Term Paper BANK[1]

8/9/2019 Term Paper BANK[1]

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INTRODUCTION

The acceptance and management of financial risk is inherent

to the business of banking and banks roles as financial

intermediaries. To meet the demands of their customers and

communities and to execute business strategies, banks

make loans, purchase securities, and take deposits with

different maturities and interest rates. These activities may

leave a banks earnings and capital exposed to movements

in interest rates.

This exposure is interest rate risk.Changes in banks

competitive environment, products, and services have

heightened the importance of prudent interest rate risk

management.

become more exposed to such volatility because of the

changing character of their liabilities. For example,

nonmaturity deposits have lost importance and purchased

funds have gained.

Each year, the financial products offered and purchased by

banks ,many of these products pose risk to the bank. For

example, an assets option features can, in certain interest

rate environments, reduce its cash flows and rates of return.

The structure of banks balance sheets has changed. Many

commercial banks have increased their holdings of long-term

assets and liabilities, whose values are more sensitive torate changes.

DEFINITION:

Interest rate risk is the risk (variability in value) borne by an

interest-bearing asset, such as a loan or a bond, due to


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variability of interest rates. In general, as rates rise, the price

of a fixed rate bond will fall, and vice versa. Interest rate risk

is commonly measured by the bond's duration

Bench mark interest rate:Kibor:

stand for karachi inter bank operation rate , money

market rate determined through demand and supply of

money used by financial instituition.

Libor:

london inter bank operation rate,

Pegged interest rate:

a rate at which a loan is available it may be at a fixed

rate or at a variable rate

Sources of interest rate risk :

Expects financial institutions to identify the sources of

interest rate risk to which they are exposed and evaluate

their effects on profitability and net value as a result of


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interest rate movements.

Depending on the nature of the asset or liability, interest

rates may be fixed (for the duration of a term) or repriceable

(based on a term), or variable (indexed) according to thecontract between the parties or the financial instrument. In

addition, certain assets or liabilities may not be considered

interest-bearing. This is notably the case for non-performing

loans or qualifying shares of a financial services cooperative.

Financial institutions may be exposed to interest rate risk in

different ways. It is therefore essential that they be fully

aware of the factors that could influence their management

of this risk, as well as interest rate changes and volatility.Some of these factors are:

1) The nature and complexity of the structure of assets and

liabilities affecting interest rate sensitivity of earnings and

net value;

2) The importance of loan risk premiums and the frequency

of repricing dates;

3) Changes in monetary policies;

4) The principal components of the economic environment,

including inflation rates, and possible declines in return

generated by certain financial products

1) Repricing risk:

Repricing risk results from differences in the timing of rate changesand the timing of cash flows that occur in the pricing and maturity of abanks assets, liabilities, and off-balance-sheet instruments.Repricingrisk is often the most apparent source of interest rate risk for a bankand is often gauged bycomparing the volume of a banks assets thatmature or reprice within a given time period with the volume of


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liabilities thatdo so. Some banks intentionally take repricing risk intheir balance sheet structure in an attempt to improve earnings.

2)Yield curve risk:

Yield-curve risk arises from variations in the movement of interestrates across the maturity spectrum. It involveschanges in the relationship between interest rates of differentmaturities of the same index or market (e.g., a three-monthTreasury versus a five-year Treasury).

3) Basis risk: Basis risk arises from a shift in the relationship of the

rates in different financial markets or on different financialinstruments. Basis risk occurs when market rates for different financialinstruments, or the indices used to price assets and liabilities, changeat different times or by different amounts. For example, basis riskoccurs when the spread between the three-month Treasury and thethree-month London interbank offered rate (Libor) changes. Thischange affects a banks current net interest margin through changes inthe earned/paid spreads of instruments that are being repriced. It alsoaffects the anticipated future cash flows from such instruments, whichin turn affects the underlying net economic value of the bank.

4)Option risk:

Option risk arises when a bank or a banks customer has the right (not

the obligation) to alter the level and timing of the cash flows of an

asset, liability, or off-balance-sheet instrument. An option gives the

option holder the right to buy (call option) or sell (put option) afinancial instrument at a specified price (strike price) over a specified

period of time. For theseller (or writer) of an option, there is an

obligation to perform if the option holder exercises the option.

