Interest Risk Management and Guidelines

8/4/2019 Interest Risk Management and Guidelines

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Interest Risk

Management &Guidelines

Rajat Sikri 1021227, Rohit Dhannawat- 1021229, Saurabh Khator- 1021231

[Pick the date]



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Interest Risk Management and Guidelines

Interest risk management means risk resulting from changes in the interest income owing to

interest rate fluctuations. It may be viewed from two different but complimentary perspectives- earning sensitivity to rate fluctuations and price sensitivity of

instruments/products to changes in interest rate. Absence of appropriate management of

interest rates is one of the primary factors for accentuating the spell of liquidity problems of

bank in recent past.

The various types (sources) of interest rate risks are detailed below:-

y Gap/Mismatch risk:-It arises from holding assets and liabilities and off balance

sheet items with different principal amounts, maturity dates & re-pricing dates

thereby creating exposure to unexpected changes in the level of market interest

rates.

y Basis Risk: It is the risk that the Interest rat of different Assets/liabilities and off

balance items may change in different magnitude. The degree of basis risk is fairly

high in respect of banks that create composite assets out of composite liabilities.

y Embedded option Risk: Option of pre-payment of loan and Fore- closure of

deposits before their stated maturities constitute embedded option risk

y Yield curve risk: Movement in yield curve and the impact of that on portfolio

values and income.

y Reprice risk: When assets are sold before maturities.

y Reinvestment risk: Uncertainty with regard to interest rate at which the future cash

flows could be reinvested.

y Net interest position risk: When banks have more earning assets than paying

liabilities, net interest position risk arises in case market interest rates adjust

downwards.

The movement of interest rates affects a bank¶s reported earnings and book capital by

changing

y Net interest income,



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y The market value of trading accounts (and other instruments accounted for by

market value), and

y Other interest sensitive income and expenses, such as mortgage servicing fees.

Changes in interest rates also affect a bank¶s underlying economic value. The value of a

bank¶s assets, liabilities, and interest-rate-related, off-balance-sheet contracts is affected by

a change in rates because the present value of future cash flows, and in some cases the cash

flows themselves, is changed.

A bank can alter its interest rate risk exposure by changing investment, lending, funding,

and pricing strategies and by managing the maturities and repricings of these portfolios to

achieve a desired risk profile.

From an earnings perspective, a bank should consider the effect of interest rate risk on net

income and net interest income in order to fully assess the contribution of noninterest

income and operating expenses to the interest rate risk exposure of the bank. In particular,

a bank with significant fee income should assess the extent to which that fee income is

sensitive to rate changes. From a capital perspective, a bank should consider how

intermediate (two years to five years) and long-term (more than five years) positions may

affect the bank¶s future financial performance. Since the value of instruments with

intermediate and long maturities can be especially sensitive to interest rate changes, it is

important for a bank to monitor and control the level of these exposures.

1Measurement of Interest Rate Risk

Managing interest rate risk requires a clear understanding of the amount at risk and the

impact of changes in interest rates on this risk position. To make these determinations,

sufficient information must be readily available to permit appropriate action to be taken

within acceptable, often very short, time periods. The longer it takes an institution to

eliminate or reverse an unwanted exposure, the greater the possibility of loss. Each

institution needs to use risk measurement techniques that accurately and frequently

measure the impact of potential interest rate changes on the institution. In choosing

appropriate rate scenarios to measure the effect of rate changes, the institution should

consider the potential volatility of rates and the time period within which the institution

could realistically react to close the position.

Gap analysis, duration analysis and stimulation models are interest rate risk measurement

techniques. Each institution should use at least one, and preferably a combination of these



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techniques in managing its interest rate risk exposure. Each technique provides a different

perspective on interest rate risk, has distinct strengths and weaknesses, and is more

effective when used in combination with another.

Interest Rate Risk Management and Control Procedures:

Each institution needs to develop and implement effective and comprehensive procedures

and information systems to manage and control interest rate risk in accordance with its

interest rate risk policies. These procedures should be appropriate to the size and

complexity of the institution¶s interest rate risk-taking activities.

The use of hedging techniques is one means of managing and controlling interest rate risk.

