Management of interest rate risk in banks

Slide 2. Meaning

 Interest rate risk: It is the chance that an unexpected change in interest rates will
negatively effect the value of an investment.
 A bank main source of profit is converting the liabilities of deposits and borrowings into
the assets of loans and securities. It profits by paying a lower interest on its liabilities
than it earn on its assets.
 The difference in these rates is the net interest margin.
Slide 3. Sources of Interest Rate Risk

 Re-pricing risk
 Basis risk
 Embedded option risk
 Yield curve risk
Slide 4. Re-pricing risk:
This risk arises from holding the assets and liabilities with different principal amounts, maturity,
or re-pricing dates, there by creating exposure to unexpected changes in the interest rates.
Slide 5. Basis risk
Basis risk arise when interest rate of different assets and liabilities changes in different
magnitudes. The basis form of IRR results from the imperfect correlation between interest
adjustments when linked to different index rates deposits having the same re-pricing
characteristics.
Slide 6. Embedded option risk

 This risk arise by prepayment of loans and bonds(with put or call option) and/ or
premature withdrawal of deposits before there stated maturity dates.
 Holder will like to exercise put option if interest rates in the meantime have edged up
while issuer will exercise call option if interest rates have fallen.
 Every time a deposit is withdrawn or, a loan is prepaid, it creates a mismatch and gives
rise to re-pricing risk.
 In order to protect themselves from this risk, bank impose penalties on premature
withdrawal of deposits
Slide 7 . Yield curve risk

 Risk caused due to the change in the yield curve from time to time depending upon re-
pricing and various other factors.
 Yield curve is the relation between the interest rate and the time of maturity of the debt
for a given borrower in a given currency.
Slide 8 . Illustration
Slide 9. Effect of interest rate risk

 Earning perspective
 Economic value perspective
 Embedded losses
Slide 10. Illustration

Slide 11. Gap analysis

 Gap analysis is a tool used by credit unions to analyze the match between rate sensitive
assets (RSA) and rate sensitive liabilities (RSL). If RSAS and RSLs are evenly matched the
effects of interest rate changes will be minimized while profitability is maximized.
 RSG= RSAS-RSLs
 Gap ratio= RSAS/RSLS
Slide 12. Illustration

Slide 13. Maturity Gap Method (IRS)

Three Options:
A) RSA>RSL= Positive Gap
B) B) RSL>RSA= Negative Gap
C) RSL-RSA= Zero Gap
Slide 14. Illustration
Slide 15. Duration Gap Analysis

Slide 16. Simulation model

 The purpose of using simulation methods is to test the non-linear effect with many
complex rate scenarios and obtain a probabilistic measure of the economic capital to be
held against ALM interest-rate risk.
 Simulates the performance under alternative interest rate scenarios and assesses the
resulting volatility in NII/NIM/ROA/ROE.
 Computer generated scenario about future and response to that in a dynamic way.
Slide 17. Simulation
Advantages

 Forward looking
 Dynamic
 Increase the value of strategic planning
 Enhance the capability of analysis
 Interpretation easy
 Timing of cash flows captured accurately
Disadvantage

 Accuracy depends on quality of data, strength of the model and validity of assumptions.
 Time consuming
 Huge investment in computer
 Requires highly skilled personnel
Slide 18. Rate shift scenarios

 It attempt to capture the non linear behavior of customers. A common scenario test is
to shift all rates up by 1%. After shifting the rates the cash flows are changed according
to the behavior expected in the new environment.
 The analysis is used to show the changes in earnings and value expected under different
rate scenarios.