The option holders ability to choose whether to exercise the option

creates an asymmetry in an options performance.Generally, option


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holders will exercise their right only when it is to their benefit. As a

result, an option holder faces limiteddownside risk (the premium or

amount paid for the option) and unlimited upside reward. The option

seller faces unlimited downside risk (an option is usually exercised at a

disadvantageous time for the option seller) and limited upside

reward(if the holder does not exercise the option and the seller retains

the premium).

Options often result in an asymmetrical risk/rewardprofile for the bank. If the bank has written (sold) options to itscustomers, the amount of earnings or capital value that a bank maylose from an unfavorable movement in interest rates may exceed theamount that the bank may gain if rates move in a favorable direction.As a result, the bank may have more downside exposure than upsidereward. For many banks, their written options positions leave them

exposed to losses from both rising and falling interest rates.

Following considerations should notably be

reflected in the institution's interest rate risk

management policy and procedures:

Operational

objectives1) segregation of roles and responsibilities and designation

of competent and experienced individuals responsible for

managing interest rate risk;

2) risk appetite for that risk;

3) terms of intra-group management of interest rates;

4)monitoring and control of interest rate risk, including:

a) explicit and prudent limits in line with the risk

tolerance;

b) effective and reliable information systems for


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controlling matching positions and ensuring compliance with

limits;

c) terms of foreign currency activities;

d) measures to unwind an undesirable matchingposition, mainly through hedging.

Aside from their roles and responsibilities with respect to

sound governance, the board of directors and senior

management should communicate with the persons

responsible for interest rate risk management as soon as

exposure limits are exceeded and continue to liaise withthem thereafter. In addition, specific approvals should be

secured for major interest rate risk hedging initiatives.

The institution should use appropriate mechanisms to

conduct regular and independent assessments of the

effectiveness of its interest rate risk management strategy.

Similarly, it must ensure compliance with the policy and

procedures resulting from the strategy.

2) Risk appetite

Expects financial institutions to establish their interest rate

risk appetite and risk tolerance levels.

The primary purpose of managing interest rate risk is to

monitor and control the impacts of this risk on a financial

institution's profitability. The institution should have

sufficient leeway to optimize its profitability, yet still remain

prudent and within its risk appetite.

The institution should establish and impose interest rate risk

limits and ensure that exposure levels do not exceed these


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limits.

3) Intra-group management

Expects financial institutions and

the group to which they belong to effectively manageinterest rate risk. Interest rate risk affecting a group of

institutions should be managed on a combined or

consolidated basis that includes the positions of subsidiaries

and other group entities. As necessary, risk management

procedures should be adapted to include the legal nature

and complexity of the activities of the group members.

However, financial institutions that are part of a group are

responsible for managing their internal interest rate risk,even if monitoring and control mechanisms are applicable

across the group.

a) Federation is are responsible for co-ordinating their own

on- and off-balance sheet asset and liability matching

activities, as well as the combined positions of member

financial services cooperatives.

b)Federation must also establish a matching profile and a

target for the financial group as a whole, including related

entities and controlled persons, which include a security

fund.

c)Financial services cooperative acting as group treasurer

that manage the group's interest rate risk may, in addition to

managing their own treasury activities, cause a range ofhedging instruments to be available to the network. At the

federation's request, this financial services cooperative may

also take hedging positions on behalf of the network.

Strategy, policy and procedures :


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Expects financial institutions to adopt an effective strategy

for sound and prudent interest rate risk management and to

implement a policy and procedures to execute the strategy

at the operational level.

Although the focus of an interest rate risk management

strategy may be the optimization of profitability, the board

of directors and senior management should bear in mind

that this risk could, conversely, pose a significant threat to

the institution's earnings and capital base.

Financial institutions should develop an interest rate risk

management strategy and periodically review the strategy,

taking into account notably:

The internal and external sources of risk that might affect

its exposure to interest rate risk;

sufficient capitalization to cover this risk as well as the

methods for evaluating its ability to absorb potential losses

stemming from unfavourable interest rate movements;

the interrelation and interdependence with other risks to

which an institution is exposed.

.

Measureme


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nt of interest rate risk

Financial institutions to measure their exposure to interest

rate risk based on a methodology commensurate with their

risk profile and size, and the nature and complexity of theiractivities.

