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 Risks

Yie E
Repricing Risk Basis Risk
Risk Option Risk
 Re-pricing 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 Investment
@ROI Maturity @ROI Maturity  
(Crore) (Crore)
Profit
Scenario-1 One Two
9% Rs 100 10% 1% (1
Rs 100 Year Year
Crore)
Loss
Scenario-2 Two Two
11% Rs 100 10% 1% (1
Rs 100 Year Year
Crore)
 Basis Risk

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

proportion

• 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 lacs)
 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 Loan
@ROI Maturity @ROI Maturity  
(Crore) (Crore)
Scenario-1 Profit
8% 90 Days Rs 100 10% 90 Days
Rs 100 2% (0.49 Crore)
Scenario-2 2% (0.164 Crore)
8% 90 Days Rs 100 10% 90 Days
Rs 100 for 30 days

 Interest Rate
1% (0.164 Crore)
      declined after 30 60 Days
for 60 days
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 re-pricing 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

Interest Rate Risks

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 re-
pricing (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. re-pricing 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 Summary

Change in Change in Change in Net

Change in
Gap Interest Interest Interest
Interest Rate
Income Expense Income
Positive Increase Increase > Increase Increase
Interest Rate Risks
Positive Decrease Decrease > Decrease Decrease

Negative Increase Increase < Increase Decrease

Negative Decrease Decrease

Yie< Decrease
E
Increase
Repricing Risk Basis Risk
Risk Option Risk

Zero Increase Increase = Increase None

Zero Decrease Decrease = Decrease None

 Example of Negative Gap

Consider the following balance sheet:

Expected Balance Sheet for Hypothetical Bank
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

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

NII = 78.5 - 37.2 = 41.3
NIM = 41.3 / 850= 4.86% GAP
= 500 - 600 = -100
 Example of Negative Gap

Consider the following balance sheet:

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

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

NII = 83.5 – 43.2 = 40.3
NIM = 40.3 / 850= 4.74% GAP
= 500 - 600 = -100
 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 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

It concentrates on the price risk and the reinvestment risk while

managing the interest rate exposure

It also measures the effect of rate fluctuation on the market

value of the assets and liabilities and NIM with the help of
duration
 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 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?

Liabilities Amount Duration Int. Rate Assets Amount Duration Int. Rate
(Crore) (months) (%) (Crore) (months) (%)
Equity 200 Cash 200
ST ST
Deposit 1,800 5.5 11.5 Loans 1,800 2.75 12.5

LT 2,500 23.7 15 LT 2,000 23 16.5

Deposit Loans

Invest
Others 500 11.5 11 1,000 10.5 13.5
ments
5,000 5,000
 Duration Gap Analysis…

Increased Increased Decreased

Amount Duration Interest Decreased Amount Duration Interest
Liabilities Int. Rate Assets Int. Rate Int. Rate
(Cr) (Months) Rate (%) Int. Rate (%) (Cr) (Months) Rate (%)
(%) (%) (%)

Equity 200         Cash 200        

ST ST
1,800 5.5 11.5 13.5 9.5 1,800 2.75 12.5 14.5 10.5
Deposit Loans

LT LT
2,500 23.7 15 15 15 2,000 23 16.5 16.5 16.5
Deposit Loans

Others 500 11.5 11 13 9 Invst 1000 10.5 13.5 15.5 11.5

  5,000           5,000        

Interest Interest
    637 683 591     690 746 634
Expense Income

NII     53 63 43            
NIM     0.0106 0.0126 0.0086            
 Simulation

What is it? Data Requirement

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

Advantages Disadvantages

- Accuracy depends on quality of data,

- Forward looking
- Dynamic
- Lessens the role of crisis management
- Increases the value of strategic planning
-Enhance capability of analysis
strength of the model and validity of
assumptions
- Time consuming
- Huge investment in computer
- Requires highly skilled personnel
- Analysis paralysis

- Interpretation easy

- Timing of cash flows captured accurately

Interest Rate Risk Management
 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

• Improved interest rate exposure forecasting and measurement capabilities

 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
• Smit Parikh (31)
• Devang Joshi (14)
• Maya Narayan (21)
• Pallavi Save (44)
• Rajiv Ajmera (02)
• Rajan Singh (53)
• Lokesh Motwani (26)