Understanding Interest Rate Risk In Banks

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: Interest rate risk is the largest market risk in the banking book. A bank's interest rate risk reflects the extent to which its financial condition is affected by changes in market interest rates. There are two different ways of thinking about such effects when analysing banks' exposure to interest rate risk: the net interest income risk measure and the investment risk measure.

The income risk measure is employed to assess the impact of a change in overall interest rate level to the net interest income from the banking book, whereas the investment risk measure is employed to assess changes in the market value of the trading portfolio (on and off balance sheet items available for sale) in response to interest rate changes.

Various economic forces affect the level and direction of interest rates in the economy. Interest rates typically climb when the economy is growing, and fall during economic downturns. Similarly, rising inflation leads to rising interest rates (although at some point, higher rates themselves become contributors to higher inflation), and moderating inflation leads to lower interest rates. Inflation is one of the most influential forces on interest rates.

Global Interest Rates
We may observe from the chart below that there are mixed trends in the global interest rate scenario. Based on this, we cannot purely correlate Indian interest rate scenario with that of the global markets.

Indian Interest Rate Scenario
Given the precipitous decline in interest rates, the importance of interest rate risk (IRR) management is acute today. The last few years witnessed a falling interest rate regime; interest rates have almost fallen by 5 per cent. Many banks profited handsomely from this drop in interest rates. Since interest rates have now reached a level where it is not easy to ascertain the direction of interest rate movement, it would be interesting to know if the banking system is prepared for further change in interest rate.

A Case of Indian Banks
A study was conducted to quantify the interest rate risk based on the Maturity Gap- Net Interest Income (NII) approach considering public and private sector banks in India on 31 March 2003, based on publicly available information.

Assets and liabilities were classified as per their rate sensitivity, NII for simulated interest rate scenarios were computed. Percentage change observed on NII was imputed on income statement to arrive at impact on profitability.

The study reveals that: