Risk Management in Banks

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The business of banking is the
business of risk as
banks unlike companies deal
in financial assets and
liabilities/ obligations

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 Moreover, unlike other
companies business of banking
is highly leveraged as capital
constitute lesser proportion of
the total funds with a bank

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 Balance sheet as on 31st March, 09
Liabilities Rs. (in Assets Rs. (in
crores) crores)
Deposits: 85 Cash 03
Short term 45 Loans and 55
Medium term 30 advances:
Long term 10 Short term 30
Borrowings 05 Medium/long 25
Capital and surplus 10 Investments 40
Fixed assets 02
Total 100 Total 100 4
Credit risk: The probability that
borrower or counterparty will fail to
meet its obligations on the due
date as per the terms and
conditions of loan agreement or
other contract (guarantees, letter
of credit)

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Besides credit risk, other
risks that a bank face is
interest rate risk and
liquidity risk

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 Interest rate risk
Measures the vulnerability/sensitivity of the
net interest earnings (interest earned on
loans and advances and balances with
RBI – interest expended on deposits and
borrowings) to changes in interest rates in
economy. In other words, it is the
exposure of a bank’s net interest earnings
to adverse movements in interest rates.

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 Liquidity risk
Failure of the bank to meet its
borrowings and deposit
obligations as and when
arise.

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 Consider an example
A bank borrows 5% for a year and
lends money at 6% to a highly
rated borrower for 5 years.
Spread = 1% still a risky
transaction as it exposes bank to
liquidity risk → solvency risk and
interest rate risk.
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 Reason ?????
Mismatch between the duration of assets
and liabilities or assets liability
mismatch/mis-management

Borrowing short and lending long

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 Asset liability management
It is concerned with assessing the probability
of occurrence of an event and the position
of bank to handle these events with
minimum impact on earnings, liquidity
and solvency. Basically deals with
Interest rate risk management and liquidity
management

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Interest rate risk management

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 Sources of interest rate risk
• Yield curve risk
• Basis risk
• Re-pricing risk
• Optionality risk
• Other risks

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 Yield curve
• It is a curve that plots, at one point of time,
the interest rates of a security of equal
credit quality at different maturity dates in
future. For instance, a yield curve may
compare the yield on government bonds of
different maturities say 3 months, 2 years,
5 years.
• It is used as a benchmark to fix the rate of
interest on loans by banks and is also an
indicator of economic activity.
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 Yield curve risk
If a bank has a policy of pricing its deposits
(liabilities) at medium term interest rates
and loans and advances (assets) at either
short and long term interest rates based
on yield curve, an increase in curvature of
yield curve would expose bank to interest
rate risk as by fixing interest rates in this
manner bank would end up paying high
rate of interest on liabilities than assets
leading to fall in NIM of the bank.
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 Basis risk
• If the rate of interest on assets (loans and
advances) and liabilities (deposits) are
fixed on different base rates and if the
base rates diverge unexpectedly it would
expose bank to interest rate risk.
• Interest rate on assets fixed on the basis
of interest rate on g-sec (low) while that on
deposits fixed at inter bank lending rates
(high).

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 Optionality risk
Arising out of options embedded in many
bank assets and liabilities like
• Put (sell) and call (buy back) option.
• Option to pre-pay or withdraw (sweep-in
FDs) before maturity

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• If call option is exercised during declining
interest rate scenario, the investing bank
would face reinvestment risk as cash
realized from assets have to be reinvested
at lower rate of interest. Same in case of
prepayment of loan.
• If the bank has issued bonds with a put
option and the customer has exercised that
option during rising interest rate scenario,
bank would face prepayment risk as it has to
raise funds at higher rate of interest to
redeem the bond obligations. Same in case
of sweep in FDs where bank do not penalize
the depositor for the pre maturity withdrawal

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 Re-pricing risk
• The risk arise in case of floating rate loans
and advances whereby interest rate on
loans and advances are reset after some
time interval. A bank has funded long term
fixed rate loan (@ 6%) with floating rate
deposit (@5.5%). If the interest rate are
rising bank would be exposed to interest
rate risk as interest earned on loan would
be fixed at 6% but payable on deposit
would increase over a period of time.
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 Others
• Lower interest rates lead to prepayment by
borrowers (so that they can refinance their
loans at lower interest rates), it not only
reduces interest income and thus exposes
a bank to reinvestment risk but also
reduces the fee based income as it lead to
reduction in the fee charged by bank from
customer for servicing loan.

