Chapter 7: Interest rate risk Flashcards
What is interest rate risk
Interest rate risk is the risk that adverse or favourable movements in interest rate that affects the banking book position changes resulting in movements in capital and earnings.
This is because when interest rates changes it changes the PV of the future cashflows. Which changes the value of the assets and liabilities, i.e., it changes the economic value.
Interest rate changes, effect the bank’s interest sensitive income and expenses, thus affecting the net interest income of the bank.
Interest rate risk can be mitigated through hedging, by locking in an interest rate. This hedge can be at risk due to early redemption resulting in a naked hedge, i.e., a hedge with no underlying exposure.
Sources of interest rate risk
Gap Risk
Basis Risk
Optionality
Yield curve risk
Define
- Gap risk
- Basis risk
- Optionality
- Yield curve risk
Gap risk : Assets (loans) do not match liabilities (funding) in terms of duration or currency.
Where assets and liabilities are mismatched, adverse interest rate movements can lead to profitability being reduced or eliminated, and, in extreme situations, losses can arise.
Basis risk: Assets and liabilities can be linked to floating rates off different benchmarks.
For example, loans can be based on T-bill rates, while borrowing is based on LIBOR. These rates would not necessarily move by the same magnitude or in the same direction.
Optionality: Risk of a customer exercising their option to pre-pay an outstanding loan, when a loan has been match-funded
Yield curve risk: Interest rates may not change across the entire yield curve, but rather in only one part of the curve. In a borrow short-term / lend long-term funding scenario, profitability could be reduced if short-term rates increase.
Similarly, profitability can also be increased, for example in an increasing rate cycle. Some banks view this increase as a hedge to potential increase in credit risk in such a cycle.
Yield curve theories
Expectation theory: Shape of the yield curve is determined by economic factors which drive the market’s expectation of future short-term interest rates
If the market expects future interest rates to rise, then the yield curve would be upwards sloping (or vice versa)
Liquidity preference theory: Investors prefer liquid assets over illiquid ones. Longer-dated bonds are less liquid than shorter dated bonds, thus to compensate for this the yield on longer dated bonds are higher. Upwards sloping at longer terms
Inflation risk premium theory : Investors require higher return for the return on assets that will be eroded by inflation. The certainty over future inflations levels get more uncertain as the term increases so longer dated bonds require an additional return for this
More upwards sloping for longer terms
Market segmentation theory: Yields are determined by supply and demand of investors with liabilities of that term.
Demand for shorter bonds come from banks and general insurers. The demand for longer-dated is from life insurers and pensions.
Name two benchmark rates
LIBOR is calculated by polling panels of banks as to the rate at which they can borrow from each other for a range of tenors and currencies.
JIBAR is calculated using contributions from 9 SARB regulated banks. JIBAR is base don interest rates at which SA banks buy and sell their own NCDs. Bid and offer rates are submitted to determine mid-rates. The two highest and lowest rates are removed before averaging to create JIBAR
Methods to measure interest rate risks
Macaulay duration: Metric that allows to measure how sensitive the banking book is to changes in interest rates. This allows the bank to quantify their interest rate risk and the potential impact on the balance sheet.
Interest rate shift: Metric that measures the impact on NPV of the expected cashflows of the banking books if there is a parallel shift in the yield curve
Economic value changes: NPV of all the cashflows of assets – liabiltieis.
Earnings at risk: Method that is used to understand how interest rate changes is transmitted to the bank’s NII and future earnings over a specific horizon
Gap analysis: Analysis that measures the difference between interest sensitive assets and interest sensitive liabilities. Assets and liabilities are grouped according to their behavioural and contractual maturities. By doing this, the bank is able to identify mismatches in their balance sheet
How does a gap analysis work
- A gap analysis is where assets and liabilities are grouped together by contractual / behavioural maturity buckets (1 day, 1 week, 1 month, 2 month, etc.)
- Banks determine probable maturities for assets and liabilities with optionality (effective / behavioural maturity).
- Floating rate obligations are measured according to their re-pricing date as opposed to their final maturity date
- Mismatch of assets and liabilities are calculated for each maturity bucket. With these gaps identified, modified duration formulas allow for time value of money to be applied and price sensitivity determined to changes in the interest rate.
- This results in estimation of the impact of a change of one basis point change in the interest rate.
