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Interest Rate Risk
Looking beyond Credit Risk, Interest Rate Risk is yet another important source of vulnerability to banks. Credit risk, till recently was a major factor for losses suffered by banks all over the world. Bad loans lead to bad debts and consequently interest loss. Often Liqudity risk accompanied by bad loans fanned the erosion to banks earnings.
In India, we have had a fairly large percentage of impounded liquidity by way of statutory liquidity ratio, forced banks to resort to Investments in Government Bonds. When there was easing of controls over bank's Cash reserve ratio went down with marginaleasing of Statutory liquidity ratio.
Banks were facing excess liquidity. More or less, during the same period credit pick up slackened. Despite aggressive marketing efforts, growth in credit lagged very much behind Investment portfolio in most banks.
Banks continued to park surplus in Investments, particularly in Government bonds despite comparatively lower yields due to lesser risk weight. The then interest rates were attractive and was very close to banks PLR @14 to 15 percent.
It may be interesting to note that investment in Government bonds from among banks is very high all over the world but not as high as in India.U.S. banks have an investment of about 6%-Euro currency area banks have around 5%-Banks in U.K. around 0.5% whereas in India banks investment in Government Bonds had aggregated to be around 27.5% as on 31-3- 2001 Historically this large holding in Govt. bonds is driven by large Reserve requirements. Fanned by poor credit off take the holding in Govt. bonds still went up, far in excess of reserve requirements.
Bulk of Govt bonds are fixed rate products of longer maturity whereas bulk of credit to corporates are largelyshort term floating rate products. Commercial banks in India by and large hold short term time deposits and demand deposits equal to 50% or moreof total deposits. If any bank's holding in Govt bonds and securities is around 30%, an increase in interest rate would erode its Net worth. This is so due to steep fall in investment portfolio without matching impact on value of deposits
Reserve bank of India fine tuning Governments borrowings through Public debt operations came out with several packages. This included triggering steep fall in interest rates. The interest on Provident fund, National savings certificates, Public provident fund deposits, Postal savings and all other long dated Govt. bonds. There had been matching fall in interest rates in various banks products.
The introduction of P.L.R. linked lending, popularized the floating rate credit products.P.L.R. which stood around 14 to 15% fell gradually to 12.5 to 11.5% and so on. Interest rates were de-controlled in the year 1993. The Governments systematic efforts to slash down the high cost borrowings resulted inunprecedented fall in interest rates in India between September, 2000 and December, 2002. Fall in interest rates in Govt. securities and Bonds were significantly high.(Nearly 500 basis points. That is 5%)
Despite this fall and consequent fall in banks P.L.R for lending, and aggressive marketing efforts, the credit portfolio of banks lagged way behind. banks investment portfolio. Interst income from investment portfolio exceeded net interest income from lending operations despite levy of high interest rates. Banks, seeing the opportunities triggered Treasury operations, reducing the holding of Permanent category and increasing the Marked-to-market category
Erstwhile investments in 14 to 15% securities are being encashed to book profits and sale proceeds reinvested in 11 to 12.5% yield Govt Bonds. The recent fall in interest rates by about 500 basis points once again afforded enormous scope for realizing huge profits by trading them off and as of date the sale proceeds stand invested in Govt securities and Bonds of much lower yield. This is the position as on date of low interest regime.Almost all banks returned sizeable profits, maintained the profitable trend and could go public, seeking capital to augment capital adequacy as per norms
While this is the position as of date what is more important is to anticipate rise in interest rates and its possible impact on banks investment and credit portfolio. It is not unfamiliar to expect fallen interest rate to climb up. A prudent bank management, should, not only anticipate, but also take proactive measures to combat the severity of its impact if and when it occurs.A few research papers are already published and it is expected that there can be a possible rise of 3 to 4% in interest rate in next 2 to 3 years. If and when this occurs every portfolio under Bonds and securities and Credit products will witness steep fall in their contribution to net interst income
The severity of such a phenomenon can be imagined particularly when it is indicated that all the banks put togaher have an investment of about 10 trillions (A trillion is million million). When the interest rate rise by 100 basis points that is 1%, banks holding bonds of 10 year duration will have to take a loss of 10%.It is mentioned that even if the assets duration on the aggregate is 3 years a rise of 1% in interest rate would result in an enormous loss of Rs.30,000 crores
This loss, to some extent may be covered by substantial portion of liabilities of long term nature such as Long dated fixed deposits in proportion to Long dated Bonds.Low interest and nil interest Savings bank account and Current account balances can also ease the pressure of risk on Long dated bonds and securities.But an hike of 300 to 350 basis points(3 to 3.5%) in interest rate is likely to leave many banks high and dry particularly those who have funded long maturity assets using short maturity liabilities.
