Interest Rate Risk Management of Prime bank

8/10/2019 Interest Rate Risk Management of Prime bank

1/19

Presentation on Interest Rate Risk

Management of a Commercial Bank in

Bangladesh

Prepared for:

Course Teacher : Tahmina AkhterAssistant Professor, Department of Finance

Management of Financial Institutions

Prepared By:

Kazi Omer Hasan ; ID#24036

Ismat Jerin Chetona ; ID#24065

Pallab Hossain Tushar ; ID#23016

Mobin Hossain ; ID#23057


2/19

Chapter 1-Introduction

This term paper provides an overview of the issues associated with understanding and

managing interest rate risk. It is intended to familiarize users with the key concepts.This

may necessitate users making further enquiries to more fully understand these issues.

The paper is supported by two appendicesone outlines key terminology and the other

provides a description of the key financial instruments which are associated with

interest rate risk management.

Defining and Managing interest rate risk

Definitionwhat is interest rate risk?

Interest rate risk should be managed where fluctuations in interest rate impact on theorganizations profitability. In an organization where the core operations are something

other than financial services, such financial risk should be appropriately managed, so

that the focus of the organization is on providing the core goods or services without

exposing the business to financial risks.

An adverse movement in interest rate risk may potentially:

increase borrowing costs for borrowers;

reduce returns for investors

reduce profitability of financial services providers such as banks; and

reduce the net present value (NPV) of organizations due to the effect of changes in

the discount rate (interest rate) on the value of financial instruments, hedges andthe return on projects.


3/19

Chapter 2

Sources of Interest Rate Risk

Interest rate risk can arise from a number of sources:

Where interest costs fluctuate according to interest rate movements during the life of

the

loan;

Resetting of interest rates on an entitys loans from banks or other lenders;

Resetting of interest rates on short-term investments such as bank deposits, commercial

paper, bank bills and so on;

The impact of interest rate changes on the value of long-term financial assets and

liabilities. For example, the value of a bond will fall as interest rates increase soinvestors in such instruments will initially benefit from a decrease in interest rates and

similarly borrowers of long-term funds may initially suffer an economic loss as rates

fall because their liabilities will increase. These economic gains and losses will only be

realized if the investment or liability is realized prior to maturity otherwise the

economic gain or loss represents an opportunity gain or a loss at the time that interestrates changed;

Derivatives e.g. interest rate swaps the value of these instruments will change as

interest rates change, representing either an opportunity gain or a loss (or real gain or

loss where the transaction is finalized prior to maturity);

Early payment discountoffered and received. For example, discount rates offered forearly payment by debtors may be higher than the organization's cost of funds;


4/19

Forward foreign exchange rates are affected by the differential between domestic

interest rates and foreign rates. For example, as Australian interest rates increase

relative to offshore rates, then the cost of hedging imports will increase and the cost of

hedging exports will fall;

Financial institutions are concerned about the interest rates on assets and liabilities

resetting at different times. This is known as mismatch risk or reprising risk. For

example, if the interest rates on its assets increase more than its liabilities then the

organization's profit will increase, and vice-versa.

Chapter 3

Impact of adverse movements in interest rates on organizations1.Borrowersin general concerned about rising rates

interest loans and associated hedges (the opposite applies where rates fall)

Investorsin general concerned about falling rates

Chapter 4 -Methods to measure interest rate risk

There are many ways to measure interest rate risk which can range from very simple

measures to very sophisticated measures which are mathematically complex and

require significant computing power. This guide provides some examples of the

simpler measures which can be applied and understood by most organizations.


5/19

Sensitivity analysis

-- Simple analysismeasurement of the impact of small changes of interest rates on the

accounting income or economic value. For example, if interest rates increase by 1 per cent now,

what will be the impact on the accounting income? Usually calculated on spreadsheets

-- Advancedmeasurement of the impact of multiple changes in interest rates and otherrelated variables on the entitys financial health. For example, if the entity is 50 per cent hedged

and interest rates increase by 1 per cent and earnings before interest, tax, depreciation and

amortization (EBITDA) fall by 10 per cent, what will be the impact on the entitys interest cover

ratio? This information may be presented in a tabular form.

-- Stress testmodeling the impact of a large change in interest rates on borrowings or

investments in accounting terms or risk outcomes. This type of measurement is frequently usedby financial institutions.

Re-pricing profiles (graphical representation of the interest reset of assets and liabilities over

time)

-- For entities this may be a graphical representation of the interest re-pricing of assets or

liabilities over time.

Chapter 5-Methods to manage interest rate risk

Before using financial instruments to manage interest rate risk, the organization should develop a

policy after determining the risk appetite of key stakeholders such as directors. Guidance in this

regard can be found in the CPA publication, Understanding and Managing Financial Risk.