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Interest Rate Risk (IRR)
Measurement

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 Approaches to IRR measurement
• Earning based approach: Measures the
impact of interest rate sensitivity on net
interest earnings/margin of a bank for a
particular period of time. GAP analysis
• Economic value based approach:
Measures the impact of interest rate
sensitivity on the market value (of equity)
of a bank. DGAP analysis.
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 Gap analysis
• Tries to measure the impact of interest rate
volatility on the future net interest earnings of
the bank by preparing a GAP report for a
particular time period, say 0-90 days.
• GAP = Rate sensitive assets (RSA) – rate
sensitive liabilities (RSL)
• ∆ NII = GAP × ∆r (interest rate)

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 Rate sensitive asset and liability
• Those assets and liabilities that have to be
re-priced due to contractual obligations (as
in case of floating rate loans and advances) or
due to change in the base rate during a
particular time interval or
• Those assets and liabilities that need to be re-
invested/redeemed during a particular time
interval on account of maturity or on account
of the option exercised by the holder.
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Assessing the Impact on future NII
based on GAP report
• Sign and magnitude of the GAP in various time
buckets is used to assess the potential earnings
volatility arising from changes in interest rates.
• Positive GAP means RSA>RSL, which means
that future NII would increase with increase in
interest rates and vice versa while,
• Negative GAP means RSL>RSA, which means
that future NII would increase with decrease in
interest rates and vice versa
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 Summary
When GAP And Interest >/</= Interest Leading to
is interest income expense a net
rates income
Positive Increase Increases > Increases Increase

Positive Decrease Decreases > Decreases Decrease

Negative Increase Increases < Increases Decrease

Negative Decrease Decreases < Decreases Increase

Zero Increase Increases = Increase No change

Zero Decrease Decreases = Decreases No change

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 Limitations of GAP Analysis
• Static analysis
• Ignores the impact of optionality
• Ignores the basis risk
• Study only short term volatility in interest
income

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Duration Gap Analysis
 Relationship between interest rates and market
price of a security
A zero-coupon bond is trading at $950 and has a par value of
$1,000 (paid at maturity in one year), the bond's rate of
return at the present time is approximately 5.26% ((1000-
950) / 950 = 5.26%).
The market rate of this bond depends on movements of interest
rates in the bond market.
If current interest rates are expected to rise, giving newly
issued bonds a yield of 10%, then the zero-coupon bond
yielding 5.26% would not only be less attractive, it wouldn't
be in demand at all.
Bond investors, like all investors, typically try to get the best
return possible.
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Relationship between interest rates
and price of security
Who wants a 5.26% yield when they can get
10%?
To attract demand, the price of the pre-existing
zero-coupon bond would have to decrease
enough to match the same return yielded by
prevailing interest rates. In this instance, the
bond's price would drop from $950 (which
gives a 5.26% yield) to $909 (which gives a
10% yield).
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 Duration GAP Analysis

A technique that tries to measure the

impact of future interest rate volatility on
the market value of equity of a bank along
with its impact on the net interest income
over the entire life of rate sensitive assets
and rate sensitive liabilities is called
duration gap analysis

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 Duration GAP
Duration GAP is the difference between the
modified weighted average duration of assets
and modified leverage adjusted weighted
average duration of liabilities. Thus,
DGAP= Modified WADA – W × Modified
leverage adjusted WADL
W = weights

