irr bank final 1.2
TRANSCRIPT
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Management of Interest Rate Risk in Banks
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Interest Rate Risk (IRR)
Definition:It is the potential loss from unexpected changes ininterest rates which can significantly alter a banksprofitability and market value of equity
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Interest Rate Risk .. explained
The amount at risk is a function of the magnitude and directionof interest rate changes and the size and maturity structure of themismatch position
If interest rates rise, the cost of funds increases more rapidlythan the yield on assets, thereby reducing net income
If the exposure is not managed properly it can erode both theprofitability and shareholder value
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Interest Rate Risks - Types
Interest Rate Risks
Yie ERepricing Risk Basis Risk Risk Option Risk
Interest RateRisk
Re-pricingRisk
BasisRisk
EmbeddedOptionRisk
YieldRisk
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Re-pricing Risk
Arises on account of mismatches in rates Can be measured by the measure of risk in different time buckets Information needed
- Balance sheet on & off on a particular day- Business plan & expected income / expenses ignored- Static vs. Dynamic
Liabilities Assets SpreadCapital(Crore) @ROI Maturity
Investment(Crore) @ROI Maturity
Scenario-1Rs 100 9% One Year Rs 100 10% Two Year
Profit1% (1Crore)
Scenario-2Rs 100 11% Two Year Rs 100 10% Two Year
Loss1% (1Crore)
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Basis Risk
Interest rates on assets and liabilities do not change in the sameproportion
Interest rates movement is based on market perception of risk andalso market imperfections
Therefore, basis risk arises when interest rates of different assets andliabilities change in different magnitudes
The `basis form of IRR results from the imperfect correlation betweeninterest adjustments when linked to different index rates despitehaving the same re-pricing characteristics
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Basis Risk - An Illustration
Repricing Liabilities (Rs Crores) Repricing Assets(Rs Crores)Savings Deposit 50 Call Money 50
Fixed Deposit 50 Cash Credit 40
Total 100 Total 90
Gap(-) 10
Calculation of Standardised Gap Fall in Rates Fall in Amount(Rs Crores)
Call Money 50 * 1.0% 0.50
Cash Credit 40 * 0.7% 0.28
A. Decrease in Interest Income (-) 0.78
Savings Deposit 50 * 0.5% 0.25
Fixed Deposit 50 * 0.4% 0.20
B. Decrease in Interest Expense (+) 0.45
Loss in Net Interest Income (A-B) (-) 0.33 (Rs 33 lacs)
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Embedded Option Risk
Risks arising out of prepayment of loans and bonds (with put or call options)and / or premature withdrawal of deposits before their stated maturity dates
Liabilities Assets SpreadCapital(Crore) @ROI Maturity
Loan(Crore) @ROI Maturity
Scenario-1Rs 100 8% 90 Days Rs 100 10% 90 Days
Profit2% (0.49 Crore)
Scenario-2
Rs 1008% 90 Days Rs 100 10% 90 Days 2% (0.164 Crore)
for 30 days
Interest Ratedeclined after 30days to 9%
60 Days 1% (0.164 Crore)for 60 days
Total 0.328 Crore
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Yield Curve Risk - An Illustration
Liabilities Assets SpreadCapital @ ROI Maturity Loan @ ROI Maturity(Crore) (Crore)
Scenario-1 3 year Loan 3 year ProfitRs100 fixed(quar 13.5% Rs100 16% float(qua 2.5%Reference: terly Reference: rterly (2.5crore)91 day T-Bill repriced) 364 day T-Bill @13% repriced)@12.5%
Scenario-2 90 90 ProfitRs100 15% days Rs100 16% days 1.0%Reference: Reference: (1crore)91 day T-Bill 364 day T-Bill @13%@14%
Date 91 T-Bill Deposit 364 T-Bill Loan Spread22.05.2008 4.48% 5.48% 4.62% 7.62% 2.14%08.08.2008 4.93% 5.93% 4.85% 7.85% 1.92%
08.12.2008 4.71% 5.71% 4.24% 7.24% 1.53%
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Interest Rate Risks - Measurement
Interest Rate Risks
Yie ERepricing Risk Basis RiskRisk Option Risk
Approachesto Measure
IRR
Maturity Gap
Analysis
Duration Gap
AnalysisSimulation
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Maturity Gap Analysis
MGA distributesinterest rate sensitiveassets, liabilities and OBSpositions into a certainnumber of predefined timebands according to their maturity (if fixed rate) or time remaining to their nextre-pricing (if floating rate)
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Maturity Gap Analysis
How is it done?The risk sensitive What is the Gap?
Objective: assets and risk The gap is thenTo improve the sensitive liabilities calculated by
net interest are grouped into considering theincome in the maturity buckets difference betweenshort run over based on maturity the absolute
discreet periods and the time until the values of the RSAsof time called the first possible and RSLs.
gap periods. re-pricing due to RSG=RSAs-RSLschange in the interestrates
Relative differences in each maturity bucket - represents the sensitivity in that
band.