6/19

There are many ways that interest rate risk can be managed.

-- A simple method is when the borrower requests its lender to fix the interest rate of its

loan for the period of the loan.

-- Where a borrower has a floating rate cost of funds, it can protect itself from rising

interest rates through an interest rate cap or option. Essentially this is like insuring

against rising rates. If the rates rise, the borrower is protected. If rates fall, the borrower

retains the benefit of the clearance in interest rates. As a borrower you pay a premium

for this protection from rising interest rates.

-- An alternative product for a borrower on floating rates would be to consider using an interest

rate swap. This product allows the borrower to lock in its floating rates for one to five years with

its own bank, or another bank if it has the credit limits. Though you do not pay an upfront fee, if

the rate falls below the fixed swap rate you have to pay the counterparty the difference.

-- Similarly borrowers can convert a fixed rate loan back to a floating loan using a derivative,

such as an interest rate swap.

-- Investors can invest in fixed rate assets or alternatively invest in floating rate assets and fix the

rate using an interest swap. Fixed rate assets may offer investors a better rate of return. However,

investors should be aware that they may experience significant losses on fixed rate assets should

interest rates increase and they terminate the investment prior to its maturity.


7/19

Changes in market interest rates might adversely affect a bank's financial condition.

Changes in interest rates affect both the current earnings (earnings perspective) as

well as the net worth of the bank (economic value perspective).

Re-pricing risk is the most apparent source of interest rate risk for a bank

Re-pricing risk is gauged by comparing the volume of a banks assets that mature or

re-price within a given time period with the volume of liabilities that do so.

The short term impact : the banks Net Interest Income (NII).

In a longer term : changes in interest rates impact the cash flows on the assets,

liabilities and off-balance sheet items.

giving rise to a risk to the net worth of the bank arising out of all re-pricing

mismatches and other interest rate sensitive position.

Interest rate risk may arise either from trading portfolio or non-trading portfolio. The

trading portfolio of the Bank consists of Government treasury bills of 28 days

maturity.


8/19

Interest rate risk is monitored through the use of re-pricing gap analysis and duration

analysis.Interest rate risk is further monitored through the ALCO.

STATEMENT OF REPRICING GAP

(Asset & Liability Maturity Analysis)

STATEMENT OF REPRICING GAP(Asset and Liability Maturity Analysis)

As at December 31, 20130

Not More than From 1 to 3 From 3 to 12 From 1 Year From 5 Years

Assets: 1 Month Month Months to 5 Years and above

Cash in hand 5,769,261,088 - - - 11,873,385,700 17,642,646,788

Balance with other Banks & Finan 807,453,658 63,093,276 151,966 - - 870,698,900

Money at Call & Short Notice - - - - -Investment 1,867,566,359 12,748,348,547 3,948,636,636 43,604,902 38,331,360,065 56,939,516,509

Loans & Advances 34,355,437,436 33,818,860,912 46,707,588,279 29,030,155,201 9,676,718,401 153,588,760,229

Premises & Fixed Assets 51,457,536 102,915,072 164,716,522 1,114,275,544 4,973,354,988 6,406,719,662

Other Assets 23,087,732 1,685,100,321 2,323,714,250 1,234,935,105 3,153,625,328 8,420,462,736

Total Assets: 42,874,263,809 48,418,318,128 53,144,807,653 31,422,970,752 68,008,444,482 243,868,804,824

Liabilities:Borrowing from Bangladesh Bank 1,968,953 - 1,166,250,000 2,690,041,929 - 3,858,260,882

Deposits 31,319,060,024 59,261,788,585 32,818,144,014 25,220,821,396 51,205,910,108 199,825,724,127

Other Accounts 2,081,417,055 - - - - 2,081,417,055

Provision and Other Liabilities 41,042,700 2,178,001,273 547,216,548 357,731,192 11,949,793,939 15,073,785,652

Total Liabilities: 33,443,488,732 61,439,789,858 34,531,610,562 28,268,594,517 63,155,704,047 220,839,187,716

Net Liquidity Gap: 9,430,775,077 (13,021,471,730) 18,613,197,091 3,154,376,235 4,852,740,435 23,029,617,108

Exposed to Reinvestment risk Refinancing risk Reinvestment risk Reinvestment risk Reinvestment risk

Cumulative Net Liquidity Gap 9,430,775,077 (3,590,696,653) 15,022,500,438 18,176,876,673 23,029,617,108

Total


9/19

Net Liquidity Gap: interest rates rise by 1%

NII = (GAP) * R= (RSA- RSL)

