If both lending and borrowing rates are reduced, but differently for different time frames, its impact should be captured which may affect a bank adversely through reduced interest income and increased interest expense. Change in interest rate also affects the assets, liabilities and off-balance sheet items because present value of future cash flow changes when interest rate changes.

There are two common perspectives of appreciating interest rate risk

(a) earning perspective and

(b) economic value perspective. Earning perspective focuses on the impact of intrest rate change on a bank's short-term earnings, whereas economic perspective focuses on underlying market value.

In an earning perspective, focus is on theimpact of interest rate change on bank's accrual or reported earnings. Many banks take earning perspective because reduced earning or loss may threaten the financial stability of an institution by undermining capital adequacy, by shaking market confidence, and by weakening liquidity.

So in earning perspective, emphasis is on analysis of impact of interest rate change on net interest income - difference between interest income and interest expense. However, some non-interest income also becomes sensitive to interest rate volatility. In lease financing or loan syndication processing fee charged is sensitive to interest rate change.

In economic perspective, focus is on the impact of interest rate change on the economic value of assets, liabilities and off-balance sheet items of a bank. Economic value of an asset or liability is given by present value of the underlying future cash flow. By extension of this basic valuation principle, economic value of a bank may be viewed as present value of net expected cashflows. Thus, through a market value balance sheet it is possible to observe the impact of interest rate change on the bank's equity.

Earning perspective provides simplest technique of measurement of interest rate risk. Under this approach, interest rate sensitive assets, liabilities and OBS items of a bank are classified into a certain number of predetermined time bands according to their maturity (if fixed rate) or time remaining for next repricing (if floating rate). Certain items may lack definitive repricing intervals. These are classified on the basis of experience and judgement. In its latest asset-liability management guidelines, RBI has adopted an earning perspective of interest rate risk management to start with.

Gap analysis technique is used to capture the earning effect of interest rate change. For this, all assets and liabilities are classified into rate sensitive and non-sensitive categories. Capital, reserve and surplus, investment in shares, cash balance etc are not rate sensitive.Deposits, loans and advances are rate sensitive. Rate sensitiveness is not simply determined in terms of maturity of rate sensitive assets and liabilities. It is guided by repricing schedule of flexible rate assets and liabilities.

The RBI circular suggests to place rate sensitive assets and liabilities into seven time buckets. (i) 1-28 days, (ii) 29 days and up to three months, (iii) over three months and up to six months, (iv) Over six months and up to one year, (v) Over one year and up to three years, (vi) Over three years and up to five years and (vii) Over five years. The difference between rate sensitive liabilities over rate sensitive assets is called gap, which may be positive or negative.

It is expected that gap analysis will capture the effect of interest rate change. If lending rate decreases by 100 basis point in response to cut in the borrowing rate by 50 basis point, in a particular time bucket the bank management would be in a position to capture the impact of this adverse rate movement onits income.

But gap analysis technique ignores the possibility of prepayment in response to interest rate war waged in the banking sector. Even SBI attempted to attract new borrowers in the mortgaged market offering lower rate. If the borrowers retire the old mortgage loan taken from another bank and switch over to a lower rate loan, prepayment penalty may not cover the interest rate risk. Even certain foreign banks offered zero prepayment penalty for loan retirement. Rate sensitive assets and liabilities of banks with optionality create a new type of interest rate risk.

FIs throughout the world are using increasingly options embedded instruments. Flexibonds issued by the development financial institutions in India carry maturity options. Many banks are offering flexible fixed deposits, which can be withdrawn at any time without any penalty.

Similarly, loans given by the FIs include pre-payment facility without any penalty. If not adequately management, this pay off characteristics of the optionembedded instruments may cause significant problem for the FI. It may be mentioned that FIs are seller of gthe options in deposit raising as well as lending. Option seller has unlimited risk but limited advantages.

Simple gap analysis is affected by run offs. Run off is defined as periodic cash flow of interest and principal amortisation on long term loans thaet can be reinvested at market rates. So these run offs on assets creates reinvestment risk and run offs on long term liabilities cause refinancing risk. Accordingly, while classification of rate sensitive asset and liabilities, it is necessary to consider the run offs and classify them appropriately to minimise the degree of mismatch.

That apart gap analysis is only a pointer of a gap not a solution of interest rate risks. To find a solution the banks should essentially look into duration matching or any other sophisticated techniques like value at risk.

(The author is senior professor (finance), Indian Institute of Management Technology,Ghaziabad)