On going through one of the recently published research papers it is seen that the position of most banks barring a few will be precarious should there be a rise in interest rate to a significant extent. The Report has taken note of the Balance sheet assets and Liabilities of 43 banks in India. Taking note of these banks investments in Govt. securities and Bonds from their Balance sheet, the Report reveals that a rise of 300 to 350 basis points interest rate following will be the position of banks.
1.2 banks will suffer no serious damage(S.B.I and I.C.I.C.I banks)
2.10 banks have hedged position(May witness 25% plus or minus erosion or gain to their Equity)
3.6 banks stand to gain and add 25 to 60% to their Equity
4.26 banks stand to lose between 25 to 350% erosion to their Equity
While one should hopefully expect that such a catastrophic situation do not occur, the contents of the report cannot get easily ignored. The bank managements will do well to anticipate, and be ready with corrective actions, Interest rate risk management systems in place and be with anticipative preparedness to avoid last minute crash programmes. It will not be out of place to note that these complex developments and its complicity are not well known to us. The Banks Board, Directors on Board, Supervisors and other senior officers are not well conversant with the new techniques to guide, steer, and counsel grass root level functionaries.
Besides, we were used to administered interest rate structure far too long.Exposure to Global phenomenon, fierce competition,Basles capital adequacy norms and strict adherence thereof emerging operational risk concept and provision of capital to insulate possible risks arising out of deficient fuctional areas threw open risks and rewards and new learning opportuinities. First thing to be prepared is to anticipate, act and manage. In the present days of falling interest rates we have tasted the fruits of earlier investment yields.
We should, now get ready to face the possible repercussions of rising interest rates and think about combating tools to mitigate adverse impact. The Report, clearly indicate that while forecasting they have taken into account every banks portfolio, its composition, yield, duration, remaining maturity periods and its financing pattern, its cost and duration of liabilities with its cost and also the banks low interest, nil interest S.B. and Current account funds
Interest Rate Risk-Measurement there of
Causes for Interest Rate Risk
The interest rate risk is a major component of market rate risk. This is also known as Earnings at risk. interest is a major source of revenue to the bank arising out of lending investment and all other activities involving laying down of funds. Cost of acquiring the liabilities such as deposits, cost of servicing the equity /stake holders is to be matched with that of revenues arising out of deployment of these funds should leave a spread to call the operations profitable This spread or the earnings is at risk whenever there is movement of interest rates.
So long as the interest rates were administered by RBI there was a protection, cushion and automatic cover Now that the interest rates are no more administerd and totally de-regulated banks are under pressure to guard the net interest margin. Market interest rate movement influence the net interest margin as the earnin assets and matching liability cost are also influenced.Net interest margin is therefore exposed to market interest movements otherwise known as Market(interest rate risk)
Interest rate risk arises out of
- Gap mis match due to carrying different assets- principal amounts, liabilities and off-balance sheet items different maturity dates, different re-pricing dates. When unexpected changes take place to market interst rate, Gap mis match occurs
- Basis risk. The changes in market interest rate do not immediately or simultaneously influence the related assets and liabilities in the same degree. This is so when the banks asset portfolio consists of diverse and composite assets and liabilities. The extent of influence of the shift may not be in the same degree or proportion.
- Embedded option risk. This is yet another source of risk arising out of depositors', investors' and borrower's option vested in them. When they consider the market interest rate shift is not favourable to them they may exercise call/put option(say on bonds and debentures) Depositors may effect premature closure option for withdrawl of deposits, borrowers may effect Vam a odpre mature closure of loans.
