MANAGEMENT OF INTEREST RATE RISK
INTRODUCTION
IRR is the potential exposure to an entity’s earnings or value occasioned by unexpected changes in interest
rates.
A key function of Fls is asset transformation, that is buying primary securities and issuing secondary securities.
The primary securities purchased by Fls, often have maturity and liquidity characteristics different from those of
secondary securities Fls sells. In mismatching the maturities of assets and liabilities as part of their assets
transformation function, Fls potentially expose themselves to interest rate risk.
Consider for example, a Fl that issues liabilities of one year maturity to finance purchase of assets with a two year
maturity. The FI is ‘‘short-funded’’, that is the maturity of its liabilities is less than the maturity of its assets.
Suppose the cost of funds (liabilities) for the Fl is 9 percent per annum and the interest return on an asset is 10%
per annum. Over the first year the Fl can lock in a profit a profit spread of 1% (10%-9%) by borrowing short term
(for one year ) and lending long term (for two years). However its profits for the second year are uncertain. If the
level of interest rates does not change, the Fl can refinance its liabilities at 9%and lock in a 1% profit for the
second year as well. There is always a risk, however that interest rates could change between years 1&2. If
interest rates were to rise and the Fl could borrow one-year liabilities only at 11% in the second year, its profit
spread in the second year would actually be negative; that is; 10% -11% = -1%. The positive spread earned in the
first year by the Fl from holding assets with a longer maturity than its liabilities would be offset by a negative
spread in the second year. As a result. Whenever a Fl holds longer term assets relative to liabilities it potentially
expose itself to refinancing risk. This is the risk that the cost of rolling over or re-borrowing funds could be more
than the return earned on asset investments.
An alternative balance sheet structure would have the Fl borrowing for a longer term than the asset in which it
invests, ie. being ‘‘long funded’’, that is the maturity of its liabilities is longer than that of its assets. Suppose the Fl
borrowed funds at 9% per annum for two years and invested the funds in an asset that yields 10% for one year.
As before, the bank locks in a one year profit spread of 1%. It would require to reinvest the funds repaid after one
year as the depositors had locked in the funds for 2 years. It may reinvest these funds at say 8%, 10% or 12%.
The Fl is thus exposed to reinvestment risk when it holds short term assets relative to liabilities, that is it faces the
uncertainty about the interest rate at which it would reinvest the funds borrowed for a longer period.
In addition to a potential refinancing or reinvestment risk that occurs when interest rates change, a Fl faces
market value risk as well. Remember that the market value of an asset or liability is conceptually equal to the
discounted future cash flows from that asset. Therefore rising interest rates increases discount rate on those
cash flows and reduce the market value on that asset or liability. Conversely, falling interest rates increases the
market value of assets and liabilities. Mismatching maturities by holding longer terms assets than liabilities means
that when interest rates rise the market value of Fl’s assets falls by a greater amount than its liabilities. This
exposes the Fl to the risk of economic loss and insolvency.
Fl’s can be hedged or protected against interest rate changes by matching maturities of their assets and liabilities.
It is one of the best approaches to management of interest rate risk, especially for Fl’s that are averse to risk.
However, matching maturities may work against an active asset transformation function for Fl’s that is Fl’s cannot
be asset transformers and direct balance sheet hedgers at the same time. While reducing exposure to interest
rate risk, matching maturities may also reduce the profitability of being Fl’s because any returns from acting as
specialized risk bearing asset transformers are eliminated . As a result some Fl’s emphasize asset-liability
maturity mismatching more than others. For example, commercial banks hold longer term assets than liabilities
whereas life insurance companies tend to match the long term nature of liabilities with long term assets. Finally
matching maturities hedges interest rate risk only partially due to the complex nature and durations of assets and
liabilities.
SOURCES AND EFFECTS OF INTEREST RATE RISK
Interest rate risk is the exposure of a bank's financial condition to adverse movements in interest rates. Accepting
this risk is a normal part of banking and can be an important source of profitability and shareholder value.
However, excessive interest rate risk can pose a significant threat to a bank's earnings and capital base. Changes
in interest rates affect a bank's earnings by changing its net interest income and the level of other interest
sensitive income and operating expenses. Changes in interest rates also affect the underlying value of the bank's
assets, liabilities, and off-balance-sheet (OBS) instruments because the present value of future cash flows (and in
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some cases, the cash flows themselves) change when interest rates change. Accordingly, an effective risk
management process that maintains interest rate risk within prudent levels is essential to the safety and
soundness of banks. Before getting to some principles for interest rate risk management, sources and effects of
interest rate risk are reviewed briefly. The primary forms of interest rate risk to which banks are typically exposed
include repricing risk, yield curve risk, basis risk and optionality, each of which is discussed. Also discussed are
the two most common perspectives for assessing a bank's interest rate risk exposure: the earnings perspective
and the economic value perspective.
