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INTRODUCTION

The acceptance and management of financial risk is inherent


to the business of banking and banks’ roles as financial
intermediaries. To meet the demands of their customers and
communities and to execute business strategies, banks
make loans, purchase securities, and take deposits with
different maturities and interest rates. These activities may
leave a bank’s earnings and capital exposed to movements
in interest rates.

This exposure is interest rate risk.Changes in banks’


competitive environment, products, and services have
heightened the importance of prudent interest rate risk
management.

become more exposed to such volatility because of the


changing character of their liabilities. For example,
nonmaturity deposits have lost importance and purchased
funds have gained.

Each year, the financial products offered and purchased by


banks ,many of these products pose risk to the bank. For
example, an asset’s option features can, in certain interest
rate environments, reduce its cash flows and rates of return.
The structure of banks’ balance sheets has changed. Many
commercial banks have increased their holdings of long-term
assets and liabilities, whose values are more sensitive to
rate changes.

DEFINITION:
Interest rate risk is the risk (variability in value) borne by an
interest-bearing asset, such as a loan or a bond, due to
variability of interest rates. In general, as rates rise, the price
of a fixed rate bond will fall, and vice versa. Interest rate risk
is commonly measured by the bond's duration

Bench mark interest rate:


Kibor:

stand for karachi inter bank operation rate , money


market rate determined through demand and supply of
money used by financial instituition.

Libor:

london inter bank operation rate,

Pegged interest rate:

a rate at which a loan is available it may be at a fixed


rate or at a variable rate

Sources of interest rate risk :


Expects financial institutions to identify the sources of
interest rate risk to which they are exposed and evaluate
their effects on profitability and net value as a result of
interest rate movements.

Depending on the nature of the asset or liability, interest


rates may be fixed (for the duration of a term) or repriceable
(based on a term), or variable (indexed) according to the
contract between the parties or the financial instrument. In
addition, certain assets or liabilities may not be considered
interest-bearing. This is notably the case for non-performing
loans or qualifying shares of a financial services cooperative.

Financial institutions may be exposed to interest rate risk in


different ways. It is therefore essential that they be fully
aware of the factors that could influence their management
of this risk, as well as interest rate changes and volatility.
Some of these factors are:

1) The nature and complexity of the structure of assets and


liabilities affecting interest rate sensitivity of earnings and
net value;

2) The importance of loan risk premiums and the frequency


of repricing dates;

3) Changes in monetary policies;

4) The principal components of the economic environment,


including inflation rates, and possible declines in return
generated by certain financial products

1) Repricing risk:
Repricing risk results from differences in the timing of rate changes
and the timing of cash flows that occur in the pricing and maturity of a
bank’s assets, liabilities, and off-balance-sheet instruments.Repricing
risk is often the most apparent source of interest rate risk for a bank
and is often gauged bycomparing the volume of a bank’s assets that
mature or reprice within a given time period with the volume of
liabilities thatdo so. Some banks intentionally take repricing risk in
their balance sheet structure in an attempt to improve earnings.

2)Yield curve risk:


Yield-curve risk arises from variations in the movement of interest
rates across the maturity spectrum. It involves
changes in the relationship between interest rates of different
maturities of the same index or market (e.g., a three-month
Treasury versus a five-year Treasury).

3) Basis risk:
Basis risk arises from a shift in the relationship of the
rates in different financial markets or on different financial
instruments. Basis risk occurs when market rates for different financial
instruments, or the indices used to price assets and liabilities, change
at different times or by different amounts. For example, basis risk
occurs when the spread between the three-month Treasury and the
three-month London interbank offered rate (Libor) changes. This
change affects a bank’s current net interest margin through changes in
the earned/paid spreads of instruments that are being repriced. It also
affects the anticipated future cash flows from such instruments, which
in turn affects the underlying net economic value of the bank.

4)Option risk:
Option risk arises when a bank or a bank’s customer has the right (not
the obligation) to alter the level and timing of the cash flows of an
asset, liability, or off-balance-sheet instrument. An option gives the
option holder the right to buy (call option) or sell (put option) a
financial instrument at a specified price (strike price) over a specified
period of time. For theseller (or writer) of an option, there is an
obligation to perform if the option holder exercises the option.