In this regard, many different financial instruments can be used for hedging purposes the

more commonly used, being derivative instruments. Examples include foreign exchange

contracts, foreign currency and interest rate future contracts, foreign currency and interest

rate options, and foreign currency and interest rate swaps.

Generally, few institutions will want or need to use the full range of hedging instruments.

Each institution should consider which are appropriate for the nature and extent of its

interest rate risk activities, the skills and experience of management, and the capacity of

interest rate risk reporting and control systems.

Financial instruments used for hedging are not distinguishable in form from instruments

that may be used to take risk positions. Before using hedging products, each institution

must ensure that they understand the hedging instrument and that they are satisfied that the

instrument matches their specific hedging needs in a cost-effective manner.

Internal inspections/audits are a key element in managing and controlling an institution¶s

interest rate risk management programme. Each institution should use them to ensure

compliance with, and the integrity of, the interest rate risk policies and procedures.

Internal inspections/audits should, at a minimum, randomly test all aspects of interest rate

risk management activities in order to:

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1 Bank of Jamaica, Interest risk management



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Ensure interest rate risk management policies and procedures are being adhered to;

y ensure effective management controls over interest rate risk positions;

y verify the adequacy and accuracy of management information reports; and

y ensure that personnel involved in interest rate risk management fully

y Understand the institution¶s interest rate risk policies and risk limits and have the

expertise required to make effective decisions consistent with the interest rate risk

policies.

2Principles for the Management and Supervision of Interest Rate Risk:

Board and senior management oversight of interest rate risk:

Principle 1: In order to carry out its responsibilities, the board of directors in a bank should

approve strategies and policies with respect to interest rate risk management and ensure that

senior management takes the steps necessary to monitor and control these risks consistent

with the approved strategies and policies. The board of directors should be informed regularly

of the interest rate risk exposure of the bank in order to assess the monitoring and controlling

of such risk against the board¶s guidance on the levels of risk that are acceptable to the bank.

Principle 2: Senior management must ensure that the structure of the bank's business and the

level of interest rate risk it assumes are effectively managed, that appropriate policies and

procedures are established to control and limit these risks, and that resources are available for

evaluating and controlling interest rate risk.

Principle 3: Banks should clearly define the individuals and/or committees responsible for

managing interest rate risk and should ensure that there is adequate separation of duties in

key elements of the risk management process to avoid potential conflicts of interest. Banks

should have risk measurement, monitoring, and control functions with clearly defined duties

that are sufficiently independent from position-taking functions of the bank and which report

risk exposures directly to senior management and the board of directors. Larger or more

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2Principles for the management and supervision of IRR, BIS



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complex banks should have a designated independent unit responsible for the design and

administration of the bank's interest rate risk measurement, monitoring, and control functions.

Adequate risk management policies and procedures

Principle 4: It is essential that banks' interest rate risk policies and procedures are clearly

defined and consistent with the nature and complexity of their activities. These policies

should be applied on a consolidated basis and, as appropriate, at the level of individual

affiliates, especially when recognising legal distinctions and possible obstacles to cash

movements among affiliates.

Principle 5: It is important that banks identify the risks inherent in new products and

activities and ensure these are subject to adequate procedures and controls before being

introduced or undertaken. Major hedging or risk management initiatives should be approved

in advance by the board or its appropriate delegated committee.

Risk measurement, monitoring, and control functions

Principle 6: 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.

Principle 7: Banks must establish and enforce operating limits and other practices that

maintain exposures within levels consistent with their internal policies.

Principle 8: 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.

Principle 9: 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.



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Internal controls

Principle 10: 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.

Information for supervisory authorities

Principle 11: 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.

Capital adequacy

Principle 12: Banks must hold capital commensurate with the level of interest rate risk they

undertake.

Disclosure of interest rate risk

Principle 13: Banks should release to the public information on the level of interest rate risk

and their policies for its management.

Supervisory treatment of interest rate risk in the banking book

Principle 14: 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



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systems, expressed in terms of the threat to economic value, using a standardised interest rate

shock.

Principle 15: 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.

Documents

Interest Risk Management and Guidelines