Presentation by S P Dhal, Faculty Member, SPBT CollegeAsset Liability Managementin BanksLive Interactive Learning Session[Module A]

Components of a Bank Balance sheetContingent Liabilities

LiabilitiesAssetsCapitalReserve & SurplusDepositsBorrowingsOther Liabilities Cash & Balances with RBIBal. With Banks & Money at Call and Short NoticesInvestmentsAdvancesFixed Assets6. Other Assets

Components of Liabilities Capital:Capital represents owners contribution/stake in the bank.It serves as a cushion for depositors and creditors.It is considered to be a long term sources for the bank.

Components of Liabilities2. Reserves & SurplusComponents under this head includes:I. Statutory ReservesII. Capital Reserves III. Investment Fluctuation ReserveIV. Revenue and Other ReservesV. Balance in Profit and Loss Account

Components of Liabilities3. DepositsThis is the main source of banks funds. The deposits are classified as deposits payable on demand and time. They are reflected in balance sheet as under:I. Demand DepositsII. Savings Bank DepositsIII. Term Deposits

Components of Liabilities4. Borrowings(Borrowings include Refinance / Borrowings from RBI, Inter-bank & other institutions)I. Borrowings in India i) Reserve Bank of India ii) Other Banksiii) Other Institutions & AgenciesII. Borrowings outside India

Components of Liabilities5. Other Liabilities & ProvisionsIt is grouped as under:

I. Bills Payable II. Inter Office Adjustments (Net) III. Interest Accrued IV. Unsecured Redeemable Bonds (Subordinated Debt for Tier-II Capital) V. Others(including provisions)

Components of AssetsCash & Bank Balances with RBI I. Cash in hand (including foreign currency notes) II. Balances with Reserve Bank of India In Current Accounts In Other Accounts

Components of Assets2. BALANCES WITH BANKS AND MONEY AT CALL & SHORT NOTICE I. In Indiai) Balances with Banks a) In Current Accounts b) In Other Deposit Accounts ii) Money at Call and Short Notice a) With Banks b) With Other InstitutionsII. Outside India a) In Current Accounts b) In Other Deposit Accounts c) Money at Call & Short Notice

Components of Assets3. InvestmentsA major asset item in the banks balance sheet. Reflected under 6 buckets as under: I. Investments in India in : * i) Government Securities ii) Other approved Securities iii) Shares iv) Debentures and Bonds v) Subsidiaries and Sponsored Institutions vi) Others (UTI Shares , Commercial Papers, COD & Mutual Fund Units etc.)II. Investments outside India in ** Subsidiaries and/or Associates abroad

Components of Assets4. AdvancesThe most important assets for a bank.A. i) Bills Purchased and Discounted ii) Cash Credits, Overdrafts & Loans repayable on demand iii) Term LoansB. Particulars of Advances : i) Secured by tangible assets (including advances against Book Debts) ii) Covered by Bank/ Government Guarantees iii) Unsecured

Components of Assets5. Fixed Asset I. PremisesII. Other Fixed Assets (Including furniture and fixtures)6. Other Assets I. Interest accrued II. Tax paid in advance/tax deducted at source (Net of Provisions) III. Stationery and Stamps IV. Non-banking assets acquired in satisfaction of claims V. Deferred Tax Asset (Net)VI. Others

Contingent LiabilityBanks obligations under LCs, Guarantees, Acceptances on behalf of constituents and Bills accepted by the bank are reflected under this heads.

Banks Profit & Loss AccountA banks profit & Loss Account has the following components:Income: This includes Interest Income and Other Income.II. Expenses: This includes Interest Expended, Operating Expenses and Provisions & contingencies.

Components of IncomeINTEREST EARNED

I. Interest/Discount on Advances / BillsII. Income on InvestmentsIII.Interest on balances with Reserve Bank of India and other inter-bank fundsIV. Others

Components of Income 2. OTHER INCOME

I. Commission, Exchange and BrokerageII. Profit on sale of Investments (Net)III.Profit/(Loss) on Revaluation of InvestmentsIV. Profit on sale of land, buildings and other assets (Net)V. Profit on exchange transactions (Net)VI. Income earned by way of dividends etc. from subsidiaries and Associates abroad/in IndiaVII. Miscellaneous Income

