IRR Bank Final

8/8/2019 IRR Bank Final

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Management ofInterest Rate Risk in Banks


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Interest Rate Risk (IRR)

Definition:It is the potential loss from unexpected changes in

interest rates which can significantly alter a banks

profitability and market value of equity


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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.


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Interest Rate Risks - Types

Interest Rate Risks

Yie ERepricing Risk Basis Risk Risk Option Risk

Interest Rate

Risk

Re-pricing

Risk

Basis

Risk

Yield

Risk

EmbeddedOption

Risk


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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 / expenses ignored- Static vs. Dynamic

Liabilities Assets Spread

Capital @ ROI Maturity Investment @ Maturity

(Crore)(Crore) ROIScenario-1 ProfitRs100 9% One year Rs100 10% Two year 1%(1crore)

Scenario-2 LossRs100 11% 2nd year Rs100 10% Two year 1%(1crore)


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Basis Risk

Interest rates on assets and liabilities do not change in the sameproportion.

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 andalso market imperfections.

Therefore, basis risk arises when interest rates of different assetsand liabilities change in different magnitudes.

The `basis form of IRR results from the imperfect correlationbetween interest adjustments when linked to different index ratesdespite having the same re-pricing characteristics.


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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)


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Embedded Option Risk

Risks arising out of prepayment of loans and bonds (with put orcall options) and / or premature withdrawal of deposits beforetheir stated maturity dates


Capital @ Maturity Loan @ ROI Maturity

(Crore) ROI (Crore)

Scenario-1 90 90 ProfitRs100 8% days Rs100 10% days 2%(0.49crore)

Scenario-2 90 90 2%(0.164crore)Rs100 for 30days8% days Rs100 10% days

Int. Rates 60 1%(0.164crore)for 60 daysdecline after days

30 days to 9%

Total 0.328 crore


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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.


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Yield Curve Risk - An Illustration


Capital @ ROI Maturity Loan @ ROI Maturity

(Crore) (Crore)

Scenario-1 3 year Loan 3 year ProfitRs100 fixed(quar13.5% 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 ProfitRs100 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%


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Interest Rate Risks - Measurement

Interest Rate Risks

Yie ERepricing Risk Basis RiskRisk Option Risk

Approachesto Measure

IRR

Maturity Gap

Analysis

Duration Gap

Analysis

Simulation


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Maturity Gap Analysis

MGA distributes

interest rate sensitive

assets, liabilities and OBS

positions into a certain

number of predefined timebands according to their

maturity(if fixed rate) or

time remaining to their next

repricing(if floating rate)


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Maturity Gap Analysis ..

How is it done?The risk sensitive What is the Gap?

Objective: assets and riskThe gap is then

To improve the sensitive liabilities calculated bynet interest are grouped into considering the

income in the maturity buckets difference betweenshort run over based on maturity the absolute

discreet periods and the time until thevalues of the RSAs

of time called the first possible and RSLs.

gap periods. repricing due to RSG=RSAs-RSLschange in the interest

rates

Relative differences in each maturity bucket - represents the sensitivity in that

band.


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Maturity Gap Method (IRS)

Three Options:

A) RSA>RSL= Positive Gap

B) RSL>RSA= Negative Gap

C) RSL=RSA= Zero Gap


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Maturity Gap Analysis Option-1

Liabil Rate Increase Decreased Asset Rate Increase Decreased(Crores)ity % d Rate% % 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 492Int 756 784 728

incomeExpe

nse

NII= 246 256 236

A case of Positive Gap:

RSAs= Rs2800, RSLs=Rs1800 GAP=Rs2800-RS1800=Rs1000


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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 492Int 756 784 728

incomeExpe

nse

NII= 246 256 236

A case of Negative Gap:

RSAs= Rs800, RSLs=Rs1800 GAP=Rs800-Rs1800=(-)Rs1000


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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 492Int 756 784 728

incomeExpe

nse

NII= 246 256 236

A case of Zero Gap:

RSAs= Rs1800, RSLs=Rs1800 GAP=Rs1800-Rs1800=0


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Inferences from above options:

SCENARIO STRATEGY

Maintain a positive gapRising Interest Rates

Declining InterestMaintain a Negative gapRates

Uncertain situationMaintain a Zero gap

(May not occur in reality)No benefits


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Duration Gap Analysis

Duration Gap Analysis - What is it?

