Banks and interest rate risk

Ila Patnaik
Ajay Shah

Banks and interest rate risk – p. 1/42

Broad issues

Banks and interest rate risk – p. 2/42

Interest rates dropped dramatically...

14 10 years

12

10

10-09-1997 25-05-1998 28-01-1999 05-10-1999 17-06-2000 03-03-2001 10-11-2001 19-07-2002

Time Banks and interest rate risk – p. 3/42

NPV of a bank
We convert assets into cashflows ai and liabilities into
cashflows li . Then:

X
N
ai
A(0) =
i=1
(1 + z(ti ))ti
X
N
li
L(0) =
i=1
(1 + z(ti ))ti

Banks and interest rate risk – p. 4/42

If interest rates went up?
If we get a parallel shift of the yield curve of ∆:

X
N
ai
A(∆) =
i=1
(1 + ∆ + z(ti ))ti
X
N
li
L(∆) =
i=1
(1 + ∆ + z(ti ))ti

The impact upon equity capital is

(A(∆) − A(0)) − (L(∆) − L(0)).

Banks and interest rate risk – p. 5/42

Think NPV, think MTM!
A great deal of confusion comes out of “the earnings
perspective”.
In terms of core economics, we need full MTM of
both assets and liabilities.
In India, banking regulation, and many banking
professionals, do not yet think MTM, do not yet
think NPV.

Banks and interest rate risk – p. 6/42

Problem 1: Reduce a bank into a set
of cashflows

Banks and interest rate risk – p. 7/42

Imputation of cashflows
Life would be very easy if:
1. The banking regulator asked banks to report
cashflows for assets and liabilities in time
buckets, and
2. Made these disclosures public.

Banks and interest rate risk – p. 8/42

Repricing date versus maturity
If a loan to a company is PLR-linked, it’s really six
month maturity, regardless of the loan duration.
Assets and liabilities can be classified by time to
repricing or time to maturity.

Banks and interest rate risk – p. 9/42

“Core versus volatile” demand de-
posits
Technically, savings accounts and current accounts
are maturity 0.
In practice, there is a lot of stability.
One can own some long assets, backed by demand
deposits, and be safe.
How much is core? How much is volatile?

Banks and interest rate risk – p. 10/42

Where we stand in India on disclo-
sure
Banks are required to classify assets by time to
maturity (but not repricing), and show this in the
annual report.
Banks are required to classify assets by time to
repricing, and submit this to RBI, but this is not
publicly released.
NYSE has superior disclosure standards, so ICICI
Bank and HDFC Bank release good data.
There is no attempt at disclosing cashflows.

Banks and interest rate risk – p. 11/42

How to make progress?
Complicated algorithms to impute cashflows out of
public domain disclosure.
500 lines of perl.
See Interest rate risk in the Indian banking system,
by Ila Patnaik and Ajay Shah.

Banks and interest rate risk – p. 12/42

Example of cashflows for SBI
(31/3/2002)
(Rs. crore)
Bucket Assets Liabilities
Zero 12409 34262
0-1mth 41659 8053
1-3mth 18382 5113
3-6mth 21927 7483
6-12mth 87411 15421
1-3yrs 43282 174229
3-5yrs 31882 55414
> 5yrs 80285 9944
Banks and interest rate risk – p. 13/42
Problem 2: What shocks to worry
about?

Banks and interest rate risk – p. 14/42

BIS Proposal
Look at five years of daily data for the long rate.
Compute the time-series of change-over-one-year
Take the 1th and 99th percentile of this distribution.

Banks and interest rate risk – p. 15/42

Using Indian data
The NSE ZCYC database allows us to do this.
We use 1/1/1997 - 31/7/2002.
In India, there are 288 days per year.
The shock to worry about is 320 bps.

Banks and interest rate risk – p. 16/42

One of the world’s highest IR vol

Rank Country Volatility

1 Turkey 32.93
2 Chile 1.74
3 India 1.72
4 Mexico 1.36
5 U.K. 0.91
6 Indonesia 0.88
7 Poland 0.81
8 Philippines 0.77
Source: Baig (2001), IMF Working Paper, out of list of
25 countries.
Banks and interest rate risk – p. 17/42
Method 1: Casual perusal of “gaps”

Banks and interest rate risk – p. 18/42

Look at them:
Note: these are cashflows.
(Rs. crore)
Bucket Assets Liabilities
Zero 12409 34262
0-1mth 41659 8053
1-3mth 18382 5113
3-6mth 21927 7483
6-12mth 87411 15421
1-3yrs 43282 174229
3-5yrs 31882 55414
> 5yrs 80285 9944
Banks and interest rate risk – p. 19/42
Does not get the job done
Is SBI carrying a significant risk?
What would happen if interest rates went up by 320
bps?
Does SBI have enough equity capital to absorb this?
A casual perusal of gaps does not convey the materiality
of mismatches (if any).

