Welcome to Banking Quest

Tutorial Agenda

• What is Interest Rate Risk (IRR)?
• Why is it important for Banks?
• Interest Rate Risk from earning perspective
• Interest Rate Risk from economic perspective
• Different types of IRR
• RBI’s Interest Rate Sensitive Statement (SIR)
• Traditional Gap Approach
• Duration Gap Approach

 What Is Interest Rate Risk?

• Interest rate risk (IRR) is defined as the potential for changing market interest rates to adversely affect a bank's earnings. 
• Interest rate risk is an integral part of banking business. Abnormal levels of interest rate risk can expose banks to big losses. The management of interest rate risk is therefore critical to the stability of any bank. 
• Hence, it is essential that banks have a comprehensive risk management process in place that effectively identifies, measures, monitors and controls interest rate risk exposures, and that is subject to appropriate board and senior management oversight. 
• Interest rate risk is the risk to income or capital of the bank arising from fluctuating interest rates. Changes in interest rates can affect the bank’s earnings by affecting its net interest income. 

 Concept of NII & NIM

Before we understand the IRR thoroughly, we have to learn the below mentioned concepts clearly. They are:

1. Net Interest Income (NII): NII will always be pronounced in absolute figures. The NII is the difference between the interest income and the interest expenses of the bank.  Bank will be getting its interest income from the loans & advances and investments and at the same time, the bank will have to pay interest on its deposits and borrowings. It is similar to the gross margin or gross profit margin of a manufacturing concern.
2. Net Interest Margin (NIM): RBI defines NIM as the net interest income (NII) divided by average interest earning assets. NIM is also called ‘Spread’. NIM will always be pronounced in percentage terms. NIM makes the comparison between banks very easy (apple to apple comparison).

 Calculation of NIM

Let assume that ABC Bank Ltd reported the following items on its financial statements this year:

A: Interest received from Loans & Advances: Rs. 60,000 crores

B: Interest Paid to Depositors: Rs. 56,000 crores.

C:Beginning Year Outstanding Loans: Rs. 80,000 crores

D:Year End Outstanding Loans: Rs. 1,50,000 crores.

E: NII of the bank is (A minus B), that is Rs. 4,000 crores

F: Average Advances/Loans is (C + D)/2 = (80,000 + 1,50,000)/2 = Rs. 1,15,000 crores.

NIM = (E/F) X 100 = (4,000/1,15,000) X 100 = 3.48%

Calculation of Economic Equity Ratio

The majority of the Total Assets of the banks are Loans & Advances. One more connected ratio in this regard is Economic Equity Ratio

• Economic Equity Ratio: This ratio is also called the shareholder equity ratio and this ratio indicates how much of a bank's assets have been generated by issuing equity shares rather than by taking on debt. 
• This ratio assesses the sustenance capacity of the bank. The lower the ratio result, the more debt a company has used to pay for its assets and higher ratio is good for the shareholders.
• The ratio, expressed as a percentage, is calculated by dividing total shareholders' equity by the total assets of the bank. The result represents the amount of the assets on which shareholders have a residual claim.
  • The following figures are taken out from the Balance Sheet of a Bank:
    • Total Assets: Rs. 300 crores.
    • Shareholders’ Equity: Rs. 225 crores.
    • Total Outside Liabilities: Rs. 75 crores.
    • Shareholders' equity ratio = (225/300) x 100 =75%
• This ratio tells the bank that it has financed 75% of its assets with shareholder equity and the balance 25% is funded by debt.
• In other words, if the Bank liquidates all of its assets to pay off its debt, the shareholders would retain 75% of the Bank's financial resources.

 IRR – Earning Perspective

• The earning perspective or the short-term effect of changes in interest rates is on Bank’s earnings through Net Interest Income (NIM).  
• IRR is a slow poison since if this risk is not managed effectively, it will slowly kill the institution. 
• If the IRR is not monitored carefully by the banks, then it would lead to the coming down of NII/NIM over a period of time. 
• NII is the biggest contributor of profit for the bank as this parameter only makes the gross margin of the bank good or bad. 
• If this is coming down, then it will have a very big impact on the bottom-line of the bank. 

