems and standards for measuring risk
  • Standards for valuing positions and measuring performance
  • A comprehensive interest rate risk reporting and interest rate risk management
  • Review process
  • Effective internal controls

Lines of Responsibility and Authority for Managing Interest Rate Risk

Banks should clearly define the individuals and/or committees responsible for managing interest rate risk and should ensure that there is adequate separation of duties in key elements of the risk management process to avoid potential conflicts of interest.

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