Chapter 7: Interest rate risk Flashcards
Interest Rate Risk
- IRRBB: Interest rate risk in the banking book (IRRBB) refers to the current or potential risk to the bank’s capital and earnings arising from adverse movements in interest rates that affect the bank’s banking book positions.
- Changes in Interest Rates: When interest rates change, the present value of future cashflows change.
- Assets and Liabilities: This in turn changes the underlying value of a bank’s assets, liabilities, and off-balance sheet items and hence its economic value.
- Incomes and Expenses: Changes in interest rates also affect a bank’s earnings by altering interest rate sensitive income and expenses, affecting its net interest income (NII).
- Trading Book: Generally marked-to-market and are subject to different risk management approaches (more around general market risk), with value at risk (VaR) being a key risk metric used.
Forms of IRRBB
GOBY
Gap risk:
* When Assets (loans) do not match Liabilities (funding) in terms of duration or currency.
* Under mismatch, adverse interest rate movements can lead to profitability being reduced or eliminated, and, in extreme situations, losses can arise.
Optionality:
* Risk of a customer exercising their option to pre-pay an outstanding loan when a loan has been match-funded.
* If interest rates fall, the matching assets need to be replaced at a lower rate than the original loan.
Basis risk:
* Assets and Liabilities can be linked to floating rates off different benchmarks (e.g., loans on T-bill rates while funding on LIBOR) or be based on the same floating rate but not change on the same date.
* These rates would not necessarily move by the same magnitude or in the same direction, and can create a risk exposure on the difference
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.
Yield curve theories
LIME
Liquidity Preference Theory:
* Investors prefer liquid assets over illiquid ones.
* Longer-dated bonds are less liquid than shorter dated bonds.
* To compensate for this, the yield on longer dated bonds is higher.
* Upwards sloping at longer terms.
Inflation risk premium theory:
* Investors require a higher return for assets that will be eroded by inflation.
* The certainty over future inflation 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 the supply and demand of investors with liabilities of that term.
* Demand for shorter bonds comes from banks and general insurers.
* Demand for longer-dated bonds comes from life insurers and pensions.
Expectation theory:
* The shape of the yield curve is determined by economic factors that 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 (and vice versa).
Key Benchmark Rates
LIBOR
* London Interbank Offered Rate
* Calculated by polling panels of major global banks as to the rate at which they can borrow from each other for a range of tenors and currencies on the London interbank market.
* The two highest and lowest rates are removed before averaging to create LIBOR
* Being phased out due to manipulation and scandals.
SONIA
* Sterling Overnight Index Average
* One of the big Alternative Reference Rates (ARRs)
* Administered by Bank of England
* Effective overnight interest paid by banks for unsecured transactions in the British Sterling market.
SOFR
* Secured Overnight Financing Rate
* One of the big Alternative Reference Rates (ARRs)
* Based on transactions in the Treasury repurchase market, where investors offer cash to financial institutions in exchange for Treasury securities as collateral.
* Calculated as a volume-weighted median of transaction-level repurchase agreement (repo) rates.
JIBAR
* Johannesburg Interbank Average Rate
* Calculated using contributions from 9 SARB regulated banks.
* Based on 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.
ZARONIA
* South African Rand Overnight Index Average
* Interest rate at which South African banks lend to each other overnight
* Trimmed, volume-weighted average of the interest rates on eligible unsecured overnight deposits
* Backward-looking metric
Methods to Measure Interest Rate Risk
GEES
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, and the resultant NII sensitivities to interest rate changes.
Economic Value Changes:
* NPV of all the cashflows of Assets – Liabilities (both on and off balance sheet banking book)
* Directly assesses the impact of interest rate shifts on the Economic Value of Equity (EVE)
* Consider interest income/expense impact, behavioural impact and discount rate impact.
Shift in Interest Rate:
* 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
* Common test PV01 (aka the Price Value of a Basis Point PVBP) for sensitivity testing
Earnings at Risk (EaR):
* Method that is used to understand how interest rate changes are transmitted to the bank’s NII and future earnings over a specific horizon.
* Repricing gap + NII sensitivity are starting point of this.
* As a final step, stochastic modelling of potential future interest rates (via the Vasicek model) can be used to get interest rates, and then Monte Carl simulations can obtain a distribution of NII changes.
* This can assist in determining an effective VaR for the bank’s NII.
Gap Analysis
- 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 (re-pricing gap = A-L for each 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 Gap Analysis
- Static Snapshot: only gives an estimation of one point in time and doesn’t incorporate future developments in the balance sheet or interest rate environment.
