1. UNIT IV
RISKS IN BANKING
Anubha Srivastava, M.Com, Ph.D, UGC NET,
CertIFR(ACCA)
2. Points to discuss
Introduction to Interest Rate Risk and Liquidity Management
IRR- Objectives, sources, Types,
RBIs ALM guidelines
Measuring IRR with GAP Analysis,
1. Maturity GA
2. Rate Sensitive Gap
3. Duration GAP Concepts,
4. Macaulay Duration & Modified Duration
3. Concept and Objective
■ Concept
– Risks faced due to mismatch between Assets and Liabilities
– Matching differences between future cash inflows and outflows (Assets and
Liabilities)
■ Maturity
■ Interest rate sensitivities
■ Objective
– Framework used to measure, manage and monitor financial risks
■ Interest Rate Risk
■ Liquidity Risk
■ Credit Risk
■ Currency Risk
4. Interest Rate Risk
■ Interest rate risk is the risk where changes in market interest rates might adversely affect
a bank's financial condition. Changes in interest rates affect both the current earnings
(earnings perspective) as also the net worth of the bank. The risk from the earnings'
perspective can be measured as changes in the Net Interest Income (Nil) or Net Interest
Margin (NIM). An asset or liability is normally classified as rate sensitive if:
i) within the time interval under consideration, there is a cash flow;
ii) the interest rate resets/reprices contractually during the interval;
5. Types of Interest Rate Risk
■ Gap or Mismatch Risk- A gap or mismatch risk arises from holding assets and liabilities and off-
balance sheet items with different principal amounts, maturity dates or repricing dates, thereby
creating exposure to unexpected changes in the level of market interest rates.
■ Basis Risk- Market interest rates of various instruments seldom change by the same degree during
a given period of time. The risk that the interest rate of different assets, liabilities and off-balance
sheet items may change in different magnitude is termed as basis risk. The degree of basis risk is
fairly high in respect of banks that create composite assets out of composite liabilities. The Loan
book in India is funded out of a composite liability portfolio and is exposed to a considerable degree
of basis risk.
■ Embedded Option Risk- Significant changes in market interest rates create another source of risk to
banks’ profitability by encouraging prepayment of cash credit/demand loans/term loans and/or
premature withdrawal of term deposits before their stated maturities. The embedded option risk is
becoming a reality in India and is experienced in volatile situations. The faster and higher the
magnitude of changes in interest rate, the greater will be the embedded option risk to the banks’
NII. Thus, banks should evolve scientific techniques to estimate the probable embedded options
and adjust the Gap statements (Liquidity and Interest Rate Sensitivity) to realistically estimate the
risk profiles in their balance sheet.
6. Cont..
■ Yield Curve Risk- In a floating interest rate scenario, banks may price their assets and
liabilities based on different benchmarks, i.e. TBs yields, fixed deposit rates, MIBOR, etc. In
case the banks use two different instruments maturing at different time horizon for pricing
their assets and liabilities, any non-parallel movements in yield curves would affect the NII.
The movements in yield curve are rather frequent when the economy moves through
business cycles.
7. Liquidity Management
Bank’s liquidity management is the process of generating funds to meet
contractual or relationship obligations at reasonable prices at all times.
New loan demands, existing commitments, and deposit withdrawals are
the basic contractual or relationship obligations that a bank must meet.
8. Adequacy of liquidity position for a bank
Analysis of following factors throw light on a bank’s adequacy of
liquidity position:
a. Historical Funding requirement
b. Current liquidity position
c. Anticipated future funding needs
d. Sources of funds
e. Options for reducing funding needs
f. Present and anticipated asset quality
g. Present and future earning capacity and
9. Funding Avenues
To satisfy funding needs, a bank must perform one or a
combination of the following:
a. Dispose off liquid assets
b. Increase short term borrowings
d. Increase liability of a term nature
e. Increase Capital funds
10. Types of Liquidity Risk
■ Liquidity Exposure can stem from both internally and
externally.
■ External liquidity risks can be geographic, systemic or
instrument specific.
■ Internal liquidity risk relates largely to perceptions of an
institution in its various markets: local, regional, national or
international
11. Assets Liability Management
It is a dynamic process of Planning,
Organizing & Controlling of Assets &
Liabilities- their volumes, mixes, maturities,
yields and costs in order to maintain liquidity
and NII.
12. Purpose & Objective of ALM
An effective Asset Liability Management Technique aims to manage the
volume, mix, maturity, rate sensitivity, quality and liquidity of assets and
liabilities as a whole so as to attain a predetermined acceptable risk/reward
ration.
It is aimed to stabilize short-term profits, long-term earnings and long-term
substance of the bank. The parameters for stabilizing ALM system are:
1. Net Interest Income (NII)
2. Net Interest Margin (NIM)
13. Practice question on NIM
■ First National Bank of Bannerville has posted interest revenues of $63 million and interest
costs from all of its borrowings of $42 million. If this bank possesses $700 million in total
earning assets, what is First National’s net interest margin? Suppose the bank’s interest
revenues and interest costs double, while its earning assets increase by 50 percent. What
will happen to its net interest margin?
14. Practice question on NII
■ If a credit union’s net interest margin, which was 2.50 percent, increases 15
percent and its total assets, which stood originally at $625 million, rise by 20
percent, what change will occur in the bank's net interest income?
15. Sensitivity of NII to respective Gaps
Gap Interest rate Change Impact on NII
Positive Increases Increase
Positive Decreases Decrease
Negative Increases Decrease
Negative Decreases Increase
16. Techniques for calculation of IRR
GAPAnalysis-
Maturity Gap Analysis
Rate Sensitive Gap
Duration GAP Concepts,
Macaulay Duration & Modified Duration
17. RBI DIRECTIVES for Gap Analysis
■ Issued draft guidelines on 10th Sept’98.
■ Final guidelines issued on 10th Feb’99 for implementation of ALM w.e.f.
01.04.99.
■ To begin with 60% of asset &liabilities will be covered; 100% from
01.04.2000.
■ Initially Gap Analysis to be applied in the first stage of implementation.
■ Disclosure to Balance Sheet on maturity pattern on Deposits, Borrowings,
Investment & Advances w.e.f. 31.03.01
The Gap Report should be generated by grouping rate sensitive liabilities, assets
and off balance sheet positions into time buckets according to residual maturity
or next repricing period, whichever is earlier. The difficult task in Gap analysis is
determining rate sensitivity. All investments, advances, deposits, borrowings,
purchased funds etc. that mature/reprice within a specified timeframe are
interest rate sensitive.
18. Maturity Gap Analysis
The simplest analytical techniques for calculation of IRR exposure
begins with maturity Gap analysis that distributes interest rate
sensitive assets, liabilities and off-balance sheet positions into a
certain number of pre-defined time-bands according to their
maturity (fixed rate) or time remaining for their next repricing
(floating rate).
19. Maturity Gap Analysis
All Assets & Liabilities to be reported as per their maturity profile
into 8 maturity Buckets:
i. 1 to 14 days
ii. 15 to 28 days
iii. 29 days and up to 3 months
iv. Over 3 months and up to 6 months
v. Over 6 months and up to 1 year
vi. Over 1 year and up to 3 years
vii. Over 3 years and up to 5 years
viii. Over 5 years
20. EXAMPLE
1-14Days
15-28
Days
30 Days-
3 Month
3 Mths -
6 Mths
6 Mths -
1Year
1Year - 3
Years
3 Years -
5 Years
Over 5
Years Total
Capital 200 200
Liab-fixed Int 300 200 200 600 600 300 200 200 2600
Liab-floating Int 350 400 350 450 500 450 450 450 3400
Others 50 50 0 200 300
Total outflow/ 700 650 550 1050 1100 750 650 1050 6500
Investments 200 150 250 250 300 100 350 900 2500
Loans-fixed Int 50 50 0 100 150 50 100 100 600
Loans - floating int 200 150 200 150 150 150 50 50 1100
Loans BPLR Linked 100 150 200 500 350 500 100 100 2000
Others 50 50 0 0 0 0 0 200 300
Total Inflow 600 550 650 1000 950 800 600 1350 6500
Gap -100 -100 100 -50 -150 50 -50 300 0
Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0
Gap % to Total Outflow
-14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57
21. Cont
■ Places all cash inflows and outflows in the maturity ladder as
per residual maturity
■ Maturing Liability: cash outflow
■ Maturing Assets : Cash Inflow
■ Classified in to 8 time buckets
■ Mismatches in the first two buckets not to exceed 20% of
outflows
■ Banks can fix higher tolerance level for other maturity buckets.