DurationDurationAnalysis:

DurationAnalysis:Duration is a Analysis:It concentratesmeasure of the It also measures

on the price riskpercentage the effect of rateand thechange in the fluctuation on

reinvestmenteconomic value the market valuerisk whileof a position that of the assets and

managing theoccurs given a liabilities andinterest ratesmall change in NIM with the helpexposure.level of interest of duration.

rate.


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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 ratesrise/fall by 2%, what would be its implication on the NIM of Bharath Bank?

Liabiliti Amount Duration Int. Rate Assets Amount Duration Int. Rate(months) (months)es (Crore) (%) (Crore) (%)

Equity Cash200 200

ST ST

Depo Loans1800 5.5 11.5 1800 2.75 12.5

LT LTDepo Loans2500 23.7 15 2000 23 16.5

Others Invest

ments500 11.5 11 1000 10.5 13.5

5000 5000


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Duration Gap Analysis

Answer:RSG = RSAs - RSLs = (1800+1000) - (1800+500) = 500

AmountDurationInterest IncreasedDecreased Amount Duratio Interest Increased DecreasedLiabi Assetsnlities

(crore) in MnthsRate(%) Int. Int. (crore) in Rate(%) Int. Int.

Rate(%) Rate(%) Mnths Rate(%) Rate(%)

Equity 200 Cash 200STST

Depos 1800 5.5 11.5 13.5 9.5 Loans 1800 2.75 12.5 14.5 10.5

LTLTDepos 2500 23.7 15 15 15 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 5000Int. 637 683 591 Int 690 746 634Expe Income

NII 53 63 43NIM 0.010 0.0126 0.0086

6


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Simulation

What is it? Data RequirementSimulates performance underalternative interest rate Maturity and repricingscenarios and assesses the Rate scenariosresulting volatility in NII / NIM Alternative management/ ROA / ROE / MVE

response under differentscenarios A financial modelYield curvesincorporating inter-Prepayment tablesrelationship of assets,

liabilities, prices, costs, Behavioural pattern of assets

volume, mix and other and liabilitiesbusiness related variables Consistency of assumptions

Computer generatedscenarios about future andresponse to that in a dynamicway


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Simulation - Other information

Risk-Return policies - management appetite for risktaking

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


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Simulation

-Advantages -DisadvantagesForward looking

Accuracy depends on qualityDynamic

of data, strength of the model

and validity of assumptionsLessens the role of crisismanagement

Time consuming

Increases the value ofHuge investment in computer

strategic planning

Requires highly skilledEnhances capability of Personnelanalysis

Analysis paralysisInterpretation easy

Timing of cash flows capturedaccurately


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Model

Deploy

Mo itorly e

ct

I tere t R te Ri k M geme t


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Interest Rate Risk Management

* The ability of these types of models to capture this type of risk will vary with them

Interest Rate Risk Models

Risk Measurement Systems

GAP

Report

Earning

SimulationEconomic Valuation

Short-term earning exposure Yes Yes

Generally does not

distinguish short-term

accounting earnings from

changes in economic value

Long-term exposure Yes Limited* Yes

Repricing Risk Yes Yes YesBasis Risk Limited* Yes Limited*

Yield Curve Risk Limited* Yes Yes

Option Risk Limited* Limited* Yes


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Benefits from IRR management

Defined financial targets based on corporate risktolerances

Reduced earnings volatility

Improved cash flow forecasting

Improved corporate credit ratings

Defined risk management and hedge methodologies


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Based on the quantity of interest rate risk and quality of

interest rate risk management, we can evaluate the

adequacy of the banks capital

Determine the component rating for sensitivity to market

risk

Determine further the effect of interest rate and earningson the business in a macroscopic view

Conclusion


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Questions? NOW

Documents

IRR Bank Final