The option holder’s ability to choose whether to exercise the option


creates an asymmetry in an option’s performance.Generally, option
holders will exercise their right only when it is to their benefit. As a
result, an option holder faces limiteddownside risk (the premium or
amount paid for the option) and unlimited upside reward. The option
seller faces unlimited downside risk (an option is usually exercised at a
disadvantageous time for the option seller) and limited upside
reward(if the holder does not exercise the option and the seller retains
the premium).

Options often result in an asymmetrical risk/reward


profile for the bank. If the bank has written (sold) options to its
customers, the amount of earnings or capital value that a bank may
lose from an unfavorable movement in interest rates may exceed the
amount that the bank may gain if rates move in a favorable direction.
As a result, the bank may have more downside exposure than upside
reward. For many banks, their written options positions leave them
exposed to losses from both rising and falling interest rates.

Following considerations should notably be


reflected in the institution's interest rate risk
management policy and procedures:
Operational
objectives
1) segregation of roles and responsibilities and designation
of competent and experienced individuals responsible for
managing interest rate risk;

2) risk appetite for that risk;

3) terms of intra-group management of interest rates;

4)monitoring and control of interest rate risk, including:

a) explicit and prudent limits in line with the risk


tolerance;

b) effective and reliable information systems for


controlling matching positions and ensuring compliance with
limits;

c) terms of foreign currency activities;

d) measures to unwind an undesirable matching


position, mainly through hedging.

Aside from their roles and responsibilities with respect to


sound governance, the board of directors and senior
management should communicate with the persons
responsible for interest rate risk management as soon as
exposure limits are exceeded and continue to liaise with
them thereafter. In addition, specific approvals should be
secured for major interest rate risk hedging initiatives.

The institution should use appropriate mechanisms to


conduct regular and independent assessments of the
effectiveness of its interest rate risk management strategy.
Similarly, it must ensure compliance with the policy and
procedures resulting from the strategy.

2) Risk appetite

Expects financial institutions to establish their interest rate


risk appetite and risk tolerance levels.

The primary purpose of managing interest rate risk is to


monitor and control the impacts of this risk on a financial
institution's profitability. The institution should have
sufficient leeway to optimize its profitability, yet still remain
prudent and within its risk appetite.

The institution should establish and impose interest rate risk


limits and ensure that exposure levels do not exceed these
limits.

3) Intra-group management

Expects financial institutions and


the group to which they belong to effectively manage
interest rate risk. Interest rate risk affecting a group of
institutions should be managed on a combined or
consolidated basis that includes the positions of subsidiaries
and other group entities. As necessary, risk management
procedures should be adapted to include the legal nature
and complexity of the activities of the group members.
However, financial institutions that are part of a group are
responsible for managing their internal interest rate risk,
even if monitoring and control mechanisms are applicable
across the group.

a) Federation is are responsible for co-ordinating their own


on- and off-balance sheet asset and liability matching
activities, as well as the combined positions of member
financial services cooperatives.

b)Federation must also establish a matching profile and a


target for the financial group as a whole, including related
entities and controlled persons, which include a security
fund.

c)Financial services cooperative acting as group treasurer


that manage the group's interest rate risk may, in addition to
managing their own treasury activities, cause a range of
hedging instruments to be available to the network. At the
federation's request, this financial services cooperative may
also take hedging positions on behalf of the network.

Strategy, policy and procedures :


Expects financial institutions to adopt an effective strategy
for sound and prudent interest rate risk management and to
implement a policy and procedures to execute the strategy
at the operational level.

Although the focus of an interest rate risk management


strategy may be the optimization of profitability, the board
of directors and senior management should bear in mind
that this risk could, conversely, pose a significant threat to
the institution's earnings and capital base.

Financial institutions should develop an interest rate risk


management strategy and periodically review the strategy,
taking into account notably:

• The internal and external sources of risk that might affect


its exposure to interest rate risk;

• sufficient capitalization to cover this risk as well as the


methods for evaluating its ability to absorb potential losses
stemming from unfavourable interest rate movements;

• the interrelation and interdependence with other risks to


which an institution is exposed.