Components of ExpensesINTEREST EXPENDED

I. Interest on DepositsII. Interest on Reserve Bank of India / Inter-Bank borrowingsIII. Others

Components of Expenses2. OPERATING EXPENSES

I. Payments to and Provisions for employees II. Rent, Taxes and LightingIII. Printing and Stationery IV. Advertisement and PublicityV. Depreciation on Bank's property VI. Directors' Fees, Allowances and ExpensesVII. Auditors' Fees and Expenses (including Branch Auditors)VIII.Law Charges IX. Postages, Telegrams, Telephones etc. X. Repairs and Maintenance XI. InsuranceXII. Other Expenditure

Assets Liability Management It is a dynamic process of Planning, Organizing & Controlling of Assets & Liabilities- their volumes, mixes, maturities, yields and costs in order to maintain liquidity and NII.

Significance of ALMVolatilityProduct Innovations & ComplexitiesRegulatory EnvironmentManagement Recognition

Purpose & Objective of ALMAn effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration.It is aimed to stabilize short-term profits, long-term earnings and long-term substance of the bank. The parameters for stabilizing ALM system are:

1. Net Interest Income (NII)2. Net Interest Margin (NIM)3. Economic Equity Ratio

RBI DIRECTIVESIssued draft guidelines on 10th Sept98.

Final guidelines issued on 10th Feb99 for implementation of ALM w.e.f. 01.04.99.

To begin with 60% of asset &liabilities will be covered; 100% from 01.04.2000.

Initially Gap Analysis to be applied in the first stage of implementation.

Disclosure to Balance Sheet on maturity pattern on Deposits, Borrowings, Investment & Advances w.e.f. 31.03.01

Liquidity ManagementBanks liquidity management is the process of generating funds to meet contractual or relationship obligations at reasonable prices at all times.New loan demands, existing commitments, and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet.

Adequacy of liquidity position for a bankAnalysis of following factors throw light on a banks adequacy of liquidity position:Historical Funding requirementCurrent liquidity positionAnticipated future funding needsSources of fundsOptions for reducing funding needsPresent and anticipated asset qualityPresent and future earning capacity andh. Present and planned capital position

Funding AvenuesTo satisfy funding needs, a bank must perform one or a combination of the following:Dispose off liquid assetsIncrease short term borrowingsDecrease holding of less liquid assetsIncrease liability of a term naturee. Increase Capital funds

Types of Liquidity RiskLiquidity Exposure can stem from both internally and externally.External liquidity risks can be geographic, systemic or instrument specific.Internal liquidity risk relates largely to perceptions of an institution in its various markets: local, regional, national or international

Other categories of liquidity riskFunding Risk- Need to replace net outflows due to unanticipated withdrawals/non-renewalTime Risk- Need to compensate for non-receipt of expected inflows of fundsCall Risk- Crystallization of contingent liability

Statement of Structural LiquidityAll Assets & Liabilities to be reported as per their maturity profile into 8 maturity Buckets:1 to 14 days15 to 28 days29 days and up to 3 monthsOver 3 months and up to 6 monthsOver 6 months and up to 1 yearOver 1 year and up to 3 years Over 3 years and up to 5 years Over 5 years

STATEMENT OF STRUCTURAL LIQUIDITYPlaces all cash inflows and outflows in the maturity ladder as per residual maturityMaturing Liability: cash outflowMaturing Assets : Cash InflowClassified in to 8 time bucketsMismatches in the first two buckets not to exceed 20% of outflowsShows the structure as of a particular dateBanks can fix higher tolerance level for other maturity buckets.

An Example of Structural Liquidity Statement

BS

LIABILITIESASSETS

Capital200Investments2600

Liabilities6000Loans & Adv3600

Fixed2600Fixed600

Floating3400Floating1100

Other Liabilities300PLR Linked1900

Others Assets300

Total65006500

Duration5Duration4

Interest Rate8Change in Interest Rate-2

Liquidity

1-14Days15-28 Days30 Days-3 Month3 Mths - 6 Mths6 Mths - 1Year1Year - 3 Years3 Years - 5 YearsOver 5 YearsTotal

Capital200200

Liab-fixed Int3002002006006003002002002600

Liab-floating Int3504003504505004504504503400

Others50500200300

Total outflow700650550105011007506501050650013000

Investments2001502502503001003509002500

Loans-fixed Int5050010015050100100600

Loans - floating int20015020015015015050501100

Loans BPLR Linked1001502005003505001001002000

Others505000000200300

Total Inflow60055065010009508006001350650013000

Gap-100-100100-50-15050-503000

Cumulative Gap-100-200-100-150-300-250-30000

Gap % to Total Outflow-14.29-15.3818.18-4.76-13.646.67-7.6928.57

&C&"Arial,Bold"&16LIQUIDITY ANALYSIS

Interest

Repricing in Bucket No3

1-28 Days30 Days-3 Month3 Mths - 6 Mths6 Mths - 1Year1Year - 3 Years3 Years - 5 YearsOver 5 YearsInsensitiveTotal

Capital200200

Dep-fixed Int5002006006003002002002600

Dep-flg Int500350255000003400

Others300300

Total outflow100055031506003002002005006500

Investment3502502503001003509002500000000

Adv - Fixed100010015050100100600000000

Adv - Flg10020080000001100

Adv - PLR Linked250200155000002000

Others300300

Total Inflow800650270045015045010003006500

Gap-200100-450-150-150250800-2000

Cumulative Gap-200-100-550-700-850-60020000

&C&"Arial,Bold"&14INTEREST RATE ANALYSIS

Gap Analysis

Re-pricing in time bucket No3

Change in Int Rate - Assets-0.25%

Change in Int Rate- Liabilities-0.25%

Time BucketsAssetsLiabilitiesGapCumulative GapChange in interest amountChange in Int Received on Assetschange in Int Paid on LiabilitiesWorst ScenarioRevised NII due to change in interest rateRevised NIM due to change in interest rateChange in NIM due to change in interest rateRevised NII due to change in interest rateRevised NIM due to change in interest rateChange in NIM due to change in interest rateWorst Scenario

Rs in CroresRs in CroresCumulative

1234567891011

11-28 DaysA800.001000.00-200.00-200.000.000.000.000.000.0093.001.50%0.00%93.001.50%0.00%

229 Days to 3 monthsB650.00550.00100.00-100.000.000.000.000.000.0093.001.50%0.00%93.001.50%0.00%

33 to 6 MonthsC2700.003150.00-450.00-550.000.71-4.25-4.960.710.0093.711.51%0.76%93.711.51%0.76%

46 to 12 MonthsD450.00600.00-150.00-700.000.10-0.29-0.390.100.0093.101.50%0.10%93.811.51%0.87%

51 to 3 YearsE150.00300.00-150.00-850.000.000.0093.001.50%0.00%93.811.51%0.87%

63 to 5 YearsF450.00200.00250.00-600.000.000.0093.001.50%0.00%93.811.51%0.87%

7Over 5 YearsG1000.00200.00800.00200.000.000.0093.001.50%0.00%93.811.51%0.87%

8Non-SensitiveH300.00500.00-200.000.0093.001.50%0.00%93.811.51%0.87%

TotalI6500.006500.000.000.000.810.87%

JChange in Interest Income during 1 year horizon - with netting0.81

KWithout netting (Worst scenario)0.00

Note: 1)The change in interest amount is 0 if re-pricing is assumed after this time bucket period.

2)The changes in interest are annualised by taking midpoint of the respective time buckets

Total Rate sensitive earning AssetsLI1 - H1Rs in Crores6200.00

NIM of the BankM1.50%

NIINL3 * M3Rs in Crores93.00

Change in Interest rateOVariable-0.25%

NII after int changePN3+I5Rs in Crores93.81

NIM after Int changeQP3 / L31.51%

=R(Q3-M3)/M3EAR0.87%

Projected EAR-1.00%

Target Gap372.00

&CINTEREST SENSITIVITY - EAR - ANALYSIS

duration

FV1000

Coupon8.00%

Market Rate (YTM)5.00%

Time to Maturity3 Years

Frequency of Interest Payment1

1234= (2) *(3)5=4/Sum(4)6=(5) * (1)6/(1+ytm)

Cash FlowsDiscounting FactorPresent Value of Cash FlowsPV of cash flow as % of PV of BondDuration SegmentM-duration Segment

TimeFV * Coupon / Frequency1/(1+YTM)**tCash flow * Disconting FactorPV of cash flow / PV of the Bond(PV of Cash flow / PV of the Bond) * timeDuration Segment / (1+YTM)

