Interest rate risk

Definition

Interest rate risk is the risk of expected earnings being influenced negatively as a result of changes in the pattern and level of interest rates. As discussed earlier, banks are intermediaries between lenders and borrowers and their liabilities and assets are not matched in terms of tenor (term to maturity) and interest rate type (fixed or floating), because the lenders have different requirements to the borrowers. The raison d'être of banks is to accommodate lenders and borrowers. They are thus exposed to interest rate risk.

There are three elements to interest rate risk:

• The bank margin. Banks endeavour to get highest rates they can negotiate on assets (MD and NMD), and the lowest rates they can negotiate on liabilities (deposits and loans); the difference between these is the bank margin.

• The interest rates are either floating (variable) or fixed.

• The term to maturity (tenor) of the fixed rate assets and liabilities.

Let us examine the meaning of floating / fixed rates and their significance in banking:

• Floating means that the rates are reprised frequently, and the accepted definition of floating is call (one day) to three months. Examples:

- Liabilities:

- A call deposit at the call deposit rate - the rate can change daily (it does not but it can).

- A deposit taken for 12 months at KIR23+0.3% - the rate is reprised every 91 days at the then prevailing KIR+0.3%.

- Assets:

- An overdraft facility at prime rate (PR) - like the call deposit rate, the rate can change daily, but it does not.

- Mortgage for 20 years at PR-0.5% - immediately above applies.

• Fixed means that the rate is fixed for the term. Examples:

- Liabilities:

- A 12-month deposit at 8% pa.

- Assets:

- A 24-months loan to Mr A at 12% pa.

- A 30-year government bond at 9.35% pa.

Figure 2: yield curve shift

Allow us to present an example (see Figure 2: YCGB = yield curve24 for government bonds; YCGB 1 = now and YCGB 2 = one-year later): if a bank buys a 20-year tenor bond now at 9.35% pa, and funds it with call money deposits at a current rate of 8.4% pa, the gross25 margin is 0.95%, and interest rate risk is high. If after a year, the yield curve has shifted to the YCGB 2 position, the margin has disappeared: the rate on the bond remains at 9.35% for 20 years, and the call money rate rose to 9.4%. (It will be evident that there are also other risks at play here: liquidity risk and market risk.)

Similarly, if a bank provides an overdraft facility at PR now (and it is used) and funds it with a 2-year fixed deposit, it is facing interest rate risk: the margin will be wiped out if interest rates decline sharply in the near future. The funding rate is fixed, while the asset rate is floating.

Ideal and extreme portfolios

Ideally, a bank would like to match liabilities and assets in terms of tenor, and have the rates on both sides being either fixed or floating, or a matched combination (see Figure 3; variable = floating), and thus enjoy a fixed margin without any interest rate risk.

Figure 3: interest rate repricing gap analysis

This seems to be an obvious statement, but in it lurks a problem: floating means call to 3 months, and fixed means 3 months to 20+ years. Therefore, if a bank funds a 20-year tenor fixed-rate bond with a fixed deposit of 4 months at a fixed rate, it still has interest rate risk. Banks are (usually) acutely aware of this and solve the problem with their risk management techniques outlined below, the most important one being the time band repricing gap analysis (which is a more detailed analysis than the one indicated in Figure 3 - see later).

But this is not possible: inevitably some of their liabilities will be of a maturity that is different from the maturity of their assets, and banks are also not able to have the rates on both sides either fixed or floating. Before we discuss this in more detail, we present the extreme cases of interest rate risk.

Figure 4: expectation = rates will fall

Figure 4 presents the extreme case of all liabilities = VRL and all assets = FRA. This portfolio construct represents the view that interest rates are about to fall. As interest rates fall, the asset rates do not change (because they are fixed rates), but the liabilities are re-priced frequently.

Figure 5: expectation = rates will rise

Figure 5 presents the extreme case of all liabilities = FRL and all assets = VRA. This portfolio construct represents the view that interest rates are about to rise. As interest rates rise, the rates on liabilities do not change, and the rates on assets are re-priced frequently.

If the interest rate expectations in these two examples are correct, the shareholders will be in high spirits (and the bonuses high). However, these portfolio constructs are extremely risky. If interest rates move in the opposite direction to that forecast, the bank/s will be insolvent within a short period, and depositors will lose much of their money.