Measureme
nt of interest rate risk
Financial institutions to measure their exposure to interest
rate risk based on a methodology commensurate with their
risk profile and size, and the nature and complexity of their
activities.

In establishing interest rate exposure limits, financial


institutions should consider, in particular, interest rate
volatility, different related factors such as its capital
adequacy, and the quality of its credit and investments, and
its profitability, generally net interest income or the present
value of assets.

Generally, institutions should establish and periodically


review the mismatch limits for each on- and off-balance
sheet position for given maturities. More sophisticated
measurement techniques could be employed according to
the type of activity and its complexity. In this regard, it is
recommended that institutions have a comprehensive view
of interest rate risk that takes into account the significance
of their financial intermediary and trading activities.

considers that a financial institution's exposure to interest


rate risk should be analyzed from an earnings perspective
and a net value perspective.

GAP:

Following are the different kind of gap

(i)POSITIVE GAP:

(ii)NEGATIVE GAP:

POSITIVE GAP:
Maturity or repricing Mismatch in a bank's assets and
liabilities where there are more assets maturing or repricing
in a given period than liabilities. A bank with a positive gap is
asset sensitive.A positive interest rate gap means that more
assets than liabilities are due to be repriced in a particular
time interval.
NEGATIVE GAP:
Repricing or duration mismatch in which interest sensitive
liabilities exceed interest sensitive assets. A bank whose
interest sensitive liabilities reprice more quickly than interest
sensitive assets is said to be liability sensitive
NOTE:
During a period of falling interest rates, a positive gap would
tend to adversely affect net interest income, while a
negative gap would tend to result in an increase in net
income. During a period of rising interest rates, a positive
gap would tend to result in an increase in net interest
income while a negative gap would tend to affect net
interest income adversely.
Calculating interest rate risk

There are a number of standard calculations for measuring


the impact of changing interest rates on a portfolio
consisting of various assets and liabilities. The most common
techniques include:

1. Repricing Model
2. Duration Model
3.Measuring the mismatch of the interest sensitivity gap of
assets and liabilities, by classifying each asset and liability
by the timing of interest rate reset or maturity, whichever
comes first.

REPRICING MODEL: is a CF analysis of interest income (+CFs) from


loans; and interest expense (-CF) on deposits, looking at Rate-Sensitive
Assets (RSAs) vs. Rate-Sensitive Liabilities (RSLs).
Rate sensitivity results from either:
a) variable rate loans or deposits that adjust to market rates, or
b) maturing loans or deposits that will adjust, and roll over to current
market rates.

If RSA < RSL and interest rates increase, the FI's net income will decrease,
because the interest expense on deposits will rise faster than interest income
on loans. Formula:

Δ NII = GAP * (ΔR), where:

Δ NII = Change in Net Interest Income ($)


GAP = (RSA - RSL)
ΔR = Change in Interest Rates
Equal changes in Rates on RSAs and RSLs are possible in some periods,
For the +Gap=10m , for every 1% increase in R:

Δ NII = ($10m) x .01 = $100,000

For the -Gap=10m ,for every 1%decrease in R:

Δ NII = (-$10m) x .01 = -$100,000

We can also calculate cumulative gaps (CGAP) over a certain period, e.g. 1
YR:

CGAP (one-year): -$10m + -$10m + -$15m + $20m = -$15m

Δ NII (one-year) = (-$15m) x .01 = -$150,000

Measuring and Managing Int. Rate Risk.


One-Year Rate Sensitivity Analysis: RSAs = $155m and RSLs = $140m
and 1-YR CGAP = +$15m.

Rules:
1. When RSA > RSL, then CGAP > 0.
2. When RSA < RSL, then CGAP < 0.
3. If CGAP > 0, if interest rates rise (fall), NII will rise (fall).
4. If CGAP < 0, when interest rate rise (fall), NII will fall (rise).