Banks and interest rate risk – p. 20/42

Method 2: Measure the NPV impact
of a shock

Banks and interest rate risk – p. 21/42

NPV impact of +320 bps rise in the
spot yield curve
∆E ∆E
Shock ∆A ∆L ∆E E A
(Rs. crore)
200 -11,126 -9,833 -1,294 -8.50 -0.37
320 -17,079 -15,375 -1,704 -11.19 -0.49

By current rules, in a +320 bps shock, SBI would be

forced to recognise -17,079 crore of losses on assets,
but no MTM happens on liabilities.

Banks and interest rate risk – p. 22/42

Method 3: Duration

Banks and interest rate risk – p. 23/42

Fisher-Weil duration
The sensitivity of PV to a parallel shift of λ:

X
N
P (λ) = ci e−(ri +λ)ti
i=0

∂P (λ) X
N
−ri ti
= − t i ci e
∂λ i=0
1 ∂P (λ)
= −DFW
P (0) ∂λ
P
where DFW = ( ti ci e−ri ti )/PV.
Banks and interest rate risk – p. 24/42
Duration is a first order taylor ap-
proximation
For small shocks λ it gives a reasonable prediction
of what will happen to PV.

Banks and interest rate risk – p. 25/42

A bad idea for us
60
Exact
Duration-based
50

40
Impact upon SBI (billion rupees)

30

20

10

-10

-20

-30

-40
-400 -300 -200 -100 0 100 200 Banks
300and interest rate400
risk – p. 26/42
Method 4: The stock market

Banks and interest rate risk – p. 27/42

The standard ‘market model’

(rj − rf ) = α + β1 (rM − rf ) + 
Note: Everything here is returns, not rates.

Banks and interest rate risk – p. 28/42

Re-express the long interest rate as
returns
On the ZCYC, the long rate goes up from r1 on day
1 to r2 on day 2.
The log returns on the bond, where the bond price
goes from p1 to p2 is:

log(p2 /p1 ) = −T (log(1 + r2 ) − log(1 + r1 ))

Banks and interest rate risk – p. 29/42

Augmented market model

(rj − rf ) = α + β1 (rM − rf ) + β2 (rL − rf ) + 

Banks and interest rate risk – p. 30/42

SBI
α 0.108
(0.218)
β1 0.8369
(6.402)
β2 0.8359
(2.316)
R2 0.3732
T 104

Speculative position on core business of SBI:

long SBI futures, short Nifty futures, short 10-year
bond futures. Banks and interest rate risk – p. 31/42
Results

Banks and interest rate risk – p. 32/42

Roughly 10 out of 44 banks have ex-
posure
BIS says that we should worry about banks where
over 25% of equity capital would be gained/lost in
the +320 bps move.
Our results use accounting data for year ended
31/3/2002.
This holds for 33 of 42 banks in our sample. SBI
and ICICI are not in this group.
7 have ’reverse’ exposures, 26 have ’normal’
exposures.

Banks and interest rate risk – p. 33/42

Policy issues

Banks and interest rate risk – p. 34/42

Poor disclosure
RBI rules require valuation at min(MTM, purchase
price).
“Hidden reserves”.
Source of fog and confusion.
Banks may not hedge a security at book value of
Rs.110 and market value of Rs.120.

Banks and interest rate risk – p. 35/42

Disclosure of cashflows
Fixed income analytics starts from cashflows.
It shouldn’t be a struggle to get to cashflows.

Banks and interest rate risk – p. 36/42

Frequency
Annual disclosure is highly unsatisfactory.
We should have daily MTM and daily disclosure.

Banks and interest rate risk – p. 37/42

IFR
Hierarchy:
Natural hedges,
Derivatives,
Equity capital.
IFR ignores the larger context and assumes the
securities portfolio is the only thing.
IFR thinks all banks are alike.
IFR is to be built up in five years.

Banks and interest rate risk – p. 38/42

Better tools for supervision
Do such computations to isolate weak banks.
Use stock market coefficients to isolate weak banks.

Banks and interest rate risk – p. 39/42

IRD market
We need an interest rate derivatives market.
Modern architecture: Bank owns the customer, lays
off the interest rate risk.

Banks and interest rate risk – p. 40/42

Metadata

Banks and interest rate risk – p. 41/42

Also see
Web page on Indian fixed income:
http://www.mayin.org/~ajayshah/FIXEDINCOME/index.html

Banks and interest rate risk – p. 42/42