Interest Rate Risk in Banking, the banks define their meaning, definition, principles, example, types with Management and Business Finance; The management should be an important part of market risk management in banks. In the past, regulatory restrictions have significantly reduced many risks in the banking system. However, deregulation of interest rates has exposed them to the negative effects of interest rate risk.

Here is the article to explain, Interest Rate Risk Management in Banking Principles Business Finance

Interest rate risk management in banking is a potential negative impact on net interest income and is related to the vulnerability of an institution’s financial position to changes in interest rates. Changes in interest rates affect income, assets, liabilities, off-balance sheet items, and cash flows. Therefore, the objectives of interest rate risk management are to maintain profitability; the ability to increase the capacity to bear losses and ensure adequate risk compensation received, and reach a compromise between return and risk.

The significance or meaning of interest rate risk;

What does mean interest rate risk? Interest rate risk is the potential investment loss caused by changes in interest rates. For example, if interest rates rise, the value of bonds or other fixed-income investments falls. The change in bond prices when interest rates change knows as duration. Interest rate risk can be reduced by holding bonds with different maturities; and, investors can also reduce interest rate risk by hedging fixed-income investments with interest rate swaps, options, or other interest rate derivatives.

Interest rate risk management aims to record the risk of non-adherence to maturity and revaluation and is measured in terms of both profit and economic value. The bank’s net interest income (NII) or net interest margin (NIM) depends on the development of interest rates. Any difference in cash flows (fixed assets or liabilities) or revaluation dates (moving assets or liabilities) will make the NII or NIM of the bank fluctuate. Returns on assets and prices of liabilities are now closely related to the volatility of market interest rates.

The profit perspective includes an analysis of the effect of changes in interest rates on fees or reported earnings shortly. This measure by measuring changes in Net Interest Income (NII); which is the difference between total interest income and total interest expense. The economic outlook includes an analysis of the expected cash flows from assets minus the expected cash flows from liabilities plus net cash flows or balance sheet items. The economic outlook determines the risk value of the difference in long-term interest rates.

Determination or Definition of interest rate risk in banking;

Interest rate risk defines as the risk of changes in asset value due to interest rate volatility. It makes the security in question uncompetitive or increases its value. Although risk should arise from an unexpected move, investors are generally concerned about reducing risk. This risk directly affects holders of fixed-income securities. If the interest rate rises, the price of fixed-income security falls and vice versa.

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It banking book describes the risk to bank capital, management; and, gains from adverse interest rate developments that affect positions in the banking book. Any changes in interest rates will affect the present value of the bank’s future cash flows. This affects the basic value of the bank’s assets, liabilities, and off-balance sheet. This causes a change in its economic value. When interest rates change, it affects the bank’s bottom line, as net interest income (NII) changes; which depends on interest-sensitive income and expenses.

Interest rate risk is the potential that changes in overall interest rates will reduce the value of bonds or other fixed-income investments:

  • If interest rates rise, bond prices fall and vice versa. This means that the market price of existing bonds will fall to offset the prices of new, more attractive bonds.
  • Interest rate risk measure by the duration of fixed-income securities, with long-term bonds being more sensitive to price changes.
  • Interest rate risk can reduce by diversifying the terms of the bonds or hedging with interest rate derivatives.

Understanding risk opportunities;

The feedback between interest rates and bond prices can explain by the possibility of risk. By buying bonds, investors accept that if interest rates rise; they will relinquish the option to buy bonds with more attractive yields. When interest rates rise, the demand for existing bonds with lower yields decreases as new investment opportunities arise (for example, new bonds with higher yields issue). Although fluctuations in interest rates affect the prices of all bonds, the rate of change varies between bonds.

Different bonds show different price sensitivity to interest rate fluctuations. It is therefore important to assess the duration of a bond when assessing interest rate risk. Bonds with shorter maturities usually involve lower interest rate risk than bonds with longer maturities. With longer-term bonds, interest rates are more likely to change. Therefore, they bear the risk of higher interest rate changes.

The principle of interest rate risk in banking;

The Basel Committee has established the following principles for measuring and managing interest rate risk. Part one below are;

  • Risks critical to all banks must specifically identified, measured, monitored, and controlled. In addition, banks must monitor and assess CSRBB (Credit Spread Risk in the banking book).
  • The governance body of each bank is responsible for overseeing the IT governance framework and the bank’s risk appetite for IRRB. Their monitoring and management may delegate by senior management, experts, or an asset-liability management committee. Banks must have an adequate IT governance framework, including periodic independent reviews and assessments of system effectiveness.
  • Bank’s risk appetite must formulate in terms of risk, both economic value, and profit. Banks should apply policy limits to keep their exposure in line with their risk appetite.
  • Your measurements should be based on the results of economic values ​​and income-based metrics derived from abroad and a precise set of interest rate shock and pressure scenarios.
  • When measuring IRRB, the most important behavioral and model assumptions should fully understand, conceptually justified and documented. These assumptions must rigorously examine and consistent with the bank’s business strategy.
  • The measurement systems and models used should be based on accurate data and subject to appropriate documentation, tests, and controls to ensure the accuracy of calculations. The model used to measure it must be comprehensive and covered by the management process to control the risk model, including a validation function that is independent of the development process.
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Part two below are;
  • The results of your hedging assessments and strategies should report regularly to the management body or its agents at the appropriate aggregation level (by consolidation level and currency).
  • Information on exposure levels and measurement and control practices should regularly disclose to the public.
  • Capital adequacy should specifically consider as part of the Authority’s Approved Capital Adequacy Assessment Process (ICAAP) in line with the bank’s risk appetite for IRRB.
  • Supervisors should regularly obtain sufficient information from banks to monitor trends in bank credit exposure, assess the soundness of bank governance, and identify additional banks that require review and/or additional regulatory capital.
  • Supervisors should regularly evaluate this and the effectiveness of the approach banks use to identify, measure, monitor, and control IRRB. Regulators should use dedicated resources to support such assessments. The supervisory authorities should cooperate and exchange information with the competent supervisory authorities in other jurisdictions regarding the supervision of banking exposures.
  • Supervisors should publish their criteria to further identify banks. Banks identified as having extraordinary value should consider as potential illegal IRRB holders. If a bank’s exposure review reveals inadequate management or excessive risk to capital, earnings, or overall risk profile, regulators should require measures to reduce risk and/or capital gain.