.
Unequal changes in Rates on RSAs and RSLs are possible in some periods,
(Prime Rate for RSAs and CD rate for RSLs). Formula:

Δ NII = (RSA x ΔRRSA) - (RSL x ΔRRSL)

Spread Effect, where interest rates rise faster for RSAs (1.2%) than for RSLs
(1%), and cause an increase in NII of $310,000 on $155m of both Assets and
Deposits . The larger the spread between (RSA - RSL), the greater the effect
on NII when interest rates change.

Advantages of Repricing Model:


Easy to understand,
Easy to work with,
Easy to forecast changes in profitability from interest rate
changes.

Disadvantages/Limitations of Repricing Model:

1. Does not account for balance sheet changes in the market value (PVA and
PVL) of the bank when interest rates change

2. Within a given time period (bucket), e.g. 1-5 years, the dollar values of
RSAs and RSLs may be equal (indicating no interest rate risk), but the assets
may be repriced early, and the liabilities repriced late, within the bucket time
period, exposing the FI to interest rate risk not accurately captured by the
Repricing Model. “Ignores CF patterns within a maturity bucket,” e.g. one-
year ARM rates might be re-set on a different date than the maturity patterns
of 1 year CDs.

3. Assumes NO prepayment of RSAs or RSLs, when there can actually be a


high volume of refinancing, e.g., recent years (2002-2003) for mortgages
when rates fell to 50 year lows. Also, assumes no reinvestment risk for rate-
insensitive assets (loans). Fixed-rate "rate-insensitive" loans generate CFs
that are rate-sensitive because of reinvestment. A 30-year fixed-rate
mortgage might not get repriced for 30 years, but its CFs have to be
reinvested at the current market rates.
4. Considers only balance-sheet items, and ignores interest rate risk/CFs
from off-balance-sheet (OBS) activities e.g., interest rate futures, loan
commitments, etc. Example: Futures contracts produce daily CFs because
of daily settlement, and expose an FI to OBS interest rate risk.

Duration Model: Duration (weighted-average maturity) measures interest


rate risk, i.e., changes in PV of securities when interest rates change:

Δ% PV Security = - D * ΔR / (1 + R)

FI's exposure to interest rate risk can be measured by its Duration Gap,
which takes into account the usual duration/maturity mismatch: DA > DL.

Equity (E) = Assets (A) - Liabilities (L), and

ΔE = ΔA - ΔL

%A, which is equal to: ( ΔA ) = - DA * (ΔR)


A (1 + R)

%L, which is equal to: ( ΔL ) = - DL * (ΔR) , or


L (1 + R)

ΔA = A * - DA * (ΔR)
(1 + R)

ΔL = L * - DL * (ΔR)
(1 + R)
and through substitution and rearranging we have (see footnote 11 on p. 614)

ΔE$ = - (DA - k DL) * A$ * ΔR


1+R
ΔE$ = - DGAP * A$ * ΔR
1+R

where k = L / A = Measure of the FI's leverage, or D / A ratio. Interest rate


risk (changes in market value of FI's net worth (E) is determined by 3
factors:

1. Leverage-adjusted duration gap (DA - k DL), measured in years and


reflects duration mismatch. The higher the duration gap, the higher the
interest rate risk.

2. Size of FI, measured by Assets (A$). The larger the size of FI, the greater
the risk exposure from a change in interest rates, i.e., the greater the change
in E, or market value.

3. Size of interest rate shock, ΔR. The greater the ΔR, the
greater the ΔE.

Interest Rate Risk Exposure:

ΔE$ = - Adjusted Duration Gap * Asset Size$ * Interest


Rate Shock

Note: Interest rate shocks (changes) are "exogenous" or external to the bank,
beyond its control, caused by _________________________________.
Bank can control its duration gap, but can't control general level of interest
rates.

Using Duration Gap. a) If Duration Gap is POS (DA > DL), the bank is
worried about an INCREASE in interest rates, because an INCREASE in
interest rates will DECREASE the Value of the Bank (E). Interest Rates and
Bank Value are inversely (neg.) related.

b) If Duration Gap is NEG (DA < DL), the bank is worried about a
DECREASE in interest rates, because a DECREASE in interest rates will
DECREASE the Value of the Bank (E). Interest Rates and Bank Value are
directly (pos) related.

