Management of

Interest Rate Risk in Banks

 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
 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.
 Interest Rate Risks - Types
Interest Rate Risk

Interest Rate Risks

Re-pricing Basis Yield Embedded Option
Risk Risk Risk Risk

Yie E
Repricing Risk Basis Risk
Risk Option Risk
 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 / expenses ignored
- Static vs. Dynamic

Liabilities Assets Spread

Capital @ ROI Maturity Investment @ Maturity
(Crore) (Crore) ROI
Scenario-1 Profit
Rs100 9% One year Rs100 10% Two year 1%(1crore)
Scenario-2 Loss
Rs100 11% 2nd year Rs100 10% Two year 1%(1crore)
 Basis Risk

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

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

• Interest rates movement is based on market perception of risk and also

market imperfections.

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

• The `basis’ form of IRR results from the imperfect correlation between
interest adjustments when linked to different index rates despite having the
same re-pricing characteristics.
 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)
 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

Liabilities Assets Spread

Capital @ Maturity Loan @ ROI Maturity
(Crore) ROI (Crore)
Scenario-1 90 90 Profit
Rs100 8% days Rs100 10% days 2%(0.49crore)
Scenario-2 90 90 2%(0.164crore)
Rs100 8% days Rs100 10% days for 30days

Int. Rates 60 1%(0.164crore)

decline after days for 60 days
30 days to 9%
Total 0.328 crore
 Yield Curve Risk

Risks caused due to the change in the yield curve from time to
time depending on the repricing and 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.
 Yield Curve Risk - An Illustration

Liabilities Assets Spread

Capital @ ROI Maturity Loan @ ROI Maturity
(Crore) (Crore)
Scenario-1 3 year Loan 3 year Profit
Rs100 13.5% fixed(quar Rs100 16% float(qua 2.5%
Reference: terly rterly
Reference: (2.5crore)
91 day T-Bill repriced) 364 day T-Bill @13% repriced)
@12.5%

Scenario-2 90 90 Profit
Rs100 15% days Rs100 16% days 1.0%
Reference: Reference: (1crore)
91 day T-Bill 364 day T-Bill @13%
@14%

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%
 Interest Rate Risks - Measurement
Approaches to Measure IRR

Interest Rate Risks

Maturity Gap Analysis Duration Gap Analysis Simulation

Yie E
Repricing Risk Basis Risk
Risk Option Risk
Maturity Gap Analysis

MGA distributes
interest rate sensitive
assets, liabilities and OBS
positions into a certain
number of predefined time
bands according to their
maturity(if fixed rate) or time
remaining to their next
repricing(if floating rate)
 Maturity Gap Analysis ..

How is it done?
The risk sensitive What is the Gap?
Objective: assets and risk
The gap is then
To improve the sensitive liabilities
calculated by
net interest are grouped into
considering the
income in the ‘maturity buckets’
difference between
short run over based on maturity
the absolute
discreet periods and the time until the
values of the RSAs
of time called the first possible
and RSLs.
gap periods. repricing due to
RSG=RSAs-RSLs
change in the interest
rates

Relative differences in each maturity bucket - represents the sensitivity in that band.
 Maturity Gap Method (IRS)

Three Options:
A) RSA>RSL= Positive Gap
B) RSL>RSA= Negative Gap
C) RSL=RSA= Zero Gap
 Maturity Gap Analysis … Option-1

Liabil Rate Increase Decreased Asset Rate Increase Decreased

ity % d Rate% (Crores) % d Rate%
(Crores) Rate% Rate%
200 200
1800* 10 11 9 800* 12 13 11
3000 11 11 11 1000* 14 15 13
1000* 16 17 15
2000 18 18 18
5000 5000
Int 510 528 492 Int 756 784 728
Expe income
nse
NII= 246 256 236

A case of Positive Gap:

RSAs= Rs2800, RSLs=Rs1800 GAP=Rs2800-RS1800=Rs1000
 Maturity Gap Analysis … Option-2

Liabil Rate Increase Decreased Asset Rate Increase Decreased

ity % d Rate% (Crores) % d Rate%
(Crores) Rate% Rate%
200 200
1800* 10 11 9 800* 12 13 11
3000 11 11 11 1000 14 15 13
1000 16 17 15
2000 18 18 18
5000 5000
Int 510 528 492 Int 756 784 728
Expe income
nse
NII= 246 256 236