- Yield curve risk. This occurs when the banks finance their assets and price them using different instrument maturing at different times. This is particularly when interest rate is on floating terms. When there is a swift movement in the economy under going different business cycles the yield curves varies when there is no parallel movement and this would affect the earnings. The risk management system should be in a position to evaluate the impact whenever changes occur.
- In the banks investment portfolio where active trading is contemplated, they look to gains in trading when there is a favourable short term movements in the interest rates and consequential price movement in bond prices. Both are inversely reacting types. Banks should have clear policies to determine the portfolio size, duration, stop-loss limits marking to market and defeasance.
- Reinvestment risks. Like prepayment, pre withdrawl of liabilities future cash flows includingtimely repayments are likely to create a gap. Wider the gap the risk of reinvestment at workable price realistion is exposed different directions to the risk of causing variation in interest earnings due to interest movements in different directions
Hence banks have to arrive at the net position and depending upon the funding pattern of the composite liability of a loan portfolio. The earnings may be favourable or unfavourable. While in some loan portfolio banks may earn they may lose in others. While for some banks with the same percentage of variance improve the net interst margin, for others may result in reduction. Basis risk therefore may be favourable or unfavourable depending upon the positionning.
These create a Gap in liquidity. The impact on the bank will be severe when the movement is volatile. Having regard to such options vested, it is prudent for the banks to anticipate the gap, adjust the gap statements, liquidity/interest rate sensitivity and forecastRISK PROFILE of their balance sheet. Premature withdrawls pre payment options when vested suitable covenants containing penalties can be stipulated to mitigate the effect of imbedded option risk.
The overall interest position will be comfortable to those banks having large float funds with nil or negligible interest. Their cost of funds will be minimal. Their profitability will be high and steady.
Measurement Of Interest Rate Risk
This is complex exercise. Banks Internal Rate of Return taking note of their balance sheet, trading book position, composition, banking book,gap position of the maturity, its duration sensitivity of the banks exposures, value at risk of their traded assets etc. is one method of measuring.
Foreign Exchange CONTRACTS CURRENCY FUTURES CURRENCY OPTIONS ARE DERIVATIVES TO HEDGE EXCHANGE RATE RISK. Exchange rates and interest rates are constantly in motion and throws open inherent risks. In order to to protect from heavy loss banks corporates use necessarily the hedging tools and techniques
The hedging instruments are called Derivatives. These are traded in Organised exchanges and Over The Counter. Banks act as intermediaries linking the buyers and sellers of swaps and forward contracts for a fee.
Banks in India are presently permitted tocross currency derivatives and that too on fully covered basis. Banks acts as brokers for the related derivative products
Banks in India manage their forex rate risk right under the close supervision of R.B.I.Banks are expected to keep near covered position and donot expose huge balances to be subject to the rate and exchange riskSquaring up operations are almost daily on daily basis and open positions are subject close surveillance. In as much as the forex funds can be deployed for rupee swaps as part of liquidity management the gaps scrutiny and discussions in A.L.M. ALCO meetings.
Settlement Risk
Forex risk, accompanied by credit risk and settlement risk can play havoc and several cases have benn already cited. SETTLEMENT RISK is the risk that a settlement in a transfer system does not take place as expected due one party defaulting on its obligations This risk comprise of both credit and liquidity risks. In as much as there is default due to inability or insolvency it is a credit risk. Such a default in full or in part even when settled later causes liquidity strain to the receiving party to scramble for funds and manage the consequential liquidity problems. The defaulting party himself struggles for liquidity and chooses to default to tide over his strain
Normally such risks occur in forex trading. B.I.S estimates highest turnover on daily basis in currency trading. Average daily turnover estimated by B.I.S is around U.S. Dollars 1230 billion in spot and outright forward. As each such trade involve 2 or more payments daily flows are likely to be a multiple of this U.S. Dollar 1230 billion. Given this volume at any point of time the amount of risk to even a single counter party could exceed a banks Capital. The need to address risk management to this risk gets automatically explained.
