CAIIB Super Notes: Bank Financial Management: Module D: Balance Sheet Management: Interest Rate Risk Management

CAIIB – Super-Notes © M S Ahluwalia Sirf Business

Interest Rate Risk Management

Module D: Balance Sheet Management

http://sirfbusiness.blogspot.com/search/label/CAIIB

http://msahluwalia.blogspot.com/

http://sirfbusiness.blogspot.com/




CAIIB – SUPER NOTES

Bank Financial Management: Interest Rate Risk Management





Contents

Coverage:

1. Essentials of Interest Rate Risk

2. Sources of Interest Rate Risk

3. Effects of Interest Rate Risk

4. Measurement of Interest Rate Risk

5. Interest Rate Risk Measurement Techniques

6. Strategies for controlling Interest Rate Risk

7. Controls and supervision of Interest Rate

Risk Management

8. Sound Interest Rate Risk Management

Practices





ESSENTIALS OF INTEREST RATE RISK

1.





Essentials of Interest Rate Risk

• Interest Rate risk is the exposure of a bank’s financial conditions to

adverse movements in interest rates

• Though this is normal part of banking business, excessive interest

rate risk can pose a significant threat to a bank’s earnings and

capital base

• Changes in interest rates affect

– Bank’s earnings by changing its Net Interest Income and level of other

interest sensitive income and operating expenses

– The underlying value of the bank’s assets, liabilities and off-balance-sheet

instruments





Interest Rate Risk

• Interest rate risk refers to volatility in Net Interest Income (NII)

or variations in Net Interest Margin(NIM)

• Therefore, an effective risk management process that

maintains interest rate risk within prudent levels is essential

to safety and soundness of the bank





SOURCES OF INTEREST RATE RISK

2.





Types of Interest Rate Risk

Gap Risk Gap Risk

•Arises from holding assets and liabilities with different principal amounts, maturity dates or repricing dates

•Bank is asset sensitive if assets are repriced much more rapidly than the liability during the period

•Liability sensitive if interest paid on its deposit is reset more rapidly than the rate being charged on the loan

Basis Risk Basis Risk

•Risk that interest rates of different assets and liabilities may change in different magnitudes

•Fairly high in respect of banks which create composite assets out of composite liabilities

Net Interest Position Risk Net Interest Position Risk

•Interest rate earned on assets changes while cost of funding of liabilities remains the same

Embedded Option Risk Embedded Option Risk

•Prepayment of loans/bonds and/or premature withdrawal of deposits

Yield Curve Risk

Yield Curve Risk

•Yield of all maturities of a particular investment

Price Risk Price Risk

•Assets are sold before maturity dates

Reinvestment Risk

Reinvestment Risk

•Uncertainty with regard to interest rate at which the future cash flows can be reinvested





EFFECTS OF INTEREST RATE RISK

3.





Effects of Interest Rate Risk

•Focus is impact of interest rate change on accrual or reported earnings particularly NII

•Traditional approach

Earnings Perspective Earnings Perspective

•Impact on Economic value of bank’s assets, liabilities and off balance sheet positions

•A view of the sensitivity of the net worth of the bank to fluctuations in interest rates

•Provides a more comprehensive view since it considers effect on present value of all future cash flows

Economic Perspective Economic Perspective

• Impact of past interest rates on bank performance

•Gains or losses reflected over time

• Instruments that are not marked to market

Embedded Losses Embedded Losses





MEASUREMENT OF INTEREST RATE RISK

4.





Measurement of Interest Rate Risk

• Before management, risk has to be identified and quantified

• Measurement systems should

– Assess all interest rate risk associated with Bank’s assets, liabilities and

OBS positions

– Utilise generally accepted financial concepts and risk management

techniques

– Have well documented assumptions and parameters





INTEREST RATE RISK MEASUREMENT TECHNIQUES

5.





Interest Rate Risk Measurement Techniques

• Simplest Technique

• Maturity/Repricing Schedule that distributes interest sensitive assets, liabilities and OBS positions into a certain no of predefined time bands based on maturity or time remaining to next repricing

Repricing Schedules Repricing Schedules

• When repricing schedules are used to assess the interest rate risk of current earnings

• A negative or liability sensitive gap

• occurs when liabilities exceed assets (RSA<RSL) in given time band

• increase in market interest rates could cause a decline in NII.

• A positive or Asset sensitive gap

• Occurs when assets exceed liabilities (RSA>RSL) in a given time band

• decrease in market interest rates could cause a decline in NII.