 IRR – Economic Value Perspective

• Economic Value Perspective happens on the long-term horizon. Variation in market interest rates can also affect the economic value of a bank’s assets, liabilities and off-balance sheet positions. 
• The economic value of an instrument represents an assessment of the present value of its expected net cash flows, discounted to reflect market rates. The Duration Gap Approach, which we are going to discuss, adopts this methodology.
• The economic value perspective reflects one view of the sensitivity of the net worth of the bank to fluctuations in interest rates. 
• Since the economic value perspective considers the potential impact of interest rate changes on the present value of all future cash flows, it provides a more comprehensive view of the potential long-term effects of changes in interest rates than offered by the earnings perspective. 
• For example, a 5-year government bond of say 8% is held by the bank and now the market rate of interest is increased to 10%. It will result in the price of the existing bond on discount, that is, this bond of Rs. 100/- may fetch presently a price less than Rs. 100/- say, Rs. 97/-, causing a loss of Rs. 3/- per bond. 
• Economic Value perspective has one more ramification on Bank’s Market Value of Equity (MVE) or Networth as reduction in net interest earnings or NIM would affect the net profit of the bank and hence the amount that would be ploughed back to the capital would come down. 
• Since the accretion to the capital comes down, this may lead to reduction in Capital Adequacy Ratio (CAR) of the bank. 
• CAR is one of the vital parameters, the investors look for assessing the health of the banks.  If CAR is coming down, then investors will move away from investing in the equity of that bank.
• Because of this, the market price of the bank would come down leading to reduction in the MVE or Market Value of Equity of that bank. This process is called the ‘Economic Value perspective’.

 Sources of IRR

• Banking corporations encounter interest rate risk in several ways, including repricing risk, yield curve risk, basis risk (also known as spread risk), and optionality risk.

Let us see these risks one by one:

• Gap or Mismatch Risk 
• Basis Risk 
• Yield curve risk 
• Embedded Optionality Risk
• Reinvestment Risk
• Net Interest Position Risk

 Gap Risk

• A Gap or Mismatch risk arises from holding assets and liabilities and off-balance sheet items with different principal amounts, maturity dates or repricing dates, thereby creating exposure to unexpected changes in the level of market interest rates.
• An example of this risk would be where an asset maturing in two years at a fixed rate of interest has been funded by a liability/deposit maturing in six months. Now, this deposit has to be renewed another three times during the tenancy of the advance of two years and every time, the deposit comes for renewal, the Bank runs the repricing risk causing variation in net interest income. 
• The liabilities of the banks are shrinking due to more investment opportunities thrown because of the liberalization process as well as more and more knowledge of the investing public whereas on the asset side the tenor of the loans are getting elongated (example Housing loans).
• Hence, most of the times, banks create the long-term loan structures out of short term liabilities or out of CASA portfolio.

 Basis Risk

• Basis Risk is the risk that the Interest Rate of different Assets / Liabilities and Off-balance sheet items may change in different magnitudes. Alternatively, Basis risk leads to changes in relationships between market rates leading to narrowing of NIM (Net Interest Margin).
  • For example, a Bank funds a one-year loan by borrowing from RBI’s Repo or from Call Money on a daily basis.  In case Repo or call money rate is steady at say 4%, the NIM can be maintained.  In case, RBI hikes the Repo or the Call money rate goes up daily, then the spread for the bank would come down. 
  • The degree of basic risk is fairly high in respect of banks that create composite assets out of composite liabilities. The basis risk is quite visible in volatile interest rate scenarios.
• RBI has directed the banks to link the retail loans to RLLR or any other benchmark offered by FBIL from October, 2019 onwards. But most of the banks have linked their retail lending to RLLR.
• The way banks set interest rates is critical for the smooth transmission of policy rates.  To make this process transparent, RBI has over the years directed banks to price their loans against their BPLR (2002), Base Rate (2010), MCLRs (2016) and finally now to RLLRs from October, 2019.
• Basis Risk is very much pronounced in Indian Scenario. Banks accept deposits on fixed rate basis but these deposits are invested on the loan side on floating rate basis either on MCLRs or on RLLR (Repo Linked Loan Rates). It can be explained as follows.
• Let us assume Bank accepts Rs. 10 cr for three 3 years at an interest rate of 7%.
• Bank gives housing loans of Rs. 50 lakhs to 20 borrowers for a 15 years period. 
• The interest on deposit never changes for the 3 years for the bank but the interest on loans linked to RLLR is susceptible for changes every 45 days as RBI reviews its Repo rate once in 45 days, that is, in a year minimum 8 times.
• Under the above situation, it is a big challenge for the banks to predict or project their NIM, which has become highly volatile presently. 