Limitations of a gap analysis
- Only gives an estimation of one point in time and doesn’t incorporate future development
- Interest rate changes do not always occur across the yield curve
- Asset performance such as loan loss and rescheduling is uncertain
- Optionality might or might not be linked to interest rate movements.
How is NII calculated
NII = Interest Income-Interest Expense
Interest Income is earned on interest-bearing assets, e.g., mortgages
Interest Expense is the interest paid on liabilities, that are used to support interest bearing assets, e.g., deposits.
Risk_Adjusted NII=Credit loss adjusted NII-Cost of Capital
Credit loss adjusted NII=NII-(Impairment charge+Write offs)
How is net interest margin calculated
Net interest margin (NIM) measures the margin earned on interest-bearing assets for a specific period. NIM is generally used as a profitability indicator to determine how the bank will perform in the long-run
NIM = NII / Average Interest Earning Assets (AIEA)
AIEA = 1/2 (Opening + Closing Balance)
Advantages and limitations of NIM
NIM Advantages
* Useful to track profitability of lending and deposit taking business in totality
* Easily adjustable to reflect a risk-adjusted view of the bank’s performance
* Can be used to compare different banks in the same jurisdiction
NIM Limitations
* Cannot spread the margin between deposit-taking and lending business, as a result the NIM per asset type cannot be isolated, e.g., mortgages and VAF.
* Cannot objectively compare the NIM between two bank due to differences in the nature of the balance sheet, e.g., if bank A focuses on mortgages and is funded through wholesale funding, and bank B focused on VAF and relies on retail deposits, the NIM cannot be compared because the banks have different natures.
* Comparison between banks are not always meaningful. This is because the NIM reflects the banks unique profile which depends on activities, strategies and customer base
NII changes through the economic cycle
Economic growth
During economic growth, it is expected that inflation increases due to increase in consumer income and spending. As result, the reserve bank increases the risk-free reference rate (repo rate).
Due to increase consumer spending, credit origination is expected to increase thus it is expected that the NII generated by the bank will increase. Credit origination increases due to the bank’s target market increases and consumers have a greater demand of credit to improve their standard of living
The banks profit is expected to increase, and so it retained earnings. Retained earings is used as CET1 capital, which increases the capital supply to the bank allowing additional risk to be taken on.
The reserve bank increases risk-free rate to maintain inflation levels within a certain target. The impact can be assessed by slitting the portfolio into floating rate assets and fixed rate assets.
Floating rate assets during economic growth
Banks funded by floating rate instruments wouldn’t feel an impact, apart from differences in the re-pricing characteristics of the bank’s floating asset and liabilities. The NII is expected to increase over the short term due to re-pricing delays
Fixed rate assets during economic growth
Consider the fixed rate portfolio alongside the bank’s hedging strategy. If the bank has hedged their fixed rate exposure to small changes in interest rates, the NII would remain relatively stable (immunised against small changes).
Credit losses is expected to subdue, increasing the risk-adjusted NII
Economic downturn
During economic downturn, it is expected that inflation decrease due to redcued consumer income and spending. As result, the reserve bank decreases the risk-free reference rate by means of quantitative easing
Due to reduced consumer spending, credit origination is expected to decrease thus it is expected that the NII generated by the bank will decrease. Due to the shrinking economy, it can be assumed that income is decreasing and unemployment increasing.
This reduces the credit target market and demand for credit
The banks profit is expected to decrease, and so it retained earnings. Retained earings is used as CET1 capital, which decreases the capital supply to the bank allowing additional risk to be taken on.
The reserve bank decrease risk-free rate to maintain inflation levels within a certain target. The impact can be assessed by slitting the portfolio into floating rate assets and fixed rate assets.
Floating rate assets during an economic downturn
Banks funded by floating rate instruments wouldn’t feel an impact, apart from differences in the re-pricing characteristics of the bank’s floating asset and liabilities. When interest rates decrease, banks tend to reprice much faster, the reprice would still lag the reprice on assets and thus lead to a slight decrease in NII
Fixed rate assets during an economic downturn
Consider the fixed rate portfolio alongside the bank’s hedging strategy. If the bank has hedged their fixed rate exposure to small changes in interest rates, the NII would remain relatively stable (immunised against small changes).
Credit losses is expected to increase, increasing the risk-adjusted NII
NII Sensitivity
NII Sensitivity=((Repricing Gap×Remaining time repriced position×Δ interest Rate))/12
