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As said above, a bank ideally would like to match liabilities and assets in terms of tenor, and have the interest rates on both sides either fixed or floating (or a matched combination), and thus enjoy a fixed margin. The reality is that the liabilities and assets of banks are not matched in terms of maturity and re-pricing frequency (i.e. fixed or floating). Banks have a variety of liabilities and assets in terms of re-pricing frequency.
Figure 6: interest rate repricing gap analysis
An example is presented in Figure 6. The interest rate gap (IRG) is:
IRG = VRL - VRA
= LCC 800 billion - LCC 600 billion = LCC 200 billion.
It will be clear that the bank's margin (which can also be called a net interest margin) is at risk. Because VRL > VRA, meaning the bank has more variable rate liabilities (also aptly called interest-sensitive liabilities) than variable rate assets (interest-sensitive assets), if interest rates in general rise, the bank has to reprice the "gap", i.e. LCC 200 million of liabilities (that does not have a counterpart asset) at increasing rates. Obviously, LCC 600 million of the VRL is matched by the LCC 600 million VRA, and the rates on both will move up together. It should also be clear that if rates fall, the bank would achieve financially (the NIM will increase), in that LCC 200 million of unmatched liabilities are repriced at decreasing rates.
• If banks have excess FRA, they are vulnerable to rising interest rates.
• If banks have excess FRL, they are vulnerable to falling rates.
Management of interest rate risk
In essence, banks have two options in terms of managing interest rate risk:
• "Physically" change the nature of their liabilities and assets according to their risk appetite, i.e. only do the business that suits the risk profile of the bank.
• Make use of money market and other derivative instruments to change the nature of their liabilities and assets according to their risk appetite.
The first option is not an option because banks are in the business of gathering in clients and retaining their business by doing the business that the clients wish to do. In most countries the banks make use of the second option, i.e. use the derivatives markets to change the profile of their assets and liabilities. The main instruments used are:
• Interest rate swaps.
• Interest rate caps and floors (and collars).
• Forward rate agreements.
• Interest rate forwards.
• Interest rate futures and options on these futures.
• Options on spot market instruments.
• Swaptions (i.e. options on interest rate swaps).
• Repurchase agreements.
The management of interest rate risk cannot take place without the bank being able to measure the risk. There are two main measures of interest rate risk:
• Interest rate repricing gap analysis.
• Duration analysis.
Interest rate repricing gap analysis
Let us take the example of one bank (the bank and the currency are not disclosed, but it is a true example). This analysis shows that despite the existence of fixed and floating rates, and flexibility of tenor for clients, the bank has managed to keep interest rate risk at a low level. The majority of deposits and assets are in the call to 3-month time band, and the mismatch is small. The total mismatch is only 6% of total assets. Note that the bank may have also engineered (with the use of derivatives) a given portfolio to this preferred portfolio, which is in harmony with its interest rate view.
Table 1: interest rate repricing gap analysis (LCC millions)
Banks are required to submit to the regulator (usually the central bank) a monthly return setting out information pertaining to interest rate risk. One central bank's26 return states that its purpose is to determine:
"(i) the repricing gap between assets and liabilities before and after the impact of derivative instruments are taken into account; (ii) the expected cumulative impact on net interest income resulting from a two per cent increase in lending rates from existing levels with a correlated change in funding rates, before and after the impact of derivative instruments are taken into account; and (iii) the expected level of selected key interest rates"
Duration is a measure of the price elasticity of an asset or liability with respect to a change in interest rates. It is the ratio of the present value of the cash flows, weighted by dates, to the market value. Put differently, it is the weighted average maturity of future discounted flows, using the ratio of the present value of each flow to the present value of all flows for the different dates. A space constraint prevents further detailed discussion here.