Duration Gap is Pos (DA= 5 YRs and DL = 3 YRs). If interest rates rise from
10% to 11%, the value of the bank will fall by -$2.09m, from $10m to
$7.91m. Net Worth to Asset (E/A) has fallen from 10% to 8.29% ($7.91m /
$95.45m). Note: This is only a 1% increase in interest rates.
We get the same result considering A and L separately:

ΔA = $100m x (-5) x (.01/1.10) = -$4.545m

ΔL = $90m x (-3) x (.01 / 1.10) = -$2.454m

ΔE = -$4.545m - (-$2.454m) = -$2.09m

To counter this effect, the bank could adjust the Duration Gap to immunize
against interest rate changes/risk. Setting DA = DL won't result in 100%
immunization because A > L ($100m > $90m),(if DA = DL = 5 yrs.). FI
would will still be exposed to interest rate risk, bank value would fall by -
$0.45m if interest rate rise by 1%.

Immunization formulas:

a. A * DA = L * DL

$100m * 5yrs = $90m * x (where x = DL that will immunize 100%)

x = DL = 5.556 years

b. DA = (L / A) * DL and

DA = k * DL (where k = L / A)

5 = .90 x

x = DL = 5.556 years

Result of immunization is ΔE = 0

ΔE = - [5 - (.9) 5.556] * $100m * (.01/1.10)

ΔE = - (0) * $100m * (.01 / 1.10)


Other strategies to immunize 100%:

1. Reduce DA (Leave L the same). DA * $100m = ($90m * 3 yrs), solve


for DA

DA = 2.7 years (Reduce DA from 5 years to 2.7 years)

2. Reduce DA (X) and increase DL (Y) at the same time.

$100m X = $90m * Y

One solution would be DA = 4 yrs. and DL = 4.4444 yrs.

3. Increase L (and k) and increase DL.

$100m * 5 = $95 * 5.2632 yrs.

SUMMARY:

A * DA > L * DL

$100m * 5 > $90m * 3

500 > 270

Decrease DA, increase DL, and/or increase L (assuming that A will not
change)

Point: Duration Model can be used to immunize bank against interest rate
risk, i.e., the bank value (ΔE = 0) will be unaffected by
interest rate changes. Duration model is endorsed by the
Bank for International Settlements (BIS) to measure and
monitor interest rate risk for banks.

Limitations of Duration Model:

1. Might be time-consuming and costly to make changes to balance sheet to


immunize. However, with advances in information technology and more
advanced capital and money markets (e.g., Fed Funds, securitization of
mortgages, etc.), transaction costs have come down over time. Also,
duration model can be used to immunize with off-balance-sheet instruments
like interest rate futures, forwards, options, and swaps.

2. Immunization is a dynamic problem, changes constantly as DA, DL, A and


L change over time, and requires continual monitoring and periodic changes
and rebalancing to keep bank immunized (A * DA = L * DL).

3. Duration assumes a simple linear relationship between


changes in interest rates (ΔR) and %PV, when the true
relationship is non-linear, As changes in interest rates increase, the
Duration Model becomes less accurate and precise.

Interest rate Mismatch:


Mismatch refers to how closely asset receipts and liability
expense dates coincide. Mismatch is measured by either
maturity or reset dates for variable rate securities.
Forecasting future interest rate resets is difficult and for that
reason most variable rate securities are bound to an interest
standard such as libor or the 3 month treasury bill rate.
If the sum of a bank's loans average 4 years at 5 percent
and borrows money on average for 6 years, then the bank
has interest rate risk for the 1 year mismatch.