Sources of interest rate risk
Repricing risk: As financial intermediaries, banks encounter interest rate risk in several ways. The primary form of
interest rate risk arises from timing differences in the maturity (for fixed-rate) and/or repricing (for floating-rate) of
bank assets, liabilities, and OBS positions. While such repricing mismatches are fundamental to the business of
banking, they can expose a bank's income and underlying economic value to unanticipated fluctuations as
interest rates vary. For instance, a bank that funded a long-term fixed-rate loan with a short-term deposit could
face a decline in both the future income arising from the position and its underlying value if interest rates increase.
These declines arise because the cash flows on the loan are fixed over its lifetime, while the interest paid on the
funding is variable, and increases after the short-term deposit matures.
Yield curve risk: Repricing mismatches can also expose a bank to changes in the slope and shape of the yield
curve. Yield curve risk arises when unanticipated shifts of the yield curve have adverse effects on a bank's
income or underlying economic value. For instance, the underlying economic value of a long position in a10-year
government bond hedged by a short position in a 5-year government notes could decline sharply if the steepness
of the yield curve increases.
Basis risk: Another important source of interest rate risk, commonly referred to as basis risk, arises from imperfect
correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing
characteristics. When interest rates change, these differences can give rise to unexpected changes in the cash
flows and earnings spread between assets, liabilities and OBS instruments of similar maturities or repricing
frequencies. For example, a strategy of funding a one-year loan that reprices monthly based on the one-month
treasury bill rate, with a one-year deposit that reprices monthly based on one-month average inter-bank rate
exposes the institution to the risk that the spread between the two rates may change unexpectedly.
Optionality: An additional and increasingly important source of interest rate risk arises from the options embedded
in many bank assets, liabilities, and OBS portfolios. Formally, an option provides the holder the right, but not the
obligation, to buy, sell, or in some manner alter the cash flow of an instrument or financial contract. Options may
be stand-alone instruments such as exchange-traded options and over-the-counter (OTC) contracts, or they may
be embedded within otherwise standard instruments. While banks use exchange-traded and OTC options in both
trading and non-trading accounts, instruments with embedded options are generally more important in non-trading
activities. Examples of instruments with embedded options include various types of bonds and notes with call or
put provisions, loans which give borrowers the right to prepay balances, and various types of non-maturity deposit
instruments which give depositors the right to withdraw funds at any time, often without any penalties. If not
adequately managed, the asymmetrical payoff characteristics of instruments with optionality features can pose
significant risk particularly to those who sell them, since the options held, both explicit and embedded, are
generally exercised to the advantage of the holder and the disadvantage of the seller. Moreover, an increasing
array of options can involve significant leverage which can magnify the influences (both negative and positive) of
option positions on the financial condition of the firm.
Effects of interest rate risk
Changes in interest rates can have adverse effects both on a bank's earnings and its economic value. This has
given rise to two separate, but complementary, perspectives for assessing a bank's interest rate risk exposure.
Earnings perspective: In the earnings perspective, the focus of analysis is the impact of changes in interest rates
on accrual or reported earnings. This is the traditional approach to interest rate risk assessment taken by many
banks. Variation in earnings is an important focal point for interest rate risk analysis because reduced earnings or
outright losses can threaten the financial stability of an institution by undermining its capital adequacy and by
reducing market confidence. In this regard, the component of earnings that has traditionally received the most
attention is net interest income (i.e. the difference between total interest income and total interest expense). This
focus reflects both the importance of net interest income in banks' overall earnings and its direct and easily
understood link to changes in interest rates. However, as banks have expanded increasingly into activities that
generate fee-based and other non-interest income, a broader focus on overall net income - incorporating both
interest and non-interest income and expenses - has become more common. Non-interest income arising from
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many activities, such as loan servicing and various asset securitization programmes, can be highly sensitive to,
and have complex relationships with, market interest rates. For example, some banks provide the servicing and
loan administration function for mortgage loan pools in return for a fee based on the volume of assets it
administers. When interest rates fall, the servicing bank may experience a decline in its fee income as the
underlying mortgages prepay. In addition, even traditional sources of non-interest income such as transaction
processing fees are becoming more interest rate sensitive. This increased sensitivity has led both bank
management and supervisors to take a broader view of the potential effects of changes in market interest rates on
bank earnings and to increasingly factor these broader effects into their estimated earnings under different
interest rate environments.