A case of Negative Gap:

RSAs= Rs800, RSLs=Rs1800 GAP=Rs800-Rs1800=(-)Rs1000
 Maturity Gap Analysis … Option-3

Liabil Rate Increase Decreased Asset Rate Increase Decreased

ity % d Rate% (Crores) % d Rate%
(Crores) Rate% Rate%
200 200
1800* 10 11 9 800* 12 13 11
3000 11 11 11 1000* 14 15 13
1000 16 17 15
2000 18 18 18
5000 5000
Int 510 528 492 Int 756 784 728
Expe income
nse
NII= 246 256 236

A case of Zero Gap:

RSAs= Rs1800, RSLs=Rs1800 GAP=Rs1800-Rs1800=0
 Inferences from above options:
SCENARIO STRATEGY

Rising Interest Rates Maintain a positive gap

Declining Interest
Rates Maintain a Negative gap

Uncertain situation Maintain a Zero gap

(May not occur in reality)
No benefits
 Duration Gap Analysis

Duration Gap Analysis - What is it?

Duration
Analysis: Duration
Duration
Duration is a Analysis:
Analysis:
measure of the It concentrates
It also measures
percentage on the price risk
the effect of rate
change in the and the
fluctuation on
economic value reinvestment
the market value
of a position that risk while
of the assets and
occurs given a managing the
liabilities and
small change in interest rate
NIM with the help
level of interest exposure.
of duration.
rate.
 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 Amount Duration Int. Rate Assets Amount Duration Int. Rate
es (Crore) (months) (%) (Crore) (months) (%)
Equity 200 Cash 200
ST ST
Depo 1800 5.5 11.5 Loans 1800 2.75 12.5
LT LT
Depo 2500 23.7 15 Loans 2000 23 16.5
Others Invest
500 11.5 11 ments 1000 10.5 13.5
5000 5000
 Duration Gap Analysis …
Answer:
RSG = RSAs - RSLs = (1800+1000) - (1800+500) = 500

Liabi Amount Duration Interest Increased Decreased Assets Amount Duratio Interest Increased Decreased
lities n
(crore) in Mnths Rate(%) Int. Int. (crore) in Rate(%) Int. Int.
Rate(%) Rate(%) Mnths Rate(%) Rate(%)
Equity 200 Cash 200
ST ST
Depos 1800 5.5 11.5 13.5 9.5 Loans 1800 2.75 12.5 14.5 10.5
LT LT
Depos 2500 23.7 15 15 15 Loans 2000 23 16.5 16.5 16.5
Others 500 11.5 11 13 9 Investm 1000 10.5 13.5 15.5 11.5
5000 5000
Int. 637 683 591 Int 690 746 634
Expe Income
NII 53 63 43
NIM 0.010 0.0126 0.0086
6
 Simulation

What is it? Data Requirement

Simulates performance under
alternative interest rate Maturity and repricing
scenarios and assesses the Rate scenarios
resulting volatility in NII / NIM Alternative management
/ ROA / ROE / MVE
response under different
A financial model scenarios
incorporating inter- Yield curves
relationship of assets, Prepayment tables
liabilities, prices, costs, Behavioural pattern of assets
volume, mix and other and liabilities
business related variables Consistency of assumptions
Computer generated
scenarios about future and
response to that in a dynamic way
 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
 Simulation

-Advantages -Disadvantages
Forward looking

Dynamic Accuracy depends on quality

of data, strength of the model and
validity of assumptions
Lessens the role of crisis
management
Time consuming
Increases the value of
strategic planning Huge investment in computer

Enhances capability of Requires highly skilled

analysis Personnel

Interpretation easy Analysis paralysis

Timing of cash flows captured

accurately
Interest Rate Risk Management

Model
Act

Deploy

Analys
e

Monitor
 Interest Rate Risk Management

Interest Rate Risk Models

  Risk Measurement Systems
GAP Earning
  Economic Valuation
Report Simulation

Generally does not

distinguish short-term
Short-term earning exposure Yes Yes
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 them
 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

 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
Questions? NOW