R

Not more

than 1

Month 9,430,775,077 0.01 94307750.77

1-3 months (13,021,471,730) 0.01 -130214717.3

3-12 months 18,613,197,091 0.01 186131970.9

1-5 years 3,154,376,235 0.01 31543762.35

5 yrs and

above 4,852,740,435 0.01 48527404.35

Total : Tk. 230296171.1

We assume that Interest risk decreases 1%, then,

Net Liquidity Gap: interest rates fall by 1%

NII = (GAP) * R= (RSA- RSL)

R

Not more than 1

Month 9430775077 -0.01 -94307750.77

1-3 months -13021471730 -0.01 130214717.3

3-12 months 18613197091 -0.01 -186131970.9

1-5 years 3154376235 -0.01 -31543762.35

5 yrs and above 4852740435 -0.01 -48527404.35

-


10/19

NII = (GAP) * R= (RSA- RSL) R

We assume interest rate increase by 1%, then,

1 month bucket the Net liquidity gap is tk. 9430775077

NII = (GAP) * R= (RSA- RSL) R

= 94307750.77

Maturity grouping of rate sensitive assets and liabilities of the bank shows

significant positive gap in the first quarter and moderate gap during the rest three

quarters.

If market rates shifts upward by one percent the bank will enjoy a positive earning

to the tune of Tk. 230296171.1 and vice versa.

The impact is very insignificant compared to total revenue of the bank and also

within the acceptable limit as stipulated by Bangladesh Bank.


11/19

Market Risk Management

Market risk : the risk of losses in on and off-balance sheet positions arising

from adverse movements in market prices which may impact the Banksearnings and capital.

The purpose : to minimize the risk of loss and maximize profit in trading

portfolio.

The risk may pertain to interest rate related instruments (interest raterisk), equities (equity price risk) and foreign exchange rate risk (currency

risk). Besides, the Bank is also exposed to liquidity or funding risk.The Bank

has adopted Standardized Approach (SA) for computation of capital

charge market risk


12/19

Market Risk management is guided by well laid policies, guidelines,

processes and systems for the identification, measurement, monitoring

and reporting of exposures against various risk limits.

The Asset Liability Management Committee meets periodically and

reviews the positions of trading groups, interest rate sensitivity, sets

deposit and benchmark lending rates and determines the asset liability

management strategy

Treasury back office monitors Risk limits including position limits and

stop loss limits for the trading book and reviews periodically.


13/19

Maturity Method has been prescribed by Bangladesh Bank in

determining capital against market risk.

In the maturity method, long or short positions in debt securities

and other sources of interest rate exposures, including derivative

instruments, are slotted into a maturity ladder comprising 13 time-

bands (or 15 time-bands in case of low coupon instruments).

Fixed-rate instruments are allocated according to the residual term

to maturity and floating-rate instruments according to the residual

term to the next repricing date.

In Standardized (rule based) Approach the capital requirement for

various market risks (interest rate risk, price, and foreign exchange

risk) are determined separately.


14/19

The Bank also ensures that the capital levels comply with regulatory requirements

and satisfy the external rating agencies and other stakeholders including depositors.

The whole objectives of the capital management process in the Bank are to

ensure that the Bank remains adequately capitalized at all times.

The total capital requirement in respect of market risk is the sum of capital

requirement calculated for each of these market risk sub-categories.

Capital Charge for Interest Rate Risk = Capital Charge for Specific Risk + Capital

Charge for General Market Risk;

Interest rate risk Consolidate Tk. 219.60m

Assessment of capital adequacy is carried out in conjunction with the capital

adequacy reporting to the Bangladesh Bank.

The Bank has maintained capital adequacy ratio on the basis of Consolidated

and Solo are 12.03% & 12.04% respectively as against the minimum regulatory

requirement of 10%.

The Bank maintains capital levels that are sufficient to absorb all material risks.


15/19

INTEREST RATE RISK ANALYSIS (FOR 1% CHANGE IN THE MARKET RATE OF INTEREST)

The increase (decline) in earnings or economic value (or relevant measure used by

management) for upward and downward rate shocks according to managementsmethod for measuring IRRBB, broken down by currency (as relevant).


16/19

Senior management of Prime Bank develops processes that

identify, measure, monitor and control risks incurred by the bank;

maintains an organizational structure that clearly assigns responsibility, authority

and reporting relationships;

ensures that delegated responsibilities are being carried out effectively; sets

appropriate internal control policies; and

monitors the adequacy and effectiveness of the internal control system.

They ensure proper control through techniques such as top level reviews,

activity controls, physical controls, compliance with exposure limit,

approvals & authorizations and verification & reconciliation of transactions of the

Bank.

