Management Of Interest

Rate Risk In Banks

 Agenda Items
for the Session:

What is Interest Rate Risk

What are the types of Interest Rate Risks

Effects of Interest Rate Risks

Measurement of Interest Rate Risks

Strategies for Controlling Interest Rate Risks

Basel Committee Recommendations

Sound Interest Rate Risk Management

Practices
 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

Yield Curve Embedded

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/ exp. 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)
 Mismatched Repricing Periods of Assets/Liabilities
Illustrations:

Liabilities Assets Spread

Capital @ ROI Maturity Investment @ ROI Maturity
(Crore) (Crore)
Scenario-1 Fixed Rate Profit
Rs100 8% 91 days Rs100 10% 91 days 2%(0.49crore)
Scenario-2 Fixed Rate Profit
Rs100 9% 91 days Rs100 11% 91 days 2%(0.49crore)
Scenario-3 Float Rate Profit
Rs100 8% 91 days Rs100 10% (1st month) 30 days 2%(0.164crore)
Float Rate Profit
11%(2nd month) 61 days 3%(0.5crore)
Asset
Sensitive Total: 0.664 Crore
Scenario-4 8% 91 days Rs100 Fixed Rate
Rs100 10% 5 years
9% 91 days
Liability
Sensitive
 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 ..

What is shape of Yield Curve

Yield Curve Yield Curve
yield curve Risk

The shape of the The risk of

Yield Curve is yield curve is
the relation TEXT experiencing
influenced by supply an adverse
between the and demand. The
interest rate shift in
yield curve may also
(or cost of be flat or hump-
market
borrowing) and shaped, due to interest rates
the time to anticipated interest associated
maturity of the rates being steady, with
debt for a or short-term investing in a
given borrower volatility
in a given
fixed income
outweighing long- instrument.
currency. term volatility.
 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 Reference: rterly (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

22.05.2013 4.48% 5.48% 4.62% 7.62% 2.14%
08.08.2013 4.93% 5.93% 4.85% 7.85% 1.92%
08.12.2013 4.71% 5.71% 4.24% 7.24% 1.53%
 Interest Rate Volatility
Impact of Interest Rate Volatility on the Net
Interest Income
IMPACT OF INCREASE / DECREASE IN RATE OF INTEREST ON NII
COL1 COL2 COL3 COL4 COL5

Maturity pattern RSL - OUTFLOWS RSA - INFLOWS GAP - RSA - RSL CHANGE IN NII FOR
0.25 % DECREASE

1- 14 DAYS 18785.27 15920.09 -2865.18 7.16

15 - 28 DAYS 31772.55 31161.34 -611.21 1.53
29 DAYS - 3 MTS 68403.39 77914.78 9511.39 (-23.78)
3-6 MONTHS 87629.72 90673.27 3043.55 (-7.61)
6-ONE YEAR 101260.22 98917.23 -2342.99 5.86
ONE - 3 YEARS 108310.71 106316.51 -1994.2 4.99
3-5 YEARS 114558.21 124538.91 9980.7 (-24.95)
ABOVE 5 YRS 134964.33 137905.36 2941.03 -7.35
 Measurement of IRR

Approaches to Measure IRR

Maturity Duration
Gap Simulation Value at
Gap
Analysis Risk
Analysis
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
 Factors Affecting Net Interest Income: An Example

• 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
 Factors Affecting Net Interest Income

• Changes in the level of interest rates

• Changes in the composition of assets and liabilities
• Changes in the volume of earning assets and
interest-bearing liabilities outstanding
• Changes in the relationship between the yields on
earning assets and rates paid on interest-bearing
liabilities
 Examine the impact of the following
changes

• A 1% increase in the level of all short-term rates?

• A 1% decrease in the spread between assets yields
and interest costs such that the rate on RSAs
increases to 8.5% and the rate on RSLs increase to
5.5%?
• Changes in the relationship between short-term
asset yields and liability costs
• A proportionate doubling in size of the bank?
 1% increase in short-term rates
Expected Balance Sheet for Hypothetical Bank
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
With a negative GAP, more liabilities than assets reprice higher; hence NII
and NIM fall
Maturity Gap Method –
Mathematical Expressions
RSG = RSAs - RSLs 1

Gap Ratio = RSAs / RSLs 2

NII = Gap x r 3
Where,

NII = Change in Net Interest Income

r = Change in Interest Rates

NII = Earning Assets x NIM 4

 Maturity Gap Method – Mathematical
Expressions ..

