This document provides an overview of interest rate risk management. It discusses the essentials of interest rate risk, sources of interest rate risk such as gap risk and basis risk, effects of interest rate risk on earnings and economic value, techniques for measuring interest rate risk including repricing schedules, gap analysis, and duration, strategies for controlling interest rate risk like reducing asset or liability sensitivity, controls and supervision of interest rate risk management practices, and sound interest rate risk management practices including board oversight and defined roles and responsibilities. The document is from a study guide on interest rate risk management for the CAIIB exam.

1. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Interest Rate Risk Management
Module D: Balance Sheet Management

2. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
CAIIB – SUPER NOTES
Bank Financial Management: Interest Rate Risk Management

3. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Contents
Coverage:
1. Essentials of Interest Rate Risk
2. Sources of Interest Rate Risk
3. Effects of Interest Rate Risk
4. Measurement of Interest Rate Risk
5. Interest Rate Risk Measurement Techniques
6. Strategies for controlling Interest Rate Risk
7. Controls and supervision of Interest Rate
Risk Management
8. Sound Interest Rate Risk Management
Practices

4. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
ESSENTIALS OF INTEREST RATE RISK
1.

5. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Essentials of Interest Rate Risk
• Interest Rate risk is the exposure of a bank’s financial conditions to
adverse movements in interest rates
• Though this is normal part of banking business, excessive interest
rate risk can pose a significant threat to a bank’s earnings and
capital base
• Changes in interest rates affect
– Bank’s earnings by changing its Net Interest Income and level of other
interest sensitive income and operating expenses
– The underlying value of the bank’s assets, liabilities and off-balance-sheet
instruments

6. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Interest Rate Risk
• Interest rate risk refers to volatility in Net Interest Income (NII)
or variations in Net Interest Margin(NIM)
• Therefore, an effective risk management process that
maintains interest rate risk within prudent levels is essential
to safety and soundness of the bank

7. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
SOURCES OF INTEREST RATE RISK
2.

8. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Types of Interest Rate Risk
Gap RiskGap Risk
•Arises from
holding assets
and liabilities
with different
principal
amounts,
maturity dates
or repricing
dates
•Bank is asset
sensitive if
assets are
repriced much
more rapidly
than the
liability during
the period
•Liability
sensitive if
interest paid
on its deposit
is reset more
rapidly than
the rate being
charged on
the loan
Basis RiskBasis Risk
•Risk that
interest rates
of different
assets and
liabilities may
change in
different
magnitudes
•Fairly high in
respect of
banks which
create
composite
assets out of
composite
liabilities
Net Interest
Position Risk
Net Interest
Position Risk
•Interest rate
earned on
assets changes
while cost of
funding of
liabilities
remains the
same
Embedded
Option Risk
Embedded
Option Risk
•Prepayment
of loans/bonds
and/or
premature
withdrawal of
deposits
Yield Curve
Risk
Yield Curve
Risk
•Yield of all
maturities of a
particular
investment
Price RiskPrice Risk
•Assets are
sold before
maturity dates
Reinvestment
Risk
Reinvestment
Risk
•Uncertainty
with regard to
interest rate at
which the
future cash
flows can be
reinvested

9. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
EFFECTS OF INTEREST RATE RISK
3.

10. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Effects of Interest Rate Risk
•Focus is impact of interest rate change on accrual or reported earnings particularly NII
•Traditional approach
Earnings PerspectiveEarnings Perspective
•Impact on Economic value of bank’s assets, liabilities and off balance sheet positions
•A view of the sensitivity of the net worth of the bank to fluctuations in interest rates
•Provides a more comprehensive view since it considers effect on present value of all
future cash flows
Economic PerspectiveEconomic Perspective
•Impact of past interest rates on bank performance
•Gains or losses reflected over time
•Instruments that are not marked to market
Embedded LossesEmbedded Losses

11. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
MEASUREMENT OF INTEREST RATE
RISK
4.

12. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Measurement of Interest Rate Risk
• Before management, risk has to be identified and quantified
• Measurement systems should
– Assess all interest rate risk associated with Bank’s assets, liabilities and
OBS positions
– Utilise generally accepted financial concepts and risk management
techniques
– Have well documented assumptions and parameters

13. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
INTEREST RATE RISK MEASUREMENT
TECHNIQUES
5.

14. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Interest Rate Risk Measurement
Techniques
• Simplest Technique
• Maturity/Repricing Schedule that distributes interest sensitive assets, liabilities and OBS positions into a
certain no of predefined time bands based on maturity or time remaining to next repricing
Repricing SchedulesRepricing Schedules
• When repricing schedules are used to assess the interest rate risk of current earnings
• A negative or liability sensitive gap
• occurs when liabilities exceed assets (RSA<RSL) in given time band
• increase in market interest rates could cause a decline in NII.
• A positive or Asset sensitive gap
• Occurs when assets exceed liabilities (RSA>RSL) in a given time band
• decrease in market interest rates could cause a decline in NII.
Gap AnalysisGap Analysis
• A measure of the percentage change in economic value of a position that will occur given a small change in
the value of interest rates
• Higher duration implies that a given change in the level of interest rates will have a larger impact on economic
value
DurationDuration
• Detailed assessments of the potential effects of changes in interest rates on earnings and economic value by
simulating the future path of interest rates and their impact on cash flows
Simulation ApproachesSimulation Approaches

15. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Shortcomings of GAP Analysis
• Does not take account of variation in characteristics of different
positions within a time band
• Ignores differences in spreads between interest rates due to change
in market interest rates
• Does not take into account changes in timing of payments that
might occur as a result of changes in the interest rate environment
• Only a rough approximation
• Fail to capture variability in non-interest revenue and expenses

16. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Duration based Measurement
• ‘Average’ duration is assumed for positions that fall into each
time band
• Average durations multiplied by assumed change in interest
rates to construct a weight
– Different weights may be used for different positions that fall within a
time band
– Different interest rate changes may also be used
• Weighted gaps are then aggregated across time bands

17. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Shortcomings of Duration approach
• Focus on just one form of interest rate risk exposure -
repricing risk
• Since average durations are used the differences in actual
sensitivity positions arising from differences in coupon rates
and timing of payments will not be reflected
• Risk of options may not be adequately captured

18. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Types of Simulation
• Cash flows arising solely from bank’s current on and off balance sheet positions
are assessed
Static SimulationStatic Simulation
• More detailed assumptions about the future course of interest rates and expected
changes in bank’s business activity over that time
• More sophisticated techniques allow for dynamic interaction of payments streams
and interest rates, and better capture the effect of embedded or explicit options
Dynamic SimulationDynamic Simulation

19. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Additional Issues
• Declines in interest rates result in increasing levels of
prepayments
• Non-maturity deposits may be withdrawn without penalty
• Treatment of positions with embedded options
• Inputs from managerial and business units

20. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
STRATEGIES FOR CONTROLLING
INTEREST RATE RISK
6.

21. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Ways to Reduce Sensitivities
Reduce Asset SensitivityReduce Asset Sensitivity
• Extend investment portfolio
maturities
• Increase floating rate deposits
• Increase fixed rate lending
• Sell floating rate loans
• Increase short term borrowings
• Increase long term lending
Reduce Liability SensitivityReduce Liability Sensitivity
• Reduce investment portfolio
maturities
• Increase floating rate lending
• Increase short term lending
• Increase long term Deposits

22. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Other options available for managing
interest rate risks
• Match long term assets preferably with non-interest bearing
liabilities
• Match repricable assets with similar repricable liabilities
• Use Forward Rate Agreements, Swaps, Options and Financial
Futures to construct synthetic securities
• Sound loaning policies and effective post-sanction monitoring and
recovery steps to contain NPAs
Full match in repricing assets and liabilities is not prudent even if it was feasible.
Appropriate tolerance limits should be placed on interest rate sensitivity gaps.

23. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
CONTROLS AND SUPERVISION OF
INTEREST RATE RISK MANAGEMENT
7.

24. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Effective Internal Control System includes
• A strong control environment
• Adequate process for identifying and evaluating risk
• Establishment of control activities such as policies, procedures and
methodologies
• Adequate information systems
• Continual review of adherence to established policies and
procedures
Banks should have their measurement, monitoring and control functions reviewed on
a regular basis by an independent party

25. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
SOUND INTEREST RATE RISK
MANAGEMENT PRACTICES
8.

26. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Basic Elements
Board and Senior Management oversight of Interest Rate RiskBoard and Senior Management oversight of Interest Rate Risk
Adequate Risk Management policies and proceduresAdequate Risk Management policies and procedures
Appropriate risk measurement, monitoring and control functionsAppropriate risk measurement, monitoring and control functions
Comprehensive internal controls and independent auditsComprehensive internal controls and independent audits

27. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
Roles and Responsibilities
• Approve Strategies and policies
• Ensure action by Senior Management in line with the above
• To be informed regularly of interest rate risk exposure
Board of DirectorsBoard of Directors
• Management of structure of bank’s business and level of interest rate risk
• To ensure that appropriate policies and procedures are established to control and limit the risks
• To ensure that resources are available for evaluating and controlling interest rate risk
• Periodic review of organisation’s interest rate risk management policies and procedures
• Also responsible for maintaining:
• Appropriate limits on risk taking
• Adequate systems and standards for measuring risk
• Standards for valuing positions and measuring performance
• Comprehensive interest rate risk reporting and interest rate risk management
• Review Process
• Effective internal controls
• Should define lines of responsibility and authority for developing strategies, implementing tactics and
conducting the risk measurement and reporting functions of the interest rate risk management
process
Senior ManagementSenior Management

28. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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29. CAIIB – Super-Notes© M S Ahluwalia Sirf Business
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M S Ahluwalia, amongst other things, is a visual artist, blogger,
blog designer and of course an MBA and Banker from New
Delhi, India.
To know more about him you may visit his blog-site: Estudiante De La Vida