IRR Bank Final 1.2

8/8/2019 IRR Bank Final 1.2

1/28

Management of Interest Rate Risk in Banks


2/28

Interest Rate Risk (IRR)

Definition:It is the potential loss from unexpected changes ininterest rates which can significantly alter a banksprofitability and market value of equity


3/28

Interest Rate Risk .. explained

The amount at risk is a function of the magnitude and directionof interest rate changes and the size and maturity structure of themismatch position

If interest rates rise, the cost of funds increases more rapidlythan the yield on assets, thereby reducing net income

If the exposure is not managed properly it can erode both theprofitability and shareholder value


4/28

Interest Rate Risks - Types

Interest Rate Risks

Yie ERepricing Risk Basis Risk Risk Option Risk

Interest RateRisk

Re-pricingRisk

BasisRisk

EmbeddedOptionRisk

YieldRisk


5/28

Re-pricing 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 SpreadCapital(Crore) @ROI Maturity

Investment(Crore) @ROI Maturity

Scenario-1Rs 100 9% One Year Rs 100 10% Two Year

Profit1% (1Crore)

Scenario-2Rs 100 11% Two Year Rs 100 10% Two Year

Loss1% (1Crore)


6/28

Basis Risk

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

Interest rates movement is based on market perception of risk andalso market imperfections

Therefore, basis risk arises when interest rates of different assets andliabilities change in different magnitudes

The `basis form of IRR results from the imperfect correlation betweeninterest adjustments when linked to different index rates despitehaving the same re-pricing characteristics


7/28

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 lacs)


8/28

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 SpreadCapital(Crore) @ROI Maturity

Loan(Crore) @ROI Maturity

Scenario-1Rs 100 8% 90 Days Rs 100 10% 90 Days

Profit2% (0.49 Crore)

Scenario-2

Rs 1008% 90 Days Rs 100 10% 90 Days 2% (0.164 Crore)

for 30 days

Interest Ratedeclined after 30days to 9%

60 Days 1% (0.164 Crore)for 60 days

Total 0.328 Crore


9/28


10/28

Yield Curve Risk - An Illustration

Liabilities Assets SpreadCapital @ ROI Maturity Loan @ ROI Maturity(Crore) (Crore)

Scenario-1 3 year Loan 3 year ProfitRs100 fixed(quar 13.5% 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 Spread22.05.2008 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%


11/28

Interest Rate Risks - Measurement

Interest Rate Risks

Yie ERepricing Risk Basis RiskRisk Option Risk

Approachesto Measure

IRR

Maturity Gap

Analysis

Duration Gap

AnalysisSimulation


12/28

Maturity Gap Analysis

MGA distributesinterest rate sensitiveassets, liabilities and OBSpositions into a certainnumber of predefined timebands according to their maturity (if fixed rate) or time remaining to their nextre-pricing (if floating rate)


13/28

Maturity Gap Analysis

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

Objective: assets and risk The gap is thenTo improve the sensitive liabilities calculated by

net interest are grouped into considering theincome in the maturity buckets difference betweenshort run over based on maturity the absolute

discreet periods and the time until the values of the RSAsof time called the first possible and RSLs.

gap periods. re-pricing due to RSG=RSAs-RSLschange in the interestrates

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

band.


14/28

Maturity Gap Method (IRS)

Three Options:

A) RSA > RSL = Positive Gap

B) RSL > RSA = Negative Gap

C) RSL = RSA = Zero Gap


15/28

Interest Rate Risks

Yie ERepricing Risk Basis RiskRisk Option Risk

Gap Change inInterest Rate

Change inInterestIncome

Change inInterest

Expense

Change in NetInterestIncome

Positive Increase Increase > Increase Increase

Positive Decrease Decrease > Decrease Decrease

Negative Increase Increase < Increase Decrease

Negative Decrease Decrease < Decrease Increase

Zero Increase Increase = Increase None

Zero Decrease Decrease = Decrease None

Maturity Gap Summary


16/28

Example of Negative Gap

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 = 41.3NIM = 41.3 / 850= 4.86%