 Yield Curve Risk

• This risk arises when unanticipated shifts of the yield curve have adverse effects on the bank’s income. The yield curve may shift due to changing relationships between interest rates for different maturities. These changes will be evident in the slope (steeper or flatter) or shape (bend) of the curve. In finance, the yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower (in a given currency).
• More formal mathematical descriptions of this relation are often called the term structure of interest rates.
• In case, the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities, (for example advance given is linked to Base Rate/MCLR) and Deposit linked to say Treasury Bills, then any non-parallel movements in interest rate or yield curve would affect the NIM or NII (Net Interest Income).
• Another example can be when a liability raised at a rate linked to say 91 days Treasury Bill (T-Bill) is used to fund an asset linked to 364 days T-Bill and in a rising interest rate scenario, 91 days and 364 days T-Bill may increase but not equally due to non-parallel movement of yield curve creating variation in NII. When 91 days T-Bill raises by say 100 bps, the 365 days T-Bill may raise only by 75 bps.
• In the above example, let us assume that both the deposit and loan are given for a tenure of 3 years. Now, the deposit interest rate will have to be refixed every 3 months (91 days) whereas the interest rate in advance will have to be refixed after every one year (364 days). 
• In the rising interest rate scenario, the deposit rate would go up every 3 months but equivalent raise cannot be passed on to advance since it is linked to 364 t. bills. Such a scenario would also affect the Bank’s NII/NIM.

 Embedded Optionality Risk

• The option of pre-payment of term loans and fore-closure (premature closure) of term deposits before their stated maturities constitute embedded option risk. Under the liquidity risk scenario, this is called Funding Risk.
• In case of term deposits, even though they are placed for a fixed term say 5 years, the depositors can ask for premature closure of the deposit before the maturity to meet their urgent commitments.
• Significant reduction in market interest rates encourage borrowers to prepay their loans ahead of time and exercise put options on bonds / debentures, for instruments built with options.  (Example Liberalization – Housing taken by the parents or Educational loans taken by the students).
• This risk alters the cash flows of the Bank to the maximum disadvantage and affects Bank’s profitability.
• The embedded option risk is more witnessed in our country by the banks when the market is in a volatile situation.

 Reinvestment Risk

• Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. 
• At falling interest rate periods, the investor would not be able to reinvest at the same interest rates at which the earlier incomes were reinvested. 
• For example, the one-year term deposit rate exactly a year back (July, 2019), was quoted at the level of 6.50% by the banks.  Since RBI has reduced the repo rate drastically to 4% now, the one-year term deposit rates are quoted now at the level of 5.10%, i.e., reduction of 140 basis points, which is a big interest rate movement.
• Since, interest rates have gone very low, the investors now would look for some other avenue other than bank deposits to invest their funds in markets like, stock market or gold market etc. Hence, presently banks run the risk of non-renewal of deposits by the depositors in view of the too low interest they are getting from the banks. 
• Particularly wholesale deposits shift their loyalty between banks based on even the slightest differences in interest rates as the amount invested is high. 

 Net Interest Position Risk

• Net Interest Rate position is the difference between earning assets and interest paying liabilities in a time bucket say 6 months, one year, 2 year etc.
• In a time-bucket, if the earning assets are more than interest paying liabilities, then it is called a positive gap. 
• In a time-bucket, if the earning assets are less than interest paying liabilities, then it is called a negative gap. 
• In the scenario of positive and negative time bucket, we get four scenarios depending upon the future interest rate movement, as given in the next slide.

 IRR Measurement – Non-parallel shift

• For the sake of simplicity in measuring IRR, we have assumed a parallel shift in interest rates. 
• But such a situation happens very rarely in the financial markets.  Most of the time, the financial markets witness non-parallel shifts.  
• By non-parallel shift, what we mean is that the interest rate can go up or come down but not uniformly. For example, in the interest raising scenario, 1 year interest may go up by 50 basis points but the 5 year rate would go up by only 30 bps. 
• When the non-parallel shift takes place, the banks and financial institutions land themselves in the situation of basis risk.
• We will see one more example of a non-parallel shift  in interest rates. 

