Description
It also explains the categories of interest rate risk and their impact, basis risk, and how to counter basis risk.
• • • • • • • •
Risk is the exposure to uncertainity Outcome could be profit/loss Risk management involves mitigating the loss RM involves …… Identifying the type of risk …….Quantifying the likely loss …….Managing the loss thru strategies ……..Control, review and monitor the RM mechanism
• Three generic categories • Credit risk • Market risk • Operational Risk • 1. Credit risk--- Failure on the part of the borrower to either repay or to service the loan as per the loan agreement. • Acc to RBI CR may appear as • - Funds not repaid in direct lending • - Case of guarentees, no funds from customer • - Treasury products, payments not coming from parties •
• 2. Market Risk • Losses in on and off balance sheet items due to movements in market prices, these include • Interest rate risk • Exchange rate risk • commodity price risk • Equity price risk •
• Types of Interest Rate Risks • Mismatch, basis, Yield Curve, Embedded option risk, • Price risk.
• 3. Operational Risk - direct or indirect loss resulting from inadequate or failed internal processes, people , systems or from external events. Use of automated technology, e-commerce, mergers, could all lead to operational risks. Internal controls and internal audit are used to control operational risk.
Factors affecting Interest Rates
• Interest is the compensation received by the saver who postpones his present consumption to a future date for a higher consumption. • Theories of Interest rates, Pure expectation Theory, Liquidity Preference Theory, Market Segmentation Theory. • Interest rate risks can be, Mismatch Risk, Basis risk etc.
Categories Of Interest Rate Risk And Their Impact • Mis-match Risk • Net Interest Income- Liabilities and Assets are priced differently and the difference between Interest Received on Assets and Interest paid on Liabilities . • Interest rate sensitive Assets/Liabilities- those which will be repriced /priced based on the interest rates prevailing at the time of issue/repricing. • Positive Gap- More interest rate sensitive assets reprice in a time bucket than liabilities . • Negative Gap- Vice Versa
• Relationship between interest rate changes and impact on Interest Income
GAP
Int rate Change Impact on NII Increases Positive
Positive
Positive
Negative Negative
Decreases
Increases Decreases
Negative
Negative Positive
• Basis Risk• The risk of interest rates attached to different groups of Bank’s assets and liabilities changing by different degrees (in response to a given change in the key interest rates in the market) • Linkages between interest rates in different segments, call, repo, etc are the basis for Basis Risk.
Interest Sensitivity Gap Position 1-30 days Bucket
Liabilities Call Money Repo Deposits Total
50 50 100 200 Total Negative Gap
Assets T Bills Advances
30 120 150 50
Net Impact on NII
Call
Repo Deposits
50
50 100
.01
.005 .0025
.5
.25 .25 1.00 .3 .9 1.2
T bills
Advances
30
120
.01
.0075
• Embedded Option Risk – Banks customers can exercise the option of premature closing the deposits /borrowers prepay the advances. NII can get affected. • Non Paying Liabilities- The NII of a bank with non paying liabilities like current deposits. With better payment and settlement infrastructure, customers would be interested in interest paying savings.
Asset Liability Management
• With deregulation of Interest Rates, the implications of Interest Rate Risk extends to the entire B/S and P/L. • Interest rates on call money, CD’s etc tended to be volatile as also the retail deposit rates due to competition etc.
• Asset Management strategy- Some banks had extensive deposit base and capable of achieving growth rates based on increased deposits. Concentration more on asset/credit . • Liability Management strategy- Banks primarily sought to achieve the maturities and volumes of funds by flexibly changing their bid rates for funds.
• Short and long term perspectives of ALM • Interest rates affect both NII and the market value of equity of a bank. • Management of NII is a short term perspective and MVE is addressed as a long term perspective. • In order to protect bank profits against interest rate changes, bank management should seek to hold bank’s Net Interest Margin(NIM) fixed and plan for business volumes and mixes which would help stabilise the NII and help achieve the projected levels of net profits • NIM = NII/Total Earning Assets
• NII does not represent the profits , because non interest expenses have not been considered. • Banks normally estimate a % acceptable NIM and then use a variety of interest rate risk hedging methods to protect the ratio. • The MVE can be protected by matching the increase in the market value of liabilities by an increase in the market value of assets or contra. • Banks can attempt to achieve increase in the MVE as well.
Measurement and management of Interest rate risk
• Traditional Gap Method • Involves an analysis of the banks position in Interest Sensitive assets ,Liabilities and Off balance sheet items. • Assets and Liabilities are grouped as per the repricing maturities under predefined “Time Buckets”. RBI has indicated Seven Time buckets. • The difference between the book values of Assets and Liabilities. repricing in a particular time bucket is called the repricing gap/Interest Sensitive Gap. • Non sensitive assets and liabilities like cash, premises are kept out of the analysis. • Refer to slide 7
• Assume.. The repricing items are spread evenly over the bucket. The repriced item continues in the B/S at the repriced rate for the remaining period. Change in rate is assumed equal for all the items . • Interest rate moves 1% adversely against the bank. • App. Change in banks NII= Size of cumulative gap* overall change in Interest rates.
• •
•
Standardised Gap Analysis In practice a zero gap does not eliminate all risks because different classes of Interest rates react differently . For a given change in Bank rate, Money market rates would react faster than loans and deposits. E.g RSA mat/rep during 1-30 days 50 150 Invest. In GSec Loans 100 200
RSL mat/rep during 1-30 days Call Money Borrow. From LAF
FD’s
Total Gap
200
400 (70)
CP
Total
30
330
•
•
As the gap is Liability sensitive an increase of 1% in Interest rate will lead to Decrease of NII by .67 crores Realistically , the change would be
Call Money LAf 1.00% .50%
FD
G secs Loans
.25%
.10% 1.25%
CP
1.50%
• To take care of the basis risk, the bank should forecast not only the direction of interest rate movements but also changes in different asset segments. • • • • • Pros and Cons of Gap Analysis Static analysis- Business growth is not considered Does not consider time value of money Traditional Gap does not consider basis risk Forecasting of Interest rates difficult
• Duration Gap Analysis • A Bank’s assets and liabilities might be mismatched beyond 1-2 years and therefore expose the bank to medium/long term risk • Duration is the average life of the asset/liability and is measured as the weighted average time to maturity using PV of the cash flows, relative to the Total PV of Asset/liability as weights. • Duration measures how much a security’s price will change with changes in market interest rates.
• • • •
Steps Interest rates for the planning period to be forecasted Est. Current mkt value of Banks assets/liab/equity Estimate the weighted average duration of assets and of liabilities • Calculate DGAP • Forecast changes in MVE under different Interest rates environments
• MVA (NEW) = D* inc r * Current MVA/(1+ current r) • Therefore a bank will have to operate at DGAP at zero if it desires to maintain its MVE while interest rates change. • The banks average asset duration should be lightly less than the average liability duration
doc_667998309.pptx
It also explains the categories of interest rate risk and their impact, basis risk, and how to counter basis risk.
• • • • • • • •
Risk is the exposure to uncertainity Outcome could be profit/loss Risk management involves mitigating the loss RM involves …… Identifying the type of risk …….Quantifying the likely loss …….Managing the loss thru strategies ……..Control, review and monitor the RM mechanism
• Three generic categories • Credit risk • Market risk • Operational Risk • 1. Credit risk--- Failure on the part of the borrower to either repay or to service the loan as per the loan agreement. • Acc to RBI CR may appear as • - Funds not repaid in direct lending • - Case of guarentees, no funds from customer • - Treasury products, payments not coming from parties •
• 2. Market Risk • Losses in on and off balance sheet items due to movements in market prices, these include • Interest rate risk • Exchange rate risk • commodity price risk • Equity price risk •
• Types of Interest Rate Risks • Mismatch, basis, Yield Curve, Embedded option risk, • Price risk.
• 3. Operational Risk - direct or indirect loss resulting from inadequate or failed internal processes, people , systems or from external events. Use of automated technology, e-commerce, mergers, could all lead to operational risks. Internal controls and internal audit are used to control operational risk.
Factors affecting Interest Rates
• Interest is the compensation received by the saver who postpones his present consumption to a future date for a higher consumption. • Theories of Interest rates, Pure expectation Theory, Liquidity Preference Theory, Market Segmentation Theory. • Interest rate risks can be, Mismatch Risk, Basis risk etc.
Categories Of Interest Rate Risk And Their Impact • Mis-match Risk • Net Interest Income- Liabilities and Assets are priced differently and the difference between Interest Received on Assets and Interest paid on Liabilities . • Interest rate sensitive Assets/Liabilities- those which will be repriced /priced based on the interest rates prevailing at the time of issue/repricing. • Positive Gap- More interest rate sensitive assets reprice in a time bucket than liabilities . • Negative Gap- Vice Versa
• Relationship between interest rate changes and impact on Interest Income
GAP
Int rate Change Impact on NII Increases Positive
Positive
Positive
Negative Negative
Decreases
Increases Decreases
Negative
Negative Positive
• Basis Risk• The risk of interest rates attached to different groups of Bank’s assets and liabilities changing by different degrees (in response to a given change in the key interest rates in the market) • Linkages between interest rates in different segments, call, repo, etc are the basis for Basis Risk.
Interest Sensitivity Gap Position 1-30 days Bucket
Liabilities Call Money Repo Deposits Total
50 50 100 200 Total Negative Gap
Assets T Bills Advances
30 120 150 50
Net Impact on NII
Call
Repo Deposits
50
50 100
.01
.005 .0025
.5
.25 .25 1.00 .3 .9 1.2
T bills
Advances
30
120
.01
.0075
• Embedded Option Risk – Banks customers can exercise the option of premature closing the deposits /borrowers prepay the advances. NII can get affected. • Non Paying Liabilities- The NII of a bank with non paying liabilities like current deposits. With better payment and settlement infrastructure, customers would be interested in interest paying savings.
Asset Liability Management
• With deregulation of Interest Rates, the implications of Interest Rate Risk extends to the entire B/S and P/L. • Interest rates on call money, CD’s etc tended to be volatile as also the retail deposit rates due to competition etc.
• Asset Management strategy- Some banks had extensive deposit base and capable of achieving growth rates based on increased deposits. Concentration more on asset/credit . • Liability Management strategy- Banks primarily sought to achieve the maturities and volumes of funds by flexibly changing their bid rates for funds.
• Short and long term perspectives of ALM • Interest rates affect both NII and the market value of equity of a bank. • Management of NII is a short term perspective and MVE is addressed as a long term perspective. • In order to protect bank profits against interest rate changes, bank management should seek to hold bank’s Net Interest Margin(NIM) fixed and plan for business volumes and mixes which would help stabilise the NII and help achieve the projected levels of net profits • NIM = NII/Total Earning Assets
• NII does not represent the profits , because non interest expenses have not been considered. • Banks normally estimate a % acceptable NIM and then use a variety of interest rate risk hedging methods to protect the ratio. • The MVE can be protected by matching the increase in the market value of liabilities by an increase in the market value of assets or contra. • Banks can attempt to achieve increase in the MVE as well.
Measurement and management of Interest rate risk
• Traditional Gap Method • Involves an analysis of the banks position in Interest Sensitive assets ,Liabilities and Off balance sheet items. • Assets and Liabilities are grouped as per the repricing maturities under predefined “Time Buckets”. RBI has indicated Seven Time buckets. • The difference between the book values of Assets and Liabilities. repricing in a particular time bucket is called the repricing gap/Interest Sensitive Gap. • Non sensitive assets and liabilities like cash, premises are kept out of the analysis. • Refer to slide 7
• Assume.. The repricing items are spread evenly over the bucket. The repriced item continues in the B/S at the repriced rate for the remaining period. Change in rate is assumed equal for all the items . • Interest rate moves 1% adversely against the bank. • App. Change in banks NII= Size of cumulative gap* overall change in Interest rates.
• •
•
Standardised Gap Analysis In practice a zero gap does not eliminate all risks because different classes of Interest rates react differently . For a given change in Bank rate, Money market rates would react faster than loans and deposits. E.g RSA mat/rep during 1-30 days 50 150 Invest. In GSec Loans 100 200
RSL mat/rep during 1-30 days Call Money Borrow. From LAF
FD’s
Total Gap
200
400 (70)
CP
Total
30
330
•
•
As the gap is Liability sensitive an increase of 1% in Interest rate will lead to Decrease of NII by .67 crores Realistically , the change would be
Call Money LAf 1.00% .50%
FD
G secs Loans
.25%
.10% 1.25%
CP
1.50%
• To take care of the basis risk, the bank should forecast not only the direction of interest rate movements but also changes in different asset segments. • • • • • Pros and Cons of Gap Analysis Static analysis- Business growth is not considered Does not consider time value of money Traditional Gap does not consider basis risk Forecasting of Interest rates difficult
• Duration Gap Analysis • A Bank’s assets and liabilities might be mismatched beyond 1-2 years and therefore expose the bank to medium/long term risk • Duration is the average life of the asset/liability and is measured as the weighted average time to maturity using PV of the cash flows, relative to the Total PV of Asset/liability as weights. • Duration measures how much a security’s price will change with changes in market interest rates.
• • • •
Steps Interest rates for the planning period to be forecasted Est. Current mkt value of Banks assets/liab/equity Estimate the weighted average duration of assets and of liabilities • Calculate DGAP • Forecast changes in MVE under different Interest rates environments
• MVA (NEW) = D* inc r * Current MVA/(1+ current r) • Therefore a bank will have to operate at DGAP at zero if it desires to maintain its MVE while interest rates change. • The banks average asset duration should be lightly less than the average liability duration
doc_667998309.pptx