• NII = Earning Assets x NIM x C

• Where, C = % change in NIM
• Since, NII = Gap x r
• Gap x r = Earning Assets x NIM x C
• Therefore,
• Earning Assets x NIM x C
• GAP = ----------------------------------------------- 5
• r
• Where; Earning Assets = Total Assets of the Bank
• NIM = Net Interest Margin
• C = Acceptable Change in NIM
• r = Expected Change in Interest Rates
 Maturity Gap Method –
Illustration
• Bharat bank has earning assets worth Rs. 3000 crores and a Net
Interest Margin(NIM) of 3%. In a swift move Bharat Bank decided
that a 2% increase/decrease in the NIM can be the acceptable limit.
It further forecasts that a 0.75% increase in the interest rate. Now
you are required to calculate the target gap which the bank can
maintain to remain within the acceptable limits of NII.
• Answer:
• Earning Assets x NIM x C
• GAP = ------------------------------------------------------
• r
• 3000 x 0.03 x 0.02 1.8
GAP = --------------------------------------------- = ----------- = Rs. 240 Crore
0.0075 0.0075
 Maturity Gap Method – Mathematical
Expressions .. Gap Ratio

• Consider the Following Illustration of two banks which have a same Gap
Ratio;
Parameters Bank A Bank B
RSA 2900 1005
RSL 2000 695
GAP 900 310
GAP Ratio 1.45 1.45
NII 830 390
Decrease in Interest 0.5 0.5
Change in NII (GAP * Change in R) 455 155
%change in NII (Change in NII /NII) 0.54% 0.40%

• Inference: Gap level is more helpful than the Gap Ratio in taking
Positions
 Maturity Gap Method – Mathematical
Expressions .. Rate Adjusted Gap

Rate Adjusted Gap = ( RSA1 * WA1 + RSA2 * WA2 + ……. )

• - ( RSL1 * W1 + RSL2 * W2 + ……. ) 6
• Where,
• WA1 , WA2, …. are Weights of the corresponding RSAs
• WL1 , WL2, …. are Weights of the corresponding RSLs
• Illustration: The case of a Positive Gap turning Negative
Increased Increased
Liability Rate% Weight Rate% Assets Rate% Weight Rate%
200 200
1800 10 0.75 10.75 800 12 0.5 12.5
3000 11 11 1000 14 0.25 14.25
1000 16 0.5 16.5
2000 18 18
• Rate Adjusted Liabilities = 1800 x 0.75 = 1350
• Rate Adjusted Assets = [(800 x 0.5) + (1000 x 0.25) + (1000 x 0.5)] = 1150
• Rate adjusted Gap = 1150 – 1350 = (-) 200
• Inference: By assigning weights the Positive Gap has actually become Negative
 Statement Of
Interest Rate Sensitivity

• Generated by grouping RSA,RSL & OFF-

Balance sheet items in to various
(10)time buckets.
RSA:
• MONEY AT CALL
• ADVANCES ( BPLR LINKED )
• INVESTMENT
RSL:
• DEPOSITS EXCLUDING CD
• BORROWINGS
 Balance Sheet looked at from Interest Rates:

Balance Sheet looked at from Interest Rates:

Whether Interest Fixed / Floating
Balance Sheet Items bearing Rate Remarks
Liabilities
Capital No
Reserves & Surplus No
Deposits
- Current Deposits No
- Savings Deposits Yes Fixed
Discretionary pricing for High
Value deposits & Inter bank
- Term Deposits Yes Fixed items
Borrowings
- From within India Yes Fixed
Sometimes, floating, linked to
- From Outside India Yes Generally Fixed LIBOR
Other Liabilities
- Interest Payable Yes Fixed
In a few cases, this is floating
- Subordinated Debts Yes Fixed rate item
- Others NO
 IRS & Interest Rate Scenario

Impact of Interest Rate Changes on NII

Rising Interest Stable Interest Falling Interest
Rate Scenario Rate Scenario Rate Scenario

Negative Mis Matches in IRS Adverse No Impact Favourable

Mis Match in IRS is NIL No Impact No Impact No Impact

Positive Mis Matches in IRS Favourable No Impact Adverse

Limitations of Maturity Gap
Analysis
To a larger extent depends on the accuracy
level of the forecasts made regarding the
quantum and the direction of the interest
rate changes

