Banks need to accept some degree of interest rate risks

Interest rate risk is one of the most critical forms of risk that banks face in their role as financial intermediaries. A sudden fluctuation in the interest rate would cause a decrease in interest income in the short term, while it affects the assets of a company in the long term. By using effective risk management, banks may optimally manage internal funds and debt capacity across periods in order to hold enough funds and be able to exploit lending opportunities as they arise.

From a macroeconomic perspective, the most important interest rates are the ones that the government pays on loans used for financing national debt. There are many other interest rates in a society, like rates for deposits of different types, bank lending rates of different types, bond rates etc.; and all interest rates are visibly correlated, if market mechanism works.

Monetary policy is the major driver of interest rates. The policy has a direct effect here because central banks tend to act upon those rates. They do so by setting their own discount rate and by lending or borrowing on such maturities.

Public deficits are normally financed through debts. The government debt tends to be spread over all maturities, and higher deficits tend to raise the term structure of rates.

For managing foreign currencies, the differentials between interest rates across countries make investing in interest rate instruments relatively more or less attractive.

For reducing the pressure on depreciation of the home currency, the central bank can increase interest rates - thereby making lending in the home currency more attractive than in foreign currencies.

The fundamentals of the economy also play a role - the better these are, the lower the interest rates should be. Expectations are a major driving force. The yield curve is a very good indicator of interest rate that represents the relationship between short and long-term interest rates, and serves a number of purposes for market analysts; it also plays a role as a predictor.

All lenders and borrowers, whether at fixed or variable rates, are exposed to interest rate risks. Lending or borrowing at a fixed rate reduces the uncertainty on interest cost or revenue, but does not eliminate interest rate risk. A lender at a fixed rate faces a risk of rates going up, in which case the lender has an 'opportunity' cost - the cost of not lending at a higher rate. The converse holds for a borrower on a fixed rate; should interest rates decline, the borrower would be better off by borrowing at lower rates. It is to be noted that, for forecasted future exposures, such as future inflows or outflows, the exposures are identical to floating rate exposures because the future interest rate is uncertain, whether it is fixed or variable.

Fundamental changes in the regulatory and market environment also make interest rate risk a vital issue.

Banks encounter interest rate risk in several ways. The primary source of interest rate risk stems from timing differences in the re-pricing of bank assets, liabilities and off-balance-sheet instruments. These re-pricing mismatches generally occur from either borrowing short-term for funding long-term assets, or borrowing long-term for funding short-term assets.  Another important source of interest rate risk arises from imperfect correlation in the adjustment of rates earned and paid on different instruments having otherwise similar re-pricing characteristics. When interest rates change, these differences can give rise to unexpected changes in the cash flows and earnings spread among assets, liabilities and off-balance-sheet instruments of similar maturities or re-pricing frequencies.

An additional and increasingly important source of interest rate risk is the presence of options in many bank assets, liabilities and off-balance-sheet portfolios. Instruments with embedded options include various types of bonds and notes with call or put provisions, loans such as residential mortgages that give borrowers the right to prepay balances without penalty, and various types of deposit products that give depositors the right to withdraw funds at any time without penalty. If not adequately managed, options can pose significant risks to a banking institution, as the options held by bank customers are generally exercised for the advantage of the holder.

It is essential that banks accept some degree of interest rate risk. However, for a bank to earn profit consistently from changes in interest rates, the ability to forecast interest rates better than the rest of the market is required. The challenge for banks is not only to forecast interest rate risk, but also to measure and manage it in such a way that the compensation they receive is adequate for the risks they shoulder.

To measure and manage interest rate risks, various instruments from gap management to derivative, can be used. A traditional measure of interest rate risk is the maturity gap between assets and liabilities, which is based on the re-pricing interval of each component of the balance sheet. Duration can also be used and is usually presented as an account's weighted average time for re-pricing, where the weights are discounted components of cash flow. Some banks simulate the impact of various risk scenarios on their portfolios. In other words, simulation analysis involves the modelling of changes in the bank's profitability and value under alternative interest rate scenarios.

These measures of interest rate risk, while convenient, provide rough approximations at best; in addition, derivatives must be used. The relatively recent ways of measuring and managing interest rate risks in financial theory, increased computerisation, changes in the foreign exchange, credit and capital markets over time, have contributed to the growth of financial derivatives.

Availability of benchmark rate is crucial for better interest rate risk management. Interest rate benchmarks play a key role in the financial system, the banking system and the economy. They are used by a variety of agents, ranging from banks that provide credit to businesses and households to derivatives-market makers. And, market-based interest rate is an important component for benchmark rate and for enabling market allocation of resources. Interest rate also serves as a benchmark for pricing many other financial products. Market-based interest rate reform should, therefore, reflect financial institutions' autonomy to price their products.

Dr. Shah Md. Ahsan Habib is Professor and Director (Training), Bangladesh Institute of Bank Management (BIBM). [email protected]