 IRR Measurement

There are several techniques available for measuring the IRR of the bank and they are discussed below:

1. Maturity/repricing schedule

• This is the simplest technique for measuring the bank’s interest rate risk exposure. Interest-sensitive assets, liabilities and Off-Balance Sheet positions (OBS) can be distributed into “time bands” according to their maturity (if fixed-rate) or time remaining to their next repricing (if floating-rate). 
• These schedules can be used to generate simple indicators of the interest rate risk sensitivity of the earnings of the bank to changing interest rates. Such scenarios (four scenarios) we have already seen under Net Interest Open Position Risk.  The size of the gap for a given time band - that is, assets minus liabilities plus OBS exposures that get repriced or mature within that time band, gives an indication of the bank’s repricing risk exposure.

2. Traditional Gap Analysis

• This is almost an extension of maturity or repricing technique discussed above. This technique begins with a maturity/repricing schedule that distributes interest-sensitive assets, liabilities and OBS positions into time bands according to their maturity (if fixed rate) or time remaining to their next repricing (if floating rate). 
• The schedule can be used to generate simple indicators of the interest rate risk sensitivity of both earnings and economic value to changing interest rates. When this approach is used to assess the interest rate risk of current earnings, it is typically referred to as Gap Analysis. 
• The size of the gap for a given time band gives an indication of the bank’s repricing risk exposure. 
• As per RBI guidelines, Banks have to prepare a monthly statement by name Statement of Interest Rate Sensitivity (SIR) and send it to RBI. This statement captures the IRR of the bank. 
• RBI has advised the banks that they should compute their interest rate risk position in each currency applying the Traditional Gap Analysis (TGA) to the Rate Sensitive Assets (RSA)/ Rate Sensitive Liabilities (RSL) items in that currency, where either the assets, or liabilities are 5% or more of the total of either the bank’s global assets or global liabilities. 
• The RSA and RSL include the rate sensitive off balance sheet asset and liabilities. The interest rate risk position in all other residual currencies should be computed separately on an aggregate basis.
• The focus of the TGA is to measure the level of a bank’s exposure to interest rate risk in terms of sensitivity of its NII to interest rate movements over the horizon of analysis which is usually one year. 
• SIR preparation involves bucketing of all RSA and RSL and off-balance sheet items as per residual maturity/ repricing date in various time bands, as is being currently done and computing Earnings at Risk (EaR) i.e. loss of income under different interest rate scenarios over a time horizon of one year.
• Time buckets stipulated by RBI under SIR:
  • 1 – 28 days
  • 29 days and upto 3 months
  • Over 3 months and upto 6 months
  • Over 6 months and upto 1 year
  • Over 1 year and upto 3 years
  • Over 3 years and upto 5 years
  • Over 5 years and upto 7 years
  • Over 7 years and upto 10 years
  • Over 15 years 
  • Non-Sensitive Assets and Liabilities.

Shortcomings of Gap Analysis:

• All the assets and liabilities captured in the time buckets are assumed to mature and repriced simultaneously, which may or may not happen actually.
• It fails to account for differences in the sensitivity of income that can arise from the option-related positions (call options and put options built on the assets and liabilities)
• Therefore, gap analysis provides only a rough approximation (not exact) of the actual changes in NII which would result from the chosen changes in the pattern of interest rates.

 Duration Analysis

• Before going to Duration Gap Analysis, let us understand what is the meaning of Duration and Modified Duration.
• Macaulay duration is a weighted average of the times until the cash flows of a fixed-income instrument are received. 
• This concept was introduced by Canadian economist Frederick Macaulay in the year 1938. It is a measure of the time required for an investor to be repaid the bond’s price by the bond’s total cash flows.
• The Macaulay duration is measured in units of time (e.g., years).
• The Macaulay duration for coupon-paying bonds is always lower than the bond’s time to maturity. For zero-coupon bonds, the duration equals the time to maturity.
• Duration is commonly used in the portfolio and risk management of fixed-income instruments. Using interest rate forecasts, a portfolio manager can change a portfolio’s composition to align its duration with the expected level of interest rates.