While gap measurement is

easy, gap management is quite
difficult.
It assumes that
change in interest
rates immediately
affects all RSAs and
RSLs
Ignores Time Value
of
Money
 Duration Gap Analysis

Duration Analysis: Duration is a measure of the

percentage change in the economic value of a position
that occur given a small change in level of interest rate.
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
occur 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 Depo LT
2500 23.7 15 Loans 2000 23 16.5
Others Investm
500 11.5 11 ents 1000 10.5 13.5
5000 5000
 Duration Gap Analysis …
Answer:
RSG = RSAs – RSLs
= (1800+1000) – (1800+500) = 500
Duratio
Liabilities Amount Duration Interest Increased Decreased Assets Amount n Interest Increased Decreased
Int. Int. in Int. Int.
(crore) in Mnths Rate(%) Rate(%) Rate(%) (crore) Mnths Rate(%) Rate(%) Rate(%)
Equity 200 Cash 200
ST Depos 1800 5.5 11.5 13.5 9.5 ST Loans 1800 2.75 12.5 14.5 10.5
LT Depos 2500 23.7 15 15 15 LT 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
Int. Expe 637 683 591 Income 690 746 634
NII 53 63 43
NIM 0.0106 0.0126 0.0086
Using the Duration analysis to assess the sensitivity of the market value of Assets and
Liabilities.
Ds x S = ( D x A ) - ( DL x L ) 7
Where,
Ds = Duration Gap / Duration of Surplus
DA = Duration of Assets, DL = Duration of Liabilities A = Assets L = Liabilities
S = Surplus / Gap
 Duration Gap Analysis ….
Substituting L = A – S in the above eqn. We get
Ds = DL + ( A / S ) x ( DA - DL ) 8
When there is a market fluctuation,
-D( r) x Current MV
MV = ------------------------------------------ 9
(1+r)
Where, MV = Change in the market value
D = Duration of assets or liabilities
r = Change in the interest rate
r = Current interest rate
MV = Market Value
Then,

New MV = Current MV + MV 9
 Duration Gap Analysis …..
Then, -D( r) x Current MV
MV = -----------------------------------
(1+r)
The following is the information about Bharath Bank. Market value of
liabilities is Rs1800 crores, MV of Assets is Rs2000 Crores, Duration of
Assets is 5 years, Duration of Liabilities is 4 years, the ROI is 10% and
Change in the ROI is +2%. You are required to asses the change in the MV of
the bank whose Equity is currently Rs200 crore.

Answer:

Parameter Change in MV Original MV New MV

Assets -5(0.02) x2000 182 2000 1818
(1+0.1)
Liabilities -4(0.02) x1800 131 1800 1669
(1+0.1)
Equity 182 – 131 51 200 149
 Simulation

• Simulate performance under alternative interest rate scenarios

and assess the resulting volatility in NII / NIM / ROA / ROE /
MVE

• A financial model incorporating inter-relationship of assets,

liabilities, prices, costs, volume, mix and other business related
variables

• Computer generated scenarios about future and response to

that in a dynamic way
 Simulation - Data Requirement

• Maturity and repricing

• Rate scenarios
• Alternative management response under different
scenarios
• Yield curves
• Prepayment tables
• Behavioural pattern of assets and liabilities
• Consistency of assumptions
 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

• Forward looking
• Dynamic
• Lessens the role of crisis management
• Increases the value of strategic planning
• Enhances capability of analysis
• Interpretation easy
• Timing of cash flows captured accurately
 Disadvantages of Simulation

• Accuracy depends on quality of data, strength of the

model and validity of assumptions
• Time consuming
• Huge investment in computer
• Requires highly skilled personnel
• Analysis paralysis
Interest Rate Risk Management
 Interest Rate Risk Management

INTEREST RATE RISK MODELS

Risk Measurement Systems
GAP EARNINGS ECONOMIC VALUATION
REPORT SIMULATION
Short-Term Yes Yes Generally does not distinguish short-term
Earnings accounting earnings from changes in
Exposure economic value.
Long-term Yes Limited* Yes
Exposure
Repricing Risk Yes Yes Yes

Basis Risk Limited* Yes Limited*

Yield Curve Limited* Yes Yes

Risk
Option Risk Limited* Limited* Yes

* The ability of these types of models to capture this type of risk will vary with the
sophistication of the model and the manner in which bank management uses
 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,
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.