1800.952380952476.19047619050.07043603260.07043603260.0670819358

2800.907029478572.56235827660.06708193580.13416387160.1277751158

310800.8638375985932.9446064140.86248203162.58744609492.4642343761

PV of Bond1081.69744088112.7920459992.6590914277

&CDURATION & M-DURATION

Duration

M - DURATION

Present Value of the Bond

Example

LiabilitiesAmountDuration

Fixed Deposit for 2 years1001.50

Fixed Deposit for 3 years2002.30

300

Portfolio Duration2.03

Assets

5 Years Term Loan1503.50

Cash Credit1500.60

300

Portfolio Duration2.05

Duration analysis

Market ValueMdurationMV* Mduration

Fixed Rate Liabiliites2600410400

Floating Rate Liabilities34000.51700

Total Liabilities600012100

Duration of Liabilities2.02

Investments2600513000

Fixed Rate Loans60031800

Floating Rate Loans11000.5550

PLR Linked Loans19000.5950

Total Assets620016300

Duration of the Assets2.63

Market ValueMdurationChange in MVNew MV

Assets62002.63-81.506118.50

Liabilities60002.02-60.505939.50

Equity2000.61-21.00179.00

Change in Interest Rate0.50%

&CDURATION - ANALYSIS

Duration - standard model

Standardised Approach to IRR

Time-bandNet Gap (Rs. Cr)Middle of time-bandProxy of modified duration (years)Assumed change in yield (BPS)Weighting factorCapital Required