In establishing interest rate exposure limits, financial

institutions should consider, in particular, interest rate

volatility, different related factors such as its capital

adequacy, and the quality of its credit and investments, and

its profitability, generally net interest income or the present

value of assets.

Generally, institutions should establish and periodically

review the mismatch limits for each on- and off-balance

sheet position for given maturities. More sophisticated

measurement techniques could be employed according to

the type of activity and its complexity. In this regard, it is

recommended that institutions have a comprehensive view

of interest rate risk that takes into account the significance

of their financial intermediary and trading activities.considers that a financial institution's exposure to interest

rate risk should be analyzed from an earnings perspective

and a net value perspective.

GAP:

Following are the different kind of gap

(i)POSITIVE GAP:(ii)NEGATIVE GAP:

POSITIVE GAP:


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Maturity or repricing Mismatch in a bank's assets andliabilities where there are more assets maturing or repricingin a given period than liabilities. A bank with a positive gap isasset sensitive.A positive interest rate gap means that more

assets than liabilities are due to be repriced in a particulartime interval.NEGATIVE GAP:Repricing or duration mismatch in which interest sensitiveliabilities exceed interest sensitive assets. A bank whoseinterest sensitive liabilities reprice more quickly than interestsensitive assets is said to be liability sensitiveNOTE:During a period of falling interest rates, a positive gap wouldtend to adversely affect net interest income, while a

negative gap would tend to result in an increase in netincome. During a period of rising interest rates, a positivegap would tend to result in an increase in net interestincome while a negative gap would tend to affect netinterest income adversely.Calculating interest rate risk

There are a number of standard calculations for measuringthe impact of changing interest rates on a portfolio

consisting of various assets and liabilities. The most commontechniques include:

1. Repricing Model2. Duration Model3.Measuring the mismatch of the interest sensitivity gap of

assets and liabilities, by classifying each asset and liabilityby the timing of interest rate reset or maturity, whichevercomes first.

REPRICING MODEL: is a CF analysis of interest income (+CFs) fromloans; and interest expense (-CF) on deposits, looking at Rate-SensitiveAssets (RSAs) vs. Rate-Sensitive Liabilities (RSLs).

Rate sensitivity results from either:a) variable rate loans or deposits that adjust to market rates, or
http://www.answers.com/topic/mismatchhttp://www.answers.com/topic/mismatch


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b) maturing loans or deposits that will adjust, and roll over to currentmarket rates.

If RSA < RSL and interest rates increase, the FI's net income will decrease,because the interest expense on deposits will rise faster than interest incomeon loans. Formula:

NII = GAP * (R), where:

NII = Change in Net Interest Income ($)GAP = (RSA - RSL)R = Change in Interest Rates

Equal changes in Rates on RSAs and RSLs are possible in some periods,For the +Gap=10m , for every 1% increase in R:

NII = ($10m) x .01 = $100,000

For the -Gap=10m ,for every 1%decrease in R:

NII = (-$10m) x .01 = -$100,000We can also calculate cumulative gaps (CGAP) over a certain period, e.g. 1YR:

CGAP (one-year): -$10m + -$10m + -$15m + $20m = -$15m

NII (one-year) = (-$15m) x .01 = -$150,000

Measuring and Managing Int. Rate Risk.One-YearRate Sensitivity Analysis: RSAs = $155m and RSLs = $140m

and 1-YR CGAP = +$15m.

Rules:1. When RSA > RSL, then CGAP > 0.2. When RSA < RSL, then CGAP < 0.3. If CGAP > 0, if interest rates rise (fall), NII will rise (fall).4. If CGAP < 0, when interest rate rise (fall), NII will fall (rise).

.


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Unequal changes in Rates on RSAs and RSLs are possible in some periods,(Prime Rate for RSAs and CD rate for RSLs). Formula:

NII = (RSA x RRSA

) - (RSL x RRSL

)

Spread Effect, where interest rates rise faster for RSAs (1.2%) than for RSLs(1%), and cause an increase in NII of $310,000 on $155m of both Assets andDeposits . The larger the spread between (RSA - RSL), the greater the effecton NII when interest rates change.

Advantages of Repricing Model:Easy to understand,Easy to work with,

Easy to forecast changes in profitability from interest ratechanges.