Economic value perspective: Variation in market interest rates can also affect the economic value of a bank's
assets, liabilities, and OBS positions. Thus, the sensitivity of a bank's economic value to fluctuations in interest
rates is a particularly important consideration of shareholders, management, and supervisors alike. The economic
value of an instrument represents an assessment of the present value of its expected net cash flows, discounted
to reflect market rates. By extension, the economic value of a bank can be viewed as the present value of the
bank's expected net cash flows, defined as the expected cash flows on assets minus the expected cash flows on
liabilities plus the expected net cash flows on OBS positions. In this sense, the economic value perspective
reflects one view of the sensitivity of the net worth of the bank to fluctuations in interest rates.
Since the economic value perspective considers the potential impact of interest rate changes on the present value
of all future cash flows, it provides a more comprehensive view of the potential long-term effects of changes in
interest rates than is offered by the earnings perspective. This comprehensive view is important since changes in
near-term earnings – the typical focus of the earnings perspective - may not provide an accurate indication of the
impact of interest rate movements on the bank's overall positions.
Embedded losses: The earnings and economic value perspectives focus on how future changes in interest rates
may affect a bank's financial performance. When evaluating the level of interest rate risk it is willing and able to
assume, a bank should also consider the impact that past interest rates may have on future performance. In
particular, instruments that are not marked to market may already contain embedded gains or losses due to past
rate movements. These gains or losses may be reflected over time in the bank's earnings. For example, a long-
term, fixed-rate loan entered into when interest rates were low and refinanced more recently with liabilities bearing
a higher rate of interest will, over its remaining life, represent a drain on the bank's resources.
INTEREST RATE RISK MEASUREMENT
There are various techniques used by banks to measure the exposure of earnings and of economic value to
changes in interest rates. They range from calculations that rely on simple maturity and repricing tables, to
simulations based on current on- and off-balance-sheet positions, to highly sophisticated dynamic modeling
techniques that incorporate assumptions about the behaviour of the bank and its customers in response to
changes in the interest rate environment.
The simpler methods are intended primarily to capture the risks arising from maturity and repricing mismatches,
while the more sophisticated methods can more easily capture the full range of risk exposures.
Ideally, a bank's interest rate risk measurement system would take into account the specific characteristics of
each individual interest rate sensitive position, and would capture in detail the full range of potential movements in
interest rates. In practice, however, measurement systems embody simplifications that move away from this ideal.
For instance, in some approaches, positions may be aggregated into broad categories, rather than modeled
separately, introducing a degree of measurement error into the estimation of their interest rate sensitivity.
Similarly, the nature of interest rate movements that each approach can incorporate may be limited: in some
cases, only a parallel shift of the yield curve may be assumed or less than perfect correlations between interest
rates may not be taken into account. Finally, the various approaches differ in their ability to capture the optionality
inherent in many positions and instruments.
The simple approaches are now discussed.
Repricing schedules
The simplest techniques for measuring a bank's interest rate risk exposure begin with a maturity/repricing
schedule that distributes interest-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). Those assets and liabilities lacking definitive repricing intervals (e.g. sight deposits or savings accounts) or
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actual maturities that could vary from contractual maturities (e.g. mortgages with an option for early repayment)
are assigned to repricing time bands according to the judgment and past experience of the bank.
Simple maturity/repricing schedules can be used to generate simple indicators of the interest rate risk sensitivity
of both earnings and economic value to changing interest rates. When this approach is used to assess the
interest rate risk of current earnings, it is typically referred to as gap analysis.
Gap analysis
To evaluate earnings exposure, interest rate-sensitive liabilities in each time band are subtracted from the
corresponding interest rate-sensitive assets to produce a repricing “gap” for that time band. This gap can be
multiplied by an assumed change in interest rates to yield an approximation of the change in net interest income
that would result from such an interest rate movement. The size of the interest rate movement used in the
analysis can be based on a variety of factors, including historical experience, simulation of potential future interest
rate movements, and the judgment of bank management.
A negative, or liability-sensitive, gap occurs when liabilities exceed assets (including OBS positions) in a given
time band. This means that an increase in market interest rates could cause a decline in net interest income.
Conversely, a positive, or asset-sensitive, gap implies that the bank's net interest income could decline as a result
of a decrease in the level of interest rates. These simple gap calculations can be augmented by information on
the average coupon on assets and liabilities in each time band. This information can be used to place the results
of the gap calculations in context. For instance, information on the average coupon rate could be used to
calculate estimates of the level of net interest income arising from positions maturing or repricing within a given
time band, which would then provide a “scale” to assess the changes in income implied by the gap analysis.