Upto 1 month-200.000.5 months0.042000.08%-0.16

1 to 3 months100.002 months0.162000.32%0.32

3 to 6 months-450.004.5 months0.362000.72%-3.24

6 to 12 months-150.009 months0.712001.42%-2.13

1 to 2 years-75.001.5 years1.382002.76%-2.07

2 to 3 years-75.002.5 years2.252004.50%-3.38

3 to 4 years425.003.5 years3.072006.14%26.10

4 to 5 years-175.004.5 years3.852007.70%-13.48

5 to 7 years760.006 years5.0820010.16%77.22

7 to 10 years460.008.5 years6.6320013.26%61.00

10 to 15 years360.0012.5 years8.9220017.84%64.22

15 to 20 years-140.0017.5 years11.2120022.42%-31.39

over 20 years-640.0022.5 years13.0120026.02%-166.53

200.006.49

settlement16-Dec-02Capital200

maturity31/Dec/0220%40

coupon5%

ytm5%

price100

freq2

mduration0

var-cal

Computation of VAR

FOR A 5 CRORE POSITION IN 12.50%, GOI, 2000

Datehighlowaveragereturns

3-Apr-99103.70103.58103.6450000000Value of the Portfolio

5-Apr-99103.89103.61103.750.1061%0.0115%MEAN RETURN

6-Apr-99103.91103.80103.8550.1012%0.2747%SD OF RETURN

7-Apr-99104.00103.00103.5-0.3418%274699DEAR at 97.5% Confidence Level

8-Apr-99104.17104.02104.0950.5749%614245VAR for 5 day holding period

9-Apr-99104.16103.59103.875-0.2113%

10-Apr-99104.20103.97104.0850.2022%

12-Apr-99104.20104.15104.1750.0865%

13-Apr-99104.19104.16104.175-0.0000%

15-Apr-99104.16104.02104.09-0.0816%

16-Apr-99104.21104.18104.1950.1009%

19-Apr-99104.25103.95104.1-0.0912%

20-Apr-99104.87104.17104.520.4035%

21-Apr-99104.25103.45103.85-0.6410%

22-Apr-99104.22104.19104.2050.3418%

23-Apr-99100.24104.21102.225-1.9001%

24-Apr-99104.25104.18104.2151.9467%

26-Apr-99104.25104.18104.2150.0000%

28-Apr-99104.26104.24104.250.0336%

29-Apr-99104.50104.26104.380.1247%

3-May-99104.48104.41104.4450.0623%

4-May-99104.48104.46104.470.0239%

5-May-99104.48104.40104.44-0.0287%

6-May-99104.49104.44104.4650.0239%

7-May-99104.51104.42104.4650.0000%

8-May-99104.51104.46104.4850.0191%

10-May-99104.48104.45104.465-0.0191%

11-May-99104.45104.44104.445-0.0191%

12-May-99104.46104.44104.450.0048%

13-May-99104.45104.44104.445-0.0048%

14-May-99104.42104.41104.415-0.0287%

15-May-99104.40104.37104.385-0.0287%

17-May-99104.41104.37104.390.0048%

18-May-99104.45104.41104.430.0383%

19-May-99104.46104.44104.450.0192%

20-May-99104.45104.43104.44-0.0096%

21-May-99104.44104.43104.435-0.0048%

22-May-99104.44104.41104.425-0.0096%

24-May-99104.43104.40104.415-0.0096%

25-May-99104.43104.40104.4150.0000%

26-May-99104.48104.40104.440.0239%

27-May-99104.48104.35104.415-0.0239%

28-May-99104.38103.90104.14-0.2634%

29-May-99104.23103.99104.11-0.0288%

31-May-99104.39104.15104.270.1537%

1-Jun-99104.37104.22104.2950.0240%

2-Jun-99104.35104.32104.3350.0384%

3-Jun-99104.36104.32104.340.0048%

4-Jun-99104.54104.42104.480.1342%

5-Jun-99104.47104.44104.455-0.0239%

7-Jun-99104.46104.44104.45-0.0048%

8-Jun-99104.45104.43104.44-0.0096%

9-Jun-99104.46104.44104.450.0096%

10-Jun-99104.46104.44104.450.0000%

11-Jun-99104.45104.45104.450.0000%

12-Jun-99104.34104.34104.34-0.1053%

14-Jun-99104.34104.25104.295-0.0431%

15-Jun-99104.31104.29104.30.0048%

16-Jun-99104.24104.20104.22-0.0767%

17-Jun-99104.32104.24104.280.0576%

18-Jun-99104.33104.28104.3050.0240%

19-Jun-99104.35104.32104.3350.0288%

21-Jun-99104.35104.32104.3350.0000%

22-Jun-99104.34104.34104.340.0048%

24-Jun-99104.33104.31104.32-0.0192%

25-Jun-99104.33104.25104.29-0.0288%

26-Jun-99104.24104.24104.24-0.0479%

28-Jun-99104.20104.19104.195-0.0432%

29-Jun-99104.18103.91104.045-0.1440%

1-Jul-99104.05103.99104.02-0.0240%

2-Jul-99104.10104.05104.0750.0529%

3-Jul-99104.10104.10104.10.0240%

5-Jul-99104.38104.04104.210.1057%

6-Jul-99104.37104.30104.3350.1200%

7-Jul-99104.36104.35104.3550.0192%

8-Jul-99104.34104.30104.32-0.0335%

10-Jul-99104.36104.32104.340.0192%

12-Jul-99104.54104.34104.440.0958%

13-Jul-99104.32104.32104.32-0.1149%

14-Jul-99104.33104.32104.3250.0048%

15-Jul-99104.35104.32104.3350.0096%

16-Jul-99104.35104.32104.3350.0000%

17-Jul-99104.38104.33104.3550.0192%

19-Jul-99104.40104.36104.380.0240%

20-Jul-99104.41104.37104.390.0096%

21-Jul-99104.42104.39104.4050.0144%

22-Jul-99104.48104.42104.450.0431%

23-Jul-99104.56104.44104.50.0479%

24-Jul-99104.47104.43104.45-0.0478%

26-Jul-99104.47104.42104.445-0.0048%

27-Jul-99104.47104.45104.460.0144%

28-Jul-99104.52104.46104.490.0287%

29-Jul-99104.58104.50104.540.0479%

30-Jul-99104.71104.50104.6050.0622%

31-Jul-99104.86104.54104.70.0908%

2-Aug-99105.00104.72104.860.1528%