 Modified Duration Analysis

Modified Duration:

• Relative to the Macaulay duration, the modified duration metric is a more precise measure of price sensitivity. It is primarily applied to bonds, but it can also be used with other types of securities that can be considered as a function of yield.
• Modified Duration measures the change in the price of the bond given an yield change of 1% or 100 basis points or bps. Unlike the Macaulay duration, modified duration is measured in percentages.
• The modified duration is often considered as an extension of the Macaulay duration.
• RBI has issued a Bond with the face of Rs. 100/- for two years at an interest rate of 8% and interest is paid annually. After 15 days of issue of the bond, the market interest rate has changed from 8 to 8.25%.  What would be the revised price of the bond using Modified Duration of the Bond.
  • Modified Duration of Rs. 100/- bond is Rs. 1.7832 (as worked out in the previous slide)
  • For Rs. 100/- bond, it is Rs. 1.7832, which is 1% movement of the bond.
  • For 0.25%, it will be Rs. 1.7832 x 0.25% = Rs. 0.4458.
  • Since the interest rate has gone up, the price of the bond will fall.
  • Rs. 100 – 0.4458 = Rs. 99.5542 or Rs. 99.55

 Duration Gap Analysis

• We have already seen the role of Statement of Interest Rate Sensitivity under Gap Analysis. 
• RBI has advised the banks to capture in the same statement, the duration gaps and carry out the Duration Gap Analysis (DGA) of all the assets and liabilities also.
• The focus of the DGA is to measure the level of a bank’s exposure to interest rate risk in terms of sensitivity of Market Value of its Equity (MVE) to interest rate movements. 
• The DGA involves bucketing of all RSA and RSL (in the same way as carried out under TGA analysis) as per residual maturity/ repricing dates in various time bands and computing the Modified Duration Gap (MDG). 
• The RSA and RSL include the rate sensitive off balance sheet asset and liabilities. 
• MDG can be used to evaluate the impact on the MVE of the bank under different interest rate scenarios.

 How to Calculate the Modified Duration Gap (MDG)?

• RBI has given the step-by-step approach for calculating the MDG and the same is given below:

1. Identify variables such as principal amount, maturity date / repricing date, coupon rate, yield, frequency and basis of interest calculation for each item / category of RSA/RSL. 
2. Plot each item / category of RSA/RSL under the various time buckets. For this purpose, the absolute notional amount of rate sensitive off-balance sheet items in each time bucket should be included in RSA if positive or included in RSL if negative.
3. The midpoint of each time bucket may be taken as a proxy for the maturity of all assets and liabilities in that time bucket. 
4. Determine the coupon for computation of MD of RSAs and RSLs. 
5. Determine the yield curve for arriving at the yields based on current market yields or current replacement cost or as specified by RBI for each item / category of asset / liability/ off-balance sheet item. 
6. Calculate the MD in each time band of each item/ category of RSA/RSL using the maturity date, yield, coupon rate, frequency, yield and basis for interest calculation.
7. Calculate the MD of each item/category of RSA/RSL as weighted average MD of each time band for that item. 
8. Calculate the weighted average MD of all RSA (MDA) and RSL (MDL) to arrive at MDG (Modified Duration Gap) and MDOE (Modified Duration of Equity).

 Limitation of Duration Gap Analysis

• Like TGS, this analysis is not capturing the Basis Risk, that is, the interest rates on assets and liabilities can change at different points in time even within the time buckets but DGA assumes that the interest rates of both assets and liabilities change uniformly at the same time.
• Because DGA typically uses the average duration for each time-bucket, the estimates would not reflect differences in the actual sensitivity of positions that can arise from differences in coupon rates and the timing of payments.  For example, in the over 1 year and upto and including 3 years’ time bucket, DGA may assume an average duration of say 2 years with an average coupon of say 7%. But if you go inside the time bucket, there can be instruments of 1 year, 9 months, 2 and 3 months with varying coupons say 6% and 6.80% etc. Such differences in cash flows are not captured individually under DGA and all the instruments under this bucket are assumed to have a duration of 2 years with a coupon of 7%.