This risk is suitably exampled in the case of a German bank known as Herstatt bank. Some of the banks counter parties had irrevocably paid huge sums during the business hours to this bank (In German marks) in good faith to receive equivalent in U.S. Dollars in Newyork. At 3-30. P.M. the local monetary authorities asked the bank to close down its operations and cancelled its license. In Newyork due to the time difference, the time was 10-30. A.M. The Newyork bank received the news about the banks suspended operations and cancellation of license. They immediately suspended all the Dollar payments on account of this Simulation Model.
This is comparatively implementable method compared to several other sophisticated models adopted by International banks abroad.
A.L.M. system enabling Maturity gap approach is recommended to banks in India before they venture into more sophisticated models
Market (Interst rate risk and Liquidity risk) showed its ugly face sometimes during 1990s. The plight of the banks in India affected by these risk factors was demonstrated.
The country's forex position was at its lowest. We had hardly net forex balance to cover a fortnight's imports. This resulted in imposing severe restrictions on imports and remittances abroad. Raw materials imports and capital goods imports were adversely affected.
Market liquidity had seen its worst. Augmenting forex position and containing inflationary trend was engaging the full attention of the Govt. and monetary authority.
There was quantitative restrictions on credit expansion. The hike in impounded funds like CRR and SLR virtually crippled the liquidity in most banks. As part of credit administration, they had impose curtailment on withdrawl from loan cashcredit limits. The import bills were asked to be paid on time. Exporters were asked to exert pressure to get their bills paid.
Grant of usance terms for some exports took beatings reducing the competetiveness of the exporters.
The dried up liquidity in banks forced them recourse almost all the refinancing opportunities. The cost of funds was mounting up as deposits and other liabilities were raised at very high rates. The call money market which was slowly climbing up was hitting the roof Banks were levying interest on their loans at such rates asnearly 20%.
This was accompanied by 2% penal rate for over dues. A further cumulative levy of 2% was to be charged on import bills not retired on presentation The banks treasury and the senior management were fully engaged in funding operations. A few banks and F.I.s having surplus were having gay time reaping unearned interest bonanza. The call money rates touched as a rate as 80 to even 90%.
This massive interest rate and dried liquidity in the market virtually forced borrowers to default. To many, default was a major source of liquidity management Banks were trying to mobilize NRE deposits at a time when the Govt itself was marketing India defence bonds with attractive terms. Banks were left with N.R.N.R deposits scheme where in the interest offered was as high as 20%.In their anxiety banks went for this in full cry and for a longer periods. Till very recentlythey were struck with this as no pre closure option was available to banks
Many banks lost their entire interest revenue in handling the high cost of funding and misery continued for very long time as if to explain how bad the combined evils of Interest rate risk and the liquidity risk when combined. Added to this the major stock market scam that rocked the country(Harshad Mehta scam) fuelled the charged market conditions. Many projects under implementation were slowed down. Cost and time over run practically made many such projects unviable. The plight overseas branches of Indian banks was already indicated elsewhere in this write up and this was also during the same concurrent period.
When the economy and the market slowly improved thanks to several corrective measures took by the Govt and R.B.I, it had taken longer time for the trade, industry and banking to improve.
The importance of Market Risk Management needs no greater emphasis.
Foreign Exchange Risk
Forex risk is the risk that a bank may suffer losses as a result of exchange rate movements during a period in which it has an open position either spot or forward or a combination of both in an individual currency. It can also be accompanied by interest rate risk that may arise from maturity mis match of foreign exchange position. It can occur even where spot /open position are balanced.
Integrating the local Indian economy with that of the global economy will generate will generate growing volume of cross border finantial and commercial transactions. Such cross border entry necessitate settlements in different countries, in different currencies involving conversions. This is the foundation of forex trading.
The forex market brings together the buyers and sellers of different currencies and brings a mechanism for settlement. When our country goes for full conversion of Rupees, we are bound to witness huge volumes of forex trade, investments and arbitrage.
Forex money market, however are markets were short term lendings and borrowings take place.