Scenarios analysis and stress testing :


expects the financial institution to analyze interest rate risk
based on various scenarios and using stress testing.
In a dynamic management environment, financial
institutions should assess their exposure to interest rate risk
arising from movements in interest rates and the potential
resulting losses.
Scenario-based analyses enable an institution to analyze,
using different probable assumptions, the sensitivity of its
on- and off-balance sheet assets and liabilities to interest
rate fluctuations in the course of its day-to-day operations as
well as during periods where such adverse fluctuations affect
the institution's earnings.
In more critical financial market conditions, such analysis
should be supplemented with stress testing. These analyses
should provide the institution with information on the
conditions under which strategies or positions would be
more vulnerable.
Consequently,financial institution should use scenarios and
conduct stress testing to measure the effects of different
variables and assess the impact on profitability and net
value. The institution should give consideration to the results
of different scenarios when establishing and reviewing their
interest rate risk policies and limits. It should also
periodically review the underlying assumptions used to
control and monitor interest rate risk.
Scenario analysis and stress testing should notably take the
following into account:
• significant changes in balance sheet structure;
• possible changes in the institution's prime rate;
• significant changes in behaviour of consumers of financial
products;
• material changes in relationships among market rates and
changes in the slope and the shape of the yield curve.
Parallel situations are often observed following downward
pressure on profitability by competitors;
• optional clauses and features of financial products.

Managing Interest
rate:
1) Interest rate swap
A swap is a derivative in which one party
exchanges a stream of interest payments for another party's
stream of cash flows. Interest rate swaps can be used by
hedgers to manage their fixed or floating assets and
liabilities. They can also be used by speculators to replicate
unfunded bond exposures to profit from changes in interest
rates. Interest rate swaps are very popular and highly liquid
instruments.
Structure
In an interest rate swap, each counterparty agrees to pay
either a fixed or floating rate denominated in a particular
currency to the other counterparty. The fixed or floating rate
is multiplied by a notional principal amount (say, USD 1
million). This notional amount is generally not exchanged
between counterparties, but is used only for calculating the
size of cashflows to be exchanged.

The most common interest rate swap is one where one


counterparty A pays a fixed rate (the swap rate) to
counterparty B, while receiving a floating rate (usually
pegged to a reference rate such as LIBOR).

A pays fixed rate to B (A receives variable rate)


B pays variable rate to A (B receives fixed rate).

Consider the following swap in which Party A agrees to pay


Party B periodic fixed interest rate payments of 8.65%, in
exchange for periodic variable interest rate payments of
LIBOR + 70 bps (0.70%). Note that there is no exchange of
the principal amounts and that the interest rates are on a
"notional" (i.e. imaginary) principal amount. Also note that
the interest payments are settled in net (e.g. Party A pays
(LIBOR + 1.50%)+8.65% - (LIBOR+0.70%) = 9.45% net. The
fixed rate (8.65% in this example) is referred to as the swap
rate.[1]

At the point of initiation of the swap, the swap is priced so


that it has a net present value of zero. If one party wants to
pay 50 bps above the par swap rate, the other party has to
pay approximately 50 bps over LIBOR to compensate for
this.
2) Forward Contracts
• A forward contract is an agreement to buy or sell an asset at a
certain time in the future for a certain price (the
delivery price)
• It can be contrasted with a spot contract which is an agreement to
buy or sell immediately
Options
• A call option isan option to buy a certain asset by a certain
date for a certain price (the strike price)
• A put option is an option to sell a certain asset by a certain
date for a certain price (the strike price)
Options vs Futures/Forwards
• A futures/forward contract gives the holder
the obligation to buy or sell at a certain
price
• An option gives the holder the right to buy
or sell at a certain price

Interest rate risk management related to foreign


currencies
Financial institutions to have an appropriate process for
managing their matching positions with respect to the
foreign currencies used in the course of their operations.
To reflect its foreign currency matching positions, financial
institutions are expected to measure their interest rate
exposure relative to each currency, since yield curves may
vary depending on the currency.
Financial institution may also use foreign currency-
denominated deposits, borrowings or on- and off-balance
sheet financial instruments to rebalance mismatching in
local or foreign currencies. The following factors should be
taken into consideration:
• the convertibility of each currency, the volatility of the
exchange rate, and the availability of foreign currency funds;

• foreign market conditions, including counterparty risk and


the level of interest rates as well as their correlation.