Disadvantages/Limitations of Repricing Model:

1. Does not account for balance sheet changes in the market value (PVA and

PVL) of the bank when interest rates change

2. Within a given time period (bucket), e.g. 1-5 years, the dollar values ofRSAs and RSLs may be equal (indicating no interest rate risk), but the assetsmay be repriced early, and the liabilities repriced late, within the bucket time

period, exposing the FI to interest rate risk not accurately captured by theRepricing Model. Ignores CF patterns within a maturity bucket, e.g. one-year ARM rates might be re-set on a different date than the maturity patternsof 1 year CDs.

3. Assumes NO prepayment of RSAs or RSLs, when there can actually be ahigh volume of refinancing, e.g., recent years (2002-2003) for mortgageswhen rates fell to 50 year lows. Also, assumes no reinvestment risk for rate-insensitive assets (loans). Fixed-rate "rate-insensitive" loans generate CFsthat are rate-sensitive because of reinvestment. A 30-year fixed-ratemortgage might not get repriced for 30 years, but its CFs have to bereinvested at the current market rates.


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4. Considers only balance-sheet items, and ignores interest rate risk/CFsfrom off-balance-sheet (OBS) activities e.g., interest rate futures, loancommitments, etc. Example: Futures contracts produce daily CFs becauseof daily settlement, and expose an FI to OBS interest rate risk.

Duration Model: Duration (weighted-average maturity) measures interestrate risk, i.e., changes in PV of securities when interest rates change:

% PV Security = - D * R / (1 + R)

FI's exposure to interest rate risk can be measured by its Duration Gap,which takes into account the usual duration/maturity mismatch: DA > DL.

Equity (E) = Assets (A) - Liabilities (L), and

E = A - L

%A, which is equal to: ( A ) = - DA * (R)

A (1 + R)

%L, which is equal to: ( L ) = - DL * (R) , or

L (1 + R)

A = A * - DA * (R)

(1 + R)

L = L * - DL * (R)

(1 + R)and through substitution and rearranging we have (see footnote 11 on p. 614)

E$ = - (DA - k DL) * A$ * R1 + R

E$ = - DGAP * A$ * R1 + R

where k = L / A = Measure of the FI's leverage, or D / A ratio. Interest raterisk (changes in market value of FI's net worth (E) is determined by 3


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factors:1. Leverage-adjusted duration gap (DA - k DL), measured in years and

reflects duration mismatch. The higher the duration gap, the higher the

interest rate risk.

2. Size of FI, measured by Assets (A$). The larger the size of FI, the greaterthe risk exposure from a change in interest rates, i.e., the greater the changein E, or market value.

3. Size of interest rate shock, R. The greater the R, thegreater the E.

Interest Rate Risk Exposure:

E$ = - Adjusted Duration Gap * Asset Size$ * InterestRate Shock

Note: Interest rate shocks (changes) are "exogenous" or external to the bank,beyond its control, caused by _________________________________.Bank can control its duration gap, but can't control general level of interest

rates.

Using Duration Gap. a) If Duration Gap is POS (DA > DL), the bank is

worried about an INCREASE in interest rates, because an INCREASE ininterest rates will DECREASE the Value of the Bank (E). Interest Rates andBank Value are inversely (neg.) related.

b) If Duration Gap is NEG (DA < DL), the bank is worried about a

DECREASE in interest rates, because a DECREASE in interest rates willDECREASE the Value of the Bank (E). Interest Rates and Bank Value aredirectly (pos) related.Duration Gap is Pos (DA= 5 YRs and DL = 3 YRs). If interest rates rise from

10% to 11%, the value of the bank will fall by -$2.09m, from $10m to$7.91m. Net Worth to Asset (E/A) has fallen from 10% to 8.29% ($7.91m /$95.45m). Note: This is only a 1% increase in interest rates.


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We get the same result considering A and L separately:A = $100m x (-5) x (.01/1.10) = -$4.545mL = $90m x (-3) x (.01 / 1.10) = -$2.454mE = -$4.545m - (-$2.454m) = -$2.09m

To counter this effect, the bank could adjust the Duration Gap to immunizeagainst interest rate changes/risk. Setting DA = DL won't result in 100%

immunization because A > L ($100m > $90m),(if DA = DL = 5 yrs.). FI

would will still be exposed to interest rate risk, bank value would fall by -$0.45m if interest rate rise by 1%.

