72870971 CAIIB Super Notes Bank Financial Management Module D Balance Sheet Management Interest Rate Risk Management

7/28/2019 72870971 CAIIB Super Notes Bank Financial Management Module D Balance Sheet Management Interest Rate Risk Management

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CAIIB Super-Notes M S Ahluwalia Sirf Business

CAIIB

SUPER NOTES

Bank Financial Management: Interest Rate Risk Management
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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 Management8. Sound Interest Rate Risk Management

Practices


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ESSENTIALS OF INTEREST RATE RISK

1.


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Essentials of Interest Rate Risk

Interest Rate risk is the exposure of a banks 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 banks earnings and

capital base

Changes in interest rates affect

Banks earnings by changing its Net Interest Income and level of other

interest sensitive income and operating expenses

The underlying value of the banks assets, liabilities and off-balance-sheet

instruments


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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 thatmaintains interest rate risk within prudent levels is essential

to safety and soundness of the bank


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SOURCES OF INTEREST RATE RISK

2.


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Types of Interest Rate Risk

Gap Risk

Arises fromholding assetsand liabilitieswith differentprincipalamounts,maturity datesor repricing

datesBank is assetsensitive ifassets arerepriced muchmore rapidlythan theliability duringthe period

Liability

sensitive ifinterest paidon its depositis reset morerapidly thanthe rate beingcharged onthe loan

Basis Risk

Risk thatinterest ratesof differentassets andliabilities maychange indifferentmagnitudes

Fairly high inrespect ofbanks whichcreatecompositeassets out ofcompositeliabilities

Net InterestPosition Risk

Interest rateearned onassets changeswhile cost offunding ofliabilitiesremains thesame

EmbeddedOption Risk

Prepaymentof loans/bondsand/orprematurewithdrawal ofdeposits

Yield CurveRisk

Yield of allmaturities of aparticularinvestment

Price Risk

Assets aresold beforematurity dates

ReinvestmentRisk

Uncertaintywith regard tointerest rate atwhich thefuture cashflows can bereinvested


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EFFECTS OF INTEREST RATE RISK

3.


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Effects of Interest Rate Risk

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

Traditional approach

Earnings PerspectiveEarnings Perspective

Impact on Economic value of banks 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 allfuture cash flows

Economic PerspectiveEconomic Perspective

Impact of past interest rates on bank performance

Gains or losses reflected over time

Instruments that are not marked to market

Embedded LossesEmbedded Losses


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MEASUREMENT OF INTEREST RATERISK

4.


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Measurement of Interest Rate Risk

Before management, risk has to be identified and quantified

Measurement systems should

Assess all interest rate risk associated with Banks assets, liabilities andOBS positions

Utilise generally accepted financial concepts and risk management

techniques

Have well documented assumptions and parameters


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INTEREST RATE RISK MEASUREMENTTECHNIQUES

5.

k


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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 SchedulesRepricing 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 (RSARSL) in a given time band

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

Gap AnalysisGap 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 economicvalue

DurationDuration

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

Simulation ApproachesSimulation Approaches


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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


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Duration based Measurement

Average duration is assumed for positions that fall into each

time band

Average durations multiplied by assumed change in interestrates 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


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Shortcomings of Duration approach

Focus on just one form of interest rate risk exposure -

repricing risk

Since average durations are used the differences in actualsensitivity positions arising from differences in coupon rates

and timing of payments will not be reflected

Risk of options may not be adequately captured


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Types of Simulation

Cash flows arising solely from banks current on and off balance sheet positions

are assessed

Static SimulationStatic Simulation

More detailed assumptions about the future course of interest rates and expectedchanges in banks business activity over that time

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

Dynamic SimulationDynamic Simulation


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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


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STRATEGIES FOR CONTROLLINGINTEREST RATE RISK

6.


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Ways to Reduce Sensitivities

Reduce Asset Sensitivity

Extend investment portfoliomaturities

Increase floating rate deposits Increase fixed rate lending

Sell floating rate loans

Increase short term borrowings

Increase long term lending

Reduce Liability Sensitivity

Reduce investment portfoliomaturities

Increase floating rate lending Increase short term lending

Increase long term Deposits

Oth ti il bl f i


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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.


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CONTROLS AND SUPERVISION OFINTEREST RATE RISK MANAGEMENT

7.


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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


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SOUND INTEREST RATE RISKMANAGEMENT PRACTICES

8.


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Basic Elements

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

Adequate Risk Management policies and proceduresAdequate Risk Management policies and procedures

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

Comprehensive internal controls and independent auditsComprehensive internal controls and independent audits


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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 DirectorsBoard of Directors

Management of structure of banks 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 oforganisations 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 andconducting the risk measurement and reporting functions of the interest rate risk managementprocess

Senior ManagementSenior Management


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CAIIB Super-Notes M S Ahluwalia Sirf BusinessFor 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
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72870971 CAIIB Super Notes Bank Financial Management Module D Balance Sheet Management Interest Rate Risk Management