How high is the detailed interest rate risk in banking?

In detail Interest rate risk in banks the risk due to changes in market interest rates which can harm the bank’s financial position, management. Changes in interest rates have a direct impact on bank profits through a decrease in net interest income (NII). Ultimately, the potential long-term effects of changes in interest rates will have an impact on the underlying economic value of bank assets, liabilities, and off-balance sheet items. Interest rate risk seen from these two perspectives refers to as “Profit Outlook” or “Economic Value Outlook”.

Simply put, a high percentage of fixed-income assets means that raising interest rates will not increase interest income (because interest rates fix), and lowering interest rates will not reduce interest income either. The low proportion of fixed assets has the opposite effect.

For the classification of securities in the trading book, the bank has set guidelines for volume, minimum period, holding period, duration, stop loss, rating standards, etc. The interest rate sensitivity declaration makes by the bank. Regulatory restrictions have been imposed on gaps in total assets, income, or equity.

Interest rates explain using examples;

For example, a bank accepts 13% long-term deposits and uses a 17% down payment. If the market interest rate falls by 1%; it must decrease the down payment rate by 1%, because advances revalue every three months. However, it will not be able to reduce the fixed time deposit interest. This will reduce the bank’s net interest income by 1%.

Or let’s say the bank has a 90-day deposit of 9% in a 12% annual bond. If the market interest rate rises by 1%, the bank must renew the deposit after 90 days at a higher interest rate. However, it still receives interest from the old bond interest rates. And in this case, net interest income fell by 1%.

Examples of interest rate risk;

Let’s understand interest rate risk using an example.

If the investor has invested a certain amount in a fixed rate of interest, the bond will be at its current price; which offers a 5% coupon; and, if the interest rate then rises to 6%, the bond price will fall. This is because bonds offer a 5% interest rate while the market offers a 6% yield. If the investor wants to sell these bonds in the market, then the buyer will offer a lower amount for the bonds; because these bonds have low yields compared to the market. New investors will try to achieve a return similar to the market because the amount invested is lower.

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In other words, the opportunity cost of earning better returns elsewhere increases as interest rates increase. Therefore, this leads to a decrease in the price of the binding. There are several ways to counter interest rate risk. One can buy interest rate swaps, buy calls or place options on securities, or invest in negatively correlated securities to hedge risk.

The effect of changes in interest rates on bonds;

Changes in interest rates have different effects on bonds with different maturities. The correlation between interest rate movements and price movements increases with increasing maturity. Because if interest rates rise, bonds with longer maturities will suffer longer from lower interest rates than bonds with shorter maturities. For this reason, investing in bonds with different maturities use as a hedging technique to combat interest rate risk.

Changes in interest rates affect coupon bonds and no-coupon bonds differently. If we look at two types of bonds with the same maturities; they will see a sharper decline in the price of a no-coupon bond compared to a coupon bond due to rising interest rates. This is because, with zero-coupon bonds, the full amount must receive at the end of the specified term and thus increases the effective duration; whereas with coupon bonds, returns generate periodically and thus the effective payment reduces the duration.

Interest rate risk also affects by interest rates. Bonds with lower interest rates carry a higher interest rate risk than bonds with higher interest rates. This is because small changes in the market rate can easily overwhelm the lower rate and lower the bond’s market price.

Types of interest rate risk in banking;

The various following types of interest rate risk in banking identified below are:

Price Risk:

Price risk arises when an asset sale before a specified maturity. In financial markets, bond prices and yields are inversely related. Price risk closely ties to the trading book, which should benefit from short-term interest rate movements. Therefore, banks that have active trading portfolios should formulate guidelines for limiting portfolio size, holding period, duration, offset period, stop loss limit, market marking, etc. This is the risk of changes in the price of a security that could result in an unexpected gain or loss on the sale of the security.

Reinvestment or Investment Risk:

Uncertainty about the rate at which future cash flows can reinvest knows as reinvestment risk. Any difference in cash flow will expose the bank to fluctuations in NII because market interest rates move in different directions. This refers to the risk of changes in interest rates that could lead to a lack of ability to reinvest at current interest rates. Also, It divides into 2 parts.

  • Duration of risk; This refers to the risk that arises from the possibility that you will not want to repay or extend an investment early after a predetermined period of time.
  • Main or Basis risks; This refers to the risk of not experiencing a reversal of changes in the interest rates of securities with an inverse characteristic.
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Interest Rate Risk in Banking Principles Management Finance; Image by Gerd Altmann from Pixabay.
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