A di 1


17/19

Appendix 1

Terminology ( Key Terms Which May be Used)

Floating ratetypically this means the interest rate on a borrowing, investment or

hedge resets (reprices)in less than 12 months.

Fixed ratetypically this means the interest rate on a borrowing, investment or hedge

resets (reprices)in more than 12 months or the life of the loan or investment.

Yield curvea graphical representation of expected interest rates by the financial

market over time. Whererates increase over time, then the yield curve is said to be

positive or normal. Where rates decrease over time, then the yield curve is said to be

inverse. An inverse yield curve implies that financial markets expect interest rates tofall.

Outright interest rate riskthe impact of a change in the overall level of interest rate

risk. For example, if an investor holds a fixed interest bond and interest rates generally

increase, then the investor will experience a loss.

Basis riskthe change in the interest rate of one instrument relative to another. Forhedges to workperfectly, the value of the hedge must change exactly in line with the

financial instrument being hedged as interest rates change. If they dont then there is

basis risk.

Yield curve riskFinancial institutions may be reliant, for their hedges to be

effective, on interest rateschanging evenly across the yield curve. If this does not

happen, then the institution will experience yield curve risk.

R i i d t i k i t t t i i t b th th t t l


18/19

Repricing and repayment riskinterest rate repricing may not be the same as the contractual

repaymentterm of the financial instrument. For example, a floating rate note may be repayable in

five years (which is its repayment risk) but have an interest rate reset (interest rate repricing) of

90 days. Therefore, the repayment profile of a floating rate note is different from its repricing

profile.

Interest cover covenantsBanks typically require borrowings to have covenants. Onecovenant relatesthe amount of cash (typically measured by earnings before interest, tax,

depreciation and amortisation (EBITDA)) to interest expense. If interest rates increase, and the

organisation has not fixed its borrowing rate, then the ratio of cash to interest cost may fall below

the ratio (covenant) agreed by the bank. If this happens, the loan may become immediately

payable or the bank may impose a penalty rate of interest.

IndexesLoan agreements and derivatives may have a floating rate which periodically needs tobe reset.To ensure fairness, often the rate setting is done by reference to a floating rate index

such as BBSW (the bank bill swap rate) or BBSY (the bank bill swap bid rate) (which are both

shown as pages on the Reuters information services).

Appendix 2

Typical financial instrument and hedges

Interest ratio swaps (IRSs)IRSs allow borrowers or investors to convert a floating rateborrowing orinvestment into a fixed rate borrowing or investment for a pre-agreed time,

typically three or five years. The IRS is a separate instrument to the borrowing or investment

instrument. It is overlayed on the borrowing or instrument. For example the borrower will

receive a floating rate (e.g. BBSW) of funds from the IRS counterparty and pay (BBSW) this

through to the loan counterparty (who ideally has arranged the loan to be paid at the BBSW

rate). In return the borrower will pay the swap counterparty the fixed rate (effectively this willnow be the cost of funds . Swa s can be used for an international interest rate ex osure.

O ti O ti i il t i t t F i b i


19/19

OptionsOptions are similar to an insurance contract. For a premium, a borrower can insure

against thecost of funds in all or some of its borrowings exceeding a pre-agreed rate. Similarly

an investor can insure against the rate falling below a pre-agreed rate.

Interest rate

Bank bills/short-term borrowings/investmentsBank bills and commercial paper are paper are

short-term instruments, issued at a discount. This means the issuer (borrower) receives lessthan the face value at issue and pays the full amount (face value) at maturity. The difference

between the two is known is interest expense. Bank bills differ from commercial paper in that

the issuer of bank bills has entered into an agreement with a bank to guarantee payment

should the issuer default. This makes bank bills attractive to investors. With commercial

paper, the investor must rely on the credit worthiness of the issuer alone.

Bonds Bonds are instruments issued by borrowers to investors. The bond typically

has a face value,maturity date and rate of interest. The interest payable may be fixed

(i.e. a coupon) or be periodically reset at a margin above or below an index rate. The

former are known as fixed interest bonds. The latter are known as floating rate bonds.

Forward rate agreements (FRAs) FRAs allow a borrower or investor to lock in aborrowing or investment rate for a future period. FRAs are similar to IRSs but only

cover a single period. For example, a borrower may wish to lock in some of its

borrowing cost starting in three months for six months. The borrower could use a 3 v 6

FRA for this purpose which would lock in the rate at the beginning of the six-month

period. FRAs are usually to manage short-term rates up to 18 months and can be usedfor any major currency

Documents

Interest Rate Risk Management of Prime bank