Interest Risk

7/29/2019 Interest Risk

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Management Of

Interest Rate

Risk In Banks


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What is Interest rate risk

Impact Of Interest Rate Risk

Types of Interest Rate Risks Effects of Interest rate risks

Measurement of Interest rate risks

Strategies to control Interest rate risks

Principles for IRR management.


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It is the loss arising from changes in the

interest rate such as bank rate, base rate, SLR,

CRR etc. which affects the banks profitabilityand market value of the equity.


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Interest rate are based on the demand-supply forces ofthe economy, if demand is more and supply is less;then the interest rate will go up., the central bankcontrols the supply side of the economy.

When the central bank raises the rate, then the cost offunds goes upward and customers will need to paymore money to avail the credit facilities. This is turn,raises the EMI, payback period and ultimately impacts

the default of various loans. When the central bank lowers the rate, then banks havemore money to lend to the customers and the supplyside becomes more, which means the customers availthe credit facilities at the lower rate.


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Repricing Risk

Basis RiskYield Curve Risk

Embedded OptionRisk


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It is the most fundamental basis of risk; it

arises due to the timing differences in thematurity of bank assets, liabilities and off-balance sheet positions.

A bank that funded a long-term fixed rate loan

with a short-term deposit could face a declinein both the future income arising from theposition and its underlying value if interestrates increase.


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It arises due to the prepayment of loans and

bonds and premature withdrawal of the

deposits.


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It arises when the interest rate of both theassets and liabilities changes in the different

magnitude. These risks arises unexpectedchanges in the cash flows and the interestearned.

If the savings rate is decreased by 1% and thecash credit rate is decreased by 2%, then thebanks have to incur additional money inpaying off the liabilities.


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Yield curve is the difference between the interest rateand the time to maturity of the debt. This risk arisesdue to the changes in the yield curve.

When the yield curve shifts, the price of the bond,

which was initially priced based on the initial yieldcurve, will change in price. If the yield curve flattens,then the yield spread between long- and short-terminterest rates narrows, and the price of the bond willchange accordingly. If the bond is a short-term bond

maturing in three years and the three-year yielddecreases, the price of this bond will increase. If the yield curve steepens, this means that the spread

between long- and short-term interest rates increases.Therefore, long-term bond prices will decrease

relative to short-term bonds.


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Earnings perspective: In the earnings perspective, the focusof analysis is the impact of changes in interest rates on accrual

or reported earnings. This is the traditional approach to

interest rate risk assessment taken by many banks. Variation in

earnings is an important focal point for interest rate riskanalysis because reduced earnings or outright losses can

threaten the financial stability of an institution by undermining

its capital adequacy and by reducing market confidence

Economic value perspective: Variation in market interest ratescan also affect the economic value of a bank's assets,

liabilities and OBS positions. Thus, the sensitivity of a bank's

economic value to fluctuations in interest rates is a

particularly important consideration of shareholders,

management and supervisors alike


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The interest rate risk is measured by the meansof GAP analysis. It is the traditional methodadopted by banks and still widely followed.

The interest rates of liabilities are subtractedfrom the corresponding interest rate of assetsto produce a repricing "gap". If the asset ismore than the liabilities, it gives positive gap

otherwise negative gap arises. In raising interest rates, the banks tend to

maintain positive gap and in lowering ofinterest rates, the banks maintain negative gap.


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SCENARIO STRATEGY

Rising InterestRates

DecliningInterest Rates Maintain aNegative Gap

Maintain a

Positive Gap


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1.Board and senior management oversight of interest rate risk: The boardof directors should approve strategy and take steps to monitor andcontrol these risks

2. Senior management must ensure that the structure of the bank'sbusiness and the level of interest rate risk it assumes are effectively

managed by having adequate controlling measures.3. Banks should have risk measurement, monitoring and control functions

with clearly defined duties that are independent from functions of thebank and which report risk exposures directly to senior managementand the board of directors.

4. Adequate risk management policies and procedures: It is essential that

banks' interest rate risk policies and procedures are clearly defined andconsistent with the nature and complexity of their activities.5. It is important that banks identify the risks inherent in new products

and activities and ensure these are subject to adequate procedures andcontrols before being introduced. Hedging and risk managementtechniques should be approved by the board.


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6. Risk measurement, monitoring and control functions: 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.7. Banks must establish and enforce operating limits and other

practices that maintain exposures within levels consistent with

their internal policies.

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.

9. Banks must have adequate information systems for measuring,

monitoring, controlling and reporting interest rate exposures.


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10.Internal controls: A fundamental component of the internalcontrol system involves regular independent reviews andevaluations of the effectiveness of the system and, wherenecessary, ensuring that appropriate revisions or enhancements

to internal controls are made. The results of such reviews shouldbe available to the relevant supervisory authorities11. Information for supervisory authorities: Supervisory authorities should

obtain from banks sufficient and timely information with which toevaluate their level of interest rate risk.

12.Capital adequacy: Banks must hold capital commensurate with thelevel of interest rate risk they undertake.

13.Disclosure of interest rate risk: Banks should release to the publicinformation on the level of interest rate risk and their policies for itsmanagement.

14.It gives supervisors the power to enforce remedial action if the bank isdeemed to be not carrying adequate capital for the risk held.


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Interest Risk