Banks have also been mobilizing forex funds under different savings schemes from the Indian non residents abroad. Schemes like NRE external accounts, F.C.N.R deposit account, E.E.F.C.R.F.C etc. These funds are deployed to fund their importers needs, and for making miscellaneous remittances. besides inter bank lending. Banks also have access to forex funds abroad to meet short term obligations
Risk covers for Forex trade bank. The German banks parties were left high and dry. So much so the risk itself came to be called HERSTATT RISK Based on Herstatt risk and similar problems in the settlements of security trading Supervisory guidance for managing settlement risk was issued. For non delivery of funds for securitied delivered similar to the Herstatt risk D.V.P system(Delivery versus Payment) was evolved O.T.C(Over the counter) derivative transactions are sought to be covered by a separate settlement procedured and counter party risk management
Operational Risk
Risk factors in this form of risk is largely internal to banks themselves. Unlike Market, liquidity risks Operational risk is the risk of un expected losses arising from deficiencies in the banks management information, control systems and procedures. Banks are in the early stages of developing an operational risk management,monitoring, measurement system or a frame work. The presence Operational risk in the face of diversified business lines with high turnover(Transaction/Time), high degree of structural change and complex support system makes its impact very severe.
The most commonly identified risk factors in operational risk measurement are Internal audit ratings, volume, turnover,complexity, data on quality of operations such as error rates and income volatility.
No report illustrates better than the Report about the bank BARRINGS, an English bank by Bank of England-Collapse of Barrings 1995. Break down in internal control and corporate governance can cause huge finantial loss through error, fraud, failure to perform timely. This may be due to human or technical error.
Well defined policies and procedures, strict internal control, setting up of effective risk based internal audit system are primary means supported by setting up of operational risk limits all these can reduce and mitigate the impact of the risk arising out of operational risk
It is also felt that a capital charge to cover operational risk is necessary if it can be estimated and quantified. One approach to calculating the capital requirement is to go for an ADD-On based on key operational areas such as variability in interst income, turnover, staff turnover, error rates technology costs. The second approach could be by applying the base requirement reflecting the scale of the banks activities expressed as a percentage of fixed costs.
In short operational risk arises when the so called time tested procedures, systems, supervision ineffectiveness and inadequacies of control mechanism. Human error and fault and culpable negligence contribute to the loss. Lack of technological advancement and too much dependence of technology support leading to casual and negligent attitudes are also factors leading to grave operational risks
Understanding the need for E-Trade, E-Commerce and E-Banking and its possible add on to the risk factors Basle committee on Banking supervision has laid down certain ground rules given below
BOARD AND MANAGEMENT OVERSIGHT PRINCIPLES
1) The board and the senior management should establish effective Management oversight over the risks associated with E-Banking activities. Specific accountability, policies and controls to be established.
2) the board and the senior management to review and approve key control process
3) They should also establish a comprehensive and ongoing Due Diligence and Oversight Process for managing banks out sourcing relationships and other third party dependencies.
SECURITY CONTROLS PRINCIPLES
4) Banks should take appropriate measures to authenticate the identity and authorization of customers with it proposes to conduct business over INTERNET.
5) Banks should use transaction authentication methods
6) Banks should ensure that appropriate measures are in place to promote adequate segregation of duties with in E-Banking systems.
7) Banks should ensure that proper authorization controls and access preveleges are in place for E-Banking systems, Data bases, and applications.
8) Appropriate measures should be in place to protect the data integrity of E- Banking transactions, records and information.
9) Banks should ensure clear audit trails exist for all E-Banking transactions
10) Proper measures for maintaining the confidentiality to be in place.
LEGAL AND REPUTATIONAL RISK MANAGEMENT PRINCIPLES
11) The web site information should be of disclosure type such that potential customers make informed conclusions about the banks identity, regulatory status in advance.
12) Customers privacy requirements to be adhered.
13) Banks should have effective capacity, business continuity and contingency planning process to help ensure the availability of E-Banking systems and services.
14) Banks should develop appropriate incident response plans the manage, contain, and minimize problems arising from unexpected events, including internal and external attacks that may hamper the provisions of E-Banking systems and services.