23. ADDRESSING THE MISMATCHES
■ Mismatches can be positive or negative
■ Positive Mismatch: M.A.>M.L. and Negative Mismatch
M.L.>M.A.
■ In case of +ve mismatch, excess liquidity can be deployed in
money market instruments, creating new assets &
investment swaps etc.
■ For –ve mismatch,it can be financed from market borrowings
(Call/Term), & deployment of foreign currency converted into
rupee.
24. Rate Sensitive Gap
Generated by grouping RSA,RSL & OFF-Balance sheet items in
to various (8)time buckets.
RSA:
■ MONEY AT CALL
■ ADVANCES
■ INVESTMENT
RSL
■ DEPOSITS
■ BORROWINGS
25. Practice question with answer
■ Calculate the repricing gap and the impact on net interest income of a 1 percent increase
in interest rates for each of the following positions:
• Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million.
• Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150 million.
• Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140 million.
1. Calculate the impact on net interest income on each of the above situations assuming a
1 percent decrease in interest rates.
2. What conclusion can you draw about the repricing model from these results?
26. Answer
1- Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million.
Repricing gap = RSA - RSL = $200 - $100 million = +$100 million.
NII = ($100 million)(.01) = +$1.0 million, or $1,000,000.
2- Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150 million.
Repricing gap = RSA - RSL = $100 - $150 million = -$50 million.
NII = (-$50 million)(.01) = -$0.5 million, or -$500,000.
3-Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140 million.
Repricing gap = RSA - RSL = $150 - $140 million = +$10 million.
NII = ($10 million)(.01) = +$0.1 million, or $100,000.
27. Cont..
■ THREE OPTIONS:
■ A) RSA>RSL= Positive Gap
■ B) RSL>RSA= Negative Gap
■ C) RSL=RSA= Zero Gap
28. Duration Gap Analysis
Matching the duration of assets and liabilities, instead of matching the maturity
or repricing dates is the most effective way to protect the economic values of
banks from exposure to IRR than the simple gap model. Duration gap model
focuses on managing economic value of banks by recognising the change in the
market value of assets, liabilities and off-balance sheet (OBS) items. When
weighted assets and liabilities duration are matched, market interest rate
movements would have almost same impact on assets, liabilities, thereby
protecting the bank’s total equity or net worth
29. Practice question with answer
Blue Moon National Bank holds assets and liabilities whose average durations and dollar amounts are
as shown in this table:
What is the weighted average duration of New Phase’s asset portfolio and liability portfolio? What is
the leverage-adjusted duration gap?
31. Macaulay Duration & Modified Duration
■ Macaulay duration is the is the weighted average term to maturity of
the cash flows from a bond.
32. Practice question with answer
■ Consider a 12-year, 12 percent annual coupon bond with a required return of 10
percent. The bond has a face value of $1,000.
■ a. What is the price of the bond?
■ b. If interest rates rise to 11 percent, what is the price of the bond?
■ c. What has been the percentage change in price?
■ d. Repeat parts (a), (b), and (c) for a 16-year bond
■ e. What do the respective changes in bond prices indicate?
Modified duration is a bond's price sensitivity to changes in interest rates.
34. SUCCESS OF ALM IN BANKS :
PRE - CONDITIONS
1. Awareness for ALM in the Bank staff at all
levels–supportive Management & dedicated
Teams.
2. Method of reporting data from Branches/ other
Departments. (Strong MIS).
3. Computerization-Full computerization,
networking.
4. Insight into the banking operations, economic
forecasting, computerization, investment,
credit.
5. Linking up ALM to future Risk Management
Strategies.