Immunization formulas:a. A * DA = L * DL

$100m * 5yrs = $90m * x (where x = DL that will immunize 100%)

x = DL = 5.556 years

b. DA = (L / A) * DL and

DA = k * DL (where k= L / A)

5 = .90 x

x = DL = 5.556 years

Result of immunization is E = 0

E = - [5 - (.9) 5.556] * $100m * (.01/1.10)E = - (0) * $100m * (.01 / 1.10)


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Other strategies to immunize 100%:1. Reduce DA (Leave L the same). DA * $100m = ($90m * 3 yrs), solve

for DA

DA = 2.7 years (Reduce DA from 5 years to 2.7 years)

2. Reduce DA (X) and increase DL (Y) at the same time.

$100m X = $90m * YOne solution would be DA = 4 yrs. and DL = 4.4444 yrs.

3. Increase L (and k) and increase DL.

$100m * 5 = $95 * 5.2632 yrs.

SUMMARY:

A * DA > L * DL

$100m * 5 > $90m * 3

500 > 270

Decrease DA, increase DL, and/or increase L (assuming that A will not

change)

Point: Duration Model can be used to immunize bank against interest raterisk, i.e., the bank value (E = 0) will be unaffected byinterest rate changes. Duration model is endorsed by theBank for International Settlements (BIS) to measure and

monitor interest rate risk for banks.

Limitations of Duration Model:1. Might be time-consuming and costly to make changes to balance sheet toimmunize. However, with advances in information technology and more


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advanced capital and money markets (e.g., Fed Funds, securitization ofmortgages, etc.), transaction costs have come down over time. Also,duration model can be used to immunize with off-balance-sheet instrumentslike interest rate futures, forwards, options, and swaps.

2. Immunization is a dynamic problem, changes constantly as DA, DL, A and

L change over time, and requires continual monitoring and periodic changesand rebalancing to keep bank immunized (A * DA = L * DL).

3. Duration assumes a simple linear relationship betweenchanges in interest rates (R) and %PV, when the truerelationship is non-linear, As changes in interest rates increase, theDuration Model becomes less accurate and precise.

Interest rate Mismatch:Mismatch refers to how closely asset receipts and liabilityexpense dates coincide. Mismatch is measured by eithermaturity or reset dates for variable rate securities.Forecasting future interest rate resets is difficult and for thatreason most variable rate securities are bound to an intereststandard such as libor or the 3 month treasury bill rate.If the sum of a bank's loans average 4 years at 5 percentand borrows money on average for 6 years, then the bankhas interest rate risk for the 1 year mismatch.

Scenarios analysis and stress testing :expects the financial institution to analyze interest rate riskbased on various scenarios and using stress testing.In a dynamic management environment, financialinstitutions should assess their exposure to interest rate riskarising from movements in interest rates and the potential

resulting losses.Scenario-based analyses enable an institution to analyze,using different probable assumptions, the sensitivity of itson- and off-balance sheet assets and liabilities to interestrate fluctuations in the course of its day-to-day operations aswell as during periods where such adverse fluctuations affect


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the institution's earnings.In more critical financial market conditions, such analysisshould be supplemented with stress testing. These analysesshould provide the institution with information on the

conditions under which strategies or positions would bemore vulnerable.Consequently,financial institution should use scenarios andconduct stress testing to measure the effects of differentvariables and assess the impact on profitability and netvalue. The institution should give consideration to the resultsof different scenarios when establishing and reviewing theirinterest rate risk policies and limits. It should alsoperiodically review the underlying assumptions used tocontrol and monitor interest rate risk.

Scenario analysis and stress testing should notably take thefollowing into account: significant changes in balance sheet structure; possible changes in the institution's prime rate; significant changes in behaviour of consumers of financialproducts; material changes in relationships among market rates andchanges in the slope and the shape of the yield curve.Parallel situations are often observed following downward

pressure on profitability by competitors; optional clauses and features of financial products.

Managing Interest

rate:1) Interest rate swap

A swap is a derivative in which one party

exchanges a stream of interest payments for another party'sstream of cash flows. Interest rate swaps can be used byhedgers to manage their fixed or floating assets andliabilities. They can also be used by speculators to replicateunfunded bond exposures to profit from changes in interestrates. Interest rate swaps are very popular and highly liquidinstruments.