Although gap analysis is a very commonly used approach to assessing interest rate risk exposure, it has a
number of shortcomings. First, gap analysis does not take account of
variation in the characteristics of different positions within a time band. In particular, all positions within a given
time band are assumed to mature or reprice simultaneously, a simplification that is likely to have greater impact
on the precision of the estimates as the degree of aggregation within a time band increases. Moreover, gap
analysis ignores differences in spreads between interest rates that could arise as the level of market interest rates
changes (basis risk). In addition, it does not take into account any changes in the timing of payments that might
occur as a result of changes in the interest rate environment. Thus, it fails to account for differences in the
sensitivity of income that may arise from option-related positions. For these reasons, gap analysis provides only a
rough approximation of the actual change in net interest income which would result from the chosen change in the
pattern of interest rates. Finally, most gap analyses fail to capture variability in non-interest revenue and
expenses, a potentially important source of risk to current income.
INTEREST RATE RISK MANAGEMENT PRINCIPLES
Board and senior management oversight of interest rate risk
Principle 1: In order to carry out its responsibilities, the board of directors in a bank should approve strategies
and policies with respect to interest rate risk management and ensure that senior management takes the steps
necessary to monitor and control these risks consistent with the approved strategies and policies. The board of
directors should be informed regularly of the interest rate risk exposure of the bank in order to assess the
monitoring and controlling of such risk against the board’s guidance on the levels of risk that are acceptable to the
bank.
Principle 2: Senior management must ensure that the structure of the bank's business and the level of interest
rate risk it assumes are effectively managed, that appropriate policies and procedures are established to control
and limit these risks, and that resources are available for evaluating and controlling interest rate risk.
Principle 3: Banks should clearly define the individuals and/or committees responsible for managing interest rate
risk and should ensure that there is adequate separation of duties in key elements of the risk management
process to avoid potential conflicts of interest. Banks should have risk measurement, monitoring, and control
functions with clearly defined duties that are sufficiently independent from position-taking functions of the bank
and which report risk exposures directly to senior management and the board of directors. Larger or more
complex banks should have a designated independent unit responsible for the design and administration of the
bank's interest rate risk measurement, monitoring, and control functions.
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Adequate risk management policies and procedures
Principle 4: It is essential that banks' interest rate risk policies and procedures are clearly defined and consistent
with the nature and complexity of their activities. These policies should be applied on a consolidated basis and, as
appropriate, at the level of individual affiliates, especially when recognising legal distinctions and possible
obstacles to cash movements among affiliates.
Principle 5: It is important that banks identify the risks inherent in new products and activities and ensure these
are subject to adequate procedures and controls before being introduced or undertaken. Major hedging or risk
management initiatives should be approved in advance by the board or its appropriate delegated committee.
Risk measurement, monitoring, and control functions
Principle 6: It is essential that banks have interest rate risk measurement systems that capture all material
sources of interest rate risk and that assess the effect of interest rate changes in ways that are consistent with the
scope of their activities. The assumptions underlying the system should be clearly understood by risk managers
and bank management.
Principle 7: Banks must establish and enforce operating limits and other practices that maintain exposures within
levels consistent with their internal policies.
Principle 8: Banks should measure their vulnerability to loss under stressful market conditions - including the
breakdown of key assumptions - and consider those results when establishing and reviewing their policies and
limits for interest rate risk.
Principle 9: Banks must have adequate information systems for measuring, monitoring, controlling, and reporting
interest rate exposures. Reports must be provided on a timely basis to the bank's board of directors, senior
management and, where appropriate, individual business line managers.
Internal controls
Principle 10: Banks must have an adequate system of internal controls over their interest rate risk management
process. A fundamental component of the internal control system involves regular independent reviews and
evaluations of the effectiveness of the system and, where necessary, ensuring that appropriate revisions or
enhancements to internal controls are made. The results of such reviews should be available to the relevant
supervisory authorities.
Information for supervisory authorities
Principle 11: Supervisory authorities should obtain from banks sufficient and timely information with which to
evaluate their level of interest rate risk. This information should take appropriate account of the range of maturities
and currencies in each bank's portfolio, including off-balance sheet items, as well as other relevant factors, such
as the distinction between trading and non-trading activities.
Capital adequacy
Principle 12: Banks must hold capital commensurate with the level of interest rate risk they undertake.
Disclosure of interest rate risk
Principle 13: Banks should release to the public information on the level of interest rate risk and their policies for
its management.
Supervisory treatment of interest rate risk in the banking book
Principle 14: Supervisory authorities must assess whether the internal measurement systems of banks
adequately capture the interest rate risk in their banking book. If a bank’s internal measurement system does not
adequately capture the interest rate risk, the bank must bring the system to the required standard. To facilitate
supervisors’ monitoring of interest rate risk exposures across institutions, banks must provide the results of their
internal measurement systems, expressed in terms of the threat to economic value, using a standardised interest
rate shock.
Principle 15: If supervisors determine that a bank is not holding capital commensurate with the level of interest
rate risk in the banking book, they should consider remedial action, requiring the bank either to reduce its risk or
hold a specific additional amount of capital, or a combination of both.
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