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Indian Banking Today & Tomorrow - Risk
Assessment & Risk Management
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Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's financial condition. The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term impact of changing interest rates is on the bank's networth since the economic value of a bank's assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. The interest rate risk when viewed from these two perspectives is known as 'earnings perspective' and 'economic value' perspective, respectively. Management of interest rate risk aims at capturing the risks arising from the maturity and repricing mismatches and is measured both from the earnings and economic value perspective. Earnings perspective involves analysing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference between the total interest income and the total interest expense. Economic Value perspectiv involves analysing the changes of impact og interest on the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off-balance sheet items. It focuses on the risk to networth arising from all repricing mismatches and other interest rate sensitive positions. The economic value perspective identifies risk arising from long-term interest rate gaps. The management of Interest Rate Risk should be one of the critical components of market risk management in banks. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. Deregulation of interest rates has, however, exposed them to the adverse impacts of interest rate risk. The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities), expose bank's NII or NIM to variations. The earning of assets and the cost of liabilities are now closely related to market interest rate volatility Generally, the approach towards measurement and hedging of IRR varies with the segmentation of the balance sheet. In a well functioning risk management system, banks broadly position their balance sheet into Trading and Banking Books. While the assets in the trading book are held primarily for generating profit on short-term differences in prices/yields, the banking book comprises assets and liabilities, which are contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity. Thus, while the price risk is
The top management of banks should lay down policies with regard to volume, maximum maturity, holding period, duration, stop loss, defeasance period, rating standards, etc. for classifying securities in the trading book. While the securities held in the trading book should ideally be marked to market on a daily basis, the potential price risk to changes in market risk factors should be estimated through internally developed Value at Risk (VaR) models. The VaR method is employed to assess potential loss that could crystallise on trading position or portfolio due to variations in market interest rates and prices, using a given confidence level, usually 95% to 99%, within a defined period of time. The VaR method should incorporate the market factors against which the market value of the trading position is exposed. The top management should put in place bank-wide VaR exposure limits to the trading portfolio (including forex and gold positions, derivative products, etc.) which is then disaggregated across different desks and departments. The loss making tolerance level should also be stipulated to ensure that potential impact on earnings is managed within acceptable limits. The potential loss in Present Value Basis Points should be matched by the Middle Office on a daily basis vis-à-vis the prudential limits stipulated (see section 2.5 for mandatory risk limits). The advantage of using VaR is that it is comparable across products, desks and Departments and it can be validated through 'back testing'. However, VaR models require the use of extensive historical data to estimate future volatility. VaR model also may not give good results in extreme volatile conditions or outlier events and stress test has to be employed to complement VaR. The stress tests provide management a view on the potential impact of large size market movements and also attempt to estimate the size of potential losses due to stress events, which occur in the 'tails of the loss distribution. Banks may also undertake scenario analysis with specific possible stress situations (recently experienced in some countries) by linking hypothetical, simultaneous and related changes in multiple risk factors present in the trading portfolio to determine the impact of moves on the rest of the portfolio. VaR models could also be modified to reflect liquidity risk differences observed across assets over time. International banks are now estimating Liquidity adjusted Value at Risk (LaVaR) by assuming variable time horizons based on position size and relative turnover. In an environment where VaR is difficult to estimate for lack of data, non-statistical concepts such as stop loss and gross/net positions can be used. The changes in market interest rates have earnings and economic value impacts on the bank's banking book. Thus, given the complexity and range of balance sheet products, banks should have IRR measurement systems that assess the effects of the rate changes on both earnings and economic value. The variety of techniques ranges from simple maturity (fixed rate) and repricing (floating rate) gaps and duration gaps to static simulation, based on current on-and-off-balance sheet positions, to highly sophisticated dynamic modelling techniques that incorporate assumptions on behavioural pattern of assets, liabilities and off-balance sheet items and can easily capture the full range of exposures against basis risk, embedded option risk, yield curve risk, etc. However, there are certain rigidities at micro level of banks and also at the systemic level, which the banks have to address. At the micro level, the banks have to strengthen their Management Information System (MIS) and computer processing capabilities for accurate measurement of interest rate risk in their banking books, which impact, in the short-term, their net interest income (NII) or net interest margin (NIM) or "spread" and in the long-term, the economic value of the bank. At the systemic level, the rigidities are the following:
The RBI has taken a number of measures to correct the systemic rigidities, like introduction of:
In order to align the Indian accounting standards with the international best practices and taking into consideration the evolving international developments, the norms for classification and valuation of investments have been modified with effect from September 30, 2000. Now, the entire investment portfolio is required to be classified under three categories, viz., Held to Maturity, Available for Sale, Held for Trading. While the securities 'Held for Trading' and 'Available for Sale' should be marked to market periodically, the securities 'Held to Maturity', which should not exceed 25% of the total investments need not be marked to market. The Narasimham Committee II on Banking Sector Reforms had recommended that in order to capture market risk in the investment portfolio, a risk-weight of 5% should be applied for Government and other approved securities for the purpose of capital adequacy. The Reserve Bank of India has prescribed 2.5% risk-weight for capital adequacy for market risk on SLR and non-SLR securities, with effect from 31 March 2000 and 2001 respectively, in addition to appropriate risk-weights for credit risk. It may be mentioned here that the Basle Committee on Banking Supervision (BCBS) of the Bank for International Settlements (BIS) has introduced capital charge for market risk, inter alia, for the interest rate related instruments and equity positions in the trading book and gold and forex position in both trading and banking books. The banks in India are required to apply the 2.5% risk-weight for capital charge for market risk for the whole investment portfolio and 100% risk-weight on open gold and forex position limits. In the "New Capital Adequacy Framework" consultative paper, the BCBS recognises the significance of interest rate risk in some banking books and proposes to develop a capital charge for interest rate risk in the banking book for banks where interest rate risks are significantly above average ("outliers"). (The proposed Basel Capital Accord is separately covered in Chapter 7 and annexure) Internationally banks use VaR models for management of equity position risk. The banks should devise specific price risk structure (like sensitivity limits, VAR, stop-loss limits) and the methods to measure liquidity of shares to mitigate equity position risk. |
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