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StructureIn an interest rate swap, each counterparty agrees to payeither a fixed or floating rate denominated in a particularcurrency to the other counterparty. The fixed or floating rate

is multiplied by a notional principal amount (say, USD 1million). This notional amount is generally not exchangedbetween counterparties, but is used only for calculating thesize of cashflows to be exchanged.

The most common interest rate swap is one where onecounterparty A pays a fixed rate (the swap rate) tocounterparty B, while receiving a floating rate (usuallypegged to a reference rate such as LIBOR).

A pays fixed rate to B (A receives variable rate)B pays variable rate to A (B receives fixed rate).

Consider the following swap in which Party A agrees to payParty B periodic fixed interest rate payments of 8.65%, inexchange for periodic variable interest rate payments ofLIBOR + 70 bps (0.70%). Note that there is no exchange ofthe principal amounts and that the interest rates are on a"notional" (i.e. imaginary) principal amount. Also note that

the interest payments are settled in net (e.g. Party A pays(LIBOR + 1.50%)+8.65% - (LIBOR+0.70%) = 9.45% net. Thefixed rate (8.65% in this example) is referred to as the swaprate.[1]

At the point of initiation of the swap, the swap is priced sothat it has a net present value of zero. If one party wants topay 50 bps above the par swap rate, the other party has topay approximately 50 bps over LIBOR to compensate forthis.2) Forward Contracts

A forward contract is an agreement to buy or sell an asset at acertain time in the future for a certain price (thedelivery price) It can be contrasted with a spot contract which is an agreement tobuy or sell immediately


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Options

A call option isan option to buy a certain asset by a certaindate for a certain price (the strike price) A put option is an option to sell a certain asset by a certaindate for a certain price (the strike price)Options vs Futures/Forwards

A futures/forward contract gives the holderthe obligation to buy or sell at a certainprice An option gives the holder the right to buyor sell at a certain price

Interest rate risk management related to foreigncurrencies

Financial institutions to have an appropriate process formanaging their matching positions with respect to theforeign currencies used in the course of their operations.

To reflect its foreign currency matching positions, financialinstitutions are expected to measure their interest rateexposure relative to each currency, since yield curves mayvary depending on the currency.Financial institution may also use foreign currency-denominated deposits, borrowings or on- and off-balance

sheet financial instruments to rebalance mismatching inlocal or foreign currencies. The following factors should betaken into consideration: the convertibility of each currency, the volatility of theexchange rate, and the availability of foreign currency funds;

foreign market conditions, including counterparty risk andthe level of interest rates as well as their correlation.

Hedging :

The expects financial institutions to adequately manage theirmatching activities and, as necessary, to offset gaps in aprudent manner through corrective measures, in particular,hedging, which enables institutions to mitigate interest raterisk within established limits.In periods of wide interest rate fluctuations, sound interest


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rate management should enable the institution to avoidpredatory selling of its income-bearing assets and liabilitiesor the use of hedging instruments that are costly or haveunfavourable conditions.

Where necessary, the institution should employ hedging tomitigate its interest rate risk exposure, by: using appropriate financial instruments consistent with thetype and scope of its operations, the competence andexpertise of its personnel, and the capacity of its dataprocessing and reporting systems;

Evaluation ofInterest Rate Exposures

Interest rates impact are observed in two prespective:a)EARNING PROSPECTIVEb)ECONOMIC PROSPECTIVE

a)EARNING PROSPECTIVE : The earnings perspective considershow interest rate changes will affect a banks reported earnings. Forexample, a decrease in earnings caused by changes in interest ratescan reduce earnings, liquidity, and capital. This perspective focuses onrisk to earnings in the near term, typically the next one or two years.

Fluctuations in interest rates generally affect reported earningsthrough changes in a banks net interest income.