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 What does bond duration mean???
• Bond duration here means its term to maturity and the
yield to maturity. In other words, it is the time
required (by a security) to recoup/recover its initial
investment from its regular/periodic cash inflows.
And cash inflows in case of bonds are the periodic
interest installments that a bond holder get.
• As more and more interest installments get paid off
the duration or the time to maturity decreases and
reaches closer to its actual maturity.
• Usually bonds with higher interest rates have lower
duration due to faster recovery of investment. 33
What does bond duration mean???
• Bonds with higher duration are considered
more risky as their market values are more
vulnerable to changes in future interest rates.
• From a Zero Coupon Bond (on which no
interests are paid) and Plain Bond (on which
interest rates are paid periodically) a typical
investor would prefer Plain bond over ZCB.
Why???
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What does bond duration mean???
• It is so because the duration of a plain bond is
lesser than its maturity and hence recovery of
initial investment is faster as compared to
ZCB where coupon and original investment
can be recovered only at maturity and there are
no interim cash inflows.

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 How to measure duration???
1. MACAULAY’s Duration: It is computed as weighted
average maturity of security's cash flows.
(a) Here, present value of each cash flow – interest
and principle amount is used as weights and
multiplied with the time when it is received , discount
rate = the coupon rate of bond
(b) The aggregate computed [in (a)] is divided by the
current value of the security.
The duration so computed presents the average time
taken to various parts of a security’s cash inflows.
Shorter the duration the lesser the risk.
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 How to measure duration???

     
1  1c1   2c2   tct 
D   .....  t
P  (1 r )   (1 r ) 
1 2 
     (1 r ) 

Where P= face value of security, r = coupon rate, t = total

time period during which cash flows are received

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 Calculation of Duration
Period Cash flow PV of cash Proportion of cash flow Time to
(1) (2) flow (3) received (4)= (3)/1000 maturity
= (1) *(4)

1 100 90.91 0.09091 0.09091

2 100 82.64 0.08264 0.16528

3 1100 826.45 0.82645 2.47935

4 1000 2.73554
 Process of computing DGAP
Compute Duration
Compute Modified DA/weighted average
modified DA (WADA) and Modified DL/
weighted average modified DL (WADL)
Compute DGAP = Modified DA – (W×
Modified DL)
where, W= Total of RSL+NRSL/Total of
liabilities side including equity
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 How to measure duration???

     
1  1c1   2c2   tct 
D   ........ t

P (1 r )     

1 2

   (1 r )   (1 r ) 
Where P= current value of security, r = coupon rate, t =
total time period during which cash flows are received

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Weighted Average Modified DA

VA1 VA2 VAn

WADA  * DA1  * DA2  ...........  * DAn
VTA VTA VTA

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Weighted Average Modified DL

VL1 VL2 VLn

WADL  * DL1  * DL2  ...........  * DLn
VTL VTL VTL

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 DGAP

DGAP = Modified DA – (W× Modified DL)

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 Duration GAP Analysis
Rate sensitive assets Market value Rate (%) Duration
(in cr.)

3 year commercial loan 400 12 2.69

5 year bonds 200 10 4.17

RSA re-pricing within a year 100 6 1

Non- RSA 300

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 Duration GAP Analysis
Rate sensitive liabilities Market value Rate duration
(in cr.) (%)

3 year term deposit 400 10 2.73

Other deposits re-pricing within 400 6 1

a year
Non-RSL 110

Equity 90

Total 1000

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 Impact on MVE of rising interest rates
MVE= MVA-MVL
If interest rate increase by 100 bps or 1%
MacaulayDuration
1  Yield
Volatility =
MVA (new)= (-Mac D×∆r× current MVA)/(1+ current
yield)
MVA= {[(-2.69 ×0.01 ×400)/1.12]+[(-4.17 ×0.01
×200)/1.10]+[(-1 ×0.01 ×100)/1.06]}
=-9.607-7.582-0.943
=-18.13
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 Impact on MVE of rising interest rates

MVL (new)= (-Mac D×∆r× current MVL)/(1+

current yield)
MVL= {[(-2.73×0.01×400)/1.10]+[(-1×0.01
×400)/1.06]}
= -9.93-3.77
= -13.70
So, MVE= MVA-MVL
= -4.43
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 Impact on MVE of declining
interest rates
• MVA= +18.13
• MVL= +13.70
Hence, MVE = +4.43

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