Management of interest rate risk in

banks
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.
Sources of Interest Rate Risk

Re-pricing risk

Basis risk

Embedded option risk

Yield curve 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.
 Example:
Liability Asset Result
3 month deposits 5 year bonds Liability sensitive

3 years deposits 3 year bond with 6 Asset sensitive

month reset
2 year deposit 364 days treasury Asset sensitive
bills
5 year deposits 5 year term loan Neutral
 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.
 Example:
Re-pricing Re-pricing assets Result
liabilities
90 days certificate 90 days At re-pricing
of deposits commercial paper certificate of
deposit rates may
fall by just 0.5%
p.a. while interest
rates on C.P. may
fall by 1% p.a.
 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 Every time a deposit is withdrawn or, a loan is prepaid, it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
 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.
Effect of interest rate risk
 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
NIM= Net Interest Margin
 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.
 Simulation
Advantages- Disadvantage-
•Forward looking  Accuracy depends on quality of
•Dynamic data, strength of the model and
validity of assumptions.
•Increase the value of
strategic planning  Time consuming
•Enhance the capability of  Huge investment in computer
analysis  Requires highly skilled
•Interpretation easy personnel
•Timing of cash flows
captured accurately
 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.