Net interest income will vary because ofdifferences in the timing of accrual changes (repricing risk), changingrate and yield curve relationships (basis and yield curve risks), andoptions positions. Changes in the general level of market interest ratesalso may cause changes in the volume and mix of a banks balancesheet products. For example, when economic activity continues toexpand while interest rates are rising, commercial loan demand mayincrease while residential mortgage loan growth and prepaymentsslow.

b)ECONOMIC PROSPECTIVE:

The economic perspective provides ameasure of the underlying value of the banks current position andseeks to evaluate the sensitivity of that value to changes in interestrates. This perspective focuses on how the economic value of all bankassets, liabilities, and interest-rate-related, off-balance-sheetinstruments change with movements in interest rates. Its reflects the


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impact of variation in the interest rate on the economic value of aninstituition.economic value of the bank can be viewed as the presentvalue of future cash flow.The economic value of these instruments equals the present value oftheir future cash flows. By evaluating changes in the present value of

the contracts that result from a given change in interest rates, one canestimate the change to a banks economic value (also known as theeconomic value of equity).

How toControl Interest Rate Risk:

1: Interest Rate Risk Measurement Systems :It is

essential that banks have interest rate risk measurementsystems that capture all material sources of interest rate riskand that assess the effect of interest rate changes in waysthat are consistent with the scope of their activities. Theassumptions underlying the system should be clearlyunderstood by risk managers and bank management.

2: Operating limits :Banks must establish and enforce

operating limits and other practices that maintain exposureswithin levels consistent with their internal policies.

3: Collapse :Banks should measure their vulnerability

to loss under stressful market conditions including thebreakdown of key assumptions - and consider those resultswhen establishing and reviewing their policies and limits forinterest rate risk

4: Adequate Information :Banks must have adequate

information systems for measuring,monitoring, controlling,and reporting interest rate exposures. Reports must beprovided on a timely basis to the bank's board of directors,senior management and,where appropriate, individual business line managers.


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5: Internal Controls:Banks must have an adequate system of internal

controls over their interest rate risk management process. A

fundamental component of the internal control systeminvolves regular independent reviews and evaluations of theeffectiveness of the system and, where necessary, ensuringthat appropriate revisions or enhancements to internalcontrols are made. The results of such reviews should beavailable to the relevant supervisory authorities

6; Information for supervisory authorities:Supervisory authorities should obtain from banks

sufficient and timely information with which to evaluate their

level of interest rate risk. This information should takeappropriate account of the range of maturities andcurrencies in each bank's portfolio, including off-balancesheet items, as well as other relevant factors, such as thedistinction between trading and non-trading activities.

7: Capital adequacy:Banks must hold capital commensurate with the

level of interest rate risk they undertake.

8: Disclosure of interest rate risk:Banks should release to the public information on

the level of interest rate risk and their policies for itsmanagement and stakeholders

9: Supervisory treatment of interest rate risk in thebanking book:

(a) Supervisory authorities must assess whether theinternal measurement systems of banks adequately capturethe interest rate risk in their banking book. If a banksinternal measurement system does not adequately capturethe interest raterisk, the bank must bring the system to the requiredstandard. To facilitate supervisors monitoring of interestrate risk exposures across institutions, banks must provide


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the results of their internal measurement systems,expressed in terms ofthe threat to economic value, using a standardised interestrate shock.

(b) If supervisors determine that a bank is notholding capital commensurate with the level of interest raterisk in the banking book, they should consider remedialaction, requiring the bank either to reduce its risk or hold aspecific additional amount of capital, or a combination ofboth.

Conclusion: The quantity of interest raterisk is (low, moderate,high). To identify the major sources of interest rate risk

assumed by the bank and those areas potentially exposed tosignificant interest rate risk.

1. Review and analyze the banks balance sheet structure, off-balance sheet activities, and trends in its balancesheet composition to identify the major sources of interest raterisk exposures. Consider:

The maturity and repricing structures of the banks loans,

investments, liabilities, and off-balance sheetitems.

Whether the bank has substantial holdings of products withexplicit or embedded options, such as

prepayment options, caps, or floors, or products whose rateswill considerably lag market interest rates.

The various indices used by the bank to price its variable rateproducts (e.g., prime, Libor, Treasury) and

the level or mix of products tied to these indices.

The use and nature of derivative products.

Other off-balance sheet items (e.g., letters of credit, loancommitments).

2. Assess and discuss with management the banks vulnerabilityto various movements in market interest ratesincluding:

The timing of interest rate changes and cash flows because ofmaturity or repricing mismatches.

Changes in key spread or basis relationships.


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Changes in yield curve relationships.

The nature and level of embedded options exposures.

Documents

Term Paper BANK[1]