Hedging :
The expects financial institutions to adequately manage their
matching activities and, as necessary, to offset gaps in a
prudent manner through corrective measures, in particular,
hedging, which enables institutions to mitigate interest rate
risk within established limits.
In periods of wide interest rate fluctuations, sound interest
rate management should enable the institution to avoid
predatory selling of its income-bearing assets and liabilities
or the use of hedging instruments that are costly or have
unfavourable conditions.
Where necessary, the institution should employ hedging to
mitigate its interest rate risk exposure, by:
• using appropriate financial instruments consistent with the
type and scope of its operations, the competence and
expertise of its personnel, and the capacity of its data
processing and reporting systems;

Evaluation of
Interest Rate Exposures
Interest rates impact are observed in two prespective:
a)EARNING PROSPECTIVE
b)ECONOMIC PROSPECTIVE

a)EARNING PROSPECTIVE :
The earnings perspective considers
how interest rate changes will affect a bank’s reported earnings. For
example, a decrease in earnings caused by changes in interest rates
can reduce earnings, liquidity, and capital. This perspective focuses on
risk to earnings in the near term, typically the next one or two years.
Fluctuations in interest rates generally affect reported earnings
through changes in a bank’s net interest income.
Net interest income will vary because of
differences in the timing of accrual changes (repricing risk), changing
rate and yield curve relationships (basis and yield curve risks), and
options positions. Changes in the general level of market interest rates
also may cause changes in the volume and mix of a bank’s balance
sheet products. For example, when economic activity continues to
expand while interest rates are rising, commercial loan demand may
increase while residential mortgage loan growth and prepayments
slow.

b)ECONOMIC PROSPECTIVE:
The economic perspective provides a
measure of the underlying value of the bank’s current position and
seeks to evaluate the sensitivity of that value to changes in interest
rates. This perspective focuses on how the economic value of all bank
assets, liabilities, and interest-rate-related, off-balance-sheet
instruments change with movements in interest rates. Its reflects the
impact of variation in the interest rate on the economic value of an
instituition.economic value of the bank can be viewed as the present
value of future cash flow.
The economic value of these instruments equals the present value of
their future cash flows. By evaluating changes in the present value of
the contracts that result from a given change in interest rates, one can
estimate the change to a bank’s economic value (also known as the
economic value of equity).

How to
Control Interest Rate Risk:
1: Interest Rate Risk Measurement Systems :
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.

2: Operating limits :
Banks must establish and enforce
operating limits and other practices that maintain exposures
within levels consistent with their internal policies.

3: Collapse :
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

4: Adequate Information :
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.
5: Internal Controls:
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

6; Information for supervisory authorities:


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.

7: Capital adequacy:
Banks must hold capital commensurate with the
level of interest rate risk they undertake.

8: Disclosure of interest rate risk:


Banks should release to the public information on
the level of interest rate risk and their policies for its
management and stakeholders

9: Supervisory treatment of interest rate risk in the


banking book:
(a) 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.
(b) 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.

Conclusion: The quantity of interest rate


risk is (low, moderate,high).
To identify the major sources of interest rate risk
assumed by the bank and those areas potentially exposed to
significant interest rate risk.

1. Review and analyze the bank’s balance sheet structure, off-


balance sheet activities, and trends in its balance
sheet composition to identify the major sources of interest rate
risk exposures. Consider:
• The maturity and repricing structures of the bank’s loans,
investments, liabilities, and off-balance sheet
items.
• Whether the bank has substantial holdings of products with
explicit or embedded options, such as
prepayment options, caps, or floors, or products whose rates
will considerably lag market interest rates.
• The various indices used by the bank to price its variable rate
products (e.g., prime, Libor, Treasury) and
the level or mix of products tied to these indices.
• The use and nature of derivative products.
• Other off-balance sheet items (e.g., letters of credit, loan
commitments).

2. Assess and discuss with management the bank’s vulnerability


to various movements in market interest rates
including:
• The timing of interest rate changes and cash flows because of
maturity or repricing mismatches.
• Changes in key spread or basis relationships.
• Changes in yield curve relationships.
• The nature and level of embedded options exposures.