3-Aug-99105.15104.97105.060.1907%

4-Aug-99105.55105.13105.340.2665%

5-Aug-99105.95105.50105.7250.3655%

6-Aug-99105.89105.00105.445-0.2648%

7-Aug-99105.82105.60105.710.2513%

9-Aug-99105.70105.63105.665-0.0426%

10-Aug-99105.67105.56105.615-0.0473%

11-Aug-99105.50105.05105.275-0.3219%

12-Aug-99105.35104.95105.15-0.1187%

13-Aug-99105.18104.80104.99-0.1522%

14-Aug-99105.48104.48104.98-0.0095%

16-Aug-99105.53105.19105.360.3620%

17-Aug-99105.50105.45105.4750.1091%

18-Aug-99105.50105.46105.480.0047%

19-Aug-99105.49105.49105.490.0095%

20-Aug-99105.48105.40105.44-0.0474%

21-Aug-99105.46105.42105.440.0000%

23-Aug-99105.53105.42105.4750.0332%

24-Aug-99105.52105.47105.4950.0190%

25-Aug-99105.46105.40105.43-0.0616%

26-Aug-99105.41105.39105.4-0.0285%

27-Aug-99105.45105.41105.430.0285%

28-Aug-99105.45105.39105.42-0.0095%

30-Aug-99105.40105.37105.385-0.0332%

31-Aug-99105.41105.30105.355-0.0285%

1-Sep-99105.31105.17105.24-0.1092%

2-Sep-99105.22105.15105.185-0.0523%

3-Sep-99105.15105.05105.1-0.0808%

4-Sep-99105.14105.05105.095-0.0048%

6-Sep-99104.92104.96104.94-0.1475%

7-Sep-99104.92104.89104.905-0.0334%

8-Sep-99104.90104.84104.87-0.0334%

9-Sep-99105.20105.02105.110.2289%

10-Sep-99105.20105.20105.20.0856%

14-Sep-99105.20105.10105.15-0.0475%

var

Value of Portfilio500

DayRatesReturns

1101.23

2102.311.07%

3102.00-0.30%

4101.37-0.62%

5103.121.73%

6102.11-0.98%

7102.570.45%

8103.000.42%

9101.78-1.18%

10102.991.19%

11102.61-0.37%

Mean Return0.14%

Standard Deviation0.01

Probability68.30%90.00%95.50%98.00%99.70%50.00%

Confidence Level84.15%95.00%97.75%99.00%99.85%84.15%95.00%97.75%99.00%99.85%

Std Devision11.6522.333

VAR for 1 day (DEAR)4.918.119.8211.4514.74

7VAR for 7 days13.0021.4425.9930.2838.99

VAR fordays

&C&"Arial,Bold"&14VALUE AT RISK - AN EXAMPLE

ADDRESSING THE MISMATCHESMismatches can be positive or negative

Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A.

In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc.

For ve mismatch,it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee.

STRATEGIESTo meet the mismatch in any maturity bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch.The bank can raise fresh deposits of Rs 300 crore over 5 years maturities and invest it in securities of 1-29 days of Rs 200 crores and rest matching with other out flows.

Maturity Pattern of Select Assets & Liabilities of A Bank

STATEMENT OF INTEREST RATE SENSITIVITYGenerated by grouping RSA,RSL & OFF-Balance sheet items in to various (8)time buckets.RSA:MONEY AT CALLADVANCES ( BPLR LINKED )INVESTMENTRSLDEPOSITS EXCLUDING CDBORROWINGS

MATURITY GAP METHOD(IRS)THREE OPTIONS:A) RSA>RSL= Positive GapB) RSL>RSA= Negative GapC) RSL=RSA= Zero Gap

SUCCESS OF ALM IN BANKS :PRE - CONDITIONSAwareness for ALM in the Bank staff at all levelssupportive Management & dedicated Teams.Method of reporting data from Branches/ other Departments. (Strong MIS).Computerization-Full computerization, networking.Insight into the banking operations, economic forecasting, computerization, investment, credit.5.Linking up ALM to future Risk Management Strategies.

Interest Rate Risk ManagementInterest Rate risk is the exposure of a banks financial conditions to adverse movements of 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 also affect the underlying value of the banks assets, liabilities and off-balance-sheet item.

Interest Rate RiskInterest rate risk refers to volatility in Net Interest Income (NII) or variations in Net Interest Margin(NIM). Therefore, an effective risk management process that maintains interest rate risk within prudent levels is essential to safety and soundness of the bank.

Sources of Interest Rate RiskInterest rate risk mainly arises from:Gap RiskBasis RiskNet Interest Position RiskEmbedded Option RiskYield Curve RiskPrice RiskReinvestment Risk

Measurement of Interest Rate RiskGap Analysis- Simple maturity/re-pricing Schedules can be used to generate simple indicators of interest rate risk sensitivity of both earnings and economic value to changing interest rates. - If a negative gap occurs (RSARSL) in a given time band, an decrease in market interest rates could cause a decline in NII.

Measurement of Interest Rate RiskDuration Analysis: Duration is a measure of the percentage change in the economic value of a position that occur given a small change in level of interest rate.

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