- Parallel Shift Assumption interest rate changes do not always occur across the yield curveas is assumed (yield curve risk ignored)
- General Risks Ignored: Optionality, Credit (diff section, but applicable) and Basis Risks ignored
Net Interest Income (NII)
= Interest Income - Interest Expense
- Interest Income is earned on interest-bearing assets
- Interest Expense is the interest paid on liabilities, that are used to support interest bearing assets
Risk_Adjusted NII = Credit loss adjusted NII - Cost of Capital
Credit loss adjusted NII = NII - (Impairment charge + Write offs)
Net Interest Margin (NIM)
= [Total net interest income]
/ [ Average interest-earning assets]
= ( [Interest received from assets] - [Interest paid on liabilities/deposits] )
/ [ Average interest-earning assets (AIEA)]
…AIEA = 1/2 (Opening + Closing Balance)
Generally used as a profitability indicator to determine how the bank will perform in the long-run
Advantages and Limitations of NIM
PACTAC
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.
* can be used to monitor same bank’s performance over Time .
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.
* Comparison between banks is not always meaningful. This is because the NIM reflects the banks unique profile which depends on activities, strategies and customer base.
NII changes through Economic Growth (p247)
Economic growth…
–> consumer income growth
–> consumer spending growth
–> inflation expected to increase
–> reserve bank increases the risk-free reference rate (repo rate) to maintain inflation levels
–> Floating rate assets wouldn’t feel impact apart from re-pricing characteristics of bank’s floating assets + liabilities
(NII expected to increase over the short term due to pricing delays)
–> Fixed rate assets that have been hedged also wouldn’t feel too much impact, as they’d be immunised against small changes.
–> credit origination expected to increase from greater consumer spending
–> larger credit portfolio
–> larger NII expected
–> larger profit expected
–> larger retained earnings
–> more CET1 capital
–> more risk can be taken on
Credit losses expected to be subdued, and the risk-adjusted NII to increase.
NII Sensitivity
=(Repricing Gap × Remaining Months at Repriced Position× Δ Interest Rate)/12
NII changes through Economic Downturn (p248)
Economic downturn…
–> consumer income reduction
–> consumer spending reduction
–> inflation expected to decrease
–> reserve bank decreases the risk-free reference rate (repo rate) to maintain inflation levels and encourage growth/spending (quantitative easing)
–> Floating rate assets wouldn’t feel impact apart from re-pricing characteristics of bank’s floating assets + liabilities
(NII expected to decrease over the short term due to pricing delays)
–> Fixed rate assets that have been hedged also wouldn’t feel too much impact, as they’d be immunised against small changes.
–> credit origination expected to decrease from reduced consumer spending
–> smaller credit portfolio
–> smaller NII expected
–> smaller profit expected
–> smaller retained earnings
–> less CET1 capital
–> less risk can be taken on
Credit losses expected to be increased, and the risk-adjusted NII to decrease.
Net Interest Spread
= [Average interest rate received on assets] - [Average interest rate paid on deposits]
Risks/Pressures on NII
PLuM
- Change in Portfolio mix
* New clients: Reprice new accounts
* Closure of accounts: Get better rates else where, e.g., fixed rates
* Defaults: Affordability pressure (fixed and variable rate)
* Deaths - Legislative changes / maximum
- interest rate changes affect assets and liabilities differently – Mismatch (Basis, Yield, Gap)
Managing Interest Rate Risk
M PAID
- Asset and Liability Management (matching)
- Pricing strategies (adjust product prices to reflect interest rate risk – better rates to more stable)
- stress testing and scenario Analysis (test capital + earnings and then develop contingency plans)
- Interest rate derivatives (interest rate swaps, forward rate agreements, options)
- Diversification (different mturities and interest rate types)
Drawbacks of Derivative Hedging
- Hedging instruments come at a cost, reducing earnings.
- Behavioural risks arise from hedging, in the form of early redemptions or prepayments, resulting in “naked” hedges which no longer have underlying offsetting exposures and incur a cost to unwind.
Types of Yield Curves
N-FISH
-
Normal (moderately positive slope)
[Lenders require reward for period of uncertainty and illiquidity; borrowers are prepared to pay more for a longer period of protection; expectation of normal economic growth and inflation] -
Steep
[Higher expectations of growth and/or inflation] -
Humped
[Mixed expectations; economy in transition] -
Flat
[Expectations of weak economy and inflation] -
Inverted (negative slope)
[Heightened expectations of weak economy and inflation – possible recession/deflation]