GAP = 500 - 600 = -100


17/28

Consider the following balance sheet:

1% Increase in Short Term Rates 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 = 40.3NIM = 40.3 / 850= 4.74%

GAP = 500 - 600 = -100

Example of Negative Gap


18/28

Inferences from above options:

Scenario Strategy

Rising Interest Rates

Declining Interest Rates

Uncertain situation(May not occur in reality)

Maintain a positive gap

Maintain a negative gap

Maintain a zero gapNo benefits


19/28

Duration Gap Analysis

Duration is a measure of the percentage change in theeconomic value of a position that occurs given a small changein level of interest rate

It concentrates on the price risk and the reinvestment risk whilemanaging the interest rate exposure

It also measures the effect of rate fluctuation on the marketvalue of the assets and liabilities and NIM with the help of duration


20/28

Duration Gap Analysis ..Illustration

Assets and Liabilities chart of Bharath Bank is presented here below along withtheir durations and interest rates. Based on the information, identify 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?

Liabilities Amount Duration Int. Rate Assets Amount Duration Int. Rate(months) (months)(Crore) (%) (Crore) (%)

Equity Cash200 200

ST STDeposit Loans1,800 5.5 11.5 1,800 2.75 12.5

LT LTDeposit Loans2,500 23.7 15 2,000 23 16.5

Others Investments500 11.5 11 1,000 10.5 13.5

5,000 5,000


21/28

Duration Gap Analysis

L iabilities Amount(Cr)

Duration(Months)

InterestRate (%)

IncreasedInt. Rate

(%)

DecreasedInt. Rate (%)

Assets Amount(Cr)

Duration(Months)

InterestRate (%)

IncreasedInt. Rate

(%)

DecreasedInt. Rate

(%)

Equity 200 Cash 200

STDeposit 1,800 5.5 11.5 13.5 9.5 STLoans 1,800 2.75 12.5 14.5 10.5

LTDeposit 2,500 23.7 15 15 15

LTLoans 2,000 23 16.5 16.5 16.5

Others 500 11.5 11 13 9 Invst 1000 10.5 13.5 15.5 11.5

5,000 5,000

InterestExpense 637 683 591

InterestIncome 690 746 634

NII 53 63 43

NIM 0.0106 0.0126 0.0086


22/28

Simulation

Data Requirement

Maturity and re-pricingRate scenarios

Alternative managementResponse under differentscenariosYield curvesPrepayment tablesBehavioural pattern of assetsand liabilitiesConsistency of assumptions

What is it?

Simulates performance under alternative interest rate scenarios

and assesses the resulting volatilityin NII / NIM / ROA / ROE

A financial model incorporatinginter-relationship of assets,liabilities, prices, costs, volume,

mix and other business relatedvariables

Computer generated scenariosabout future and response to thatin a dynamic way


23/28

Simulation

Advantages

- Forward looking

- Dynamic

- Lessens the role of crisis management

- Increases the value of strategic planning

-Enhance capability of analysis

- Interpretation easy

- Timing of cash flows captured accurately

Disadvantages

- 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


24/28

Model

Deploy

Mo itor ly e

ct

I tere t R te Ri k M geme t


25/28

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

GAPReport

EarningSimulation Economic Valuation

Short-term earning exposure Yes Yes

Generally does notdistinguish short-term

accounting earnings fromchanges 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


26/28

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

Improved interest rate exposure forecasting and measurement capabilities


27/28

Based on the quantity of interest rate risk and quality of interest rate risk management, we can evaluate the adequacyof the banks 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

Conclusion


28/28

Smit Parikh (31)

Devang Joshi (14)

Maya Narayan (21)

Pallavi Save (44) Rajiv Ajmera (02)

Rajan Singh (53)

Lokesh Motwani (26)

Documents

IRR Bank Final 1.2