Gap Analysis Gap Analysis

• A measure of the percentage change in economic value of a position that will occur given a small change in the value of interest rates

• Higher duration implies that a given change in the level of interest rates will have a larger impact on economic value

Duration Duration

• Detailed assessments of the potential effects of changes in interest rates on earnings and economic value by simulating the future path of interest rates and their impact on cash flows

Simulation Approaches Simulation Approaches





Shortcomings of GAP Analysis

• Does not take account of variation in characteristics of different

positions within a time band

• Ignores differences in spreads between interest rates due to change

in market interest rates

• Does not take into account changes in timing of payments that

might occur as a result of changes in the interest rate environment

• Only a rough approximation

• Fail to capture variability in non-interest revenue and expenses





Duration based Measurement

• ‘Average’ duration is assumed for positions that fall into each

time band

• Average durations multiplied by assumed change in interest

rates to construct a weight

– Different weights may be used for different positions that fall within a

time band

– Different interest rate changes may also be used

• Weighted gaps are then aggregated across time bands





Shortcomings of Duration approach

• Focus on just one form of interest rate risk exposure -

repricing risk

• Since average durations are used the differences in actual

sensitivity positions arising from differences in coupon rates

and timing of payments will not be reflected

• Risk of options may not be adequately captured





Types of Simulation

• Cash flows arising solely from bank’s current on and off balance sheet positions are assessed

Static Simulation Static Simulation

• More detailed assumptions about the future course of interest rates and expected changes in bank’s business activity over that time

• More sophisticated techniques allow for dynamic interaction of payments streams and interest rates, and better capture the effect of embedded or explicit options

Dynamic Simulation Dynamic Simulation





Additional Issues

• Declines in interest rates result in increasing levels of

prepayments

• Non-maturity deposits may be withdrawn without penalty

• Treatment of positions with embedded options

• Inputs from managerial and business units





STRATEGIES FOR CONTROLLING INTEREST RATE RISK

6.





Ways to Reduce Sensitivities

Reduce Asset Sensitivity Reduce Asset Sensitivity

• Extend investment portfolio maturities

• Increase floating rate deposits

• Increase fixed rate lending

• Sell floating rate loans

• Increase short term borrowings

• Increase long term lending

Reduce Liability Sensitivity Reduce Liability Sensitivity

• Reduce investment portfolio maturities

• Increase floating rate lending

• Increase short term lending

• Increase long term Deposits





Other options available for managing interest rate risks

• Match long term assets preferably with non-interest bearing

liabilities

• Match repricable assets with similar repricable liabilities

• Use Forward Rate Agreements, Swaps, Options and Financial

Futures to construct synthetic securities

• Sound loaning policies and effective post-sanction monitoring and

recovery steps to contain NPAs

Full match in repricing assets and liabilities is not prudent even if it was feasible. Appropriate tolerance limits should be placed on interest rate sensitivity gaps.





CONTROLS AND SUPERVISION OF INTEREST RATE RISK MANAGEMENT

7.





Effective Internal Control System includes

• A strong control environment

• Adequate process for identifying and evaluating risk

• Establishment of control activities such as policies, procedures and

methodologies

• Adequate information systems

• Continual review of adherence to established policies and

procedures

Banks should have their measurement, monitoring and control functions reviewed on a regular basis by an independent party





SOUND INTEREST RATE RISK MANAGEMENT PRACTICES

8.





Basic Elements

Board and Senior Management oversight of Interest Rate Risk Board and Senior Management oversight of Interest Rate Risk

Adequate Risk Management policies and procedures Adequate Risk Management policies and procedures

Appropriate risk measurement, monitoring and control functions Appropriate risk measurement, monitoring and control functions

Comprehensive internal controls and independent audits Comprehensive internal controls and independent audits





Roles and Responsibilities

• Approve Strategies and policies

• Ensure action by Senior Management in line with the above

• To be informed regularly of interest rate risk exposure

Board of Directors Board of Directors

• Management of structure of bank’s business and level of interest rate risk

• To ensure that appropriate policies and procedures are established to control and limit the risks

• To ensure that resources are available for evaluating and controlling interest rate risk

• Periodic review of organisation’s interest rate risk management policies and procedures

• Also responsible for maintaining:

• Appropriate limits on risk taking

• Adequate systems and standards for measuring risk

• Standards for valuing positions and measuring performance

• Comprehensive interest rate risk reporting and interest rate risk management

• Review Process

• Effective internal controls

• Should define lines of responsibility and authority for developing strategies, implementing tactics and conducting the risk measurement and reporting functions of the interest rate risk management process

Senior Management Senior Management





Do you have any questions or queries or some feedback to give?

Just mark an email to [email protected]




mailto:[email protected]

CAIIB – Super-Notes © M S Ahluwalia Sirf Business For more Super-Notes: Click Here

M S Ahluwalia, amongst other things, is a visual artist, blogger,

blog designer and of course an MBA and Banker from New

Delhi, India.

To know more about him you may visit his blog-site: Estudiante De La Vida

















http://twitter.com/msahluwalia

http://www.facebook.com/pages/M-S-Ahluwalia/258015240783

Economy & Finance

CAIIB Super Notes: Bank Financial Management: Module D: Balance Sheet Management: Interest Rate Risk Management