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Maturity Gap Method (IRS)
Three Options:
A) RSA > RSL = Positive Gap
B) RSL > RSA = Negative Gap
C) RSL = RSA = Zero Gap
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Interest Rate Risks
Yie ERepricing Risk Basis RiskRisk Option Risk
Gap Change inInterest Rate
Change inInterestIncome
Change inInterest
Expense
Change in NetInterestIncome
Positive Increase Increase > Increase Increase
Positive Decrease Decrease > Decrease Decrease
Negative Increase Increase < Increase Decrease
Negative Decrease Decrease < Decrease Increase
Zero Increase Increase = Increase None
Zero Decrease Decrease = Decrease None
Maturity Gap Summary
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Example of Negative Gap
Consider the following balance sheet:
Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost
Rate sensitive $ 500 8.0% $ 600 4.0%
Fixed rate $ 350 11.0% $ 220 6.0%Non earning $ 150 $ 100$ 920
Equity$ 80
Total $ 1,000 $ 1,000
NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)NII = 78.5 - 37.2 = 41.3NIM = 41.3 / 850= 4.86%
GAP = 500 - 600 = -100
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Consider the following balance sheet:
1% Increase in Short Term Rates Assets Yield Liabilities Cost
Rate sensitive $ 500 9.0% $ 600 5.0%
Fixed rate $ 350 11.0% $ 220 6.0%Non earning $ 150 $ 100$ 920
Equity$ 80
Total $ 1,000 $ 1,000
NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)NII = 83.5 43.2 = 40.3NIM = 40.3 / 850= 4.74%
GAP = 500 - 600 = -100
Example of Negative Gap
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Inferences from above options:
Scenario Strategy
Rising Interest Rates
Declining Interest Rates
Uncertain situation(May not occur in reality)
Maintain a positive gap
Maintain a negative gap
Maintain a zero gapNo benefits
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Duration Gap Analysis
Duration is a measure of the percentage change in theeconomic value of a position that occurs given a small changein level of interest rate
It concentrates on the price risk and the reinvestment risk whilemanaging the interest rate exposure
It also measures the effect of rate fluctuation on the marketvalue of the assets and liabilities and NIM with the help of duration
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Duration Gap Analysis ..Illustration
Assets and Liabilities chart of Bharath Bank is presented here below along withtheir durations and interest rates. Based on the information, identify the NIM.During the forecasting period of one year, if the interest rates rise/fall by 2%,what would be its implication on the NIM of Bharath Bank?
Liabilities Amount Duration Int. Rate Assets Amount Duration Int. Rate(months) (months)(Crore) (%) (Crore) (%)
Equity Cash200 200
ST STDeposit Loans1,800 5.5 11.5 1,800 2.75 12.5
LT LTDeposit Loans2,500 23.7 15 2,000 23 16.5
Others Investments500 11.5 11 1,000 10.5 13.5
5,000 5,000
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Duration Gap Analysis
L iabilities Amount(Cr)
Duration(Months)
InterestRate (%)
IncreasedInt. Rate
(%)
DecreasedInt. Rate (%)
Assets Amount(Cr)
Duration(Months)
InterestRate (%)
IncreasedInt. Rate
(%)
DecreasedInt. Rate
(%)
Equity 200 Cash 200
STDeposit 1,800 5.5 11.5 13.5 9.5 STLoans 1,800 2.75 12.5 14.5 10.5
LTDeposit 2,500 23.7 15 15 15
LTLoans 2,000 23 16.5 16.5 16.5
Others 500 11.5 11 13 9 Invst 1000 10.5 13.5 15.5 11.5
5,000 5,000
InterestExpense 637 683 591
InterestIncome 690 746 634
NII 53 63 43
NIM 0.0106 0.0126 0.0086
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Simulation
Data Requirement
Maturity and re-pricingRate scenarios
Alternative managementResponse under differentscenariosYield curvesPrepayment tablesBehavioural pattern of assetsand liabilitiesConsistency of assumptions
What is it?
Simulates performance under alternative interest rate scenarios
and assesses the resulting volatilityin NII / NIM / ROA / ROE
A financial model incorporatinginter-relationship of assets,liabilities, prices, costs, volume,
mix and other business relatedvariables
Computer generated scenariosabout future and response to thatin a dynamic way
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Simulation
Advantages
- Forward looking
- Dynamic
- Lessens the role of crisis management
- Increases the value of strategic planning
-Enhance capability of analysis
- Interpretation easy
- Timing of cash flows captured accurately
Disadvantages
- Accuracy depends on quality of data,strength of the model and validity of assumptions
- Time consuming
- Huge investment in computer
- Requires highly skilled personnel
- Analysis paralysis
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Model
Deploy
Mo itor ly e
ct
I tere t R te Ri k M geme t
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Interest Rate Risk Management
* The ability of these types of models to capture this type of risk will vary with them
Interest Rate Risk Models
Risk Measurement Systems
GAPReport
EarningSimulation Economic Valuation
Short-term earning exposure Yes Yes
Generally does notdistinguish short-term
accounting earnings fromchanges in economic value
Long-term exposure Yes Limited* Yes
Repricing Risk Yes Yes YesBasis Risk Limited* Yes Limited*
Yield Curve Risk Limited* Yes Yes
Option Risk Limited* Limited* Yes
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Benefits from IRR management
Defined financial targets based on corporate risk tolerances
Reduced earnings volatility
Improved cash flow forecasting
Improved corporate credit ratings
Defined risk management and hedge methodologies
Improved interest rate exposure forecasting and measurement capabilities
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Based on the quantity of interest rate risk and quality of interest rate risk management, we can evaluate the adequacyof the banks capital
Determine the component rating for sensitivity to market risk
Determine further the effect of interest rate and earnings on
the business in a macroscopic view
Conclusion
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