Due to the very nature of its business, a bank should accept interest rate risk not by chance but by choice. And when the bank has to take a risk as a choice, then it should ensure that the risk taken is firstly manageable and secondly it does not get transformed into yet another undesirable risk. As stated earlier, the focal point in managing any risk will be to understand the nature of the risk. This is especially essential for interest rate risk management. Interest rate risk is the gain/loss that arises due to sensitivity of the interest income/interest expenditure or values of assets/liabilities to the interest rate fluctuations.
Types of Interest Rate Risks
The sensitivity to interest rate fluctuations will arise due to the mixed affect of a host of other risks that comprise the interest rate risk. These risks when segregated fall into the following categories.
- Rate Level Risk: During a given period there is possibility for restructuring the interest rate levels either due to the market conditions or due to regulatory intervention. This phenomenon will, in the long run, affect decisions regarding the type and the mix of assets/liabilities to be maintained and their maturing periods. The present interest rate restructuring taking place in the Indian markets is a very good example of this aspect. The Reserve Bank of India which is the apex body regulating the Indian monetary system, has been lowering the Statutory Cash Reserve Ratio for banks in a phased manner. Every time the CRR is lowered, there is an increase in the liquidity which further results in lowering of the interest rate levels. The risk that arises due to this reduction can be understood from the fact that the revised rates of interest will be applicable to all the new deposits, which will lower the marginal costs of funds. However, the affect will be seen on all the existing assets. Consequently the loss of interest income on assets is likely to be higher than the reduction in the interest cost of deposits leading to lower spreads.
- Volatility Risk: In additions to the long run implications of the interest rate changes, there are short term fluctuations which are to be considered in deciding on the mix of assets and liabilities, the pricing policies and thereby the business volumes. However, the risk will acquire serious proportions in a highly volatile market when the impact will be felt on the cash flows and profits. The 1994 volatility witnessed in the Indian call money market explains the presence and the impact of volatility risk. The interest rate in the call money market, which generally hovered around 5-7 %, zoomed to 95% within a couple of weeks during September, 1994. While some banks defaulted in the maintenance of CRR, many banks borrowed funds at high rates, which had substantially reduced their profits. Thus, it can be seen that the affect of fluctuations in the short term have a greater impact since the adjustment period is very short.
- Prepayment Risk: The fluctuations in the interest rate may sometimes lead to prepayment of loans. For instance, in a situation where the interest rate is declining, any cash inflows that arise due to prepayment of loans will have to be redeployed at a lower rate invariably resulting in lowered yields.
- Call/Put Risk: Sometimes when the funds are raised by the issue of bonds/securities, it may include call/put options. A call option is exercised by an issuer to redeem the bonds before maturity, while the put option is exercised by the investor to seek redemption before maturity. These two options expose to a risk when the interest rate fluctuate. A call option is generally exercised in a declining interest rate scenario. This will affect the bank if it invests in such bonds since the intermediate cash inflows will have to be reinvested at a lower rate. Similarly, when the investor exercises the put option in an increasing interest rate scenario, the banks, which issue the bonds, will have to face greater replacement costs.
- Reinvestment Risk: The risk can be associated to the intermediate cash flows arising due to the payment of interest, installments on loans etc. These intermediate cash flows arising from a security/loan are usually reinvested and the income from such re-investments will depend on the prevailing rate of interest at the time of reinvestment and the reinvestment strategy. Due to the volatility in the interest rates, these intermediate cash flows when received may have to be reinvested at a lower rates resulting in lower yields. This variability in the returns from the re-investments due to changes in the interest rates is called the reinvestment risk.
- Basis Risk: When the cost of liabilities and the yields of assets are linked to different benchmarks resulting in a floating rate and there are no simultaneous matching movements in the benchmark rates, it leads to basis risk. When the change in the interest rates, which are set as a benchmark for assets/liabilities, is not uniform, it will lead to a decrease/increase in the spreads.
- Real Interest Rate Risk: Yet another dimension of the interest rate risk is the inflation factor, which has to be considered in order to assess the real interest cost/yields. This occurs because the changes in the nominal interest rates may not match with the changes in inflation.
The presence of the above mentioned risks would either individually or collectively result in interest rate risk. These risks will affect the income/expenses of the bank’s asset/liability portfolio. This, further, will also have an impact on the value of assets and liabilities of the bank, thereby affecting even the market value of the bank.
Source: Bank Management Notes-MGU