Interest Rate Management: How Banks Manage Interest Rates

The interest rate risk is the second major concern and ongoing risk monitoring and management for a bank. However, the tradition has been for the banking industry to diverge somewhat from other parts of the financial sector in treating interest rate risk.

Interest Rate Management Procedures

• Traditionally, the Asset-liability Management group within a bank has been concerned with controlling interest rate risk on the balance sheet.
• For the deposit product, once the bank decides on the maturity of the deposit incurs interest rate risk.
• A sudden rise in interest rate would decrease the net interest margin per month. It focuses on the sensitivity of profit and loss accounts in the short run.
• The effect on net economic value will be considered in the long run.

However, most commercial banks clearly distinguish between their trading activity and their balance sheet interest rate exposure.

Investment banks generally have viewed interest rate risk as a classic part of market risk and have developed elaborate trading risk management systems to measure and monitor exposure.

For large commercial banks and European-type universal banks with an active trading business, such systems have become a required part of the infrastructure.

But, in fact, these trading risk management systems vary substantially from bank to bank and generally are less real than imagined.

In many firms, fancy value-at-risk models, now known by the acronym VaR, are up and running. But, in many more cases, they are still in the implementation phase.

In the interim, simple ad hoc limits and close monitoring substitute for elaborate real-time systems. While this may be completely satisfactory for institutions with little trading activity and work primarily on behalf of clients, the absence of adequate trading systems elsewhere in the industry is a bit distressing.

For institutions that do have active trading businesses, value-at-risk has become the standard approach.

Suffice it to say that the daily, weekly, or monthly volatility of the market value of fixed-rate assets is incorporated into a measure of total portfolio risk analysis along with equity’s market risk and that of foreign-denominated assets.

Commercial banking firms follow a different drummer for balance sheet exposure to interest rate risk.

Given the Generally Accepted Accounting Principles (GAAP) established for bank assets and the close correspondence of asset and liability structures, commercial banks tend not to use market value reports, guidelines, or limits.

Rather, their approach relies on cash flow and book values at the expense of market values. Asset cash flows are reported in various repricing schedules.

This system construction has been labeled a “gap reporting system traditionally,” as the asymmetry of the repricing of assets and liabilities results in a gap.

This has classically been measured in ratio or percentage mismatch terms over a standardized interval such as a 30-day or one-year period.

This is sometimes supplemented with a duration analysis of the portfolio.

However, many assumptions are necessary to move from cash flows to duration. Asset categories that do not have fixed maturities, such as prime rate loans, must be assigned a duration measure based on actual repricing flexibility.

A similar problem exists for core liabilities, such as retail demand and savings balances. Nonetheless, the industry attempts to measure these estimates accurately and include both on- and off-balance sheet exposures in this reporting procedure.

The result of this exercise is a rather crude approximation of the duration gap. Let’s have a closer look at gap and duration analysis:

Gap Analysis

The difference between interest-sensitive assets and liabilities for a given time interest is the gap.

In gap analysis, each bank’s assets and liabilities category is classified according to the date. The asset or liability is repriced, and time buckets groupings assets or liabilities are placed in the buckets.

There are incremental and cumulative gap results.

An incremental gap result is defined as earning assets less funding sources in each time bucket, and the cumulative gap is the cumulative subtotals of the incremental gaps.

• Positive Gap: The gap is the amount by which means rate-sensitive asset (RSA) > rate-sensitive liability (RSL).
• Negative Gap: The gap is the amount by which means rate-sensitive asset (RSA) < rate-sensitive liability (RSL).
• Gap Ratio: The gap ratio is defined as CGAP/A, where. CGAP = Cumulative Gap. A = Total Assets.
• Maturity Gap: The term maturity gap emphasizes that the difference in maturity affects both sides of a bank’s balance sheet.

Maturity gap= WARSA- WLRSL Where WA = Weighted Average of Rate Sensitive Assets WL = Weighted Average of Rate Sensitive Liabilities The bigger the maturity gap, the more a bank’s net worth will be affected by a change in interest rates.

Duration Analysis

Duration analysis expands on the gap analysis presented above by taking duration into account. Duration is the present value-weighted average term to repricing and was originally applied to bond with coupon.

It allows for the possibility that the average life of an asset or liability differs from their respective maturities.

The duration of an impure bond is expressed as follows:

Durations = T [ 1 – { coupon-size / (MV * r) } ] + [ ( 1 + r ) / r ] [ 1 – ( DPVR / MV ) ] Where; T = time to redemption, r = market interest rate, MV = market Value, DPVR = discounted present value of redemption The duration of equity is computed as follows: DE = [ ( MVA * DA ) – ( MVL – DL ) ] / ( MVA – MVL ) Where. DE = Duration of an equity DA = duration of Assets DL =duration of Liabilities MVA =Market value of assets MVL = Market value of liabilities

Most banks, however, have attempted to move beyond this gap and duration methodology.

They recognize that the gap and duration reports are static and do not fit well with the dynamic nature of the banking market, where assets and liabilities change over time and spreads fluctuate.

In fact, the variability of spreads is largely responsible for the highly profitable performance of the industry over the last two years.

Accordingly, the industry has added the next level of analysis to its balance sheet interest rate risk management procedures.

Currently, many banks are using balance sheet simulation models to investigate the effect of interest rate variation on reported earnings over one-three and five-year horizons.

These simulations, of course, are a bit of science and a bit of art. They require relatively informed reprising schedules and estimates of prepayments and cash flows.

In terms of the first issue, such an analysis requires an assumed response function on the pan of the bank to rate movement, in which bank pricing decisions in both their local and national franchises are simulated for each rate environment.

In terms of the second area, the simulations require precise prepayment models for proprietary products, such as middle-market loans, and standard products, such as residential mortgages or traditional consumer debt. In addition, these simulations require yield curve simulation over a presumed relevant range of rate movements and yield curve shifts.

Once completed, the simulation reports the resultant deviations in earnings associated with the rate scenarios considered.

Whether or not this is acceptable depends upon the limits imposed by management, which are usually couched in terms of deviations of earnings from the expected or most likely outcome. This notion of Earnings At Risk, EaR., is emerging as a common benchmark for interest rate risk.

However, it is of limited value. It presumes that the range of rates considered is correct and/or the bank’s response mechanism contained in the simulation is accurate and feasible.

Nonetheless, the results are viewed as indicative of the effect of the underlying interest rate mismatch contained in the balance sheet.

Because of concerns over the potential earnings outcomes of the simulations, treasury officials often use the cash, futures, and swap markets to reduce the implied earnings risk contained in the bank’s embedded rate exposure.

However, as has become increasingly evident, such markets contain their own set of risks. Accordingly, every institution has an investment policy that defines allowable assets and limits the bank’s participation in any area.

All institutions restrict treasury activity by defining the set of activities they can employ to change the banks’ interest rate position in both the cash and forward markets.

Some are willing to accept derivative activity, but all restrict their positions in the swap caps and floors market to some degree to prevent unfortunate surprises.

As reported losses by some institutions mount in this area, investment guidelines are becoming increasingly circumspect concerning allowable investment and hedging alternatives.