Interest rate risk in DCCBs in Telangana

The benchmark rates have been falling continuously in the past few years. However
the following graph gives a long term perspective of the benchmark rates prevailing
in india.

The RBI maintains monetary stability in the country (moderate and stable inflation).
They use repo rates, which is the rate at which banks borrow rupees from RBI with a
one day maturity. This is why it is also called the key short term lending rate.
However, in the past three years, after the regulator had mandated the SLR
maintenance entirely in government securities for DCCBs, the benchmark rate has
only seen general reducing trend (as can be observed from the graph). However the
rates were always lower than the 2016-17 levels when most of the DCCBs in Telangana
had made their investment in government securities.
Since the benchmark rates had decreased, it was inevitable that the prices of these
government securities had increased (owing to the higher coupon rate which was
offered at the time of purchase; refer to https://www.thebalance.com/why-do-bond-prices-go-
down-when-interest-rates-rise-2388565). Since almost all DCCBs have held all their
government securities under Held to Maturity (HTM), it may be seen that a market
valuation of government securities of any DCCB bought at any point of time would
show a higher valuation than the book value reflected in their books.
Whether my bank is facing a interest rate risk?
It depends on the ALM profile of the bank. It is in this light that the statement of
interest rate sensitivity, which NABARD is persuading the banks to prepare get their
importance.
Why should I prepare an interest rate sensitivity statement?
Interest rate sensitivity statement groups rate sensitive assets and liabilities into time
buckets according to their residual maturity or next repricing period whichever is
earlier.
Illustration:
Let us take a simple case where the bank has only one loan account given
from one deposit with 5 years maturity (interest rate @ 7%) of amount
₹100.
1. A loan of ₹100 which is given at 10% per annum at a fixed interest rate for 5
years does not have a repricing period. It has a residual maturity period only
depending on the inflows from the repayments.
2. A same loan if given at PLR+1.5%. The situation is different. The periodicity of
review and increase in the interest rates may be mentioned - once in a quarter
or once in six months in the interest rate reset clause in the loan agreement.
The NIM would be 3%. Now, generally the term deposits have a fixed interest rate.

Case 1 - Scenario 1
If the benchmark rates increase i.e., the repo increases; the general interest rates in
the market increase. This would put two risks in case 1;

1. The depositor might find better avenues for investment of his money inspite of
accounting for loss in interest due to pre-mature withdrawal; which might
leave me dry.
2. Assuming another depositor volunteers to deposit ₹100; new deposits will
have to be given at a higher rate owing to market situation; this increases my
cost of funds.

The situation leads to a decrease in NIM of the bank; resulting in reduction in bank’s
profitability in the short term and Market Value of Equity in the long term.

Case 1 - Scenario 2
If the bench mark rates decrease;

1. Depositor is happy; he gets more than the prevailing market rates

2. Since cost of funds would have decreased; NIM would have increased. More
profitability; More money,

This is what is happening right now!

Case 2 – Scenario 1

If the bench mark rates increase

1. My cost of funds will be higher, however I can reset my PLR based on the
prevailing rates and I still keep my margin. So NIM can be managed.

Case 2- Scenario 2
If the bench mark rates decrease
 1. Cost of funds will be lower, I can choose to reset/ not reset my PLR depending
on whether I want to pass on the benefit to the borrower or not.

In all possibility, case 2 gives better outcomes in any market condition. That is your
interest rate risk is lower in floating interest rate contracts.

References:
https://economictimes.indiatimes.com/banks-introduce-reset-clause-to-alter-interest-
rates/articleshow/2516011.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst